Businesses can borrow savings to: Businesses can borrow savings to: produce new goods and services produce new goods and services build new plants and equipment build new plants and equipment create more jobs create more jobs

Financial Asset: Financial Asset: Legal claim on the property and income of the borrower. Legal claim on the property and income of the borrower. e.g. certificate of deposit – a piece of paper that says, “ABC Bank has my $1000 and promises to repay me on this date.” e.g. certificate of deposit – a piece of paper that says, “ABC Bank has my $1000 and promises to repay me on this date.” I (lender) have provided ABC Bank with funds that they can loan. I (lender) have provided ABC Bank with funds that they can loan. My CD is a claim on the property/income of the bank for that $1000. My CD is a claim on the property/income of the bank for that $1000.

Lenders (businesses/individuals): Lenders (businesses/individuals): can provide funds directly to the borrower (govt./business) can provide funds directly to the borrower (govt./business) Stocks, bonds – financial assets in the hands of the lenders. Stocks, bonds – financial assets in the hands of the lenders.

Financial intermediaries (“lying between”) Financial intermediaries (“lying between”) Institutions that collect and channel funds from savers to borrowers. Institutions that collect and channel funds from savers to borrowers. Borrowers use the funds to: Borrowers use the funds to: Invest in capital equipment Invest in capital equipment Build plant Build plant Hire and train workforce Hire and train workforce

Benefits of capital formation: Benefits of capital formation: Lenders: Lenders: Don’t have to find borrowers Don’t have to find borrowers Liquidity Liquidity Less risk Less risk Credit underwriting Credit underwriting Pooled portfolio Pooled portfolio “Guaranteed” rate of return (FDIC) “Guaranteed” rate of return (FDIC)

Benefits of capital formation: Benefits of capital formation: Borrowers: Borrowers: Don’t have to find lenders Don’t have to find lenders Economies of scale Economies of scale Reduced time and expense Reduced time and expense Ready capital Ready capital

Non-bank financial intermediaries Non-bank financial intermediaries Pooled loan capital Pooled loan capital Life Insurance companies (e.g. MetLife) Life Insurance companies (e.g. MetLife) Collect premiums Collect premiums Long-term finance Long-term finance Pension Funds (e.g. MD State Retirement and Pension System)– set aside assets which must be invested. Pension Funds (e.g. MD State Retirement and Pension System)– set aside assets which must be invested.

Non-financial intermediaries (contd.) Non-financial intermediaries (contd.) Finance company (e.g. Ford Motor Credit) Finance company (e.g. Ford Motor Credit) Nontraditional loans Nontraditional loans Installment contracts Installment contracts

Investment Considerations: Investment Considerations: Consistency: Consistency: “Can’t beat the market.” “Can’t beat the market.” 11% historical average 11% historical average Magic of compounding (1¢ or $5 million) Magic of compounding (1¢ or $5 million)

Investment Considerations: Investment Considerations: Simplicity: Simplicity: KISS KISS Credit Default Swaps Credit Default Swaps

Investment Considerations: Investment Considerations: Risk: Risk: “The degree to which the outcome is uncertain, but a probable outcome can be estimated. “The degree to which the outcome is uncertain, but a probable outcome can be estimated.

Investment Considerations: Investment Considerations: Objective: Objective: Rainy Day Fund Rainy Day Fund House Down payment House Down payment College Tuition College Tuition Retirement Retirement

Debt Instruments Debt Instruments Junk bonds Speculative stock Common stock Preferred stock Investment-grade bonds Prime commercial paper U.S. Treasury bills

Bonds : Bonds : Long-term financing instruments that pay principle and interest. Long-term financing instruments that pay principle and interest. Coupon rate Coupon rate Maturity Maturity Par (face) value Par (face) value

Bond prices change when: Bond prices change when: Market interest rates change: Market interest rates change: Ex: You hold a 10-yr. bond paying 7.5%, but market rates have declined to 5.5%; Ex: You hold a 10-yr. bond paying 7.5%, but market rates have declined to 5.5%; Investors will pay a premium to own the higher yielding bond. Investors will pay a premium to own the higher yielding bond. Company’s ability to repay changes Company’s ability to repay changes

Bonds are rated by: Bonds are rated by: Standard and Poor’s (S&P) Standard and Poor’s (S&P) Moody’s Moody’s Determine the basic financial health of the issuer. Determine the basic financial health of the issuer. Ratings range from AAA (highest quality) to D (junk). Ratings range from AAA (highest quality) to D (junk). Investment grade bonds are rated BBB and above. Investment grade bonds are rated BBB and above.

