Principles of Economics - 3e Chapter 17 Financial Markets

Financial Markets FIGURE Building Home Equity Many people choose to purchase their home rather than rent . This chapter explores how the global crisis has influenced home ownership . Credit red sold sign by Diana Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about How Businesses Raise Financial Capital How Households Supply Financial Capital How to Accumulate Personal Wealth Introduction to Financial Markets BRING IT HOME The Housing Bubble and the 2007 Financial Crisis In 2006 , housing equity in the United States peaked at 13 trillion . That means that the market prices of homes , less what was still owed on the loans they used to buy these houses , equaled 13 trillion . This was a very good number , since the equity represented the value of the financial asset most citizens owned . However , by 2008 this number declined to trillion , and it plummeted further still in 2009 . Combined with the decline in value of other assets held by citizens , by 2010 , homeowners wealth had shrunk 14 trillion ! This is a staggering result , and it affected millions of lives people had to alter their retirement , housing , and other important consumption decisions . Just about every other large economy in the world suffered a decline in the market value of financial assets , as a result of the global crisis . This chapter will explain why people purchase houses ( other than as a place to live ) why they buy other types of

408 17 Financial Markets assets , and why businesses sell those assets in the place . The chapter will also give us insight into why markets and assets go through boom and bust cycles like the one we described here . When a needs to buy new equipment or build a new facility , it often must go to the market to raise funds . Usually will add capacity during an economic expansion when are on the rise and consumer demand is high . Business investment is one of the critical ingredients needed to sustain economic growth . Even in the sluggish 2009 economy , invested trillion in new equipment and structures , in the hope that these investments would generate in the years ahead . Between the end of the recession in 2009 through the second quarter 2013 , for the 500 companies grew by despite the weak economy , with cost cutting and reductions in input costs driving much of that amount , according to the . Figure shows corporate after taxes ( adjusted for inventory and capital consumption ) Despite the steep decline in quarterly net in 2008 , have recovered and surpassed levels . 600 400 3800 Billions of Dollars 3200 FIGURE Corporate Profits ( Adjusted for Inventory and Capital Consumption ) Prior to 2008 , corporate after tax more often than not increased each year . There was a drop in during 2008 and into 2009 . The trend has since continued to increase each year , though at a less steady or consistent rate . Source Federal Reserve Economic Data ( FRED ) Many , from huge companies like General Motors to startup writing computer software , do not have the resources within the to make all the desired investments . These need capital from outside investors , and they are willing to pay interest for the opportunity to obtain a rate of return on the investment of that capital . On the other side of the capital market , capital suppliers , like households , wish to use their savings in a way that will provide a return . Individuals can not , however , take the few thousand dollars that they save in any given year , write a letter to General Motors or some other , and negotiate to invest their money with that . Financial capital markets bridge this gap that is , they ways to take the of funds from many separate capital suppliers and transform it into the funds of capital desire . Such markets include stocks , bonds , bank loans , and other investments . Click to view content ( books pages Corporate After Tax ( Adjusted for Inventory and Capital Consumption ) Access for free at

How Businesses Raise Financial Capital 409 LINK IT UP Visit this website ( to read more about markets . Our perspective then shifts to consider how these investments appear to capital suppliers such as the households that are saving funds . Households have a range of investment options bank accounts , of deposit , money market mutual funds , bonds , stocks , stock and bond mutual funds , housing , and even tangible assets like gold . Finally , the chapter investigates two methods for becoming rich a quick and easy method that does not work very well at all , and a slow , reliable method that can work very well over a lifetime . How Businesses Raise Financial Capital LEARNING OBJECTIVES By the end of this section , you will be able to Describe capital and how it relates to Discuss the purpose and process , bonds , and corporate stock Explain how choose between sources of capital Firms often make decisions that involve spending money in the present and expecting to earn in the future . Examples include when a buys a machine that will last 10 years , or builds a new plant that will last for 30 years , or starts a research and development project . Firms can raise the capital they need to pay for such projects in four main ways ( from investors ( by ( by borrowing through banks or bonds and ( by selling stock . When business owners choose capital sources , they also choose how to pay for them . Financial Capital Firms that are just beginning often have an idea or a prototype for a product or service to sell , but few customers , or even no customers at all , and thus are not earning . Such face a problem when it comes to raising capital How can a that has not yet demonstrated any ability to earn pay a rate of return to investors ?

For many small businesses , the original source of money is the business owner . Someone who decides to start a restaurant or a gas station , for instance , might cover the startup costs by dipping into their own bank account , or by borrowing money ( perhaps using a home as collateral ) Alternatively , many cities have a network individuals , known as angel investors , who will put their own money into small new companies at an early development stage , in exchange for owning some portion of the . Venture capital make investments in new companies that are still relatively small in size , but that have potential to grow substantially . These gather money from a variety of individual or institutional investors , including banks , institutions like college endowments , insurance companies that hold reserves , and corporate pension funds . Venture capital do more than just supply money to small startups . They also provide advice on potential products , customers , and key employees . Typically , a venture capital fund invests in a number of , and then investors in that fund receive returns according to how the fund as a whole performs . The amount of money invested in venture capital substantially from year to year as one example , venture capital invested more than billion in 2014 , according to the National Venture Capital Association . All investors realize that the majority of small startup businesses will never hit it big many of them will go out of business within a few months or years . They also know that getting in on the ground of a few huge successes like a or an can make up for multiple failures . Therefore , investors are willing to take large risks in order to position themselves to gain substantial returns on their investment .

410 17 Financial Markets Profits as a Source of Financial Capital If are earning ( their revenues are greater than costs ) they can choose to reinvest some of these in equipment , structures , and research and development . For many established companies , their own is one primary source of capital . Companies and just getting started may have numerous attractive investment opportunities , but few current to invest . Even large can experience a year or two of earning low or even suffering losses , but unless the can a steady and reliable capital source so that it can continue making real investments in tough times , the may not survive until better times arrive . Firms often need to capital sources other than . Borrowing Banks and Bonds When a has a record of at least earning revenues , and better still of earning , the can make a credible promise to pay interest , and so it becomes possible for the to borrow money . Firms have two main borrowing methods banks and bonds . A bank loan for a works in much the same way as a loan for an individual who is buying a car or a house . The borrows an amount of money and then promises to repay it , including some rate of interest , over a predetermined period of time . If the fails to make its loan payments , the bank ( or banks ) can often take the to court and require it to sell its buildings or equipment to make the loan payments . Another source of capital is a bond . A bond is a contract a borrower agrees to repay the amount that it borrowed and also an interest rate over a period of time in the future . A corporate bond is issued by , but bonds are also issued by various levels of government . For example , a municipal bond is issued by cities , a state bond by states , and a Treasury bond by the federal government through the Department of the Treasury . A bond an amount that one will borrow , the interest rate that one will pay , and the time until repayment . A large company , for example , might issue bonds for 10 million . The promises to make interest payments at an annual rate of , or per year and then , after 10 years , will repay the 10 million it originally borrowed . When a issues bonds , it may choose to issue many bonds in smaller amounts that together reach the total amount it wishes to raise . A that seeks to borrow 50 million by issuing bonds , might actually issue bonds of each . In this way , an individual investor could , in effect , loan the , or any multiple of that amount . Anyone who owns a bond and receives the interest payments is called a bondholder . If a issues bonds and fails to make the promised interest payments , the can take the to court and require it to pay , even if the needs to raise the money by selling buildings or equipment . However , there is no guarantee the will have assets to pay off the bonds . The may recoup only a portion of what they loaned the . Bank borrowing is more customized than issuing bonds , so it often works better for relatively small . The bank can get to know the extremely because the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals . Relatively large and often issue bonds instead . They use bonds to raise new capital that pays for investments , or to raise capital to pay off old bonds , or to buy other . However , the idea that or individuals use banks for relatively smaller loans and bonds for larger loans is not an ironclad rule sometimes groups make large loans and sometimes relatively small and issue bonds . Corporate Stock and Public Firms A corporation is a business that incorporates is owned by shareholders that have limited liability for the company debt but share in its ( and losses ) Corporations may be private or public , and may or may not have publicly traded stock . They may raise funds to their operations or new investments by raising capital through selling stock or issuing bonds . Those who buy the stock become the owners , or shareholders . Stock represents ownership that is , Access for free at

