Download ch.11

Chapter Introduction
Section 1: Savings and
the Financial
System
Section 2: Financial Assets
and Their Markets
Section 3: Investing in
Equities and
Options
Visual Summary
You have just been hired as a
financial planner to provide
advice on how to invest wisely
and effectively. Miguel, your
client, is a widower raising two
young children. He wants to be
sure that (1) he will have
enough money to send his
children to college, and (2) he
will be financially secure in his
retirement. What advice would
you give Miguel? Read Chapter
11 to learn more about how
people can accomplish their
financial goals.
Governments and institutions
help participants in a market
economy accomplish their
financial goals.
Section Preview
In this section, you will learn how the components
of a financial system work together to transfer
savings to investors.
Content Vocabulary
• saving
• nonbank financial institution
• savings
• finance company
• certificate of deposit
• premium
• financial asset
• pension
• financial system
• pension fund
• financial intermediary • risk
Academic Vocabulary
• sector
• compensation
Have you ever thought about what your
financial goals are and what steps you
need to take to reach them?
A. Yes, often
A
0%
C
C. Never
A. A
B. B
0% C 0%
C.
B
B. Occasionally
Savings and the Financial System
• Saving—absence of spending
• Savings—dollars that are available once
you abstain from consumption
Saving and Economic Growth
The financial system brings
savers and borrowers
together and helps the
economy grow.
Saving and Economic Growth (cont.)
• Saving makes economic growth possible.
• Individuals save by
– Opening a savings account
– Purchasing a bond
– Purchasing a certificate of deposit
Overview of the Financial System
Saving and Economic Growth (cont.)
• Documents are given in each case
showing money saved—financial assets.
• The economy has a financial system to
transfer savings to investors.
Overview of the Financial System
Saving and Economic Growth (cont.)
• Three parts to the financial system
– Funds a saver transfers to a borrower
– Financial assets that certify conditions of
the loan
– Organizations that bring the surplus
funds and financial assets together
Overview of the Financial System
Saving and Economic Growth (cont.)
• Financial intermediaries—institutions
that lend funds savers provide
• Governments and businesses are the
largest sector of borrowers.
• Households and businesses are the
biggest sources of funds.
Overview of the Financial System
In the financial system, who really
benefits?
A. Savers
B. Borrowers
0%
D
A
0%
C
D. No one
A. A
B. B
C. 0%C
0%
D. D
B
C. Everyone
Nonbank Financial Intermediaries
Organizations other than
banks can transfer money
from savers to borrowers.
Nonbank Financial Intermediaries (cont.)
• Another group of financial intermediaries
are the nonbank financial institutions.
– Finance company
– Life insurance companies—charge a
premium
– Pension fund—pays a pension to
specified individuals for specific reasons
Profiles in Economics:
Sallie Krawcheck
Which entity would charge you a
higher interest rate for your car loan?
A. Bank
B. Credit union
0%
D
A
0%
C
D. Relative
A. A
B. B
C. 0%C
0%
D. D
B
C. Finance company
Basic Investment Considerations
Investors should consider
several factors before
investing their money.
Basic Investment Considerations (cont.)
• Before investing, consider the following
– Consistency
– Simplicity
The Power of Compound Interest
Basic Investment Considerations (cont.)
– The risk-return relationship
• Risk—degree to which outcome is uncertain
but a probable outcome can be estimated
– Investment objectives
Risk and Return
An investment that appears too good
to be true probably is worth the risk.
A. True
B. False
A. A
B. B
0%
B
A
0%
Section Preview
In this section, you will learn about the
characteristics of various investments to help with
your investments.
Content Vocabulary
• bond
• savings bond
• money market
• coupon rate
• beneficiary
• primary market
• maturity
• Treasury note • secondary market
• par value
• Treasury bond
• current yield
• Treasury bill
• junk bond
• Individual Retirement
Account (IRA)
• municipal bond
• tax-exempt
• capital market
Academic Vocabulary
• offset
• presumed
What determines the price and yield
of a bond?
