Principles of Microeconomics Scarcity and Social Provisioning Chapter 23 Financial Markets

CHAPTER 23 . FINANCIAL MARKETS INTRODUCTION TO FINANCIAL MARKETS Figure . Building Home Equity . Many people choose to purchase their home rather than rent . This chapter explores how the global financial crisis has home ownership . Credit modification of work by Diana Creative ) THE HOUSING BUBBLE AND THE FINANCIAL CRISIS OF 2007 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 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 US . citizens owned . However , by 2008 this number had gone down to trillion , and it declined further still in 2009 . Combined with the decline in value of other financial assets held by citizens , by 2010 , US . homeowners wealth had declined by 14 lion ! This is a staggering result , and it affected millions of lives people had to alter their retirement decisions , housing , and other important consumption decisions . ust about every other large economy in the world suffered a decline in the market value of financial assets , as a result of the global financial crisis of . This chapter will explain Why people buy houses ( other than as a place to live ) why they buy other types of financial assets , and why businesses sell those financial assets in the first place . The chapter will also give us insight into Why financial and assets go through boom and bust cycles like the one described here .

PRINCIPLES or ECONOMICS 649 CHAPTER OBJECTIVES Introduction to Financial Markets In this chapter , you will learn about How Businesses Raise Financial Capital How Households Supply Financial Capital How to Accumulate Personal Wealth hen a firm needs to buy new equipment or build a new facility , it often must go to the market to raise funds . Usually firms will add capacity during an economic expansion when profits 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 economy of 2009 , firms invested trillion in new equipment and structures , in the hope that these investments would generate profits in the years ahead . Between the end of the recession in 2009 through the second quarter 2013 , profits for the 500 companies grew to despite the weak economy , with much of that amount driven by cost cutting and reductions in input costs , according to the Wall Street . Figure shows corporate profits after taxes ( adjusted for inventory and capital consumption ) Despite the steep decline in quarterly net profit in 2008 , profits have recovered and surpassed levels . A 3400 Billions of Dollars 8200 Figure . Corporate Profits After Tax ( Adjusted for Inventory and Capital Consumption ) Until 2008 , corporate profits after tax have generally continued to increase each year . There was a significant drop in profits during 2008 and into 2009 . The profit trend has since continued to increase each year , though at a less steady or consistent rate . Source Federal Reserve Economic Data ( FRED )

650 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Many firms , from huge companies like General Motors to startup firms writing computer software , do not have the financial resources within the firm to make all the desired investments . These firms need financial capital from outside investors , and they are willing to pay interest for the opportunity to get a rate of return on the investment for that financial capital . On the other side of the financial capital market , suppliers of financial capital , like households , wish to use their savings in a way that will provide a return . Individuals can not , however , take the few sand dollars that they save in any given year , write a letter to General Motors or some other firm , and negotiate to invest their money with that firm . Financial capital markets bridge this gap that is , they find ways to take the of funds from many separate suppliers of financial capital and transform it into the funds desired by of financial capital . Such financial markets include stocks , bonds , bank loans , and other financial investments . Visit this Website to read more about financial markets . I Slate II Our perspective then shifts to consider how these financial investments appear to suppliers of capital such as the households that are saving funds . Households have a range of investment options bank accounts , certificates 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 indeed over a lifetime .

HOW BUSINESSES RAISE FINANCIAL CAPITAL LEARNING OBJECTIVES By the end of this section , you will be able to Describe financial capital and how it relates to profits Discuss the purpose and process of borrowing , bonds , and corporate stock Explain how firms choose between sources of financial capital often make decisions that involve spending money in the present and expecting to earn profits in the future . Examples include when a firm 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 financial capital they need to pay for such projects in four main ways ( from investors ( by profits ( by borrowing through banks or bonds and ( by selling stock . When owners of a business choose sources of financial capital , they also choose how to pay for them . EARLY STAGE 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 profits . Such firms face a difficult problem when it comes to raising financial capital How can a firm that has not yet demonstrated any ability to earn profits pay a rate of return to financial investors ?

For many small businesses , the original source of money is the owner of the business . Someone who decides to start a restaurant or a gas station , for instance , might cover the startup costs by dipping into his or her own bank account , or by borrowing money ( perhaps using a home as collateral ) many cities have a network of individuals , known as angel investors , who will put their own money into small new companies at an early stage of development , in exchange for owning some portion of the firm . Venture capital firms make financial investments in new companies that are still relatively small in size , but that have potential to grow substantially . These firms gather money from a variety of or institutional investors , including banks , institutions like college endowments , insurance that hold financial reserves , and corporate pension funds . Venture capital firms 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 firms , and then investors in that fund receive returns according to how the fund as a whole performs .

