Intro to Business - Ch 10: Financial Markets: Allocating Financial Resources
The price at which shares of an open-end mutual fund are issued and redeemed is based on the fund's _____.
net asset value per share (10-3d)
electronic communications networks (ECNs) (10-4b)
an automated, computerized securities trading system that automatically matches buyers and sellers, executing trades quickly and allowing trading when securities exchanges are closed If you place an order to buy a security on an ECN, the computer system checks to see if there is a matching order from another trader to sell the same security. If so, it immediately and automatically executes the transaction in a process that typically takes less than a second to complete. They also make it possible for investors to trade securities "after hours" when the U.S. exchanges are closed.
Mutual funds (10-3d)
an institutional investor that raises funds by selling shares to investors and uses the accumulated funds to buy a portfolio of many different securities
Market orders (10-5b)
an order telling a broker to buy or sell a specific security at the best currently available price Placing a market order virtually guarantees that your order will be executed. The downside is that you may end up buying at a higher price than you expected to pay (or selling your stock for less than you expected to receive).
Limit orders (10-5b)
an order to a broker to buy a specific stock only if its price is below a certain level, or to sell a specific stock only if its price is above a certain level You'd want this approach if you wanted to make sure you didn't pay more for the stock than you thought it was worth.
Stock (or securities) exchange (10-4b)
an organized venue for trading stocks and other securities that meet its listing requirements Each exchange establishes its own requirements for the securities it lists. The requirements vary among the exchanges but they're typically based on the earnings of the company, the number of shares of stock outstanding, and the number of shareholders.
Full-service broker
provides a wide range of services such as market research, investment advice, and tax planning in addition to carrying out your trades
Buying and Holding (10-5c)
purchasing a diversified set of securities and holding them for a long period of time Buy-and-hold investors put their faith in the ability of the overall market to continue the long-run upward trend it has exhibited throughout its history. One way that many buy-and-hold investors do this is by investing in index mutual funds and ETFs. The buy-and-hold strategy seldom allows investors to "get rick quick," but it usually results in a solid financial return over the long haul. Obviously, the buy-and-hold strategy will work only if you can afford to leave your money invested for a long time. And if you can get through nosedives such as the stock market taking a dive, it can take years for stocks to regain their original value.
Stock index (10-6a)
a statistic that tracks how the prices of a specific set of stocks have changed Many investors like to compare how the stocks in their own portfolio compare to the performance of these broad indices. Two of the best-known indices are the Dow Jones Industrial Average and the S&P 500.
Standard & Poor's 500 (10-6a)
a stock index based on prices of 500 major US corporations in a variety of industries and market sectors Still, like the Dow, the companies included in the S&P 500 are large, well-established American corporations such as 3M, Adobe Systems, Amazon, Google, Facebook, Wells Fargo, etc.
Underwriting syndicate (10-4a)
a group of other bankers formed by an investment banker to share the financial risk associated with underwriting new securities
Bonds: Earning Your Interest (10-3c)
A bond is a formal IOU issued by a corporation or government entity. They can come in many different varieties. The date a bond comes due is called its maturity date, and the amount the issuer owes the bondholder at maturity is called the bond's par value (or face value) (the value of a bond at its maturity, what the issuer promises to pay the bondholder when the bond matures). Bondholders can sell their bonds to other investors to other investors before they mature, but the price they receive might not correspond to the bond's par value because bond prices fluctuate with conditions in the bond market.
Securities Exchange Act of 1934 (10-2a)
A federal law dealing with securities regulation that established the Securities and Exchange Commission to regulate and oversee the securities industry. The Securities Exchange Act of 1934 required that all publicly traded firms with at least 500 shareholders and $10 million in assets file quarterly and annual financial reports with the Securities and Exchange Commission (SEC).
securities brokers (10-1b)
A financial intermediary that acts as an agent for investors who want to buy and sell financial securities (such as corporate stocks or bonds). Brokers earn commissions and fees for the services they provide (such as financial planning and market research).
