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Chapter Introduction Section 1: Savings and the Financial System Section 2: Financial Assets and Their Markets Section 3: Investing in Equities and Options Visual Summary
You have just been hired as a financial planner to provide advice on how to invest wisely and effectively. Miguel, your client, is a widower raising two young children. He wants to be sure that (1) he will have enough money to send his children to college, and (2) he will be financially secure in his retirement. What advice would you give Miguel? Read Chapter 11 to learn more about how people can accomplish their financial goals.
Resources are limited, so people must make choices.
Section Preview In this section, you will learn how the components of a financial system work together to transfer savings to investors.
Content Vocabulary • saving • nonbank financial institution • savings • finance company • certificate of deposit • premium • financial asset • pension • financial system • pension fund • financial intermediary • risk Academic Vocabulary • sector • compensation
Have you ever thought about what your financial goals are and what steps you need to take to reach them? A. Yes, often B. Occasionally C. Never A. A B. B C. C
Savings and the Financial System • Saving—absence of spending • Savings—dollars that are available once you abstain from consumption
Saving and Economic Growth The financial system brings savers and borrowers together and helps the economy grow.
Saving and Economic Growth (cont. ) • Saving makes economic growth possible. • Individuals save by – Opening a savings account – Purchasing a bond – Purchasing a certificate of deposit Overview of the Financial System
Saving and Economic Growth (cont. ) • Documents are given in each case showing money saved—financial assets. • The economy has a financial system to transfer savings to investors. Overview of the Financial System
Saving and Economic Growth (cont. ) • Three parts to the financial system – Funds a saver transfers to a borrower – Financial assets that certify conditions of the loan – Organizations that bring the surplus funds and financial assets together Overview of the Financial System
Saving and Economic Growth (cont. ) • Financial intermediaries—institutions that lend funds savers provide • Governments and businesses are the largest sector of borrowers. • Households and businesses are the biggest sources of funds. Overview of the Financial System
In the financial system, who really benefits? A. Savers B. Borrowers C. Everyone D. No one A. B. C. D. A B C D
Nonbank Financial Intermediaries Organizations other than banks can transfer money from savers to borrowers.
Nonbank Financial Intermediaries (cont. ) • Another group of financial intermediaries are the nonbank financial institutions. – Finance company – Life insurance companies—charge a premium – Pension fund—pays a pension to specified individuals for specific reasons Profiles in Economics: Sallie Krawcheck
Which entity would charge you a higher interest rate for your car loan? A. Bank B. Credit union C. Finance company D. Relative A. B. C. D. A B C D
Basic Investment Considerations Investors should consider several factors before investing their money.
Basic Investment Considerations (cont. ) • Before investing, consider the following – Consistency – Simplicity The Power of Compound Interest
Basic Investment Considerations (cont. ) – The risk-return relationship • Risk—degree to which outcome is uncertain but a probable outcome can be estimated – Investment objectives Risk and Return
An investment that appears too good to be true probably is worth the risk. A. True B. False A. A B. B
Section Preview In this section, you will learn about the characteristics of various investments to help with your investments.
Content Vocabulary • bond • savings bond • money market • coupon rate • beneficiary • primary market • maturity • Treasury note • secondary market • par value • Treasury bond • current yield • Treasury bill • junk bond • Individual Retirement Account (IRA) • municipal bond • tax-exempt • capital market
Academic Vocabulary • offset • presumed
What determines the price and yield of a bond? A. Risk of investment B. Supply and demand C. Current interest rates A. A B. B C. C
Bonds as Financial Assets A bond is a long-term investment, with the price determined by supply, demand, and the buyer’s assessment of repayment risk.
Bonds as Financial Assets (cont. ) • Governments and businesses issue a bond when they need to borrow funds for long periods. • Bonds have three main components: – Coupon rate – Maturity – Par value Bond Ratings
Bonds as Financial Assets (cont. ) • To compare bonds, investors compute the bond’s current yield. • Interest received and price paid determines the actual current yield of each bond. • Bond ratings are published by Standard & Poor’s and Moody’s. Bond Ratings
Bonds as Financial Assets (cont. ) • Bonds rated on – Basic financial health of the issuer – Expected ability to make future coupon and principal payments – Issuer’s past credit history • Bonds with higher ratings sell at higher prices than bonds with lower ratings. Bond Ratings
Which of the following rated bonds has the greatest risk? A. BBB or Baa B. CCC or Caa C. CC or Ca A. A B. B C. C
Financial Assets and Their Characteristics Investments include CDs, bonds, bills, and IRAs, all of which vary in cost, maturity, and risk.
