Intro to Economics - Finance

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    Financial Markets

    Dr. Katherine SauerA Citizens Guide to Economics ECO 1040

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    Overview:

    I. 4 Financial InstrumentsII. Stocks and BondsIII. Time Value of Money

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    Finance is the field that studies how people makedecisions regarding the handling of risk and resourceallocation over time .

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    Financial instruments , like every other good or servicein a market economy, must create some value .

    Meaning:both the buyer and seller must perceivethemselves to be better off by entering into thedeal or they wouldnt choose to enter in to it .

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    I. The 4 Basic Functions of Financial Instruments

    1. Raise Capital

    Examples of borrowing:

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    2. Deal with Excess Capital

    - Store It- in bank, buy assets- not mattress why?

    - Protect It Against Inflation

    - Make Profitable Use of It

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    3. Insure Against Risk

    - health/auto insurance

    - explain futures contracts

    - explain catastrophe bonds

    - explain mutual funds

    - explain credit default swaps

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    4. Speculate

    The same financial instruments that are used tomitigate risk or to raise capital can also be used to

    bet in the short run .

    Analogy:Financial products are to speculation what

    sporting events are to gambling.

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    When it comes to credit default swaps, parties other than those in the original contract can get involved.

    Explain.Brother-in-law:

    US financial crisis:

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    II. Stocks and Bonds

    A. BondsA bond is a certificate of indebtedness . IOU

    When a firm or government issues a bond, they areborrowing money from anyone who buys the bond.

    They are promising to pay you back a certain value in the

    future.

    A bond has a date of maturity and a rate of interestassociated with it.

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    Suppose you buy a $1,000 bond that matures in 5 years

    and pays 6% interest.

    - Today, you give up $1,000 and receive the bond .

    - You will receive annual interest payments of 6% for the next 5 years.

    1,000 x 0.06 = $60 per year

    - At the end of the 5 years, you receive $1,000 .

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    Bonds can be sold atpar value (face value)a discounta premium

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    Issue price: $18.75

    Face value: $25This bond sold at a discount .

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    What determines the price of a bond?

    term: length of time until the bond matures- longer maturity time riskier

    credit risk : the probability that the borrower will fail topay the interest or the principal

    tax treatment : some bonds have interest that is tax free

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    B. Stocks

    A stock is a claim of partial ownership of a firm.- shareholder

    If you buy a stock, you are not guaranteed to get yourmoney back.

    The price of a stock generally reflects the perception of afirms future profitability.

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    What determines the price of a stock?

    1. Fundamental analysis is the study of a companysaccounting statements and future prospects.

    It includes doing an economic analysis, industryanalysis, and company analysis.- P/E ratio (stock price / net income per share)- competitors

    - the market for its product- management- credit risk

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    2. The Efficient Markets Hypothesis is the theory thatasset prices reflect all publicly available informationabout the value of the asset.

    - equilibrium of supply and demand sets the price

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    According to this theory, at the market price, thenumber of people wanting to sell exactly equals thenumber wanting to buy.

    Any stock that you think is hot and about toincrease in value, someone else thought it was not hotand was willing to sell it.

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    3. Market IrrationalityStock prices sometimes seem to be driven bypsychological reasons.

    Herd Mentality is the tendency for individuals to copy

    the actions of a larger group, even though without thegroup the person may not choose to take the action ontheir own.

    - when the stock market is booming and everyone isinvesting, a person might decide it is a great time to buysome stocks, too

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    Herd mentality comes from two forces:

    - social pressure to conform- the belief that such a large group cant bewrong

    Ex: If your friends and neighbors are investing andmaking money on a hot stock, you want to join in.

    Additionally, your brain tells you that if so many peopleare doing it, it must be safe.

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    Many analysts point to the dot -com bubble and crashas a recent example of the effects of herd mentality ininvesting.

    - late 1990s, investors were pouring money into anycompany having to do with the internet

    - other investors saw all the money going into thisindustry and so they invested in it, too because if otherswere willing to invest in it, it must be a good bet

    - many investors neglected to research their investments

    - many of the dot-com firms turned out to not have sound

    business plans

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    - the economy began to slow and many of the dot-comfirms still werent turning a profit, some investors beganto sell the stock

    - chain reaction was triggered and even more people jumped on the stock selling bandwagon

    - the dot-com bubble had burst

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    Following a Stock Google Finance 2/21/12

    current price per share,

    the last price a sharewas traded at

    company namename of stock exchange and stock symbol

    change: compared to most recent closing price

    percent change: change x 100

    close price

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    Range: daily high and low price

    52 Week: high and low price for the last 52 weeks

    Open: the price at the beginning of trading today

    Vol/Avg: Volume = number of shares traded todayAverage = average number of shares traded daily

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    Mkt cap: Market Capitalization is a measure of the total value of the company

    Mkt Cap= Total Shares Outstanding x Current Price

    P/E: Price-to-Earnings Ratio is the price of a share divided bylast years earnings per share

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    Div/Yield: a Dividend is the amount of money the firm will payyou (typ. each quarter) for each share you own.The Yield = dividend / price

    - not all firms pay dividends

    EPS: Earnings Per Share is the amount of earnings per eachoutstanding share

    Shares: the number of shares outstanding

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    Beta: A statistical estimate of how closely the stocksperformance matches the stock market in general. The higher thebeta, the closer the stock matches the general market.

    Inst. Own: Institutional Ownership is percent of the shares thatthe firm owns

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    III. Time Value of Money

    Intuitively we understand that an amount of money today is

    more valuable than the same amount of money in thefuture.

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    A. Future Value is the amount of money that can resultfrom an amount of money we have today.

    Future Value = Present Value x (1 + r ) n

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    Ex: The average bride is 26 at her first wedding. Theaverage US wedding costs $18,000.

    What if instead the bride invested the $18,000 in her

    retirement account, earning 4% interest over 40 years?

    Future Value = 18,000 x (1.04) 40

    Future Value = $86,418

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    The higher the interest rate, the higher the future value of your money saved today.

    The longer the time frame, the higher the future value of your money saved today.

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    B. Present Value is the amount of money one would needtoday to produce a given amount of money in the future.

    Present Value = Future Value / (1 + r ) n

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    Ex. you want to have $1,000,000 in 25 years and theinterest rate is 5%

    Present Value = 1,000,000 / (1.05) 25

    Present Value = $295,303

    Put this amount into an account earning 5% interestand youd have $1million in 25 years.

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    The higher the interest rate, the smaller the amount of money needed in the present to obtain a particular futureamount.

    The longer the time frame, the smaller the amount of money needed in the present to obtain a particular futureamount.

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    Summary:

    Financial instruments are based on 4 types of activities.

    Stocks and bonds are two common financial instruments.

    Calculate the future value of money to see how muchmoney today would be worth in the future.

    Calculate the present value of money to see how muchmoney you would need to start with today to have acertain amount of money in the future.

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    What did you learn today?

    Please explain 2 concepts from todays class.