Chapter 11: Financial Markets Section 1

1. Chapter 11: Financial MarketsSection 1

2. Objectives Describe how investing contributes to the free enterprise system. Explain how the financial system brings together savers and borrowers. Explain the role of financial intermediaries in the financial system. Identify the trade-offs among liquidity, return, and risk.

3. Key Terms investment: the act of redirecting resources from being consumed today so that they may create benefits in the future financial system: the network of structures and mechanisms that allows the transfer of money between savers and borrowers financial asset: a claim on the property or income of a borrower

4. Key Terms, cont. financial intermediary: an institution that helps channel funds from savers to borrowers mutual fund: an organization that pools the savings of many individuals and invests this money in a variety of stocks, bonds, and other financial assets hedge fund: a private investment organization that employs risky strategies to try to make huge profits for investors

5. Key Terms, cont. diversification: the strategy of spreading out investments to reduce risk portfolio: a collection of financial assets prospectus: an investment report that provides information to potential investors return: the money an investor receives above and beyond the sum of money initially invested

6. Introduction What are the benefits and risks of saving and investing? Savings you deposit in a bank will grow with hardly any risk at all. Investing, while more risky, may yield a larger return for your initial investment. It may also prove to be financially devastating if it is ill-timed or mismanaged.

7. Investing and Free Enterprise Investing is essential to the free enterprise system. It promotes economic growth and contributes to a nation�s wealth. People deposit money into a savings account and the bank lends this money to businesses. Businesses can then increase production, which leads to expansion and growth.

8. The Financial System Financial systems are established in an economy so investments can take place. When people save money they are really loaning it to other people. Savers receive a document, such as a passbook or a bond certificate, that confirms their purchase or deposit. These documents represent the claims, or financial assets, of the borrower.

9. Savers and Investors Financial systems bring together savers and investors, or borrowers, which fuels investment and economic growth. Savers include: Households Individuals Businesses Investors include: Businesses Government

10. Financial Intermediaries Financial intermediaries, including banks and other financial institutions, accept funds from savers to make loans to investors.

11. Sharing Risk Dealing with financial intermediaries offers three advantages: Sharing risk Providing information Providing liquidity Sharing risk Diversification allows you to spread out your investments so that you don�t put all of your money into one single investment. Sharing risk helps ward against losing everything on a bad investment.

12. Types of Risk Investors must weigh the risks of investment against the potential rate of return on their investment. How does diversification lesson the risks described in the chart? Answer: By spreading out your investments, or diversifying, you encounter less risk than if you put all of your money into one single investment.Answer: By spreading out your investments, or diversifying, you encounter less risk than if you put all of your money into one single investment.

13. Providing Information and Liquidity By providing vital data, either in a portfolio or a prospectus, financial intermediaries reduce the costs in time and money that lenders and borrowers would pay if they had to get the information on their own. Financial intermediaries also help people get access to their money when they need it, depending on how liquid the investment is. Checkpoint: Why do savers and investors generally work through financial intermediaries? Checkpoint Answer: Because financial intermediaries share in the investment risk, provide information to savers and investors, and provide liquidity to savers and investors. Checkpoint Answer: Because financial intermediaries share in the investment risk, provide information to savers and investors, and provide liquidity to savers and investors.

14. Return and Risk Some investments, like CDs, are very safe because they are insured by the government. Investing in a new business is far more riskier, but if the business is a success, the return could be very big.

15. Return and Risk, cont. In general, the higher the potential return, the riskier the investment. Whenever people evaluate their potential investments, they must balance the risks involved with the rewards they expect to gain.

16. Review Now that you have learned about the benefits and risks of saving and investing, go back and answer the Chapter Essential Question. How do your saving and investment choices affect your future?

17. Chapter 11: Financial MarketsSection 2

18. Objectives Describe the characteristics of bonds as financial assets. Identify different types of bonds. Describe the characteristics of other types of financial assets. List four different types of financial asset markets.