How Businesses Raise Financial Capital 411 a person who owns 100 of a company stock , by , owns the entire company . The company stock is divided into shares . Corporate giants like IBM , AT , Ford , General Electric , and all have millions of stock shares . In most large and , no individual owns a majority of the stock shares . Instead , large numbers of those who hold thousands of have only a small slice of the overall ownership . When a large number of shareholders own a company , there are three questions to ask . How and when does the company obtain money from its sale of stock ?

What rate of return does the company promise to pay when it sells stock ?

Who makes decisions in a company owned by a large number of shareholders ?

First , a receives money from the stock sale only when the company sells its own stock to the public ( the public includes individuals , mutual funds , insurance companies , and pension funds ) We call a stock sale to the public an initial public offering ( The is important for two reasons . For one , the , and any stock issued thereafter , such as stock held as treasury stock ( shares that a company keeps in their own treasury ) or new stock issued later as a secondary offering , provides the funds to repay the investors , like the angel investors and the venture capital . A venture capital may have a 40 ownership in the . When the sells stock , the venture capital sells its part ownership of the to the public . A second reason for the importance of the is that it provides the established company with capital for substantially expanding its operations . However , most of the time when one buys and sells corporate stock the receives no return at all . Ifyou buy General Motors stock , you almost certainly buy it from the current share owner , and General Motors does not receive any ofyour money . This pattern should not seem particularly odd . After all , if you buy a house , the current owner receives your money , not the original house builder . Similarly , when you buy stock shares , you are buying a small slice of the ownership from the existing the that originally issued the stock is not a part of this transaction . Second , when a decides to issue stock , it must recognize that investors will expect to receive a rate of return . That rate of return can come in two forms . A can make a direct payment to its shareholders , called a dividend . Alternatively , a investor might buy a share of stock in for 45 and then later sell it to someone else for 60 , for 15 gain . We call the increase in the stock value ( or of any asset ) between when one buys and sells it a capital gain . Third Who makes the decisions about when a will issue stock , or pay dividends , or ?

To understand the answers to these questions , it is useful to separate into two groups private and public . A private company is frequently owned by the people who generally run it on a basis . Individuals can run a private company . We call this a sole proprietorship . If a group runs it , we call it a partnership . A private company can also be a corporation , but with no publicly issued stock . A small law run by one person , even if it employs some other lawyers , would be a sole proprietorship . Partners own a larger law . Most private companies are relatively small , but there are some large private corporations , with tens of billions of dollars in annual sales , that do not have publicly issued stock , such as farm products dealer , the Mars candy company , and the engineering and construction . When a decides to sell stock , which investors can buy and sell , we call it a public company . Shareholders own a public company . Since the shareholders are a very broad group , often consisting of thousands or even millions of investors , the shareholders vote for a board of directors , who in turn hire top executives to run the on a basis . The more stock a shareholder owns , the more votes that shareholder is entitled to cast for the company board of directors . In theory , the board of directors helps to ensure that the runs in the interests of the true shareholders . However , the top executives who run the have a strong voice in choosing the candidates

412 17 Financial Markets who will serve on their board of directors . After all , few shareholders are knowledgeable enough or have enough personal incentive to spend energy and money nominating alternative board members . How Firms Choose between Financial Capital Sources There are clear patterns in how businesses raise capital . We can explain these patterns in terms of imperfect information , which as we discussed in Information Risk and Insurance , is a situation where buyers and sellers in a market do not both have full and equal information . Those who are actually running a will almost always have more information about whether the is likely to earn in the future than outside investors who provide capital . Any young startup is a risk . Some startup are only a little more than an idea on paper . The founders inevitably have better information than anyone else about how hard they are willing to work , and whether the is likely to succeed . When the founders invested their own money into the , they demonstrate a belief in its prospects . At this early stage , angel investors and venture capitalists try to overcome the imperfect information , at least in part , by knowing the managers and their business plan personally and by giving them advice . Accurate information is sometimes not available because corporate governance , the name economists give to the institutions that are supposed to watch over top executives , fails , as the following Clear It Up feature on Brothers shows . CLEAR IT UP How did lack of corporate governance lead to the Brothers failure ?

In 2008 , Brothers was the fourth largest investment bank , with employees . The had been in business for 164 years . On September 15 , 2008 , Brothers for Chapter 11 bankruptcy protection . There are many causes of the Brothers failure . One area of apparent failure was the lack of oversight by the Board of Directors to keep managers from undertaking excessive risk . We can attribute part of the oversight failure , according to Tim April 10 , 2010 , testimony to Congress , to the Executive Compensation emphasis on gains without enough consideration of the risks . In addition , according to the court examiner report , the Brothers Board of Directors paid too little attention to the details of the operations of Brothers and also had limited service experience . The board of directors , elected by the shareholders , is supposed to be the first line of corporate governance and oversight for top executives . A second institution of corporate governance is the auditing firm the company hires to review the company records and certify that everything looks reasonable . A third institution of corporate governance is outside investors , especially large shareholders like those who invest large mutual funds or pension funds . In the case of Brothers , corporate governance failed to provide investors with accurate information about the firms operations . As a becomes at least somewhat established and its strategy appears likely to lead to in the near future , knowing the individual managers and their business plans on a personal basis becomes less important , because information has become more widely available regarding the company products , revenues , costs , and . As a result , other outside investors who do not know the managers personally , like and shareholders , are more willing to provide capital to the . At this point , a must often choose how to access capital . It may choose to borrow from a bank , issue bonds , or issue stock . The great disadvantage money from a bank or issuing bonds is that the commits to scheduled interest payments , whether or not it has income . The great advantage of borrowing money is that the maintains control of its operations and is not subject to shareholders . Issuing stock involves selling off company ownership to the public and becoming responsible to a board of Access for free at

