MAcro CHAPTER 4.1:

CHAPTER SUMMARY

The financial sector is the part of the economy involving lenders, borrowers, and money.

When people have extra money, they have many different options for how to invest it. One thing they can do is simply hold the cash in their bank account, or even in paper money. The benefit of this is that it is very liquid, meaning it is extremely easy to use in transactions. Some other options that have less liquidity are:

• Stocks: An ownership share of a company. The company does not owe you any money, but if they choose to pay out some of their profits, you get a piece of it.

• Bonds: Lending money to a company or government. When a company or a government issues a bond, it means they offer the public the opportunity to lend to them in exchange for interest.

Stock prices are based on the predicted current value of all the company's future profits (if you want to know more about how that works...take Principles of Business!).

The price of a bond represents what people are willing to pay for the payout at the bond's maturity (end date). Because bonds have a fixed interest rate, on the day it is issued, we already know how much the company or government will pay out at the end. For example, I might invest $100 in a bond that will pay $110 at the end of this year, meaning it has a 10% rate of return or interest rate.

However, I don't have to hold that bond. I can sell it at a higher or lower price than the $100 I paid for it, in which case the company or government would pay the person I sold it to when it reaches maturity. If the interest rate in the market was 10% when I bought it, but the next day, they rose to 15%, I would rather have my money in something else, so the value of the bond might fall closer to $95. Similarly, if the market interest rate fell to 5%, people might be willing to pay closer to $105 to get the bond that will pay out $110 at the end of the year. Because of this, bond prices and interest rates have an inverse relationship - when one goes up, the other goes down.

As a general rule, high-risk investments usually have higher interest rates. Risk means there is a chance that the investment will not pay out as expected, so people want to receive a higher interest rate to account for that risk.

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