Chapter 5 provides an overview of financial instruments including but not limite

Question

Chapter 5 provides an overview of financial instruments including but not limited to stocks, bonds, and derivative securities – i.e., securities that “derive” their value from other securities (examples include options, futures, swaps, etc.). Emphasis is also placed on the securities markets. Use what you have learned from reading the text to discuss how the bond market works. How about the stock market? How can we solve for our “return on investment” in stocks? How about bonds? More specifically, where do stocks and bonds “derive” their value?

Explanation / Answer

How Bond Market works, bonds derive their value and Return on investment in bonds:

The bond market moves when expectations change about economic growth and inflation. Unlike stocks, whose future earnings are anyone's guess, bonds make fixed payments for a certain period of time. Investors decide how much to pay for a given bond (that is, for a stream of fixed payments of a certain length) based on how much they expect inflation to erode the value of those fixed payments.

The higher their expectations of inflation, the less they will pay for bonds. The lower they expect inflation to be, the more they will pay.

In Bond Markets, lower prices correspond to higher yields, and higher prices correspond to lower yields. When prices fall, yields rise, and vice versa.

The reason is simple: Yield measures the value of a bond to an investor, depending on how much the investor paid for it. The lower the price at which you buy, the better the deal you are getting. The higher the price, the worse the deal. An investor who pays a price of 98 for a bond that pays interest at the rate of 7% (its so-called coupon rate) for 10 years gets a better deal than an investor who pays 100 for the same instrument. The investor who pays 98 gets a yield of 7.25%. The investor who pays 100 gets a yield of 7%.

How Stock Market works, stocks derive their value and Return on investment in stocks:

Stocks are issued by companies to raise cash, and the stock then continues to trade on an exchange.
Prices on markets move very quickly, as demand for stocks ebbs and flows along with the latest news and investors’ moods. So the price one sees quoted for a stock may not be exactly the price you pay when you try to buy it. Overall stocks have risen over the long-term, which makes owning shares attractive. There are also additional perks such as dividends (income), profit potential and voting rights. Share prices also fall, though, which is why investors typically choose to invest in a wide array of stocks, only risking a small percentage of their capital on each one. Shares can be bought or sold at any time, assuming there is enough volume available to complete the transaction, which means investors can cut losses or take profits whenever they wish. As far as return on investment in stock is concerned it is basically as mentioned above is the amount of dividend received therein.

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