How Households Supply Financial Capital 413 directors and the shareholders . The of issuing stock is that a small and growing increases its visibility in the markets and can access large amounts of capital for expansion , without worrying about repaying this money . Ifthe is successful and , the board will need to decide upon a dividend payout or how to reinvest to further grow the company . Issuing and placing stock is expensive , requires the expertise of investment bankers and attorneys , and entails compliance with reporting requirements to shareholders and government agencies , such as the federal Securities and Exchange Commission ( SEC ) How Households Supply Financial Capital LEARNING OBJECTIVES By the end of this section , you will be able to Show the relationship between savers , banks , and borrowers Calculate bond yield Contrast bonds , stocks , mutual funds , and assets Explain the between return and risk The ways in which would prefer to raise funds are only half the story of markets . The other half is what those households and individuals who supply funds desire , and how they perceive the available choices . The focus of our discussion now shifts from on the demand side of capital markets to households on the supply side of those markets . We can divide the mechanisms for savings available to households into several categories deposits in bank accounts bonds stocks money market mutual funds stock and bond mutual funds and housing and other tangible assets like owning gold . We need to analyze each of these investments in terms of three factors ( the expected rate of return it will pay ( the risk that the return will be much lower or higher than expected and ( the investment liquidity , which refers to how easily one can exchange money or assets for a good or service . We will do this analysis as we discuss each of these investments in the sections below . First , however , we need to understand the difference between expected rate of return , risk , and actual rate of return . Expected Rate of Return , Risk , and Actual Rate of Return The expected rate of return refers to how much a project or an investment is expected to return to the investor , either in future interest payments , capital gains , or increased . It is usually the average return over a period of time , usually in years or even decades . We normally measure it as a percentage rate . Risk measures the uncertainty of that projects . There are several types of risk , including default risk and interest rate risk . Default risk , as its name suggests , is the risk that the borrower fails to pay back the bond or loan . Interest rate risk is the danger that you might buy a long term bond at a interest rate right before market rates suddenly rise , so had you waited , you could have received a similar bond that paid . A investment is one for which a wide range payoffs is reasonably probable . A investment may have actual returns that are fairly close to its expected rate of return year after year . A risk investment will have actual returns that are much higher than the expected rate of return in some months or years and much lower in other months or years . The actual rate of return refers to the total rate of return , including capital gains and interest paid on an investment at the end of a time period . Bank Accounts An intermediary is one who stands between two other parties . For example , a person who arranges a blind date between two other people is one kind of intermediary . In capital markets , banks are an example ofa is , an institution that operates between a saver who deposits funds in a bank and a borrower who receives a loan from that bank . When a bank serves as a intermediary , unlike the situation with a couple on a blind date , the saver and the borrower never meet . In fact , it is not even possible to make direct connections between those who deposit funds in banks and those who borrow from banks , because all deposited funds end up in one big pool , which the institution then lends out .

414 17 Financial Markets Figure illustrates the position of banks as a intermediary , with a pattern of deposits into a bank and loans out , and then repayment of the loans back to the bank , with interest payments for the original savers . Deposits Loans i Repayment of Interest payments Interest payments FIGURE Banks as Financial Intermediaries Banks are a intermediary because they stand between savers and borrowers . Savers place deposits with banks , and then receive interest payments and withdraw money . Borrowers receive loans from banks , and repay the loans with interest . Banks offer a range of accounts to serve different needs . A checking account typically pays little or no interest , but it facilitates transactions by giving you easy access to your money , either by writing a check or by using a debit card ( that is , a card which works like a credit card , except that purchases are immediately deducted from your checking account rather than billed separately through a credit card company ) A savings account typically pays some interest rate , but getting the money typically requires you to make a trip to the bank or an automatic teller machine ( or you can access the funds electronically ) The lines between checking and savings accounts have blurred in the last couple of decades , as many banks offer checking accounts that will pay an interest rate similar to a savings account ifyou keep a certain minimum amount in the account , or conversely , offer savings accounts that allow you to write at least a few checks per month . Another way to deposit savings at a bank is to use a ( With a , you agree to deposit a certain amount of money , often measured in thousands of dollars , in the account for a stated period of time , typically ranging from a few months to several years . In exchange , the bank agrees to pay a higher interest rate than for a regular savings account . While you can withdraw the money before the allotted time , as the advertisements for always warn , there is a substantial penalty for early Figure shows the annual rate of interest paid on a , and since 1984 , as reported by . The interest rates that savings accounts pay are typically a little lower than the rate , because investors need to receive a slightly higher rate of interest as compensation for promising to leave deposits untouched for a period of time in a , and thus forfeiting some liquidity . Access for free at

How Households Supply Financial Capital 415 10 Interest Rate ( 32 FIGURE Interest Rates on , and Certificates of Deposit The interest rates on of deposit have fluctuated over time . The high interest rates of the early are indicative of the relatively high inflation rate in the United States at that time . Interest rates fluctuate with the business cycle , typically increasing during and decreasing during a recession . Note the steep decline in rates since 2008 , the beginning of the Great Recession . The great advantages accounts are that investors have very easy access to their money , and also money in bank accounts is extremely safe . In part , this safety arises because a bank account offers more security than keeping a few thousand dollars in the toe of a sock in your underwear drawer . In addition , the Federal Deposit Insurance Corporation ( protects the savings of the average person . Every bank is required by law to pay a fee to the , based on the size of its deposits . Then , if a bank should go bankrupt and not be able to repay depositors , the guarantees that all customers will receive their deposits back up to . The bottom line on bank accounts looks like this low risk means low rate of return but high liquidity . Bonds An investor who buys a bond expects to receive a rate of return . However , bonds vary in the rates of return that they offer , according to the riskiness of the borrower . We always can divide an interest rate into three components ( as we explained in Choice in a World of Scarcity compensation for delaying consumption , an adjustment for an rise in the overall level , and a risk premium that takes the borrowers riskiness into account . The government is an extremely safe borrower , so when the US . government issues Treasury bonds , it can pay a relatively low interest rate . Firms that appear to be safe borrowers , perhaps because of their sheer size or because they have consistently earned over time , will pay a higher interest rate than the US . government . Firms that appear to be riskier borrowers , perhaps because they are still growing or their businesses appear shaky , will pay the highest interest rates when they issue bonds . We call bonds that offer high interest rates to compensate for their relatively high chance of default bonds bonds . A number of today issued junk bonds in the 19805 when they were starting to grow , including Turner Broadcasting and . LINK up Visit this website ( to read about Treasury bonds . A bond issued by the government or a large corporation may seem to be relatively low risk after all , the