A. Risk of investment
B. Supply and demand
C
A
0%
A. A
B. B
0% C 0%
C.
B
C. Current interest rates
Bonds as Financial Assets
A bond is a long-term
investment, with the
price determined by
supply, demand, and the
buyer’s assessment of
repayment risk.
Bonds as Financial Assets (cont.)
• Governments and businesses issue a
bond when they need to borrow funds for
long periods.
• Bonds have three main components:
– Coupon rate
– Maturity
– Par value
Bond Ratings
Bonds as Financial Assets (cont.)
• To compare bonds, investors compute the
bond’s current yield.
• Interest received and price paid
determines the actual current yield of
each bond.
• Bond ratings are published by Standard &
Poor’s and Moody’s.
Bond Ratings
Bonds as Financial Assets (cont.)
• Bonds rated on
– Basic financial health of the issuer
– Expected ability to make future coupon
and principal payments
– Issuer’s past credit history
• Bonds with higher ratings sell at higher
prices than bonds with
lower ratings.
Bond Ratings
Which of the following rated bonds
has the greatest risk?
A. BBB or Baa
B. CCC or Caa
C
A
0%
A. A
B. B
0% C 0%
C.
B
C. CC or Ca
Financial Assets and Their
Characteristics
Investments include CDs,
bonds, bills, and IRAs, all of
which vary in cost, maturity,
and risk.
Financial Assets and Their
Characteristics (cont.)
• Investors today have many choices.
– Certificates of deposit—loans investors
make to financial institutions
– Corporate bonds—IRS considers
interest and payments as taxable
income.
• Junk bonds—offer high rate of return due to
exceptionally high risk
Financial Assets and Their
Characteristics (cont.)
– Municipal bonds—issued by state and
local governments, generally tax exempt
– Government Savings Bonds—savings
bonds are paper-based or paperless
• Bonds can be purchased for investor’s heirs
by designating a beneficiary.
Financial Assets and Their
Characteristics (cont.)
– Treasury notes—U.S. government
borrows funds for 2 to 10 years
– Treasury bonds—U.S. government
borrows funds for 10 to 30 years
– Treasury bills—(T-bills) short term
obligations, maturity of 4, 13, or 26 weeks
– Individual Retirement Account (IRAs)
Which of the following could you
invest in today?
A. Savings bonds
B. IRA
C. T-bill
D. 401(k) plan
0%
A
A. A
B. B
C. 0%C
0%
D. D
B
C
0%
D
Markets for Financial Assets
Financial assets are grouped
into different markets
depending on their maturity
and liquidity.
Markets for Financial Assets (cont.)
• Markets for financial assets
– Capital market—money is loaned for
more than one year.
– Money market—money is loaned for
periods less than one year.
Financial Assets and Their Markets
Markets for Financial Assets (cont.)
– Primary market—original issuer can
sell or repurchase a financial asset.
– Secondary market—existing financial
assets can be resold to new owners.
Financial Assets and Their Markets
Under which financial market(s)
would Disney bonds with maturity in
5 years be classified?
A. Money market
0%
D
0%
A
D. Secondary market
C
C. Primary market
A. A
B. B
C. 0%C
0%
D. D
B
B. Capital market
Section Preview
In this section, you will learn more about the
equities, or stocks, that are traded in markets.
Content Vocabulary
• equities
• 401(k) plan
• stockbroker
• stock exchange
• Efficient Market
Hypothesis (EMH)
• securities exchange
• mutual fund
• Dow Jones Industrial
Average (DJIA)
• over-the-counter market
• portfolio diversification
(OTC)
• net asset value
(NAV)
• Standard & Poor’s 500
(S&P 500)
Content Vocabulary (cont.)
• bull market
• option
• bear market
• call option
• spot market
• put option
• futures contract
Academic Vocabulary
• prospects
• implication
Do you think investing is a wise
decision?
A. Yes
B. No
A. A
B. B
0%
B
A
0%
Stocks and Efficient Markets
Investors can purchase
stock through stockbrokers
on exchanges, through
mutual funds, or through
401(k) plans.
