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Economics Dr.

Katie Sauer

Chapter 7 Reading Guide: Financial Markets I. Introduction Explain what miracle diets and many peoples investing strategies have in common.

Financial instruments, like every other good or service in a market economy, must create some value. Both the buyer and seller must perceive themselves to be better off by entering into the deal or they wouldnt choose to enter in to it. II. The Role of Financial Instruments All financial instruments are based on 4 simple needs in society: 1) The Need to Raise Capital Some examples of borrowing:

Three examples of borrowing you have in your own life: -

Individuals, firms and governments need capital to __________________________________________. Financial markets provide the capital to them, but at a price. Modern economies could not survive without credit. Explain how access to credit is helping people in developing nations.

Economics Dr. Katie Sauer

2) The Need to Store, Protect and Make Profitable Use of Excess Capital Three reasons not to store your money under your mattress: Harvard endowment example: Explain what consumption smoothing is.

Give 3 examples of ways you have engaged in consumption smoothing in your life. 3) The Need to Insure Against Risk Some of the reasons a person might face financial ruin:

Health, life and auto insurance are three common ways people try to minimize their financial risks. Which of those three do you personally have? Why/why not?

Most people are willing to pay a predictable amount of money to protect against the unpredictable. Almost anything can be insured: Pirate attacks:


Products that function like insurance policies: -Explain how a futures contract works:

Corn trader: 2

Economics Dr. Katie Sauer


Fast food restaurants:


-Explain what a catastrophe bond is:

- Explain how a mutual fund works:

- Explain what a credit default swap is:

4) The Need to Speculate The same financial instruments that are used to mitigate risk or to raise capital can also be used to bet in the short run. Analogy: Financial products are to speculation what sporting events are to gambling. When it comes to credit default swaps, parties other than those in the original contract can get involved. Explain. Brother-in-law:

US financial crisis:

Economics Dr. Katie Sauer

Explain how gambling in Las Vegas is a zero-sum game but the speculating on Wall Street is not.

III. Capital Markets Give some examples of losing in the capital market.

Financial markets allocate capital to the uses that can earn the highest return. What are some ways that government can help and hinder the capital markets?

IV. Investment Strategies The reason get-rich-quick schemes fail is because they violate even the most basic economic principles. Home buying example:

Economics Dr. Katie Sauer

Hot-stocks example:

The efficient markets theory says:

An index fund is:

How do index funds compare to actively managed ones?

Irrationality and Investing In recent years, neither the stock market nor the housing market has behaved in ways consistent with rational human behavior. Behavioral economists point out that individuals are prone to making flawed decisions: An interesting finding from neuroeconomics is:

Even though people are known to behave irrationally, the efficient markets hypothesis isnt going away anytime soon because 1)


Economics Dr. Katie Sauer

Basic economic principles give us a set of rules for investment advice: 1. Save. Invest. Repeat.

2. Take risk, earn reward.

3. Diversify.

4. Invest for the long run.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.