ECON 07NA se CH11 CO 8/3/05 1:19 PM Page 270 Financial …edtechnology.com/ECON/textbook/ECON CH-11.pdf · 2015-11-30 · Web Code: mng-4111 Look through the ﬁnancial pages of a

WWhat is the Dow? Where isWall Street? What does a

daytrader do? You may haveheard these terms but beunsure of exactly what theymean. In this chapter you willlearn the meaning of these andother terms from the world ofinvestment. You will also learnhow the stock market worksand how investors choose fromamong stocks, bonds, andother standard investments.

Financial Markets

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Look through the financial pages of amajor newspaper for stock and bondreports. Jot down the kinds of infor-mation you find. Then make a list ofquestions about the information thatyou don’t understand.

Economics JournalEconomics Journal

ECON_07NA_se_CH11_CO 8/3/05 1:19 PM Page 270

II f you go to school today, you give upyour time now so that you will be

prepared for a career in the future. If a firmbuilds a new plant, it spends money todayfor the sake of earning more money in thefuture. A government may spend moneytoday to build a dam to ensure that peoplewill have a source of hydroelectric power inthe future. All of these actions representinvestments.

In its most general sense, investment is theact of redirecting resources from beingconsumed today so that they may createbenefits in the future. In more narrow,economic terms, investment is the use ofassets to earn income or profit.

Investing and Free EnterpriseAs you have read, one of the chief advan-tages of the free enterprise system is thatit allows people to make a profit. Thisprofit motive leads individuals and busi-nesses to make investments. Investing, infact, is an essential part of the free enter-prise system.

Investment promotes economic growthand contributes to a nation’s wealth. Whenpeople deposit money in a savings accountin a bank, for example, the bank may thenlend the funds to businesses. The busi-

nesses, in turn, may invest that money innew plants and equipment to increase theirproduction. As these businesses use theirinvestments to expand and grow, theycreate new and better products and providenew jobs.

investment the act ofredirecting resourcesfrom being consumedtoday so that they maycreate benefits in thefuture; the use of assetsto earn income or profit

Saving and Investing

Chapter 11 ■ Section 1 271

ObjectivesAfter studying this section you will be able to:1. Understand how investing contributes to

the free enterprise system.2. Explain how the financial system brings

together savers and borrowers.3. Describe how financial intermediaries link

savers and borrowers.4. Identify the trade-offs among risk, liquidity,

and return.

PreviewSection FocusInvestment promotes economicgrowth and contributes to a nation’swealth. The financial system includessavers and borrowers, as well as theinstitutions that transfer savers’dollars to borrowers. Whenborrowers invest these funds, theyfuel economic growth.

Key Termsinvestmentfinancial systemfinancial assetfinancial intermediarymutual funddiversification portfolioprospectusreturn

� How does thisillustration suggestthat investmentpromotes economicgrowth?

ECON_07NA_se_CH11_S1 8/3/05 1:23 PM Page 271

272 Financial Markets

The Financial SystemIn order for investment to take place, aneconomy must have a financial system. Afinancial system includes savers andborrowers and allows the transfer of moneybetween them to take place.

Financial AssetsWhen people save, they are, in essence,lending funds to others. As you read inChapter 10, people can save money in avariety of ways. They may put money in asavings account, purchase a certificate ofdeposit, or buy a government or corporatebond. In each case, savers obtain adocument that confirms their purchase ordeposit. These documents may be pass-books, computer printouts, bond certifi-cates, or other records.

Such documents represent claims on theproperty or income of the borrower. Theseclaims are called financial assets, or securi-ties. If the borrower fails to pay back theloan, these documents can serve as proof incourt that money was borrowed and thatrepayment is expected.

For example, suppose you have $100 ina savings account at your local bank. Yourpassbook (or computer printout) is proofof the money in your account.

The Flow of Savings and InvestmentsFigure 11.1 shows how the financial systembrings together savers and borrowers,fueling investment and economic growth.On one side are savers—households, indi-viduals, and businesses that lend out theirsavings in return for financial assets. On the

other side are borrowers—governmentsand businesses—who invest the moneythey borrow to build roads, factories, andhomes. Borrowers may also use these fundsto develop new products, create newmarkets, or provide new services.

Financial IntermediariesSavers and borrowers may be linkeddirectly. As you examine Figure 11.1, youwill notice that borrowers and savers mayalso be linked through a variety of institu-tions pictured as “in between” the two.These financial intermediaries are institu-tions that help channel funds from saversto borrowers. They include the following:

• Banks, Savings and Loan Associations,and Credit Unions As you read inChapter 10, banks, S&Ls, and creditunions take in deposits from savers, thenlend out some of these funds to busi-nesses and individuals.

• Finance companies Finance companiesmake loans to consumers and smallbusinesses. Because finance companiessometimes lend money to people who donot repay their loans, they take on ahigh degree of risk. Finance companies,therefore, charge borrowers higher feesand interest rates to cover their lossesfrom the loans that are not repaid.

• Mutual funds Mutual funds pool thesavings of many individuals and investthis money in a variety of stocks, bonds,and other financial assets. Mutual fundsallow people to invest in a broad range ofcompanies in the stock market. This way,

financial system thesystem that allows thetransfer of moneybetween savers andborrowers

financial asset claim onthe property or incomeof a borrower

financial intermediaryinstitution that helpschannel funds fromsavers to borrowers

mutual fund fund thatpools the savings ofmany individuals andinvests this money in avariety of stocks,bonds, and otherfinancial assets

� Documents suchas (from left to right)a stock certificate, asavings passbook,and savings bondsare financial assets.



diversificationspreading outinvestments to reduce risk

investors do not risk their savings bypurchasing the stock of only one or twocompanies that might do poorly.

• Life insurance companies The mainfunction of life insurance is to providefinancial protection for the family orother beneficiaries of the insured.Working members of a family, forexample, may buy life insurance policiesso that if they die, money will be paid tosurvivors to make up for lost income.Insurance companies collect paymentscalled premiums from the people whobuy insurance. They lend out part of thepremiums they collect to investors.

• Pension funds A pension is income thata retiree receives after working a certainnumber of years or reaching a certainage. In some cases, injuries may qualifya working person for pension benefits.Employers may contribute to the pensionfund on behalf of their employees, theymay withhold a percentage of workers’salaries to deposit in a pension fund, orthey may do both. Employers set uppension funds to collect deposits anddistribute payments. Pension fundmanagers invest these deposits in stocks,bonds, and other financial assets.

Now that you know something aboutthe types of financial intermediaries, youmay wonder why savers don’t deal directlywith investors. The answer is that, ingeneral, dealing with financial intermedi-aries offers three advantages. Intermediariesshare risks, provide information, andprovide liquidity to investors.

Sharing Risk As a saver, you may not want to investyour entire life savings in a single companyor enterprise. For example, if you had$500 to invest and your neighbor wasopening a new restaurant, would you giveher the entire $500? Since it is estimatedthat more than half of all new businessesfail, you probably would not want to riskall of your money. Instead, you wouldwant to spread the money around tovarious businesses to reduce the chances oflosing your entire investment.

This strategy of spreading out invest-ments to reduce risk is called diversification.If you deposited $500 in the bank orbought shares of a mutual fund, those insti-tutions could pool your money with otherpeople’s savings and put your money towork by making a variety of investments.

Investors

Figure 11.1 Financial Intermediaries

Commercial banksSavings & loan associations

Savings banksMutual savings banks

Credit unions

Life insurance companiesMutual fundsPension funds

Finance companies

Savers make deposits to . . . Financial Institutions that make loans to . . .

Figure 11.1 Financial Intermediaries

Financial intermediaries, including banks and other financial institutions, accept fundsfrom savers and make loans to investors. Investors include entrepreneurs, businesses,and other borrowers. Economic Institutions What advantages do financialintermediaries provide for savers?



portfolio a collection offinancial assets

prospectus aninvestment report topotential investors

return the money aninvestor receives aboveand beyond the sum ofmoney initially invested

In other words, financial intermediariesdiversify your investments and thus reducethe risk that you will lose all of your funds ifa single investment fails.

Providing Information Financial intermediaries are also goodsources of information. Your local bankcollects information about borrowers bymonitoring their income and spending. Sodo finance companies when borrowers fillout credit applications. Mutual fundmanagers know how the stocks in theirportfolios, or collections of financial assets,are performing. As required by law, allintermediaries provide this informationto potential investors in an investmentreport called a prospectus. Financial inter-mediaries reduce the costs in time andmoney that lenders and borrowers wouldpay if they had to search out such informa-tion about investment opportunities ontheir own.

Providing Liquidity Financial intermediaries also provideinvestors with liquidity. (Recall thatliquidity is the ease with which people canconvert an asset into cash.) It is intermedi-aries that provide this liquidity in the finan-cial system.