Stocks and Efficient Markets (cont.)
• Equities or shares of common stock
represent another financial asset for
investors.
• Ways to purchase equities
– Stockbroker
– Internet account with discount
brokerage firm
A New York Stock Exchange Listing
Stocks and Efficient Markets (cont.)
– Mutual funds
• Net asset value (NAV)
– 401(k) plan
A New York Stock Exchange Listing
Stocks and Efficient Markets (cont.)
• Value of stock depends on
– Number of outstanding shares to be
traded
– Company’s profitability
– Expectations of growth
Stocks and Efficient Markets (cont.)
• Efficient Market Hypothesis (EMH)
states that each stock is analyzed
constantly by many professional analysts.
Any observations result in buying or selling
of the stock immediately.
• Portfolio diversification—investors offset
losses of one stock with increases in other
stocks.
How Much Money Will You Have at Retirement?
Which is not an advantage of investing in
a 401(k)?
A. Analysts on staff to
monitor market conditions
B. Highly diversified
0%
D
A
B
C
0%
D
C
A
D. Penalties for early
withdrawal
0%
A.
B.
C.
0%
D.
B
C. Employers typically match
a portion of employee’s
contribution
Stock Markets and Their Performance
Several different stock
markets exist, and each is
organized in a different way
Stock Markets and Their Performance
(cont.)
• Historically, stocks were traded at a stock
or securities exchange.
– New York Stock Exchange (NYSE) is the
oldest exchange in the United States.
– American Stock Exchange (AMEX) is also
in New York City.
Stock Markets and Their Performance
(cont.)
– Regional exchanges located in several
big cities across the United States
– Exchanges in major Cities throughout
the world
• Majority of stocks, however, are traded in
an over-the-counter market (OTC).
– The NASDAQ is the world’s largest
electronic stock market.
Stock Markets and Their Performance
(cont.)
• Stock performance can be monitored by
several popular indicators.
– Dow Jones Industrial Average (DJIA)
– Standard & Poor’s 500 (S&P 500)
– NASDAQ Composite
Stock Markets and Their Performance
(cont.)
• Bull market—“strong,” prices moving up
• Bear market—“mean” or “nasty” market
with prices falling sharply
Is it more advantageous to purchase
stocks in a bear or bull market?
A. Bear
B. Bull
C
A
0%
A. A
B. B
0% C 0%
C.
B
C. Does not matter
Trading in the Future
Financial assets can be
bought and sold in the future
as well as the present.
Trading in the Future (cont.)
• Most buying and selling takes place
immediately, a spot market.
• Exchanges that take place later in time are
a futures contract.
– Option—buyer has the right to cancel
futures contract.
• Call option—purchase
• Put option—sell
The total number of stocks listed on
the NASDAQ
A. is less than the total on
the NYSE but greater
than the total on the AMEX.
0%
C
A
C. is less than the total on the
AMEX but greater than
the total on the NYSE.
B
A. A
B. B
0%C. 0%
C
B. is greater than the total on
the NYSE and the AMEX.
Financial System Households and businesses
invest their surplus funds to earn interest.
Governments and businesses invest this money for
economic growth.
Investment Risk and Return Investors must weigh
the risks of their investments against the returns
they expect. Generally, the higher the risk of an
investment, the higher the return investors require.
Equities and Futures The riskiest investments
consist of equities and futures. Equities can be
purchased as individual stocks, or as a part of a
mutual fund or 401(k) plan. Futures allow investors
to speculate on future prices of commodities.
