notech26 - Chapter 26 Financial Markets Savings and...

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Chapter 26 Financial Markets, Savings, and investment This chapter goes into details of how capital is allocated from the suppliers of capital to the users of capital. Matching the suppliers and users of capital occurs in financial markets. Just as the buyers and sellers of oranges meet in the orange market, the suppliers or capital meet the demanders of capital in financial markets. There are a number of different types of vehicles for moving capital. Bonds are one vehicle. A bond is a promissory note – it specifies that the borrower repay a specific amount at a specific date, typically with interest. One key defining characteristic of a bond is its term – how long of a period before a borrower is required to pay back the loan. Another is the quality of the bond, sometimes called credit risk. Borrowers who have high quality credit risk pay a low interest rate,
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because they are perceived to be unlikely to default. Borrowers who have a higher likelihood of defaulting pay higher interest rates. You may have heard of junk bonds. These are bonds issued by borrowers who have a relatively high probability of default. Another characteristic is the tax treatment of the bond. Some bonds, such as those issued by some state and local governments, are not taxed by the federal government. Consequently, they pay lower interest rates than taxable bonds (why?) Stocks are another vehicle for moving capital from savers to the users of capital. Stock represents ownership in a company. For example, if a company has 100 shares of stock, and you own 1 share, then you own 1% of the company. Stocks are very different than bonds. Bonds are a promissory note, paying a pre-specified interest rate. Owning stock gives you a share of the profits in the company. That is, you are entitled to the revenues from the company after it has paid all its bills, including taxes and interest on its bonds. This makes stock risky – you may earn a lot of profits if the
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company performs very well, or there may be no profits at all after the company pays all of its expenses. There are several stock exchanges, where stocks are traded. The New York stock exchange is where a number of old and very well established companies trade, such as General Motors and IBM. The NASDAQ market is where many newer companies trade, including Microsoft. Two popular stock indexes are the Standard and Poors 500 index, which is comprised of 500 large companies. Another is the Dow Jones 30 industrials, which represents the 30 largest industrial companies.
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