Financial Assets and Their Characteristics (cont. ) • Investors today have many choices. – Certificates of deposit—loans investors make to financial institutions – Corporate bonds—IRS considers interest and payments as taxable income. • Junk bonds—offer high rate of return due to exceptionally high risk
Financial Assets and Their Characteristics (cont. ) – Municipal bonds—issued by state and local governments, generally tax exempt – Government Savings Bonds—savings bonds are paper-based or paperless • Bonds can be purchased for investor’s heirs by designating a beneficiary.
Financial Assets and Their Characteristics (cont. ) – Treasury notes—U. S. government borrows funds for 2 to 10 years – Treasury bonds—U. S. government borrows funds for 30 years – Treasury bills—(T-bills) short term obligations, maturity of 4, 13, 26, or 52 weeks – Individual Retirement Account (IRAs)
Which of the following could you invest in today? A. Savings bonds B. IRA C. T-bill D. 401(k) plan A. B. C. D. A B C D
Markets for Financial Assets Financial assets are grouped into different markets depending on their maturity and liquidity.
Markets for Financial Assets (cont. ) • Markets for financial assets – Capital market—money is loaned for more than one year. – Money market—money is loaned for periods less than one year. Financial Assets and Their Markets
Markets for Financial Assets (cont. ) – Primary market—original issuer can sell or repurchase a financial asset. – Secondary market—existing financial assets can be resold to new owners. Financial Assets and Their Markets
Under which financial market(s) would Disney bonds with maturity in 5 years be classified? A. Money market B. Capital market C. Primary market D. Secondary market A. B. C. D. A B C D
Section Preview In this section, you will learn more about the equities, or stocks, that are traded in markets.
Content Vocabulary • equities • 401(k) plan • stockbroker • stock exchange • Efficient Market Hypothesis (EMH) • securities exchange • mutual fund • Dow Jones Industrial Average (DJIA) • over-the-counter market • portfolio diversification (OTC) • net asset value (NAV) • Standard & Poor’s 500 (S & P 500)
Content Vocabulary (cont. ) • bull market • option • bear market • call option • spot market • put option • futures contract
Academic Vocabulary • prospects • implication
Do you think investing is a wise decision? A. Yes B. No A. A B. B
Stocks and Efficient Markets Investors can purchase stock through stockbrokers on exchanges, through mutual funds, or through 401(k) plans.
Stocks and Efficient Markets (cont. ) • Equities or shares of common stock represent another financial asset for investors. • Ways to purchase equities – Stockbroker – Internet account with discount brokerage firm An NYSE Euronext Listing
Stocks and Efficient Markets (cont. ) – Mutual funds • Net asset value (NAV) – 401(k) plan An NYSE Euronext Listing
Stocks and Efficient Markets (cont. ) • Value of stock depends on – Number of outstanding shares to be traded – Company’s profitability – Expectations of growth
Stocks and Efficient Markets (cont. ) • Efficient Market Hypothesis (EMH) states that each stock is analyzed constantly by many professional analysts. Any observations result in buying or selling of the stock immediately. • Portfolio diversification—investors offset losses of one stock with increases in other stocks. How Much Money Will You Have at Retirement?
Which is not an advantage of investing in a 401(k)? A. Analysts on staff to monitor market conditions B. Highly diversified C. Employers typically match a portion of employee’s contribution D. Penalties for early withdrawal A. B. C. D. A B C D
Stock Markets and Their Performance Several different stock markets exist, and each is organized in a different way.
Stock Markets and Their Performance (cont. ) • Historically, stocks were traded at a stock or securities exchange. – New York Stock Exchange (NYSE) is the oldest exchange in the United States. • In 2007 NYSE merged with Euronext and became NYSE Euronext. – American Stock Exchange (AMEX) was also in New York City. • In 2008 AMEX merged with Nasdaq and became AMEX-NASDAQ.
Stock Markets and Their Performance (cont. ) – Exchanges in major Cities throughout the world • Majority of stocks, however, were traded in an over-the-counter market (OTC). – The NASDAQ was the world’s largest electronic stock market. – In 2008 NASDAQ merged with AMEX. Then they merged with NYSE Euronext.
Stock Markets and Their Performance (cont. ) • Stock performance can be monitored by several popular indicators. – Dow Jones Industrial Average (DJIA) – Standard & Poor’s 500 (S&P 500) – NASDAQ Composite
Stock Markets and Their Performance (cont. ) • Bull market—“strong, ” prices moving up • Bear market—“mean” or “nasty” market with prices falling sharply
Is it more advantageous to purchase stocks in a bear or bull market? A. Bear B. Bull C. Does not matter A. A B. B C. C
Trading in the Future Financial assets can be bought and sold in the future as well as the present.
