Financial Market Reference Financial decision-making is difficult because of future uncertainty and risk Risk involves possible outcomes Uncertainty involves unknown outcomes Massive amount of data and chaotic events Financial decision-making faces unsolvable problems Knowledge is Power If we understand the forces that drive financial markets, then we can make better decisions Macroeconomics information will help make sense of the chaos, so we can make better decisions 1 Copyright © 2014 Dr. Tom Porter

Basic Terms: Financial Instruments Stocks –Own a right to dividends –Value of stocks fluctuate with expectations for profits Bonds –Lend funds and earn interest payments –Asset value of bonds fluctuate as the interest rate of other opportunities change Cash –Perfectly liquid - buy anything –No interest, but inflation is the opportunity cost of holding cash 2 Copyright © 2014 Dr. Tom Porter

Basic Terms: Stock Market (pp ) Market –Any venue where financial instruments are bought and sold, whether in person or electronically. Stock Index –An average of selected stocks that shows general trends that are common for these stocks Multiple Stock Indexes –Indexes are usually associated with a specific market. –Dow-Jones Industrial Average (30 companies) –S&P 500 (500 companies traded in New York) –S&P/TSX (200 companies traded in Toronto) 3 Copyright © 2014 Dr. Tom Porter

Glossary: Commodities Commodities are often traded as though these are financial assets. Three broad categories: 1. Valuable –These have an intrinsic value such as silver or gold 2. Industrial –These are valuable because of their use in production –Copper, silver, rare earth minerals, oil&gas 3. Perishable –Grains, livestock –Firms trade in commodities and futures markets to mitigate risks from future price shocks 4 Copyright © 2014 Dr. Tom Porter

Glossary: Debt Three types of debt: 1. Debt for investment Borrowing funds to go to school or open a business is productive or potentially productive. 2. Debt for long-term consumption Borrowing for a house or car is consumption that is spread out over time, and we are planning to use future income for the purchase. 3. Debt for immediate consumption Borrowing for current consumption (a vacation) – that is, you are reducing future income and future consumption for current non-productive purposes. 5 Copyright © 2014 Dr. Tom Porter

Glossary: Investment The term “investment” has many uses: 1. Real Investment In macroeconomics investment refers to increases in capital for future production. Capital refers to the “produced means of production”. 2. Financial Investment Financial investment is the purchase of a stock. This is sometimes called capital as well, but it is financial capital intended to earn a financial return. 3. Savings (as financial investment) If we save using a financial intermediary (i.e., a bank) then it is a financial investment. 6 Copyright © 2014 Dr. Tom Porter

Glossary: Other Finance Terms Terms from stock market quotes Div&yield – dividend in dollars and yield as a percent of most recent closing price Dividend is only a portion of profits paid out. Companies retain a portion of profits (earnings) for operations EPS – earnings per share. This is the actual income of a company. P/E – price to equity ratio. Stock price divided by EPS and is a measure of how expensive a stock is and can be compared to other stocks. 7 Copyright © 2013 Dr. Tom Porter

Financial Markets: Participants Price determined by supply and demand Supply is from: –companies raising funds for real investment –traders seeking income from price fluctuations Demand includes: –savers seeking returns from profits (i.e., dividends) –traders seeking income from price fluctuations Characteristics –Competitive, international –Liquid, instant, perfect substitution 8 Copyright © 2014 Dr. Tom Porter

Financial Markets: Fluctuations Drivers – some combination of news effecting: 1.Company – its products or management 2.Market – its competitors or market demand 3.Economic – macroeconomic context Time Horizon – how long to own –Short-term – day trading to quarterly positions –Long-term – annual to 10-year buy and hold –Everything in between 9 Copyright © 2014 Dr. Tom Porter

Financial Markets: Returns Two sources of financial return 1. Investment Income –Return from lending activities –Interest income on a loan –Dividends as income based on a share of company profits 2. Growth and Appreciation –Return from trading Trading based on growth in asset value, or Trading based on fluctuations in asset value –Buy low, sell high over time –The potential for financial returns depends on changing conditions or changing expectations about market conditions 10 Copyright © 2014 Dr. Tom Porter

Financial Markets: Asset Prices Bonds, Real Estate, other Physical Assets: Prices are based on supply and demand. Costs of production are not a factor, so demand tends to dominate. Demand factors include growth in valuation. Future expectations drive demand and can lead to greater demand. This force leads to frequent over-valuation and speculative bubbles. 11 Copyright © 2014 Dr. Tom Porter