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Chapter 11Chapter 11
Financial Markets and Financial Markets and InvestingInvesting
InvestingInvesting Investing – the act of Investing – the act of
redirecting resources from redirecting resources from consumption today so that consumption today so that they may create additional they may create additional benefits in the futurebenefits in the future
Investment sacrifices spending Investment sacrifices spending today to have more in the today to have more in the futurefuture
SavingSaving In the end, saving your In the end, saving your
money is really lending it to money is really lending it to othersothers
The people you place your The people you place your money with are called money with are called financial intermediaries – financial intermediaries – they channel funds from they channel funds from savers to borrowerssavers to borrowers
Types of Financial Types of Financial IntermediariesIntermediaries
Banks, S&Ls, and Credit Banks, S&Ls, and Credit Unions – take deposits and Unions – take deposits and loan out the moneyloan out the money
Types of IntermediariesTypes of Intermediaries Mutual Funds – take the Mutual Funds – take the
savings of many individuals savings of many individuals and place them in a variety of and place them in a variety of stocks and bondsstocks and bonds
Life Insurance Companies – Life Insurance Companies – collect premiums (fees) from collect premiums (fees) from many savers, and guarantee many savers, and guarantee financial protection to family financial protection to family members who lose someonemembers who lose someone
Types of IntermediariesTypes of Intermediaries
Pension Funds – collect funds from Pension Funds – collect funds from many employees, then pay pensions to many employees, then pay pensions to employees who retireemployees who retire These funds usually invest the money paid These funds usually invest the money paid
inin 401(k) – Retirement account where you 401(k) – Retirement account where you
save and invest part of your paychecksave and invest part of your paycheck Employers will usually match what you put Employers will usually match what you put
in, to a certain pointin, to a certain point
Sharing RiskSharing Risk
It’s a bad idea to place all of It’s a bad idea to place all of your financial faith in one place your financial faith in one place – you might lose everything!– you might lose everything!
Diversification – spreading out Diversification – spreading out investments to reduce riskinvestments to reduce risk
Typical Risk ModelTypical Risk Model
0
10
20
30
40
50
60
70
80
20 40 60
Stocks
Bonds
Banks
Other Key TermsOther Key Terms Portfolio – collection of financial Portfolio – collection of financial
assetsassets Prospectus – an investment Prospectus – an investment
report provided by your report provided by your intermediaryintermediary
Liquidity – the ease with which Liquidity – the ease with which you can convert assets into cashyou can convert assets into cash
Return – money you make on the Return – money you make on the investmentinvestment
Return vs. LiquidityReturn vs. Liquidity Many times, investment Many times, investment
decisions depend on what decisions depend on what you value more of the twoyou value more of the two
Assets that can become cash Assets that can become cash easily often have a low returneasily often have a low return
Assets that have a high Assets that have a high return are difficult to convert return are difficult to convert into cash quicklyinto cash quickly
Return vs. RiskReturn vs. Risk
Assets that have a high Assets that have a high potential return are usually potential return are usually very riskyvery risky
Assets that have low risk Assets that have low risk usually provide a low usually provide a low potential returnpotential return
BondsBonds
Bond – a piece of paper Bond – a piece of paper signifying a loan given to the signifying a loan given to the government or a corporationgovernment or a corporation
Bonds pay the investor (or Bonds pay the investor (or lender) a fixed interest rate lender) a fixed interest rate for a certain amount of timefor a certain amount of time
Generally low risk, low returnGenerally low risk, low return
3 Components of Bonds3 Components of Bonds Coupon Rate – interest rate the Coupon Rate – interest rate the
bond issuer will paybond issuer will pay Maturity – the time at which Maturity – the time at which
payment to the bondholder is due payment to the bondholder is due (usually 10 to 30 years)(usually 10 to 30 years)
Par Value – the amount the Par Value – the amount the investor pays to purchase the investor pays to purchase the bond, to be paid back upon bond, to be paid back upon maturitymaturity
Bond RatingsBond Ratings Standard & Poor’s and Moody’s Standard & Poor’s and Moody’s
rate bonds based on their rate bonds based on their assessment of the issuer’s ability assessment of the issuer’s ability to repay the loanto repay the loan Letter grade system: AAA is best, Letter grade system: AAA is best,
D means company is in defaultD means company is in default Higher risk bonds usually offer a Higher risk bonds usually offer a
higher interest ratehigher interest rate
That’s all well and good, but how do bonds
work?