652 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER The amount of money invested in venture capital fluctuates substantially from year to year as one example , venture capital firms invested more than billion in 2014 , according to the National Venture Capital Association . All investors realize that the majority of small startup will never hit it big indeed , 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 Netflix or an can make up for a lot of failures . investors are therefore willing to take large risks in order to be in a position to gain substantial returns on their investment . PROFITS AS A SOURCE OF FINANCIAL CAPITAL If firms are earning profits ( their revenues are greater than costs ) they can choose to reinvest some of these profits in equipment , structures , and research and development . For many established , their own profits is one primary source of financial capital . Companies and firms just getting started may have numerous attractive investment opportunities , but few current profits to invest . Even large firms can experience a year or two of earning low profits or even suffering losses , but unless the firm can find a steady and reliable source of financial capital so that it can continue making real investments in tough times , the firm may not survive until better times arrive . Firms often need to find sources of financial capital other than profits . BORROWING BANKS AND BONDS When a firm has a record of at least earning significant revenues , and better still of earning profits , the firm can make a credible promise to pay interest , and so it becomes possible for the firm to borrow money . Firms have two main methods of borrowing banks and bonds . A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house . The firm borrows an amount of money and then promises to repay it , including some rate of interest , over a predetermined period of time . If the firm fails to make its loan payments , the bank ( or banks ) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments . Another source of financial capital is a bond . A bond is a financial contract a borrower agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future . A corporate bond is issued by firms , 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 specifies an amount that will be borrowed , the interest rate that will be paid , and the time until repayment . A large company , for example , might issue bonds for 10 million the firm 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 firm issues bonds , the total amount that is borrowed is divided up . A firm 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 firm , or any multiple of that amount . Anyone who owns a bond and receives the interest payments is called a bondholder . If a firm issues bonds and fails to make the promised interest payments , the can take the firm to court and require it to pay , even if the firm needs to raise the money by selling buildings or ment . However , there is no guarantee the firm will have sufficient assets to pay off the bonds . The may get back only a portion of what they loaned the firm .

PRINCIPLES or ECONOMICS 653 Bank borrowing is more customized than issuing bonds , so it often works better for relatively small firms . The bank can get to know the firm extremely because the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals . Relatively large and known firms often issue bonds instead . They use bonds to raise new financial capital that pays for investments , or to raise capital to pay off old bonds , or to buy other firms . However , the idea that banks are usually used for relatively smaller loans and bonds for larger loans is not an ironclad rule sometimes groups of banks make large loans and sometimes relatively small and firms issue bonds . CORPORATE STOCK AND PUBLIC FIRMS A corporation is a business that incorporates is owned by shareholders that have limited for the debt of the company but share in its profits ( and losses ) Corporations may be private or public , and may or may not have stock that is publicly traded . They may raise funds to finance their operations or new investments by raising capital through the sale of stock or the issuance of bonds . Those who buy the stock become the owners , or shareholders , of the firm . Stock represents ship of a firm that is , a person who owns 100 of a company stock , by definition , owns the entire company . The stock of a company is divided into shares . Corporate giants like IBM , AT , Ford , General Electric , and all have millions of shares of stock . In most large and firms , no individual owns a majority of the shares of the stock . Instead , large numbers of those who hold thousands of have only a small slice of the overall ownership of the firm . When a company is owned by a large number of shareholders , there are three questions to ask . How and when does the company get money from the sale of its 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 firm receives money from the sale of its stock only when the company sells its own stock to the public ( the public includes individuals , mutual funds , insurance companies , and pension funds ) A firm first sale of stock to the public is called 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 firms . A venture capital firm may have a 40 ownership in the firm . When the firm sells stock , the venture capital firm sells its part ownership of the firm to the public . A second reason for the of the is that it provides the established company with financial capital for a substantial expansion of its operations . Most of the time when corporate stock is bought and sold , however , the firm receives no financial return at all . If you buy shares of stock in General Motors , you almost certainly buy them from the current owner of those shares , and General Motors does not receive any of your money . This pattern should not seem particularly odd . After all , if you buy a house , the current owner gets your money , not the original builder of the house . Similarly , when you buy shares of stock , you are buying a small slice of ownership of the firm from the existing the firm that originally issued the stock is not a part of this transaction .

654 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Second , when a firm 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 firm can make a direct payment to its shareholders , called a dividend . Alternatively , a financial investor might buy a share of stock in Mart for 45 and then later sell that share of stock to someone else for 60 , for a gain of 15 . The increase in the value of the stock ( or of any asset ) between when it is bought and when it is sold is called a capital gain . Third Who makes the decisions about when a firm will issue stock , or pay dividends , or profits ?

To understand the answers to these questions , it is useful to separate firms into two groups private and public . A private company is owned by the people who run it on a basis . A private company can be run by individuals , in which case it is called a sole proprietorship , or it can be run by a group , in which case it is a partnership . A private company can also be a corporation , but with no publicly issued stock . A small law firm run by one person , even if it employs some other lawyers , would be a sole proprietorship . A larger law firm may be owned jointly by its partners . 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 firm . When a firm decides to sell stock , which in turn can be bought and sold by financial investors , it is called 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 firm on a basis . The more shares of stock a shareholder owns , the more votes that shareholder is entitled to cast for the board of directors . In theory , the board of directors helps to ensure that the firm is run in the interests of the true shareholders . However , the top executives who run the firm have a strong voice in choosing the candidates who will be on their board of directors . After all , few shareholders are knowledgeable enough or have enough of a personal incentive to spend energy and money nominating alternative members of the board . HOW FIRMS CHOOSE BETWEEN SOURCES OF FINANCIAL CAPITAL There are clear patterns in how businesses raise financial capital . These patterns can be explained in terms of imperfect information , which as discussed in Information , Risk , and Insurance , is a tion where buyers and sellers in a market do not both have full and equal information . Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital . Any young startup firm is a risk indeed , some startup firms are only a little more than an idea on paper . The firms founders inevitably have better information about how hard they are willing to work , and whether the firm is likely to succeed , than anyone else . When the founders put their own money into the firm , 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 and their business plan personally and by giving them advice . Accurate information is sometimes not available because corporate governance , the name

