CH 12, Section 2:

• Risk• a situation in which the outcome is not certain.– Probabilities for each possible outcome can be estimated

• Financial assets are “risky”– Prices may go up OR down.– Agency issuing bond, note, or bill, may not redeem and

investor loses all investment• Higher risk means higher interest rates demanded by

investors.

401(k) Plan• an investment and savings plan that acts as a

personal pension fund for employees• tax-deferred (reduces annual income = reduces

annual income tax)• 401k vs. Pension• 401K the risk of investment is put on the individual

employee• Pension the risk of investment is on the employer

and the recipient receives a percent of income in retirement.

Components of Bonds

• Coupon– the stated interest on a bond debt

• Maturity– the life of a bond

• Par value • the principal or the total amount initially

borrowed that must be repaid to the lender at maturity

Current yield

• the annual interest divided by the purchase price of the bond.

Municipal bonds• aka “munis”• Bonds issued by state and local governments

– Finance for….• Highways• State buildings• Schools• Parks• libraries• Public works

• Considered safe because governments have – low chance of going out of business– power to tax– And they are …..

Tax-exempt

• the federal government does not tax the interest paid to investors owning municipal bonds.

Savings bonds• low-denomination, non-transferable bonds• Issued by the US government• Through payroll savings plan• Low risk• Easy to obtain– Bought at a lower price than the face value,– Owner must wait for term to expire to collect that amount

• Ex: $50 bond is bought for $25, but recipient must wait a number of years before the bond is actually worth $50.

Treasury Notes

• US obligations with maturity of two to ten years.

Treasury Bonds

• US obligations with maturity of ten to thirty years.

• Smallest denomination is $1000

Treasury Bills

• aka “T-bill”• Short-term obligation with a majority of 13,

26, or 52 weeks• Minimum denomination of $1000• Sold on a “discount” basis, at auction.

Individual Retirement Account

• Aka “IRA”• Long-term time deposit • Set up for retirement• Tax-sheltered• Convenient for married couples• Taxable when used at maturity.

Roth IRA

• an IRA whose contributions are made after taxes so that no taxes are taken out at maturity– Tax already paid each month.

Capital market

• a market where money is loaned for more than one year.

• Long-term CDs• Corporate and government bonds

Money market

• A market where money is loaned for periods of less than one year.

• CD with maturity of one year or less• Mutual funds

Primary market

• a market where only the original issuer can repurchase or redeem a financial asset

• Government savings bonds• IRAs• Small CDs

Secondary market

• market in which existing financial assets can be resold to new owners

• Liquidity to investors– Can be bought and sold faster– More competitive

Section 3

• Equities• stocks that represent ownership shares in

corporations• Large number of buyers and sellers– Well informed

Efficient Market Hypothesis

• aka “EMH”• Argument that stocks are always priced about

right• that bargains are hard to find – because they are followed closely by so many

investors

Portfolio diversification

• the practice of holding a large number of different stocks

• Increases in some will offset unexpected declines in others.

• Popular strategy

Diversification• Energy• Financials• Materials• Industrials• Utilities• Information Tech• Telecommunications• Consumer Discretionary • Consumer Staples• Health Care

• Exxon Mobil• Goldman Sachs• BHP Billiton• Deere & Company• First Energy Corp.• Google• Tellabs Inc.• Wal-Mart• Coca-Cola• Johnson and Johnsons

stockbroker

• a person who buys or sells equities for clients.– Arranges stocks or bonds to be bought on the

exchange floor by a trader– Also supplies the securities from an inventory– Buys them from some other broker

Securities exchange

• place where buyers and sellers meet to trade securities

• Members pay fee to join• Trades can only take place on the floor of the

exchange.– NYSE– AMEX

seats

• membership on an exchange– Ex: NYSE has 1400 seats– Only seat holders may trade on the exchange floor– Larger brokerage companies have more seats

because they can afford them.– Each seat may cost several million dollars…..• Fees vary with market• Bidding process

Trading floor of NYSE

Over-the-counter market

• aka: OTC• Electronic marketplace for securities that are

not traded on an organized exchange.– NASDAQ

Dow-Jones Industrial Average• the most popular and widely publicized measure of stock

market performance on the NYSE.• Covers 30 major stocks• Various industrial/business sectors

– Value of “point” varies due to – value of money traded and volume of stock

• Better way to evaluate performance is to look at percentage gained or lost

• Some criticize that 30 companies are not enough to judge the performance of thousands of companies being traded

Standard and Poor’s 500

• uses the price changes of 500 representative stocks as an indicator of overall market performance.

