CHAPTER 12 FINANCIAL MARKETS

1. CHAPTER 12FINANCIAL MARKETS 12.1 “Savings and the Financial System” 12.2 “Investment Strategies and Financial Assets” 12.3 “Investing in Equities, Futures, and Options”

2. Sherlock Holmes and Dr. Watson went on a camping trip. After a good meal and a bottle of wine they lay down for the night, and went to sleep. Some hours later, Holmes awoke and nudged his faithful friend awake. "Watson, look up at the skya nd tell me what you see." Watson replied, "I see millions and millions of stars.“ "What does that tell you?" Holmes questioned. • Watson pondered for a minute. "Astronomically, it tells me that there are millions of galaxies and potentially billions of planets. Astrologically, I observe that Saturn is in Leo. Horologically, I deduce that the time is approximately a quarter past three. Theologically, I can see that God is all powerful and that we are small and insignificant. Meteorologically, I suspect that we will have a beautiful day tomorrow. What does it tell you?" • Holmes was silent for a minute, then spoke. • "Watson, you idiot. Someone has stolen our tent."

4. What is the difference between saving and savings? • SAVING = Absence of spending • SAVINGS = $$$ that become available when people abstain from consumption

5. DISCRETIONARY INCOMEDISPOSABLE INCOME PROBLEM—WHEN CONSUMER SPENDING EXCEEDS DISCRETIONARY INCOME

6. Does saving $$$ help or hurt the economy? • Good question • Helps: • If people have $$$ in banks, then the banks have money to lend to people who __________. • Buying/selling process continues • Hurts: • If people save their $$$ at home or pull out of investments like the stock market, businesses can’t invest or re-invest $$$ INVEST!

7. NY TIMES ARTICLE “Debt and Easy Credit”

8. One philosophy for debt reduction • THE DEBT SNOWBALL

9. DEBT SNOWBALL • The basic steps in the debt snowball method are as follows: • List all debts in ascending order from smallest balance to largest. This is the method's most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list. • Commit to pay the minimum payment on every debt. • Determine how much extra can be applied towards the smallest debt. • Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off. • Then, add the old minimum payment from the first debt to the extra amount, and apply the new sum to the second smallest debt. • Repeat until all debts are paid in full.

10. DEBT SNOWBALL • In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name). The theory works as much on human psychology as it does on finance; by paying the smaller bills first, the individual, couple, or family sees fewer incoming payment requests as more bills are paid off, thus giving the impression that they are making headway towards debt elimination. • All retirement contributions are to be halted during the debt snowball, thus freeing up more money to pay down the debt snowball. Many dispute this practice, citing the cost of compounding interest to be greater than the gains of paying off debt. Some compromise by reducing retirement contributions to only what a company will match with an employee. Ramsey teaches that this halting of retirement contributions should last no more than two years. • A first home mortgage is not generally included in the debt snowball, but is instead paid off as part of one's larger financial plan. As an example, the Ramsey plan pays off home mortgages in "Baby Step 6", along with any other debt which is equal to or greater than half of one's annual take-home pay.

11. DEBT SNOWBALL • Ignoring interest rates, let's pretend you have the following debt (along with the minimum payments): • Car Payment - $2500 balance - $150/month minimum • Credit Card A - $250 balance - $25/month minimum • Loan - $5000 balance - $200/month minimum • Credit Card B - $500 balance - $26/month minimum • Your minimum payments for all debt would be $401 per month. You would order your debts in the following order (lowest to highest): • Credit Card A - $250 balance - $25/month minimum • Credit Card B - $500 balance - $26/month minimum • Car Payment - $2500 balance - $150/month minimum • Loan - $5000 balance - $200/month minimum • Now, assuming you had $100 extra per month to send in, you would apply that $100 to the Credit Card A so that the payment for it would be $125 per month and the other debt would receive the minimums. • After Credit Card A is paid off (in two months), you would apply the extra $100 to Credit Card B PLUS the $25 you were sending in to Credit Card A. So now your payment to Credit Card B would be: $26 normal minimum + $25 that you normally sent in to Credit Card A + $100 that you are able to send extra. • Your payment to Credit Card B would be $151 instead of $26. Therefore, you would pay it off much faster. Then, when Credit Card B is paid off, you would now send in the following to the Car Payment: $150 normal minimum + $25 that you normally sent in to Credit Card A + $26 that you normally sent in to Credit Card B + $100 that you are able to send extra • Your payment to Car Payment would now be $301 instead of $150. • If you didn't have $100 extra (or any extra amount) the debt snowball would be the same minus $100 per month.