PRINCIPLES or ECONOMICS 655 mists give to the institutions that are supposed to watch over top executives , fails , as the following Clear It Up feature on Brothers shows . HOW DID LACK OF CORPORATE GOVERNANCE LEAD TO THE BROTHERS FAILURE ?

In 2008 , Brothers was the fourth largest US . investment bank , with employees . The firm had been in ness for 164 years . On September 15 , 2008 , Brothers filed 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 . Part of the oversight failure , according to Tim April 10 , 2010 , testimony to Congress , can be attributed to the Executive Compensation Committee emphasis on gains out 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 financial vice 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 hired to go over the financial records of the company 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 financial information about the firm operations . As a firm becomes at least somewhat established and its strategy appears likely to lead to profits 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 , revenues , costs , and profits . As a result , other outside investors who do not know the managers personally , like and shareholders , are more willing to provide financial capital to the firm . At this point , a firm must often choose how to access financial capital . It may choose to borrow from a bank , issue bonds , or issue stock . The great disadvantage of borrowing money from a bank or ing bonds is that the firm commits to scheduled interest payments , whether or not it has sufficient income . The great advantage of borrowing money is that the firm maintains control of its operations and is not subject to shareholders . Issuing stock involves selling off ownership of the company to the public and becoming responsible to a board of directors and the shareholders . The benefit of issuing stock is that a small and growing firm increases its visibility in the financial markets and can access large amounts of financial capital for expansion , without worrying about ing this money back . If the firm is successful and profitable , the board of directors will need to decide upon a dividend payout or how to reinvest profits 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 . KEY CONCEPTS AND SUMMARY Companies can raise financial capital in several ways from their owners or managers personal savings , or credit cards and from private investors like angel investors and venture capital firms .

656 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER A bond is a financial contract through which a borrower agrees to repay the amount that was rowed . A bond specifies an amount that will be borrowed , the amounts that will be repaid over time based on the interest rate when the bond is issued , and the time until repayment . Corporate bonds are issued by firms 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 of a firm . The stock of a company is divided into shares . A firm receives financial capital when it sells stock to the public . A company first sale of stock to the public is called the initial public offering ( However , a firm does not receive any funds when one shareholder sells stock in the firm to another investor . The rate of return on stock is received in two forms and capital gains . A private company is usually owned by the people who run it on a basis , although it can be run by hired managers . A private company owned and run by an individual is called a sole , while a firm owned run by a group is called a partnership . When a firm decides to sell stock that can be bought and sold by financial investors , then the firm is owned by its in turn elect a board of directors to hire top is called 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 . SELF CHECK QUESTIONS . Answer these three questions about corporate finance 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 firm is likely to earn profits , a venture capitalist or a potential bondholder , and why ?

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

How are they different ?

REVIEW QUESTIONS What are the most common ways for firms to raise financial capital ?

Why can firms not just use their own profits for financial capital , with no need for outside investors ?

Why are banks more Willing to lend to firms ?

What is a bond ?

What does a share of stock represent ?

When do firms receive money from the sale of stock in their firm and when do they not receive money ?

What is a dividend ?

What is a capital gain ?

What is the difference between a private company and a public company ?

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

PRINCIPLES OF ECONOMICS 657 CRITICAL THINKING QUESTIONS . If you owned a small firm that had become somewhat established , but you needed a surge of financial 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 . PROBLEMS The Darkroom Company has shares of stock outstanding . The investors in the firm 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 of the company ?

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

REFERENCES National Venture Capital Association . Recent Stats ?

Freddie Mac . 2015 . Freddie Mac Update March Accessed April 13 , Former , Jamie Should Your Small Business Go Public ?

