Financial MarketsBusinesses 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•Debt Instruments

Junk bonds

Speculative stock

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).