Suppose, for example, that you decide toinvest in a mutual fund. You keep theinvestment for two years, but then mustsell it to pay your college tuition. If youhad purchased an investment-qualitypainting instead, you would need to findanother investor who would buy the artfrom you. As you can see, financial inter-mediaries and the liquidity they provideare crucial to meeting borrowers’ andlenders’ needs in our increasingly complexfinancial system.

Risk, Liquidity, and ReturnAs you have read, most decisions involvetrade-offs. For example, the trade-off forgoing to a movie may be two additionalhours of sleep. Saving and investinginvolves trade-offs as well.

Return and LiquiditySuppose you save money in a savingsaccount. Savings accounts are good ways tosave when you need to be able to get toyour cash for immediate use. On the otherhand, savings accounts pay relatively lowinterest rates, about 2 to 3 percentagepoints below a certificate of deposit (CD).In other words, savings accounts are liquid,but they have a low return. Return is the

Name Description Example

Credit risk

Liquidity risk

Inflation rate risk

Time risk

You lend $20 to your cousin, who promises to pay you back in two weeks. When your cousin fails to pay you on time, you don‘t have money for the basketball tickets you had planned to buy.

Borrowers may not pay back the money they have borrowed, or they may be late in making payments.

Your CD player is worth $100. You need cash to buy concert tickets, so you decide to sell your CD player. To convert your CD player into cash on short notice, you have to discount the price to $75.

You may not be able to convert the investment back into cash quickly enough for your needs.

Ricardo lends Jeff $1,000 for one year at 10 percent interest. If the inflation rate is 12 percent, Ricardo loses money.

Inflation rates erode the value of your assets.

Lili invests $100 in May‘s cleaning business, to be repaid at 5 percent interest one year later. Six months later, Lili is unable to invest in Sonia’s pet-sitting business, which pays 10 percent interest, because she has already invested her savings.

You may have to pass up better opportunities for investment.

Figure 11.2 Types of RiskFigure 11.2 Types of Risk

Investors must weighthe risks explained inthis chart against thepotential rate of returnon their investment.Income Whatadditional examplescan you think of toillustrate each of thetypes of risk explainedin the chart?



money an investor receives above andbeyond the sum of money initially invested.

What if, however, you suddenly inherit$5,000? You do not need ready access tothose funds, since your part-time job paysyour day-to-day expenses. If you are willingto give up some degree of ready access toyour money, you can earn higher interestrates than offered by a savings account. Forexample, you can invest your money in acertificate of deposit that pays 4 percentinterest. You would not be allowed towithdraw your money for, say, two yearswithout paying a penalty. Therefore, beforebuying the CD, you would want to weighthe greater return on your investmentagainst the loss of liquidity.

Return and RiskCertificates of deposit (up to $100,000) areconsidered very safe investments becausethey are insured by the federal government.When you buy a CD, you are giving upliquidity for a certain period of time, butyou are not risking losing any money. Whatif, however, you decided to invest themoney in a new company that your friendsare starting? If the company succeeds, you

could double your invest-ment. If it fails, however, youcould lose all or part of themoney you invested.

To take another example,suppose your savings accountis earning 2 percent interest.Would you be willing to lendmoney to your friend Emilyfor that same 2 percentinterest rate, knowing thatshe rarely pays back loans ontime? Probably not. For youto lend Emily the money, shewould have to offer you ahigher return than the bankcould offer. This higher returnwould help offset the greater risk thatEmily will not repay the loan on time.Likewise, investors and lenders mustconsider the degree of risk involved in aninvestment and decide what return theywould require to make up for that risk.

The higher the potential return, theriskier the investment. Whenever individ-uals evaluate an investment, they mustbalance the risks involved with the rewardsthey expect to gain from the investment.

Section 1 Assessment

Key Terms and Main Ideas1. How does investing promote financial growth?2. Explain how savers, borrowers, and financial

intermediaries contribute to the financial system.3. Describe three roles of financial intermediaries.4. Explain the following statement in your own words. “The

higher the potential return on an investment, the higherthe risk.”

Applying Economic Concepts5. Critical Thinking Explain why a student with $500 in a

savings account is participating in the American finan-cial system.

6. You Decide Suppose your cousin Bill asks to borrow $50from you for concert tickets. Bill has offered to pay youinterest on the loan. What factors should you considerbefore you decide how much interest to charge?

7. Try This What are three questions concerning risk,return, and liquidity that you would ask a financialadvisor before investing your savings?

8. You Decide Explain the potential risks and returns of thefollowing savings plans and investments. (a) a savingsaccount (b) a certificate of deposit (c) your neighbor’ssuccessful pet care service

In the News Read more about returnand risk in “How Much Risk Can YouTolerate,” an article in The Wall Street Journal Classroom Edition.

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ECONOMICEconomist

Entrepreneur

WWarrarren Bufen Bufffettett (b. 1930)(b. 1930)

When Warren Buffett was 5 years old, he set up a stand to sell lemon-ade—not in front of his own house, but at a friend’s house on anotherstreet, where the traffic was heavier. The son of an Omaha,Nebraska, stockbroker, Buffett announced while still in grade schoolthat he intended to be rich before he was 35. Today, Buffett is widelyconsidered to be a financial genius and is one of the most successful

investors in the world.

1. Source Reading SummarizeWarren Buffett’s approach to investingby creating a list of his “dos” and“don’ts” when deciding whether to buystock in a company.

2. Critical Thinking Why might it bea plus for a company to have such ahigh share price that trading in itsstock is discouraged? What draw-backs might there be for a company inthis situation?

3. Problem Solving Is Buffett’s firm amutual fund or a holding company?Use the Internet and other resourcesto learn more about BerkshireHathaway in order to support yourresponse.

CHECK FOR UNDERSTANDING

The Oracle of OmahaAt age 14, Warren Buffett bought 40 acresof land and rented it to a farmer. By the ageof 21, Buffett had accumulated nearly$10,000. Nearly every dollar of the $20 billion he is worth today can be tracedback to that original bankroll. Because ofthis phenomenal success, he is known asthe financial “Oracle of Omaha.”

Investing the Buffett WayBuffett learned how to invest at ColumbiaUniversity, where he earned a master’sdegree in business in 1951. A professortaught him to pick his investments by doinghis own research. “You’re not right orwrong because 1,000 people agree withyou or disagree with you,” the professortold him. “You’re right because your factsand reasoning are right.”

Buffett has continued to follow thatadvice to this day. He will not invest in abusiness he does not understand. For thisreason, he has shied away from high-techcompanies and focuses on communications,retail, and insurance companies. Heavoided the rise and fall of the dot-coms.

Buffett chooses companies whose stockis selling for less than it is worth. If such a

company is well managed, has fewcompetitors, and is concentrating on whatit does best, he will buy stock and wait forit to go up.

For example, many analysts predicted in1963 that American Express would go outof business after it suffered a majorfinancial setback. In Omaha, Buffett sawthat people were still using their AmericanExpress charge cards. Ignoring the experts,he bought 5 percent of American Express.Five years later, the stock was worth nearlysix times what he paid for it.

The Berkshire Hathaway CompanyBuffett objects to those who label hisBerkshire Hathaway investment company amutual fund. Because it owns Dairy Queen,GEICO Insurance, and Executive Jetoutright—and holds controlling interests inother corporations—Buffett prefers to thinkof it as a holding company.

The cost of Berkshire Hathaway stock,as much as $75,500 a share in 2003, puts itbeyond the reach of most investors. That’sfine with Buffett. Not only does the highprice make Berkshire Hathaway the “RollsRoyce” of investing, it also limits trading inthe company’s shares on the stock market.

276

ECON_05_se_PR_CH11 6/21/05 6:24 AM Page 276

HH ow do borrowers raise money forinvestment? One of the most important

ways is by selling bonds. As you read inChapter 8, bonds are certificates sold by acompany or government to finance projectsor expansion.

For example, starting in 1942, the UnitedStates Department of Treasury launchedbond drives to encourage Americans tobuy “war bonds”—government savingsbonds that helped finance World War II.Movie stars and war heroes urged thepublic to buy bonds. Even school childrenbrought their dimes and quarters to schooleach week, buying defense stamps thatwould eventually add up to the price of awar bond.

Bonds as Financial AssetsBonds are basically loans, or IOUs, thatrepresent debt that the government or acorporation must repay to an investor.Bonds typically pay the investor a fixedamount of interest at regular intervals for afixed amount of time. Bonds are generallylower-risk investments. As you mightexpect from your reading about the rela-tionship between risk and return, the rateof return on bonds is usually also lowerthan for other investments.