Consider the Benefits and Risks of ing a Publicly Traded US . Small Business Administration Community Blog ( blog ) Publication date March 23 , bond a financial contract through which a borrower like a corporation , a city or state , or the federal government agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future bondholder someone who owns bonds and receives the interest payments capital gain a financial gain from buying an asset , like a share of stock or a house , and later selling it at a higher price corporate bond a bond issued by firms that wish to borrow corporate governance the name economists give to the institutions that are supposed to watch over top executives in companies owned by shareholders corporation a business owned by shareholders who have limited liability for the company debt yet a share of the company profits may be private or public and may or may not have stock dividend a direct payment from a firm to its shareholders initial public offering ( the first sale of shares of stock by a firm to outside investors

653 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER municipal bonds a bond issued by cities that wish to borrow partnership a company run by a group as opposed to an individual private company a firm owned by the people who run it on a basis public company a firm that has sold stock to the public , which in turn can be bought and sold by investors shareholders people who own at least some shares of stock in a firm shares the stock of a firm , divided into individual portions sole proprietorship a company run by an individual as opposed to a group stock a claim on partial ownership of a specific firm Treasury bond a bond issued by the federal government through the Department of the Treasury venture capital financial investments in new companies that are still relatively small in size , but that have potential to grow substantially SOLUTIONS Answers to Questions a . The management of small companies might rather do an right away , but until they get the company up and running , most people would pay very much for the stock because of the risks involved . A small company may be earning few or zero profits , and its owners want to reinvest their earnings in the future growth of the company . If this company issues bonds or borrows money , it is obligated to make interest payments , which can eat up the company cash . If the company issues stock , it is not obligated to make payments to anyone ( although it may choose to pay dividends ) Venture capitalists are private investors who can keep close tabs on the management and strategy of the thus reduce the problems of imperfect information about whether the firm is being well run . Venture capitalists often own a substantial portion of the firm and have much better information than a typical shareholder would . From a firm point of view , a bond is very similar to a bank loan . Both are ways of borrowing money . Both require paying interest . The major difference is who must be persuaded to lend money a bank loan requires persuading the bank , while issuing bonds requires persuading a number of separate . Since a bank often knows a great deal about a firm ( especially if the firm has its accounts with that bank ) bank loans are more common where imperfect information would otherwise be a problem .

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 he ways in which firms would prefer to raise funds are only half the story of financial 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 firms on the demand side of financial capital markets to households on the supply side of those markets . The mechanisms for saving available to households can be divided into several categories deposits in bank accounts bonds stocks money market mutual funds stock and bond mutual funds and housing and other assets like owning gold . Each of these investments needs to be analyzed 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 liquidity of the investment , which refers to how easily money or financial assets can be exchanged for a good or service . We will do this analysis as we discuss each of these 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 profitability . It is usually the average return over a period of time , usually in years or even decades . Risk measures the of that projects profitability . 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 . Interest rate risk is the danger that you might buy a long term bond at a interest rate right before market rates suddenly raise , so had you waited , you could have gotten a similar bond that paid . A investment is one for which a wide range of potential payoffs is reasonably probable . A risk investment will have actual returns that are fairly close to its expected rate of return year after year . A 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

660 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER refers to the total rate of return , including capital gains and interest paid on an investment at the end of a period of time . 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 financial capital markets , banks are an example of a financial 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 financial 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 funds deposited end up in one big pool , which is then loaned out . Figure illustrates the position of banks as a financial 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 . Loans it I of loans Interest payments Interest payments Figure . Banks as Financial Intermediaries . Banks are a financial 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 being billed separately through a credit card company ) A savings account typically pays some interest rate , but getting the money 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

PRINCIPLES OF ECONOMICS 661 account if you 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 certificate of deposit ( With a , as it is commonly called , 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 paid by savings accounts are typically a little lower than the rate , because financial investors need to receive a slightly higher rate of interest as for promising to leave deposits untouched for a period of time in a , and thus giving up some liquidity . 1260 1080 LO ( 20 540 Interest Rate ( 360 180 000 I I I ' I ) Figure . Interest Rates on , and Certificates of Deposit . The interest rates on certificates of deposit have over time . The high interest rates of the early are indicative of the relatively high rate in the United States at that time . Interest rates 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 of bank accounts are that financial 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 wear 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 happen to go bankrupt and not be able to repay depositors , the guarantees that all customers will receive their deposits back up to .

662 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 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 . An interest rate can always be divided up into three components ( as explained in Choice in a World of Scarcity ) compensation for delaying consumption , an adjustment for an rise in the overall level of prices , and a risk premium that takes the borrowers riskiness into account . The government is considered to be an extremely safe borrower , so when the government issues Treasury bonds , it can pay a relatively low rate of interest . Firms that appear to be safe ers , perhaps because of their sheer size or because they have consistently earned profits over time , will still pay a higher interest rate than the 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 . Bonds that offer high interest rates to compensate for their relatively high chance of default are called high yield bonds or junk bonds . A number of today firms issued junk bonds in the when they were starting to grow , including Turner Broadcasting and . 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 issuer of the bond has promised to make certain payments over time , and except for rare cases of bankruptcy , these payments will be made . If the issuer of a corporate bond fails to make the that it owes to its , the can require that the company declare , sell off its assets , and pay them as much as it can . Even in the case of junk bonds , a wise investor can reduce the risk by purchasing bonds from a wide range of different companies since , even if a few firms 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 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 est rate of , you have tied up and receive payments of only 80 per year . In the meaningful sense of opportunity cost , you are missing out on the higher payments that you could have received . Furthermore , the amount you should be willing to pay now for future payments can be calculated . To place a present discounted value on a future payment , decide what you would need in the present to

