Chapter 11 Financial Markets and Investing

Investing Investing – the act of redirecting resources from consumption today so that they may create additional benefits in the future Investing – the act of redirecting resources from consumption today so that they may create additional benefits in the future Investment sacrifices spending today to have more in the future Investment sacrifices spending today to have more in the future

Saving In the end, saving your money is really lending it to others In the end, saving your money is really lending it to others The people you place your money with are called financial intermediaries – they channel funds from savers to borrowers The people you place your money with are called financial intermediaries – they channel funds from savers to borrowers

Types of Financial Intermediaries Banks, S&Ls, and Credit Unions – take deposits and loan out the money Banks, S&Ls, and Credit Unions – take deposits and loan out the money

Types of Intermediaries Mutual Funds – take the savings of many individuals and place them in a variety of stocks and bonds Mutual Funds – take the savings of many individuals and place them in a variety of stocks and bonds Life Insurance Companies – collect premiums (fees) from many savers, and guarantee financial protection to family members who lose someone Life Insurance Companies – collect premiums (fees) from many savers, and guarantee financial protection to family members who lose someone

Types of Intermediaries Pension Funds – collect funds from many employees, then pay pensions to employees who retire Pension Funds – collect funds from many employees, then pay pensions to employees who retire These funds usually invest the money paid in These funds usually invest the money paid in 401(k) – Retirement account where you save and invest part of your paycheck 401(k) – Retirement account where you save and invest part of your paycheck Employers will usually match what you put in, to a certain point Employers will usually match what you put in, to a certain point

Sharing Risk It’s a bad idea to place all of your financial faith in one place – you might lose everything! It’s a bad idea to place all of your financial faith in one place – you might lose everything! Diversification – spreading out investments to reduce risk Diversification – spreading out investments to reduce risk

Typical Risk Model

Other Key Terms Portfolio – collection of financial assets Portfolio – collection of financial assets Prospectus – an investment report provided by your intermediary Prospectus – an investment report provided by your intermediary Liquidity – the ease with which you can convert assets into cash Liquidity – the ease with which you can convert assets into cash Return – money you make on the investment Return – money you make on the investment

Return vs. Liquidity Many times, investment decisions depend on what you value more of the two Many times, investment decisions depend on what you value more of the two Assets that can become cash easily often have a low return Assets that can become cash easily often have a low return Assets that have a high return are difficult to convert into cash quickly Assets that have a high return are difficult to convert into cash quickly

Return vs. Risk Assets that have a high potential return are usually very risky Assets that have a high potential return are usually very risky Assets that have low risk usually provide a low potential return Assets that have low risk usually provide a low potential return

Bonds Bond – a piece of paper signifying a loan given to the government or a corporation Bond – a piece of paper signifying a loan given to the government or a corporation Bonds pay the investor (or lender) a fixed interest rate for a certain amount of time Bonds pay the investor (or lender) a fixed interest rate for a certain amount of time Generally low risk, low return Generally low risk, low return

3 Components of Bonds Coupon Rate – interest rate the bond issuer will pay Coupon Rate – interest rate the bond issuer will pay Maturity – the time at which payment to the bondholder is due (usually 10 to 30 years) Maturity – the time at which payment to the bondholder is due (usually 10 to 30 years) Par Value – the amount the investor pays to purchase the bond, to be paid back upon maturity Par Value – the amount the investor pays to purchase the bond, to be paid back upon maturity

Bond Ratings Standard & Poor’s and Moody’s rate bonds based on their assessment of the issuer’s ability to repay the loan Standard & Poor’s and Moody’s rate bonds based on their assessment of the issuer’s ability to repay the loan Letter grade system: AAA is best, D means company is in default Letter grade system: AAA is best, D means company is in default Higher risk bonds usually offer a higher interest rate Higher risk bonds usually offer a higher interest rate

That’s all well and good, but how do bonds work?

How Bonds Work 2 different ways 2 different ways Corporate bonds, treasury bonds, and municipal bonds Corporate bonds, treasury bonds, and municipal bonds Pay you the % interest of the bond each year, then give you the par value at maturity Pay you the % interest of the bond each year, then give you the par value at maturity

How Bonds Work 2 different ways 2 different ways Savings bonds Savings bonds Bond grows in value over time and can be redeemed for twice the value at maturity Bond grows in value over time and can be redeemed for twice the value at maturity

Types of Bonds Savings Bonds – issued by the U.S. government to finance their debt Savings Bonds – issued by the U.S. government to finance their debt Treasury Bonds – like a corporate bond from the U.S. government, and tax free Treasury Bonds – like a corporate bond from the U.S. government, and tax free

