FIN 3302 Chapter 02 Study Guide
Capital markets are all the financial institutions that help a business raise long-term capital. TRUE or FALSE
TRUE Page 23
Individuals, corporations, and governments can be either savings deficit units or savings surplus units. TRUE or FALSE
TRUE Page 24
The date today is January 1, 2010. A one-year security maturing on 1/1/11 yields 3%. A two-year security maturing on 1/1/12 yields 6%. A three-year security maturing on 1/1/13 yields 11%. Calculate the expected annual return on a two-year security beginning 1/1/11 and maturing on 1/1/13.
$1,000 × (1.11)^3 = $1,367.63 at the end of three years (1/1/13) $1,000 × (1.03) = $1,030 at the end of one year (1/1/11) $1,367.63 - $1,030 = $337.63 to be earned on two-year security from 1/1/11 to 1/1/13 $1,030 × (1 + k)^2 = $1,367.63 k = ($1,367.63/$1,030)^.5 - 1 = 15.23% Page 45, 46
The current rate of return on a one-year U.S. Government security is 3%. The rate of return on a two-year U.S. Government security is 5%. According to the expectations theory, what is the return on a one-year U.S. Government security purchased one year from today?
$1,000 × 1.03 = $1,030 at the end of year one $1,000 × (1.05)^2 = $1,102.50 at the end of two years $1,102.50 - $1,030 = $72.50 interest needed in year 2 $72.50/$1,030 = 7.04% Page 45, 46
An investment banker assumes underwriting risk in both negotiated purchases and privileged subscriptions with standby agreements. TRUE or FALSE
FALSE Page 30, 31
What are the five key methods by which securities are distributed to final investors?
A Negotiated Purchase: In a negotiated underwriting, the firm that needs funds makes contact with an investment banker, and deliberations concerning the new issue begin. If all goes well, a method is negotiated for determining the price the investment banker and the syndicate will pay for the securities. The negotiated purchase is the most prevalent method of securities distribution in the private sector. A Competitive Bid Purchase: In a competitive underwriting, several underwriting groups bid for the right to purchase the new issue from the corporation that is raising funds. The firm does not directly select the investment banker. Instead, the investment banker that underwrites and distributes the issue is chosen by an auction process. The one willing to pay the greatest dollar amount per new security will win the competitive bid. A Commission or Best-Efforts Basis: Here, the investment banker acts as an agent rather than as a principal in the distribution process. The securities are not underwritten. The investment banker attempts to sell the issue in return for a fixed commission on each security actually sold. Unsold securities are then returned to the corporation. This arrangement is typically used for more speculative issues. A Privileged Subscription: When a new issue is marketed to a definite and select group of investors, it is called a privileged subscription. Three target markets are typically involved: (1) current stockholders, (2) employees, or (3) customers of the firm. Of these, distributions directed at current stockholders are the most prevalent. Such offerings are called rights offerings. In a privileged subscription, the investment banker may act only as a selling agent. It is also possible that the issuing firm and the investment banker might sign a standby agreement, which obligates the investment banker to underwrite the securities that are not purchased by the privileged investors. A Direct Sale: In a direct sale the issuing firm sells the securities directly to the investing public without involving an investment banker. Page 30, 31
During the period 1990 to 2017, the average yield on 3-month U.S. Treasury bills was 2.78%, the average inflation rate was 2.48%, the average yield on 30-year Treasury bonds was 5.22%, and the average return on 30-year Aaa-rated corporate bonds was 6.08%. The real risk-free short-term interest rate is A) 0.30%. B) 2.13%. C) 2.97%. D) 4.76%.
A) 0.30%. Page 37
You are considering an investment in a AAA-rated U.S. corporate bond but you are not sure what rate of interest it should pay. Assume that the real risk-free rate of interest is 1.0%; inflation is expected to be 1.5%; the maturity risk premium is 2.5%; and, the default risk premium for AAA rated corporate bonds is 3.5%. What rate of interest should the U.S. corporate bond pay? A) 8.5% B) 6.0% C) 5.0% D) 2.5%
A) 8.5% Page 40
Bill is a public accountant auditing Expo Corporation. Based on information in Expo's confidential records, Bill recommends the purchase of Expo stock to his brother. A) Bill is involved in insider trading prohibited by the SEC. B) Bill's brother has no direct connection to Expo Corporation and therefore his purchase of the stock is not prohibited by insider trading laws. C) Bill is not an insider because he is not an officer or employee of Expo Corporation D) If Bill told a non-relative who purchases Expo stock, no insider trading laws would be violated.
