Financial Markets

Introduction

Definitions and Basics

Stock Market, from the Concise Encyclopedia of Economics

The price of a share of stock, like that of any other financial asset, equals the present value of the sum of the expected dividends or other cash payments to the shareholders, where future payments are discounted by the interest rate and risks involved. Most of the cash payments to stockholders arise from dividends, which are paid out of earnings and other distributions resulting from the sale or liquidation of assets….

Bonds, from the Concise Encyclopedia of Economics

Bond markets are important components of capital markets. Bonds are fixed-income financial assets–essentially IOUs that promise the holder a specified set of payments. The value of a bond, like the value of any other asset, is the present value of the income stream one expects to receive from holding the bond….

The U.S. government is highly unlikely to default on promised payments to its bondholders because the government has the right to tax as well as the authority to print money. Thus, virtually all of the variation in the value of its bonds is due to changes in market interest rates. That is why most securities analysts use prices of U.S. government bonds to compute market interest rates.

Because the U.S. government’s tax revenues rarely cover expenditures, it relies on debt financing for the balance. Moreover, on the occasions when the government does not have a budget deficit, it still sells new debt to refinance the old debt as it matures. Most of the debt sold by the U.S. government is marketable, meaning that it can be resold by its original purchaser. Marketable issues include treasury bills, treasury notes, and treasury bonds. The major nonmarketable federal debt sold to individuals is U.S. savings bonds.

Efficient Capital Markets, from the Concise Encyclopedia of Economics

The efficient markets theory (EMT) of financial economics states that the price of an asset reflects all relevant information that is available about the intrinsic value of the asset. Although the EMT applies to all types of financial securities, discussions of the theory usually focus on one kind of security, namely, shares of common stock in a company. A financial security represents a claim on future cash flows, and thus the intrinsic value is the present value of the cash flows the owner of the security expects to receive….

In economics the word “investment” does not mean buying stocks and bonds! Investment, from the Concise Encyclopedia of Economics

By investment, economists mean the production of goods that will be used to produce other goods. This definition differs from the popular usage, wherein decisions to purchase stocks or bonds are thought of as investment.

Investment is usually the result of forgoing consumption. In a purely agrarian society, early humans had to choose how much grain to eat after the harvest and how much to save for future planting. The latter was investment. In a more modern society, we allocate our productive capacity to producing pure consumer goods such as hamburgers and hot dogs, and investment goods such as semiconductor foundries….

In the News and Examples

When the stock market goes down, where does the wealth go? Roberts on Wealth, Growth, and Economics as a Science. Podcast on EconTalk, April 20, 2009.

EconTalk host Russ Roberts talks with reporter Robert Pollie about the basics of wealth and growth. What happens when the stock market goes down or the price of housing? When wealth goes down, where does the wealth go? How do these changes affect our wealth? What is the relationship between wealth and inflation? Roberts explains the economic fundamentals of these changes. At the end of the conversation, Roberts discusses the implications of the current economic crisis for assessing the state of economics as a discipline.

Financing startup businesses. Esther Dyson on the Attention Economy and the Quantification of Everything. EconTalk Podcast.

Esther Dyson talks with EconTalk host Russ Roberts about the market for attention and how technology has changed, how much we pay attention to others, and vice versa. Along the way Dyson reminisces about Steve Jobs, the nature of the start-up and venture capital world, and the future of space travel.

Nassim Taleb on the Financial Crisis. Podcast on EconTalk, March 23, 2009.

Nassim Taleb talks about the financial crisis, how we misunderstand rare events, the fragility of the banking system, the moral hazard of government bailouts, the unprecedented nature of really, really bad events, the contribution of human psychology to misinterpreting probability and the dangers of hubris. The conversation closes with a discussion of religion and probability.

Arnold Kling on Credit Default Swaps, Counterparty Risk, and the Political Economy of Financial Regulation. Podcast on EconTalk, November 10, 2008.

Arnold Kling of EconLog talks with EconTalk host Russ Roberts about the role of credit default swaps and counterparty risks in the current financial mess. The conversation opens with the logistics of credit default swaps and counterparty risks and moves on to their role in the financial collapse. The conversation closes with a discussion of the political economy of pending financial regulation.

More Podcast episodes on Finance. EconTalk, with host Russ Roberts.

More Podcast episodes on the Financial Crisis of 2008. EconTalk, with host Russ Roberts.

Insider Trading, from the Concise Encyclopedia of Economics

“Insider trading” refers to transactions in a company’s securities, such as stocks or options, by corporate insiders or their associates based on information originating within the firm that would, once publicly disclosed, affect the prices of such securities. Corporate insiders are individuals whose employment with the firm (as executives, directors, or sometimes rank-and-file employees) or whose privileged access to the firm’s internal affairs (as large shareholders, consultants, accountants, lawyers, etc.) gives them valuable information. …

Pensions, from the Concise Encyclopedia of Economics

A private pension plan is an organized program to provide retirement income for a firm’s workers. Some 56.7 percent of full-time, full-year wage and salary workers in the United States participate in employment-based pension plans (EBRI Issue Brief, October 2003)….

A Little History: Primary Sources and References

Corporate Debt, from the Concise Encyclopedia of Economics

The Bond Market Association estimates that U.S. corporations had more than $4.5 trillion in bonds outstanding at the end of 2003, with debt averaging about 50 percent of equity (the value of the stock) from 1994 through 2003. Thus, corporations depend heavily on debt financing. One question that market participants or academic observers have not answered adequately, however, is how companies determine what fraction of their corporate activities should be funded through borrowing and what fraction through issuing stock.

