Financial Markets

On this page:

Definitions and Basics
In the News and Examples
A Little History: Primary Sources and References
Advanced Resources
Related Topics

Definitions and Basics

Stock Prices, 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 expected stream of future cash payments to the owner. The cash payments available to a shareholder are uncertain and subject to the earnings of the firm. This uncertainty contrasts sharply with cash payments to bondholders, the value of which is fixed by contractual obligation. Most of the cash payments to stockholders arise from dividends, which are paid out of earnings, and 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 securities—securities 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 extremely unlikely to default on promised payments to its bondholders. Thus, virtually all of the variation in the value of its bonds is due to changes in market interest rates. That is why analysts use changes in prices of U.S. government bonds to compute changes in market interest rates.

Because the U.S. government's tax revenues rarely cover expenditures nowadays, it relies heavily on debt financing. Moreover, even if the government did not have a budget deficit now, it would have to sell new debt to obtain the funds to repay old debt that 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

Shortly after the Constitution went into effect, Secretary of the Treasury Alexander Hamilton proposed that Congress redeem at face value securities that had been issued by the states and the federal government. At the time, these securities were selling for much less than face value because people were uncertain whether they would ever be redeemed. After Hamilton's proposal was made public but before it was adopted, however, congressmen and others who knew of the redemption plan made large profits by sending their agents into the countryside to buy the securities at depressed prices before most security holders heard of the plan.

Contrast this scenario with security markets today, in which the prices of securities react very quickly to new information about their value....

To an economist the difference between the market in the late 1700s and today is that today's market is more "efficient" at incorporating information into security prices. Efficient capital markets are commonly thought of as markets in which security prices fully reflect all relevant information that is available about the fundamental value of the securities.

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

Although in general parlance investment may connote many types of economic activity, economists normally use the term to describe the purchase of durable goods by households, businesses, and governments....

In the News and Examples

Insider Trading, from the Concise Encyclopedia of Economics

Since the depths of the Great Depression, the Securities and Exchange Commission (SEC) has tried to prevent insider trading in U.S. securities markets. Insiders—a firm's principal owners, directors, and management, as well as its lawyers, accountants, and similar fiduciaries—routinely possess information that is unavailable to the general public. Because some of that information will affect the prices of the firm's securities when it becomes public, insiders can profit by buying or selling in advance....

Pensions, from the Concise Encyclopedia of Economics

A private pension plan is an organized program to provide retirement income for a firm's workers. Private pension plans receive special tax treatment and are subject to eligibility, coverage, and benefit standards. Private pensions have become an important financial intermediary in the United States, with assets totaling nearly $1.9 trillion in 1989. By comparison, all New York Stock Exchange listed stocks and bonds totaled $4.4 trillion at year-end 1989. In other words, pension plan assets were large enough to purchase about 40 percent of all stocks and bonds listed on the NYSE....

A Little History: Primary Sources and References

Corporate Debt, from the Concise Encyclopedia of Economics

The eighties were the decade of corporate debt. Tremendous changes in corporate financing occurred. The phenomenal growth in the use of junk bonds, the onslaught of debt-financed hostile takeovers and leveraged buyouts, and massive corporate restructuring dominated news stories and discussions about U.S. business. Many commentators warned that these debt-bloated companies and an economic downturn could turn the nineties into the decade of bankruptcy.

In determining how much debt to use, corporate managers have reacted rationally to taxes. Indeed, the U.S. tax code may be the number one explanation for high debt levels. By allowing corporations to deduct interest payments from income before taxation, the U.S. government essentially subsidizes every dollar paid in interest. So instead of asking why the use of corporate debt has increased, perhaps the question should be why it has taken so long for the increase to occur....

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 seventies and early eighties, radical changes in the international currency system and in the way the Federal Reserve managed the nation's money supply produced unprecedented volatility in interest rates and in 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. They are not contracts directly between buyers and sellers of goods. The farmer who sells a futures contract and commits to deliver corn in six months does not make his commitment to a specific corn buyer, but rather to the clearinghouse of the futures exchange. The clearinghouse stands between buyers and sellers and, in effect, guarantees that both buyers and sellers will receive what they have contracted for....

Junk Bonds, from the Concise Encyclopedia of Economics

Junk bonds, also known more respectfully as high-yield securities, are debt instruments that are issued by corporate borrowers and which the major bond-rating agencies say are less than "investment grade." A corporate bond is considered "junk" if it is rated as BaA or lower by Moody's or Ba3 or lower by Standard and Poor's bond-rating services. Bond ratings measure the riskiness of bonds (that is, the chance that the issuer will be unable to make interest payments or repay the principal). The riskier a bond, the lower its rating. Bonds with more A's are less risky than bonds with fewer A's, and the highest rating (for Standard and Poor's) is AAA, or triple-A....

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 takeover usually 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....

Related Topics

Saving and Investing
Risk and Return
Monetary Policy and the Federal Reserve
Foreign Currency Markets and Exchange Rates
Credit