Chapter 1: Financial Markets and the Economy
Dow Jones Utility Average
- 15 stocks of the US gas and electric utilities industries - Price-weighted
Dow Jones Transportation Average
- 20 stocks of the airline, trucking, railroad, and shipping business - Price-weighted
Capitalization-Weighted Index
- Also known as market value weighted index - Reflects size of company - Each company's value is computed by market cap (share price x shares outstanding) ex) S&P 500 Index and Hang Seng Index (Hong Kong)
Central Bank
- Banking institution that functions primarily to control a nation's money supply
Derivatives Markets
- Buying and selling of financial instruments that derive their value, or part of it, from another security - Often highly leveraged, used to speculate and to hedge or mitigate risk ex) Underlying assets include commodities, mortgages, stocks, bonds, or currencies
Producer Price Index (PPI)
- Calculation used to measure inflation at the wholesale level
Lagging Indicators
- Change after the economy has already begun to follow a particular pattern or trend ex) Interest rates (particularly the prime rate = key bank lending rate often used as a reference rate for credit cards and other loans), unemployment rate, corporate profits, labor cost per unit of output, commercial and industrial loans outstanding
Leading Indicators
- Change before the economy starts to follow a particular pattern or trend ex) Bond yields, building permits, stock market indices and averages, average of weekly unemployment insurance claims, changes in business inventories
S&P 500 Composite Stock Price Index
- Composed of 500 stocks - Widely regarded as the standard of measuring large-cap US stock market performance - Used as a benchmark by more than 95% of US money managers and pension plan sponsord - Capitalization-weighted
Wilshire 5,000 Total Market Index
- Composed of over 4,000 companies and all S&P 500 stocks - Intended to measure entire US stock market - Considered one of the broadest market indices - Capitalization-weighted
Monetary Policy
- Concerned with the amount of money in circulation, as well as interest rates and inflation - The raising and lowering of money supply to control inflation and economic growth - Supervised and implemented by a central bank or monetary authority
Dealer/Negotiated Market (Nasdaq)
- Dealers hold inventories, or make markets in certain securities - Stand ready to buy/sell from other market participants - Profit from spread of price at which securities are bought or sold - No physical location (telecommunications networks only)
Nasdaq-100 Index
- Designed to track performance of the 100 largest and most actively traded non-financial domestic and international securities listed on Nasdaq - Must have average daily trading volume of 100,000 shares to be included - Must have been traded on Nasdaq or been listed on another major exchange for at least two years - Modified capitalization-weighted
Balance of Trade
- Difference between a country's imports and exports - Debit items (increase deficit) = imports, foreign aid, domestic spending abroad, and domestic investments abroad - Credit items (decrease deficit) = exports, foreign spending in domestic economy, and foreign investment in domestic economy
Discount Window/Rate
- Direct lending from Fed to depository institutions - Discount Rate = interest rate on credit available from the Discount Window - Typically higher than federal funds rate - Institutions typically exhaust all other options before borrowing from here
Fourth Market
- Direct trading of large blocks of securities between institutions and/or retail investors - Transacted through electronic networks off exchange floor known as Electronic Communication Networks (ECN)
Coincident Indicators
- Economic factors that vary simultaneously with the business cycle ex) GDP, employees on non-agricultural payrolls (non-farm payrolls), personal income, consumer spending, inventory/sales ratio, retail and manufacturing sales, industrial production index*, capacity utilization index* - (*) = most important
The Securities Act of 1933
- Enacted to achieve two objectives: 1) To require that investors receive significant material information concerning securities being offered for public sale (prospectus) 2) To prohibit deceit, misrepresentations, and other fraud in the sale of securities to the public - Prohibits fraud in initial sale of securities
Consumer Price Index (CPI)
- Estimates the average price of goods and services purchased by households - Calculation used to measure inflation at the retail level - One of the most closely watched national economic statistics
Secondary Market
- Existing securities are bought and sold directly among investors or traders - Takes place on exchanges, OTC, or elsewhere
Primary Market
- Facilitate the selling of new stock or bond issues - Directly from issuing company to investors
Foreign Currency Markets
- Facilitate trading of foreign currency - Worldwide, decentralized OTC marketplace - One of the largest financial markets in the world - Participants include banks and financial institutions, speculators, governments, importers and exporters, and tourists
Non-Systematic/Business Risk
- Generally will not impact an investor's entire portfolio, but rather a single stock - Best protection is through diversification ex) changes in corporate management or product recalls
Economic Policy
- Government intervention to impact economic performance
The Securities Exchange Act of 1934
- Governs the secondary market - Regulates US financial markets and their participants, and requires that they be registered - Prohibits fraud in secondary market transactions
Dow Jones Industrial Average (DJIA)
- Index of 30 blue chip US stocks of industrial companies (excluding transportation and utility companies) - Oldest and most widely quoted US index - Price-weighted
Federal Funds Rate (Overnight Rate)
- Interest rate charged for banks lending to one another - Heavily influenced by open market operations
Prospectus
- Investor disclosure document compiled by issuers - Part of mandatory securities registration process with SEC enacted by the Securities Act of 1933
Open Market Operations
- Manipulation of the quantity of money in circulation through the buying and selling of Treasury securities with primary dealers - Primary tool of monetary policy - Controlled by the Federal Open Market Committee (FOMC) - Sell securities = (-) money supply, (+) interest rates - Buy securities = (+) money supply, (-) interest rates
Beta
- Measure of volatility, or systematic risk, of a security or portfolio in comparison to the market as a whole
Russell 2,000 Index
- Measures performance of the 2,000 smallest publicly traded US companies in terms of market cap - Capitalization-weighted
Third Market
- OTC negotiated-price trading of exchange-traded securities ex) Market maker provides liquidity in a NYSE listed stock
Capital Markets
- Offer companies and governments the opportunity to raise long-term funds, by matching those that want capital with those that have it.
