17.2 How Households Supply Financial Capital
2 min read•june 24, 2024
Financial markets are the lifeblood of our economy, connecting with borrowers. They help allocate resources efficiently, enabling economic growth through various investment vehicles like , , and .
Understanding these markets is crucial for making informed financial decisions. We'll explore the key characteristics of different investments and the tradeoffs between risk and return, helping you navigate the complex world of finance.
Financial Markets and Investments
Financial Markets Connect Savers and Borrowers
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- Financial markets transfer money from savers to borrowers through bond market (debt securities) and stock market (equity securities)
- Savers are households or institutions with excess funds that lend money to earn interest or invest in assets for potential returns
- Borrowers are households, businesses, or governments that need funds and borrow money, pay interest, or issue securities to raise capital
- Financial like banks, investment companies, and insurance companies facilitate the flow of funds between savers and borrowers
- Financial markets ensure efficient allocation of capital by directing funds to the most productive uses, promoting economic growth and development
Key Characteristics of Bonds, Stocks, and Mutual Funds
- Bonds are debt securities issued by governments or corporations where bondholders lend money to the issuer, receive interest payments, and get principal repaid at maturity date; generally lower risk than stocks
- Stocks are equity securities representing ownership in a company where stockholders have a claim on assets and earnings with potential for capital appreciation and dividend payments; generally higher risk than bonds
- Mutual funds are investment vehicles that pool money from many investors, managed by professional fund managers, investing in a diversified portfolio of stocks, bonds, or other securities; offer diversification and professional management to individual investors with shares bought or sold based on net asset value (NAV)
Tradeoffs Between Expected Return and Risk for Various Investments
- shows higher expected returns generally come with higher levels of risk while lower risk investments typically offer lower expected returns
- Risk tolerance is an investor's willingness to accept risk in pursuit of higher returns depending on factors like age, income, and investment goals
- Diversification reduces the impact of any single investment's performance on the overall portfolio by spreading investments across different asset classes and securities, helping manage risk without necessarily sacrificing expected returns
- Asset allocation optimizes the risk-return tradeoff by dividing an investment portfolio among different asset categories considering an investor's risk tolerance and investment objectives
Key Terms to Review (28)
Balanced Funds: Balanced funds are investment vehicles that aim to provide a balance between growth and stability by investing in a diversified portfolio of assets, typically including stocks and bonds. These funds seek to offer investors a moderate risk profile and a steady stream of income while also providing the potential for capital appreciation.
Beta: Beta is a measure of the volatility or systematic risk of a financial asset in relation to the overall market. It quantifies the sensitivity of an asset's returns to changes in the broader market's returns, providing investors with a way to assess the risk-return profile of their investments.
Bonds: Bonds are debt securities issued by governments, municipalities, and corporations to raise capital. They represent a loan from the bond investor to the bond issuer, who agrees to pay the investor a specified interest rate over a predetermined period of time and to repay the principal amount at the bond's maturity.
Capital Gain: A capital gain is the profit realized when an asset, such as a stock, bond, or real estate, is sold for a price higher than its original purchase price. It represents the increase in the value of the asset over time and is a key component of how households supply financial capital to the economy.
Commodities: Commodities are basic goods or raw materials that are interchangeable and can be bought and sold on the open market. They are typically unprocessed or minimally processed products that can be used as inputs for the production of other goods or services.
Compound Interest: Compound interest is the interest earned on interest, where the interest accumulated from previous periods is added to the principal amount, and interest is then calculated on the new, higher balance. This concept is central to understanding how households can supply financial capital and accumulate personal wealth over time.
Coupon Payments: Coupon payments refer to the periodic interest payments made by the issuer of a bond or other fixed-income security to the bond's holder. These payments are made at a predetermined rate, known as the coupon rate, and are typically made on a semi-annual or annual basis until the bond matures or is redeemed.
Cryptocurrencies: Cryptocurrencies are digital or virtual currencies that use cryptography for secure financial transactions. They operate independently of a central bank or government and enable peer-to-peer exchanges of value without the need for intermediaries.
Current Yield: Current yield is a measure of the annual income generated by a bond or other fixed-income investment, expressed as a percentage of the investment's current market price. It represents the return an investor would receive if they held the bond until maturity and the issuer made all scheduled interest payments.
