7.6 Financial Markets: Stocks and Bonds

Notes

Financial markets connect savers with businesses and governments that need money to invest.

• Stocks are shares of ownership in a corporation. Shareholders may earn dividends (a share of profits) and capital gains (selling for more than the purchase price). They may also suffer capital losses.
• Bonds are loans to a company or government. The issuer pays interest (the coupon) and repays the face value (par value) at maturity. When market interest rates rise, the prices of existing bonds fall, and when rates fall, bond prices rise.
• Stocks are traded on exchanges such as the New York Stock Exchange and Nasdaq. Indexes track the market: the Dow Jones Industrial Average (30 large companies) and the S&P 500 (500 large companies).
• A bull market is a long period of rising prices; a bear market is a period of falling prices (often defined as a drop of $20\%$ or more).
• Risk-return trade-off: investments with higher possible returns usually carry more risk. Diversification, spreading money across many investments, reduces risk. Mutual funds and index funds pool money to buy many stocks or bonds.
• Worked example: you buy 50 shares at $40 ($2,000), receive $1 per share in dividends ($50), and sell at $46 for a $300 capital gain. Total return is $\displaystyle \frac{350}{2{,}000} = 17.5\%$.