416 17 Financial Markets bond issuer has promised to make certain payments over time , and except for rare bankruptcy cases , these payments will occur . If a corporate bond issuer fails to make the payments that it owes to its , the can require that the company declare bankruptcy , sell off its assets , and pay them as much as it can . Even in the case ofjunk bonds , a wise investor can reduce the risk by purchasing bonds from a wide range of different companies since , even if a few go broke and do not pay , they are not all likely to go bankrupt . As we noted before , bonds carry an interest rate risk . For example , imagine you decide to buy a bond for that would pay an annual interest rate of . Soon after you buy the bond , interest rates on bonds rise , so that now similar companies are paying an annual rate of 12 . Anyone who buys a bond now can receive annual payments of 120 per year , but since your bond was issued at an interest rate of , you have tied up and receive payments 80 per year . In the meaningful sense of opportunity cost , you are missing out on the higher payments that you could have received . Furthermore , you can calculate the amount you should be willing to pay now for future payments . To place a present discounted value on a future payment , decide what you would need in the present to equal a certain amount in the future . This calculation will require an interest rate . For example , if the interest rate is 25 , then a payment of 125 a year from now will have a present discounted value of is , you could take 100 in the present and have 125 in the future . We discuss this further in the appendix on Present Discounted Value . In financial terms , a bond has several parts . A bond is basically an I owe you note that an investor receives in exchange for capital ( money ) The bond has a face value . This is the amount the borrower agrees to pay the investor at maturity . The bond has a coupon rate or interest rate , which is usually , but can be paid at different times throughout the year . Bonds used to be paper documents with coupons that investors clipped and turned in to the bank to receive interest . The bond has a maturity date when the borrower will pay back its face value as well as its last interest payment . Combining the bonds face value , interest rate , and maturity date , and market interest rates , allows a buyer to compute a bond present value , which is the most that a buyer would be willing to pay for a given bond . This may or may not be the same as the face value . The bond yield measures the rate of return a bond is expected to pay over time . Investors can buy bonds when they are issued and they can buy and sell them during their lifetimes . When buying a bond that has been around for a few years , investors should know that the interest rate printed on a bond is often not the same as the bond yield , even on new bonds . Read the next Work It Out feature to see how this happens . Calculating the Bond Yield You have bought a bond whose coupon rate is . To calculate your return or yield , follow these steps . Assume the following Face value of a bond Coupon rate Annual payment 80 per year . Consider the risk of the bond . If this bond carries no risk , then it would be safe to assume that the bond will sell for when it is issued and pay the purchaser 80 per year until its maturity , at which time the interest payment will be made and the original will be repaid . Now , assume that over time the interest rates prevailing in the economy rise to 12 and that there is now only one year left to this maturity . This makes the bond an unattractive investment , since an investor can find another bond that perhaps pays 12 . To induce the investor to buy the bond , the bond seller will lower its price below its face value of . Calculate the bond price when its interest rate is less than the market interest rate . The expected payments from the bond one year from now are , because in the bonds last year the bond issuer will make the interest payment and then also repay the original . Given that interest rates are Access for free at

How Households Supply Financial Capital now 12 , you know that you could invest 964 in an alternative investment and receive a year from now that is , 964 ( 1080 . Therefore , you will not pay more than 964 for the original bond . the investor will receive the face value , plus 80 for the last year interest payment . The yield on the bond will be ( 1080 964 ) 964 12 . The yield , or total return , means interest payments , plus capital gains . Note that the interest or coupon rate of did not change . When interest rates rise , bonds previously issued at lower interest rates will sell for less than face value . Conversely , when interest rates fall , bonds previously issued at higher interest rates will sell for more than face value . Figure shows bond yield for two kinds Treasury bonds ( which are called notes ) and corporate bonds issued by that have been given an rating as relatively safe borrowers by Moody , an independent that publishes such ratings . Even though corporate bonds pay a higher interest rate , because are riskier borrowers than the federal government , the rates tend to rise and fall together . Treasury bonds typically pay more than bank accounts , and corporate bonds typically pay a higher interest rate than Treasury bonds . ii ?

year ( bonds Interest Rate 35 2014 70 ?

Year FIGURE Interest Rates for Corporate Bonds and Treasury Bonds The interest rates for corporate bonds and Treasury bonds ( officially notes ) rise and fall together , depending on conditions for borrowers and lenders in markets for borrowing . The corporate bonds always pay a higher interest rate , to make up for the higher risk they have of defaulting compared with the government . The bottom line for bonds rate of to moderate , depending on the borrower risk to moderate , depending on whether interest rates in the economy change substantially after the bond is issued , because the investor needs to sell the bond before the investor regains the cash . Stocks As we stated earlier , the rate of return on a investment in a share of stock can come in two forms as dividends paid by the and as a capital gain achieved by selling the stock for more than you paid . The range returns from buying stock is . Firms can decide to pay dividends or not . A stock price can rise to a multiple of its original price or sink all the way to zero . Even in short periods of time , well established companies can see large movements in their stock prices . For example , on July , 2011 , stock peaked at 295 per share one year later , on July 30 , 2012 , it was at per share in 2022 , it had recovered to 199 . When Facebook went public , its shares of stock sold for around 40 per share , but in 2022 , they were selling for slightly over 212 . We will discuss the reasons why stock prices fall and rise so abruptly below , but you need to know how we measure stock market performance . There are a number of different ways to measure the overall performance 417

418 17 Financial Markets of the stock market , based on averaging different subsets of companies stock prices . Perhaps the stock market measure is the Dow Jones Industrial Average , which is based on 30 large companies stock prices . Another stock market performance gauge , the Standard Poor 500 , follows the stock prices of the 500 largest companies . The Wilshire 5000 tracks the stock prices of essentially all companies that have stock the public can buy and sell . Other stock market measures focus on where stocks are traded . For example , the New York Stock Exchange monitors the performance of stocks that are traded on that exchange in New York City . The stock market includes about stocks , with a concentration of technology stocks . Table lists some of the most commonly cited measures of and international stock markets . Measure of the Stock Market Comments Dow Jones Industrial Average ( on 30 large companies from a diverse set of representative , chosen by analysts at Dow Jones and Company . The index was started in 1896 . Standard Poor 500 on 500 large , chosen by analysts at Standard Poor to represent the economy as a whole . Wilshire 5000 es essentially all companies with stock ownership . Despite the name , this index includes about . New York Stock Exchange The and largest stock market , dating back to 1792 . It trades stocks for companies of all sizes . It is located at 18 Broad in New York City . ed in 1971 as an electronic stock market , allowing people to buy or sell from many physical locations . It has about companies . es the 100 largest companies on the London Stock Exchange . Pronounced Originally stood for Financial Times Stock Exchange . stands for , which translates as the Japan Economic Journal , a major business newspaper in Japan . Index includes the 225 largest and most actively traded stocks on the Tokyo Stock Exchange . DAX Tracks 30 of the largest companies on the Frankfurt , Germany , stock exchange . DAX is an abbreviation for Index ( German Stock Index ) TABLE Some Stock Market Measures The trend in the stock market is generally up over time , but with some large dips along the way . Figure 176 shows the path of the Standard Poor 500 index ( which is measured on the vertical axis ) and the Dow Jones Index ( which is measured on the vertical axis ) Broad stock market measures , like the ones we list here , tend to move together The 500 Index is the weighted average market capitalization of the selected to be in the index . The Dow Jones Industrial Average is the price weighted average of 30 industrial stocks tracked on the New York Stock Exchange . When the Dow Jones average rises from to , you know that the average price of the stocks in that index has roughly doubled . Figure shows that stock prices did not rise much in the , but then started a steady climb in the 19805 . From 2000 to 2013 , stock prices bounced up and down , but ended up at Access for free at

How Households Supply Financial Capital about the same level . 800 313 000 600 000 400 32 000 200 000 000 28 one 800 26 000 600 24 000 2400 22 000 200 20000 a 1800 10000 yam 14 000 Saw 500 1400 12 000 ' 200 10 000 non 800 emu 4000 400 200 ' ours 50762 err . Year FIGURE The Dow Jones Industrial Index and the Standard Poor 500 , Stock prices rose dramatically from the 19805 up to about 2000 . From 2000 to 2013 , stock prices bounced up and down , but ended up at about the same level . Since 2009 , both indexes have for the most part increased . Table 172 shows the total annual rate of return an investor would have received from buying the stocks in the 500 index over recent decades . The total return here includes both dividends paid by these companies and also capital gains arising from increases in the stock value . For technical reasons related to how we calculate the numbers , the dividends and capital gains do not add exactly to the total return . From the 19505 to the 19805 , the average paid annual dividends equal to about of its stock value . Since the 19905 , dividends have dropped and now often provide a return closer to to . In the 19605 and 19705 , the gap between percent earned on capital gains and dividends was much closer than it has been since the 19805 . In the 19805 and 19905 , capital gains were far higher than dividends . In the , dividends remained low and , while stock prices , they ended the decade roughly where they had started . In the 20105 , dividends remained low and stock prices increased , and this continued at the beginning of the 20205 . 419

