Financial Markets Learning Objectives Explain the function of
Financial Markets
Learning Objectives � Explain the function of capital markets in a market economy � Identify how diversification can reduce risk in an investment portfolio
THE MARKET BASKET History of United States Postage Rates (Rate for first-class postage for a one-ounce letter) Date Rate July 6, 1932 3 cents February 3, 1991 29 cents August 1, 1958 4 cents January 1, 1995 32 cents January 7, 1963 5 cents January 10, 1999 33 cents January 7, 1968 6 cents January 7, 2001 34 cents May 16, 1971 8 cents June 30, 2002 37 cents March 2, 1974 10 cents January 8, 2006 39 cents December 31, 1975 13 cents May 14, 2007 41 cents May 29, 1978 15 cents May 12, 2008 42 cents March 22, 1981 18 cents May 11, 2009 44 cents November 1, 1981 20 cents January 22, 2012 45 cents February 17, 1985 22 cents January 27, 2013 46 cents April 3, 1988 25 cents Source: http: //en. wikipedia. org/wiki/History_of_United_States_postage_rates; http: //www. akdart. com/postrate. html.
THE MARKET BASKET Inflation is a general, sustained upward movement of prices for goods and services in an economy. As a result of inflation, it takes more money to buy the same goods and services. Inflation means prices go up!
THE MARKET BASKET • The Bureau of Labor Statistics (BLS) is a federal agency that collects and analyzes economic data. • The BLS reports price changes using the consumer price index (CPI) a market basket of consumer goods and services • Items are divided into more than 200 categories, arranged into eight major groups:
THE MARKET BASKET The Eight Major Groups of the CPI Food and beverages Housing Apparel Transportation Medical care Recreation Education and communication Other goods and services
ARKET BASKET THE MARKET BASKET The CPI inflation rate can be determined comparing the percentage increase in the price level of goods and services from one time period to another. Annual CPI Inflation Rate Formula: Inflation rate CPI later year ─ CPI earlier year X 100
Financial Markets 1. 2. 3. 4. Raise Capital Storing, Protecting, and Making Profitable Use of Excess Capital Insuring Against Risk Speculation
Raising Capital � What does it mean to “raise capital”? Why is this important within the economy? (150151)
Raising Capital � Financial markets allow individuals, firms, and governments to do things today that they could not otherwise afford � Capital ◦ 1. Financial assets or the financial value of assets, such as cash. 2. The factories, machinery and equipment owned by a business and used in production.
Excess Capital � What is “excess capital”? What is the role of financial instruments in putting excess capital to use? � How does this work?
Excess Capital � Nominal return = how much money one earns in Interest � Inflation calculated from the Consumer Price Index (CPI) ◦ 1. 6% 2013 -2014 � Real Return = Nominal return – Inflation � Investing allows “excess capital” to not lose real value
Risk � What is risk? What role does insurance play in negotiating risk?
Insuring Against Risk � Insurance � Futures Contract- an agreement to sell a product in the future for a currently determined price � Credit Default Swaps (CDO’s) � Diversify investments (more later)
Speculation � What does it mean to “speculate”? (157)
Speculating � The act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain � Basically Gambling
Terms � Stocks � Dividend � Bonds � Mutual Fund � Index Fund
Stocks �A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings. � Return comes from two factors: ◦ Change in price of the share ◦ Dividends
Price Movement
Dividend �A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
Bonds A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate � Stocks Versus Bonds �
Mutual Fund � an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks or bonds
Index Fund � An index fund (also index tracker) is a fund that aims to replicate the movements of an index regardless of market conditions.
S & P 500 � Standard and Poor’s 500 � Made up of 500 Large Cap companies meant to mirror to US economy over all � Large Cap = market capitalization value of more than $10 billion ◦ Wal-Mart ◦ Microsoft ◦ General Electric � Market Capitalization= number of stock shares X stock price
Investing � How does the “efficient markets theory” play a role in how the financial markets work? � How is investing (buying stocks, etc. ) like a line at the grocery store?
Efficient Market Theory � An investment theory that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. � the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
� What other factors in how people invest challenge the efficient markets theory?
Author’s Investment Advise �Save, Invest, Repeat �Take Risk, Earn �Diversify �Invest for the Long Term
Save, Invest, Repeat �A good rule of thumb for young people is often: ◦ 50% of income used for needs ◦ 30% for lifestyle choices ◦ 20% saved
Take Risk, Earn � More risk = higher return � More risk = higher probability of loss of principle
Diversification and Risk The Pyramid of Risks and Reward Highest Risk - Highest Potential Return or Loss 10. commodities 9. collectibles 8. real estate 7. stocks 6. mutual funds 5. corporate bonds 4. government bonds 3. certificates of deposit 2. savings accounts 1. cash and checking accounts Lowest Risk - Lowest Potential Return or Loss
Invest for the Long Run
Diversification and Risk Portfolio a collection of financial investments held by an individual or financial organization Diversification investing in various financial instruments in order to reduce risk
Diversification and Risk Would you bet $100 on a coin flip if the deal were that you keep your $100 and receive an additional $5. 00 for heads, but lose $100 for tails? Would you bet $100 on a coin flip if the deal were that you keep your $100 and receive an additional $100 for heads, but lose $100 for tails? Would you bet $100 on a coin flip if the deal were that you keep your $100 and receive an additional $400 for heads, but lose $100 for tails?
Diversification and Risk Invest only what you can afford to lose. Invest at your comfort level. Invest according to your age.
Diversify � Diversify across different financial instruments ◦ ◦ Stocks Bonds Cash and CD’s Diversify across sectors and geographic locations � Electronically Traded Funds (ETF’s) and Mutual funds can provide easy diversification
Sample Portfolio
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