Key Terms

Key Terms

actual rate of return the total rate of return, including capital gains and interest paid on an investment at the end of a time period bond a financial contract through which a borrower like a corporation, a city or state, or the federal government agrees to repay the amount that it borrowed and also a rate of interest over a period of time in the future bond yield the rate of return a bond is expected to pay at the time of purchase bondholder someone who owns bonds and receives the interest payments capital gain a financial gain from buying an asset, like a share of stock or a house, and later selling it at a higher price certificate of deposit (CD) a mechanism for a saver to deposit funds at a bank and promise to leave them at the bank for a time, in exchange for a higher interest rate checking account a bank account that typically pays little or no interest, but that gives easy access to money, either by writing a check or by using a “debit card” compound interest an interest rate calculation on the principal plus the accumulated interest corporate bond a bond issued by firms that wish to borrow corporate governance the name economists give to the institutions that are supposed to watch over top executives in companies that shareholders own corporation a business owned by shareholders who have limited liability for the company’s debt yet a share of the company’s profits; may be private or public and may or may not have publicly-traded stock coupon rate the interest rate paid on a bond; can be annual or semi-annual debit card a card that lets the person make purchases, and the financial institution immediately deducts cost from that person’s checking account diversification investing in a wide range of companies to reduce the level of risk dividend a direct payment from a firm to its shareholders equity the monetary value a homeowner would have after selling the house and repaying any outstanding bank loans used to buy the house expected rate of return how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability face value the amount that the bond issuer or borrower agrees to pay the investor financial intermediary an institution, like a bank, that receives money from savers and provides funds to borrowers high-yield bonds bonds that offer relatively high interest rates to compensate for their relatively high chance of default index fund a mutual fund that seeks only to mimic the market's overall performance initial public offering (IPO) the first sale of shares of stock by a firm to outside investors junk bonds see high-yield bonds liquidity refers to how easily one can exchange money or financial assets for a good or service maturity date the date that a borrower must repay a bond municipal bonds a bond issued by cities that wish to borrow mutual funds funds that buy a range of stocks or bonds from different companies, thus allowing an investor an easy way to diversify partnership a company run by a group as opposed to an individual present value a bond’s current price at a given time private company a firm frequently owned by the people who generally run it on a day-to-day basis public company a firm that has sold stock to the public, which in turn investors then can buy and sell risk a measure of the uncertainty of that project’s profitability savings account a bank account that pays an interest rate, but withdrawing money typically requires a trip to the bank or an automatic teller machine shareholders people who own at least some shares of stock in a firm shares a firm's stock, divided into individual portions simple interest an interest rate calculation only on the principal amount sole proprietorship a company run by an individual as opposed to a group stock a specific firm's claim on partial ownership Treasury bond a bond issued by the federal government through the U.S. Department of the Treasury venture capital financial investments in new companies that are still relatively small in size, but that have potential to grow substantially

Key Concepts and Summary

17.1 How Businesses Raise Financial Capital

Companies can raise early-stage financial capital in several ways: from their owners’ or managers’ personal savings, or credit cards and from private investors like angel investors and venture capital firms. A bond is a financial contract through which a borrower agrees to repay the amount that it borrowed. A bond specifies an amount that one will borrow, the amounts that one will repay over time based on the interest rate when the bond is issued, and the time until repayment. Corporate bonds are issued by firms; municipal bonds are issued by cities, state bonds by U.S. states, and Treasury bonds by the federal government through the U.S. Department of the Treasury. Stock represents firm ownership. A company's stock is divided into shares. A firm receives financial capital when it sells stock to the public. We call a company’s first stock sale to the public the initial public offering (IPO). However, a firm does not receive any funds when one shareholder sells stock in the firm to another investor. One receives the rate of return on stock in two forms: dividends and capital gains. A private company is usually owned by the people who run it on a day-to-day basis, although hired managers can run it. We call a private company owned and run by an individual a sole proprietorship, while a firm owned and run by a group is a partnership. When a firm decides to sell stock that financial investors can buy and sell, then the firm is owned by its shareholders—who in turn elect a board of directors to hire top day-to-day management. We call this a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, though it does not always work.

17.2 How Households Supply Financial Capital

We can categorize all investments according to three key characteristics: average expected return, degree of risk, and liquidity. To obtain a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the Federal Deposit Insurance Corporation (FDIC), banks purchase insurance against the risk of a bank failure. A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the financial institution issues the bond, and when the borrower repays it. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed interest rate, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss. Changes in the stock price depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the fund's overall performance as a whole. A mutual fund that seeks to imitate