420 17 Financial Markets Period Total Annual Return Capital Gains Dividends 2020 2021 TABLE Annual Returns on 500 Stocks , The overall pattern is that stocks as a group have provided a high rate of return over extended periods of time , but this return comes with risks . The market value of individual companies can rise and fall substantially , both over short time periods and over the long run . During extended periods of time like the or the decade of the , the overall stock market return can be quite modest . The stock market can sometimes fall sharply , as it did in 2008 . The bottom line on investing in stocks is that the rate of return over time will be high , but the risks are also high , especially in the short run . Liquidity is also high since one can sell stock in publicly held companies readily for spendable money . Mutual Funds Buying stocks or bonds issued by a single company is always somewhat risky . An individual may find itself buffeted by unfavorable supply and demand conditions or hurt by unlucky or unwise managerial decisions . Thus , a standard recommendation from investors is , which means buying stocks or bonds from a wide range of companies . A saver who is following the old proverb Don out all your eggs in one basket . In any broad group of companies , some will do better than expected and some will do the has a tendency to cancel out extreme increases and decreases in value . a group of stocks or bonds has become easier in the internet age , but it remains something ofa task . To simplify the process , companies offer mutual funds , which consist ofa variety of stocks or bonds from different companies . The financial investor buys mutual fund shares , and then receives a return based on how the fund as a whole performs . In 2021 , according to the Investment Company , over 47 of US . households had a investment in a mutual many people who their retirement savings or pension money invested in this way . Mutual funds can focus in certain areas one mutual fund might invest only in company stocks based in , or only in bonds issued by large manufacturing companies , or only in biotechnology companies stock . At the other end of the spectrum , a mutual fund might be quite broad . At the extreme , some mutual own a tiny share of every in the stock market , and thus the mutual fund value will with the overall stock market average . We call a mutual fund that seeks only to mimic the market overall an index fund . Access for free at

How Households Supply Financial Capital 421 can offset some of the risks of individual stocks rising or falling . Even investors who buy an indexed mutual fund designed to mimic some measure of the broad stock market , like the Standard Poor 500 , had better prepare against some ups and downs , like those the stock market experienced in the decade of the . In 2008 average stock funds declined 38 , reducing individual and household wealth . This steep drop in value hit hardest those who were close to retirement and were counting on their stock funds to supplement retirement income . The bottom line on investing in mutual funds is that the rate of return over time will be high . The risks are also , but the risks and returns for an individual mutual fund will be lower than those for an individual stock . As with stocks , liquidity is also high provided the mutual fund or stock index fund is readily traded . Housing and Other Tangible Assets can also seek a rate of return by purchasing tangible assets , especially housing . About of US . households own their own home . An owner equity in a house is the monetary value the owner would lave after selling the house and repaying any outstanding bank loans they used to buy the house . For example , imagine that you buy a house for , paying 10 of the price as a down payment and taking out a bank oan for the remaining . Over time , you pay off some of your bank loan , so that only remains , and the house value on the market rises to . At that point , your equity in the home is the value of the home minus the value of the loan outstanding , which is . For many Americans , home equity is their single greatest asset . The total value of all home equity held by US . was trillion as of the middle of 2021 , according to Federal Reserve data . in a house is tangibly different from bank accounts , stocks , and bonds because a house offers both a and a return . Ifyou buy a house to live in , part of the return on your investment occurs rom your consumption of housing services is , having a place to live . Of course , ifyou buy a home and rent it out , you receive rental payments for the housing services you provide , which would offer a return . Buying a house to live in also offers the possibility of a capital gain from selling the house in the future or more than you paid for it . There can , however , be different outcomes , as the Clear It Up on the housing market shows . prices have usually risen steadily over time . For example , the median sales price for an existing amily home was in 1990 , but at the end of December 2016 , according to FRED ?

Economic Data . Over these 24 years , home prices increased an average of per year , which is an average return over this time . Figure shows Census data for the average sales price ofa new home in the States from 1965 to 2021 . LINK up Go to this website ( to experiment with a compound annual growth rate calculator . However , the possible capital gains from rising housing prices are riskier than these national price averages . Certain regions of the country or metropolitan areas have seen drops in housing prices over time . The median housing price for the United States as a whole fell almost in 2008 and again in 2009 , dropping the median price from to . As of 2016 , home values had recovered and even exceeded their recession levels , and they have continued to increase into the early . LINK IT UP Visit this website to watch the trailer for Inside Job , a movie that explores the modern crisis .

422 17 Financial Markets mil uni mi SEMI mu Average Sale Price of New Homes FIGURE The Median Average Sales Price for New Homes , The median price is the price where half of sales prices are higher and half are lower . The median sales price for a new home was in 1990 . It rose as high as in 2007 , before falling to in 2008 . In 2015 , the median sales price was . Of course , this national conceals many local differences , like the areas where housing prices are higher or lower , or how housing prices have risen or fallen at certain times . Source Census ) Investors can also put money into other tangible assets such as gold , silver , and other precious metals , or in duller commodities like sugar , cocoa , coffee , oil , and natural gas . The return on these investments derives from the saver hope buying low , selling high , and receiving a capital gain . Investing in , say , gold or coffee offers relatively little in the way of to the user ( unless the investor likes to caress gold or gaze upon a warehouse ull of coffee ) Typically , investors in these commodities never even see the physical good . Instead , they sign a contract that takes ownership ofa certain quantity of these commodities , which are stored in a warehouse , and later they sell the ownership to someone else . As one example , from 1981 to 2005 , the gold prices general between about 300 and 500 per ounce , but then rose sharply to over per ounce by early 2010 . In January 2017 , prices were hovering around per ounce , and they have since increased , ting over by early 2022 . A area of tangible assets consists of collectibles like paintings , wine , jewelry , antiques , or even baseball cards . Most collectibles provide returns both in the form of services or ofa potentially higher selling price in the future . You can use by hanging them on the wall jewelry by wearing it baseball cards by displaying them . You can also hope to sell them someday for more than you paid for them . However , the evidence on prices of collectibles , while scanty , is that while they may go through periods where prices skyrocket for a time , you not expect to make a rate of return over a sustained period of time from investing in this way . The bottom line on investing in tangible assets rate of , especially if you can receive from , for example , living in the house for housing or high if you buy gold or baseball cards , because it often takes considerable time and energy to sell a house or a piece of art and turn your capital gain into cash . The next Clear It Up feature explains the issues in the recent housing market crisis . CLEAR IT UP What was all the commotion in the recent housing market ?