A) Bill is involved in insider trading prohibited by the SEC. Page 26
Which of the following statements is false? A) Brokers purchase securities for their own account. B) Most corporate bond trading takes place over the counter. C) Broker-dealers stand ready to buy and sell specific securities at selected prices. D) none of the above
A) Brokers purchase securities for their own account. Page 33
Which of the following represents the correct ordering of returns over the period 1926 to 2017 (from lowest to highest return)? A) Treasury bills, long-term government bonds, long-term-125term corporate bonds, common stocks B) common stocks, long-term government bonds, long-term corporate bonds, Treasury bills C) Treasury bills, common stocks, long-term corporate bonds, long-term government bonds D) long-term corporate bonds, Treasury bills, long-term government bonds, common stocks
A) Treasury bills, long-term government bonds, long-term corporate bonds, common stocks Page 35
Which of the following securities will likely have the highest maturity risk premium? A) U.S. Treasury bond maturing in 2032 B) Bbb-rated corporate bond maturing in 2025 actively traded on a major exchange C) Aaa-rated corporate bond maturing in 2020 not actively traded D) U.S. Treasury bill
A) U.S. Treasury bond maturing in 2032 Page 38
Common examples of financial intermediaries include all of the following EXCEPT A) Venture Capital Firms. B) Life Insurance Companies. C) Pension Funds. D) Mutual Funds.
A) Venture Capital Firms. Page 25
An example of a primary market transaction involving a money-market security is A) a new issue of a security with a very short maturity. B) a new issue of a security with a very long maturity. C) the transfer of a previously-issued security with a very short maturity. D) the transfer of a previously-issued security with a very long maturity.
A) a new issue of a security with a very short maturity. Page 26, 27
An example of a primary market transaction is A) a new issue of common stock by AT&T. B) a sale of some outstanding common stock of AT&T by an investor. C) AT&T repurchasing its own stock from a stockholder. D) all of the above
A) a new issue of common stock by AT&T. Page 26
In August 2004, Google first sold its common stock to the public at $85 per share and raised $1.76 billion. This is an example of A) a primary market transaction. B) a secondary market transaction. C) a venture capital firm transaction. D) a money-market transaction.
A) a primary market transaction. Page 26
A commitment fee is A) an amount paid on the unused portion of a loan in a private placement. B) an amount paid by an investment banker to ensure the sale of securities. C) paid by investors to guarantee that a company will borrow from them. D) paid by bondholders to secure the right to convert bonds into common stock.
A) an amount paid on the unused portion of a loan in a private placement. Page 32
The costs associated with issuing securities to the public can be high. Some types of securities have greater expenses associated with them than others. Which of the following is the most costly security to issue? A) common stock B) corporate bonds C) preferred stock D) all of the above
A) common stock Page 33
All of the following securities are sold in money markets EXCEPT A) common stock. B) commercial paper. C) 3-month U.S. Treasury bills. D) 6-month certificates of deposit.
A) common stock. Page 27
If a corporation wants a guarantee that all of its shares of stock will be sold, it should use which of the following distribution methods? A) competitive bid purchase B) privileged subscription with no standby agreement C) commission or best-efforts contract D) direct sale
A) competitive bid purchase Page 30
Investment firms, such as Goldman Sachs, assist the transfer of capital by A) facilitating indirect transfers from savers (investing public) to borrowers (corporations needing capital). B) selling indirect securities to savers and using the funds to buy common stock for corporations needing funds. C) selling direct securities. D) selling common stock for corporate clients in the secondary market.
A) facilitating indirect transfers from savers (investing public) to borrowers (corporations needing capital). Page 29
All of the following are benefits of organized stock exchanges EXCEPT A) increased stock price volatility. B) continuous markets. C) fair security prices. D) easier access to new capital for business expansion.
