I. STRUCTURE OF THE FINANCIAL MARKETS
1) EQUITY MARKETS ("Stock Markets")
Stocks are issued by private sector corporations and represent the ownership interest ("equity") in the corporation. As such, the stock does not have to be redeemed by the company, and the dividend can vary with the profitability or payout policy of the company.
The stocks of the largest corporations are listed on the New York Stock Exchange, which is the leading stock exchange in the world. Other significant stock exchanges are Tokyo, Hong Kong, Singapore, Milan, Zurich, Frankfort, Paris, and London. In the United States, lesser known stocks are listed on the NASDAQ exchange which is a computerized exchange connecting hundreds of local stock brokers.
The Dow Jones Industrial Stock Index is the best known index for stock prices on the New York Exchange. It actually measures changes in the stock prices of only thirty corporations, but these are the best corporations in the United States -- the "blue chip" companies. Besides the DJ industrial index, there are also DJ indexes for transportation stocks and for utilities stocks. A broader index is the Standard and Poor 500 Index which measures price changes in the 500 best stocks. There is also a NASDAQ Index which measures the changes in the prices of all the stocks handled by the NASDAQ system.
2) DEBT MARKETS ("Bond Markets")
Debt instruments are issued by governments (federal, state, local) and by private sector corporations. In the corporation, these instruments represent the creditor interest in the company. Debt instruments must pay a fixed amount of interest each year, and must be repurchased at maturity by the issuer. The debt instruments are usually distinguished by the maturity length from the date they were issued. Bills and Commercial Paper mature within one year, Notes mature within one to five years, while Bonds mature over five years.
Debt markets may be divided into two broad markets -- the short-term debt market or Money Market, and the long-term debt market or Bond Market. Bills and commercial paper are part of the money market, while notes and bonds are part of the bond market.
The longest term debt now issued by the U.S. Treasury is a ten year bond. (Previously, the Treasury issued bonds with a maturity up to thirty years.) The ten year bond has replaced the thirty year bond as a broad indicator of bond prices and yields in the bond market. It is often referred to as a "bellwether" bond. The longest maturity debt issued by private corporations is usually thirty years, although some 100 year bonds ("Centuries") have been issued by railroad companies. Most home mortgages are also for thirty years.
II. BOND YIELDS AND BOND PRICES
Bond Principal = $1,000 (Standard denomination for bonds.)
Interest = amount of money paid each year to the owner of the bond.
Coupon Yield = the interest paid each year as percent of $1,000.
Maturity = date the bond will be redeemed by the issuer.
Consider a 30 year bond issued by Acme Toon Props, Inc., in 1980 carrying a coupon yield of 10%. This means that Acme will pay the owner of the bond $100 each year, for the thirty year period 1980 through 2010. In 2010, Acme will redeem the bond from its current owner for $1000. The reason the bond carries a 10% coupon yield is that this was the going interest rate on new long-term bonds in 1980.
Now, consider 1995. In 1995, long-term interest rates are 5%, and newly issued bonds priced at $1,000 will pay $50 per year in interest. Your "Acme 2010 10%" is paying $100 per year. If you wanted to sell your bond in 1995, what would be the market price? Since the Acme bond pays $100 per year, while newly issued bonds pay only $50 per year, a fair price for your bond would be well above the principal amount of $1,000. Given that (1) the 10% coupon yield of your bond is twice the 5% long-term interest rate, and (2) your bond will be redeemed in 15 years for $1,000, the 1995 market price for your bond would be around $1,500.
What will happen to the market price of your bond as you get closer to 2010, the maturity date? The market price will move towards the redemption value of $1000.
1) If current interest rates are below the coupon yield of a bond, the bond price will exceed $1,000.
2) If current interest rates are above the coupon yield of a bond, the bond price will be less than $1,000.
3) Thus, when current interest rates decline, the prices of existing bonds will increase. When current interest rates increase, the prices of existing bonds will decrease. Bond prices and bond interest rates move inversely.
III. APPLICATION: FINANCIAL PORTFOLIOS
A financial portfolio is your holding of money, stocks, and bonds. What happens when investors decide to change their holdings of financial assets?
Assume that investors sell their stocks and use the money to buy bonds. This means that the supply of stocks (equity instruments) will increase while the demand for bonds (debt instruments) will increase. In the equity markets, the prices of stocks will fall, and this will be shown by a decline in stock price indexes such as the DJ industrials. In the debt markets, the prices of bonds will rise and interest rates will fall. What kind of an event would make investors want to shift their investments out of stocks and into bonds?
Now, assume that investors decide to sell their bonds and purchase stocks. The prices of bonds will go down (and interest rates will rise), while stock prices (and stock price indexes) will go up. What kind of event would cause investors to act this way?
Next, assume that investors want to maximize their liquidity. They will sell stocks and bonds and keep their financial holdings in the form of money. This will increase the supply of stocks and bonds in the markets and drive down the prices of both stocks and bonds (and push up interest rates as a result). What could cause this behavior?
Finally, assume that investors want to minimize their financial holdings altogether and invest in real estate. They will sell stocks and bonds and use the money to purchase real estate (land and structures). This will drive down the prices of stocks and bonds, increase interest rates, and increase the prices of real estate. Such a movement away from financial assets -- including money -- and into real assets could be caused by very high rates of inflation.