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Chapter 11
Financial Markets
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Financial Assets and the
Financial System
• A financial system consists of a network of
savers, investors, and financial institutions
that work together to transfer savings to
investors. 
• Financial assets include savings accounts,
certificates of deposit, and government and
corporate bonds. 
• Financial assets represent claims on the
borrower.
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Financial Assets and the
Financial System (cont.)
• Financial intermediaries are financial
institutions that bring together savers and
lenders. 
• The circular flow of funds shows how funds
are transferred from savers to borrowers. 
• Any part of the economy can supply and
borrow savings, but governments and
businesses are the largest borrowers.
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Financial Assets and the
Financial System (cont.)
Figure 12.1
Overview of the Financial System
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• Deciding to save
– People save for purchases that require more funds
than available, for emergencies, and for retirement.
– Economies benefit from individuals who save
because people have more money to invest or spend,
leading to expanding business.
– When choosing a place to save, think about tradeoffs.
• A. Basic Investment Considerations
•
1. The relationship between risk &
return
•
2. investment objectives
•
3. consistency
•
4. simplicity
5. Liquidity
• How much to save and invest?
– There are many factors involved in deciding how
much to save versus how much to invest
– Invest in several different types of accounts to lower
your overall risk (diversify)
– If you cannot afford any losses, use banks or savings
bonds.
– Your values may affect your investment choices.
Basic Investment Considerations
• High risk investments pay higher rates of
return than low risk investments.
Figure 12.2
The relationship Between
Risk and Return
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Basic Investment Considerations (cont.)
• The type of investment chosen depends on
the goals of the investor. 
• Consistent investing can yield large
returns.
Figure 12.3
The Power of Compound Interest
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Basic Investment Considerations (cont.)
• Investors should avoid complex
investments they do not understand.
Figure 12.3
The Power of Compound Interest
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• Savings Accounts
– savings accounts accrue a low interest but
allow immediate access to funds.
– Money market accounts accrue high interest
with immediate access through checks, but
have a high minimum balance requirement.
• Time Deposits
– Time deposits refer to a wide range of savings plans
or certificates of deposit (CDs) with a high interest
rate that increases over time, but a person cannot
remove funds before a certain time period or maturity
without paying a penalty.
– Before the 1930s, people could lose all the money in
their accounts if the bank failed.
– Now the federal government insures bank accounts
(in FDIC member banks) up to $250,000, giving
people security when making deposits.
• Stocks and Bonds
– Stocks entitle the buyer to future profits and assets of
the corporation. You buy a share of the corporation
when you purchase stock.
– Stockholders make money through dividends, return
on bought stock, or by speculating- buying stock
hoping it will increase in price so they can sell it at
profit.
– A capital gain is money earned by selling stock for
more than you paid for it.
– A capital loss is money lost by selling stock for less
than you paid for it.
Investing: Taking
• Stocks and Bonds cont…
– A bond is a certificate promising to repay a loan at a
stated interest rate.
– A bondholder is NOT part-owner of the organization.
– Two general types of Bonds
• 1. Corporate bonds
– Rated, fixed interest, preservation of principal
– Expensive, no say in the company’s decision making
• 2.Govornment bonds
– May be exempt from taxes, more stable, discounted price
– U.S. savings bonds are popular
Bonds as Financial Assets
• Bonds have three main components: the
coupon, the maturity, and the par value. 
• Bond prices are determined by supply and
demand. 
• The current yield on a bond is the annual
interest rate divided by the purchase price.
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Bond Ratings
• Most bonds are rated on the financial
health of the issuer, the ability to make
future coupon and principal payments, and
the issuer’s past credit history. 
• Bond ratings, ranging from D (lowest) to
AAA (highest), indicate the quality of the
bond. 
• If a bond is in default, it means the issuer
has not kept up with the interest or the par
value payments.
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With savings bonds you pay half of
the bond’s face value and the
interest increases yearly until the
face value is reached.
T-Bills, T-Notes, and T-Bonds are
government bonds exempt from
state and local tax and mainly for
larger investments.
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Financial Assets and
Their Characteristics (cont.)
• Savings bonds are low-denomination,
nontransferable bonds issued by the
federal government and are very attractive
because they have a virtually no risk of
default. 
• Treasury notes and bonds are large longterm obligations issued by the federal
government and are seen as the safest of
all financial assets.
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Financial Assets and
Their Characteristics (cont.)
• Treasury bills are large short-term
obligations issued by the federal
government. 
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Markets for Financial Assets
• Capital markets are markets in which
money is loaned for more than one year. 
• Money markets
are markets in
which money is
loaned for less
than one year.
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Figure 12.6
Financial Assets and Their Markets
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Money Markets (cont.)
