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Financial Markets
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Chapter 11: Financial Markets
KEY CONCEPT
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The financial system consists of institutions, such as banks,
insurance markets, bond markets, and stock markets, that help
transfer funds between savers and investors.
WHY THE CONCEPT MATTERS
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When you open a savings account, you play an important role in our
economy. Your savings will be borrowed and invested by businesses
and the government. The new products created by these investments
help to fuel the nation’s economy.
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Savings and Investment
The Financial System
KEY CONCEPTS
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Savings—income not used for consumption
Investment—use of income now in a way that provides a future
benefit
– economic investment: money lent to businesses
– personal investment: individuals putting savings into financial
assets
Financial system—transfers funds between savers and investors
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The Financial System
Bringing Savings and Investment Together
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People, businesses save funds; receiver issues written confirmation
– confirmation called financial asset, or claim on borrower’s property
Financial market—where buyers and sellers exchange assets
directly
Financial intermediary—collects funds from savers, invests in
financial assets
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Financial Intermediaries
KEY CONCEPTS
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Includes banks, S&Ls, credit unions
– also finance companies, pension funds, life insurance companies
Mutual fund—pools individuals’ money to buy range of financial
assets
– investors own shares of entire fund
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Financial Intermediaries
Example: Banking Financial Intermediaries
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Provide checking, savings, money market deposit accounts, CDs
– depositors earn interest
– federal government insures deposits up to $100,000
Make loans; to make profit charge higher interest than pay depositors
Offer uninsured money market mutual funds, stocks, bonds,
insurance
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Financial Intermediaries
Example: Nonbank Financial Intermediaries
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Finance companies make small loans to households, small
businesses
Mutual funds let individuals own many assets; managers make
decisions
Pension funds invest employees’ money, so will have more at
retirement
Life insurance companies invest income in financial assets
– let people save by building cash values, protect them against loss
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Financial Asset Markets
KEY CONCEPTS
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Financial markets categorized according to time, resalability
Capital market—for buying and selling long-term financial assets
Money market—for buying and selling short-term financial assets
Primary market—for financial assets that original buyer must redeem
Secondary market—where financial assets are resold
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Financial Asset Markets
Factor 1: Time
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Capital markets—assets held for over a year
– include stocks, bonds, mortgages, long-term CDs
Money markets—loans made for less than a year
– include short-term CDs, Treasury bills
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Financial Asset Markets
Factor 2: Resalability
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Primary markets—financial assets can be redeemed only by original
buyer
– include savings bonds, small denomination CDs
– also market where first issue of stock sold through investment
bankers
Secondary markets—resale markets; offer liquidity to investors
– include stocks, bonds
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Reviewing Key Concepts
Explain the differences between the terms in each of
these pairs:
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savings and investment
capital market and money market
primary market and secondary market
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Investing in a Market Economy
Why Are You Investing?
KEY CONCEPTS
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Personal investing is saving
Individual must first determine own investment objective:
financial goal investor uses to decide if an investment is appropriate
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Why Are You Investing?
Investment Objectives
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Main considerations: when money will be needed, available income
Other issues: need to pay off debts, tax concerns
Savings for emergencies should be liquid
Long-term investments good for retirement and college
Can choose CDs to coincide with timing of savings goals
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Mellody Hobson: Investing in the Future
Creating Educated Investors
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President of Ariel Capital Management, mutual fund company
Teaches children, ordinary adults about investing; uses celebrities
Developed study on African-American investing; works to promote it
Believes more people should participate in stock market
– as financial contributor on ABC, reaches millions with information
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Risk and Return
KEY CONCEPTS
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Risk—possibility for loss on an investment
Return—profit or loss on an investment
– refers to interest paid on savings or increase in value of stock
Diversification—investing in different financial assets
– purpose: maximize returns, minimize risk
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Risk and Return
What Kind of Risk Are You Willing to Take?
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Risk usually means loss of part of initial investment, or principal
– no-risk investments: insured savings and CDs, U.S. government
bonds
Safe investments risk interest rate may not keep up with inflation
Return on riskier investments depends on how profitable company is
– bonds less risky than stocks; bondholders paid off first
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Risk and Return
What Kind of Return Do You Want?
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Safe investments have lowest return through fixed interest rates
Stocks, bonds—no guaranteed rates; stocks—higher return over time
If investing over long period, can risk losses in stock some years
– if less time and money, may want safer investment
Diversification gives better chance of offsetting a loss with a gain
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Reviewing Key Concepts
Use each of the three terms below in a sentence that
illustrates the meaning of the term:
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investment objective
Return
diversification
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Buying and Selling Stocks
The Stock Market
KEY CONCEPTS
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Companies issue stock, sell to investment bankers in primary market
– initial public offering (IPO) is sale that raises money for corporation
Stock exchange—secondary market where securities resold and
bought
– buyers expect stock price to rise, so they can resell for a profit
Capital gains—profit made from sale of stock
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The Stock Market
Why Buy Stock?
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Buy to earn dividends, share of company profits
– investors who want income, want dividends
Buy to earn capital gains through resale of stock
– investors who want growth look for potential for capital gains
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The Stock Market
Types of Stock
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Common stock—gives shareholders voting rights, share of profits
– one vote per share owned to elect board of directors
Preferred stock—gives shareholders share of profits, no voting rights
– investors get guaranteed dividends, paid off first if company closed
– dividends do not increase if stock increases in value
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Trading Stock
KEY CONCEPTS
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Most people buy stock to earn capital gains
Stock prices determined by demand and supply; influencing factors:
– company profits or losses, technological advances, overall
economy
Stockbroker—buys and sells securities for customers, earns
commission
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Trading Stock
Organized Stock Exchanges
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New York Stock Exchange (NYSE) on Wall Street; oldest, largest in
U.S.