Sallie Krawcheck (1965– )
• chief financial officer for
Citigroup Inc., the
world’s largest financial
institution
• ranked number 6 on
Forbes’s top 100 of
“The World’s Most
Powerful Women” for
2006
saving
absence of spending that frees
resources for use in other activities or
investments
savings
the dollars that become available for
investors to use when others save
certificate of deposit
document showing that an investor
has made an interest-bearing loan to
a financial institution
financial asset
a stock or other document that
represents a claim on the income and
property of the borrower, such as a
CD, bond, Treasury bill, or mortgage
financial system
network of savers, investors, and
financial institutions working
together to transfer savings for
investment uses
financial intermediary
institution that channels savings to
investors
nonbank financial institution
nondepository institution that
channels savings to investors
finance company
firm that makes loans directly to
consumers and specializes in buying
installment contracts from merchants
who sell on credit
premium
price paid at regular intervals for an
insurance policy
pension
regular payments to someone who
has worked a certain number of
years, reached a certain age, or has
suffered an injury
pension fund
fund that collects and invests income
until payments are made to eligible
recipients
risk
situation in which the outcome is not
certain, but the probabilities can be
estimated
sector
an area of the economy in which
businesses offer the same or similar
products or services
compensation
something, such as money, given or
received as an equivalent for goods
or services, injury, debt, or high risk
bond
contract to repay borrowed money
and interest on the borrowed money
at regular future intervals
coupon rate
stated interest on a corporate,
municipal, or government bond
maturity
life of a bond or length of time funds
are borrowed
par value
principal of a bond or total amount
borrowed
current yield
bond’s annual coupon interest divided
by purchase price; measure of a
bond’s return
junk bond
bond that carries an exceptionally
high risk of nonpayment and a low
rating
municipal bond
bond, often tax exempt, issued by
state and local governments
tax-exempt
not subject to tax by federal or state
governments
savings bond
low-denomination, non-transferable
bond issued by the federal
government
beneficiary
person designated to take
ownership of an asset if the owner
of the asset dies
Treasury note
U.S. government bond with a maturity
of 2 to 10 years
Treasury bond
U.S. government bond with maturity
of 10 to 30 years
Treasury bill
short-term United States government
obligation with a maturity of one year
or less in denominations of $1,000
Individual Retirement Account
(IRA)
retirement account in the form of a
long-term time deposit, with annual
contributions not taxed until
withdrawn during retirement
capital market
market in which financial capital is
loaned and/or borrowed for more than
one year
money market
market in which financial capital is
loaned and/or borrowed for one year
or less
primary market
market in which only the original
issuer can sell or repurchase a
financial asset
secondary market
market in which financial assets can
be sold to someone other than the
original issuer
offset
to balance higher levels of risk with a
larger payoff
presumed
taken for granted; supposed
equities
stocks that represent ownership
shares in corporations
stockbroker
person who buys or sells securities
for investors
Efficient Market Hypothesis
(EMH)
argument that stocks are always
priced about right because they are
closely watched
portfolio diversification
strategy of holding different
investments to protect against risk
mutual fund
company that sells stock in itself and
uses the proceeds to buy stocks and
bonds issued by other companies
net asset value (NAV)
the market value of a mutual fund
share found by dividing the net value
of the fund by the number of shares
issued
401(k) plan
tax-deferred investment and savings
plan that acts as a personal pension
fund for employees
stock exchange
physical place where buyers and
sellers meet to exchange securities
securities exchange
physical place where buyers and
sellers meet to exchange securities
over-the-counter market (OTC)
electronic marketplace for securities
not listed on organized exchanges
such as the New York Stock
Exchange
Dow Jones Industrial Average
(DJIA)
measure of stock market performance
based on 30 representative stocks
Standard & Poor’s 500
(S&P 500)
measure of stock market performance
based on 500 stocks traded on the
NYSE, AMEX, and OTC market
bull market
period during which stock market
prices move up for several months or
years in a row
bear market
period during which stock market
prices move down for several months
or years in a row
spot market
market in which a transaction is made
immediately at the prevailing price
futures contract
an agreement to buy or sell at a
specific date in the future at a
predetermined price
option
futures contract giving a buyer the
right to cancel the contract
call option
futures contract giving a buyer the
right to cancel a contract to buy
something
put option
futures contract giving a buyer the
right to cancel a contract to sell
something
prospects
potential or expectations
implication
something suggested to be naturally
understood
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