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Chapter 17
FINANCIAL MARKETS
WHAT IS THIS CHAPTER ALL ABOUT?
After establishing the basics of financial markets, this chapter describes how financial markets
affect the economy. Three central questions guide the discussion.
What is traded in financial markets?
How do the financial markets affect the economic outcomes of WHO,
WHAT, and FOR WHOM.
Why do financial markets fluctuate so much?
After reading this chapter, the students should:
1. Know the Role of Financial Markets in the economy.
2. Be able to calculate the time value of money.
3. Know what effect interest rates have on financial markets.
4. Understand the basics of the stock market.
5. Understand the basics of the bond market.
NEW TO THIS EDITION
Note the new chapter title, “Financial Markets.”
Net present value using the lottery has been updated.
The stock quote explanation is updated.
A new In the News looks on Google’s IPO
The bond price explanation is updated.
One new Question for Discussion
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 527
LECTURE LAUNCHERS
How long will this chapter take? Two 75-minute class periods.
Where should you start?
1. The stock market has been headline news for the last 10 years and will continue to be so.
In general, students are eager to learn about the stock market. Ask students for
definitions of the Dow Jones Industrial Average, the S & P 500, and the Nasdaq index.
Most students will not know what these different averages measure but they want
to know and are great lecture launchers. They have also heard a lot about mutual
funds but do know what they are. Briefly introduce the concept of mutual funds.
2. Ask students who wants to get rich quick. Then follow up with who wants to get poor
quick.
This series of questions can be used to illustrate that there is a large potential for
gain in the stock market, but also an associated high degree of risk.
3. Ask students who has heard of E-Trade.
Use this to discuss how stock trading has become much easier, and cheaper,
because of the Internet.
4. Ask students to define the term financial intermediaries and then explain their role.
5. Ask students whether, if they won $1 million in the lottery, they would rather take
$500,000 now or $1 million five years from now.
The answer to this question helps introduce the discussion on the time value of
money. Work through the answer to this question in class.
COMMON STUDENT ERRORS
Students often believe the following statements are true. The correct answer is explained after
the incorrect statement is presented.
1. The primary function of financial intermediaries is to provide checking accounts for
customers. Financial intermediaries provide access to the savings pool for government and
the business sector. They also reduce the search and information costs involved with lending
and investment opportunities. As a result they change the mix of output and increase
market efficiency.
2. As bond prices rise, the rate of return or current yield also rises. The rate of interest earned
on a bond, or the coupon rate, is stated on the bond certificate and does not change. The
current yield represents the rate of return on a bond. It is calculated as the annual interest
payment divided by the bond price. The price of a bond in the secondary bond market varies
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 528
based on changes in expectations and opportunity cost. If the annual interest payment stays
constant and the bond price increases, the rate of return or current yield falls.
ANNOTATED OUTLINE
I. Introduction
A. This chapter examines the following questions:
1. What is traded in financial markets?
2. How do the financial markets affect the economic outcomes of WHO, WHAT,
and FOR WHOM.
3. Why do financial markets fluctuate so much?
II. The Role of Financial Markets
A. A central question for every economy is WHAT to produce.
B. Financial Intermediaries (Figure 32.1)
1. For those without a great inheritance, the problem of raising startup funds to
start a business boils down to two options:
Borrow the necessary funds
Invite other people to invest in the new venture.
2. Definition: Financial Intermediary – Institution, (e.g., a bank or the
stock market) that makes savings available to dissavers (e.g.,
investors)
3. The function of financial intermediaries is to transfer income from savers to
dissavers.
4. Finance intermediaries reduce search and information costs.
5. Although financial intermediaries make the job of acquiring start-up funds a lot
easier, there’s no guarantee that the funds needed will be acquired.
C. The Supply of Loanable Funds
1. Time Preferences
In deciding to save rather than spend, people effectively reallocate their
spending over time.
How much to save depends partly on time preference.
If a person doesn’t give any thought to the future, she’s likely to save little.
If a person wants to buy a car or house in the future, he’s more inclined to
save income now.
2. Interest Rates
If interest rates are high, the future payoff to present savings is greater.
Higher interest rates increase the quantity of available savings (loanable
funds).
3. Risk Management
The interest rate paid on savings is linked to the risk of future
nonpayment.
People readily lend funds to the federal government at low interest rates
because the risk of default is so low.
By diversifying an investment portfolio, an investor can select any degree
of average risk. This is the essence of risk management.
4. Risk Premiums
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 529
Although diversification permits greater risk management, lenders will
want to be compensated for any above-average risks they take.