– traditionally, each stock auctioned from trading post on exchange
floor
– today, hand-held computers used to execute many trades
– 2006 merger with Archipelago Exchange allowed electronic trades
American Stock Exchange (AMEX) companies smaller than on the
NYSE
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Trading Stock
Electronic Markets
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Over-the-counter (OTC) market for stocks not traded on NYSE or
AMEX
NASDAQ is centralized computer system for OTC trading
– second largest exchange in world in number of companies, shares
traded
– companies from many sectors of U.S. economy, most in
technology
OTC Bulletin Board is electronic market for smaller companies
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Trading Stock
Futures and Options Markets
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Most investors do not trade futures and options
Future—contract to buy, sell on specific future date at preset price
Option—contract giving right to buy, sell in future at preset price
– investor pays small fraction of stock’s current price for option
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Trading Stock
Recent Developments
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1990s regulations allow any firm to trade stocks in any exchange
Through electronic communications networks (ECNs), 24-hour
trading
Investors access Internet; huge growth in online brokerage
companies
– lower commissions than traditional brokers
– computer technology matches buyers, sellers automatically; rapid
trades
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Measuring How Stocks Perform
KEY CONCEPTS
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About half of U.S. households own stocks
Stock index measures, reports the change in prices of a set of stocks
– measures individual stocks and stock market as a whole
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Measuring How Stocks Perform
Stock Indexes
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U.S. indexes: DJIA, Standard & Poor’s 500, NASDAQ Composite
Global indexes: Hang Seng, DAX, Nikkei 225, TSE 300, FTSE 100
Since 1896, Dow Jones Industrial Average changed with U.S.
economy
– includes most successful companies in most important economic
sectors
– uses points to measure changes in prices at which stocks traded
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Measuring How Stocks Perform
Tracking the Dow
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Bull market—prices rise steadily over a relatively long period
Bear market—prices decline steadily over a relatively long period
1972 to 2000 longest bull market in history; most last two to three
years
Dow affected by previous close, Fed, foreign indexes, trade balance
About 21 stock markets overseas with over 1,000 large companies
each
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Reviewing Key Concepts
Explain the relationship between the terms in each of
these pairs:
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stock exchange and stockbroker
future and option
bear market and bull market
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Bonds and Other
Financial Instruments
Why Buy Bonds?
KEY CONCEPTS
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Bonds issued by companies, governments
Par value—amount issuer must pay buyer at maturity
Maturity—date when bond is due to be repaid
Coupon rate—interest rate bondholder gets every year until maturity
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Why Buy Bonds?
KEY CONCEPTS
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Investors buy bonds for interest paid and gains made by selling
Yield—annual rate of return on a bond
If bond sold at par value, yield is same as coupon rate
– if sold for less, yield is higher; if sold for more, yield is lower
Bonds with longer maturity dates have higher yields than with shorter
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Why Buy Bonds?
Types of Bonds
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U.S. government issues Treasury bonds, notes, bills; very safe
Safety of foreign government bonds depends on the country
State, local governments issue bonds; no federal income tax
Corporate bonds higher risk than government, pay higher coupon rate
– Junk bonds are high-risk, high-yield corporate bonds
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Why Buy Bonds?
Buying Bonds
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Most buyers want guaranteed interest income; yield is most important
Investors who sell before maturity want to make profit
– as market interest rates rise, price of bonds with lower rate falls
Main risk to investor is default
– governments, companies get evaluated by credit-rating companies
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Other Financial Instruments
KEY CONCEPTS
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Certificates of deposit (CDs), money market mutual funds (MMMFs):
– are very low risk; provide interest income
– not generally sold for profit
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Other Financial Instruments
Certificates of Deposit
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CDs offered primarily by banking institutions; have maturity date
Pay fixed or variable interest, reinvested for compound interest
– longer maturity dates pay higher interest rates
Federal government insures funds up to $100,000
Risks: can lose interest, some principal if funds withdrawn early
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Other Financial Instruments
Money Market Mutual Funds
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MMMFs’ financial assets have maturities of one year or less
Give higher yield than savings accounts with similar liquidity
– can redeem shares by check, phone, electronic transfer
Funds not insured but tightly regulated, so principal considered safe
Yield varies based on yield of assets in fund
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Reviewing Key Concepts
Use each of the terms below in a sentence that illustrates
the meaning of the term:
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coupon rate
Maturity
yield
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The Rise and Fall of Dot-Coms
Background
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The Internet provided a new tool for accessing potential buyers. Many new
companies, known as dot-coms, quickly appeared.
The value of dot-com stock rose quickly as investors were encouraged by the
initial success of dot-coms and low interest rates in the 1990s. In 2000 and
2001, dot-com stocks fell and many companies went out of business.
What’s the Issue
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Why did so many dot-com companies fail?
Thinking Economically
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During the dot-com bubble, do you think it was relatively easy or difficult for
Internet start-up companies to raise capital? Why?
Why do you think so many dot-coms failed? Explain with evidence.
What lessons might investors learn from the information presented in
documents A and C?
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