12. ENOUGH ABOUT DEBT, LET’S GET TO SAVING/INVESTING

13. BEFORE INVESTING IN A FINANCIAL ASSET, WHAT SHOULD A PERSON CONSIDER? • 1. Risk-return relationship • Some—more important to get money back • Others—risk of losing is worth the possibility of big $ • 2. Investment Objectives • If for retirement, perhaps purchase assets that simply appreciate in value rather than generate current income • If for now (vacation, living expenses), invest in something highly ________ (easily converted into cash) • 3. Simplicity • General rules: (1) If it seems too complicated, then ignore it & invest in something else. (2) If it seems too good to be true, then it probably is. • Example #1: Individual stocks; Example #2: Pyramid schemes • 4. Consistency • ***MOST SUCCESSFUL INVESTORS INVEST CONSISTENTLY OVER LONG PERIODS OF TIME*** (Save early & often) LIQUID

14. The Power of Compound Interest • What’s the difference between interest and compound interest? • The earlier people start saving the better!

15. Compound v. Simple Interest

17. Figure 12.3 • Compound interest calculator • http://www.moneychimp.com/calculator/compound_interest_calculator.htm

18. DIFFERENT WAYS TO INVEST/SAVE • Checking Account • Savings Account • CDs • Bonds • Junk Bonds • Stocks • Mutual Funds • Pension Funds • Real Estate Investment Trust • Futures • Money Market

19. Discussion Question What type of investments are available to an investor with $1,000 or less? Certificates of deposit, savings bonds, and IRAs. Click the mouse button or press the Space Bar to display the answer.

20. CDs • “Certificate of Deposit” • Money invested for a set period of time (3 mo, 6 mo, 1 yr, 3 yrs, etc.) with a set amount of interest • #1 Pro: • GUARANTEED interest rate (around 3-6%) makes it a safe investment • (Another pro: Good if a big investment is coming up at a definite point in the future) • #1 Con: • Big penalty for taking $ out early • (Another con: No potential for dramatic growth) • http://www.schwab.com/public/schwab/investment_products/cds_money_markets/certificates_deposit?refid=P-1061773&refpid=P-1001546 (Look on the right side for current rates)

21. BONDS…

22. Section 2-Assessment 1 What is a bond? A long-term obligation by the government or a corporation to pay a fixed (usually low) amount of interest every year for a specified number of years. Click the mouse button or press the Space Bar to display the answer.

23. How do bonds work? Bonds have 3 main components: • coupon Interest on the debt • maturity Life of the bond • par value Total amount initially borrowed If a corporation sells a 6%, 20-year, $1,000 bond that pays interest semiannually, what is the coupon? Maturity? Par Value? How much $ does a person who has this bond make every 6 months?

24. INVESTMENT RISK

25. INVESTMENT RISK

27. Stocks: Good Investments? • Wal-Mart: 10,000 in 1970 has increased 13,000 times. Every $10,000 then = $130,000,000 today (2007) • Southwest Airlines: 10,000 in 1980 = $2.7 million today • Dell: $10,000 in 1990 = $6,000,000 • Has the US stock market increased every 10-year period since its existence? • Almost. From 1871 to 2002, only 2 of the 121 overlapping 10-year periods did the stock market not gain. • How do stock prices not get too high for investors to buy them? • Splitting in half

28. Now for real life examplesfrom Senor Duncan

29. Individual Stocks • Krispy Kreme doughnuts (kkd): • July 29, 2003: Bought 45 Shares @ $44.00 • Aug. 18, 2003: High 49.74 • Apr. 26, 2004: 35.33 • May 3, 2004: Opened 32.60, Closed 22.48 • May 10, 2004: 20.76 • Feb. 21, 2005: Closed 5.54 • May 21, 2007: Closed 8.39 • Last 52 weeks: • High 13.93 (Jan. 24,07); Low 7.14 (July 14,06)

30. Individual Stocks • CHICO’S (CHS): • July 29, 2003: Bought 80 shares @ $25.55 • October 29, 2003: Sold 80 shares @ $37.00 for a _______ profit • Feb. 27, 2006: Open 47.41, High 48.28, Closed @ 40.96 • May 1, 2006: Open 37.80, Closed 29.31 • May 21, 2007: Closed 24.37 • Last 52 weeks: • High 31.70 (May 26,07); Low 17.26 (Aug 25,06)

31. STOCK PROBLEM • Investor confidence is important for market stability.  • After the attack on the World Trade Towers, for example, investor uncertainty caused a temporary 14 percent decline in overall stock prices. Click the mouse button or press the Space Bar to display the information.