The cumulative average annual growth rate in housing prices from 1981 to 2000 was . The price of an average home then took off from 2003 to 2005 , rising more than 10 per year . No serious analyst believed this rate of growth was sustainable after all , if housing prices grew at , say , 11 per year over time , the average price of a home Access for free at

How Households Supply Financial Capital 423 would more than double every seven years . However , at the time many serious analysts saw no reason for deep concern . After all , housing prices often change in and starts , like all prices , and a price surge for a few years is often followed by prices that are flat or even declining a bit as local markets adjust . The sharp rise in housing prices was driven by a high level of demand for housing . Interest rates were low , so institutions encouraged people to borrow money to buy a house . Banks became much more flexible in their lending , making what were called subprime loans . Banks loaned money with low , or sometimes no down payment . They offered loans with very low payments for the first two years , but then much higher payments after that . The idea was that housing prices would keep rising , so the borrower would just refinance the mortgage two years in the future , and thus would not ever have to make the higher payments . Some banks even offered NINJA loans , which meant a institution issued a loan even though the borrower had no income , no job , nor assets . In retrospect , these loans seem outlandish . Many borrowers , however , that as long as housing prices kept rising , it made sense to buy . Many lenders used a process called , in which they sold their mortgages to financial companies , which put all the mortgages into a big pool , creating large securities , and then these securities to investors . In this way , the lenders the mortgage risks to investors . Investors were interested in securities as they appeared to offer a steady stream of income , provided the borrowers repaid them . Investors relied on the ratings agencies to assess the credit risk associated with the securities . In hindsight , it appears that the credit agencies were far too lenient in their ratings of many of the loans . Bank and regulators watched the steady rise in the market for securities , but saw no reason at the time to intervene . When housing prices turned down , many households that had borrowed when prices were high found that what they owed the bank was more than what their home was worth . Many banks believed that they had by selling their individual loans and instead buying securities based on mortgage loans from all overthe country . After all , banks thought back in 2005 , the average house price had not declined at any time since the Great Depression in the . These securities based on mortgage loans , however , turned out to be far riskier than expected . The bust in housing prices weakened both bank and household , and thus helped bring on the Great Recession . The between Return and Risk The discussion of investments has emphasized the expected rate of return , the risk , and the liquidity of each investment . Table summarizes these characteristics . Financial Investment Return Risk Liquidity Checking account Very low Very little Very high Savings account Low Very little High of deposit Low to medium Very little Medium Stocks High Medium to high Medium Bonds Medium Low to medium Medium Mutual funds Medium to high Medium to high Medium to high Housing Medium Medium Low TABLE Key Characteristics of Financial Investments

424 17 Financial Markets Financial Investment Return Risk Liquidity Gold Medium High Low Collectibles Low to medium High Low TABLE Key Characteristics of Financial Investments The household investment choices listed display a the expected return and the degree of risk involved . Bank accounts have very low risk and very low returns bonds have higher risk but higher returns and stocks are riskiest of all but have the potential for still higher returns . In effect , the higher average return compensates for the higher degree of risk . If risky assets like stocks did not also offer a higher average return , then few investors would want them . This tradeoff between return and risk complicates the task of any investor Is it better to invest safely or to take a risk and go for the high return ?

Ultimately , choices about risk and return will be based on personal preferences . However , it is often useful to examine risk and return in the context of different time frames . The high returns of stock market investments refer to a high average return that we can expect over a period of several years or decades . The high risk of such investments refers to the fact that in shorter time frames , from months to a few years , the rate of return may fluctuate a great deal . Thus , a person near retirement age , who already owns a house , may prefer reduced risk and certainty about retirement income . For young workers , just starting to make a reasonably living , it may make sense to put most of their savings for retirement in mutual funds . Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors . Stocks are risky in the short term , to be sure , but when the worker can look forward to several decades during which stock market ups and downs can even out , stocks will typically pay a much higher return over that extended period than will bonds or bank accounts . Thus , one must consider between risk and return in the context the investor is in life . How to Accumulate Personal Wealth LEARNING OBJECTIVES By the end of this section , you will be able to Explain the random walk theory Calculate simple and compound interest Evaluate how capital markets transform capital Getting rich may seem straightforward enough . Figure out what companies are going to grow and earn high in the future , or out what companies are going to become popular for everyone else to buy . Those companies are the ones that will pay high dividends or whose stock price will climb in the future . Then , buy stock in those companies . Presto ! Multiply your money ! Why is this path to riches not as easy as it sounds ?

This module discusses the problems with picking stocks , and then discusses a more reliable but undeniably duller method of accumulating personal wealth . Why It Is Hard to Get Rich Quick The Random Walk Theory The with attempting to buy stock in companies that will have higher prices in the future is that many other investors are trying to do the same thing . Thus , in attempting to get rich in the stock market , it is no help to identify a company that is going to earn high if many other investors have already reached the same conclusion , because the stock price will already be high , based on the expected high level of future . The idea that stock prices are based on expectations about the future has a powerful and unexpected Access for free at

How to Accumulate Personal Wealth 425 implication . determine stock price , then shifts in expectations will determine shifts in the stock price . Thus , what matters for predicting whether the stock price ofa company will do well is not whether the company will actually earn in the future . Instead , you must a company that analysts widely believe at present to have poor prospects , but that will actually turn out to be a shining star . Brigades of stock market analysts and individual investors are carrying out such research 24 hours a day . The fundamental problem with predicting future stock winners is that , by , no one can predict the future news that alters expectations about . Because stock prices will shift in response to unpredictable future news , these prices will tend to follow what mathematicians call a random walk with a The random walk part means that , on any given day , stock prices arejust as likely to rise as to fall . With a trend means that over time , the upward steps tend to be larger than the downward steps , so stocks do gradually climb . If stocks follow a random walk , then not even professionals will be able to choose those that will beat the average consistently . While some investment advisers are better than average in any given year , and some even succeed for a number ofyears in a row , the majority of investors do not outguess the market . If we look back over time , it is typically true that half or of the mutual funds that attempted to pick stocks which would rise more than the market average actually ended up performing worse than the market average . For the average investor who reads the newspaper business pages over a cup of coffee in the morning , the odds of doing better than professionals is not very good at all . Trying to pick the stocks that will gain a great deal in the future is a risky and unlikely way to become rich . Getting Rich the Slow , Boring Way Many US . citizens can accumulate a large amount of wealth during their lifetimes , if they make two key choices . The is to complete additional education and training . In 2020 , the Bureau of Labor Statistics reported median weekly usual earnings for wage and salary workers age 25 and over that corresponded to annual income of for those with a high school diploma , for those with a two year associate degree , and for those with a bachelors degree . Learning is not only good for you , but it pays off , too . The second key choice is to start saving money early in life , and to give the power of compound interest a chance . Imagine that at age 25 , you save and place that money into an account that you do not touch . In the long run , it is not unreasonable to assume a real annual rate of return ( that is , above the rate of ) on money invested in a stock portfolio . After 40 years , using the formula for compound interest , the original investment will have multiplied nearly fold ( Having does not make you a millionaire . Notice , however , that this tidy sum is the result of saving exactly once . Saving that amount every year for several saving more as income multiply the total considerably . This type will not rival the riches of CEO Bill Gates , but remember that only half of Americans have any money in mutual funds at all . Accumulating hundreds of thousands by retirement is a perfectly achievable goal for a person who starts saving early in that amount of accumulated wealth will put you at or near the top 10 of all American households . The following Work It Out feature shows the difference between simple and compound interest , and the power of compound interest . Simple and Compound Interest Simple interest is an interest rate calculation only on the principal amount .