A) increased stock price volatility. Page 28
The ________ is the premium to compensate for the price change expected to occur over the life of the bond or investment instrument. A) inflation-risk premium B) maturity premium C) real risk-free interest rate premium D) default-risk premium
A) inflation-risk premium Page 38, 39
Suppose the following rates are averages for banks in your area: interest checking accounts pay 1%, savings accounts pay 2%, and one-year certificates of deposit pay 3%. All accounts are federally insured by the FDIC. The difference in rates can be explained mainly by A) liquidity premiums. B) default risk premiums. C) maturity premiums. D) inflation risk premiums.
A) liquidity premiums. Page 37
Financial intermediaries A) offer indirect securities. B) include the national and regional stock exchange. C) usually are underwriting syndicates. D) constitute the various secondary markets.
A) offer indirect securities. Page 25
Which of the following is an advantage of using private placements for debt? A) reduced costs from the elimination of the registration statement for the SEC, investment-banking underwriting fees and distribution costs B) lower interest costs C) fewer and less burdensome restrictive covenants D) the possibility of future SEC registration
A) reduced costs from the elimination of the registration statement for the SEC, investment-banking underwriting fees and distribution costs Page 31, 32
ExxonMobil generates about $50 billion in cash annually from its operations and invests about half of that on new exploration. Therefore, ExxonMobil is an example of a(n) A) savings surplus unit. B) savings deficit unit. C) investment banker. D) financial intermediary
A) savings surplus unit. Page 24
John calls his stockbroker and instructs him to purchase 100 shares of Microsoft Corporation common stock. This transaction occurs in the A) secondary market. B) primary market. C) credit market. D) futures market.
A) secondary market. Page 26
Which of the following statements concerning private placements is MOST correct? A) Private placements do not involve investment bankers. B) Although not selling the securities to the public, investment bankers may provide advice on the evaluation of prospective buyers and the terms of sale for private placements. C) Private placements are limited to stocks, not bonds. D) More than half of all private placements are sold to federal, state, or local governments or government agencies.
B) Although not selling the securities to the public, investment bankers may provide advice on the evaluation of prospective buyers and the terms of sale for private placements. Page 31, 32
Which of the following securities will likely have the highest default risk premium? A) U.S. Treasury bond maturing in 2030 B) Bbb-rated corporate bond maturing in 2023 actively traded on a major exchange C) Aaa-rated corporate bond maturing in 2019 not actively traded D) U.S. Treasury bill
B) Bbb-rated corporate bond maturing in 2023 actively traded on a major exchange Page 37
Which of the following statements about investment banking in the United States is MOST correct? A) Investing banking is dominated by a few, very large, stand-alone investment banking firms, such as Bear Stearns. B) The investment banking industry is dominated by large banks that are also investment bankers. C) The top five banks involved in investment banking account for less than 25% of the industry's total market share. D) The investment banking industry became more competitive following the financial crisis in 2007 and 2008.
B) The investment banking industry is dominated by large banks that are also investment bankers. Page 29
Spandra Electronics wants to raise money by selling stock. After talking to several investment banking firms, Spandra decides to hire Goldman Sachs to sell 5 million shares of its common stock. Goldman sells 4.5 million shares and returns the rest to Spandra. This is an example of A) a privileged subscription with a standby agreement. B) a commission or best-efforts agreement. C) a privileged subscription with a standby agreement. D) a competitive bid purchase.
B) a commission or best-efforts agreement. Page 30
A "Dutch auction" was used by Google to raise money in 2004. A Dutch auction involves A) selling bonds in Europe. B) allowing investors to submit bids saying how many shares they'd like to buy and at what price. C) allowing investment banking firms to submit bids on how many shares they are willing to sell and at what price. D) hiring a Dutch firm to sell a company's securities at auction.
B) allowing investors to submit bids saying how many shares they'd like to buy and at what price. Page 31
Capital market transactions include which of the following? A) any security that is purchased from a brokerage firm that is well capitalized B) common stock of a public corporation C) all securities that are purchased in the open market D) U.S. Treasury bills
B) common stock of a public corporation Page 23, 27
Which of the following represents the correct ordering of standard deviation of returns over the period 1926 to 2014 (from highest to lowest standard deviation of returns)? A) Treasury bills, long-term corporate bonds, long-term government bonds, common stocks B) common stocks, long-term government bonds, long-term corporate bonds, Treasury bills C) Treasury bills, long-term government bonds, long-term corporate bonds, common stocks D) Treasury bills, long-term government bonds, common stocks, long-term corporate bonds
B) common stocks, long-term government bonds, long-term corporate bonds, Treasury bills Page 35
Capital market instruments include A) negotiable certificates of deposit. B) corporate equities. C) commercial paper. D) Treasury bills.
