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Key Concepts and Summary

Key Concepts and Summary

All investments can be categorized according to three key characteristics: average expected return, degree of risk, and liquidity. To get 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 program, 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 bond is issued, and then repayment of what was borrowed. 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 rate of interest, 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 price of a stock 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 overall performance of the investments made by the fund as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.

Housing and other tangible assets can also be regarded as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.

Glossary

actual rate of return

the total rate of return, including capital gains and interest paid on an investment at the end of a period of time

bond yield

the rate of return a bond is expected to pay at the time of purchase

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 rate of interest

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”

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 cost is immediately deducted from that person’s checking account

diversification

investing in a wide range of companies to reduce the level of risk

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 overall performance of the market

junk bonds

see high yield bonds

liquidity

refers to how easily money or financial assets can be exchanged for a good or service

maturity date

the date that a bond must be repaid

mutual funds

funds that buy a range of stocks or bonds from different companies, thus allowing an investor an easy way to diversify

present value

a bond’s current price at a given time

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

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