The Three Components of Bonds Bonds have three basic components:

• Coupon rate The coupon rate is theinterest rate that the bond issuer will payto the bondholder.

• Maturity Maturity is the time at whichpayment to the bondholder is due.

coupon rate theinterest rate that abond issuer will pay toa bondholder

maturity the time atwhich payment to abondholder is due

Bonds and OtherFinancial Assets


Section FocusCorporations andgovernments borrow moneyby selling bonds and otherfinancial assets. Thecorporation or governmentpays the purchaser interest on the bonds and repays theprincipal, or money borrowed,at a specified time.

Key Termscoupon rate maturity par valueyieldsavings bondmunicipal

bondcorporate

bond

Securities and Exchange Commission

junk bondcapital marketmoney marketprimary marketsecondary

market

ObjectivesAfter studying this section you will be able to:1. Describe the characteristics of bonds as

financial assets.2. Identify different types of bonds.3. Describe the characteristics of other types

of financial assets.4. Explain four different types of financial

asset markets.

Preview

� This poster usedpowerful images toconvince people tobuy war bondsduring World War II.



Different bonds have different lengths ofmaturity. Bonds typically mature in 10,20, or 30 years.

• Par value A bond’s par value is theamount that an investor pays to purchasethe bond and that will be repaid to theinvestor at maturity. Par value is alsocalled face value or principal.

Suppose that you buy a $1,000 bondfrom the corporation Jeans, Etc. Theinvestor who buys the bond is called the“holder.” The seller of a bond is the“issuer.” You are therefore the holder ofthe bond, and Jeans, Etc. is the issuer. Thecomponents of this bond are as follows:

• Coupon rate: 5 percent, paid to thebondholder annually

• Maturity: 10 years • Par Value: $1,000

How much money will you earn fromthis bond, and over what period of time?The coupon rate is 5 percent of $1,000 peryear. This means that you will receive apayment of $50 (.05 times $1,000) eachyear for ten years, or a total of $500 ininterest. In ten years, the bond will havereached maturity, and Jeans, Etc. will retirethe debt. This means that the company’sdebt to you will have ended, and that Jeans,Etc. will pay you the par value of the bond,or $1,000. Thus, for your $1,000 invest-ment, you will have received $1,500 over aperiod of ten years.

Not all bonds are held to maturity. Overtheir lifetime they might be bought orsold, and their price may change. Becauseof these shifts in price, buyers and sellersare interested in a bond’s yield, or yield tomaturity. Yield is the annual rate of returnon the bond if the bond were held tomaturity (5 percent in the example aboveinvolving Jeans, Etc.).

Buying Bonds at a Discount Investors earn money from interest on thebonds they buy. They can also earn moneyby buying bonds at a discount, called adiscount from par. In other words, if Natewere buying a bond with a par value of$1,000, he may be able to pay only $960for it. When the bond matures, Nate willredeem the bond at par, or $1,000. He willthus have earned $40 on his investment, inaddition to interest payments from thebond issuer.

Why would someone sell a bond for lessthan its par value? The answer lies in thefact that interest rates are always changing.For example, suppose that Sharon buys a$1,000 bond at 5 percent interest, which isthe current market rate. A year later, sheneeds to sell the bond to help pay for a newcar. By that time, however, interest rateshave risen to 6 percent. No one will pay$1,000 for Sharon’s bond at 5 percentinterest when they could go elsewhere andbuy a $1,000 bond at 6 percent interest.For Sharon to sell her bond at 5 percent,she will have to sell it at a discount. (SeeFigure 11.3.)

par value the amountthat an investor pays topurchase a bond andthat will be repaid tothe investor at maturity

yield the annual rate ofreturn on a bond if thebond were held tomaturity

Figure 11.3 Discounts from ParFigure 11.3 Discounts from Par

$1,000$1,000BondBond$1,000Bond$1,000$1,000$1,000

$1,000Bond$1,000Bond$960$960

Bond purchase without discount from par

Bond purchase with discount from par

1. Sharon buys a bond with a par value of $1,000 at 5 percent interest.

2. Interest rates go up to 6 percent.

3. Sharon needs to sell her bond. Nate wants to buy it, but is unwilling to buy a bond at 5 percent interest when the current rate is 6 percent.

4. Sharon offers to discount the bond, taking $40 off the price and selling it for $960.

5. Nate accepts the offer. He now owns a $1,000 bond paying 5 percent interest, which he purchased at a discount from par.

=

=

Investors can earn money bybuying bonds at a discount,called a discount from par.Interest Rates How do interestrates affect bond prices?



Bond RatingsHow does an investor decide which bondsto buy? Investors can check bond qualitythrough two firms that publish bondratings. Standard & Poor’s and Moody’srate bonds on a number of factors,including the issuer’s ability to make futureinterest payments and to repay the prin-cipal when the bond matures. Thesecompanies’ rating systems rank bondsfrom the highest investment grade (AAA inthe Standard & Poor’s system or Aaa inthe Moody’s rating system) to the lowest(D in both systems). A bond rating of Dgenerally means that the bond is indefault—that is, the issuer has not kept upwith interest payments or has defaulted onpaying principal.

The higher the bond rating, the lower theinterest rate the company usually has topay to get people to buy its bonds. Forexample, a AAA bond may be issued at a5 percent interest rate. A BBB bond,however, may be issued at a 7.5 percentinterest rate. The buyer of the AAA bondtrades off a lower interest rate for lowerrisk. The buyer of the BBB bond tradesgreater risk for a higher interest rate.

Similarly, the higher the bond rating, thehigher the price at which the bond will sell.For example, a $1,000 bond with an AAA

(or “triple A”) rating may sell at $1,100. A$1,000 bond with a BBB rating may sell foronly $950 because of the increased riskthat the seller could default.

In essence, holders of bonds with highratings who keep their bonds untilmaturity face relatively little risk of losingtheir investment. Holders of bonds withlower ratings, however, take on more riskin return for potentially higher interestpayments.

Advantages and Disadvantages to the IssuerFrom the point of view of the investor,bonds are good investments because theyare relatively safe. Bonds are desirablefrom the issuer’s point of view as well, fortwo main reasons:

1. Once the bond is sold, the coupon ratefor that bond will not go up or down.For example, when Jeans, Etc. sellsbonds, it knows in advance that it will bemaking fixed payments for a specificlength of time.

2. Unlike stockholders, bondholders do notown a part of the company. Therefore,the company does not have to shareprofits with its bondholders if thecompany does particularly well.

Standard & Poor’s Moody’s

Highest investment gradeHigh gradeUpper medium gradeMedium gradeLower medium gradeSpeculativeVulnerable to defaultSubordinated to other debt rated CCCSubordinated to CC debtBond in default

Best qualityHigh qualityUpper medium gradeMedium gradePossesses speculative elementsGenerally not desirablePoor, possibly in defaultHighly speculative, often in defaultIncome bonds not paying incomeInterest and principal payments in default

AaaAaA

BaaBaB

CaaCaCD

AAAAAA

BBBBBB

CCCCCCD

Figure 11.4 Bond RatingsFigure 11.4 Bond Ratings

Standard & Poor’s and Moody’s rate bonds according to their assessments ofthe issuer’s ability to make interest payments and to repay the principal whenthe bond matures.Income What bond rating carries the least risk?



On the other hand, bonds also pose twomain disadvantages to the issuer:

1. The company must make fixed interestpayments, even in bad years when it doesnot make money. In addition, it cannotchange its interest payments even wheninterest rates have gone down.

2. If the firm does not maintain financialhealth, its bonds may be downgraded toa lower bond rating and thus may beharder to sell unless they are offered at adiscount.

Types of BondsDespite these risks to the issuer, whencorporations or governments need toborrow funds for long periods, they oftenissue bonds. There are several differenttypes of bonds.

Savings BondsYou may already be familiar with savingsbonds, which are sometimes given to youngpeople as gifts. Savings bonds are low-denomination ($50 to $10,000) bondsissued by the United States government.The government uses funds from the saleof savings bonds to help pay for publicworks projects like buildings, roads, anddams. Like other government bonds,savings bonds have virtually no risk ofdefault, or failure to repay the loan.

The federal government pays intereston savings bonds. However, unlike mostother bond issuers, it does not send interestpayments to bondholders on a regularschedule. Instead, the purchaser buys asavings bond for less than par value. Forexample, you can purchase a $50 savingsbond for only $25. When the bondmatures, you receive the $25 you paid forthe bond plus $25 in interest.

