BUS202 Study Guide

Unit 4: Stocks, Bonds, and Financial Markets

4a. Compare stocks and bonds

What is the difference between stocks and bonds?
What are the advantages and disadvantages of stocks?
What are the advantages and disadvantages of bonds?
How do stocks and bonds generate returns for investors?

Stocks represent an equity interest in a corporation, while bonds represent debt to the company. Stockholders are the firm's owners and have voting rights to elect the board of directors and major issues of the company. Stockholders may receive dividends and earn a return through the appreciation of the stock price, but dividends can be reduced or canceled in poor financial conditions, and returns are not fixed. Stocks offer potential for higher returns through growth but come with higher risk and volatility.

Bondholders receive interest payments and repayment of the principal upon the bond's maturity. Bonds have the advantage of high liquidity, legal protection, and relatively low volatility, but do not have voting rights and cannot share in the upside success of the firm. Stocks have the possibility of price appreciation and dividends, but they have no legal claim to payments and are a higher risk than bonds. Bonds provide stable, predictable income and are generally less risky, especially for conservative investors. Bonds usually offer lower long-term returns than stocks, especially in periods of low interest rates or inflation.

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4b. Compute the value of a bond

How do you calculate the value of a bond?
How does a bond's value vary with interest rates?
How does the time to maturity affect a bond's value?

Bond values are calculated using the present value approach. The price of a bond is equal to the present value of the interest payments plus the present value of the principal repayment at maturity. The interest payments represent an annuity, so the PV of an annuity must be calculated. The principal is a lump sum, so the PV of a single amount is used. Both present values are added together to calculate the value of the bond. The easiest way to calculate the PV of a bond is to use Excel or a calculator application. The mathematical formula is given below:

\(P=\left(\frac{C}{1+i}+\frac{C}{{(1+i)^2}}+...+\frac{C}{(1+i)^{N}}\right)+\frac{M}{(1+i)^{N}}\\ =\left(\sum_{n=1}^{N}\frac{C}{(1+i)^{n}}\right)+\frac{M}{(1+i)^{N}}\\ =C\left(\frac{1-(1+i)^{-N}}{i}\right)+M(1+i)^{-N}\)

The interest rate used to calculate the bond's value is the discount rate based on the yield of similar investments, or the market rate. As interest rates increase, the price of a bond will decrease, and vice versa. This inverse relationship means that bond prices increase in value during times of decreasing interest rates and decrease in value when rates rise.

The time to maturity significantly affects a bond's value due to its impact on the present value of future cash flows (coupon payments and face value).

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4c. Compute the value of a share of stock

What is the difference between the intrinsic value and the market value of a stock?
How do you calculate the value of a share of stock?
How do investors use the P/E ratio?

The intrinsic value of a stock is the theoretical or estimated worth of a stock based on fundamental analysis, such as future cash flows, earnings, dividends, and growth potential. Meanwhile, the market value of a stock is the current trading price in the stock market: what buyers are willing to pay and what sellers are willing to accept.

The value of a share of stock is equal to the present value of the expected returns associated with the stock. The returns may include dividends or price appreciation, known as capital gains. The Gordon Growth Model, known as the dividend discount model, is the mathematical formula to calculate the value of stock under constant growth rate assumptions:

\(P=D\times \sum^{\infty}_{i=1}(1+g1+k)i=D \times 1+gk-g\)

The value of a stock can also be calculated using the P/E ratio. Knowing the stock's historical P/E ratio and the EPS, you can calculate the expected stock price.

P/E = market price/EPS

A high P/E ratio can indicate a stock that is expected to grow in the future, or that a stock is overpriced. A low P/E ratio can indicate a value stock, a stock that is not seen as attractive.

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Stock Valuation

4d. Explain the role of financial intermediaries in US financial markets

What is the role of financial intermediaries in the US financial markets?
What are the main types of financial intermediaries?
How do financial intermediaries differ from direct finance?

A financial intermediary helps transfer funds from those who have excess to those who need funds. Intermediaries include banks, mutual funds, credit unions, insurance companies, brokers, and pension funds. Stock exchanges allow companies to raise capital by selling shares to the investing public, transferring money from investors to corporations.

Banks help companies raise capital by underwriting and issuing securities; provide advisory services. Mutual funds pool money from many investors to buy a diversified portfolio of stocks, bonds, or other securities. Pension funds manage retirement savings for employees by investing in long-term assets. Insurance companies collect premiums to provide protection against risks and invest the collected funds in capital markets. Financial brokers act as intermediaries between buyers and sellers in financial markets. They do not own the assets being traded but help facilitate transactions, often for a commission or fee.

Financial intermediaries help by pooling savings, managing risk, and ensuring liquidity. Meanwhile, direct finance offers potentially lower costs for borrowers but requires more transparency and investor knowledge.

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4e. Identify the markets investors use to trade securities

What are financial markets, and why are they important for investors?
What are the different types of market organizations for trading securities?
What is the difference between a primary market and a secondary market?

Financial markets are platforms or systems where buyers and sellers come together to trade financial assets such as stocks (equity securities), bonds (debt securities), commodities, currencies, and derivatives (like options or futures). Financial markets connect savers (investors) with borrowers (companies, governments). They are essential for building personal wealth, funding business expansion, and facilitating efficient economic activity. Without financial markets, investors would find it much harder to invest, trade, or evaluate risk and return.

There are three main types of market organization for trading securities: an auction market, a brokered market, and a dealer market. An auction market brings buyers and sellers together directly to execute orders. The NYSE is the most famous auction market. Brokered markets are when an intermediary finds trading partners for their clients directly, such as the municipal bond market. Dealer markets have quote systems where dealers provide continuous bids for securities investors want to buy or sell. NASDAQ is the most notable dealer market.

Primary markets deal with the issue of new securities. When a company goes public for the first time through an initial public offering (IPO), that is a primary market transaction. In contrast, secondary markets facilitate trading securities previously issued between owners and subsequent buyers. Markets are important in providing liquidity for investors and price transparency.

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Unit 4 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

auction market
bond
brokered market
capital gains
dealer market
dividend discount model
financial broker
financial intermediary
initial public offering (IPO)
insurance company
mutual fund
pension fund
P/E ratio
primary market
secondary market
stock