Definition: Risk Premium – The difference in rates of return on
risky (uncertain) and safe (certain) investments.
Risk premiums help explain why blue-chip corporations such as
Microsoft can borrow money from a bank at the low “prime” rate while
ordinary consumers have to pay much higher interest rates on personal
loans.
III. The Present Value of Future Profits
A. In deciding whether to assume the risk of supplying funds to a new venture, financial
intermediaries assess the potential rewards.
B. Time Value of Money (Table 32.1)
1. To assess the value of future receipts, we have to consider the time value of
money.
2. As long as interest-earning opportunities exist, present dollars are worth more
than future dollars.
3. We “discount” future dollars by the opportunity cost of money.
4. Definition: Present Discounted Value – The value today of future
payments, adjusted for interest accrual.
5. To compute the present discounted value (PDV) of future payments, we discount
as follows:
6. Formula:
Future Payment N
PDV value
(1 interest rate) N
7. The longer one has to wait for a future payment, the less present value it has.
C. Interest Rate Effects (Table 32.2)
1. Interest rates have a significant effect on present discounted values.
2. The present discounted value of a future payment declines with:
Higher interest rates
Longer delays in future payments.
D. Uncertainty - The valuation of future payments also considers the possibility of
nonpayment.
E. Expected Value
1. Whenever an anticipated future payment is uncertain, a risk factor should be
included in present-value computations. This is done by calculating the expected
value.
2. Definition: Expected Value – The probable value of a future payment,
including the risk of nonpayment.
3. Formula:
Expected Value = (1 – risk factor) present discounted value
F. The Demand for Loanable Funds (Figure 32.2)
1. In general, the higher the expected returns on an investment, the more willing
people are to borrow funds to finance it.
2. Specifically, the greater the expected return on an investment, the greater will be
the quantity of loanable funds demanded at the prevailing interest rate.
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 530
IV. The Stock Market
A. The principles of supply, demand, and risk management help explain the activity in
stock markets.
B. Corporate Stock
1. When People buy a share of stock, they’re buying partial ownership of a
corporation. The three legal forms of business entities are:
Corporations
Partnerships
Proprietorships
2. Limited Liability
Proprietorships are businesses owned by a single individual. The owner-
proprietor is responsible for all the business, including repayment of any
debts.
By contrast, a corporation is a limited liability form of business. The
corporation itself, not is individual shareholders, is responsible for all
business activity and debts.
Definition: Corporation – A business organization having a
continuous existence independent of its members
(owners) and power and liabilities distinct from those
of its members.
3. Shared Ownership
The ownership of a corporation is defined in terms of stock shares.
Each share of corporate stock represents partial ownership of the
business.
Definition: Corporate Stock – Shares of ownership in a
corporation.
In principle, the owners of corporate stock collectively run the business.
In practice, the shareholders select a board of directors to monitor
corporate activity and protect their interests.
C. Stock Returns
1. Owners (shareholders) of a corporation hope to share in the profits the
corporation earns.
2. Dividends
Shareholders don’t necessarily receive their share of the company’s
profits in cash.
The corporation may choose to retain earnings or pay them out to
shareholders as dividends.
Definition: Dividend – Amount of corporate profits paid out for
each share of stock.
Formula:
Dividends = corporate profits – retained earnings
3. Capital Gains
The increase in the value of a stock represents a capital gain for
shareholders.
Definition: Capital Gain – An increase in the market value of an
asset.
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 531
There are two motivations for buying and holding stocks:
The expectation of dividends.
The anticipation of capital gains.
D. Initial Public Offering
1. By “going public”, a corporation seeks to raise funds for investment and growth.
2. The first offering of shares in a corporation to the public is known as an initial
public offering (IPO)
3. Definition: Initial Public Offering (IPO) – The first issuance (sale) to
the general public of stock in a corporation.
4. People who buy the newly issue stock are putting their savings directly into the
corporation’s accounts.
5. As new owners, they stand to profit from the corporation’s business or take their
lumps if the corporation fails.
E. Secondary Trading
1. Definition: Price/Earnings (P/E) ratio – The price of a stock share
divided by earnings (profit) per share.
2. Formula:
price of stock share
P/E ratio
earnings (profit) per share
3. In 1997, the P/E ratio for Amazon.com was $190 based on the PDV of $1 profit
per share expected by 2001.
4. By contrast, the P/E ratio is closer to 28 for the average corporation.
5. People purchased Amazon.com stock in hopes of high future earnings, but also
because they expected the price of Amazon.com stock to appreciate.