PRINCIPLES or ECONOMICS 663 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 . This is discussed 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 is given to an investor in exchange for capital ( money ) The bond has a face value . This is the amount the rower 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 were 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 . Bonds are bought not only when they are issued they are also bought and sold 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 , 000 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 final 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 bond 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 price of the bond 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 issuer of the bond will make the final interest payment and then also repay the original . Given that interest rates are 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 . Consider that the investor will receive the face value , plus 80 for the last year interest payment . The yield on the bond will be

664 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER ( 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 of bonds Treasury bonds ( Which are officially called notes ) and corporate bonds issued by firms that have been given an rating as relatively safe rowers by Moody , an independent firm that publishes such ratings . Even though corporate bonds pay a higher interest rate , because firms 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 . Corporate bonds US Treasury bonds rest Rate I I I I I I I ' I I ' I I ' 53 07 ' on ) 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 financial 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 risk of the borrower to moderate , depending on whether interest rates in the economy change substantially after the bond is issued , because the bond needs to be sold before the investor regains the cash . STOCKS As stated earlier , the rate of return on a financial investment in a share of stock can come in two forms as dividends paid by the firm and as a capital gain achieved by selling the stock for more than you paid . The range of possible returns from buying stock is . Firms can decide to pay

PRINCIPLES OF ECONOMICS 665 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 , companies can see large movements in the price of their stock . For example , 201 , stock peaked at 295 per share one year later , 30 , 2012 , it was at per share in 2015 , it had recovered to 414 . When Facebook went public , its shares of stock sold for around 40 per share , but in 2015 , they were selling for slightly over 83 . The reasons why stock prices fall and rise so abruptly will be discussed below , but first you need to know how we measure stock market performance . There are a number of different ways of ing the overall performance of the stock market , based on averaging the stock prices of different sets of companies . Perhaps the measure of the stock markets is the Dow Jones Industrial Average , which is based on the stock prices of 30 large companies . Another gauge of stock market performance , 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 measures of stock markets 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 Industrial Average ( on 30 large companies from a diverse set of representative industries , chosen by analysts at and Company . The index was started in 1896 . Standard Poor 500 on 500 large US . firms , chosen by analysts at Standard Poor to represent the economy as a whole . Wilshire 5000 essentially all US companies with stock ownership . Despite the name , this index includes about firms . New York Stock Exchange The oldest and largest US stock market , dating back to 1792 . It trades stocks for companies of all sizes . It is located at 18 Broad in New York City . in 1971 as an electronic stock market , allowing people to buy or sell from many physical locations It has about 600 companies , the 100 largest companies on the London Stock Exchange . Pronounced footsie . Originally stood for Financial Times Stock Exchange . stands for , which translates as the japan Economic , a major business newspaper . Index includes the 225 largest and most actively traded stocks on the Tokyo Stock Exchange . Tracks 30 of the largest companies on the Frankfurt , Germany , stock exchange . DAX DAX ) eXChange de is an abbreviation for Index . Table . Some Measures of Stock Markets The trend in the stock market is generally up over time , but with some large dips along the way . Figure shows the path of the Standard Poor 500 index ( which is measured on the vertical axis ) and the Index ( which is measured on the vertical axis ) Broad measures of the stock market , like the ones listed here , tend to move together . The 500 Index is the weighted average market capitalization of the firms selected to be in the index . The Industrial age is the price weighted average of 30 industrial stocks tracked on the New York Stock Exchange . When the average rises from to , you know that the average price of the stocks

666 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 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 about the same level . 16000 500 1400 . 200 A 800 A 600 400 A 200 A 2000 I I I I I I I I I I I I In ) In ) In 07 ( NI Year Figure . The 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 . Table 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 value of the stock . For technical sons related to how the numbers are calculated , the dividends and capital gains do not add exactly to the total return . From the to the , the average firm paid annual dividends equal to about of the value of its stock . Since the , dividends have dropped and now often provide a return closer to to . In the and , the gap between percent earned on capital gains and was much closer than it has been since the . In the and , however , capital gains were far higher than dividends . In the , dividends remained low and , while stock prices fluctuated , they ended the decade roughly where they had started .

PRINCIPLES or ECONOMICS 667 Period Total Annual Return Capital Gains Dividends 2010 2011 2012 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 first decade of the , the overall return on the stock market 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 stock in publicly held companies can be readily sold for spendable money . MUTUAL FUNDS Buying stocks or bonds issued by a single company is always somewhat risky . An individual firm may find itself buffeted by unfavorable supply and demand conditions or hurt by unlucky or unwise decisions . Thus , a standard recommendation from financial investors is diversification , which means buying stocks or bonds from a wide range of companies . A saver who is following the old proverb Don put all your eggs in one In any broad group of companies , some firms will do better than expected and some will do the extremes have a tendency to cancel out extreme increases and decreases in value . Purchasing a diversified group of the stocks or bonds has gotten easier in the Internet age , but it remains something of a task . To simplify the process , companies offer mutual funds , which are that buy a range of stocks or bonds from different companies . The financial investor buys shares of the mutual fund , and then receives a return based on how the fund as a whole performs . In 2012 , according to the Investment Company , about 44 of households had a financial investment in a mutual many people who have their retirement savings or pension money invested in this way . Mutual funds can be focused in certain areas one mutual fund might invest only in stocks of based in Indonesia , or only in bonds issued by large manufacturing companies , or only in stock of biotechnology companies . At the other end of the spectrum , a mutual fund might be quite broad at the extreme , some mutual funds own a tiny share of every firm in the stock market , and thus the value of the mutual fund will with the average of the overall stock market . A mutual fund that seeks only to mimic the overall performance of the market is called an index fund .