Exchange Traded Funds: Real Basket Cases (and We Mean That in a Good Way) (10-3e)
An exchange-traded fund (ETF) (shares traded on securities markets that represent the legal right of ownership over part of a basket of individual stock certificates or other securities) is similar to a mutual fund in some respects but differs in how it is created and how it shares are initially distributed. ETFs allow investors to buy ownership in what is called a market basket of many different securities. But in recent years more specialized ETFs that focus on narrower market baskets of assets have appeared on the market. Like closed-end mutual funds--but unlike the more common open-end funds--ETFs are traded just like stocks. Thus, you can buy and sell ETFs any time of the day. Compared to most actively managed mutual funds, ETFs usually have lower costs and fees. However, since ETFs are bought and sold like stocks, you do have to pay brokerage commissions every time you buy or sell shares.
Dow Jones Industrial Average (DJIA) (10-6a)
An index that tracks stock prices of 30 large, well-known U.S. corporations. E.g. Apple, General Electric, Coca-Cola, McDonald's, Verizon, Disney, etc. The Dow is based on the adjusted average price of 30 stocks picked by the editors of The Wall Street Journal.
Recent Developments: Reregulation in the Aftermath of Financial Turmoil (10-2b)
But the wave of deregulation didn't last. A series of accounting scandals at the beginning of the 21st century, followed by a near collapse of the financial system in 2008, created pressure for new laws: 1. Sarbanes Oxley Act in 2002: This law included provisions to ensure that external auditors offered fair, unbiased opinions when they examined a company's financial statements. It also increased the SEC's authority to regular financial markets and investigate charges of fraud and unethical behavior. 2. Dodd-Frank Act of 2010.: This far-reaching law expanded the Fed's regulatory authority over nondepository financial institutions, such as hedge funds and mortgage brokers that had previously operated with little regulatory oversight or accountability. - It also created the Financial Stability Oversight Council to identify emerging risks in the financial sector so that action could be take to rein in risky practices before they led to a crisis. - The council was given the authority to recommend new rules to the Federal Reserve that would limit risky practices of the nation's largest, most complex financial institutions.
Preferred Stock: Getting Preferential Treatment (10-3b)
Common stock is the basic form of corporate ownership, but some companies also issue preferred stock, so named because it offers its holders preferential treatment in two respects. - Claim on Assets: Holders of preferred stock have a claim on assets that comes before common stockholders if the company goes out of business. - Payment of Dividends: Unlike dividends on common stock, dividends of preferred stock are usually a stated amount. And a corporation can't pay any dividend to its common stockholders unless it pays the full stated dividend on its preferred stock. Still, it is important to note that a corporation has no legal obligation to pay a dividend to any stockholders, not even those who hold preferred stock. Preferred stock sometimes includes a cumulative feature. This means that if the firm skips a preferred dividend in one period, the amount it must pay the next period is equal to the dividend for that period plus the amount of the dividend it skipped in the previous period. Things to note: - Preferred stockholders also don't have voting rights. - They also aren't guaranteed a better dividend (the board can declare a dividend to common stockholders that offers a higher return), even though they are more likely to receive one. - Finally, when a company experiences strong earnings, the market price of its common stock can--and often does--appreciate more in value than the price of its preferred shares, thus offering common shareholders a great capital gain.
Common Stock: Back to Basics (10-3a)
Common stock is the basic form of ownership in a corporation. As owners of corporations, common stockholders have certain basic rights: - Voting rights: Owners of common stock have the right to vote on important issues in the annual stockholders' meeting. - Right to dividends: Dividends are a distribution of earnings to the corporate stockholders. - Capital gains: Stockholders receive another type of return on their investment, called a capital gain (the return on an asset that results when its market price rises above the price the investor pays for it). - Preemptive Right: If a corporation issues new stock, existing stockholders sometimes have a preemptive right to purchase new shares in proportion to their existing holdings before the stock is offered to the other investors. - Right to a Residual Claim on Assets: The final stockholder right is a residual claim on assets. If the corporation goes out of business and liquidates its assets, stockholders have a right to share in the proceeds in proportion to their ownership. BUT note that this is a residual claim--it comes after all other claims have been satisfied.
