The financial system consists of financial markets; suppliers and demanders of capital; the
financial intermediaries that offer market access to the suppliers and demanders of capital; and
the system regulators.
Financial markets are places where financial assets, or securities, are bought and sold. Securities
differ from each other in the types of claims they offer to investors. As a result, they also differ in
their risk and return characteristics. The return on a security is composed of the periodic income
earned plus any capital gains. Risk has many definitions, but volatility of return is the most
The principal securities making up the financial marketplace are Treasury bills (T-bills), bonds,
common and preferred shares, and derivative securities such as options and futures. Many of
these securities are listed for trade on organized exchanges. Others are traded on the market
for unlisted securities; this is the over-the-counter (OTC) market. The market for newly issued
securities is called the primary market. The market for previously issued securities is known as the
Other important financial markets, in addition to the long-term capital, money, and derivatives
markets, are the foreign exchange market and the real estate market.
Over the period from 1991 to 2011, T-bills have had the lowest average return but the lowest
amount of volatility (risk) of the three basic securities: T-bills, long-term bonds, and common
shares (or equities). Bonds have had a higher return than T-bills but have been riskier (more
volatile). Common shares have earned more than T-bills or bonds but have shown the greatest
amount of risk over the period.
The returns on securities can be viewed in either nominal or real (inflation-adjusted) terms.
Maintaining purchasing power for an investor means earning a nominal return at least equal
to the rate of inflation, or, alternatively, earning a real return of zero percent. Increasing wealth
requires earning a positive real return on investment. Investments in all three basic securities have
allowed investors to maintain purchasing power and to increase wealth in the time period of 1991 to 2010.
Explain what is meant by a financial claim. Give examples of two financial claims.
A financial claim represents the right to receive some type of cash flow. It often takes theform of a piece of paper called a security. A common share is an example of a financialclaim in which the owner has the right to share in the profits earned by the company. Agovernment bond is another type of financial claim in which the owner has the right toshare in some of the cash flow that the government will bring in from taxes.
Why is volatility an important thing for investors to understand?
Volatility is important for investors to understand because it is one reason why investmentreturns are risky. Volatility is the amount of change in the investment returns over a givenperiod. The more change that occurs, the more volatile the investment and the riskier it is.Investors who cannot tolerate risk (and therefore the possibility of a decline in the value oftheir investments) should avoid volatility.
Define investment horizon and give examples of three different investment horizons. Whatis the relationship between investment risk and investment horizon?
Investment horizon – also referred to as Time Horizon - is the period that will elapse before an investor will require money from the investment. Three examples are:
1) a long horizon resulting from a young person (25 years old) saving for retirement (atage 65)
2) a medium-term horizon represented by a couple saving for the university education oftheir eight-year-old child; in this case the horizon until age 18 is 10 years
3) a short horizon in which an investor is saving for a car purchase in two years.Investment horizon is related to investment risk in that short investment horizons mustbe matched with lower investment risk (or volatility).
Even though equity investmentsmight provide superior returns in the long run, in the short run the high volatilitymeans that investors might see a significant decline in the value of their investments.
List the four groups making up the financial system.
The four groups (as given by Figure 2.3) are the markets, the financial intermediaries, the suppliers and demanders of capital, and the regulators.
Name and briefly describe two securities traded in each of:
a) the long-term capital market;
b) the money market;
c) the derivatives market.
a) Two securities of the long-term capital market are stocks and bonds. Stocks, either common or preferred, are claims on the future profits of a company. Bonds, or debt securities, are claims on the cash flows generated by governments or companies.
b) Two money market securities are T-bills and commercial paper. T-bills are short-term debt securities issued by the Government. They come in maturities ranging from 91days to 364 days. Commercial paper is short-term promissory notes issued by firms with very high credit ratings.
c) Two securities of the derivatives market are options and futures. Options can be either calls (option to buy stocks) or puts (option to sell stocks). Futures are contracts in which investors agree to take delivery or to deliver goods (or securities) at a particular future date at a predetermined price.
Give an example of how each of the following can be both a supplier and demander of capital:
a) Governments are (net) suppliers of capital when they run budget surpluses; they are demanders of capital when they run budget deficits.
b) Companies are suppliers of capital when they buy T-bills for short-term investments; they are demanders of capital when they issue shares or negotiate loans.
c) Individuals are suppliers of capital when they put money in their savings accounts or buy shares (or units) of a mutual fund; they are demanders of capital when they takeout a loan or a mortgage.
Give two similarities and two differences between common stock and preferred stock.
Common stock and preferred stock are similar in that they are both claims on the future profits of companies and they often provide part of the return to shareholders in the form of dividends. They are also similar in that they are both owners of the company. They are different in that common shares provide shareholders with the right to vote at annual meetings to elect the board of directors; preferred shares do not provide the right to vote. A second difference between them is that preferred shares have a senior claim to dividends ranking before the claim of common shares; that is, if the company pays any dividends at all, it must pay them first to preferred shareholders.
What is the difference between an organized exchange and the OTC market?
Organized exchanges are physical locations where trading in listed securities takes place. The OTC market is the market for all unlisted securities, including many stocks and virtually all bonds. The OTC market is a large computer data base.
How does the money market differ from the long-term capital market?
The money market is characterized by the trading of highly liquid short-term securities through an interconnected computer network. The long-term capital market is characterized by the trading of stocks and bonds on either organized exchanges or the OTC market.
What is a prospectus and of what importance is it in the financial marketplace?
A prospectus is a document that must be produced and submitted to securities regulator before a security may be offered to the public. It contains important information about the financial condition of the firm, the uses to which the capital raised will be put, and the risks involved. It is important in the financial marketplace in that it provides all investors with the same base of information about newly issued securities.
Summarize the historical risk and return performance of equities in real terms for the period from 1991 through 2010. Compare that information to T-bills and long-term bonds.
For the period 1991 to 2010, the real return on equities has been higher than that for either long-term bonds or T-bills. All were able both to maintain purchasing power and to increase wealth.
What is the difference between maintaining purchasing power and increasing wealth?
Maintaining purchasing power means being able to use the proceeds from an investment to purchase the same amount of goods at some future date as can be bought on the date of investment. To be able to buy the same amount of goods, the investment must have earned at least the rate of inflation. Increasing wealth means earning not only the rate of inflation(and therefore maintaining purchasing power) but also earning more than that rate.
An investment was purchased for $1,000.00 and sold one year later for $1,075.00. During the year inflation was 2.5%. Calculate the nominal return and the real return.
To calculate the nominal return: ($1,075.00 - $1,000.00) / $1,000.00 = .075 = 7.5%To calculate the real return: 7.5% - 2.5% = 5.0%.