663 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Diversification 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 buckle their seatbelts against some ups and downs , like those the stock market experienced in the first decade of the . In 2008 average stock funds declined 38 , reducing the wealth of individuals and households . 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 high , 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 Households can also seek a rate of return by purchasing tangible assets , especially housing . About of households own their own home . An owner equity in a house is the monetary value the owner would have after selling the house and repaying any outstanding bank loans 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 loan for the remaining . Over time , you pay off some of your bank loan , so that only remains , and the value of the house 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 est financial asset . The total value of all home equity held by households was trillion at the end of 2015 , according to Federal Reserve Data . Investment in a house is tangibly different from bank accounts , stocks , and bonds because a house offers both a financial and a nonfinancial return . If you buy a house to live in , part of the return on your investment occurs from your consumption of housing services is , having a place to live . Of course , if you buy a home and rent it out , you receive rental payments for the housing services you provide , which would offer a financial return . Buying a house to live in also offers the possibility of a capital gain from selling the house in the future for more than you paid for it . There can , however , be different outcomes , as the Clear It Up on the housing market shows . Housing prices have usually risen steadily over time for example , the median sales price for an ing home was in 1990 , but in 2015 . Over these 23 years , home prices increased an average of per year , which is an average financial return over this time . Figure shows Census data for the median average sales price of a house in the United States over this time period . Go to this website to experiment with a compound annual growth rate calculator .

PRINCIPLES or ECONOMICS 669 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 2015 , home values had almost recovered to their levels . Visit this Website to watch the trailer for , a movie that explores the modern financial crisis . 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 , orange juice , oil , and natural gas . The return on these investments derives from the saver hope of buying low , selling high , and receiving a capital gain . Investing in , say , gold or coffee offers relatively little in the way of nonfinancial benefits to the user ( unless the investor likes to caress gold or gaze upon a warehouse full of coffee ) Indeed , cally investors in these commodities never even see the physical goods instead , they sign a contract that takes ownership of a 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 price of gold generally between about 300 and 500 per ounce , but then rose sharply to over per ounce by early 2010 . A final area of tangible assets are collectibles like paintings , fine wine , jewelry , antiques , or even baseball cards . Most collectibles provide returns both in the form of services or of a potentially higher selling price in the future . You can use paintings 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 should 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

670 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Median Price 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 an 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 figure 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 ) nonfinancial benefits 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 fine art and turn your capital gain into cash . The next Clear It Up feature explains the issues in the recent housing market crisis . WHAT WAS ALL THE COMMOTION IN THE RECENT HOUSING MARKET ?

The cumulative average growth rate in housing prices from 1981 to 2000 was . The price of an average home then took off from 2003 to 2005 , rising at 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 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 fits 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 people were encouraged to borrow money to buy a house . Banks became much more 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 for the first two years , but then much higher payments after that the idea was that housing prices would keep ing , 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 loan given even though the borrower had No Income , Nojob or Assets .

PRINCIPLES or ECONOMICS 671 In retrospect , these loans seem nearly crazy . Many borrowers figured , 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 financial securities , and then these backed securities to investors . In this way , the lenders the risks of the mortgages to investors . Investors were interested in securities as they appeared to offer a steady stream of income , provided the mortgages were repaid . Investors relied on the ratings agencies to assess the credit risk associated with the mortgage backed securities . In hindsight , it appears that the credit agencies were far too lenient in their ratings of many of the loans . Bank and financial 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 their home was worth . Many banks believed that they had diversified by selling their individual loans and instead buying securities based on mortgage loans from all over the country . After all , banks thought back in 2005 , the average price of a house had not declined at any time since the Great Depression of the . These securities based on mortgage loans , however , turned out to be far riskier than expected . The bust in housing prices weakened the finances of both banks and households , and thus helped bring on the Great Recession of . THE BETWEEN RETURN AND RISK The discussion of financial 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 Certificate 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 Gold Medium High Low Collectibles Low to medium High Low Table . Key Characteristics for Financial Investments The household investment choices listed here display a tradeoff between 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 financial 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 can be expected over