B) corporate equities. Page 23
Which of the following would NOT normally be considered a "flotation cost"? A) underwriter's spread B) dividends C) legal fees D) printing and engraving expenses
B) dividends Page 33
Private placements usually have several advantages associated with them, but also tend to suffer from specific disadvantages. Which of the following is a disadvantage of a private placement when compared to other methods of selling new securities? A) strictly standardized features/terms B) higher interest costs C) reduced flotation costs D) avoidance of registration with the SEC
B) higher interest costs Page 32, 33
General Motors raises money by selling a new issue of common stock. This transaction occurs in A) the secondary market. B) the capital market. C) the money market. D) the futures market.
B) the capital market. Page 23, 27
The one-year interest rate is 4%. The interest rate for a two-year security is 6%. The one-year interest rate one year from now is 8.34%. According to the liquidity preference theory, the risk premium for the second one-year investment is A) 0.50%. B) 0.34%. C) 0.30%. D) 1.66%.
C) 0.30%. Page 46
What was the average annual rate of return on common stocks during the period 1926 to 2017? A) 15.4% B) 18.6% C) 10.1% D) 9.5%
C) 10.1% Page 35
What was the average annual rate of return on 3-month U.S. Treasury bills during the period 1990 to 2017? A) 2.15% B) 4.23% C) 2.78% D) 5.68%
C) 2.78% Page 36
You are considering an investment in a U.S. Treasury bond but you are not sure what rate of interest it should pay. Assume that the real risk-free rate of interest is 1.0%; inflation is expected to be 1.5%; the maturity risk premium is 2.5%; and, the default risk premium for AAA rated corporate bonds is 3.5%. What rate of interest should the U.S. Treasury bond pay? A) 8.5% B) 6.0% C) 5.0% D) 2.5%,
C) 5.0% Page 40
What was the average annual rate of return on long-term government bonds (30-year Treasury bonds) during the period 1990 to 2017? A) 4.14% B) 5.88% C) 5.22% D) 7.82%
C) 5.22% Page 36
What was the average annual rate of return on long-term corporate bonds during the period 1926 to 2017? A) 8.3% B) 6.5% C) 6.08% D) 7.00%
C) 6.08% Page 35
The one-year interest rate is 4%. The interest rate for a two-year security is 6%. According to the unbiased expectations theory, the one-year interest rate one year from now must be equal to A) 5.00%. B) 8.00%. C) 8.04%. D) 10.00%.
C) 8.04%. Page 45, 46
Which of the following statements is an example of a futures market transaction? A) An investor purchases 100 shares of IBM hoping to sell it in two years for a profit. B) A company purchases an option to buy 1000 barrels of oil anytime between now and the end of the year. C) A company agrees to purchase 1000 barrels of oil for delivery in six months at a price of $70 per barrel. D) An executive has a portion of his current year salary deferred until he retires.
C) A company agrees to purchase 1000 barrels of oil for delivery in six months at a price of $70 per barrel. Page 27
Which of the following securities will likely have the highest liquidity premium? A) U.S. Treasury bond maturing in 2030 B) Bbb-rated corporate bond maturing in 2023 actively traded on a major exchange C) Aaa-rated corporate bond maturing in 2019 not actively traded D) U.S. Treasury bill
C) Aaa-rated corporate bond maturing in 2019 not actively traded Page 37
Which of the following is an example of both a capital market and a primary market transaction? A) The U.S. Government sells 3-month Treasury bills. B) Microsoft common stock owned by an individual investor is sold to another investor. C) Ford Motor Company sells a new issue of common stock to raise funds through a public offering. D) No transactions occur in both primary and capital markets at the same time.
C) Ford Motor Company sells a new issue of common stock to raise funds through a public offering. Page 26
The telecommunications system that provides a national information linkup among brokers and dealers operating in the over-the-counter market is called A) NCIS. B) NSQA. C) NASDAQ. D) NASQ.
