CHAPTER 16 Stocks and Bonds. SECTION 1 Stocks Financial Markets Stocks and bonds are bought and sold in a financial market. Financial markets channel

CHAPTER 16

Stocks and Bonds

SECTION 1

StocksFinancial Markets

Stocks and bonds are bought and sold in a financial market.

Financial markets channel money from some people to other people.

• They bring together people that have money to invest with other people who would like to start a new company or expand an existing one.

What Are Stocks?

A stock is a claim on the assets of a corporation that gives the purchaser a share of the corporation.

Where Is Stock Bought and Sold?

Stocks are bought and sold through these venues:

• The New York Stock Exchange (NYSE)

• Stock brokers over the phone, in person, or online

• Other stock exchanges, such as the American Stock Exchange (AMEX) and the National Association of Securities Dealers Automated Quotations (NASDAQ)

• NASDAQ is an electronic stock market where trades are executed through a sophisticated telecommunications network

Americans can also buy and sell stock in foreign exchanges and markets.

The Dow Jones Industrial Average (DJIA)

The Dow Jones Industrial Average (DJIA) is the most popular, most widely cited indicator of day-to-day stock market activity. The DJIA is a weighted average of 30 widely traded stocks on the New York Stock Exchange.

Why did Charles Dow create the DJIA?

• Answer: To tell people something about what was really happening in the market. At the time he created it, people were suspicious of the stock market so he wanted to create a way to keep people informed about more than just individual stocks.

Thirty stocks currently make up the DJIA. The list changes from time to time, as determined by the editors of the Wall Street Journal.

In addition there are other commonly cited stock indices in the U.S. including the NASDAQ Composite, the Standard & Poor’s 500 and the Wilshire 5000.

The 30 Stocks of the Dow Jones Industrial Average

How the Stock Market Works

If a company wants to raise money, it has three sources:

(1) borrowing from a bank

(2) issuing bonds

(3) selling or issuing stock in the company

An initial public offering (IPO) is a company’s first offering of stock to the public.

Typically, an investment bank acts as an intermediary between the company that issues the stock and the public that wishes to buy the stock.

People buy a particular stock if they think that the earnings of the company are likely to rise.

Remember that a share of stock represents ownership in the company. The more profitable the company becomes, the greater the demand for the stock of that company.

Why Do People Buy Stock?

Millions of people, in countries all over the world, buy stock every day.

Some people buy stocks for the dividends, which are payments made to stockholders based on a company’s profits.

Another reason to buy stocks is for the expected gain in price.

People also sell stock for many reasons, including paying for college expenses, helping finance a house, or because they expect the price of the stock to go down in the future.

How to Buy and Sell Stock

Buying and selling stock is relatively easy.

You can buy or sell stock through brokerage firms, or online.

An account can usually be opened by depositing a certain amount of money, typically between $1,000 and $2,500.

With a full-service broker, you may call your broker and ask for recommendations, and he or she will place an order to purchase the stocks you desire.

If you do not require help to buy stocks you can go to either a discount broker or to an online broker.

Deciding Which Stocks to Buy

One way to buy stocks is to purchase shares of companies that are familiar to you, such as Coca Cola, Disney, or Microsoft.

Mutual funds are a commonly used method of investing in stocks. A mutual fund is a collection of stocks managed by a fund manager. Several hundred people often own shares in each mutual fund. It is up to the fund manager to do what she or he thinks is best to maximize the overall returns from the fund.

Another strategy for buying stocks is to buy the stocks that make up a stock index. An index is a portfolio of stocks, which represents a particular market or a portion of it, used to measure changes in a market or an economy. The DJIA is a stock index.

How to Read the Stock Market Page

The newspaper is a good source for stock prices. Most stock price listings contain the same components.

• “52W high” is the highest price of the stock during the past year, or the past 52 weeks.

• “52W low” is the lowest price of the stock during the past 52 weeks.

• The “Stock” column provides an abbreviated name of the company.