672 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 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 a great deal . Thus , a person near retirement age , who already owns a house , may prefer reduced risk and certainty about ment income . For young workers , just starting to make a reasonably profitable living , it may make sense to put most of their savings for retirement in stocks . 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 , between risk and return must be considered in the text of where the investor is in life . KEY CONCEPTS AND SUMMARY All investments can be categorized according to three key characteristics average expected return , degree of risk , and liquidity . To get a higher rate of return , an investor must typically accept either more risk or less liquidity . Banks are an example of a financial intermediary , an institution that ates to coordinate supply and demand in the financial capital market . Banks offer a range of accounts , including checking accounts , savings accounts , and certificates of deposit . Under the federal deposit insurance program , banks purchase insurance against the risk of a bank failure . A typical bond promises the financial investor a series of payments over time , based on the interest rate at the time the bond is issued , and then repayment of what was borrowed . Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high yield or junk 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 fixed rate of interest , 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 price of a stock depend on changes in expectations about future profits . Investing in any individual firm is somewhat risky , so investors are wise to practice diversification , which means investing in a range of companies . A mutual fund purchases an array of stocks or bonds . An investor in the mutual fund then receives a return depending on the overall performance of the made by the fund as a whole . A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund . Housing and other tangible assets can also be regarded as forms of financial investment , which pay a rate of return in the form of capital gains . Housing can also offer a nonfinancial , you can live in it . SELF CHECK QUESTIONS . Calculate the equity each of these people has in his or her home Fred just bought a house for by putting 10 as a down payment and borrowing the rest from the bank . bought a house for in cash , but if she were to sell it now , it would sell for .

21 31 673 PRINCIPLES OF ECONOMICS Frank 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 higher 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 ?

REVIEW QUESTIONS Why are banks called financial intermediaries ?

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

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

Why should a financial investor care about diversification ?

What is a mutual fund ?

What is an index fund ?

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

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

CRITICAL THINKING QUESTIONS What are some reasons Why the investment strategy of a might differ from the investment strategy of a ?

Explain why a financial investor in stocks can not earn high capital gains simply by buying companies with a demonstrated record of high profits . PROBLEMS Imagine that a bond was issued 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 five year bond with a face value of that pays an annual coupon payment of 150 .

674 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER a . What is the interest rate Ford is paying on the borrowed funds ?

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

REFERENCES , Kathleen . Home Value Highest Since 07 as . Houses Make Last modified March 26 , 2015 . Facebook , Inc . Historical Stock Accessed March 28 , historical . National Association of Realtors . 2015 . Sales Latest Accessed April , data . 2015 . Annual Venture Capital Investment Tops 48 Billion in 2014 , Reaching Level in Over a Decade , According to the Accessed April , Ben . Trading Program Sparked May Flash Crash . Money . Last modified October , Investment Company Institute . 2013 Investment Company Fact Book , Chapter Characteristics of Mutual Fund . actual rate of return the total rate of return , including capital gains and interest paid on an investment at the end of a period of time bond yield the rate of return a bond is expected to pay at the time of purchase certificate 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 rate of interest 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 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 cost is immediately deducted from that persons checking account diversification investing in a wide range of companies to reduce the level of risk 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 profitability face value the amount that the bond issuer or borrower agrees to pay the investor

PRINCIPLES OF ECONOMICS 675 financial intermediary an institution , like a bank , that receives money from savers and provides funds to borrowers high yield 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 overall performance of the market junk bonds see high yield bonds liquidity refers to how easily money or financial assets can be exchanged for a good or service maturity date the date that a bond must be repaid mutual funds funds that buy a range of stocks or bonds from different companies , thus allowing an investor an easy way to diversify present value a bond current price at a given time risk a measure of the uncertainty of that projects profitability 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 SOLUTIONS Answers to Questions Remember , equity is the market value of the house minus what is still owed to the bank . Thus the value of the house is , Fred owes to the bank , and his equity is . The value of house is . It does not matter What price she bought it for . She owes zero to the bank , so her equity is the whole . The value of Frank house is . He owes to the bank ( the original minus the he has paid off the loan ) His equity is . Over a sustained period of time , stocks have an average return higher than bonds , and bonds have an average return higher than a savings account . This is because in any given year the value of a savings account changes very little . In contrast , stock values can grow or decline by a very large amount ( for example , the 500 increased 26 in 2009 after declining 37 in 2008 . The value of a bond , which depends largely on interest rate , varies far less than a stock , but more than a savings account . When people believe that a investment must have a low return , they are getting confused between What risk and return mean . Yes , a investment might have a low return , but it might also have a high return . Risk refers to the fact that a wide range of outcomes is possible . However , a investment must , on average , expect a relatively high return or else no one would be willing to take the risk . Thus , it is quite an investment to have high risk and high return . Indeed , the reason that an investment has a high expected return is that it also has a high risk .

HOW TO ACCUMULATE PERSONAL WEALTH LEARNING OBJECT ES 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 financial capital rich may seem straightforward enough . Figure out what companies are going to grow and earn high profits in the future , or figure 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 first discusses the problems with ing 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 chief problem with attempting to buy stock in companies that will have higher prices in the future is that many other financial 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 profits 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 profits . The idea that stock prices are based on expectations about the future has a powerful and unexpected implication . If expectations determine stock price , then shifts in expectations will determine shifts in the stock price . Thus , what matters for predicting whether the stock price of a company will do well is not whether the company will actually earn profits in the future . Instead , you must find a company that is widely believed at present to have poor prospects , but that will actually turn out to be a ing 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 definition , no one can the future news that alters expectations about profits . Because stock prices will shift in response to unpredictable future news , these prices will tend to follow what mathematicians call a random