F. Market Fluctuations (Figure 32.3 and Table 32.3)
1. The price of a stock at any moment is the outcome of supply and demand
interactions.
2. Computers and live brokers help find the equilibrium price by matching up “buy”
(demand) and “sell” (supply) orders from thousands of market participants.
3. Changing Expectations
Stock prices rise or fall due to the interplay of demand and supply in the
financial markets.
Changes in expectations imply shifts in supply and demand for a
company’s stock.
In the News: “Growth Undergirds Google’s Pricey IPO But Can
It Keep Up”
The 2004 Google IPO is analyzed. The question posed is: can Google
continue to come up with new ways to profit from its dominant position
in the Web-search business?
4. The Value of Information
The abrupt rise in the price of Amazon.com stock highlights a critical
dimension of financial markets, namely, the value of information.
The value of information also explains the demand for information
services. People pay hundreds and even thousands of dollars for
newsletters, wire services, and online computer services that provide up-
to date information.
4. Booms and Busts (Table 32.4)
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 532
Broad changes in the economic outlook tend to push all stock prices up or
down at the same time.
In The News: “Market Battered, but Intact”
Description of the largest one day decline to this date following the
September 11, 2001 attacks.
The stock market often has exaggerated movements due to sudden and
widespread changes in expectations.
The value of stock depends on anticipated future profits and expectations
for interest rates and the economic outlook.
People use present clues to try to discern the likely course of future
events.
All information must be filtered through people’s expectations.
5. Resource Allocations – Financial markets facilitate resource reallocations.
V. The Bond Market
A. The bond market is another mechanism for transferring the pot of national savings into
the hands of would-be spenders.
B. In the stock market, people buy and sell shares of corporate ownership. In the bond
market, people buy and sell promissory notes (“IOUs”).
C. Definition: Bond – A certificate acknowledging a debt and the amount of interest
to be paid each year until repayment; an IOU.
D. Bond Issuance
1. A bond is first issued when an institution wants to borrow money.
2. The advantage of borrowing funds rather than issuing stock is that the owners
can keep control of their company.
3. Typically, each bond certificate has a par value of $1000.
4. Definition: Par Value – The face value of a bond: the amount to be
repaid when the bond is due.
5. The initial bond purchaser lends funds directly to the bond issuer.
6. It is possible that a firm might default on its obligations.
7. Definition: Default – Failure to make scheduled payments of interest or
principal on a bond.
8. Hence, lenders want a hefty premium to compensate them for the risk of default.
9. The initial interest rate on a bond is known as the coupon rate.
10. Definition: Coupon Rate – Interest rate set for a bond at time of
issuance.
E. Bond Trading
1. Once a bond has been issued, the initial lenders don’t have to wait 10 years to get
their money back. Rather they can sell their bonds to someone else.
2. This liquidity is an important consideration for prospective bondholders.
3. Definition: Liquidity – The ability to convert an asset into cash.
4. By facilitating resales, the bond market increases the availability of funds to new
ventures and other borrowers.
F. Current Yields (Figure 32.4 and Table 32.5))
1. As bond prices rise, their implied effective interest rate (current yield) falls.
2. Definition: Current Yield – The rate of return on a bond, the annual
interest payment divided by the bond’s price.
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 533
VI. The Economy Tomorrow: Venture Capitalists – Financing
Tomorrow’s Products
A. Venture capitalists provide financial support for entrepreneurial ideas and share in the
risks and rewards.
B. In the News: “Venture Capital Falls 72 Percent from Last Year” After the dot-
com collapse, venture capital fell. The September 11, 2001 attacks were expected to cause
an even greater decline.
ANSWERS TO QUESTIONS FOR DISCUSSION
1. If there were no organized financial markets, how would an entrepreneur acquire
resources to develop and produce a new product?
If no organized financial markets existed, an entrepreneur must either save the
money or solicit individual investors to acquire the needed financial resources to
develop and produce her new product.
2. Why would anyone buy shares of a corporation that had no profits and paid no
dividends? What’s the highest price a person would pay for such a stock?
Many people are willing to purchase shares of a corporation in hopes that the
corporation will earn future profits and/or that the value of the stock will
appreciate. Theoretically, the most a rational person would pay for a stock is the
expected present discounted value of the firm’s profit per share as demonstrated in
the section on secondary trading. Sometimes, however, individual investor’s pay
too much for a stock due to irrational exuberance or incomplete or inaccurate
information.
