Financial Markets

Financial Markets Businesses can borrow savings to: produce new goods and services build new plants and equipment create more jobs

Financial Markets Financial Asset: Legal claim on the property and income of the borrower. e.g. certificate of deposit – a piece of paper that says, “ABC Bank has my $1000 and promises to repay me on this date.” I (lender) have provided ABC Bank with funds that they can loan. My CD is a claim on the property/income of the bank for that $1000.

Financial Markets Lenders (businesses/individuals): can provide funds directly to the borrower (govt./business) Stocks, bonds – financial assets in the hands of the lenders.

Financial Markets Financial intermediaries (“lying between”) Institutions that collect and channel funds from savers to borrowers. Borrowers use the funds to: Invest in capital equipment Build plant Hire and train workforce

Financial Markets Benefits of capital formation: Lenders: Don’t have to find borrowers Liquidity Less risk Credit underwriting Pooled portfolio “Guaranteed” rate of return (FDIC)

Financial Markets Benefits of capital formation: Borrowers: Don’t have to find lenders Economies of scale Reduced time and expense Ready capital

Financial Markets Non-bank financial intermediaries Pooled loan capital Life Insurance companies (e.g. MetLife) Collect premiums Long-term finance Pension Funds (e.g. MD State Retirement and Pension System)– set aside assets which must be invested.

Financial Markets Non-financial intermediaries (contd.) Finance company (e.g. Ford Motor Credit) Nontraditional loans Installment contracts

Financial Markets Investment Considerations: Consistency: “Can’t beat the market.” 11% historical average Magic of compounding (1¢ or $5 million)

Financial Markets Investment Considerations: Simplicity: KISS Credit Default Swaps

Financial Markets Investment Considerations: Risk: “The degree to which the outcome is uncertain, but a probable outcome can be estimated.

Financial Markets Investment Considerations: Objective: Rainy Day Fund House Down payment College Tuition Retirement

Financial Markets Junk bonds Speculative stock Debt Instruments Common stock Preferred stock Investment-grade bonds Prime commercial paper U.S. Treasury bills

Financial Assets Bonds: Long-term financing instruments that pay principle and interest. Coupon rate Maturity Par (face) value

Financial Assets Bond prices change when: Market interest rates change: Ex: You hold a 10-yr. bond paying 7.5%, but market rates have declined to 5.5%; Investors will pay a premium to own the higher yielding bond. Company’s ability to repay changes

Financial Assets Bonds are rated by: Standard and Poor’s (S&P) Moody’s Determine the basic financial health of the issuer. Ratings range from AAA (highest quality) to D (junk). Investment grade bonds are rated BBB and above.

Financial Assets Bond yield (rate of return) – seller wants to profit from market price: Coupon rate ÷ market price Ex: $1000 bond with a 6% face value $60 ÷ 950 = 6.32% $60 ÷ 850 = 7.01% $60 ÷ 1100 = 5.45%

Financial Assets Bond Types: CDs – issued by banking entities $500- 1000 par value Varying maturities, “penalty for early withdrawal” FDIC insured Taxable income

Financial Assets Corporate bonds: $1000 – 10,000 par value “Par” is the amount borrowed by the debtor Some bonds are discounted from par Usually to avoid paying interest (“coupon”) Long-term investment Easily liquidated in the market Taxable income

Financial Assets Municipal bonds (“munis”): Low-risk “borrower” Government repays easily since it can tax Tax-exempt interest Easier and cheaper for the issuer to borrow

Financial Assets U.S. Savings Bonds: $50 - $10,000 50% discount from face value Accrued interest collected upon redemption Easy to obtain “No” risk

Financial Assets Treasuries: T-bills: 1, 3, 6 month maturities Discounted like savings bond T-notes – 2-10 year maturities T-bonds – 10-30 year maturities

Financial Assets IRAs – long-term, tax sheltered Various investment amounts 2010 limitation on $5000 Reduced taxable income Interest earned tax deferred

Equities and Options Value of a share of stock depends on: Outstanding number of shares Company profitability Market expectations

Equities and Options The market is infinitely efficient: Efficient Market Hypothesis (EMH) – there are no bargain-priced stocks. Portfolio diversification – “win some, lose some”: 401 (k), 403 (b) –tax-deferred income (up to 6%) Lowers taxable personal income taxes Usually employer-matched (usually 50%) Mutual funds Share of stock in a portfolio of stocks Managed by experts

Equities and Options Ex: $50,000 income with a marginal tax rate of 25%; contribute 6% pre-tax to a 401k plan with employee match. $3000 plus $1500 match. Reduced taxes by $750. Net $2250 plus earnings on investment. Initial investment earns 75% return (before interest). $2250/3000 = 0.75 or 75%

Equities and Options Trading – 3 markets: NYSE – largest and most profitable corps. AMEX – smaller corps; offering more speculative stocks NASDAQ (OTC) – all stocks not traded on the other two organized exchanges.

Equities and Options Measurement: DJIA (“the Dow”) – 30 major corps. S&P 500 – 500 representative stocks NASDAQ – tracks all the stocks traded on this exchange (about 3300).

Equities and Options Futures: different from “spot” trades An agreement to buy or sell at a future date for a specific price Ex: On 1/1/10, buy a 7/1/10 gold contract for $600/oz. (I will buy an oz. for $600 from seller) I expect gold to rise to $800/oz. On 7/1/10, I buy one ounce ($600 worth back on 1/1) of gold from contract buyer and sell for $800. Advantage: I keep $600 for six months. Only the cost of the contract incurred.

Equities and Options Options – suppose you are not sure about the movement of commodity prices: Call option – the right to buy at a future price Put option – the right to sell at a future price Ex: I expect gold to rise to $800/oz. If it doesn’t, I tear up the contract. Used by industries that want to lock in commodity price (e.g. oil, lumber).

Financial Markets