Chapter 11: Financial Markets Opener

Chapter 11: Financial MarketsOpener

Essential Question • How do your saving and investment choices affect your future?

Guiding Questions • Section 1: Saving and Investing • What are the benefits and risks of saving and investing? • Saving your money has a low risk and a guarantee of interest returned on your principle while investing may yield a greater return but has a higher risk of loss.

Guiding Questions • Section 2: Bonds and Other Financial Assets • Why are bonds bought and sold? • Bonds are bought and sold to help corporations and the government fund projects.

Guiding Questions • Section 3: The Stock Market • How does the stock market work? • Individuals and businesses buy stock in a company and, if the company does well, they can receive dividends and capital gains on their original investment. If the company does poorly or if the economy is bad, people can lose their money.

Chapter 11: Financial MarketsSection 1

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.

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

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

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

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.

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.

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.

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

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

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.

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?

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?

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.

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.

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?

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.

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

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

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

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.

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

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?

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.

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.

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. Which of these three types of government securities is the most liquid?

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?

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.

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.

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.

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?

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?

Objectives • Identify the benefits and risks of buying stocks. • Describe how stocks are traded. • Explain how stock performance is measured. • Describe the Great Crash of 1929 and more recent stock market events.

Key Terms • share: a portion of stock • capital gain: the difference between the selling price and purchase price that results in a financial gain for the seller • capital loss: the difference between the selling price and purchase price that results in a financial loss for the seller • stock split: the division of each single share of a company’s stock into more than one share • stockbroker: a person who links buyers and sellers of stock

Key Terms, cont. • brokerage firm: a business that specializes in trading stocks • stock exchange: a market for buying and selling stock • futures: contracts to buy or sell commodities at a particular date in the future at a price specified today • options: contracts that give investors the right to buy or sell stock and other financial assets at a particular price until a specified future date • call option: a contract for buying stock at a particular price until a specified future date

Key Terms, cont. • put option: a contract for selling stock at a particular price until a specified future date • bull market: a steady rise in the stock market over a period of time • bear market: a steady drop or stagnation in the stock market over a period of time • speculation: the practice of making high-risk investments with borrowed money in hopes of getting a big return

Introduction • How does the stock market work? • Stock, or shares in a company, are bought and sold on the stock market. • Stock brokers help individuals and businesses invest their money in the stock market. • Investors can keep track of the stock market by checking their local paper. When the market is doing well, people see a large return on the initial investment. When it is not doing well, people may lose a great deal of money.

Benefits of Buying Stock • Checkpoint: What are two ways that an investor can make a profit from buying stocks? • In addition to selling bonds, corporations can raise money by selling stock shares in that corporation. • The benefits of buying stock include: • Dividends—part of the firm’s profits • Capital gains—selling the stock for more than you paid for it

Types of Stock • Stock may be classified by whether or not it pays dividends. • Income stock—provides investors with income by paying dividends • Growth stock—pays few or no dividends and earnings are reinvested in the company

Types of Stock, cont. • Stock is also classified by whether or not the holder has a voice in the company: • Common stock: These holders are voting members of the company. • Preferred stock: These holders are nonvoting members of the company. • Common stock owners may initiate a stock split when the price of a stock becomes to high.

Risks of Buying Stock • Buying stock is risky because the dividends are determined by how well a company is doing. • Because of the laws governing bankruptcy, stocks are riskier than bonds since bondholders are paid before stockholders when a company goes bankrupt.

How Stocks are Traded • If you want to buy stock, you would first contact a stockbroker to advise you on which stocks to buy. • You buy stocks on a secondary market known as a stock exchange. • The New York Stock Exchange is the country’s largest and most powerful exchange, handling stock and bond transactions for the top companies in the United States and the world. • The Nasdaq is the second largest securities market and the largest electronic market.

Futures and Options • Futures are contracts to buy or sell commodities at a particular date in the future at a specified price today. • Similarly, options are contracts that give investors the choice to buy or sell stock and other financial assets. • Most people who buy stock hold their investment for a significant period of time. • Day traders, on the other hand, trade stocks daily, which is very risky.

Chapter 11: Financial Markets Opener