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163
PART
2
INVESTMENTS
Introduction
The fi eld of fi nance is composed of three areas—institutions and markets, investments, and
fi nancial management. Part 2 focuses on the investments area of fi nance. Investments involve
the sale or marketing of securities, the analysis and valuation of securities and other fi nan-
cial claims, and the management of investment risk through holding diversifi ed portfolios.
Money fl ows into the fi nancial markets from the savings of households and the earnings
retained by businesses. Funds fl ow into fi nancial institutions, such as banks and life insurance
companies, which, in turn, invest the funds in various securities, such as stocks and bonds as
well as other fi nancial claims. Financial claims are anything that has a debt or equity claim
on income or property, such as a car loan, a mortgage, or an equity investment in a small part-
nership. Financial institutions facilitate the work of the fi nancial markets by directing funds
from savers to those individuals, fi rms, or governments who need funds to fi nance current
operations or growth.
Part 1 dealt with the operations of the fi nancial markets in general within the context of
the fi nancial system. The combined fi nancial crisis and Great Recession of 2007–09, some-
times referred to as the “perfect fi nancial storm,” tested the workings of the U.S. fi nancial sys-
tem to an extent not seen since the 1930s depression. Although some evidence suggested that
the U.S. fi nancial system was on the verge of collapse in late 2008, eff orts on the part of policy
makers, business leaders, and individuals set the stage for economic recovery and a return to
fi nancial stability as the decade of the 2000s came to an end. However, slow economic growth
accompanied by very low interest rates continues to be of concern as we progress through the
second decade of the twenty-fi rst century.
Part 2 introduces many of the important concepts and tools that fi nancial institutions
and investors use in the fi nancial markets. For example, no one would want to invest (except
perhaps altruistically) $100 now and expect to receive only their $100 back after one year.
Because they give up the use of their money for some time, investors expect a return on their
investments. Thus, we say that money has a “time value.” Having one dollar today is of greater
value to us than the promise of receiving one dollar sometime in the future.
How much can we expect to receive for our $100 investment? The answer is determined
in the fi nancial markets. As with any other market, the fi nancial markets consider demand and
supply forces to determine the “price” of money; namely, the interest rate, or the expected
return on an investment. The amount of interest received on a certifi cate of deposit or a bond,
or the expected return on a common stock investment, all depend on the workings of the
fi nancial markets and the marketplace’s evaluation of the investment opportunity.
It is through the investing process that institutions, fi rms, and individual investors come
together. Firms and governments go to the fi nancial markets seeking investors and institu-
tions to which they can sell fi nancial securities. Investors and institutions participate in the
164
C H A PT E R 7 Savings and Investment Process
fi nancial markets, seeking profi table investments to help meet their goals. For an investor,
the goal may be a comfortable retirement, or accumulating funds to purchase a car or house.
For fi nancial institutions, the higher the returns they earn on prudent investments, the greater
will be their profi ts and the stronger their competitive position. A fi nancial institution that
prudently earns higher returns in the fi nancial markets will be able to off er current and poten-
tial customers higher interest rates on their deposits than a competitor whose fi nancial market
returns are lower.
Part 2 also introduces us to the process of investing and to the tools that can be used to
evaluate fi nancial market securities. Chapter 7 examines the work of fi nancial markets to dir-
ect savings into various investments. Chapter 8 discusses infl uences that aff ect the fi nancial
market’s determination of the price of money, or the interest rate or expected return on an
investment. Chapter 9 examines the eff ect of interest rates more closely by introducing the
concept of time value of money. This chapter shows us how we can compare diff erent dollar
amounts of cash over time to determine whether an investment is attractive or not. Chapter 10
introduces us to bonds and stocks. We review their characteristics and we use the time value
concepts from Chapter 9 in a pragmatic manner to see how we can estimate their value. We
also learn in Chapter 10 how to read and interpret information about bonds and stocks from
the fi nancial pages of papers such as
The Wall Street Journal
.
Chapter 11 delves deeper into the workings of the securities markets. It focuses on the
processes that institutions and fi rms use to issue securities, and the process that investors use
when buying or selling securities. Chapter 12 completes our overview of investing in the
securities markets by examining the trade-off between risk and expected return—to have an
incentive to invest in higher-risk securities, investors must have higher returns. Chapter 12
introduces us to the tools that investors and securities market participants use to evaluate and
control investment risk.
INSTITUTIONS
AND MARKETS
FINANCIAL
MANAGEMENT
INVESTMENTS
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