• Primary markets are markets in which only
the original issuer can repurchase or
redeem a financial asset. 
• Secondary markets are markets in which
financial assets can be resold to new
owners.
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Introduction
• In addition to financial assets, investors
may buy equities. 
• Equities are stocks that represent
ownership shares in corporations. 
• The markets for equities are reasonably
competitive because there are a large
number of buyers and sellers, and
investors possess reasonably good
information.
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• Stocks
– Stocks are bought/sold through brokers.
– Stocks are traded at stock exchanges.
– Stocks that are not traded in specific place are called
over-the-counter stocks.
– Bonds are sold on exchanges and over-the-counter
markets.
Introduction
• Investor confidence is important for
market stability. 
• After the attack on the World Trade Towers,
for example, investor uncertainty caused a
temporary 14 percent decline in overall
stock prices.
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Organized Stock Exchanges
• The New York Stock Exchange (NYSE) lists
the shares of about 2,800 large companies,
and has 1,400 seats or memberships with
access to the trading floor. 
• The American Stock Exchange (AMEX)
lists the shares of about 750 companies. 
• Regional stock exchanges list shares that
are too small or too new to be listed on the
NYSE or the AMEX. 
• Global stock exchanges include stock
exchanges around the world.
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The New York Stock Exchange (cont.)
Figure 12.7
The New York Stock Exchange
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The Over-the-Counter Market
• Most shares are not traded on exchanges
but in electronic over-the-counter (OTC)
trades. 
• NASDAQ lists information on companies
traded OTC.
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Measures of Stock Performance
• The Dow-Jones Industrial Average is an
index made up of 30 stocks.
• Standard & Poor’s 500 is a index made
up of 500 representative stocks.
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Measures of Stock Performance
• A bull market is a market in which prices
are rising; a bear market is a market in
which prices are falling.
Figure 12.8
Tracking Stocks With the DJIA and the S&P 500
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Classification of Stock Investments
• Income stocks: stocks with history of paying high
dividends
•
-does not reinvest profits for future growth
• growth stocks: share of stock in companies that
pay lower dividends and reinvest most of their
profits
•
-better growth in the long run
penny stocks: a stock that sells for less than $5
per share
-very speculative
-big gains or big losses
-issued by companies with "hot" or new
products
blue chip stocks: stocks of large well
established businesses
-products and services have been around
for years
-less risky and speculative
Disney, Pepsi, Coca-Cola, General Motors
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Classification of Stock Investments
• defensive stocks: a stock that remains stable
and pays dividends during an economic
decline
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-utilities, food, and health care
•
-demand for these products rarely changes
• cyclical stocks: stocks that do well when
economy is good and poorly when the
economy is having difficulties
• Airlines, manufacturing companies, other
industries based on travel-product that are not
needed
Trading in the Future
• A spot market is a market in which
transaction are made at the prevailing
price. 
• A futures market is a market in which
futures contracts are bought and sold. 
• Futures contracts are agreements to sell
at a specific date at a predetermined
price.
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Trading in the Future
• An options market is a market in which put
and call options are bought and sold. 
• A call option gives the owner the right to
buy a share of stock at a specified price
some time in the future. 
• A put option gives the owner the right to sell
a share of stock at a specified price in the
future.
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– Mutual funds are investment companies that combine
many investors’ funds to buy a large variety and quantity
of stocks.
Stock and Bond Markets cont…
– Some mutual funds mirror index funds.
– Managed mutual funds have managers who adjust and mix the
stocks bought, attempting to generate the highest yields.
– Money market mutual funds allow inventors to write checks
against the money in the fund.
• Government Regulations
– The Securities and Exchange Commission
regulates brokerage firms, stock exchanges,
and most businesses that issue stock.
– Congress passed the Securities Act to avoid
another stock market crash.
– The Act requires a prospectus to be given to
each potential buyer of stocks or bonds.
• Investing for Retirement
– Most companies have pension plans, such as
401k, that provide retirement income.
– Some people will combine a retirement plan
with their Social Security checks because
Social Security alone is not enough.
– Personal or private pension plans have the
benefit of tax savings.
• Investing for Retirement cont…
– The Keogh plan is an individual retirement plan for
self-employed people where they can save up to 15%
of income.
– Traditional IRAs allow you to contribute up to $5000
per year, which is not taxed when put in, and any
earnings and interest are not taxed until money is
withdrawn.
– Roth IRAs allow you to save up to $5000 per year,
which is taxed when put in, interest and earning are
never taxed, and money is not taxed when withdrawn.
• Investing for Retirement cont…
– Real estate is a popular form of investing for
the future.
– Housing generally increases in value over
time.
– Buying undeveloped land is a more risky
investment.
– It is hard to turn real estate into cash on short
notice.
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