• Total of all sales reduced to an easy to understand “index” number.

• Covers stocks on more than NYSE– AMEX– OTC

Bull market• A “strong” market with the prices moving up

for several months or years in a row.• At time of text publishing, the DJIA peaked at

12,000 points, in 2000.• Current DJIA is 18,000

Bear market

• A “weak” or “mean” market with the prices falling sharply for several months or years in a row.

• 2001-2003 market lost 30+% of it value

Spot market

• transactions are made immediately at the prevailing price.

• “spot” denotes – the current price in the city where the trade takes

place, not a world average.– The current price at the moment of purchase, not

in the future.

Futures contract

• agreement to buy or sell at a specific price at a specific date in the future.

• Regardless of market price at the specific date.• Ex: airline buys aviation fuel at $3 a gallon, to be

collected 1 year from now.– Market price of aviation fuel climbs to $5 a gallon in the

course of that year.– Airline saves $2/gallon– Aviation fuel seller makes good money now and had got

rid of stock of aviation fuel.

Futures market

• marketplace where futures contracts are bought and sold.

• Ex.:– Chicago Board of Trade/Chicago Mercantile

Exchange/New York Mercantile Exchange (CME)– Intercontinental Exchange (ICE)

option

• contract that provides the right to purchase or sell commodities or financial assets at some point in the future.

• At an agreed upon price today.• Either party may choose to back out.

Call-option

• the right to buy a share of stock at a specified price some time in the future.– Later price lower than purchase price, you can buy

BELOW the call-option price.– If later price higher than purchase price, you can

buy AT the call-option price.

Put option• the right to sell a share of stock at a specified price

some time in the future.– If you pay a price for the right to sell at a specified higher

price and the actual future price is lower than that target price, you can require the buyer to pay the target price.• You get back your initial fee• And you get the difference

– If the market price exceeded the target price, you could ignore the agreement with the other buyer and sell it yourself.• You would get profit from the higher market price minus your

initial fee.

Options market

• the markets where options are bought and sold.

Assessments: Checking for Understanding

• 1 What rules do many investors follow in regard to investment goals?

• Invest wisely• Analyze the risk and return

Assessment

• 3 List four important investment considerations.

• Risk and return• Personal investment goals• Consistency• simplicity

Assessment

• 4 Identify the three main characteristics of bonds.

• Coupon• Maturity• Par value

Assessment

• 5 Describe the characteristics of major financial assets.

• Ex: CDs cost as little as $100 and are a safe investment

• Investors select the length of maturity

Assessment

• 6 Differentiate between the four markets of financial assets.

• A capital market grants longer-term loans than does a money market.

• A primary market, the issuer only can redeem a financial asset

• A secondary market, previously owned securities are sold.

Assessments: Checking for Understanding

• 1• Quantity demanded greater than quantity

supplied

Image, p. 319

• Why do investors require higher returns for some investments?

• To compensate for greater risk

Image, p. 320

• How much interest is earned after the first 10 years at 6 percent?

• $439

Image, p. 321

• How much more would a traditional IRA earn over a basic savings plan?

• Approximately $42,000

Image, p. 322

• How do bond ratings affect the price of bonds?

• Bonds prices are determined by supply and demand.

• Because low-rated bonds probably would be in less demand, prices would be lower.

Image, p. 325

• Why do some financial assets, like CDs, appear in more than one market?

• Because they may have various long-term and short-term maturities

Image, p. 326

• What is the difference between a capital market and a money market?

• A capital market is a market where money is loaned for periods of more than one year.

• A money market is a market where money is loaned for periods of less than one year.

Image, p. 329

• What factors influence the price of equities?• Number of outstanding shares to be traded• Company profitability• expectations

image, p. 330

• Of the stocks shown, which made the biggest gain on this particular days?

• Ford Motor

Image, p. 332

• What are the two most popular indicators of the market’s performance?

• The Dow-Jones Industrial Average and the Standard & Poor’s 500