Convertible Securities: The Big Switch (10-3d)
Corporations sometimes issue convertible securities, which are bonds or shares of preferred stock that investors can exchange for a given number of shares of the issuing corporations common stock. A conversion ratio indicates the number of shares of common stock exchanged for each convertible security. Owning a convertible security allows investors to gain from an increase in the price of common stock, while limiting their risk if the price of the stock falls. If the price of the common stock increases, the holders of convertible securities can convert them into the now more valuable stock. But if the price of the company's common stock falls, investors can continue to hold their convertible securities and collect their interest or preferred dividends. The firm can also benefit from issuing convertible bonds because the popularity of this feature with investors allows it to offer a lower coupon rate on convertible bonds (or a lower dividend on preferred stock), thus reducing its fixed payments. And if investors convert to common stock, the firm no longer has to make these fixed payments at all.
Financial Regulation: Early Efforts (10-2a)
During most of the 20th century, the federal government responded to financial upheavals by introducing new laws and regulations. This trend first emerged in the wake of the banking panic of 1907, which created pressure for Congress to find a way to stabilize the nation's banking systems. The result was the Federal Reserve Act of 1913. As its name implies, this act created the Federal Reserve System (the Fed) to serve as the central bank in the United States. This law gave the Fed the primary responsibility for overseeing our nation's banking system.
Mutual Funds and ETFs: Diversification Made Easy (10-3d)
Financial diversification--the practice of holding many different securities in many different sectors--is generally considered a desirable strategy because it helps reduce (but not completely eliminate) risk.
The Role of Financial Markets and Their Key Players (10-1 heading)
Financial markets (markets that transfer funds from savers to borrowers) perform a vital function: they transfer funds from savers (individuals and organizations willing to defer using some of their income to earn a financial return and build their wealth) to borrowers (individuals and organizations that need additional funds to achieve their financial goals). Without these markets, companies would find it difficult to obtain the financial resources needed to meet payrolls, invest in new facilities, develop new products, and compete effectively in global markets. In the United States and other well-developed market economies, the vast majority of financing occurs indirectly, with financial intermediaries coming between the ultimate savers and borrowers.
Regulating Financial Markets to Protect Investors and Improve Stability (10-2 heading)
Financial markets work well only when savers and borrowers have confidence in the soundness of key financial institutions and in the fairness of the market outcomes. When depositors lose confidence in the banks, or when investors discover that financial markets are rigged by practices such as insider trading or unethical and deceptive accounting, the financial system breaks down. E.g. The financial crisis of 2008 is only the latest example of the disruptions that result when financial markets malfunction.
Investing in Financial Securities: What are the Options? (10-3 heading)
Financial securities markets are critical to corporations that rely on them to obtain much of their long-term financial capital. They also provide one of the most important venues that individuals can use to build their long-term wealth and earn significant financial returns.
institutional investors (10-1b)
Large organizations such as pension funds or mutual funds that invest their own funds or the funds of others. (View Exhibit 10.1 on pg. 173 for examples).
Accredited investors (10-4a)
In a private placement, the issuing firm negotiates the terms of the offer directly with a small number of accredited investors. an organization or individual investor who meets certain criteria established by the SEC and so qualifies to invest in unregistered securities The main reason private placements are simpler and less expensive than public offerings is that privately placed securities are exempt from the requirement to register with the SEC. The ability to obtain financing without having to prepare complex registration documents can be a real attraction
Investing for Growth (10-5c)
Investing in companies that have the potential to grow much faster than average for a sustained time Investing for growth entails significant risk. Small new companies lack established track records. And rapidly expanding industries tend to attract many start-up companies, co competition can be intense. Finally, given the rapid pace of technological change, today's hot prospects may soon be dethroned by the next big thing. It's hard to predict which firms will be winners; even experts often make the wrong choice.
Value Investing (10-5c)
Investing in stocks that are undervalued in the market They believe that the market price will rise over time to reflect its true value, thus generating a capital gain. This approach requires intensive research to identify discrepancies between a company's true (or intrinsic) value and its current market price. The drawback with value investing is that thousands of investors are all trying to do the same thing, so the competition to locate undervalued stocks is intense.
Registration statement (10-4a)
a long, complex document that firms must file with the SEC when they sell securities through a public offering (View Exhibit 10.3 on pg. 182 for more information).