Treasury Bonds, Bills, and NotesThe United States Treasury Departmentissues Treasury bonds, as well as Treasurybills and notes (T-bills and T-notes). Theseinvestments offer different lengths ofmaturity, as shown in Figure 11.6. Backedby the “full faith and credit” of the UnitedStates government, these securities areamong the safest investments in terms ofdefault risk. The federal governmenttemporarily stopped selling 30-year bondsin 2001, upsetting many investors who likesafe, long-term investments.

savings bondlow-denomination bondissued by the UnitedStates government

Treasury Bond Treasury Note

Term

Maturity

Liquidity andsafety

Minimumpurchase

Denomination

long-term intermediate-term

from 10 to 30 years from 2 to 10 years

safe safe

$1,000 $1,000

$1,000

Treasury Bill

short-term

3, 6, or 12 months

liquid and safe

$1,000

$1,000$1,000

Figure 11.6 Treasury Bonds, Notes, and BillsFigure 11.6 Treasury Bonds, Notes, and Bills

Treasury bonds, notes, and bills represent debt that thegovernment must repay the investor.Government How do these three types of governmentsecurities differ?

Figure 11.5 Average Bond Yields, 1992–2003Figure 11.5 Average Bond Yields, 1992–2003P

erce

nt y

ield

per

yea

r

0

10

8

6

4

2

12

1998199719961995199419931992

Year

Source: Statistical Abstract of the United States, 1997 and 2004–2005

1999 2000 2001 2002 2003

Corporate bonds30-year Treasury bondMunicipal bonds

From the early 1990s to the start of the 2000s, bond yieldsdipped slightly for all three types of bonds shown.Corporate bonds, however, continued to have the highestyield. Income Which of the three types of bonds wouldyou expect to carry the least risk? Explain your answer.

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Municipal BondsState and local governments and munici-palities (government units with corporatestatus) issue bonds to finance suchimprovements as highways, state buildings,libraries, parks, and schools. These bondsare called municipal bonds, or “munis.”

Because state and local governments havethe power to tax, investors can assume thatthese governments will be able to keep upwith interest payments and repay the prin-cipal at maturity. Standard & Poor’s andMoody’s therefore consider most municipalbonds to be safe investments, dependingupon the financial health of a particularstate or town. In addition, the interest paidon municipal bonds is not subject to incometaxes at the federal level or in the issuingstate. Because they are relatively safe andare tax-exempt, “munis” are very attractiveto investors.

Corporate BondsAs you read in Chapter 8, corporationsissue bonds to help raise money to expandtheir businesses. These corporate bonds areissued in fairly large denominations, suchas $1,000, $5,000, and $10,000. Theinterest on corporate bonds is taxed asordinary income.

Unlike city and other governments, corpo-rations have no tax base to help guarantee

their ability to repay their loans, so thesebonds have moderate levels of risk. Investorsin corporate bonds must depend on thesuccess of the corporation’s sales of goodsand services to generate enough income topay interest and principal.

Corporations that issue bonds arewatched closely not only by Standard &Poor’s and Moody’s, but also by theSecurities and Exchange Commission (SEC).The SEC is an independent governmentagency that regulates financial markets andinvestment companies. It enforces lawsprohibiting fraud and other dishonestinvestment practices.

Junk Bonds Junk bonds, or high-yield securities, arelower-rated, and potentially higher-paying,bonds. They became especially popularinvestments during the 1980s and 1990s,

municipal bond a bondissued by a state orlocal government ormunicipality to financesuch improvements ashighways, statebuildings, libraries,parks, and schools

corporate bond a bondthat a corporationissues to raise moneyto expand its business

Securities andExchange Commissionan independent agencyof the government thatregulates financialmarkets and investmentcompanies

junk bond a lower-rated, potentiallyhigher-paying bond

� Municipal bonds, or munis, help finance localprojects such as libraries and schools.



when large numbers of aggressive investorsmade—but also sometimes lost—largesums of money buying and selling thesesecurities.

Junk bonds have been known to payover 12 percent interest at a time whengovernment bonds are yielding only about8 percent interest. On the other hand, junkbonds also carry bond ratings of “lowermedium grade” or “speculative” (BB, Ba,or lower). Investors in junk bonds thereforeface a strong possibility that some of theissuing firms will default on their debt.

Nevertheless, in many cases junk bondshave enabled companies to undertake activ-ities that would otherwise have been impos-sible to complete. (For more information onhow to follow the progress of a stock byreading stock market reports, see page 284.)

Other Types of Financial AssetsIn addition to bonds, investors may chooseother financial assets. These include certifi-cates of deposit and money market mutualfunds, as well as stock. You will read moreabout stock in Section 3.

Certificates of DepositCertificates of deposit (CDs) are one of themost common forms of investment. As youread in Chapter 10, CDs are availablethrough banks, which lend out the fundsdeposited in CDs for a fixed amount oftime, such as 6 months or a year.

CDs are attractive to small investorsbecause they cost as little as $100.Investors can also choose among manyterms of maturity. This means that if aninvestor foresees a future expenditure, suchas college tuition or a major homeimprovement, he or she can buy a CD thatmatures just before the expenditure is due.

Money Market Mutual FundsMoney market mutual funds are specialtypes of mutual funds. As you read inSection 1, businesses collect money fromindividual investors and then buy stocks,bonds, or other financial assets to form amutual fund.

In the case of money market mutualfunds, intermediaries buy short-term finan-cial assets. Investors receive higher intereston a money market mutual fund than theywould receive from a savings account. Onthe other hand, money market mutualfunds are not covered by FDIC insurance.(As you read in Chapter 10, FDIC insur-ance protects bank deposits up to $100,000per account). This makes them slightlyriskier than savings accounts.

� From what you have read, how accurate is the cartoonist’sview of junk bonds?

International Bonds The United States government isn’t the onlygovernment that issues bonds. Many other countries, including Saudi Arabia,Germany, and Japan, also issue bonds. International bonds are usually issuedin large denominations, starting at $1 million. In addition, principal and couponpayments are often made in foreign currencies. The investors, therefore,cannot know what the value of payments will turn out to be. What are twodrawbacks to buying international bonds?

Global Connections



Financial Asset MarketsFinancial assets, including bonds, certifi-cates of deposit, and money market mutualfunds, are traded on financial asset markets.The various types of financial asset marketsare classified in different ways.

Capital and Money MarketsOne way to classify financial asset marketsis according to the length of time for whichfunds are lent. This type of classificationincludes capital markets and moneymarkets.

• Capital markets Markets in whichmoney is lent for periods longer than ayear are called capital markets. Financialassets that are traded in capital marketsinclude long-term CDs and corporateand government bonds that require morethan a year to mature.

• Money markets Markets in whichmoney is lent for periods of less than ayear are called money markets. Financialassets that are traded in money marketsinclude short-term CDs, Treasury bills,and money market mutual funds.

Primary and Secondary MarketsMarkets may also be classified according towhether assets can be resold to otherbuyers. This type of classification includesprimary and secondary markets.

• Primary markets Financial assets thatcan be redeemed only by the originalholder are sold on primary markets.Examples include savings bonds, whichare non-transferable (that is, the originalbuyer cannot sell them to anotherbuyer). Small certificates of deposit arealso in the primary market becauseinvestors would most likely cash them inearly rather than try to sell them tosomeone else.

• Secondary markets Financial assets thatcan be resold are sold on secondarymarkets. This option for resale providesliquidity to investors. If there is a strongsecondary market for an asset, theinvestor knows that the asset can beresold fairly quickly without a penalty,thus providing the investor with readycash. The secondary market also makespossible the lively trade in stock that isthe subject of the next section.

capital market marketin which money is lentfor periods longer thana year

money market marketin which money is lentfor periods of less thana year

primary market marketfor selling financialassets that can only beredeemed by theoriginal holder

secondary marketmarket for resellingfinancial assets


Key Terms and Main Ideas1. Describe two ways in which investors can earn money

from bonds.2. Why are bond ratings useful to investors?3. Describe five different types of bonds.4. How do capital markets and money markets differ?

Applying Economic Concepts5. Math Practice Suppose that you buy a bond for $100

that pays 4 percent interest per year. How much moneywill you have earned when the bond reaches maturity infive years?

6. Decision Making Suppose that you have saved $1,000.In which of the financial assets described in this sectionwould you invest? Explain your choice.

7. Critical Thinking Which bond would you expect to bemore expensive, a bond with a AAA rating or a bond witha BBB rating? (Assume that both bonds pay the samerate of interest.)

8. Try This Assume that you are an investment advisorwith a client who is interested in buying bonds. Create afact sheet that shows your client the different types ofbonds and their characteristics.