All three strategies–paying out large dividends, risk shifting, and underinvestment–are more likely the more indebted is the firm. Lenders know this. Therefore, those who organize the firm, wanting to attract lenders, rationally limit the debt. Bond covenants exist to restrict these games that shareholders might play, but bond contracts cannot prevent all eventualities. An interesting development of the 1980s, however, was the “poison put.” In reaction to the large leveraged buyouts of the 1980s, many companies introduced these poison puts to protect bondholders in the event of a leveraged transaction….

Advanced Resources

Index funds and mutual funds: John Bogle on Investing. EconTalk podcast.

The legendary John Bogle, founder of the Vanguard Group and creator of the index mutual fund, talks about the Great Depression, the riskiness of bond funds, how he created the Index 500 mutual fund—now the largest single mutual fund in the world—how the study of economics changed his life and ours, and Sarbanes-Oxley. At the end of the conversation, he reflects on his life and career….

How mutual funds work: Good Timing: A Mutual-Fund “Scandal”?, by Fred S. McChesney. Econlib, January 5, 2004

Mutual funds perform several functions for investors, and do so through different kinds of funds. Specialized (e.g., high-tech, energy-company) funds research opportunities for investors, and invest in specific sectors accordingly. Index funds hold a diversified portfolio of different stocks that replicates the entire equity market rather than particular sectors.

But the funds are all alike in several fundamental respects. Every fund is owned by its shareholders, who are also its investors. Mutual funds are a sort of holding company, owning the securities of other firms. And so, the value of mutual funds depends on the value of the underlying firms whose securities they hold. And there begins the story of the current mutual-fund “scandal.”…

Enron’s collapse and subsequent legislation: Sarbanes-Oxley (SOX), Belts and Suspenders: The Regulatory Aftermath of the Corporate Accounting Scandals, by Richard Mahoney. Econlib, February 2, 2004.

The market drop had another result, potentially more damaging. A dozen or more companies, the most prominent of which was Enron, were alleged to be “cooking the books”—inflating earnings in an attempt to keep stock prices up in a rapidly declining market. Other complaints against various companies included alleged self-dealing insider schemes and lavish personal use of shareowner assets….

Futures and Options Markets, from the Concise Encyclopedia of Economics

In the late 1970s and early 1980s, radical changes in the international currency system and in the way the Federal Reserve managed the U.S. money supply produced unprecedented volatility in interest rates and currency exchange rates. As market forces shook the foundations of global financial stability, businesses wrestled with heretofore unimagined challenges. Between 1980 and 1985, Caterpillar, the Peoria-based maker of heavy equipment, saw exchange-rate shifts give its main Japanese competitor a 40 percent price advantage. Meanwhile, even the soundest business borrowers faced soaring double-digit interest rates. Investors clamored for dollars as commodity prices collapsed, taking whole nations down into insolvency and ushering in the Third World debt crisis….

Futures are standardized contracts that commit parties to buy or sell goods of a specific quality at a specific price, for delivery at a specific point in the future. The concept of buying and selling for future delivery is not in itself new. In thirteenth-and fourteenth-century Europe, buyers contracted for wool purchases one to several years forward. Cistercian monasteries that produced the wool sold forward more than their own production, expecting to buy the remainder on the market (presumably at a lower price) to satisfy their obligation….

Junk Bonds, from the Concise Encyclopedia of Economics

Junk bonds, also known less pejoratively as high-yield bonds, are bonds that are rated as “speculative” or “below investment” grade issues: below BBB for bonds rated by Moody’s and below Baa for bonds rated by Standard and Poor’s (the two main debt-rating agencies). Bond ratings measure the perceived risk that the bonds’ issuer will not make interest payments or repay the principal at maturity. The riskier a bond is, other things being equal, the lower its rating. The highest-rated nondefaulted bonds are rated AAA or Aaa, and the lowest are rated C, with defaulted bonds rated D; thus, junk bonds can be rated anywhere between Baa (BB) and D. As junk bonds are perceived to be riskier than other types of debt, they typically trade at higher yields–that is, higher rates of return–than investment-grade bonds. …

Program Trading, from the Concise Encyclopedia of Economics

Program trading, the subject of considerable controversy in recent years, is the simultaneous trading of a portfolio of stocks, as opposed to buying or selling just one stock at a time. The New York Stock Exchange defines program trading as any trade involving fifteen or more stocks with an aggregate value in excess of $1 million….

Although it carries connotations of computers trading without supervision or human control, program trading need not have anything to do with computers. And even when they are involved, computers simply speed up the process. The actual decisions to buy and sell are made by people, not computers….

Takeovers and Leveraged Buyouts, from the Concise Encyclopedia of Economics

Corporate takeovers became a prominent feature of the American business landscape during the seventies and eighties. A hostile takeoverusually involves a public tender offer—a public offer of a specific price, usually at a substantial premium over the prevailing market price, good for a limited period, for a substantial percentage of the target firm’s stock. Unlike a merger, which requires the approval of the target firm’s board of directors as well as voting approval of the stockholders, a tender offer can provide voting control to the bidding firm without the approval of the target’s management and directors.

Because it allows bidders to seek control directly from shareholders—by going “over the heads” of target management—the tender offer is the most powerful weapon available to the hostile bidder….

Merton Miller, biography from the Concise Encyclopedia of Economics

Miller’s contribution was the Modigliani-Miller theorem, which he developed with Franco Modigliani while both were professors at Carnegie Institute of Technology. (Modigliani had earned the prize in 1985 for his life-cycle model of saving and for the Modigliani-Miller theorem.)

The Modigliani-Miller theorem says that under certain assumptions, the value of a firm is independent of the firm’s ratio of debt to equity….