Tracking the Performance of Specific Securities
Many financial websites offer detailed stock quotes that provide the current price of a company's stock and a wealth of related information. To check out a specific stock, you simply type its stock symbol--a short combination of letters that uniquely identifies a corporate security--into a "Get Quote" box. Illustrating information about a company's common stock, this includes key figures such as: - Last trade: The price of McDonald's common stock for the most recent trade was $124.63. - Change: The last trade of McDonald's stock was $0.04 lower than the closing price for the stock on the previous day. - Bid and Ask: The highest price currently offered (bid) to buy McDonald's stock is $124.64 for 100 shares. The lowest price currently offered (asked) to sell the stock is $124.99 for 2,000 shares. - Day's range: The highest price for the stock during the day was $124.98 and the lowest price was $124.36. - 52-Week Range: The highest price for McDonald's stock over the previous 52 weeks was $131.96 while its lowest price was $110.33. - Volume: 1,420,703 shares of the stock have been traded up to this point in the current trading session--well below the average of 3,882,779 shares. - Market Cap: The total market value of all shares of McDonald's common stock outstanding was 103.51 billion. This is found by multiplying the price per share times the number of shares of common stock outstanding. - P/E: The price-to-earnings of 23.42 is found by dividing the stock's price per share by its earnings per share. In general, a higher P/E ratio means investors expect a greater growth in earnings over time. - EPS (earnings per share): McDonald's earned $5.32 per share of common stock outstanding. EPS is computed by dividing the net income available to common stockholders by the number of shares of common stock outstanding. - Div & Yield: The sums of dividends paid by McDonald's over the past 12 months was $3.76 per share. Yield is found by dividing the dividend per share by the previous day's price per share. It tells us that at that price the dividend paid by McDonald's represented a 3.02% return to the investor. (But since the total return to stockholders may also include a capital gain or loss, this yield doesn't tell us the whole story). Financial websites also provide information about other types of securities such as mutual funds, ETFs, and bonds.
Choosing a Broker: Gaining Access to the Markets (10-5a)
Members of the general public cannot directly trade stocks and other securities on the exchanges, the over-the-counter market, or the ECNs described earlier in the chapter. Thus most investors enlist the services of a brokerage firm to carry out their trades. Choosing the right broker is the first step in implementing your investment plans.
Keeping Tabs on the Market (10-6 heading)
Once you've begun to invest in securities, you'll want to keep track of how your investments are doing. Using the Internet, you can easily find information about both general market trends and the performance of specific securities.
Buying Securities: Let's Make a Deal (10-5b)
Once you've setup your account, you can trade securities by contacting your broker and indicating the security you want to trade and the quantity you want to buy or sell. You can also specify the type of order you want to place. The most common types of orders are market orders and limit orders.
Stock Indices: Tracking the Trends (10-6a)
One of the most common ways to track general market conditions and trends is to follow what's happening to various stock indices.
Nondepository Financial Institutions (10-1b)
Other types of financial institutions that offer banking services. Do not accept deposits Examples of nondepository financial institutions: - institutional investors - securities brokers - securities dealers - investment banks
Discount brokers (10-5a)
Provide basic services needed to buy and sell securities but offer fewer additional services They may also restrict your ability to trade certain types of securities. For example, some discount brokers don't offer the ability to buy and sell foreign securities. Once you've decided on a broker, you need to open an account. This is a fairly simple process; it requires filling out some forms (usually available online) and making an initial investment. The minimum initial investment varies, but $1000 to $3000 is fairly typical.
Investing for Income (10-5c)
Some investors focus on buying bonds and preferred stocks to generate a steady, predictable flow of income.
Secondary Securities Markets: Let's Make a Deal (10-4b)
The firms that issue stocks and bonds don't receive any additional funds when their securities are traded in the secondary markets,. But few investors would want to buy securities issued in the primary markets without the liquidity and possibility of earning capital gains provided by the opportunity to sell these securities in the secondary markets.
Securities Act of 1933 (10-2a)
The first major federal law regulating the securities industry. It requires firms issuing new stock in a public offering to file a registration statement with the SEC.
Banking Act of 1933 (10-2a)
The law that established the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits. It also prohibited commercial banks from selling insurance or acting as investment banks. Another major provision of the Glass Stegall Act banned commercial banks from dealing in securities markets, selling insurance, or otherwise competing with nondepository institutions such as insurance companies and investment banks.