32. Stocks—Big Swings • May 21, 2007 • Biggest gainer % • LUNALUNA INNOVATIONS INC • Closed 5.06 4:00PM ET plus 2.06(68.67%) • Biggest loser % • NTBKNET.BANK INC • Closed 0.59 4:00PM ET (opened 1.70) minus 1.11 • Today • http://finance.yahoo.com/gainers?e=us

33. 2 MEASURES OF STOCK PERFORMANCE • 1. Dow-Jones Industrial Average • Most popular & widely publicized measure on the NYSE • Sample of 30 “blue chip” stocks • Wal-Mart, McDonald’s, Citigroup, Hewlett-Packard, INTEL, etc. • http://money.cnn.com/data/dow30/

34. Did You Know? • The 30 stocks included in the Dow-Jones Industrial Average represent about a fifth of the $8 trillion-plus market value of all U.S. stocks and about a fourth of the value of stocks listed on the New York Stock Exchange. Click the mouse button or press the Space Bar to display the information.

35. 2 MEASURES OF STOCK PERFORMANCE • 2. Standard & Poor’s 500 (S & P 500) • Uses price change of, you guessed it, 500 stocks to indicate overall market performance • Unlike the Dow Jones, it reports on stocks in AND OUT of the NYSE • Is this one more effective at measuring the market?

37. BEAR v. BULL MARKETS • BULL = “Strong” = Prices increase for long periods • USA 1990s • BEAR = “Mean” = Prices decrease for long periods • USA 1930-1932

38. STOCK INDICES (+ BUFFETT) • http://finance.google.com/finance?tkr=1&q=INDEXSP:.INX • S & P 500 • http://finance.google.com/finance?client=ob&q=INDEXDJX:DJI • Dow Jones • http://finance.yahoo.com/q?s=%5Eks11 • KOSPI • http://finance.google.com/finance?tkr=1&q=NYSE:BRK.A • Berkshire Hathaway

39. Dow Jones 2007

40. Market Efficiency • The Efficient Market Hypothesis states that it is not possible to “beat the market” regularly.  • WHY? • Stocks are almost always priced right – bargains are hard to find b/c the market is followed so closely by investors Click the mouse button or press the Space Bar to display the information.

41. …UNLESS YOU ARE THIS GUY November 10, 2008 www.forbes.com “Mimicking Berkshire’s buys has generated annual returns of 25%, double the return of the S & P 500” from 1976-2006.” WARREN BUFFETT World’s Richest Man $62 billion

42. DILEMMA • The stock market almost always goes up in the long run, but consistently picking individual stocks that never lose (“beating the market”) is highly unlikely • What should a potential investor do? • Diversify their portfolios by holding a large number and variety of stocks so that increases in some will offset unexpected declines in others • Used to be done almost exclusively by stockbrokers (people who buy and sell equities for clients)—Now much investing is done online • WHY? • FYI: (EQUITIES: Stocks that represent ownership shares in a company)

45. MUTUAL FUNDS • Massachusetts. 1924. 3 stock salesmen who owned 45 stocks and $50,000 in assets created the first mutual fund. • As of April 2006, there are 8,606 mutual funds in the U.S. with combined assets of $9.207 trillion. ($9,207,000,000,000!) • So what’s a mutual fund? • A company that sells stock in itself to individual investors and then invest the money in stocks and bonds of other corporations (They do the diversifying for you!) • They became popular after IRAs became possible • So what’s an IRA? 

46. IRAs (Individual Retirement Accounts) • Long-term, tax-sheltered deposits people set up to provide income during retirement • 401k(s): $ put in the account is taxed only WHEN TAKEN OUT • Roth IRA: $ put in the account is taxed only WHEN PUT IN • Advantages/Disadvantages? • Many IRAs are invested as mutual funds

47. ROTH v. 401k?

48. Quick Terms • Money Market: $ is loaned for periods of less than 1 year • Capital Market: $ is loaned for more than 1 yr