Risk/Return Profile
- Optimal mix of risky and risk-averse products unique to any individual investor
Unemployment Rate
- Percentage of those in the labor force who are without work - Important measurement of economic performance - High unemployment is considered a negative economic factor and usually accompanies economic downturns
Systematic Risk
- Performance of an individual security will be impacted by the performance of the overall market - Risk that cannot be avoided through diversification ex) recessions, wars, significant political events, and interest rates
Consumer Spending
- Personal expenditures of US consumers along with their attitudes about spending - Increases and decreases in consumer spending directly relate to manufacturing output and available services
Institutional Investors
- Pool large sums of money and invest those sums in companies - Act on behalf of other investors in managing investments in financial products ex) banks, insurance companies, retirement or pension funds, hedge funds, mutual funds, and othe rorganizations
Price-Weighted Index
- Price of each included stock is the basis for determining index value - Fluctuations of single stocks can have large influence on index value, regardless of company size ex) Dow Jones Industrial Average
Securities and Exchange Commission (SEC)
- Primary overseer and regulator of securities markets
Gross Domestic Product (GDP
- Primary tool used for measuring US economic growth and analyzing economic performance - Total market value of goods and services produced within the borders of a country, regardless of the nationality of those who produced them ex) Goods produced by foreign owned business within the US
Recession
- Prolonged period of contraction - Decline in GDP for two or more consecutive quarters
Interest Rates
- Reflect the cost of capital, considered the price of credit - Greatly influences investments ex) high interest = (-) investment/borrowing, (+) saving; low interest = (+) investment/borrowing, (-) saving
Inflation
- Rise in the general level of prices of goods and services in an economy over a period of time - Erodes the purchasing power of money
Liquidity Risk
- Risk associated with the time it takes to sell or convert an asset into cash - More illiquid assets carry more liquidity risk ex) Shares in direct participation programs and real estate
Political Risk
- Risk of new legislation or changes in political control - One of the major reasons developing countries may lack foreign investment ex) change of government overthrow, war, insurrection, terrorism, legislation, and elections
Credit/Default Risk
- Risk that a bond issuer will default on payment or that its credit rating will be downgraded, leading to capital risk or loss of principal, or a missed payment
Call Risk
- Risk that a bond may be called by an issuer when interest rates are falling - Leads to reinvestment risk, which is the risk that there are no available investments that can provide a similar return to a bond that has been called - Limited to bonds and other callable instruments such as callable preferred stock
Country Risk
- Risk that a country could default on its financial obligations and harm the performance of all other financial obligations - Applies to stocks, bonds, mutual funds, options, and futures issued within a particular country
Inflationary/Purchasing Power Risk
- Risk that an investment's return will be adversely impacted because of inflation - Often associated with retirement planning and other scenarios where an investor's objective is current income ex) Bonds or preferred stock are susceptible to inflationary risk because interest payments remain constant while cost of goods and services continues to rise
Interest Rate Risk
- Risk that an investment's value will change as a result of a change in interest rates - Effects value of bonds more than stocks - (+) Interest rates = (-) bond prices and vice versa
Foreign Exchange/Currency Risk
- Risk that currency exchange rates can change the price of the asset - Consideration for any enterprise doing business internationally ex) Resident of US invests in Australian stock and Australian dollars could lose money if Australian dollar depreciates relative to American dollar
Capital/Principal Risk
- Risk that investor could lose all of the money that was invested
Economic Indicators
- Specific measures that help assess the health of the economy and also provide some insight into the future - Categorized into three groups (Leading, Lagging, and Coincident)
Exchange Rates
- Specifies how much one currency is worth in terms of another currency - Measures value of foreign nations currency against the home nation's currency - Fluctuating exchange rates have a huge impact on both business profits and on securities prices ex) weak dollar = (+) exports, (-) imports; strong dollar = (-) exports, (+) imports
Listing Requirements
- Standards required of stock traded on national exchanges - Relatively stringent - Stock is usually of large and established companies