Types of Bonds Municipal Bonds – issued by the city to pay for parks or libraries, etc. Municipal Bonds – issued by the city to pay for parks or libraries, etc. Corporate Bonds – cannot guarantee repayment, but have a higher interest rate than U.S. gov’t bonds Corporate Bonds – cannot guarantee repayment, but have a higher interest rate than U.S. gov’t bonds Junk Bonds – Higher risk, higher return corporate bonds (rated BBB or lower) Junk Bonds – Higher risk, higher return corporate bonds (rated BBB or lower) Still lower risk than most stocks, though Still lower risk than most stocks, though

With Members of the U.S. Congress

How do you Profit? 2 Ways to Profit: 2 Ways to Profit: Dividends – some corporations pay part of their profits out to stockholders quarterly (4 times a year) Dividends – some corporations pay part of their profits out to stockholders quarterly (4 times a year) Capital Gains – selling the stock for more than you paid for it Capital Gains – selling the stock for more than you paid for it

How do you Profit? If you are interested in receiving dividends, you should buy income stock If you are interested in receiving dividends, you should buy income stock If you’re more interested in capital gains, you should buy growth stock – pays no dividend If you’re more interested in capital gains, you should buy growth stock – pays no dividend

Stock Split Companies can decide to split stocks – double the number of shares, while cutting their value in half Companies can decide to split stocks – double the number of shares, while cutting their value in half 50 shares worth $20 each becomes 100 shares worth $10 each 50 shares worth $20 each becomes 100 shares worth $10 each In both situations, the stock is worth a total of $1,000 In both situations, the stock is worth a total of $1,000

How do you buy Stock? Must go through a brokerage firm – they are licensed by the SEC to conduct stock trades Must go through a brokerage firm – they are licensed by the SEC to conduct stock trades Stockbroker – a person who links buyers and sellers of stock Stockbroker – a person who links buyers and sellers of stock

Examples of Brokerage Firms Examples: Charles Schwab, Edward Jones, Merrill Lynch, Smith Barney, AIG Examples: Charles Schwab, Edward Jones, Merrill Lynch, Smith Barney, AIG Online Brokerages: TD Ameritrade, Scottrade, ETrade, Fidelity (do it yourself, but reduced commission) Online Brokerages: TD Ameritrade, Scottrade, ETrade, Fidelity (do it yourself, but reduced commission)

Stock Exchanges Stock Exchange – market for buying and selling stock Stock Exchange – market for buying and selling stock Newspapers and websites publish information on what happens in the major stock exchanges Newspapers and websites publish information on what happens in the major stock exchanges

Major Stock Exchanges New York Stock Exchange (NYSE) – largest and most powerful companies New York Stock Exchange (NYSE) – largest and most powerful companies NASDAQ – specializes in tech companies, usually higher risk than NYSE NASDAQ – specializes in tech companies, usually higher risk than NYSE

Major Stock Exchanges The OTC Market – “over the counter” The OTC Market – “over the counter” Not an actual stock exchange Not an actual stock exchange Traded through an electronic marketplace Traded through an electronic marketplace Mostly new and growing companies Mostly new and growing companies Most stocks traded this way Most stocks traded this way

Futures and Options Futures – contracts to buy or sell a particular commodity on a specific date in the future at a price set today Futures – contracts to buy or sell a particular commodity on a specific date in the future at a price set today Investors may buy futures now, hoping the price of the commodity will rise before they must sell it Investors may buy futures now, hoping the price of the commodity will rise before they must sell it

Futures and Options Options – contracts that give investors the choice to buy or sell stock and other financial assets LATER for TODAY’S price Options – contracts that give investors the choice to buy or sell stock and other financial assets LATER for TODAY’S price Call Option – choice to buy Call Option – choice to buy Put Option – choice to sell Put Option – choice to sell

Measuring Stock Performance “Bull Market” – stock market is rising steadily “Bull Market” – stock market is rising steadily “Bear Market” – stock market is falling “Bear Market” – stock market is falling 1980’s and 1990’s were the longest sustained bull markets in U.S. history 1980’s and 1990’s were the longest sustained bull markets in U.S. history

The Dow Jones Industrial Average Shows the performance of 30 stocks from various industries as a representation of the whole market Shows the performance of 30 stocks from various industries as a representation of the whole market What is the deal with the Dow?

The S&P 500 Just like the Dow Jones, but uses 500 different companies Just like the Dow Jones, but uses 500 different companies Mostly NYSE stocks, but also some from NASDAQ-AMEX and OTC Mostly NYSE stocks, but also some from NASDAQ-AMEX and OTC