• The “Ticker” column contains the stock or ticker symbol for the company.

• In the “Div” column you will find the amount of the last annual dividend.

• “Yield %” is the dividend divided by the closing price.

• “P/E” is the price-earnings ratio, and is obtained by taking the latest closing price per share and dividing it by the latest available net earnings per share. A high PE ratio usually indicates that people believe the stock will experience higher than average growth in earnings.

• “Vol 00s” is the volume, in this case represented in hundreds, of shares that were bought and sold on that particular day.

• “High” is the high price the stock traded for on that day.

• “Low” is the low price the stock traded for on that day.

• “Close” is the share price of the stock when trading stopped that day.

• “Net chg” is the difference between the current closing price and the previous day’s closing price.

Stock Quotes

SECTION 2

Bonds

What Is a Bond?

A bond is an IOU, or a promise to pay, issued by companies, governments, or government agencies to borrow money.

The Components of a Bond

The face value, or par value, of a bond is the dollar amount specified on a bond. It is the total amount the bond issuer will repay to the bond buyer.

The maturity date is the day when the bond issuer must pay the bond buyer the face value of the bond.

The coupon rate is the percentage of the face value that the bondholder receives each year until the bond matures.

Bond Ratings

The more likely the bond issuer will pay the face value of the bond at maturity and will meet all scheduled coupon payments, the higher the bond’s rating.

Two of the best-known rating agencies are Standard & Poor’s and Moody’s.

A bond rating of AAA from Standard & Poor’s or a rating of Aaa from Moody’s is the highest rating possible.

• Bonds rated in the B to D category are lower-quality bonds that may be in jeopardy of being in default (the issuer cannot pay off the bond)

Bond Prices and Yields

The price that a person pays for a bond depends on market conditions.

The yield on a bond is equal to the annual coupon payment divided by the price paid for the bond.

• For example, if you pay $985 for a bond with a face value of $1,000, and the annual coupon payment is $40, the bond yield is 4.06 percent.

• The yield on bonds can also be referred to as the “interest rate”

Write this formula in your notes!!!

Types of Bonds

A corporate bond is issued by a private corporation. Corporate bonds typically have $10,000 face values. Corporate bonds may sell for a price above or below the face value depending on current supply and demand conditions for the bond. The interest that corporate bonds pay is fully taxable.

Municipal bonds are issued by state and local governments. Municipal bond interest is not subject to federal taxes.

Treasury bills (T-bills), notes, and bonds are issued by the federal government. The only difference between them is their time to maturity. Treasury bills mature in 13, 26, or 52 weeks. Treasury notes mature in 2 to 10 years, and Treasury bonds mature in 10 to 30 years. They are considered safe investments because the government is unlikely to default.

A new issue for the federal government is inflation-indexed bonds. The government will increase the coupon payment to match inflation.

Risk and Return

Stocks and bonds often come with different risk and return factors.

Treasury bonds often pay relatively low returns because they carry the least risk.

What Would Life Be Like Without Financial Markets?

In a world of financial markets, people with good ideas can be matched with people who have saved money that they would like to invest. The result is that society produces more goods and services than it would otherwise.

Applying the Principles (Stocks)

1. What are dividends?

DIVIDENDS ARE PAYMENTS MADE TO STOCKHOLDERS BASED ON A COMPANY’S PROFITS.

2. If you own 100 shares of company A and company A pays an annual dividend of $1.32 per share, how much would you receive in dividend payments for the year?

YOU WOULD RECEIVE $132 (100 x $1.32 = $132) FOR THE YEAR.


3. The dividend for a stock is listed as 1.43. What does this mean?

IT MEANS THAT THE LAST ANNUAL DIVIDEND PER SHARE OF THE STOCK WAS $1.43. IT FOLLOWS THEN, THAT A PERSON WHO OWNS 100 SHARES OF STOCK WOULD HAVE RECEIVED $143 IN DIVIDENDS.