How Bonds WorkHow Bonds Work
2 different ways2 different waysCorporate bonds, treasury Corporate bonds, treasury bonds, and municipal bondsbonds, and municipal bondsPay you the % interest of Pay you the % interest of the bond each year, then the bond each year, then give you the par value at give you the par value at maturitymaturity
How Bonds WorkHow Bonds Work
2 different ways2 different waysSavings bondsSavings bonds
Bond grows in value over Bond grows in value over time and can be redeemed time and can be redeemed for twice the value at for twice the value at maturitymaturity
Types of BondsTypes of Bonds
Savings Bonds – issued by the Savings Bonds – issued by the U.S. government to finance U.S. government to finance their debttheir debt
Treasury Bonds – like a Treasury Bonds – like a corporate bond from the U.S. corporate bond from the U.S. government, and tax freegovernment, and tax free
Types of BondsTypes of Bonds Municipal Bonds – issued by the city Municipal Bonds – issued by the city
to pay for parks or libraries, etc. to pay for parks or libraries, etc. Corporate Bonds – cannot guarantee Corporate Bonds – cannot guarantee
repayment, but have a higher repayment, but have a higher interest rate than U.S. gov’t bondsinterest rate than U.S. gov’t bonds Junk Bonds – Higher risk, higher Junk Bonds – Higher risk, higher
return corporate bonds (rated BBB return corporate bonds (rated BBB or lower)or lower)Still lower risk than most stocks, Still lower risk than most stocks, thoughthough
With Members of the U.S. With Members of the U.S. CongressCongress
How do you Profit?How do you Profit? 2 Ways to Profit:2 Ways to Profit:
Dividends – some corporations Dividends – some corporations pay part of their profits out to pay part of their profits out to stockholders quarterly (4 times stockholders quarterly (4 times a year)a year)
Capital Gains – selling the stock Capital Gains – selling the stock for more than you paid for itfor more than you paid for it
How do you Profit?How do you Profit? If you are interested in receiving If you are interested in receiving
dividends, you should buy dividends, you should buy income stockincome stock
If you’re more interested in If you’re more interested in capital gains, you should buy capital gains, you should buy growth stockgrowth stock – pays no dividend – pays no dividend
Stock SplitStock Split Companies can decide to split Companies can decide to split
stocks – double the number of stocks – double the number of shares, while cutting their shares, while cutting their value in halfvalue in half
50 shares worth $20 each 50 shares worth $20 each becomes 100 shares worth becomes 100 shares worth $10 each$10 each
In both situations, the stock is In both situations, the stock is worth a total of $1,000worth a total of $1,000
How do you buy Stock?How do you buy Stock? Must go through Must go through
a brokerage firm a brokerage firm – they are – they are licensed by the licensed by the SEC to conduct SEC to conduct stock tradesstock trades Stockbroker – a Stockbroker – a
person who links person who links buyers and buyers and sellers of stocksellers of stock
Examples of Brokerage Examples of Brokerage FirmsFirms
Examples: Charles Examples: Charles Schwab, Edward Schwab, Edward Jones, Merrill Lynch, Jones, Merrill Lynch, Smith Barney, AIGSmith Barney, AIG
Online Brokerages: Online Brokerages: TD Ameritrade, TD Ameritrade, Scottrade, ETrade, Scottrade, ETrade, Fidelity (do it Fidelity (do it yourself, but reduced yourself, but reduced commission)commission)
Stock ExchangesStock Exchanges
Stock Exchange – market for Stock Exchange – market for buying and selling stockbuying and selling stock
Newspapers and websites publish Newspapers and websites publish information on what happens in information on what happens in the major stock exchangesthe major stock exchanges
Major Stock ExchangesMajor Stock Exchanges
New York Stock Exchange New York Stock Exchange (NYSE) – largest and most (NYSE) – largest and most powerful companiespowerful companies
NASDAQ – specializes in tech NASDAQ – specializes in tech companies, usually higher companies, usually higher risk than NYSErisk than NYSE
Major Stock ExchangesMajor Stock Exchanges The OTC Market – “over the The OTC Market – “over the
counter”counter” Not an actual stock exchangeNot an actual stock exchange Traded through an electronic Traded through an electronic
marketplacemarketplace Mostly new and growing Mostly new and growing
companiescompanies Most stocks traded this wayMost stocks traded this way
Futures and OptionsFutures and Options Futures – contracts to buy or Futures – contracts to buy or
sell a particular commodity sell a particular commodity on a specific date in the on a specific date in the future at a price set todayfuture at a price set today
Investors may buy futures Investors may buy futures now, hoping the price of the now, hoping the price of the commodity will rise before commodity will rise before they must sell itthey must sell it
Futures and OptionsFutures and Options Options – contracts that give Options – contracts that give
investors the choice to buy or investors the choice to buy or sell stock and other financial sell stock and other financial assets LATER for TODAY’S assets LATER for TODAY’S pricepriceCall Option – choice to buyCall Option – choice to buyPut Option – choice to sellPut Option – choice to sell
Measuring Stock Measuring Stock PerformancePerformance
““Bull Market” – stock market Bull Market” – stock market is rising steadilyis rising steadily
““Bear Market” – stock market Bear Market” – stock market is fallingis falling
1980’s and 1990’s were the 1980’s and 1990’s were the longest sustained bull longest sustained bull markets in U.S. historymarkets in U.S. history
The Dow Jones Industrial The Dow Jones Industrial AverageAverage
Shows the Shows the performance of 30 performance of 30 stocks from stocks from various industries various industries as a representation as a representation of the whole of the whole marketmarket
What is the deal with the
Dow?
The S&P 500The S&P 500
Just like the Dow Jones, but Just like the Dow Jones, but uses 500 different companiesuses 500 different companies
Mostly NYSE stocks, but also Mostly NYSE stocks, but also some from NASDAQ-AMEX some from NASDAQ-AMEX and OTCand OTC