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Financial Markets

Dr. Katherine Sauer A Citizens Guide to Economics ECO 1040

I. 4 Financial Instruments II. Stocks and Bonds III. Time Value of Money

Finance is the field that studies how people make decisions regarding the handling of risk and resource allocation over time.

Financial instruments, like every other good or service in a market economy, must create some value. Meaning: 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.

I. The 4 Basic Functions of Financial Instruments 1. Raise Capital Examples of borrowing:

2. Deal with Excess Capital - Store It - in bank, buy assets - not mattress why? - Protect It Against Inflation

- Make Profitable Use of It

3. Insure Against Risk

- health/auto insurance - explain futures contracts - explain catastrophe bonds - explain mutual funds

- explain credit default swaps

4. 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:

II. Stocks and Bonds A. Bonds

A bond is a certificate of indebtedness.


When a firm or government issues a bond, they are borrowing money from anyone who buys the bond. They are promising to pay you back a certain value in the future. A bond has a date of maturity and a rate of interest associated with it.

Suppose you buy a $1,000 bond that matures in 5 years and pays 6% interest. - Today, you give up $1,000 and receive the bond. - You will receive annual interest payments of 6% for the next 5 years. 1,000 x 0.06 = $60 per year - At the end of the 5 years, you receive $1,000.

Bonds can be sold at par value (face value) a discount a premium

Issue price: $18.75 Face value: $25 This bond sold at a discount.

What determines the price of a bond?

term: length of time until the bond matures - longer maturity time riskier
credit risk: the probability that the borrower will fail to pay the interest or the principal tax treatment: some bonds have interest that is tax free

B. Stocks A stock is a claim of partial ownership of a firm. - shareholder If you buy a stock, you are not guaranteed to get your money back. The price of a stock generally reflects the perception of a firms future profitability.

What determines the price of a stock? 1. Fundamental analysis is the study of a companys accounting statements and future prospects. It includes doing an economic analysis, industry analysis, and company analysis. - P/E ratio (stock price / net income per share) - competitors - the market for its product - management - credit risk

2. The Efficient Markets Hypothesis is the theory that asset prices reflect all publicly available information about the value of the asset. - equilibrium of supply and demand sets the price

According to this theory, at the market price, the number of people wanting to sell exactly equals the number wanting to buy.

Any stock that you think is hot and about to increase in value, someone else thought it was not hot and was willing to sell it.

3. Market Irrationality Stock prices sometimes seem to be driven by psychological reasons. Herd Mentality is the tendency for individuals to copy the actions of a larger group, even though without the group the person may not choose to take the action on their own. - when the stock market is booming and everyone is investing, a person might decide it is a great time to buy some stocks, too

Herd mentality comes from two forces: - social pressure to conform - the belief that such a large group cant be wrong

Ex: If your friends and neighbors are investing and making money on a hot stock, you want to join in.
Additionally, your brain tells you that if so many people are doing it, it must be safe.

Many analysts point to the dot-com bubble and crash as a recent example of the effects of herd mentality in investing.

- late 1990s, investors were pouring money into any company having to do with the internet
- other investors saw all the money going into this industry and so they invested in it, too because if others were willing to invest in it, it must be a good bet

- many investors neglected to research their investments

- many of the dot-com firms turned out to not have sound business plans

- the economy began to slow and many of the dot-com firms still werent turning a profit, some investors began to sell the stock - chain reaction was triggered and even more people jumped on the stock selling bandwagon - the dot-com bubble had burst

Following a Stock
Google Finance 2/21/12

company name name of stock exchange and stock symbol

change: compared to most recent closing price current price per share, the last price a share was traded at percent change: change x close price 100

Range: daily high and low price 52 Week: high and low price for the last 52 weeks Open: the price at the beginning of trading today Vol/Avg: Volume = number of shares traded today Average = average number of shares traded daily

Mkt cap: Market Capitalization is a measure of the total value of the company Mkt Cap= Total Shares Outstanding x Current Price P/E: Price-to-Earnings Ratio is the price of a share divided by last years earnings per share

Div/Yield: a Dividend is the amount of money the firm will pay you (typ. each quarter) for each share you own. The Yield = dividend / price - not all firms pay dividends

EPS: Earnings Per Share is the amount of earnings per each outstanding share
Shares: the number of shares outstanding

Beta: A statistical estimate of how closely the stocks performance matches the stock market in general. The higher the beta, the closer the stock matches the general market. Inst. Own: Institutional Ownership is percent of the shares that the firm owns

III. Time Value of Money Intuitively we understand that an amount of money today is more valuable than the same amount of money in the future.

A. Future Value is the amount of money that can result from an amount of money we have today. Future Value = Present Value x (1 + r )n

Ex: The average bride is 26 at her first wedding. The average US wedding costs $18,000. What if instead the bride invested the $18,000 in her retirement account, earning 4% interest over 40 years? Future Value = 18,000 x (1.04)40 Future Value = $86,418

The higher the interest rate, the higher the future value of your money saved today.
The longer the time frame, the higher the future value of your money saved today.

B. Present Value is the amount of money one would need today to produce a given amount of money in the future. Present Value = Future Value / (1 + r )n

Ex. you want to have $1,000,000 in 25 years and the interest rate is 5% Present Value = 1,000,000 / (1.05)25 Present Value = $295,303 Put this amount into an account earning 5% interest and youd have $1million in 25 years.

The higher the interest rate, the smaller the amount of money needed in the present to obtain a particular future amount.

The longer the time frame, the smaller the amount of money needed in the present to obtain a particular future amount.

Financial instruments are based on 4 types of activities. Stocks and bonds are two common financial instruments. Calculate the future value of money to see how much money today would be worth in the future. Calculate the present value of money to see how much money you would need to start with today to have a certain amount of money in the future.

What did you learn today? Please explain 2 concepts from todays class.