In general, as Table 3.3 shows, an important axiom in finance is that an investment's expected return should be commensurate with its risk. The fundamental reason for this tradeoff is that most investors are risk-averse. The risk aversion of investors implies that they prefer less risk and choose the investment with the least risk if returns are comparable across investment options. For risk-averse investors to participate in risky investments, they must be rewarded with higher expected returns.
FIGURE 3.9 Recent Annual Returns on the Dow Jones Industrial Average
This figure shows the Dow Jones Industrial Average between 2010 and 2019.
Note: Daily returns between 2010 and 2019 are unadjusted for any seasonal effect and were last updated on August 28, 2019.
Source: S&P Dow Jones Indices LLC (2019b).
STOCKS VERSUS BONDS: THE ISSUER'S PERSPECTIVE
Up to this point, the chapter focuses on an equity investment from the investor's perspective. However, examining the implications of choosing stock (equity) financing or debt (bond) financing from a firm's perspective is also important. Stocks and bonds represent two distinct financing choices for firms.
When a firm sells equity to investors, it sells a firm's ownership and control, providing stockholders with ownership or an ownership claim on both the firm's assets and earnings. As owners, common stockholders have a right to some control over the organization as provided via their right to vote on important issues. Shareholders receive residual claims of assets and earnings after other stakeholders are paid.
Alternatively, debt interest and principal payments are legal obligations. If a firm fails to pay periodic interest or principal, it is technically in default of a contractual obligation and faces the possibility of bankruptcy or reorganization, a process in which the firm's ownership may be transferred from shareholders to debtholders by a court order.
SUMMARY AND CONCLUSIONS
To summarize, the financial markets and the economy differ but are closely related. The financial markets provide a place for both investing excess funds as well as obtaining funds to meet funding needs. Well-functioning secondary markets provide investors with information, low-cost trading, and liquidity. Without such markets, an economy would suffer because investors would be much less inclined to invest their money.
Equity investments provide investors with a claim of ownership and a residual claim on assets and cash flows. An efficient equity market enables firms to obtain funds at lower costs than in an inefficient market and to borrow funds at lower costs. Lower costs with fixed-cost debt financing can magnify earnings, thus providing even more economic benefit than possible with variable-cost equity funding.
When an economy is strong, the magnification of earnings can lead to more demand for products and services, which in turn leads to higher employment and, ultimately, greater consumer spending as well as consumer and business investment. Under these conditions, the economy continues to grow. When an economy is weak, leverage, which is a mechanism that magnifies gains in a boom and losses in a recession, can magnify losses through the following chain: demand for products and services falls, employment situations worsen, and both business and consumer investments decline as a result of less consumer spending.
In conclusion, the financial markets and the economy are related. Good economic conditions lead to investment and growth, while weak economies lead to reductions in investment funding and lower growth.
DISCUSSION QUESTIONS
1 Explain at least two ways to classify financial markets.
2 Discuss why the equity market is important to the economy.
3 Define and differentiate between at least two of the equity market indices used as market indicators.
4 Explain the difference between liquidity and marketability for a financial market.
5 Define financial market efficiency.
6 Define and differentiate among the weak form, semi-strong form, and strong form levels of market efficiency.
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17 S&P