1. Financial Markets

2. Savings and the Financial System
For an economic system to grow, it must produce capital – the equipment, tools, and machinery used in production – this requires savings.
Saving – absence of spending that frees resources for use in other activities or investments
Savings - the dollars that become available for investors to use when others save
Savings Is Necessary For Investment

3. Savings and the Financial System
intermediaries
Savings is a leakage from the circular flow.
The money goes through financial intermediaries to
business for investment

4. Savers and Financial Assets
People can save in many ways such as savings accounts, bonds, stocks, etc.
Certificate of Deposit (CD)– document showing that an investor has made an interest-bearing loan to a financial institution
Financial Assets – a stock or other document that represents a claim on the income and property of a borrower, such as a CD, bond, Treasury bill, or mortgage

5. Savers and Financial Assets
Financial System -network of savers, investors, and financial institutions working together to transfer savings for investment uses
The financial system has three parts:
Funds that a saver transfers to a borrower
Financial assets that certify conditions of the loan
The organizations that bring the surplus funds and financial assets together
Financial Intermediary – institution that channels savings to investors – banks, credit unions, life insurance companies, pension funds, etc.

6. Overview of the Financial System
Surplus Funds
Financial Intermediaries
Commercial banks
Savings and loan associations
Savings banks
Mutual savings banks
Credit unions
Life insurance companies
Mutual funds
Pension funds
Finance companies
Households,
businesses
Government,
Businesses
Financial Assets

7. Nonbank Financial Intermediaries
Nonbank financial institutions – nondepository institutions that channels savings to investors
Finance company – firm that makes loans directly to consumers and specializes in buying installment contracts from merchants who sell on credit
Many stores sell goods on an installment plan, but they can’t afford to wait for the installment payments, so they sell the contract for a lump sum. This allows stores to sell expensive items to consumers without accepting the risk of the loan.
The finance company then carries the loan for the full term and either makes money on the interest or could lose money if the customer cannot repay the loan

8. Nonbank Financial Intermediaries
Life Insurance Company – people buy life insurance policies to leave money for a spouse and children in case of his or her death. The primary purpose of the company is to provide financial protection to people it insures, but it also collects a great deal of cash from people paying their premiums
Premium – price paid at regular intervals for an insurance policy
The companies lend their surplus funds to other people

9. Nonbank Financial Intermediaries
Pension – regular payments to someone who has worked a certain number of years, reached a certain age, or has suffered an injury
Pension Fund – fund that collects and invests income until payments are made to eligible recipients
Pension funds are usually collected monthly from a workers paycheck
During the 30- to 40-year lag between the time savings are deposited and the time the workers generally use them, the money is usually invested in high-quality corporate stocks and bonds

10. Basic Investment Considerations
Consistency – even if the amount is small, invest on a regular basis – consider the results of a $10 monthly investment
Compound Interest on a monthly $10 investment
Annual interest (in percent)
Value at end of year 5 10 15 20 25 30
$600
$1,200
$1,800
$2,400
$3,000
$3,600 2
$630
$1,327
$2,097
$2,948
$3,888
$4,927 4
$663
$1,472
$2,461
$3,668
$5,141
$6,940 6
$698
$1,639
$2,908
$4,620
$6,930
$10,045 8
$735
$1,829
$3,460
$5,890
$9,510
$14,904
$774
$2,048
$4,145
$7,594
$13,268
$22,605 12
$817
$2,300
$4,996
$9,893
$18,788
$34,950

11. Basic Investment Considerations
Simplicity – investors should stay with what they know
Ignore any investment that seems too complicated
Investments that seem too good to be true probably are
The Risk – Return Relationship – the greater the risk, the greater the chance for return; less risk means a lower return
Investment Objectives – know your reasons for investing; is it important to be able to convert them into cash?; how long before you need the $?

12. Bonds as Financial Assets
Bond – contract to repay borrowed money and interest on the borrowed money at regular future intervals
A bond has three main components:
Coupon Rate – the stated interest on a corporate, municipal, or government bond
Maturity – life of a bond or length of time funds are borrowed
Par Value – principal of a bond or total amount borrowed

13. Bonds as Financial Assets
A bond example
A company sells a 6 percent, 20-year, $1,000 par value bond that pays interest semiannually
The holder receives $30 twice a year (.06 times $1,000, divided by 2) and after 20 years the company pays the holder par value of $1,000
The investor may offer $950, $1,000, $1,100, or any other amount. Investors consider changes in future interest rates, the risk the company will default, and other factors
Supply and Demand will establish the final price of the bond

14. Bonds as Financial Assets
Current yield – bond’s annual coupon interest/by purchase price; measure of a bond’s return
For instance: an investor paid $950 for the bond described earlier, the current yield is $60/$950 or 6.32%. If they paid $1,100 it would be $60/$1,100 or 5.45 percent.
Bond Ratings – there are two major corporations that publish bond ratings: Standard & Poor’s and Moody’s. They rate bonds on many factors including the financial health of the issuer and past credit history

15. Bond Ratings Junk bonds, those with ratings of BB or Ba and lower
Standard & Poor’s
Moody’s
Highest investment grade
AAA
Aaa
Best quality
High grade AA Aa
High quality
Upper medium grade A a
Medium grade
BBB
Baa
Lower medium grade BB Ba
Possesses speculative elements
Speculative B
Generally not desirable
Vulnerable to default
CCC
Caa
Poor, possibly in default
Subordinated to other debt rated CCC CC Ca
Highly speculative, often in default
Subordinated to CC debt C
Income bonds not paying income
Bond in default D
Interest and principal payments in default
Junk bonds, those with ratings of BB or Ba and lower
are generally the riskiest types of bonds.

