Ch. 11: Financial Markets

1. Ch. 11: Financial Markets

2. Sec. 1: Savings and Investment

3. The Financial System • Savings – • Investments – is the use of income today in a way that allows for a future benefit • Economic investment – • Personal investment – refers to the act of individuals putting their savings into financial assets – CDs, stocks, bonds or mutual funds • putting money into a savings account • you benefit – earn interest • others benefit – funds available to lend • Financial system –

4. Bringing Savings and Investment Together • Individuals and businesses can save surplus funds in many ways • Savings accounts at commercial banks/S & Ls, certificates of deposit, corporate or govt. bonds, stocks • agent receiving funds is a borrower • issues savers written confirmation of transaction • Financial asset –

5. Bringing Savings and Investment Together • Financial market – • Financial intermediary – is a financial institution that collects funds from savers and then invests these funds in loans and other financial assets • bring savers, borrowers, and financial assets together – see figure 11.1

6. Financial Intermediaries • Bring savers & investors together • One group – • other financial intermediaries – • finance companies – make small loans • pension funds – • life insurance companies –

7. Financial Intermediaries • Mutual fund – • investors own shares of the entire fund based on the amount invested • gather money in different ways & provide many different financial assets to a variety of investors

8. Example: Banking Financial Intermediaries • Includes commercial banks, S & Ls, & credit unions • provide checking and saving accounts - depositors earn interest on both in some cases • most offer CDs & money market deposits accounts that have higher interest rates • federal govt. insures deposits up to $250,000 per depositor in any given bank

9. Example: Banking Financial Intermediaries • Lend a portion of their deposits to borrowers • banks charge a higher interest rate to pay back savers & make a profit • if borrower does not pay back loan – • Can also offer other financial assets – • federal govt. does not insure these funds

10. Example: Nonbank Financial Intermediaries • Includes – • finance companies make loans to households & small businesses • loans generally under $2000 & paid back in monthly installments with interest • Mutual fund pools money from many personal investors • each investor receives shares in a fund made up of a large # & variety of stocks, bonds, or other financial assets • make it more affordable for individual investors to own a wide variety of financial assets • once investors purchase a share of funds –

11. Example: Nonbank Financial Intermediaries • Pension funds allow employees to save money for - • then invests pooled contributions in various financial assets that will increase in value • Life insurance companies allow - • Companies lend or invest some of the income earned from policyholders in a variety of financial assets

12. Financial Asset Markets-categorize markets based on 2 factors time – how long the loan is for whether the financial assets can be resold Primary market – Secondary market – • Capital market – • Money market –

13. Factor 1: Time-2 time sensitive market • Capital markets – • ex of assets – • b/c loans are for longer periods - money may be invested in projects that require large amounts of capital • building homes, building new factories, financing govt. projects • Money markets - • ex of assets – short term CDs that can be redeemed in a few months & treasury bills (allow govt. to borrow money for short periods)

14. Factor 2: Resalability • 2 markets based on whether financial assets can be resold • Primary markets are for financial assets that can be redeemed only by the original buyer • ex – • also refers to market where the 1st issue of a stock is sold to the public through investment bankers • Secondary markets are resale markets for financial assets • offer liquidity to personal investors • investors able to turn assets into cash relatively quickly • ex –

15. Sec. 2: Investing in a Market Economy Investment objective – *ex – *goals help -

16. Investment Objective • 2 issues will help determine which investment will help achieve objective • Time – • amount of time influences kind on investment is most appropriate • Income – • leads to other questions: • Will income change in the future? • Money available for emergencies?

17. Need a savings plan that is realistic & flexible enough to adjust to changing circumstances • other questions: • Do you have outstanding debts? • Are you paying taxes on time?