Face Value: Face value refers to the nominal or printed value of a financial instrument, such as a bond or stock certificate, without consideration of any premium or discount. It represents the amount that will be paid to the holder at maturity or upon redemption.
Financial Assets: Financial assets are any assets that can be easily converted into cash. They include investments, savings, and other liquid resources that can be readily accessed and used to fund various financial obligations or investment opportunities.
How Households Supply Financial Capital: How Households Supply Financial Capital refers to the ways in which individual households provide financial resources, such as savings and investments, that can be used for economic activities and investment. This is a fundamental concept in understanding the flow of financial capital in an economy.
Inflation: Inflation is the sustained increase in the general price level of goods and services in an economy over time. It represents a decline in the purchasing power of a currency, as each unit of currency can buy fewer goods and services. Inflation is a crucial macroeconomic concept that affects various aspects of the economy, including households, businesses, and government policies.
Interest Rates: Interest rates refer to the cost of borrowing money or the return on saving money. They are a crucial factor in the functioning of financial markets and the broader economy, as they influence the decisions of households, businesses, and policymakers.
Intermediaries: Intermediaries are entities that facilitate transactions or interactions between two or more parties, acting as a bridge or conduit between them. They play a crucial role in the financial system by connecting households that supply financial capital with those who demand it.
Junk Bonds: Junk bonds are high-yield, high-risk debt securities issued by companies with poor credit ratings or a high risk of default. They offer higher returns than investment-grade bonds, but also carry a greater chance of the issuer being unable to repay the debt.
Liquidity: Liquidity refers to the ease and speed with which an asset can be converted into cash without significant loss in value. It is a critical concept in the context of financial markets, household financial decisions, and monetary policy.
Mutual Funds: Mutual funds are investment vehicles that pool money from multiple investors and invest that pooled capital in a diversified portfolio of securities, such as stocks, bonds, or other assets. They provide investors with professional management and the ability to access a wide range of investment opportunities, often with lower investment minimums compared to direct investments.
Opportunity Cost: Opportunity cost is the value of the next best alternative that must be forgone when making a choice. It represents the tradeoffs individuals and societies make when deciding how to allocate scarce resources among competing uses.
Portfolio Diversification: Portfolio diversification is the practice of investing in a variety of assets to reduce the overall risk of an investment portfolio. By spreading investments across different asset classes, industries, and geographic regions, investors can minimize the impact of any single investment's underperformance on the overall portfolio's returns.
Risk-Return Tradeoff: The risk-return tradeoff is a fundamental principle in finance that states the higher the risk of an investment, the higher the potential return. Conversely, investments with lower risk typically offer lower potential returns. This concept is crucial for understanding how households supply financial capital and accumulate personal wealth.
Savers: Savers are individuals or households that set aside a portion of their income for future use rather than spending it immediately. They are an important source of financial capital that can be used for investment and economic growth.
Standard Deviation: Standard deviation is a statistical measure that quantifies the amount of variation or dispersion of a set of data values from the mean or average value. It is a fundamental concept in probability theory and statistics, used to understand the spread and distribution of data points.
Stocks: Stocks represent ownership shares in a publicly traded company. They are financial instruments that allow individuals and institutions to invest in and become partial owners of businesses, with the potential to earn returns through dividend payments and capital appreciation.
Systematic Risk: Systematic risk, also known as market risk or undiversifiable risk, is the risk inherent to the entire market or market segment. It is the risk that cannot be mitigated through diversification, as it affects the overall economy or a broad market index. Systematic risk is a crucial concept in the context of how households supply financial capital.
Time Value of Money: The time value of money is the concept that money available at the present time is worth more than the same amount of money available in the future, due to its potential earning capacity. This principle is fundamental to understanding how households supply financial capital and accumulate personal wealth.
Unsystematic Risk: Unsystematic risk, also known as diversifiable risk or idiosyncratic risk, is the component of an investment's total risk that is unique to that particular asset or investment. It is the risk that is specific to a company or industry and can be reduced or eliminated through diversification. Unsystematic risk is in contrast to systematic risk, which is the market-wide risk that cannot be diversified away.
Yield to Maturity: Yield to Maturity (YTM) is the total return expected on a bond if the bond is held until its maturity date. It represents the discount rate that makes the present value of all future coupon payments and the final principal repayment equal to the current market price of the bond. YTM is a key metric used by investors to evaluate the attractiveness and potential returns of fixed-income securities.