Blue Chip Stocks
- Stock of well established companies and industrial firms that have long been the backbone of the US economy - Traded on the NYSE
OTC Markets
- Stocks that don't trade on a national exchange - Generally have fewer regulations and requirements than national exchanges - Rely on market makers who stand ready to buy/sell shares - Often issued by small companies - Two primary markets: 1) OTC Bulletin Board 2) OTC Pink
Depression
- Sustained, long-term downturn in economic activity in one or more economic sectors - Decline in real GDP exceeding 10% or at least six consecutive quarters of negative GDP growth
Moral Suasion
- Tactic used to influence and pressure, but not force, banks into adhering to policy ex) Fed Chairman speaks on markets
Spot Exchange Rate
- The current exchange rate (referring to FX Market)
Forward Exchange Rate
- The exchange rate that is quoted and traded today, but for delivery and payment on a specific future date (referring to FX Market)
Reserve Requirements
- The portion of deposits banks are not permitted to lend, and must keep either on hand or on deposit at a Federal Reserve Bank - Increase = decrease money supply - Decrease = increase money supply
Fiscal Policy (Keynesian)
- The use of government spending and taxation to influence the economy - Neutral = balanced budget where gov't spending equals tax revenue - Expansionary = increase in gov't spending over tax revenue - Contractionary = gov't spending is reduced on its own or in combination with higher taxation
Gross National Product (GNP)
- Total market value of goods and services produced by the residents of a country, even if they're living abroad ex) US resident earns money form overseas investment
NYSE Composite Index
- Tracks price movements of all common stocks listed on the NYSE - Includes more than 2,000 issues (both US and non-US issues) - Capitalization-weighted
Auction Marketplace (NYSE)
- Trades directed to exchange floor and broker matches interested buyers and sellers - Physical location
Insurance Markets
- Where instruments that transfer risk of loss from one entity to another are bought and sold - In exchange for a premium payment, insurances companies guarantee against various types of loss
Commodity Markets
- Where raw material and agricultural products, including food, metals, and electricity are exchanged - Takes place on regulated commodities exchanges
Money Markets
- Where short term debt financing and investment takes place - Financial instruments with high liquidity and very short maturities ex) CDs, banker's acceptances, T-Bills, commercial paper, municipal notes, federal funds, and repurchase agreements
Real Economic Growth
- Year-over-year change in GDP adjusted for inflation or deflation
Inflation Effect (four types)
1) Cash- Inflation causes rising interest rates, savers tend to earn a better return with (+) inflation 2) Bonds- (+) inflation = (+) interest rates = (-) bond prices 3) Stocks- (+) inflation = (+) asset values = (-) cash flows (do best when inflation is low to moderate) 4) Real Estate- (+) inflation = (+) asset values and (+) cash flows
Performance of a financial market is dependent on:
1) Efficiency- existing prices quickly react to and reflect all available information 2) Liquidity- Enough buyers and sellers so assets can be bought/sold quickly 3) Continuity- Market prices don't change drastically between transactions 4) Marketability- Facilitate rapid conversion of assets into cash at price determined by market 5) Timely and Accurate Information- New information flows to market with speed and precision
The fours phases of a business cycle are:
1) Expansion- increased economic activity and increased availability of goods and services in the marketplace 2) Peak- highest point of expansion and begins to turn 3) Contraction- slow down in the pace of economic activity 4) Trough- lowest point of contraction and begins to turn
The two types of economic policy are:
1) Fiscal policy 2) Monetary policy
The seven measures of economic performance are:
1) GDP and GNP 2) Consumer Spending 3) Exchange Rates 4) Interest Rates 5) Inflation 6) Unemployment 7) Balance of Trade
The four tools the Fed uses to influence economic growth, inflation, exchange rates, and unemployment are:
1) Open market operations 2) Reserve requirements 3) Discount window lending 4) Moral suasion
The capital market consists of:
1) Stock Markets- Provide equity financing through the issuance of shares of common stock and their subsequent trading 2) Bond Markets- Provide debt financing through the issuance of corporate, municipal, or government bonds and their subsequent trading
The 11 types of financial risk are:
1) Systematic/Market Risk 2) Non-Systematic/Business Risk 3) Capital Risk 4) Country Risk 5) Foreign Exchange Risk 6) Inflationary/Purchasing Power Risk 7) Liquidity Risk 8) Political Risk 9) Interest Rate Risk 10) Credit/Default Risk 11) Call Risk
Financial markets facilitate:
1) The raising of capital 2) The transfer of risk 3) International trade