Financial Markets Chapter 11

BELLRINGER  What would you do if you suddenly received a cash payment of $100,000 that you were not expecting and didn’t need to fulfill your daily expenses?

Section 1 – Saving and Investing  Investing in Free Enterprise  The Financial System  Financial Assets  The Flow of Savings and Investment  Financial Intermediaries  Sharing Risk  Providing Information  Providing Liquidity  Risk, Liquidity, and Return  Return and Liquidity  Return and Risk

Investing and Free Enterprise  Investment: redirecting resources from being consumed today so that they may create benefits in the future. The use of assets to earn income or profit

Investing and Free Enterprise  Spend money today to earn money in the future  Going to college to get a “better job”  Expanding manufacturing for a new product  Building a dam for a hydroelectric plant

Investing and Free Enterprise  Consumer spending vs Consumer savings  People depositing money into savings accounts so banks can lend to businesses to grow and expand  New jobs and better products are created

The Financial System  Financial System: a system in which there is a transfer of money between savers and borrowers  Financial Assets: claim on the property or income of a borrower  A way to indicate ownership of owning a money device

The Financial System  Savers  Households, individuals, and businesses  Make deposits to Financial Institutions  Receive financial assets

The Financial System  Financial Institutions  Banks, Credit Unions, Finance Companies, etc  Make loans to investors

The Financial System  Investors  The borrowers  Government and Business  Build roads, factories, homes etc  Develop new products, markets, or services

Financial Intermediaries  You can obtain a direct link between savers in borrowers  Financial Intermediaries: institution that helps channel funds from savers to borrowers

Financial Intermediaries  Banks, Savings and Loan Associations and Credit Unions  Take deposits from savers  Lend out money to businesses and individuals  Finance Companies  Higher risk lending companies  People who typically cannot meet the standards to borrow from a Bank, S&L or CU

Financial Intermediaries  Mutual Funds  Pool savings of many and invest in stocks, bonds or other financial assets  Allow for a broad range of investments  Diversification  Life Insurance Companies  Financial protection for a family for the death of a family member  Customers pay “premiums”  Lend premiums to investors for return

Financial Intermediaries  Pension Fund  Income a retiree receives after working a certain number of years  Withholding of a portion of your pay

Financial Intermediaries  Why have Financial Intermediaries?  Share Risk  Provide information  Provide liquidity

Financial Intermediaries  Sharing Risk  50% of new business fail  Reduce the risk of losing your entire investment  Diversification: spreading out investment to reduce risk

Financial Intermediaries  Providing information  Monitoring borrowers spending and income  Classify borrowers based on risk of default  Saves individuals the time to research individual borrowers

Financial Intermediaries  Providing Liquidity  Matching investors (bringing borrowers and sellers together)  Investing in mutual funds vs buying a Picasso  Allow you to sell and receive cash upfront instead of waiting for a buyer

Risk, Liquidity and Return  Tradeoffs in investing  Placing money in a savings account for the convenience and access, despite lower rate of return  Using a CD to earn a higher rate but having limited access in an emergency  Weighing the return against the loss of liquidity

Risk, Liquidity and Return  Placing your money in a bank account that is insured with a lower rate of return?  Using your money to invest in a new business?  Higher potential return, the greater the risk

Bonds as Financial Assets  A business can obtain money by borrowing  When a business or government borrows money, they issue bonds  Bonds  Low risk  Low interest rate (relatively)

Bonds as Financial Assets  Three Components of Bonds  Coupon Rate  Maturity  Par Value

Bonds as Financial Assets  Coupon Rate  Interest rate that a bond issuer will pay to a bondholder  Maturity  The time at which payment to a bondholder is due  Par Value  The amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity

Bonds as Financial Assets  A business needs $1,000  The issue a bond for $1,000  Set an interest rate of 5%  The Bond will mature in 10 years

Bonds as Financial Assets  Mary takes $1,000 out of her savings account paying 1% interest to buy a bond at 5%  She will receive interest payments of $50 each year (5% of $1,000) for 10 years  At the end of 10 years, she will receive her final payment of $50 + her initial investment of $1,000  In total, she will earn $500 in 10 years and get back what she put in of $1,000

Bonds as Financial Assets  What was the coupon rate?  What is the maturity?  What is the Par Value?

Bonds as Financial Assets  Buying bonds at a discount  Selling/Buying a bond less than par value  Interest rate increase, sell/buy at a discount  If $1,000 bonds go from 5% to 6%, you would buy the 6% bond  Selling/Buying at a discount is an incentive to buy the lower rate bond

Bonds as Financial Assets  Bond Ratings  A way to measure the risk of a bond  AAA --- highest rating  D --- Bond in Default  Triple A Bonds (AAA) pay lowest interest rate  May sell “above par”  BBB bonds are riskier and pay higher interest rate  May sell “below par”

Bonds as Financial Assets  For an investor, bonds are relatively safe  Advantages to the issuer  Locked in interest rate  Does not give up ownership  Disadvantages to the issuer  Must make fixed interest payments/cannot change  Poor financial health, bonds are downgraded

Types of Bonds  Savings Bonds  Treasury Bonds, Bills and Notes  Municipal Bonds  Corporate Bonds  Junk Bonds

Types of Bonds  Savings Bonds  Low denomination bond issued by the US Government  Government issues to fund projects  Does not have a “coupon” rate  Purchase below par value then redeem for face value at maturity