Deregulation During the 1980s and 1990s: Temporarily Reversing Course (10-2b)
The passage of these laws ushered in a period of more stable financial markets. But critics argued that the laws--especially the Glass-Steagall Act--represented an onerous government intrusion into the financial sector that stifled competition and impeded financial innovation. During the 1980s and 1990s, Congress responded to these criticisms by easing restrictions on banks and other depository institutions. For instance, the Financial Services Modernization Act of 1999, also known as the Gramm-Bliley-Leach Act, reversed the Glass-Steagall Act's prohibition of banks selling insurance or acting as investment banks. As a result, the financial sector prospered in the new freedom with a variety of new services (new technologies such as ATMs and online banking made financial transactions easier and more convenient).
Strategies for Investing in Securities (10-5c)
There are several strategies you can use to guide your investment decisions. We'll provide an overview of the more common approaches, but none of these approaches is foolproof--alas, there is no known strategy that is guaranteed to earn you millions.
Issuing and Trading Securities: The Primary and Secondary Markets (10-4 heading)
There are two distinct types of securities markets: the primary securities market (the market where newly issued securities are traded. the primary market is where the firms that issue securities raise additional financial capital) and the secondary securities market (the market where previously issued securities are traded).
The Primary Securities Market: Where Securities Are Issued (10-4a)
There are two markets of issuing securities in the primary market: - In a public offering, new securities are sold (in concept, at least) to anyone in the investing public who is willing and financially able to buy them. - In a private placement, securities are sold to one or more private investors (who may be individuals or institutions) under terms negotiated between the issuing firm and the private investors. Which of the following is a drawback of private placements? Unregistered securities cannot be sold to anyone except accredited investors.
Market Timing (10-5c)
Use a variety of analytical techniques to try to predict when prices of specific stocks are likely to rise and fall. Market timers try to make quick gains by buy low and selling high over a relatively short time horizon. The problem with market timing is that so many factors can influence stock prices--some of them random in nature--that it's tough to consistently identify the timing and direction of changes in stock prices. Which of the following is a disadvantage of strongly relying on market timing? It requires the investor to make frequent trades.
Investment banks (10-1b)
a financial intermediary that specializes in helping firms raise financial capital by issuing securities in primary markets Sometimes investment banks actually buy the newly issued securities themselves; in other cases, they simply help arrange for their sale. Today's investment companies aren't actually independent companies. Instead, they are typically divisions of huge bank holding companies that also own commercial banks.
Personal Investing (10-5 heading)
Would investing in stocks, bonds, and other securities make sense for you? If so, how could you get started? What are the potential risks and rewards of various investment changes? Investing in securities requires you to think carefully about your specific situation, your personal goals, and your attitudes: - What are your short-term and long-term goals? - Given your budget, how much are you able to invest? - How long can you leave your money invested? - How concerned are you about the tax implications of your investments? - How much tolerance do you have for risk?
Depository Institutions (10-1a)
a financial intermediary that obtains funds by accepting checking and savings deposits and then lending those funds to borrowers Examples of depository intermediaries: - Commercial banks: When you make a deposit into a checking or savings account at your bank, you are providing funds that the bank can use for making loans to businesses, government, or other individuals. - Credit unions: a depository institution that is organized as a cooperative, meaning that it is owned by its depositors. As not-for-profit organizations, they strive to pay higher interest rates on member deposits and charge lower interest rates on loans. They are also a much smaller player in financial markets than commercial banks. - Savings and loan associations (also called S&Ls): A depository that has traditionally obtained most of its funds by accepting savings deposits, which have been used primarily to make mortgage loans.
securities dealers (10-1b)
a financial intermediary that participates directly in securities markets, buying and selling stocks and other securities for its own account They earn a profit by selling securities for higher prices than they paid to purchase them. (The difference between the prices at which they buy and sell a security is called the spread).
Open-end mutual fund (10-3d)
doesn't have a fixed number of shares nor are its shares traded like stocks. fund issues additional shares when demand increases and redeems old shares when investors want to cash in.