19. Key Terms coupon rate: the interest rate that a bond issuer will pay to the bondholder maturity: the time at which payment to a bondholder is due par value: a bond�s stated value, to be paid to the bondholder at maturity yield: the annual rate of return on a bond if the bond is held to maturity savings bond: a low-denomination bond issued by the United States government

20. Key Terms, cont. inflation-indexed bond: a bond that protects the investor against inflation by its linkage to an index of inflation municipal bond: a bond issued by a state or local government or a municipality to finance a public project corporate bond: a bond issued by a corporation to help raise money for an expansion junk bond: a bond with high risk and potentially high yield

21. Key Terms, cont. capital market: a market in which money is lent for periods longer than a year money market: a market in which money is lent for periods of one year or less primary market: a market for selling financial assets that can be redeemed only by the original holder secondary market: a market for reselling financial assets

22. Introduction Why are bonds bought and sold? Bonds are sold by governments and or corporations to finance projects. Bonds offer a higher return than savings accounts, although they are generally riskier than savings accounts.

23. Bonds as Financial Assets Bonds are loans that represent debt that the seller must repay to the investor. Bonds have three basic components: Coupon rate - the 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 to be paid to the bondholder at maturity

24. Discounts From Par Investors can not only earn money from the interest on their bonds but they can also earn money by buying bonds at a discount, called a discount from par. According to the chart, how do interest rates affect bond prices? Answer: Rising interest rates can make it more difficult to sell a bond that was bought at a lower interest rate.Answer: Rising interest rates can make it more difficult to sell a bond that was bought at a lower interest rate.

25. Bond Ratings In order to decide which bonds to buy, investors can check bond quality through independent firms, such as Standard & Poor�s and Moody�s, which publish bond issuers� credit ratings. These firms rate bonds on the issuer�s financial strength, its ability to make future interest payments, and its ability to repay the principal when the bond matures. A high grade, such as AAA, means that the bond is safe to invest in.

26. Advantages and Disadvantages Advantages Once a bond is sold, the coupon rate remains the same. The company does not have to share profits with bondholders if it is doing well. Disadvantages The company must make fixed interest payments and cannot change its interest payments. A firm�s bonds may be given a low bond rating and be harder to sell when the firm is not doing well.

27. Types of Bonds Savings Bonds Low-denomination bonds issued by the U.S. government, who pays interest on the bonds. Treasury Bonds, Bills, and Notes The U.S. Treasury Department issue Treasury bonds, bills, and notes, which are among the safest investments in terms of default risk. Answer: Treasury billAnswer: Treasury bill

28. Municipal Bonds State and local governments issue municipal bonds to finance such projects as highways, libraries, parks, and schools. These are attractive to long-term investments and are relatively safe. Checkpoint: What type of bond might have been used to fund the construction of your school? Checkpoint Answer: Municipal bondsCheckpoint Answer: Municipal bonds

29. Corporate and Junk Bonds Corporate bonds are issued by corporation to help raise money to expand business. These bonds have a moderate risk level because investors must depend on the corporation�s success. Junk bonds are bonds with a high risk and a potentially high return. Investors in junk bonds face a strong possibility that some of the issuing firms will default on their debt.

30. Other Types of Financial Assets Certificates of Deposit CDs are available through banks, which lend out funds deposited in CDs for a fixed amount of time. Money Market Mutual Funds Investors receive higher interest on a money market mutual fund than they would on a savings account. These funds, however, are not covered by FDIC insurance.

31. Financial Asset Markets Bonds, CDs, and money market mutual funds are traded on financial asset markets. One way to classify financial asset markets is according to the length of time for which the funds are lent. Capital Markets In these markets, money is lent for periods longer than a year, like in a CD. Money Markets In these markets, money is lent for periods of a year or less and include Treasury bills and money market mutual funds.

32. Financial Asset Market, cont. Markets may also be classified according to whether or not assets can be resold to other buyers. Primary Markets In a primary market, financial assets can be redeemed only by the original holder. Examples include savings bonds and small CDs. Secondary Markets In a secondary market, financial assets can be resold, which provides liquidity to investors. Checkpoint: What are two ways of classifying financial asset markets? Checkpoint Answer: By the amount of time in which the funds are lent and by whether or not assets can be resold to other buyers. Checkpoint Answer: By the amount of time in which the funds are lent and by whether or not assets can be resold to other buyers.

33. Review Now that you have learned why bonds are bought and sold, go back and answer the Chapter Essential Question. How do your saving and investment choices affect your future?

34. Chapter 11: Financial MarketsSection 3