Financial MarketsChapter 11

SAVING AND INVESTINGSection 1

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.

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.

Return and Risk• Some investments, like CDs, are very

safe because they are insured by the government.

• Investing in a new business is far 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.

BONDS AND OTHER FINANCIAL ASSETS

Section 2

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.

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 & 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.

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 Markets, 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.

THE STOCK MARKETSection 3

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• 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.

Measuring Stock Performance• When the stock market rises steadily

over a period of time it is known as a bull market.

• When the stock market falls or stagnates for a significant period it is a bear market.

• The Dow Jones Industrial Average measures stock performance. It represents the average value of a particular set of stocks, and it is reported as a certain number of points.

The Great Crash• In the 1920s, the stock market was soaring.

– Speculation and buying on margin, however, led to a crash in the market that crippled the U.S. economy.

• The Dow began steadily dropping in September, 1929. People began to sell their shares and companies couldn’t keep up with it. On October 29, 1929, a record 16.4 million shares were sold and the market crashed

The Aftermath• The Crash led to the Great Depression.

– Many people lost everything—their homes, their jobs, and their farms.

• After the Depression, many people saw stocks as risky investments and avoided them.

• By the 1980s, with the development of mutual funds, Americans became more comfortable with stock ownership once again.– The stock market crashed again in 1987 but was

able to recover much faster than in did in 1929.

Scandals & the Stock Market Today• By the 1990s, when people began once again

to buy more stock, investors started to worry that many companies could not make enough money to justify their high stock prices.

• The Enron scandal and others caused many investors to question how much they knew about the companies they invested in.

• In 2008, the stock market began falling, causing a major economic crisis in the United States once again.