Closed-end fund (10-3d)
issues a fixed number of shares and invests the money received from selling these shares in a portfolio of assets Shares of closed-end funds can be traded among investors much like stocks.
market makers (10-4b)
securities dealers that make a commitment to continuously offer to buy and sell the stock of a specific corporation listed on the NASDAQ exchange or traded in the OTC market Each NASDAQ stock has several market makers who compete against each other by posting two prices for each stock: the bid price indicates how much the market maker will pay per share to buy a stated quantity of the stock, while the ask price indicates the price per share at which it will sell the same stock. The ask price is higher than the bid price; the difference is called the bid/ask spread (or just the spread) and is the source of the market maker's profit.
Current yield (10-3c)
the amount of interest earned on a bond, expressed as a percentage of the bond's current market price rather than its par value Unlike dividends on stock, a firm has a legal obligation to pay interest on bonds--and to pay the bondholder the par value of the bond when it matures.
Best efforts approach (10-4a)
the bank provides advice about pricing and marketing the securities and assists in finding potential buyers It doesn't guarantee that the firm will sell all of its securities at a high enough price to meet its financial goals though. The investment bank earns a commission on all of the shares sold under a best efforts approach.
Securities and Exhange Commission (SEC) (10-2a)
the federal agency with primary responsibility for regulating the securities industry. The Securities Exchange Act also gave the SEC the power to prosecute individuals and companies that engaged in fraudulent securities market activities. E.g. the SEC has the authority to go after individuals who engage in illegal insider trading, which is the practice of using inside information (important information about a company that isn't available to the general investing public) to profit unfairly from trading in a company's securities.
Initial public offering (IPO) (10-4a)
the first time a company issues stock that may be bought by the general public Going public is a complicated and high-stakes process; obtaining sufficient funds in an IPO is often critical to the firm's success. So, almost all firms that go public enlist the help and advice of an investment bank that specializes in helping firms issue new securities. One of the key responsibilities of the investment bank is to arrange for the actual sale of the securities. The investment bank either uses a best efforts or a firm commitment approach.
Coupon rate (10-3c)
the interest paid on a bond, expressed as a percentage of the bond's par value For example, investors who own a bond with a par value of $1,000 and a coupon rate of 7.5% receive $75 in interest (7.5% of each year until the bond reaches maturity--or until they sell their bonds to someone else).
Firm commitment approach (10-4a)
the investment bank underwrites the issue This means that the investment bank itself purchases all of the shares at a specified price, thus guaranteeing that the firm issuing the stock will receive a known amount of new funds. The investment bank that underwrites the offer seeks to earn a profit by reselling the stock to investors at a higher price.
Over-the-counter market (OTC) (10-4b)
the market where securities that are not listed on exchanges are traded The market for most OTC stocks is much less active than for stocks listed on the major exchanges. Because of this, most stocks listed on the OTC have only a few market makers. The lack of competition often leads to much higher spreads between bid and ask prices for stocks.
Net asset value per share (NAVPS) (10-3d)
the value of a mutual fund's securities and cash holdings minus any liabilities, divided by the number of shares of the fund outstanding Though the NAVPS is the basis for the price of a fund's shares, investors often also pay commissions and purchase fees. Several features make mutual funds a popular choice for investors: - Diversification at Relatively Low Cost: By pooling the funds of thousands of investors, mutual funds have the financial resources to invest in a broader portfolio of securities than individual investors could afford. This high level of diversification can help reduce risk. - Professional Management: Most mutual funds are managed by a professional fund manager who selects the assets in the fund's portfolio. This can be appealing to investors who lack the time and expertise to make complex investment decisions. - Variety: Whatever your investment goals and philosophy, you can probably find a fund that's a good match. - Liquidity: It's easy to withdraw funds from a mutual fund. For a closed-end fund, you simply sell your shares. For an open-end fund, you redeem your shares from the fund itself. Drawbacks: Mutual funds do have some drawbacks. -Perhaps the most serious is that the professional management touted by many funds doesn't come cheap. - Another drawback of actively managed funds is that when their professional managers engage in a lot of trading, significant tax consequences are associated with those financial gains. It is also important to realize that some of the specialized mutual funds that invest in only one sector of the economy or only one type of security may not provide enough diversification to reduce risk significantly.