Types of Bonds  Treasury Bonds, Bills and Notes  Government Issued debt for varying lengths of maturity  Treasury Bond (T-Bond)  10 – 30 Years  Treasury Note (T-Note)  2 – 10 Years  Treasury Bill (T-Bills)  3, 6 or 12 months

Types of Bonds  Municipal Bonds  State and local governments  “Safe” because of taxing authority  Poor financial health?  Tax Free (at federal level)

Types of Bonds  Corporate Bonds  Business issued debt  Can be riskier  Depends on business strength to repay debt

Types of Bonds  Junk Bonds (High Yield)  Lower rated, potentially higher paying bond  Lower medium grade

Other Types of Financial Assets  Certificates of Deposit  Money Market Mutual Funds

Financial Asset Markets  Capital Markets  Market in which money is lent for periods longer than a year  Money Markets  Market in which money is lent for periods less than a year

Financial Asset Markets  Primary Market  Market for selling financial assets that can only be redeemed by the original holder  Secondary Market  Market for reselling financial assets

Section 3 – The Stock Market  Buying Stock  Benefits of Buying Stock  Types of Stock  Stock Splits  Risk of Buying Stock  How Stocks are Traded  Stock Exchanges  The New York Stock Exchange  The OTC Market  NASDAQ  Futures and Options  Day Trading  Measuring Stock Performance  Bull and Bear Markets  The Down Jones Industrial Average  S & P 500  The Great Crash of 1929  Investing During the 1920’s  Signs of Trouble  The Crash  The Aftermath of the Crash  The Market Today

Buying Stock  Corporations can raise money by selling stock  Represents ownership in the corporation  Shares: portion of stock  Equities: claims of ownership in a corporation

Buying Stock  How do you make money buying stock?  Dividends  Capital Gains

Buying Stock  Dividends  Paid 4 times per year (quarterly)  Payout based on profits  Paid per share

Buying Stock  Capital Gains  Selling the stock for more than the purchase price  Capital Gain: the difference between a higher selling price and a lower purchase price resulting in a financial gain for the seller.  Capital Loss: the difference between a lower selling price and a higher purchase price resulting in a financial loss to the seller

Buying Stock  Types of Stock  Income Stock: Pays dividends at regular times during the year  Growth Stock: Pays few or no dividends, company reinvests to grow the company and make stock worth more

Buying Stock  Types of Stock  Common Stock: owners of the company with one vote. A vote is used to elect the directors of the company  Preferred Stock: Non voting owners of the company. First to receive a dividend, paid back first if business shuts down

Buying Stock  Stock Split: the division of a single share of stock into more than one share.  Does not increase % of ownership but doubles the number of shares.  Owning 100 shares that are $100 each  After a 2 for 1 split, 200 Shares at $50

Buying Stock  Risks of buying stock  Smaller profits, smaller stock value  May sell stock for less than the purchase  Going out of business  Sell assets  Pay off debt Pay off preferred stock  Pay off common stock

How Stocks Are Traded  Contact a Stockbroker  A person who links buyers and sellers of stocks  Works for a brokerage firm: a business that specializes in trading stocks  Buy stocks to sell at a premium to earn money on the “spread”

How Stocks Are Traded  Stock Exchanges  A market for buying and selling stocks  NYSE (______ _______ _______ _____________)  OTC Market  National Association of Securities Dealers Automated Quotations (___________)

How Stocks Are Traded  New York Stock Exchange  Began in 1792 as an informal outdoor exchange  Must have a “seat” on the exchange  Handles stock and bond transactions for the largest most established companies in the US  Blue Chips – Large profitable companies that are considered stable

How Stocks Are Traded  Over the Counter (Electronic)  Stocks and bonds that are not traded on the NYSE  Investors buy directly from a dealer or a broker

How Stocks Are Traded  Nasdaq  Created in 1971  Bring the OTC market together  No trading floor; sends out information automatically through 360,000 computer terminals worldwide

How Stocks Are Traded  Futures and Options  Futures: contracts to buy or sell at a specific date in the future at a price specified today  For commodities  New York Mercantile

How Stocks Are Traded  Options  Contracts that give investors the choice to buy or sell stock and other financial assets  Call Options  Buy shares of stock at a specified time in the future  Put Options  Sell shares of stock at a specified time in the future

How Stocks Are Traded  Call Option  Pay a fee for a call (example: $10)  Gives you the right to buy stock at $100 per share in a specific time period  If stock is greater than $100 + the Call Fee, you would exercise your Call  Stock goes to $115 per share, you would buy at $100 per share, plus your $10 per share fee, make a $5 per share profit

How Stocks Are Traded  Put Option  Pay a fee for a call (example: $5)  Gives you the right to sell stock at $50 per share in a specific time period  If stock is now $40 + the Put Fee, you would exercise your Put  Selling stock at $50 per share when the market rate is $40 you make a $5 profit  If stock is above $50 you can just sell above that price

How Stocks Are Traded  Day Trading  Very Risky  Trading stocks minute by minute instead of holding for the long term

Measuring Stock Performance  Bull and Bear Markets  Bull Market: Steady rise in the stock market over a period of time  Bear Market: Steady drop in the stock market over a period of time

Measuring Stock Performance  The Dow Jones Industrial Average  30 Large Companies  The S & P 500  Tracks the price of 500 different stocks as a measure of overall stock market performance