Financial Markets, Stocks, Bonds and Risk Management Explained
Financial Markets and Financial Intermediaries
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Financial Market (Direct)
- Short-Run (Money Market): CD, CP, RP (maturity within 1 year)
- Long-Run (Capital Market): Stock, Bond (maturity over 1 year)
Financial Intermediary (Indirect): Bank, mutual fund
Bonds
Bond (debt certificate): National and public bonds, corporate bonds, financial bonds
- Maturity: Repayment; no repayment means default
- Credit Rating: High risk leads to high return
Stocks
Stock: A claim to partial ownership of a corporation
Listing (상장)
- Only high-quality companies
- Advantage: Easy to raise funds
- Disadvantage: Vulnerable to M&A (mergers and acquisitions)
- Unlisted companies: stock trading is difficult
PER (Price-Earnings Ratio)
PER = Stock price / Earnings per share (EPS)
It shows how many times higher the current stock price is compared to net earnings.
- South Korea: 9–10 (other countries: around 15)
- A lower PER suggests the stock may have potential to rise.
Saving = Y - C
Investment: Purchasing new investment value
S = I (Classical school), S ≠ I (Keynes)
Loanable Funds Market Model (Classical School)
Under the classical view that S = I, the Loanable Funds Market model applies: S = f(i) (suppliers), I = f(i) (demanders). Adjustment of the interest rate (i = real interest rate) makes S and I equal.
Assumptions: The financial system consists only of the loanable funds market, and all borrowers are investors.
Keynes: S ≠ I
- S = f(i) becomes S = f(income): saving is determined by national income.
- I = f(expectations of future profitability): investment depends on future income.
- This leads to the Paradox of Thrift: increasing saving can actually be harmful. Consumption is seen as a virtue.
Role of the Financial System
- Link lenders with borrowers, thereby reducing transaction costs
- Provide means of managing risks
History of U.S. Debt
Fiscal deficits have accumulated over time, and debt has piled up. During wars, taxes (T) could not be raised while government spending (G) increased. As T - G kept growing negative, deficits built up. In the 1980s, even without being at war, debt was high. Under Reagan (1981–1988), the U.S. pursued a "Strong America" agenda and engaged in an arms race with the Soviet Union. Later, under Bush, wars increased debt further.
Why is high debt a problem? People may refuse to purchase government bonds even when they are issued.
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Compound Interest, Risk and Information
Compounding vs. Simple Interest
- Compound interest: P × (1 + N)n
- Simple interest: P × (1 + N × n)
Example: Assume 10,000 won today and receiving 1,000 won annually. With compound interest at N = 5%, the final amount received is 10,000 + 1,000 / (1 - (1 + 0.05)).
Rule of 70
Time for the principal to double = 70 / N (N = interest rate)
Attitude Toward Risk
- Risk-averse
- Risk-neutral
- Risk-loving
Information Asymmetry
Information asymmetry occurs when one party in a transaction has more or better information than the other.
- Adverse Selection: A party with less information ends up trading with an undesirable counterpart.
- Moral Hazard
Financial Products
- Risk-free asset (e.g., fixed deposits)
- Risky assets (e.g., stocks and bonds)
Markowitz Portfolio Selection Theory
Diversified investment can reduce risk.
Asset Valuation Methods
- Technical Analysis: Uses past patterns to predict the future, such as chart analysis.
- Fundamental Analysis (for experts): Compares intrinsic value with market value. Intrinsic value = net asset value (from financial statements) + net earnings (earnings value). Net earnings analysis proceeds through economic analysis, industry analysis, and company analysis.
- Efficient Market Hypothesis: Publicly available information is already reflected in prices. Stock prices follow a random walk, so changes in variables cannot be predicted.