C) NASDAQ. Page 28
Prices of securities that are traded on the organized exchanges are determined by A) a "bid" and "ask" negotiation process amongst brokers who hold these securities in their own account. B) the Securities Exchange Commission. C) a continuous auction process reflecting the sentiments of buyers and sellers. D) the sellers of the securities.
C) a continuous auction process reflecting the sentiments of buyers and sellers. Page 28
Which of the following premiums is NOT factored into the price of a long-term Treasury bond? A) a real risk-free interest rate B) a maturity premium C) a default-risk premium D) an inflation-risk premium
C) a default-risk premium Page 39, 40
The New York Stock Exchange (NYSE) is A) an automated electronic trading platform. B) an auction market with face-to-face trading on the floor of the stock exchange in addition to automated, electronic trading. C) a hybrid market, allowing for face-to-face trading on the floor of the stock exchange in addition to automated, electronic trading. D) primarily a futures market.
C) a hybrid market, allowing for face-to-face trading on the floor of the stock exchange in addition to automated, electronic trading. Page 28
General Electric (GE) has been a public company for many years with its common stock traded on the New York Stock Exchange. If GE decides to sell 500,000 shares of new common stock, the transaction will be describe as A) an initial public offering. B) a secondary market transaction because GE common stock has been trading for years. C) a seasoned equity offering because GE has sold common stock before. D) a money-market transaction because GE raises new money to fund its business.
C) a seasoned equity offering because GE has sold common stock before. Page 26
Three ways that savings can be transferred through the financial markets include all of the following EXCEPT A) direct transfer of funds. B) indirect transfer using the investment banker. C) indirect transfer using the venture capital firm. D) indirect transfer using the financial intermediary.
C) indirect transfer using the venture capital firm. Page 25
The real rate of return is the return earned above the A) default risk premium. B) risk-adjusted return. C) inflation risk premium. D) variability of returns measured by standard deviation.
C) inflation risk premium. Page 34, 35
Advantages of private placements do NOT include which of the following? A) more financing flexibility B) lower flotation costs C) investor protection through extensive regulation D) funds which are available more quickly than through a public offering
C) investor protection through extensive regulation Page 31, 32
Which of the following refers to all institutions and procedures that provide for transactions in short-term debt instruments generally issued by borrowers with very high credit ratings? A) capital market B) commercial banks C) money market D) stock market
C) money market Page 27
Reynolds, Inc. needs to raise $5 million by selling common stock. Reynolds sells 1 million shares of stock at $5 each to Goldman Sachs, who then is responsible for selling the shares to investors. This is an example of a A) privileged subscription. B) standby agreement. C) negotiated purchase. D) commission or best-efforts agreement.
C) negotiated purchase. Page 30
When an investment banking firm "underwrites" an issue of securities, the firm is performing which of the following? A) agreeing to market the securities to investors for a fee B) giving legal advice to the firm that is issuing the securities C) offering to purchase the securities from the firm, thereby assuming the risk of resale to investors D) agreeing to provide insurance that the firm's securities will sell for a price that is established by the firm
C) offering to purchase the securities from the firm, thereby assuming the risk of resale to investors Page 29
A basis point is equal to A) one percent. B) one-tenth of one percent. C) one-hundredth of one percent. D) one-half of one percent.
C) one-hundredth of one percent. Page 36
Which of the following is an advantage of organized stock exchanges? A) increased stock price volatility B) screening companies to ensure only low risk stocks are sold C) providing a continuous market D) Only profitable companies may issue new securities on an organized exchange.
C) providing a continuous market Page 28
The Securities and Exchange Commission (SEC) A) regulates only initial public offerings, or IPOs. B) regulates only primary market transactions to ensure investors are provided with adequate and accurate information on new securities. C) regulates both primary and secondary markets. D) regulates initial public offerings, but not seasoned equity offerings, in the primary market.
C) regulates both primary and secondary markets. Page 26
A life insurance company purchases $1 billion of corporate bonds from premiums collected on its life insurance policies. Therefore A) the corporate bonds are indirect securities and the life insurance policies are direct securities. B) the corporate bonds are indirect securities and the life insurance policies are indirect securities. C) the corporate bonds are direct securities and the life insurance policies are indirect securities. D) the corporate bonds are direct securities and the life insurance policies are direct securities.
