In-Depth Notes on Financial Sector and Financial Assets

Financial Sector Overview

• The financial sector is crucial for connecting individuals, businesses, and governments who save and borrow.
• It consists of various institutions that facilitate these financial interactions, including:
  • Banks
  • Mutual funds
  • Pension funds
  • Other financial intermediaries

Key Definitions

• Financial Assets: Items that have value and can be categorized as tangible or intangible.
• Interest Rate: The cost charged by lenders to borrowers for obtaining loans, akin to the "price" of borrowing money.
• Interest-bearing Assets: Assets that generate interest over time (e.g., bonds).

Personal Finance and Its Components

• Personal Finance encompasses budgeting, saving, and spending strategies for individuals and families.
• Key components covered in personal finance classes include:
  • Checking and savings accounts
  • Credit cards and loans
  • Stock market knowledge
  • Retirement plans
  • Asset management
• In economic terms, "investment" specifically refers to business expenditure on tools and machinery.
• A decrease in interest rates typically stimulates higher levels of investment.

Risks Associated with Buying Assets

• Market Risk: Risk of incurring losses due to fluctuations in market prices.
• Default Risk: The potential that companies or individuals cannot meet their debt obligations.
• Inflation Risk: The risk where the value of investments diminishes due to inflation.

Liquidity Explained

• Liquidity refers to how easily an asset can be converted to cash. The higher the liquidity, the lower the expected rate of return on that asset.

Bonds vs. Stocks

• Bonds:

  • Represent loans or IOUs where the issuer must repay the lender.
  • Bondholders do not have ownership stakes in the issuing entity but receive periodic interest payments.
  • Example: If you borrow $100 from your grandmother for a lemonade stand, this is analogous to issuing a bond to her.

• Stocks:

  • Represent ownership in a corporation, with stockholders entitled to a share of profits as dividends.
  • To raise more funds, you could sell equity by issuing shares of stock.

Bond Prices and Interest Rates

• A bond is issued with a fixed interest rate that remains constant throughout its term.

• Example Scenario: A 30-year U.S. Treasury bond with a face value of $1000 and a 5% interest rate yields $50 annually.

  • If prevailing interest rates drop to 3%, the fixed 5% bond becomes more attractive for potential buyers, demonstrating the inverse relationship between bond prices and interest rates.

• When existing bonds are sold before maturity, their prices adjust based on current rates and demand, often leading to price increases if interest rates fall

  • Point to remember: Bond prices and interest rates move in opposite directions; as one increases, the other decreases.