16. Other Financial Assets
Certificates of Deposit – document showing that an investor has made an interest-bearing loan to a financial institution – they are attractive to investors because they can be for as little as $500, investors can select the length of maturity, and they are covered by the FDIC insurance limit.
Corporate Bonds – usually for $10,000 or more – risk varies greatly, usually a long-term investment, but can be quickly sold, coupon payments are taxable
Junk Bonds – bond that carries an exceptionally high risk of nonpayment and a low rating

17. Other Financial Assets
Municipal bond – bond, often tax exempt, issued by state and local governments “munis” – generally considered very safe
Tax-Exempt – not subject to tax by federal or state governments
Savings Bonds – low-denomination, non-transferable bond issued by the federal government
Savings Bonds range from $50 to $10,000 and are purchased at a 50 percent discount from their redemption value – very safe investment, but they take a long time to mature – often bought for a beneficiary – a person designated to take ownership of an asset if the owner of the asset dies – no inheritance taxes

18. Other Financial Assets
Treasury Notes – U.S. government obligation with a maturity of 2 to 10 years
Treasury Bond – U.S. government bond with a maturity of 10 to 30 years
They both come in denominations of $1,000 and are issued electronically and are purchased directly from the U.S. Treasury
They are considered very safe – but have the lowest returns of all financial assets

19. Other Financial Assets
Treasury Bills – short-term United States government obligation with a maturity of one year or less in denominations of $1,000
T-bills don’t pay interest directly, so investors buy them on a discount basis. Ex. You buy a $1, week T-bill for $960. You receive $1,000 at the maturity date. $40/$960 = a 4.2% return.
Individual Retirement Accounts (IRAs) – retirement account in the form of a long-term time deposit with annual contributions not taxed until withdrawn during retirement

20. Markets for Financial Assets
Capital Market – market in which financial capital is loaned and/or borrowed for more than one year
Money Market – market in which financial capital is loaned and/or borrowed for one year or less
Primary Market – market in which only the original issuer can sell or repurchase a financial asset
Secondary Market – market in which financial assets can be sold to someone other than the original issuer

21. Markets for Financial Assets
Money market
(less than 1 year)
Capital market
(more than 1 year)
Primary Market
mutual funds
Small CDs
Government savings
bonds
IRAs
Secondary Market
Jumbo CDs
Treasury bills
Corporate bonds
International bonds
Municipal bonds
Treasury bonds
Treasury notes

22. Stocks
Equities (shares of common stocks) – stocks that represent ownership shares in corporations
Stockbroker – person who buys or sells securities for investors
Stock prices go up and down, often daily, due to several factors, including the number of outstanding shares and a company’s profitability.
Their value is determined by the supply and demand in the market. If people think a company will do well, then demand for the stock rises and so will price. If the opposite is true, then the supply of shares for sale will rise and price will fall.

23. Stocks
Efficient Market Hypothesis – argument that stocks are always priced about right because they are closely watched.
Portfolio Diversification – strategy of holding different investments to protect against risk
Mutual Fund – company that sells stock in itself and uses the proceeds to buy stocks and bonds issued by other companies
Net Asset Value (NAV) – the market value of a mutual fund share found by dividing the net value of the fund by the number of shares issued

24. Stocks
Mutual funds are popular because they are run by a large staff of experts and they allow investors to invest without risking all their money in only one or two stocks
401(k) Plans – tax-deferred investment and savings plan that acts as a personal pension fund for employees
Employees have a small amount deducted from their paychecks. These amounts are rolled in with other people and invested in mutual funds etc. An added bonus is that employers often match the funds to a certain level

25. Stock Markets
Stock or Security Exchanges – physical place where buyers and sellers meet to exchange securities
The oldest of the exchanges is the New York Stock Exchange (NYSE)
It lists 2,700 companies
They must pay a fee to belong
They must meet profitability and size requirements
The American Stock Exchange (AMEX) is also located in New York City
It features smaller and more speculative companies

26. Stock Markets
Other exchanges are found around the country and exchanges exist in most major cities all over the world
Over the Counter Markets (OTC) – electronic marketplace for securities not listed on organized exchanges such as the NYSE
The most important (OTC) is the National Association of Securities Dealers Automated Quotation (NASDAQ) – trading is executed with a telecommunications and computer network that connects investors in more than 80 countries
It is bigger than the NYSE and AMEX combined

27. Measures of Performance
Most investors consult one of two popular indicators – in general, when these indicators go up, stocks go up. When they go down, stocks go down.
Dow Jones Industrial Average (DJIA) – measure of stock market performance based on 30 NYSE representative stocks – it began in 1884 with 11 stocks – it now includes 30 stocks and the stocks that make up the DJIA change from time to time
Standard & Poor’s 500 (S&P 500) – measure of stock market performance based on 500 stocks traded on the NYSE, AMEX, and OTC market

28. Measures of Performance
Bull Market – period during which stock market prices move up for several months or years in a row
One of the strongest bull markets began in 1995 when the DJIA broke 4,000 – and then reached 12,000 five years later
Bear Market – period during which stock market prices move down for several months or years in a row
The worst bear market since the Great Depression was in 2001 – 2003, when the DJIA lost more than one-third of it value

29. Futures Trading
Spot Market – market in which a transaction is made immediately at the prevailing price
Futures Contract – an agreement to buy or sell at a specific date in the future at a predetermined price
You agree to buy gold in six months at a price of $580 an ounce. If the price is higher than that when the contract is up, then you make money
A futures contract can be written on almost anything
In most cased the profit or loss on the contract is settled with a cash payment rather than the buyer taking delivery

30. Futures Trading
Option – futures contract giving a buyer the right to cancel the contract
Call Option – futures contract giving a buyer the right to cancel a contract to buy something
Put Option – futures contract giving the buyer the right to sell something