Financial Markets
Summary :How Firms Raise Financial Capital
Firms often need money today to fund a project that will only pay off years later, whether that project is a new production line, a new storefront, or a research effort into a better product. Economists call the funds a firm raises for this purpose financial capital, and firms typically raise it in one of two broad ways: borrowing or selling ownership. Consider a mid-sized bakery equipment manufacturer planning to build a second factory. It could borrow the funds, either through a bank loan or by issuing bonds, which are essentially IOUs promising to repay the amount borrowed plus periodic interest over a set number of years. Alternatively, it could raise the funds by selling shares of stock, giving new shareholders partial ownership of the company in exchange for cash today, with no fixed obligation to repay a set amount, but with a share of future profits and decision-making power going to the new owners instead. Which route a firm chooses depends on its size, its credit history, and how much control its founders are willing to give up in exchange for funding growth.
How Households Save: Bank Accounts and Certificates of Deposit
On the other side of the financial market are households and individuals deciding where to place their savings, each option involving a different combination of expected return, risk, and liquidity, meaning how quickly the saver can convert the asset back into spendable cash without losing value. A checking or savings account at a bank is the most liquid option, letting a saver withdraw funds almost instantly, but it typically pays a fairly low interest rate in exchange for that convenience. A certificate of deposit locks a saver's funds away for a fixed term, commonly six months to five years, in exchange for a somewhat higher interest rate than a regular savings account offers, with a penalty charged if the saver withdraws early. Suppose a saver deposits four thousand dollars into a two-year certificate of deposit paying three percent annually rather than leaving it in a savings account paying half a percent; over two years the certificate earns roughly two hundred forty dollars in interest compared to about forty dollars in the savings account, illustrating the basic tradeoff of accepting reduced liquidity in exchange for a better return.
Bonds and the Risk-Return Tradeoff
A bond is a loan the buyer makes to the issuer, whether a government or a corporation, in exchange for regular interest payments and the return of the original amount when the bond matures. The interest rate a bond pays reflects how risky investors judge the borrower to be. A national government that has a long history of repaying its debts can typically borrow at a low interest rate, since investors see default as unlikely, while a smaller, newer company must offer a higher interest rate to attract lenders willing to accept the greater chance that it might struggle to repay. Suppose a national government bond pays three percent annually while a bond issued by a young furniture-manufacturing company pays eight percent; the higher rate compensates bondholders for taking on the extra risk that the furniture company could face financial trouble before the bond matures. Bond prices also move with prevailing interest rates after they are issued: if market interest rates rise above a bond's stated rate, that older, lower-paying bond becomes less attractive, and its resale price falls below its original face value to compensate a new buyer for accepting the below-market rate.
Stocks and Mutual Funds
Buying a share of stock makes the buyer a partial owner of the company, entitled to a share of any dividends the company pays out and to any capital gain if the stock's price rises before it is sold. Stocks generally offer a higher average return over long periods than bonds or bank deposits, but with considerably more risk, since an individual company's share price can rise sharply or fall to nearly nothing depending on how the business performs. Because holding stock in just one or two companies concentrates risk heavily, many savers instead buy into a mutual fund, a pooled investment that holds shares of dozens or hundreds of different companies at once. Suppose an investor purchases units of a mutual fund that owns small stakes in two hundred different companies rather than buying stock in a single company directly; if any one of those two hundred companies performs poorly, the loss is diluted across the fund's broad holdings rather than falling entirely on the investor, a strategy economists call diversification.
Housing and Other Tangible Assets
Beyond bank accounts, bonds, and stocks, households also invest in tangible assets, most commonly housing, but also occasionally commodities such as gold or agricultural goods. A house purchased to live in offers a return in two forms: the ongoing value of having a place to live, sometimes called housing services, and any capital gain if the home's market value rises before it is sold. Someone who instead buys a small rental duplex, living in one unit and renting out the other, earns both housing services and a stream of rental income, plus the possibility of price appreciation, though property also comes with costs, including maintenance, taxes, and the risk that local home prices could fall rather than rise. Investments in commodities like gold work differently still, since gold pays no interest or dividend at all; an investor holding gold profits only if its price rises enough to be sold for more than its purchase price, which is why economists generally classify commodities as a higher-risk, purely price-driven investment compared to interest-bearing or dividend-paying assets.
Quick Revision Summary
Firms raise financial capital either by borrowing, through bank loans or bonds, or by selling ownership through stock, with the choice depending on firm size, credit history, and how much control the founders wish to retain. Households save through bank accounts and certificates of deposit, which are highly liquid but offer relatively low returns, or through certificates of deposit that trade some liquidity for a better rate. Bonds pay interest that reflects the borrower's riskiness, and bond prices move inversely with prevailing market interest rates after issuance. Stocks offer higher average long-run returns than bonds or bank deposits but carry more risk, and mutual funds let investors diversify across many companies at once to reduce that risk. Tangible assets such as housing and commodities like gold provide a different kind of return, often combining a usable service or price appreciation with generally higher risk and lower liquidity than financial assets like bonds and stocks.