18. Paying off debts first step to investing • generally – • Tax considerations most important to investors with higher incomes subject to higher tax rates • Saving for emergencies – • Saving for vacation – • Long term goals – • CDs – timing with major purchases or starting college • bonds from state & local govt. offer tax free earnings

19. Economic Pacesetters: Mellody Hobson: Investing in the Future • Pres. of Ariel Capital Management, LLC – b. April 3, 1969 • discovered her career investing as a college intern • received degree in 1991 & position in marketing department of Ariel Capital Management • In 2000 – became pres. of the company • runs an operation with over $21 billion in assets

20. Ariel was first minority owned mutual fund company in the country • pioneers programs to teach inter-city kids about investing • she give presentations about investing • Developed 1st study of investing by African-Americans & looked for ways to increase participation • marketing efforts – events with Chicago Bulls & a stock picking contest with hip-hop artists • In 2000 – became financial contributor to the Good Morning America show • able to reach millions with easy to understand info about economic matters

21. Risk and Return • Risk – • Return – • can be interest paid on savings account, CD, or increase in value of stock over time • most saving are insured against a loss – an investments are not • investors try to balance risk & return through diversification • Diversification –

22. What Kind of Risk Are You Willing to Take? Low Risk higher risk – stocks & corporate bonds – return depends on how profitable the company is Purchase with expectation that value will appreciate but could lose money if company runs into problems or other econ. factors investors than may not be able to sell stock for what they paid – corporate bonds hold similar risk – bond holders are paid off before stockholders if company has financial problems • Investor & risk – • even if not get a lot – • investments that guarantee no loss of principal: insured savings deposits & CDs • bonds backed by US govt. are considered risk-free • highly unlikely the govt. would not pay back loans • all other investments carry some risk

23. What Kind of Return Do You Want? • With investments – • Safest investment – • stocks & bonds are not guaranteed and returns vary at different time • depends on economy as a whole, how well the company is performing • do have a higher return over time then other investments

24. What Kind of Return Do You Want? • Risks & returns are directly related – • investors want highest return possible – • time & income become important • Investing for retirement in 20-30 years – • less time and lower income will be less risky • Diversification is best way to minimum risk and maximize return • ex – 70% in stocks, 20% in bonds, 10% in CDs – retirement investing • better chance of off-setting losses from one investment with gains from another • Mutual funds help small investors diversify their investments

26. Sec. 3: Buying and Selling Stocks

27. The Stock Market • Company 1st issues stock – sold to investment bankers in the primary market • called an initial public offer (IPO) – • stock then resold to investors through a stock exchange • Stock exchange – • most buy stock as financial investment with expectation that price will rise then they will be able to resell for a profit • Capital gains –

28. Why Buy Stock? • Investor buy stock for 2 reasons: • 1. To earn dividend payments – • 2. Earn capital gains by selling the stock at a price greater than the purchase price • if sold below buying price – • if investor wants income – • if investor wants to see investment grow –

29. Why Buy Stock? • Investing in stocks carries higher risk – • corporations not required to pay dividends – • no guarantee that stock price will be higher when investor wants to sell

30. Types of Stock -2 types of stock – common stock – preferred stock – Holders of preferred receive guaranteed dividends & paid before common stockholders is company is liquidated Holders of preferred have no voting rights & dividends do not increase if stock increases in value • Both types give ownership in corporation – can receive dividends • Holders of common get one vote per share owned to elect board of directors

31. Trading Stock • Most invest in stock with goal of earning capital gains when they sell it • stock prices determined by supply & demand • things affecting stock prices: • company profit or losses • technological advances that affect company or industry • overall state of economy

32. Trading Stock • If investor perceive that company value will increase – demand for stock ↑ & price ↑ • as price rises – • few companies sell directly to an investor • Stockbroker – • also called brokers generally work for brokerage firms • interact with customers in person, phone or online • job – • buy & sell on a variety of stock exchanges

33. Organized Stock Exchanges • New York Stock Exchange (NYSE) – • located on Wall Street in NY City – • about 1.5 billion shares of 2,800 of largest companies in US traded each day • brokerage firms pay for privilege of being one of 1,336 members of exchange • Smaller American Stock Exchange (AMEX) located in NYC • trading structure similar to NYSE – • 2006 – introduced practice to combine floor & electronic trading