4. If the closing price of a stock is $53.48 and its dividend is $1.22, what is the yield? (Yield should be written as a percentage rounded to the second decimal place)

THE YIELD IS THE DIVIDEND PER SHARE DIVIDED BY THE CLOSING PRICE PER SHARE: $1.22 / $53.48 = 2.28%.


5. Which stock has the highest yield?

PEPSICO – 3.30%

6. If you bought 100 shares of Sirius Satellite Radio at the highest price for the year and sold it at the lowest price for the year, what was your capital loss? Explain.

THE HIGHEST PRICE FOR THE YEAR WAS $3.89 AND THE LOWEST PRICE FOR THE YEAR WAS $0.08.

THE CAPITAL LOSS WAS $381.

• $0.08 - $3.89 = $-3.81

• $-3.81 x 100 = $-381


7. If you bought 100 shares of Best Buy at the lowest price for the year and sold it at the closing price on February 6, what was your capital gain? Explain.

THE LOWEST PRICE FOR THE YEAR WAS $16.42 AND THE CLOSING PRICE WAS $29.84. THE CAPITAL GAIN WAS $1,342.

• $29.84 - $16.42 = $13.42

• $13.42 x 100 = $1,342


8. If you bought 100 shares of Google at the lowest price for the year and sold it at the highest price for the year, what was your capital gain/loss? Explain.

THE LOWEST PRICE FOR THE YEAR WAS $247.30 AND THE HIGHEST PRICE FOR THE YEAR WAS $602.45. THE CAPITAL GAIN WAS $35,515.

• $602.45 - $247.30 = $355.15

• $355.15 x 100 = $35,515


9. How many shares of Microsoft traded on Friday, February 6?

86,717,800 SHARES

10. What was the closing price of Pepsico on Thursday, February 5?

PEPSICO CLOSED $1.18 HIGHER ON FRIDAY THAN IT DID THE DAY BEFORE. SO THE CLOSING PRICE OF PEPSICO ON THURSDAY WAS $53.53 - $1.18 = $52.35.


11. If you have owned 100 shares of Kellogg for a year, how much money did you receive in dividend payments last year?

$136 ($1.36 PER SHARE x 100 SHARES)

12. If you owned 200 shares of Wal-Mart, how much would you expect to receive in dividend payments this year?

$190 ($0.95 PER SHARE x 200 SHARES)


13. What might you conclude about Sirius, which has a closing price but does not have a PE ratio?

BECAUSE THE PE RATIO IS CALCULATED BY DIVIDING THE CLOSING PRICE PER SHARE BY THE NET EARNING PER SHARE, SIRIUS MAY NOT HAVE ANY NET EARNINGS.

14. What is Wal-Mart's PE ratio and what does it mean?

WAL-MART’S PE RATIO IS 14. THIS MEANS THAT THE SHARE PRICE OF WAL-MART STOCK IS 14 TIMES ITS EARNINGS PER SHARE. IN OTHER WORDS, INVESTORS ARE WILLING TO PAY $14 FOR EVERY $1 OF LAST YEAR’S EARNINGS.


15. What does Google’s relatively high PE ratio signify?

IT SIGNIFIES THAT THE PEOPLE WHO ARE BUYING GOOGLE STOCK TODAY (AT A SHARE PRICE OF 28 TIMES SHARE EARNINGS) BELIEVE THAT THE FUTURE GROWTH OF GOOGLE WILL WARRANT THE RELATIVELYL HIGH PRICE (OVER EARNINGS) THEY ARE CURRENTLY PAYING.

16. Why are people willing to buy stock with a high PE ratio?

A STOCK WITH A HIGH PE RATION MAY NOT BE A GOOD VALUE BASED ON CURRENT EARNINGS, BUT IF THE COMPANY GROWS AT A FAST RATE, THE STOCK MAY PROVE TO BE A GOOD INVESTMENT IN THE FUTURE.

Applying the Principles (Bonds)

What are the three ways a company can raise money?