PRINCIPLES or ECONOMICS 677 walk with a The random walk part means that , on any given day , stock prices are just 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 financial 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 of years in a row , the majority of financial 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 ally ended up doing worse than the market average . For the average investor who reads the business pages of the newspaper 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 citizens can accumulate a large amount of wealth during their lifetimes , if they make two key choices . The first is to complete additional education and training . In 2014 , the Census Bureau reported median earnings for households where the main earner had only a high school degree of for those with a associate degree , median earnings were and for those with a bachelors degree , median income was . Learning is not only good for you , but it pays off financially , too . The second key choice is to start saving money early in life , and to give the power of compound est 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 fifteen fold ( 44 , 923 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 of wealth 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 of dollars 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 . Step . Learn the formula for simple interest Principal Rate Time Interest Step . Practice using the simple interest formula .

673 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 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 ) 115 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 Value Present Value 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 105 ( 105 ) Year Amount in Bank Bank Interest Rate Total ( Compound interest 100 Table . Step . Note that , after three years , the total is 1575 . Therefore the total compound interest is . This is more than was 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 .

PRINCIPLES or ECONOMICS 679 Getting additional education and saving money early in life obviously will not make you rich overnight . Additional education typically means putting off 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 sacrifices . For most ple , the for achieving substantial personal wealth will require effort , patience , and sacrifice . HOW CAPITAL MARKETS TRANSFORM FINANCIAL FLOWS Financial capital markets have the power to repackage money as it moves from those who supply financial capital to those who demand it . Banks accept checking account deposits and turn them into loans to companies . Individual firms 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 decisions by buying stock in that company . Stocks and bonds are sold and resold by financial investors 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 . Visit this Website to read an article about how austerity can Work . In this chapter , we discussed the basic mechanisms of financial markets . A more advanced course in economics or finance will consider more sophisticated tools . The fundamentals of those financial capital markets remain the same Firms are trying to raise financial capital and households are looking for a desirable combination of rate of return , risk , and liquidity . Financial markets are society for bringing together these forces of demand and supply . 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 , started with the fall of home prices starting in 2007 . As home values fell , many home prices fell below the amount owed on the mortgage and owners stopped paying and defaulted on their loan . Banks found that their assets ( loans ) became Worthless . Many financial institutions around the World had invested in securities , or had purchased insurance on securities . When housing prices collapsed , the value of those financial assets collapsed as well . The asset side of the banks balance sheets dropped , causing bank failures and bank runs . Around the globe , financial institutions were bankrupted or nearly so . The result was a large decrease in lending and borrowing , referred to as 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 .

580 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER If businesses can not access financial capital , they can not make physical capital investments . Those investments ultimately lead to job creation . So 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 . pounding these events , as economic conditions worsened , financial institutions were even less likely to make loans . To make matters even worse , as businesses sold less , their expected future profit 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 2009 . During this time , the ployment rate rose from to a peak of . Four years after the recession officially 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 financial assistance , bailouts , to the institutions that make up their financial markets . There was good reason to do this . Financial markets bridge the gap between and suppliers of financial capital . These institutions and need to function in order for an economy to invest in new financial 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 financial crisis and the resulting bailouts , many countries found themselves with high deficits . They chose to undertake austerity measures , large decreases in government spending and large tax increases , in order to reduce their deficits . Greece , Ireland , Spain , and Portugal have all had to undertake relatively severe austerity measures . The ramifications of this crisis have spread the viability of the euro has even been called into question . KEY CONCEPTS AND SUMMARY It is extremely difficult , even for financial professionals , to predict changes in future expectations and thus to choose the stocks whose price is going to rise in the future . Most Americans can accumulate considerable financial wealth if they follow two rules complete significant additional education and training after graduating from high school and start saving money early in life . SELF CHECK QUESTIONS . What is the total amount of interest collected from a loan after three years with a simple interest rate of ?

If your 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 two key choices citizens need to make that determines their relative wealth ?

Is investing in housing always a very safe investment ?

PRINCIPLES OF ECONOMICS 681 CRITICAL THINKING QUESTIONS Explain what happens in an economy when the financial markets limit access to capital How does this affect economic growth and employment ?

A You and your friend have opened an account on and have each decided to select five similar companies in which to invest . You are diligent in monitoring your selections , tracking prices , current events , and actions taken by the company . Your friend chooses his companies randomly , pays no attention to the financial 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 . 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 ?

REFERENCES Department of Commerce United States Census Bureau . Income Table . Educational Attainment of with Householder 25 Years Old and Over by Median and Mean . United States Department of Labor . Bureau of Labor Statistics . 2015 . Table . and Selected of Usual Weekly Earnings of Wage and Salary Workers by Selected Characteristics , 2014 Annual Accessed April , GLOSSARY compound interest an interest rate calculation on the principal plus the accumulated interest simple interest an interest rate calculation only on the principal amount SOLUTIONS Answers to Questions Principal ( principal rate time )

682 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Principal ( principal rate time ) Interest Principal rate time 500 rate 500 rate 50 , 000 rate Rate Principal ( interest rate ) ti (