Bond yield (rate of return) – seller wants to profit from market price: Bond yield (rate of return) – seller wants to profit from market price: Coupon rate ÷ market price Coupon rate ÷ market price Ex: $60 ÷ 950 = 6.32% Ex: $60 ÷ 950 = 6.32% $60 ÷ 850 = 7.01% $60 ÷ 1100 = 5.45%

Bond Types: Bond Types: CDs – issued by banking entities CDs – issued by banking entities $ $ Varying maturities, “penalty for early withdrawal” Varying maturities, “penalty for early withdrawal” FDIC insured FDIC insured Taxable income Taxable income

Corporate bonds: Corporate bonds: $1000 – 10,000 $1000 – 10,000 Long-term investment Long-term investment Easily liquidated in the market Easily liquidated in the market Taxable income Taxable income

Municipal bonds (“munis”): Municipal bonds (“munis”): Low-risk “borrower” Low-risk “borrower” Government repays easily since it can tax Government repays easily since it can tax Tax-exempt interest Tax-exempt interest Easier and cheaper for the issuer to borrow Easier and cheaper for the issuer to borrow

U.S. Savings Bonds: U.S. Savings Bonds: $ 50 - $10,000 $ 50 - $10,000 50% discount from face value 50% discount from face value Accrued interest collected upon redemption Accrued interest collected upon redemption Easy to obtain Easy to obtain “No” risk “No” risk

Treasuries: Treasuries: T-bills: T-bills: 1, 3, 6 month maturities 1, 3, 6 month maturities Discounted like savings bond Discounted like savings bond T-notes – 2-10 year maturities T-notes – 2-10 year maturities T-bonds – year maturities T-bonds – year maturities

IRAs – long-term, tax sheltered IRAs – long-term, tax sheltered Various investment amounts Various investment amounts Reduced taxable income Reduced taxable income Interest earned tax deferred Interest earned tax deferred

Value of a share of stock depends on: Value of a share of stock depends on: Outstanding number of shares Outstanding number of shares Company profitability Company profitability Market expectations Market expectations

The market is infinitely efficient: The market is infinitely efficient: Efficient Market Hypothesis (EMH) – there are no bargain-priced stocks. Efficient Market Hypothesis (EMH) – there are no bargain-priced stocks. Portfolio diversification – “win some, lose some”: Portfolio diversification – “win some, lose some”: 401 (k), 403 (b) –tax-deferred income 401 (k), 403 (b) –tax-deferred income Lowers taxable personal income taxes Lowers taxable personal income taxes Usually employer-matched Usually employer-matched Mutual funds Mutual funds Share of stock in a portfolio of stocks Share of stock in a portfolio of stocks Managed by experts Managed by experts

Trading – 3 markets: Trading – 3 markets: NYSE – largest and most profitable corps. NYSE – largest and most profitable corps. AMEX – smaller corps. offering more speculative stocks AMEX – smaller corps. offering more speculative stocks NASDAQ (OTC) – all stocks not traded on the other two organized exchanges. NASDAQ (OTC) – all stocks not traded on the other two organized exchanges.

Measurement: Measurement: DJIA (“the Dow”) – 30 major corps. DJIA (“the Dow”) – 30 major corps. S&P 500 – 500 representative stocks S&P 500 – 500 representative stocks NASDAQ – tracks all the stocks traded on this exchange (about 3300). NASDAQ – tracks all the stocks traded on this exchange (about 3300).

Futures: Futures: different from “spot” trades different from “spot” trades An agreement to buy or sell at a future date for a specific price An agreement to buy or sell at a future date for a specific price Ex: On 1/1/10, buy a 7/1/10 gold contract for $600/oz. Ex: On 1/1/10, buy a 7/1/10 gold contract for $600/oz. I expect gold to rise to $800/oz. I expect gold to rise to $800/oz. On 7/1/10, I buy $600 worth of gold from contract buyer and sell for $800. On 7/1/10, I buy $600 worth of gold from contract buyer and sell for $800. Advantage: I keep $600 for six months. Advantage: I keep $600 for six months.

Options – suppose you are not sure about the movement of commodity prices: Options – suppose you are not sure about the movement of commodity prices: Call option – the right to buy at a future price Call option – the right to buy at a future price Put option – the right to sell at a future price Put option – the right to sell at a future price Ex: I expect gold to rise to $800/oz. If it doesn’t, I tear up the contract. Ex: I expect gold to rise to $800/oz. If it doesn’t, I tear up the contract. Used by industries that want to lock in commodity price (e.g. oil, lumber). Used by industries that want to lock in commodity price (e.g. oil, lumber).