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LIFESkills for

Year

1996

1997

1998

1999

2000

2001

2002

GDP Growth(1996 dollars)

Discount rateon January 1

4.3%

4.4%

4.3%

4.1%

3.8%

0.3%

2.4%

–.25%

0%

–.5%

+.5%

+1%

–4.75%

–.5%

5.25%

5%

5%

4.5%

5%

6%

1.25%

Discount Rateon December 31

Rate Change

5%

5%

4.5%

5%

6%

1.25%

.75%

GDP Growth, 1996–2002GDP Growth, 1996–2002

Sources: Bureau of Economic Analysis; The World Almanac 2003

Predicting Consequences

Economists, politicians, and entrepreneurs use economic data as a windowinto the future. On the basis of past events and the current situation, they

sometimes try to predict how an economy or an individual market will behave.Thousands of variables and events have an impact on an economy, so predic-tions will not always come true. However, one can observe broad trends in aneconomy and try to imagine what will happen if these trends continue into thefuture. Follow the steps below to analyze the table and use the data to makepredictions about the American economy.

1. Identify the kinds of information in thetable. The table below lists the rate ofgrowth of Gross Domestic Product(GDP) each year from 1996 to 2002.Also listed is the discount lending rate,one of the key factors that determineshow expensive it is to borrow moneyto start a new business or invest in cap-ital. The higher the discount rate, themore expensive it is to borrow money.A relatively high discount rate cancause slow GDP growth, while a lowdiscount rate may encourage economicgrowth the following year. Because thediscount rate can change several timesduring the year, rates are given for theend of December. Read the columnheadings and introductory notes for thetable. (a) What information does thistable give you for each year?

2. Look for relationships within the data.Lower interest rates encourage peopleto invest in new businesses because thecost of borrowing money is lower.Because too much borrowing can leadto inflation, the Federal Reserve Bankwill raise the discount rate if there is alot of new investment in the economy.(a) In which year did the U.S. economygrow most quickly? (b) How did the interest rates in 2001compare with rates in other years? (c) What is a possible relationshipbetween interest rates in 2000 andeconomic growth in 2001?

Using the Internet or your locallibrary, locate recent articles aboutthe state of the economy and inter-est rates. What indicators do econ-omists use to judge the health of theeconomy? Based on these indica-tors, do you think interest rates willgo up, stay the same, or go down inthe near future? Explain.

Additional Practice

284

ECON_05_se_SK_CH11 6/21/05 6:25 AM Page 284

TT he New York Stock Exchange is atangle of telephones, video monitors,

computer screens, and frantic activity. Thewrong decision may mean the differencebetween gaining or losing thousands ofdollars. This is one of the places wherestock is bought and sold—and fortunes aremade and lost. Just what is stock, exactlyhow is it traded, and when is it a goodinvestment?

Buying StockBesides bonds, corporations can raise fundsby issuing stock, which represents owner-ship in the corporation. Stock is issued inportions known as shares. By selling sharesof stock, corporations raise money to start,run, and expand their businesses. Stocksare also called equities, or claims of owner-ship in the corporation.

Benefits of Buying StockThere are two ways for stockholders tomake a profit:

• Dividends As you read in Chapter 8,many corporations pay out part of theirprofits as dividends to their stockholders.Dividends are usually paid four times a

year (quarterly). The size of the dividenddepends on the corporation’s profit. Thehigher the profit, the larger the dividendper share of stock.

share portion of stock

equities claims ofownership in acorporation

The Stock Market


Section FocusCorporations sell stock toraise money for starting,running, or expanding theirbusinesses. Investors buystocks to profit throughregular payments, calleddividends, or by selling thestock at a price higher thanthe purchase price. Stocks aretraded on secondary marketscalled stock exchanges.

Key Termsshareequities capital gaincapital lossstock splitstockbrokerbrokerage firmstock

exchangeNasdaqOTC market

futuresoptionscall optionput optionbull marketbear marketThe DowS & P 500Great Crashspeculation

ObjectivesAfter studying this section you will be able to:1. Understand the benefits and risks of buying

stock.2. Describe how stocks are traded.3. Identify how stock performance is

measured.4. Explain the causes and effects of the Great

Crash of 1929.

Preview

� Daytime at the Chicago Board of Trade (top photo) shows the franticpace of trade. The frenzied pace of a day of trading is perhaps even bettersuggested by a view of the Chicago Stock Exchange at night (bottom photo).



• Capital gains A secondway an investor can earn aprofit is to sell the stock formore than he or she paid forit. The difference between thehigher selling price and thelower purchase price is calleda capital gain. An investor whosells a stock at a price lowerthan the purchase price,however, suffers a capital loss.

Types of StockStock may be classified inseveral ways, such as whetheror not it pays dividends.

• Income stock This stock pays divi-dends at regular times during the year.

• Growth stock This stock pays few orno dividends. Instead, the issuingcompany reinvests its earnings in itsbusiness. The business (and its stock)thus increases in value over time.

Stock may also be classified as to whetherstockholders have a vote in companypolicy.

• Common stock Investors who buycommon stock are voting owners of thecompany. They usually receive one votefor each share of stock owned. They mayuse this vote, for example, to elect thecompany’s board of directors. In somecases, a relatively small group of peoplemay own enough shares to give themcontrol over the company.

• Preferred stock Investors who buypreferred stock are nonvoting owners ofthe company. Owners of preferred stock,however, receive dividends before theowners of common stock. If the companygoes out of business, preferred stock-holders get their investments back beforecommon stockholders.

Stock SplitsOwners of common stock may sometimesvote on whether to initiate a stock split. Astock split means that each single share ofstock splits into more than one share. A

company may seek to split a stock whenthe price of stock becomes so high that itdiscourages potential investors frombuying it.

For example, suppose you own 200shares in a sporting goods company calledUltimate Sports. Each share is worth $100.After the split, you own two shares ofUltimate Sports stock for every single shareyou owned, so that you now own 400shares. Because the price is divided alongwith the stock, however, each share is nowworth only $50. Although the split has notimmediately resulted in any financial gain,shareholders like stock splits because pricestend to rise afterward.

Risks of Buying StockPurchasing stock is risky because the firmselling the stock may earn lower profitsthan expected, or it may lose money. If so,the dividends will be smaller than expectedor nothing at all, and the market price ofthe stock will probably decrease. If theprice of the stock decreases, investors whochoose to sell their stock will get less thanthey paid for it, experiencing a capital loss.

How do the risk and rate of return onstocks compare to the risk and rate ofreturn on bonds? As you have read,investors expect higher rates of returnwhen they take on greater risk. Because ofthe laws governing bankruptcy, stocksare more risky than bonds. When a firmgoes bankrupt, it sells its assets (such asland and equipment) and then pays itscreditors, including bondholders, first.Stockholders receive dividends only ifthere is money left over after bondholdersare paid. As you might expect, becausestocks are riskier than bonds, the returnson stocks are generally higher.

How Stocks Are TradedSuppose you decide that you want to buystock. Do you call up the company andplace an order? Probably not, because veryfew companies sell stock directly. Instead,you would contact a stockbroker, a personwho links buyers and sellers of stock.

capital gain thedifference between ahigher selling price anda lower purchase price,resulting in a financialgain for the seller

capital loss thedifference between alower selling price anda higher purchase priceresulting in a financialloss to the seller

stock split the divisionof a single share ofstock into more thanone share

stockbroker a personwho links buyers andsellers of stock

In the News Read more about stocktrading in “How to Get Started in OnlineTrading,” an article in The Wall Street Journal Classroom Edition.

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Stockbrokers usually work with individualinvestors, advising them to buy or sellparticular stocks.

Stockbrokers work for brokerage firms,or businesses that specialize in tradingstocks. Stockbrokers and brokerage firmscover their costs and earn a profit bycharging a commission, or fee, on eachstock transaction. Sometimes they also actas dealers of stock, meaning that they buyshares at a lower price and sell them toinvestors at a slightly higher price, profitingfrom the difference, or “spread.”

Stock ExchangesStock is bought and sold on stockexchanges, or markets for buying andselling stock. These markets act assecondary markets for stocks and bonds.Most newspapers publish data on transac-tions in major stock exchanges. (See Figure11.7 to learn how to read a newspaperstock market report.)

Major United States stock exchangesinclude the New York Stock Exchange

(NYSE) and Nasdaq. In addition, a largenumber of people trade stocks on theInternet. (See Skills for Life on page 284 tolearn more about reading a stock marketreport on the Internet.)

The New York Stock ExchangeThe New York Stock Exchange (NYSE) isthe country’s largest and most powerfulexchange. The NYSE began in 1792 as aninformal, outdoor exchange under a now-famous buttonwood tree in New York’sfinancial district. Over time, as the financialmarket developed and the demand to buyand sell financial assets grew, the exchangemoved indoors and became restricted to alimited number of members, who buy“seats” allowing them to trade on theexchange. Today, new technologies maketrading so fast that a transaction takes onlyan instant.