3. Why would anyone sell a bond for less than its par value?
The market price of a bond depends on the current yield, which is the annual
interest payment divided by the price of the bond. For example, if the annual
interest rate on a bond with a face value of $1,000 is $100, then the promised yield
is 10%. The current yield must, however, compete with the yield on other financial
instruments such as government bonds. If the current yield on other bonds is 12%,
then the price of the bond must be lowered below the par value so that the current
yield equals 12%. In this case, the price of the bond must fall to $833.33
4. If you could finance a new venture with either a stock issue or bonds, which option
would you choose? What are their respective (dis) advantages?
Issuing stock offers the advantage that no interest payments must be made, but you
must relinquish partial ownership in the company to the new stockholders. Bonds
have the advantage that you do not have to relinquish partial ownership, but you
must pay interest on the money borrowed. Current U.S. tax law, in general, favors
bond issuance in that the interest can be deducted as a business expense. Also,
corporate profits are subject to double taxation when distributed as dividends. The
profits are taxed at the corporate level prior to distribution. Any remaining profits
that are distributed are then taxed again as personal income.
5. Why is it considered riskier to own stock in a software company than to hold U.S.
Treasury savings bonds? Which asset will generate a higher return?
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 534
The only way a U.S. Treasury savings bond will not be repaid is if the U.S. federal
government ceases to exist, which is unlikely. A software company is at much
greater risk of failing and, consequently, owning the stock is much riskier. Because
of this risk, the software company must offer a higher rate of return or investors
will not be willing to purchase the company’s stock.
6. How does a successful IPO affect WHAT, HOW, and FOR WHOM the economy
produces?
A successful IPO is one in which the company is able to convince people to purchase
the companies stock. Because of this purchase, resources in the economy are
directed toward the company. In this way, investors choose what (the companies
product), how (the companies manufacturing process) and for whom (the
companies target customers) the economy produces?
7. What considerations might have created the difference between the coupon rate and
current yield on ATT bonds (Table 32.5)?
The prices of bonds reflect the general level of interest in the economy. Even though
the coupon rate was 7 ½ percent at the time of issue, bonds may have become a
more attractive investment alternative since issuance. As a result, the market price
of the bond increased and the yield on the bond decreased to 6.8 percent.
8. What is the price of Google stock now? What has caused the change in price since its
2004 IPO?
See recent newspapers or online services for the stock price.
ANSWERS TO PROBLEMS CHAPTER
32
1. Total dividend is $4. Yield is $4/$48 = 8.33% 1. 8.33%
2. Earnings = $32/20 per share = $1.60 per share. Dividend = 2. 2%
40% x $1.60 = $0.64/share. Yield = $0.64/$32 = 2%
3.
a) $952.38
b) $783.52
c) $613.91
4. The present discounted value is calculated as:
Future Payment N
PDV value
(1 interest rate) N
a.Thus, the PDV of $10,000 in n = 5 periods at an interest rate 4a. $10,000
of 0 percent is $10,000.
b.If the interest rate is 5 percent, the PDV = (10,000/ 1.276) = b. $7835
$7,835.26
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 535
c.If the interest rate is 10 percent, the PDV = (10,000/1.629) = c. $6139
$6,139.13
5. The expected return on Columbus’ expedition was: 5.$502,500
0.50($1,000,000) + 0.25($10,000) + 0.25 (0) = $50,250.
6.The answer to this question depends on which day you
choose, however, an example is as follows. On February 2,
1999, General Motor Stock is quoted as closing at 93 3/8, up 3
5/8 since the close of the market on February 1, 1999.
a.The price of GM stock was up 3.8 percent since the previous
day.
b.The P/E ratio (PE)was 23 meaning that the price per share is
23 times last years earnings of $4.28 per share.
c.Of this profit, $2 were paid in dividends (Div)
d.As a result, GM must have retained $2.28 of the profits per
share.
7. Current yield = 9 = actual interest payment/market 7. 93.06
price = 83.75/ price; So, price = 930.56 for $1000 bond,
or 93.06
8. Current yield = actual interest payment/market price 8.
(a) 6.7%
(b) 6%
(c) 5.5%
9. $294 million x 0.0447 / 365 = $35,763 9. $35,763
10. (a) Demand shifts to left; supply shifts to right; price falls
(b) Demand shifts for right; supply shifts to left; price rises
(c)Supply shifts to right; demand shifts to left; price falls
(d)Demand shifts to left; supply shifts to right; price falls
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 536
IN-CLASS DEBATE, EXTENDING THE DEBATE, AND
DEBATE PROJECT
In-class Debate
Which would you rather own a Treasury security or a corporate bond of the same
maturity and face value? Why?