34. Organized Stock Exchanges • Traditionally trading organized in auction format • each stock had specific location of trading post on the floor • Specialist representing that stock ran the auction to match buyers & sellers though open bidding to determine the price of shares • prices vary from minute to minute as auction continues through the day • since 1996 – floor trades use hand held computers to execute trades • more than half of order to buy & sell are done electronically • 2006 – NYSE merged with Archipelago Exchange(electronic trading company) – to speed up transactions & trade stocks in electronic markets

35. Electronic Markets • Over-the-counter (OTC) – • 1970 – National Association of Securities Dealers (NASD) introduce centralized computer system that allows OTC traders around the country to make trades at best prices possible • automated quote system called NASDAQ • 2005 – • companies covers many sectors – but most are technology • NASD also regulates OTC Bulletin Board as an electronic market for trading shares in companies too small to be traded on NASDAQ

36. Futures and Options Markets • Complicated and high risk investments that involve trying to predict the future • Future – • investor who wants to buy in futures wants to lock in a low price • investor who wants to sell in futures wants to lock in a high price • Option – • the investor pays a small fraction of a stock’s current price for the option to buy or sell the stock at a better price in the future

37. Recent Developments • Late 1990s – • stocks listed on any exchange available to any trading firm • growth of electronic communication networks (ECN) increased electronic stock trading • trading now takes place 24 hrs a day – not just when the exchanges are open • many investors have internet access and are more knowledgeable about trading • huge growth in online brokerages • investors can trade at any time and pay lower commissions • combines rapid trades and best possible prices

38. Measuring How Stocks Perform About half of all US households now own stock Stock index – an instrument used to measure and report change in prices of a set of stocks Measure the performance – of many individual stocks & the stock market as a whole

39. Stock Indexes - each index measures the performance of a different group of stocks provide a snapshot of how the stock market is performing global stock indexes – Hang Seng Index – Hong Kong The DAX – Nikkei 225 – Japan TSE 300 – FTSE 100 – Britain • The Dow – • Standard & Poor’s 500 – • The NASDAQ Composite

40. The Dow Jones Company the DJIA is a price index Measures changes in the prices at which stocks are traded original DJIA was the actual average of the prices of the 12 stocks Now – the average is weighted so the higher priced stocks have more influence on the average the # quoted is not a price – but an average measured in points not dollars • Publisher of Wall Street Journal – 1st published the DJIA in 1896 • only had 12 companies and reflected agriculture & mining • Since 1928 – the Dow has included 30 companies – General Electric is only 1 of original companies left • US economy has changed from agriculture to industry to service – companies in the index change to reflect the most successful companies in most important sectors • called blue chip stocks

41. Tracking the Dow • Changes in the Dow reflect trends in stock market prices • Bull market – • Bear market – • track the market to determine if market is trending toward bull or bear

42. the 1st DJIA measure was 40.94 well known bear market followed the Stock Market Crash of 1929 During the 20s – the Dow rose from 60 to 381.17 in month after Oct 29, 1929 – dropped to a low of just under 199 next closing price of 400 was Dec. 29, 1954 • In 1972 it reached 1,000 for the 1st time • In May 1999 – it topped 11,000 for the 1st time – topped out at 11,722.98 on Jan 14, 2000 – ended longest bull market in history • during the 1990s – market climbed from 2,800 to its peak • most bull markets last 2 or 3 years

43. Sec. 4: Bonds and Other Financial Instruments

44. Why Buy Bonds? • Bond – • govt. can also issue bonds • Par value – the amount that the bond issuer promises to pay the buyer at maturity • Maturity – • Coupon rate – is the interest rate a bondholder receives every year until a bond matures

45. 2 reasons to invest in bonds – • 1. • 2. • Most people buy bonds for the interest • bonds considered less risky b/c holders are paid before stockholder

46. Yield – • important to determine this when deciding whether to buy or sell • if sold at par value – • if sold for less than par value – yield higher than coupon rate • if demand strong & price is higher than par value – • Generally – • why? – more uncertainty and risk involved with repayment dates that are farther in the future

47. Type of Bonds • Many different kinds of bonds • like stocks – higher the risk – • classified by who issues the bonds