426 17 Financial Markets Step . Learn the formula for simple interest Principal Rate Time Interest Step . Practice using the simple interest formula . Example 100 Deposit at a simple interest rate of held for one year is 100 Simple interest in this example is . Example 100 Deposit at a simple interest rate of held for three years is 100 15 Simple interest in this example is 15 . Step . Calculate the total future amount using this formula Total future amount principal interest Step . Put the two simple interest formulas together . Total future amount ( with simple interest ) Principal ( Principal Rate Time ) Step . Apply the simple interest formula to our three year example . Total future amount ( with simple interest ) 100 ( 100 ) 15 Compound interest is an interest rate calculation on the principal plus the accumulated interest . Step . To find the compound interest , we determine the difference between the future value and the present value of the principal . This is accomplished as follows Future Value Principal ( interest rate ) Compound interest Future Present Valve Step . Apply this formula to our scenario . Follow the calculations in Table Year Amount in Bank 100 Bank Interest Rate Total 105 100 ( 100 ) Year Amount in Bank 105 Bank Interest Rate Total TABLE Access for free at

How to Accumulate Personal Wealth 427 105 ( 105 ) Year Amount in Bank Bank Interest Rate Total ( Compound interest 100 TABLE Step . Note that , after three years , the total is . Therefore the total compound interest is . This is more than we obtained with simple interest . While this may not seem like much , keep in mind that we were only working with 100 and over a relatively short time period . Compound interest can make a huge difference with larger sums of money and over longer periods of time . Obtaining additional education and saving money early in life obviously will not make you rich overnight . Additional education typically means deferring earning income and living as a student for more years . Saving money often requires choices like driving an older or less expensive car , living in a smaller apartment or buying a smaller house , and making other . For most people , the for achieving substantial personal wealth will require effort , patience , and . How Capital Markets Transform Financial Flows Financial capital markets have the power to repackage money as it moves from those who supply capital to those who demand it . Banks accept checking account deposits and turn them into loans to companies . Individual sell shares of stock and issue bonds to raise capital . Firms make and sell an astonishing array of goods and services , but an investor can receive a return on the company decisions by buying stock in that company . Financial investors sell and resell stocks and bonds to one another . Venture capitalists and angel investors search for promising small companies . Mutual funds combine the stocks and thus , indirectly , the products and many different companies . LINK up Visit this website ( to read an article about how austerity can work . Then visit this website ( for another perspective on austerity . In this chapter , we discussed the basic mechanisms of markets . A more advanced course in economics or will consider more sophisticated tools . The fundamentals of those capital markets remain the same Firms are trying to raise capital and households are looking for a desirable combination of rate of return , risk , and liquidity . Financial markets are society mechanisms for bringing together these forces of demand and supply .

428 17 Financial Markets BRING IT HOME The Housing Bubble and the Financial Crisis of 2007 The housing boom and bust in the United States , and the resulting decline in home equity , began with the fall of home prices starting in 2007 . As home values dipped , many home prices fell below the amount the borrower owed on the mortgage and owners stopped paying and defaulted on their loan . Banks found that their assets ( loans ) became worthless . Many institutions around the world had invested in securities , or had purchased insurance on securities . When housing prices collapsed , the value of those assets collapsed as well . The asset side of the banks balance sheets dropped , causing bank failures and bank runs . Around the globe , institutions were bankrupted or nearly so . The result was a large decrease in lending and borrowing , or a freezing up of available credit . When credit dries up , the economy is on its knees . The crisis was not limited to the United States . Iceland , Ireland , the United Kingdom , Spain , Portugal , and Greece all had similar housing boom and bust cycles , and similar credit freezes . If businesses can not access capital , they can not make physical capital investments . Those investments ultimately lead to job creation . When credit dried up , businesses invested less , and they ultimately laid off millions of workers . This caused incomes to drop , which caused demand to drop . In turn businesses sold less , so they laid off more workers . Compounding these events , as economic conditions worsened , institutions were even less likely to make loans . To make matters even worse , as businesses sold less , their expected future decreased , and this led to a drop in stock prices . Combining all these effects led to major decreases in incomes , demand , consumption , and employment , and to the Great Recession , which in the United States officially lasted from December 2007 to June 2009 . During this time , the unemployment rate rose from to a peak of . Four years recession ended , unemployment was still stubbornly high , at , and million people were still unemployed . As the world leading consumer , if the United States goes into recession , it usually drags other countries down with it . The Great Recession was no exception . With few exceptions , trading partners also entered into of their own , of varying lengths , or suffered slower economic growth . Like the United States , many European countries also gave direct assistance , bailouts , to the institutions that make up their markets . There was good reason to do this . Financial markets bridge the gap between and suppliers of capital . These institutions and markets need to function in order for an economy to invest in new capital . However , much of this bailout money was borrowed , and this borrowed money contributed to another crisis in Europe . Because of the impact on their budgets of the crisis and the resulting bailouts , many countries found themselves with high . They chose to undertake austerity measures , large decreases in government spending and large tax increases , in order to reduce their . Greece , Ireland , Spain , and Portugal all had to undertake relatively severe austerity measures . The of this crisis have spread . Economists even called into question the euro viability . Access for free at

17 Key Terms 429 Key Terms actual rate of return the total rate of return , including capital gains and interest paid on an investment at the end of a time period bond a contract through which a borrower like a corporation , a city or state , or the federal government agrees to repay the amount that it borrowed and also a rate of interest over a period of time in the future bond yield the rate of return a bond is expected to pay at the time of purchase bondholder someone who owns bonds and receives the interest payments capital gain a gain from buying an asset , like a share of stock or a house , and later selling it at a higher price of deposit ( a mechanism for a saver to deposit funds at a bank and promise to leave them at the bank for a time , in exchange for a higher interest rate checking account a bank account that typically pays little or no interest , but that gives easy access to money , either by writing a check or by using a debit card compound interest an interest rate calculation on the principal plus the accumulated interest corporate bond a bond issued by that wish to borrow corporate governance the name economists give to the institutions that are supposed to watch over top executives in companies that shareholders own corporation a business owned by shareholders who have limited liability for the company debt yet a share of the company may be private or public and may or may not have stock coupon rate the interest rate paid on a bond can be annual or debit card a card that lets the person make purchases , and the institution immediately deducts cost from that person checking account investing in a wide range of companies to reduce the level of risk dividend a direct payment from a to its shareholders equity the monetary value a homeowner would have after selling the house and repaying any outstanding bank loans used to buy the house expected rate of return how much a project or an investment is expected to return to the investor , either in future interest payments , capital gains , or increased face value the amount that the bond issuer or borrower agrees to pay the investor intermediary an institution , like a bank , that receives money from savers and provides funds to borrowers bonds bonds that offer relatively high interest rates to compensate for their relatively high chance of default index fund a mutual fund that seeks only to mimic the market overall performance initial public offering ( the sale of shares of stock by a to outside investors junk bonds see bonds liquidity refers to how easily one can exchange money or assets for a good or service maturity date the date that a borrower must repay a bond municipal bonds a bond issued by cities that wish to borrow mutual funds funds that buy a range of stocks or bonds from different companies , thus allowing an investor an easy way to diversify partnership a company run by a group as opposed to an individual present value a bond current price at a given time private company a frequently owned by the people who generally run it on a basis public company a that has sold stock to the public , which in turn investors then can buy and sell risk a measure of the uncertainty of that projects savings account a bank account that pays an interest rate , but withdrawing money typically requires a trip to the bank or an automatic teller machine