Teaching notes
Have students answer individually; post signs on the walls of the room labeled with Treasury
Security or Corporate Bond. Ask students to stand up and move to the part of the room
representing their position. Call on individual students to explain their position. Announce
that students may shift position if they change their minds based on student comments.
Ask students to pair with someone who has the same position. Together they might write a
paragraph explaining their position.
Extending the Debate
What does the yield curve tell us?
There is a discussion among economists about the importance of the yield curve for securities
and the long run health of the economy.
Go to: http://www.econreview.com/uscharts/index.htm
Look at the yield curve for March 1979, March 1980 and March of the last year.
Read the article: "What makes the yield curve move?" at
http://www.frbsf.org/publications/economics/letter/2003/el2003-15.html
Explain why you think the yield curves are shaped the way they are.
Should policy makers be concerned about the shape of the yield curve? Why?
Teaching note
Ask students to write a short essay on the relationship of the yield curve and economic
performance.
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 537
Debate Project
Do financial markets take a random walk?
What are the prospects for profitable investment in financial markets? Do markets follow a
random walk so that profits are mostly a matter of chance? Is it possible to outguess the
market? What are the best investment strategies?
Such questions raise issues beyond the scope of the course. Nonetheless these important and
inherently interesting questions involve topics covered in this chapter. Use the following
sources to document the applicability of key chapter concepts including: expected value, risk
premium, capital gain, dividends, corporate stocks and bonds, and present discounted value.
For a recent overview by two experts in the field, The Efficient Market Hypothesis and Its Critics
Burton G. Malkiel and From Efficient Markets Theory to Behavioral Finance Robert J.
Shiller at:
http://www.aeaweb.org/jep/contents/Winter2003.html#malkiel
For discussion of the issue see:
The Economist at:
http://www.economist.com/research/Economics/alphabetic.cfm?TERM=EFFICIENT%20MA
RKET%20HYPOTHESIS#EFFICIENT%20MARKET%20HYPOTHESIS
The Wikipedia at:
http://www.fact-index.com/e/ef/efficient_market_hypothesis.html
ABG Analyitics at:
http://www.abg-analytics.com/philosophy.shtml
The Street.com at:
http://www.thestreet.com/funds/managerstoolbox/10003635.html
EconPapers at:
http://econpapers.hhs.se/paper/rbarbardp/rdp2000-01.htm
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 538
PRINT MEDIA EXERCISE Name: _________________
Chapter 32 Section: __________________
Uncertainty, Risk, and Financial Markets Grade: ___________________
Find an article that describes the risk associated with investing in the stock market. Use the
article you have found to fulfill the following instructions and questions:
1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page.
Make sure there is room at the bottom of the article to write the answers to the questions.
2. Explain what the source of risk is as stated in the article.
3. Under what circumstances are investors at most risk with this investment. In other words,
what economic conditions or conditions of the firm are likely to cause a financial loss to the
investors.
4. In the remaining space below your article, indicate the source (name of newspaper or
magazine), title (newspaper headline or magazine article title), date, and page for the article
you have chosen. Use this format:
Source: ______________________ Date: ______________ Page: ___________
Title: __________________________________________________________
If this information also appears in the article itself, circle each item.
5. Neatness counts.
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 539
Professor’s Note
Learning Objective for Media Exercise
To expose the students to the concept or risk in the financial markets. Also to help the students
think about what can be the sources of risk.
Suggestions for Correcting Media Exercise
1. Look to see if the students have chosen an article which clearly suggests a risky investment.
2. Have the students identified the sources of risk?
Likely Student Mistakes and Lecture Opportunities
1. The student is likely to look for risk only specific to the investment chosen and ignore the
general risk associated with general market movements. This is an excellent opportunity to
discuss the general level of risk associated with investing in the stock market, especially with
individual stocks. This is also a good opportunity to discuss how risk can be minimized
through diversification that occurs in mutual fund investments.
SUPPLEMENTARY RESOURCES
There are a large number of books on financial markets. Among the best (and most
accessible to students) are:
Bernstein, Peter L. Capital Ideas: The Improbably Origins of Modern Wall Street, New
York: Free Press, 1992.
Bernstein, Peter L. The Portable MBA in Investment, New York: John Wiley, 1995.
Fortune, Peter, Series of articles in New England Economic Review 1993 – 1997.
Henwood, Doug, Wall Street: How it Works and for Whom, New York: Verson, 1997.
Shiller, Robert, Irrational Exuberance, New York: Broadway Books, 2001.
Siegel, Jeremy, Stocks for the Long Run New York: Irwin, 1994.
Chapter 17 - Uncertainty, Risk, and Financial Markets - Page 540