The NYSE handles stock and bondtransactions for only the largest and mostestablished companies in the country. Thelargest and best-known companies listed

brokerage firm abusiness thatspecializes in tradingstocks

stock exchange amarket for buying andselling stock

52 Weeks YldHi

40.3852.5622.7516.5022.38

136.88

Lo22.5026.9412.885.06

12.1374.69

StockDisneyDoleFoodDominResDonnaKrnDonnely ADowChem

SymDISDOLDOMDKDONDOW

DIV0.210.402.56

0.403.48

%0.701.30

15.80...

2.90 2.50

PE40.0072.00 ...

21.0025.00

Vol100s

74244.002927.00288.00

1283.00270.00

13513.00

Hi Lo Close30.5631.7516.199.88

13.75138.00

29.6931.3815.88 8.8813.25

29.7531.6316.199.88

13.75136.94

NetChg

–0.250.440.130.880.563.38

Figure 11.7 Reading a Newspaper Stock ReportFigure 11.7 Reading a Newspaper Stock Report

132.38

52 Weeks Hi and Lo: the highest and lowest prices paid for the stock over the past year

Vol 100s: This column lists the number of shares sold (in hundreds). Multiply this number by 100 to find out how many shares were traded for that day.

Hi and Lo: the highest and lowest prices paid for the stock on that day

Close: the price paid for the stock in the last trade of the day

Net Chg: how much the stock moved up or down during the day

PE: The price-to-earnings (PE) ratio is equal to the stock‘s current price divided by the company‘s earnings per share the previous year.

Sym: the stock‘s symbol

Yld %: Yield is equal to the dividend as a percentage of the stock price.

Div: Most companies send dividends, or payments, to shareholders. Div shows the amount of the dividend in dollars per share.

Many newspaperspublish daily reportsof stock markettransactions. Theexplanations of theabbreviations in thissample report willhelp you read stockmarket reports inyour own daily paper.Income Which ofthe companies listedpays the highestdividend?



on the NYSE are referred to as blue chipcompanies. Blue chip stocks are often inhigh demand because investors expect thecompanies to continue to do business prof-itably for a long time.

The OTC Market Despite the importance of organized stockexchanges like the New York StockExchange, many stocks, as well as bonds,are not traded on the floor of stockexchanges. Instead, they are traded on theOTC market, that is, over-the-counter, orelectronically. Investors may buy directlyfrom a dealer or from a broker who willsearch the market for the best price.

NasdaqNasdaq (the National Association ofSecurities Dealers Automated Quotations)is the American market for over-the-countersecurities. Nasdaq was created in 1971 tohelp solve the problem of fragmentation inthe OTC market by using automation. Bythe 1990s, it had grown into the secondlargest securities market in the United Statesand the third largest in the world, linkingmarkets in the United States, Asia, andEurope. Because it does not have a tradingfloor, Nasdaq’s trading information is

simultaneously broadcast to some360,000 computer terminalsthroughout the world.

Futures and OptionsFutures are contracts to buy or sellcommodities at a specific date inthe future at a price specifiedtoday. For example, a buyer andseller might agree today on a priceof $4.50 for a bushel of soybeanssix or nine months in the future.The buyer would pay someportion of the money today, andthe seller would deliver the goodsin the future. Many of themarkets in which futures arebought and sold are associatedwith grain and livestockexchanges. These markets include

the New York Mercantile Exchange andthe Chicago Board of Trade.

Similarly, options are contracts that giveinvestors the choice to buy or sell stock andother financial assets. Investors may buy orsell a particular stock at a particular priceup until a certain time in the future—usually three to six months. The option tobuy shares of stock at a specified time in thefuture is known as a call option.

For example, you may pay $10 pershare today for a call option. The calloption gives you the right, but not theobligation, to purchase a certain stock at aprice of, say, $100 per share. If at the endof six months, the price has gone up to$115 per share, your option still allowsyou to purchase the stock for the agreed-upon $100. You thus earn $5 per share($15 minus the $10 you paid for the calloption). If, on the other hand, the pricehas dropped to $80, you can throw awaythe option and buy the stock at the goingrate.

The option to sell shares of stock at aspecified time in the future is called a putoption. Suppose that you, as the seller, pay$5 for the right to sell a particular stockthat you do not yet own at $50 per share.If the price per share falls to $40, you can

OTC market anelectronic marketplacefor stocks and bonds

Nasdaq Americanmarket for OTCsecurities

futures contracts to buyor sell at a specific datein the future at a pricespecified today

options contracts thatgive investors thechoice to buy or sellstock and otherfinancial assets

call option the option tobuy shares of stock at aspecified time in thefuture

put option the option tosell shares of stock at aspecified time in thefuture

� Stockbrokers link buyers and sellers of stock.



Figure 11.8 The Dow, 1896–2005Figure 11.8 The Dow, 1896–2005

March 16, 2000Biggest-ever point gain, 499.19, or 4.93%, astechnology boom peaks

October 9, 2002DJIA closes at a five-year low, 7,286.27,on worries of recession and war in Iraq

December 5, 1996Greenspan warns of “irrationalexuberance” in markets

May 1996Centennial of DJIA celebrated

November 21, 1995DJIA first-ever close above 5,000,just nine months after 4,000

October 19, 1987Black Monday crash of record 22.61%, or 508 points

August 12, 1982Birth of long-term bull market, in some analysts‘ view

November 14, 1972First close above 1,000, calledWall Street‘s equivalent ofbreaking the sound barrier

February 8, 1971NASDAQ StockMarket is born

October 28–29, 1929Stock market crashes of 12.82% and 11.73% back to back (38.33 and 30.57 points) usher in Great Depression

May 26, 1896Index‘s launch by Charles Dow, at 40.94 points. Index then had only 12 stocks, not 30.

September 17, 2001The NYSE reopens after the September 11terrorist attacks force a four-day closure.Biggest-ever point loss, 684.81, or 7.13%

May 3, 1999DJIA reaches 11,014.69, breaking the 11,000 points mark. It will attain an all-time high of 11,722.98 on January 14, 2000

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

11,000

0

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Source: The Wall Street Journal; Yahoo! Finance

October 11, 1990Commonly recognized start of bull market

buy the share at that price and require thecontracted buyer to pay the agreed-upon$50. You would then make $5 on the sale($10 minus the $5 you paid for the putoption). If the price rises to $60, however,you can throw away the option and sellthe stock for $60.

DaytradingMost people who buy stock hold theirinvestment for a period of time—some-times many years—with the expectationthat it will grow in value. Recently,however, a different type of stock trading,called daytrading, has become popular.Daytraders try to predict minute-by-minute price changes based on computerprograms that tell the trader when to buyand sell. These traders might make dozensof trades a day in hopes of making aprofit. Unfortunately, daytrading is a riskybusiness in which traders can lose a greatdeal of money.

Measuring StockPerformanceYou may have heard newscasters speak of a“bull” or “bear” market or of the marketrising or falling. What do these terms meanand how are increases and decreases in thesale of stocks measured?



Bull and Bear MarketsWhen the stock market rises steadily over aperiod of time, a bull market exists. On theother hand, when the stock market falls fora period of time, people call it a bear market.In a bull market, investors expect anincrease in profits and thus buy stock.During a bear market, investors sell stockin expectation of lower profits. The 1980sand 1990s brought the longest sustainedbull market in the nation’s history. A multi-year bear market began in 2000.

The Dow Jones Industrial AverageThe Dow (The Dow Jones IndustrialAverage) has shown how certain stockshave traded daily since 1896. To make surethat the stocks remain representative of thestock market as a whole, over the years thecompanies on the Dow have changed.Today, the stocks on the Dow represent 30large companies in various industries, suchas food, entertainment, and technology.

S & P 500The S & P 500 (Standard & Poor’s 500) givesa broader picture of stock performance. Ittracks the price changes of 500 differentstocks as a measure of overall stock marketperformance. The S&P 500 reports mainly

on stocks listed on the NYSE, but some ofits stocks are traded on the Nasdaq andOTC markets.

The Great Crash of 1929Like the 1980s and 1990s, the 1920s saw along-term bull market. Unfortunately, thisperiod ended in a horrifying collapse of thestock market known as the Great Crash. Thecauses of this collapse contain importantlessons for investors today.

Investing During the 1920sWhen President Herbert Hoover tookoffice in 1929, the United States economyseemed to be in excellent shape. The stockmarket is widely viewed as the nation’smain economic indicator, and the stockmarket was soaring. In 1925, the marketvalue of all stocks had been $27 billion. Byearly October 1929, combined stock valueshad hit $87 billion, rising by almost $11.4billion in 1928 alone.

