Economic Notes — Chapter 13
Topic 41—Savings and Financial System
saving—absence of spending
savings—refers to the dollars that become available in the absence of consumption
Saving and Capital Formation
Saving makes economic growth possible, frees resources for others to use (borrow).
When people save income, it allows banks to have funds to lend out to entrepreneurs.
For investment to take place, someone in the economy must save.
Financial Assets and the Financial System
financial system—a way to transfer savers' dollars to investors
Financial assests—claims on the property and the income of the borrower; receipt
Savers obtain receipts for funds they save (savings book for savings account,
receipt for a CD, etc)
If borrower defaults, lender can use financial asset as proof (in court) that
funds were borrowed
The Financial System
components— 1. funds, 2. financial assets, 3. savers, 4. borrowers, 5. institutions
Savers: most important savers are households and businesses
Financial intermediaries—institution that channels savings from savers to borrowers;
banks, insurance companies, savings and loan associations, credit unions
Borrowers: most important borrowers are governments and businesses
Generate financial assets when they borrow funds
Investments
Nonbank Financial Intermediaries
Nonbank financial institutions—important group of financial intermediaries, obtain
funds in different manner, finance and life insurance companies, etc.
1. Finance Companies—make loans directly to consumers and specializes in
buying installment contracts
Merchants who sell goods on credit
i.e. merchants unable to wait for customers to pay off high—cost items
Bill consolodation loan—a loan consumers use to pay off all other bills
2. Life Insurance Companies — Does not get its funds through deposits
Main function—to provide financial protection for survivors of the insured.
Premium—the price paid for life insurance policy.
3. Mutual Fund—company that sells stock in itself to and then invests the money in
stocks and bonds
Allows people to have money managed in the market generally funds are
diversified to reduce risk.
4. Pension Fund— a fund to collect income and disburse payments when eligible
for retirement, old age, or disability benefits
Pension—a regular allowance intended to provide income security to someone
who has worked a certain # of yrs
5. Real Estate Investment Trusts—a company organization to make loans to
construction companies to to own property.
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Topic 42 Investing in Financial Assets
Basic Investment Considerations: investors keep 4 factors in mind when
buying financial assets:
1. The Relationship Between Risk and Return
Risk— a situation in which the outcome is not certain, but the probabilities
can be estimated
Riskier assets must offer higher returns
2. Investment Objectives— reasons for investing
3. Consistency—investing consistently, no matter the amount, called "Dollar cost Averaging"
4. Avoiding Complexity—avoid complicated or "too good to be true" investments
Bonds as Financial Assets
Bond Components
1. coupon—the stated interest on the debt
2. maturity—the life of the bond
3. principal—the amount that will be repaid to the lender at maturity;
assigned a par value
Zero Coupon Bonds — No payment until maturity.
Company may not be able to pay.
Bond Prices—supply and demand establish the final price
Current yield—the annual interest divided by the purchase price
What investors pay depends on creditworthiness
Bond Ratings—published by Standard & Poor's and Moody's
Rated on financial health of the issuer
Issuers ability to make coupon and par value payments, and
Issuer's past credit history. Scale goes from AAA to D.
Each rating service uses a different scale
Financial Assets and Their Characteristics
Certificates of Deposit
Loans investors make to financial institutions, one of the most common.
Example Insurance Compnay lends money to a Bank.
Private citizens can now have CD's. Limited and restricted
availability of funds.
Good for small investors for college tuition, vacation, etc. Long term.
Jumbo CD—CD in denominations of more than $100,000
Corporate Bonds (figure 13.5)
Usually purchased as long—term investments, but can be liquidated (sold)
Interest payments on bonds is taxable income.
junk bonds—bonds rated w/ BB or lower on Standard & Poor's, or a
Moody's rating of Ba or lower
Zero Coupon Bonds
Municipal Bonds—"munis," issued by state and local government unit. Attractive because
1. They are safe since government Usually doesn't go out of business
2. Government has taxing power to pay interest and principal in the future
Municipal bonds are tax exempt (federal government doesn't tax the interest)
Government Savings Bond
Savings bond—low—denomination, nontransferable bonds issued by
the US government
Easy to obtain
No risk of default
International Bonds
Available in large denomination, more risk
Coupon and principal payment in another currency
Money Market Mutual Funds—business that collects funds from small investors and
then makes loans
Higher interest
Riskier than CDs, higher return
Treasury Bill—T-Bill short term federal obligation with a maturity of 13, 26 & 52 wks
minimum denomination of $1,000 or $10,000 depending on term.
Sold on a discount basis. You send in $10K, they are auctioned and you
get interest back.
Principle (face value) paid on maturity. Many renew bond.
Individual Retirement Accounts — IRA — tax sheltered time deposits, a federally
recognized retirement plan
May be able to deduct IRA deposits from taxable income.
Markets for Financial Assets
Capital Markets—a market where money is loaned for periods of more than one yr.
Long—term CDs, corporate and government bonds
Money Market—a market where money is loaned for periods of less than one yr.
Primary Market—market in which only the original issuer will redeem a financial asset
Government savings bonds and IRAs
Secondary Market—market in which existing securities can be resold to new owners
Asset can be liquidated quickly and w/o penalty
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Topic 43 Investing in Equities, Futures, and Options
Market Efficiency
Efficient Market Hypothesis—argues that stocks are always priced about
right and bargains are hard to find
Portfolio diversification—holding a # of stocks
Stockbroker—a person who buys or sells securities
Organized Stock Exchanges
Security exchanges—places where buyers and sellers meet
to trade securities
The New York Stock Exchange (NYSE)
Oldest, largest, and most prestigious
Has 1,400 seats, memberships hat allow access to the trading floor,
and 2,400 stocks
The American Stock Exchange (AMEX)
660 seats and 1,000 stocks
Fourth largest exchange in the country
Regional Stock Exchanges
Too small or too new companies
Global Stock Exchanges
Over The Counter Market (OTC) —electronic marketplace for securities
not listed on organized exchange
computer network called the National Market System (NMS)
NASDAQ - National Association of Security Dealers Automated Quotation System.
Measures of Stock Performance
Dow Jones Industrial Average DJIA — measure of the NYSE market performance
Used selected Industrial Stocks. One point=45 cent change
Standard & Poor's 500 S&P — index that uses 500 rep stocks as an
indicator of overall market performance
Trading in the Future
Spot Markets—a market in which a transaction is made immediately at the prevailing price
Spot means "immediate"
Futures Markets—market where futures are bought and sold
Futures—contracts to buy or sell at a specific date in the future
Options Markets—the markets in which options are traded
Options—option to buy or sell commodities or financial assets in the future at a price
agreed upon today
Call option—the right to buy a share of stock at a specified price in the future
Put option—the right to sell a share of stock at a specified price in the future