Unit 5: Stocks, Bonds, and Financial Markets
This unit is designed to help you understand stocks, bonds, and the financial markets they are traded in. You've heard the terms "stocks and bonds" often, but do you really understand the difference? Understanding these important financial instruments can help you professionally and personally as you navigate the choices for your retirement savings accounts and other financial decisions. Stocks and bonds are an important source of capital for businesses to fund new equipment and new projects. For individuals, they present opportunities for their savings to grow over time. Financial markets bring together these investors and corporations so that each can achieve these objectives efficiently and transparently.
Completing this unit should take you approximately 11 hours.
Upon successful completion of this unit, you will be able to:
- compare and contrast the characteristics of stocks and bonds;
- compute the value of a bond;
- compute the value of a share of stock;
- explain the role of financial intermediaries in the U.S. financial markets; and
- distinguish the markets available to investors for trading securities.
5.1: Stocks
The first video here explains the definition of a stock and what individual investors obtain when they buy a share of a company's stock. The next video explains the definition of a bond and what individual investors obtain when they buy a corporate bond. The final video explains the difference between a stock and a bond.
A company's stock represents the original capital paid into the business by its founders and can be purchased as shares. Shareholders have the right of preemption, meaning they have the first chance to buy newly issued shares of stock before the general public. By the end of this section, you will be able to explain what it means to own stock and describe some of the rights of shareholders.
By the end of this article, you will be able to define common stock and preferred stock and differentiate between these two types of stock.
This article explains the rights of shareholders, depending on what kind of stock they own, including the right to claim income in the case of bankruptcy, voting rights, and the right to buy newly created shares. This section further differentiates preferred stock and common stock.
The actors in the stock market include individual retail investors, mutual funds, banks, insurance companies, hedge funds, and corporations. The world's largest stock exchange market is the New York Stock Exchange (NYSE), and the NASDAQ is an American dealer-based stock market in which dealers sell electronically to investors or firms. By the end of this section, you will be able to differentiate among these stock markets and explain the purpose and function of a market index.
Valuations rely heavily on the expected growth rate of a company; the past growth rate of sales and income provide insight into future growth. A no-growth company would be expected to return high dividends under traditional finance theory. Ideally, the portion of the earnings not paid to investors is left for investment to provide for future earnings growth. By the end of this section, you will be able to explain how a stock is valued and describe the limitations of valuing a company with dividends that have a non-constant growth rate.
5.2: Bonds
The cost of money is the opportunity cost of holding cash instead of investing it, depending on the interest rate. An interest rate is the rate at which a borrower pays interest for using money that they borrow from a lender. Market interest rates are driven mainly by inflationary expectations, alternative investments, risk of investment, and liquidity preference. The term structure of interest rates describes how interest rates change over time.
A yield curve shows the relationship between interest rate levels (or cost of borrowing) and the time to maturity. It also tells what investors' expectations for interest rates are and whether they believe the economy will expand or contract. Three variables determine interest rates: inflation rate, GDP growth, and the real interest rate.
Par value is the amount of money a holder will get back once a bond matures; a bond can be sold at par, at a premium, or at a discount. The coupon rate is the amount of interest that the bondholder will receive per payment, expressed as a percentage of the par value. Maturity date refers to the final payment date of a loan or other financial instrument. A callable bond allows the issuer to redeem the bond before the maturity date; this is likely to happen when interest rates go down. A sinking fund is a method by which an organization sets aside money to retire debts. Other important features of bonds include the yield, market price, and putability of a bond.
Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures. However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
A bond is an instrument of indebtedness of the bond issuer to the holders. Duration is the weighted average of the times until fixed cash flows of a financial asset are received. A bond indenture is a legal contract issued to lenders that defines the commitments and responsibilities of the seller and buyer. Bond credit rating agencies assess and report the creditworthiness of a corporation's or government's debt issues.
A government bond is a bond issued by a national government denominated in the country's domestic currency. A zero-coupon bond is a bond with no coupon payments, bought at a price lower than its face value, with the face value repaid at the time of maturity. Floating rate bonds have a variable coupon equal to a money market reference rate (such as LIBOR), plus a quoted spread. Other bonds include register vs. bearer bonds, convertible bonds, exchangeable bonds, asset-backed securities, and foreign currency bonds.
Most individuals purchase bonds via a broker or through bond funds. By the end of this section, you will be able to describe the process for purchasing a bond and explain why bond markets may not have price transparency.
The value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. Yield to maturity is the discount rate at which the sum of all future cash flows from the bond is equal to the price of the bond. "Time to maturity" refers to the length of time before the par value of a bond must be returned to the bondholder. This section will show you how to calculate a bond's yield to maturity and calculate the price of a bond.
Bondholders face several types of risk, including price risk, reinvestment risk, and default risk. Credit rating agencies assign a bond's credit rating as a financial indicator; bond ratings below BBB-/Baa are considered junk bonds.
5.3: Security Markets
This article will introduce stock market transactions, including IPOs, secondary market offerings, private placement, and stock repurchase. By the end of this section, you will be able to differentiate between the different types of market organizations that facilitate trading securities: auction market, brokered market, and dealer market.
This article will help you define and distinguish realized returns from unrealized returns. By the end of this section, you will be able to calculate an investment's dollar return and percentage return. You will also be able to describe how to use historical and average returns to predict future performance.
This article explains why transparent financial markets provide efficient information about financial instruments, and aid in the discovery of financial information by interested parties. There are three ways to categorize markets based on the information available in the market. After reading, you will be able to identify all three market conditions called "efficiencies". When markets provide the most efficient form of readily available information, no one party can benefit unfairly from the price changes in a market.
This section discusses some of the most important legislation meant to regulate finance and protect stakeholders.
5.4: Convertibles, Options, and Derivitives
Convertible securities are convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock. By the end of this section, you will be able to identify the different features of convertible bonds and discuss the advantages and disadvantages of convertible bonds.
- Options give the owner the right, but not the obligation, to buy or sell an underlying asset or instrument. By the end of this section, you will be able to describe the different factors that influence the value of an option and differentiate between the types of options.
A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date.
A derivative is a financial instrument whose value is based on one or more underlying assets. By the end of this section, you will be able to identify the uses of derivatives and differentiate between the different types of derivatives.
Derivatives allow risk related to the price of underlying assets, such as commodities, to be transferred from one party to another.
Unit 5 Practice and Assessment
Complete these exercises and problems and then check your work.
Complete these exercises and problems and then check your work.