Signs of TroubleDespite widespread optimism aboutcontinuing prosperity, there were signs oftrouble. A relatively small number ofcompanies and families held much of thenation’s wealth. Many farmers andworkers, on the other hand, were sufferingfinancially. In addition, many ordinarypeople went into debt buying consumergoods such as refrigerators and radios—new and exciting inventions at the time—on credit. Finally, industries wereproducing more goods than consumerscould buy. As a result, some industries,including the important automobileindustry, developed large surpluses ofgoods, and prices began to slump.

Another economic danger sign was thedebt that investors were piling up byplaying the stock market. The dizzyingclimb of stock prices encouraged wide-spread speculation, the practice of makinghigh-risk investments with borrowedmoney in hopes of getting a big return. Tomake matters worse, before World War I,only the wealthy had bought and sold

bull market a steadyrise in the stock marketover a period of time

bear market a steadydrop in the stockmarket over a period oftime

The Dow index thatshows how certainstocks have traded

S & P 500 index thatshows the pricechanges of 500different stocks

Great Crash thecollapse of the stockmarket in 1929

speculation thepractice of makinghigh-risk investmentswith borrowed moneyin hopes of getting a bigreturn

� As stock market prices fell in 1929, nervous investors crowded ontoWall Street hoping to hear the latest news.



shares in the stock market. Now, however,the press was reporting stories of ordinarypeople making fortunes in the stock market.Small investors thus began speculating instocks, often with their life savings.

To attract less-wealthy investors, stock-brokers encouraged a practice called buyingon margin. Buying on margin allowedinvestors to purchase a stock for only afraction of its price and borrow the restfrom the brokerage firm. Brokers’ loans tothese investors went from about $5 millionin mid-1928 to $850 million in September1929. The Hoover administration did littleto discourage such borrowing.

The CrashBy September 3, 1929, the Dow hadreached an all-time high of 381. The risingstock prices dominated the news. Eagerinvestors filled brokerage firms to catch thelatest news coming in on ticker tape. Pricesfor many stocks soared far above their realvalues in terms of the company’s earningsand assets.

After their peak in September, stockprices began to fall. Some brokersdemanded repayment of loans. When thestock market closed on Wednesday,October 23, 1929, the Dow had dropped21 points in an hour. The next day, worriedinvestors began to sell, and stock prices fellfurther. Business and political leaders toldthe public not to worry about their losses,but widespread panic began.

By Monday, October 28, 1929, the valueof shares of stock were dropping to afraction of what people had paid for them.Investors all over the country were there-fore racing to get what was left of theirmoney out of the stock market. OnOctober 29, 1929, known as BlackTuesday, a record 16.4 million shares weresold, compared with the average 4 to 8million shares per day earlier in the year.The Great Crash had begun.

The Aftermath of the CrashDuring the bull market that led up to theCrash, about 4 million people had investedin the stock market. Although they were

the first to feel the effects of the Crash,eventually the whole country was affected.The Crash contributed to the GreatDepression, in which millions of Americanslost their jobs, homes, and farms.

Mistakes in monetary policy slowed thenation’s recovery. In 1929, the Fed hadbegun limiting the money supply in orderto discourage excessive lending. With toolittle money in circulation, individuals andbusinesses could not spend enough to helpthe economy improve.

After the Depression, manypeople saw stocks as riskyinvestments to be avoided. In1980, only about 2.5 percentof American households heldstock. Gradually, however,attitudes began to change. Thedevelopment of mutual fundsalso made it easy to own awide range of stocks.Americans became morecomfortable with stockownership.

After a period of very stronggrowth, stocks crashed againon “Black Monday,” October18, 1987. The Dow Jones

The story of the rise, fall, and recovery of General Motors offers a lesson for investors who saw technology stocks soar, then rapidly lose value in the late 1990s and early 2000s. When William C. Durant founded General Motors in the early 1900s, investment capital poured in. GM stock rose more than 5,500% from 1914 to 1920. When the overcrowded auto industry began to disappoint investors in the early 1920s, however, auto stocks plummeted, and GM stock lost two-thirds of its value in six months. Eventually, of course, GM recovered and prospered.

FAST FACT

� What does the cartoonist suggest about investors in the 1990swho assumed that the stock market would only keep climbing?



lost 22.6% of its value that day—nearlytwice the one-day loss that began theCrash of 1929. This time the marketrebounded on each of the next two days,and impact on the economy was much lesssevere. The Fed moved quickly to addliquidity and reduce interest rates to stimu-late economic growth. Within two years,the Dow returned to pre-crash levels.

The Market TodayDuring the second half of the 1990s, stockprices rose dramatically. Many peoplebought stock for the first time or investedin new technology companies. At the endof the 1990s, almost half of Americanhouseholds owned mutual funds.

By 2000, however, investors hadbecome worried that most companiescould not make enough money to justifytheir high stock prices. Stocks fell, andmany investors lost most or all of theirprior gains. The following year, aneconomic recession and terrorist attacksfurther battered the stock market.

In 2002, several large corporations,including Enron and WorldCom, declaredbankruptcy and revealed that they hadissued false financial reports for severalyears. Stock prices fell even more asinvestors questioned how much they reallyknew about the companies they hadinvested in. The federal government intro-duced new rules for corporations to restoreconfidence in the market. The stock marketrecovered, but it remained below the peakvalues reached during the bull market ofthe 1990s.


Key Terms and Main Ideas1. What are two benefits and two risks of buying stock?2. Identify two stock exchanges and describe the

differences between them.3. Describe two popular indexes of stock performance.4. What were three causes of the Great Crash?

Applying Economic Concepts5. Critical Thinking Many people believe that electronic

trading services will replace stockbrokers in the future.What might be the advantages and disadvantages of thisdevelopment?

6. Critical Thinking What might be the advantages anddisadvantages of trading in futures and options? Choosea specific example to support your conclusions.

7. Try This What three questions would you ask a stock-broker before buying a company’s stock?

8. You Decide Would you advise a friend to become adaytrader? Explain your answer.

9. You Decide Suppose you were given $1,000 to invest inthe stock market. How would your choice of stock beinfluenced by the fact that you will soon need to paycollege tuition?

� Following theSeptember 11,2001, terroristattacks, theAmerican flagdraped over theNew York StockExchangesymbolizedAmerican unityand patriotism.

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The Fate of the Dot-ComsThe “dot-coms” are companies that sprang up to take advantage of the potential business

opportunities offered by the Internet. The first of these companies to take off providedservices directly relating to the Internet—companies like America Online and Netscape.Right behind them came a big group of “B2C” companies, businesses marketing products

to consumers. Amazon.com is the best known of these, butthere were hundreds—even thousands—more looking for ashare of consumers’ spending.

Unlimited Potential? Many dot-coms were started by youngentrepreneurs with more vision than experience. Companieslike Amazon declared that making a profit in the short termwas less important than developing a large market share forthe long run. Even though the companies were losing money,and often did not expect to be profitable for years, excitedinvestors flocked to the stocks. Stock prices soared, which inturn generated more excitement, attracted more investors, andpushed stock prices even higher. Venture capitalists fundedfledgling companies and pushed them quickly to market inorder to take advantage of the hot stock market.

The Fall of the Dot-Coms In the middle of 2000, Internet stocksfell sharply as investors became concerned about the lack ofprofits. The companies could stay in business if investors werewilling to put up more money or if they had profits to reinvest.Otherwise, they could quickly run out of money. Many dot-coms filed for bankruptcy protection or closed their doorsentirely. Investors saw the value of their holdings plummet.

The Future of the Dot-Coms After the fall of technology stocks,many formerly enthusiastic entrepreneurs and investors beganto think that dot-coms would never be a good investment. In

reality, they were probably never as good as people thought at the height of the market,or as bad as people thought after the fall. Certainly theInternet will continue to expand, and its use in busi-ness will grow. Companies that are able to developuseful Web-based services may find that they growmore steadily, but more reliably, than during the boomyears.

Applying Economic Ideas1. Why did the initial success of dot-coms make it easier

for other dot-com companies to get started?

2. What might a dot-com entrepreneur have done to avoid the “boom and bust” cycle that many technology stocks experienced?

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Supply and Demand

� What does the cartoon suggest about investing in dot-coms?

� One technology stock, Cisco Systems,reflected the decline of the value ofdot-coms in 2001.

Source: Nasdaq

Cisco Systems, 2000–2001

Jul Sep Nov Jan Mar May Jul

Pri

ce p

er s

ale

Month

0$15$30$45$60$75

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Chapter SummaryChapter Summary

AA summary of major ideas in Chapter 11 appearsbelow. See also the Guide to the Essentials

of Economics, which provides additional review andtest practice of key concepts in Chapter 11.