430 17 Key Concepts and Summary shareholders people who own at least some shares of stock in a shares a stock , divided into individual portions simple interest an interest rate calculation only on the principal amount sole proprietorship a company run by an individual as opposed to a group stock a claim on partial ownership Treasury bond a bond issued by the federal government through the US . Department of the Treasury venture capital investments in new companies that are still relatively small in size , but that have potential to grow substantially Key Concepts and Summary How Businesses Raise Financial Capital Companies can raise capital in several ways from their owners or managers personal savings , or credit cards and from private investors like angel investors and venture capital . A bond is a contract through which a borrower agrees to repay the amount that it borrowed . A bond an amount that one will borrow , the amounts that one will repay over time based on the interest rate when the bond is issued , and the time until repayment . Corporate bonds are issued by municipal bonds are issued by cities , state bonds by states , and Treasury bonds by the federal government through the Department of the Treasury . Stock represents ownership . A company stock is divided into shares . A receives capital when it sells stock to the public . We call a company stock sale to the public the initial public offering ( However , a does not receive any funds when one shareholder sells stock in the to another investor . One receives the rate of return on stock in two forms dividends and capital gains . A private company is usually owned by the people who run it on a basis , although hired managers can run it . We call a private company owned and run by an individual a sole proprietorship , while a owned and run by a group is a partnership . When a decides to sell stock that investors can buy and sell , then the is owned by its in turn elect a board of directors to hire top management . We call this a public company . Corporate governance is the name economists give to the institutions that are supposed to watch over top executives , though it does not always work . How Households Financial Capital We can categorize all investments according to three key characteristics average expected return , degree of risk , and liquidity . To obtain a higher rate of return , an investor must typically accept either more risk or less liquidity . Banks are an example ofa intermediary , an institution that operates to coordinate supply and demand in the capital market . Banks offer a range of accounts , including checking accounts , savings accounts , and of deposit . Under the Federal Deposit Insurance Corporation ( banks purchase insurance against the risk ofa bank failure . A typical bond promises the investor a series of payments over time , based on the interest rate at the time the institution issues the bond , and when the borrower repays it . Bonds that offer a high rate of return but also a relatively high chance on the payments are called bonds . The bond yield is the rate of return that a bond promises to pay at the time of purchase . Even when bonds make payments based on a interest rate , they are somewhat risky , because if interest rates rise for the economy as a whole , an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss . Changes in the stock price depend on changes in expectations about future . Investing in any individual is somewhat risky , so investors are wise to practice , which means investing in a range of companies . A mutual fund purchases an array of stocks bonds . An investor in the mutual fund then receives a return depending on the funds overall performance as a whole . A mutual fund that seeks to imitate Access for free at

17 Questions 431 the overall behavior of the stock market is called an index fund . We can also regard housing and other tangible assets as forms of investment , which pay a rate of return in the form of capital gains . Housing can also offer a , you can live in it . How to Accumulate Personal Wealth It is extremely , even for professionals , to predict changes in future expectations and thus to choose the stocks whose price will rise in the future . Most Americans can accumulate considerable wealth if they follow two rules complete additional education and training after graduating from high school and start saving money early in life . Questions . Answer these three questions about corporate a . Why do very small companies tend to raise money from private investors instead of through an ?

Why do small , young companies often prefer an to borrowing from a bank or issuing bonds ?

Who has better information about whether a small is likely to earn , a venture capitalist or a potential , and why ?

From a point of view , how is a bond similar to a bank loan ?

How are they different ?

Calculate the ec each of these people has in their home bought a house for by putting 10 as a down payment and borrowing the rest from the bank . a house for in cash , but if she were to sell it now , it would sell for . Ben bought a house for . He put 20 down and borrowed the rest from the bank . However , the value of the house has now increased to and he has paid off of the bank loan . Which has a average return over time stocks , bonds , or a savings account ?

Explain your answer . Investors sometimes fear that a investment is especially likely to have low returns . Is this fear true ?

Does a high risk mean the return must be low ?

What is the amount of interest from a loan after three years with a simple interest rate of ?

Ifyou receive 500 in simple interest on a loan that you made for for years , what was the interest rate you charged ?

You open a for that pays interest , compounded annually . What is the value of that at the end of the years ?

Review Questions . What are the most common ways for to raise capital ?

10 . Why can notjust use their own for capital , with no need for outside investors ?

11 . Why are banks more willing to lend to ?

12 . What is a bond ?

13 . What does a share of stock represent ?

14 . When do receive money from a stock sale in their and when do they not receive money ?

15 . What is a dividend ?

16 . What is a capital gain ?

432 17 Critical Thinking Questions 17 . 18 . 19 . 20 . 21 . 22 . 23 . 24 . 25 . 26 . 27 . 28 . Wiat is the difference between a private company and a public company ?

How do the shareholders who own a company choose the actual company managers ?

Way are banks called intermediaries ?

Name several different kinds of bank account . How are they different ?

Way are bonds somewhat risky to buy , even though they make predetermined payments based on a rate of interest ?

Way should a investor care about ?

Wiat is a mutual fund ?

is an index fund ?

How is buying a house to live in a type of investment ?

Way is it hard to forecast future movements in stock prices ?

Wiat are the two key choices citizens need to make that determines their relative wealth ?

Is investing in housing always a very safe investment ?

Critical Thinking Questions 29 . 30 . 31 . 32 . 33 . 34 . 35 . Ifyou owned a small that had become somewhat established , but you needed a surge of capital to carry out a major expansion , would you prefer to raise the funds through borrowing or by issuing stock ?

Explain your choice . Explain how a company can fail when the safeguards that should be in place fail . What are some reasons why the investment strategy ofa might differ from the investment strategy ofa ?

Explain why a investor in stocks can not earn high capital gains simply by buying companies with a demonstrated record of high . Explain what happens in an economy when the markets limit access to capital . How does this affect economic growth and employment ?

You and your friend have opened an account on and have each decided to select similar companies in which to invest . You are diligent in monitoring your selections , tracking prices , current events , and actions the company has taken . Your friend chooses his companies randomly , pays no attention to the news , and spends his leisure time focused on everything besides his investments . Explain what might be the performance for each of your portfolios at the end of the year . How do bank failures cause the economy to go into recession ?

Problems 36 . The Darkroom Company has shares of stock outstanding . The investors in the own the following numbers of shares investor has shares investor has shares investor has shares investor has shares investor has shares and investors through 11 have shares each . What is the minimum number of investors it would take to vote to change the top management ?

If investors and agree to vote together , can they be certain of always getting their way in how the company will be run ?

Access for free at ' 38 . 39 . 40 . Problems 433 Imagine that a local water company issued bond at an interest rate of . You are thinking about buying this bond one year before the end of the ten years , but interest rates are now . a . Given the change in interest rates , would you expect to pay more or less than for the bond ?

Calculate what you would actually be willing to pay for this bond . Suppose Ford Motor Company issues a year bond with a face value of that pays an annual coupon payment of 150 . a . What is the interest rate Ford is paying on the borrowed funds ?

Suppose the market interest rate rises from to a year after Ford issues the bonds . Will the value of the bond increase or decrease ?

How much money do you have to put into a bank account that pays 10 interest compounded annually to have in ten years ?

Many retirement funds charge an administrative fee each year equal to on managed assets . Suppose that and each invest in the same stock this year . invests directly and earns a year . uses a retirement fund and earns . After 30 years , how much more will have than ?