TAKING OUT A LOAN FROM A BANK

ISSUING STOCK

ISSUING BONDS

What is a bond?

A BOND IS AN IOU, OR A PROMISE TO PAY, ISSUED BY COMPANIES, GOVERNMENT OR GOVERNMENT AGENCIES FOR THE PURPOSE OF BORROWING MONEY

Applying the Principles (Bonds)Component: FACE VALUE

Description: THE FACE VALUE OF A BOND IS THE TOTAL AMOUNT THE ISSUER OF THE BOND WILL REPAY TO THE BUYER OF THE BOND.

Component: MATURITY DATE

Description: THE MATURITY DATE OF A BOND IS THE DAY WHEN THE ISSUER OF THE BOND MUST PAY THE BUYER OF THE BOND THE FACE VALUE OF THE BOND.

Component: COUPON RATE

Description: THE COUPON RATE OF A BOND IS THE PERCENTAGE OF THE FACE VALUE THAT THE BONDHOLDER RECEIVES EACH YEAR UNTIL THE BOND MATURES.


Elena pays $10,000 for a bond with a face value of $10,000 and a coupon rate of 6 percent. Scott buys a bond for $9,500. The face value of the bond is $10,000 and the coupon rate is 6 percent.

Elena will receive a coupon payment of $600 (10,000 x .06) each year.

When the bond matures, Elena will receive $10,000 (face value) from the issuer of the bond.

The yield that Elena will receive on the bond is 6.00% (coupon payment of $600 / the price she paid of $10,000 then move the decimal two places to the right to make a percentage).

If the maturity date is five years from the day Elena buys the bond, she will earn a total of $3,000 (coupon payment x 5 years) on her investment.



Scott will receive a coupon payment of $600 (10,000 x .06) each year.

The yield that Scott will receive on the bond is 6.31% ($600 / $9,500).

When the bond matures, Scott will receive $10,000 (face value) from the issuer of the bond.

If the maturity date is five years from the day Scott buys the bond, he will earn a total of $3,500 (coupon payment x 5 years + $500 because he paid less than the face value) on his investment.



Both Elena and Scott bought bonds with face values of $10,000, coupon rates of 6 percent, and maturity dates five years from the date of purchase. Scott will earn $500 MORE on his investment than Elena will earn on her investment because he paid $500 LESS than the face value of the bond.


What is the main difference among corporate bonds, municipal bonds, and treasury bills?

THE MAIN DIFFERENCE IS THAT CORPORATE BONDS ARE ISSUED BY PRIVATE CORPORATIONS, MUNICIPAL BONDS ARE ISSUED BY STATES AND LOCAL GOVERNMENT, AND TREASURY BILLS ARE ISSUED BY THE FEDERAL GOVERNMENT.

Which type of investment, stocks or bonds, is riskier? Why?

AN INVESTMENT IN STOCKS IS RISKIER THAN AN INVESTMENT IN BONDS BECAUSE STOCKS CAN FALL IN VALUE AND BONDS (ESPECIALLY GOVERNMENT BONDS) WILL LIKELY BE PAID OFF.


What is the relationship between the returns and the risks of various investments?

HIGHER RETURNS COME WITH HIGHER RISKS AND LOWER RETURNS COME WITH LOWER RISKS.

If a person wants high returns from investments and is willing to take high risks, he or she would likely invest mainly in STOCKS.

If a person wants low risk investing, she or he would likely invest mainly in BONDS.

If the yield on a 10-year Treasury bond is 4.60 percent and the yield on a 10-year corporate bond is 5.26 percent, which bond do you think would involve more risk? Why?

THE CORPORATE BOND WOULD LIKELY INVOLVE MORE RISK BECAUES THE RETURN IS HIGHER ON THE CORPORATE BOND THAN IT IS ON THE TREASURY BOND.

Documents

CHAPTER 16 Stocks and Bonds. SECTION 1 Stocks Financial Markets Stocks and bonds are bought and sold in a financial market. Financial markets channel