Section 1 Saving and Investing (pp. 271–275)Saving and investment are essential parts of theAmerican free enterprise system. In our financialsystem, institutions called financial intermediariesbring together savers and borrowers to channelfunds for investment. Investors must weigh potentialrisks and returns when choosing among the manytypes of investments available.

Section 2 Bonds and Other Financial Assets (pp. 277–283) Businesses and governments issue bonds and otherfinancial assets in order to finance expansion. Bondsare relatively low-risk investments for purchasers,who generally receive the purchase price of the bondplus interest when the bond matures. Other financialassets, such as money market mutual funds and cer-tificates of deposit, offer additional investmentopportunities.

Section 3 The Stock Market (pp. 285–292) The stock market is another way for people to investtheir earnings. Stocks offer possibilities for highreturn, but also present certain risks. Major stockexchanges in the United States include the New YorkStock Exchange and the Nasdaq, an electronic stockexchange. Stock performance is measured by TheDow and the S & P 500. The Great Crash of 1929 dealtthe stock market one of its worst economic blows inour history. Following a period of distrust of thestock market in the decades after the Crash, howev-er, investors returned to the stock market in greatnumbers.

Key TKey TermsermsMatch the following terms with the definitionslisted below. You will not use all of the terms.

1. Spreading out your investments to reducerisk

2. Difference between a higher selling priceand a lower purchase price

3. The interest rate to be paid to the bondholder4. A period of time during which the stock

market steadily rises5. An action taken today that will create bene-

fits in the future6. Institution that helps channel funds from

savers to investors7. Lower-rated, higher-paying bonds8. The practice of making high-risk invest-

ments in hopes of getting a big return9. Collection of financial assets

Using Graphic OrganizersUsing Graphic Organizers10. On a separate sheet of paper, copy the web

map below. Complete the web map by writ-ing and describing examples of investmentoptions in the circles. More circles may beadded.

brokerage firmjunk bondsbull marketcoupon rateinvestmentspeculation

portfoliofinancial intermediary

maturity diversification capital gain

mutual funds(pool the funds

of manyinvestors)

income stock(pays regular

dividends)

investment

options

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Reviewing Main IdeasReviewing Main Ideas11. What do financial intermediaries do? 12. How do bond ratings influence which bonds

investors buy? How are bond ratings established?13. Describe three ways that stocks are traded.14. How does diversification strengthen an investor’s

portfolio?

Critical ThinkingCritical Thinking15. Drawing Conclusions Using evidence from the

chapter, support the following statement:Savings and investments play an essential role inthe free enterprise system.

16. Making Comparisons Compare different means bywhich savings can be invested and the risks eachstrategy poses to the consumer.

17. Drawing Conclusions Review the causes of theGreat Crash of 1929. What lessons can investorslearn from the Crash?

18. Demonstrating Reasoned Judgment Analyze theeconomic impact of investing in the stock andbond market.

Problem-Solving ActivityProblem-Solving Activity19. Suppose that you have been handed $10,000.

Now, create your own hypothetical investmentportfolio that best suits your needs and goals.What types of financial intermediaries will youuse? Will you invest more money in stocks,bonds, or other financial assets?

Skills for LifeSkills for LifePredicting Consequences Review the steps shownon page 284; then answer the following questionsusing the table below.20. What is the topic of the table?21. What economic indicators does the table show?22. What time period do the data cover?23. Identify two trends that you can find in these

data. 24. How might you explain these trends in the data?

Synthesizing Information Review the list ofquestions you created at the beginning of thechapter. Use what you have learned in the chapterto answer your questions. Research any remainingquestions in the library or on the Internet.

Economics Journal Progress Monitoring Online

As a final review, take the Economics Chapter 11 Self-Testand receive immediate feedback on your answers. Thetest consists of 20 multiple-choice questions designed totest your understanding of the chapter content.

For: Chapter 11 Self-Test Visit: PHSchool.comWeb Code: mna-4111

Number ofShares Traded

(millions)

Dow JonesIndustrial Average

(average daily close)

January 2007 35,410 11,359.25February 2007 42,491 12,014.98March 2007 47,345 11,895.42April 2007 41,109 11,012.01May 2007 39,882 10,891.11

Stock Market Data Stock Market Data

Data are fictional.

ECON_07NA_se_CH11_CA 8/3/05 1:31 PM Page 295

Long ago, many people saved their money by tucking it awayin a sugar bowl or underneath a mattress. These are relativelysafe, but not very profitable, options for savings. Today, there

are a wide number of investment options available to help your sav-ings multiply. Banks offer various typesof savings accounts and certificates ofdeposit (CDs). These are safe andaccrue small amounts of interest. Moreagressive investments, such as mutualfunds, government bonds, and stocksand bonds, potentially offer greaterreturns, but are relatively risky.

In this simulation, you and yourgroup are trying to raise enough moneyto pay for all 100 students in yoursenior class to visit a nearby amusementpark. You plan to take the trip in oneyear, and you have already saved somemoney. You want to earn as muchinterest or dividends as you can, butyou only have one year. How will youmake your money grow?

MaterialsPaperCalculator

Preparing the SimulationThe best way to make sound investments isto understand your choices thoroughly. Yourtask in this simulation is to determine thebest way to raise enough money for yoursenior trip in only one year.

Step 1: First, form fundraising groups of fiveto eight students. Each fundraising groupwill begin with $5,000 to invest for one year.

Step 2: Your goal is to raise enough moneyfor everyone in your senior class to spend aSenior Weekend at a nearby amusementpark. There are 100 students in your seniorclass, and you have figured out that it willcost $8,000 to buy two-day passes foreveryone.

Conducting the Simulation The simulation will consist of two parts.First, you will discuss your investmentoptions and make your choices. Then youwill calculate the results and discover howmuch you would have made—or lost.

Step 1: First, examine your investmentoptions. Of all the options available, youhave narrowed down your choices to thefive shown in the investment choices chart.Some of your choices have guaranteedreturns on your investment, but others donot. Be sure you understand the risks aswell as the potential returns of each kind ofinvestment.

� How will you raise enough money to pay for asenior class trip to an amusement park?

EconomicsSimulation Making Investment DecisionsMaking Investment Decisions

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As a final step, meet with the otherfundraising groups and compare yourinvestment choices and their results.

1. How many of the groups met theirgoal of turning their $5,000 into$8,000 in one year?

2. Which group’s investments earnedthe most? Did this group take risksor make “safe” choices?

3. Did any groups lose money? Was itbecause they took risks? Or werethere changes in the economy overthe year?

4. Identifying Alternatives If you coulddo this simulation again, would youhave made different investmentchoices? Why or why not?

Step 2: As a group, discuss your philosophy of invest-ing. Do you want to take risks in hopes of a higherreturn? Would you rather avoid risk in your invest-ments, but earn a smaller return?

As you discuss each fundraising choice, keepthese questions in mind:• Does this alternative guarantee a certain rate of

return, or might the rate of return vary?• Is this choice aggressive enough to earn the neces-

sary amount of money in one year?• What is the risk associated with this investment

choice?

Step 3: Decide how to invest your group’s $5,000.Make an investments and returns chart like the oneon this page, and record your investment choices.

Step 4: Now, suppose it is one year later, and it is timeto analyze the results of your investment decisions.Your teacher will provide you with the performancefigures for each investment option. Using that informa-tion, calculate your profits and losses on stock andmutual funds. Figure out the interest you would haveaccumulated from bank deposits or CDs.

Fundraising OptionsFundraising Options

This CD is fully guaranteed by the FDIC, but deposits may only be withdrawn after the end of one full year.

4% guaranteed

This mutual fund invests in blue chip stocks, which are stocks for large, well-established companies that expect slow and steady growth.

8% return last year; return not guaranteed

This brand-new technology company has been all over the news in the last few weeks. The new technology it developed has revolutionized how companies conduct business across the Internet.

brand new; no data to determine how this stock will perform

This company is in financial trouble but could turn itself around. The bonds it has issued are considered junk bonds; if the company is able to pay interest on the bonds, investors will make a healthy profit.

15%, if the company can pay the interest when it is due

A traditional savings account at your local bank is fully guaranteed by the FDIC, and deposits can be withdrawn at any time.

2% guaranteed

Options Potential Return

Invest in the stock market Rock Solid Mutual Fund

Hurrah! (individual company stock)

Wycombe and Marlow Health Care

Deposit the money in a bank Gibraltar Bank Savings Acount

One-Year Certificate of Deposit

Amount Amount

ChoicesInvested of Return

Gibraltar Bank $ $

Savings Account

One-Year Certificate $ $

of Deposit (CD)

Rock Solid Mutual Fund $ $

Hurrah! Stock$ $

Wycombe and $ $

Marlow Health Care

Totals$ $

Investments and

Returns ChartSimulation AnalysisSimulation Analysis

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