Trading in the Future (cont. ) • Most buying and selling takes place immediately, a spot market. • Exchanges that take place later in time are a futures contract. – Option—buyer has the right to cancel futures contract. • Call option—purchase • Put option—sell
What do the DJIA, the S&P 500, and the NASDAQ composite measure? A. the total number of stocks being traded at one time B. the value of the most expensive stock C. the overall performance of the stock market A. A B. B C. C
Financial System Households and businesses invest their surplus funds to earn interest. Governments and businesses invest this money for economic growth.
Investment Risk and Return Investors must weigh the risks of their investments against the returns they expect. Generally, the higher the risk of an investment, the higher the return investors require.
Equities and Futures The riskiest investments consist of equities and futures. Equities can be purchased as individual stocks, or as a part of a mutual fund or 401(k) plan. Futures allow investors to speculate on future prices of commodities.
Sallie Krawcheck (1965– ) • chief financial officer for Citigroup Inc. , the world’s largest financial institution • ranked number 6 on Forbes’s top 100 of “The World’s Most Powerful Women” for 2006
saving absence of spending that frees resources for use in other activities or investments
savings the dollars that become available for investors to use when others save
certificate of deposit document showing that an investor has made an interest-bearing loan to a financial institution
financial asset a stock or other document that represents a claim on the income and property of the borrower, such as a CD, bond, Treasury bill, or mortgage
financial system network of savers, investors, and financial institutions working together to transfer savings for investment uses
financial intermediary institution that channels savings to investors
nonbank financial institution nondepository institution that channels savings to investors
finance company firm that makes loans directly to consumers and specializes in buying installment contracts from merchants who sell on credit
premium price paid at regular intervals for an insurance policy
pension regular payments to someone who has worked a certain number of years, reached a certain age, or has suffered an injury
pension fund that collects and invests income until payments are made to eligible recipients
risk situation in which the outcome is not certain, but the probabilities can be estimated
sector an area of the economy in which businesses offer the same or similar products or services
compensation something, such as money, given or received as an equivalent for goods or services, injury, debt, or high risk
bond contract to repay borrowed money and interest on the borrowed money at regular future intervals
coupon rate stated interest on a corporate, municipal, or government bond
maturity life of a bond or length of time funds are borrowed
par value principal of a bond or total amount borrowed
current yield bond’s annual coupon interest divided by purchase price; measure of a bond’s return
junk bond that carries an exceptionally high risk of nonpayment and a low rating
municipal bond, often tax exempt, issued by state and local governments
tax-exempt not subject to tax by federal or state governments
savings bond low-denomination, non-transferable bond issued by the federal government
beneficiary person designated to take ownership of an asset if the owner of the asset dies
Treasury note U. S. government bond with a maturity of 2 to 10 years
Treasury bond U. S. government bond with maturity of 30 years
Treasury bill short-term United States government obligation with a maturity of one year or less in denominations of $100
Individual Retirement Account (IRA) retirement account in the form of a long-term time deposit, with annual contributions not taxed until withdrawn during retirement
capital market in which financial capital is loaned and/or borrowed for more than one year
money market in which financial capital is loaned and/or borrowed for one year or less
primary market in which only the original issuer can sell or repurchase a financial asset
secondary market in which financial assets can be sold to someone other than the original issuer
offset to balance higher levels of risk with a larger payoff
presumed taken for granted; supposed
equities stocks that represent ownership shares in corporations
stockbroker person who buys or sells securities for investors
Efficient Market Hypothesis (EMH) argument that stocks are always priced about right because they are closely watched
portfolio diversification strategy of holding different investments to protect against risk
mutual fund company that sells stock in itself and uses the proceeds to buy stocks and bonds issued by other companies
net asset value (NAV) the market value of a mutual fund share found by dividing the net value of the fund by the number of shares issued
401(k) plan tax-deferred investment and savings plan that acts as a personal pension fund for employees
stock exchange physical place where buyers and sellers meet to exchange securities
securities exchange physical place where buyers and sellers meet to exchange securities
over-the-counter market (OTC) electronic marketplace for securities not listed on organized exchanges such as the New York Stock Exchange
Dow Jones Industrial Average (DJIA) measure of stock market performance based on 30 representative stocks
Standard & Poor’s 500 (S&P 500) measure of stock market performance based on 500 stocks traded on the NYSE, AMEX, and OTC market
bull market period during which stock market prices move up for several months or years in a row
bear market period during which stock market prices move down for several months or years in a row
spot market in which a transaction is made immediately at the prevailing price
futures contract an agreement to buy or sell at a specific date in the future at a predetermined price
option futures contract giving a buyer the right to cancel the contract
call option futures contract giving a buyer the right to cancel a contract to buy something
put option futures contract giving a buyer the right to cancel a contract to sell something
prospects potential or expectations
implication something suggested to be naturally understood
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