C) the corporate bonds are direct securities and the life insurance policies are indirect securities. Page 25
The investment banker performs what three basic functions? A) underwriting, distributing, and regulating B) underwriting, advising, and price-pegging C) underwriting, distributing, and advising D) underwriting, distributing, and negotiating
C) underwriting, distributing, and advising Page 29
A "normal" yield curve is A) downward sloping. B) downward sloping, then upward sloping. C) upward sloping. D) upward sloping, then downward sloping.
C) upward sloping. Page 44
What is the term for a graphical representation of the relationship between interest rates and the maturities of debt securities? A) term curve B) maturity chart C) yield curve D) inflationary expectations
C) yield curve Page 43
The nominal interest rate is 7% and the expected inflation rate is 2%. Based on the Fisher effect, the real rate of interest is A) 5.0%. B) 6.86%. C) 5.1%. D) 4.9%.
D) 4.9%. Page 35
Which of the following statements is MOST correct concerning flotation costs? A) Flotation costs are the same for common stock, preferred stock and bonds because they reflect mainly printing costs and legal fees. B) Flotation costs are generally higher for bonds rather than stocks because the dollar amounts involved are much higher, allowing for economies of scale. C) Flotation costs as a percentage of gross proceeds increase as the size of the security issue increases. D) Flotation costs are higher for common stocks than for preferred stocks and bonds due to the higher level of risk associated with owning common stock.
D) Flotation costs are higher for common stocks than for preferred stocks and bonds due to the higher level of risk associated with owning common stock. Page 33
Money-market instruments include A) common stock. B) preferred stock. C) T-bonds. D) T-bills.
D) T-bills. Page 27
Over the period 1926 to 2017, the standard deviation of returns has been the greatest for which of the following? A) Treasury bills B) corporate bonds C) government bonds D) common stocks
D) common stocks Page 35
Prices of securities that are traded in the Over-the-Counter Markets are determined by A) the Federal Trade Commission. B) a continuous modified auction process. C) the buyers of these securities. D) a "bid" and "ask" negotiation process of broker-dealers of these securities.
D) a "bid" and "ask" negotiation process of broker-dealers of these securities. Page 28
The Sarbanes-Oxley Act, or SOX A) holds corporate advisors strictly accountable in a legal sense for any instances of misconduct. B) pretexts the interests of shareholders by providing greater protection against accounting fraud and financial misconduct. C) reduces the cost of financial reporting by standardizing reporting requirements. D) accomplishes both A and B.
D) accomplishes both A and B. Page 34
Activities of the investment banker include A) assuming the risk of selling a security issue. B) selling new securities to the ultimate investors. C) providing advice to firms issuing securities. D) all of the above
D) all of the above Page 29, 30
The Sarbanes-Oxley Act of 2002, in order to protect investors, requires a higher level of accountability for which of the following groups? A) corporate officers B) public accountants C) boards of directors D) all of the above
D) all of the above Page 34
A wealthy private investor providing a direct transfer of funds is called A) a venture capitalist. B) an investment banker. C) a financial intermediary. D) an angel investor.
D) an angel investor. Page 25
Investment banking firms offer to facilitate the sale of securities to the public in a variety of ways. Which of the following methods guarantees the corporation with a pre-determined price for the securities? A) a best efforts basis B) a commission basis C) a competitive bid D) an underwriting
D) an underwriting Page 29
The investment banker does NOT underwrite the securities to be issued in which of the following? A) initial public offering B) primary market transaction C) firm commitment D) best efforts
D) best efforts Page 30
The risk premium would be greater for an investment in an oil and gas exploration in unproven fields than an investment in preferred stock because A) oil and gas exploration investments have a greater variability in possible returns. B) the preferred stock is more liquid. C) the inflation rate would vary more with oil and gas exploration investments. D) both A and B
D) both A and B Page 35
Insurance companies invest in the "long-end" of the securities market by purchasing securities with longer maturities. In which of the following instruments would an insurance company be least likely to invest most of its assets? A) corporate stocks B) corporate bonds C) mortgages D) commercial paper
D) commercial paper Page 27
Which of the following relationships is true regarding the costs of issuing the following securities? A) common stock > bonds > preferred stock B) preferred stock > common stock > bonds C) bonds > common stock > preferred stock D) common stock > preferred stock > bonds
D) common stock > preferred stock > bonds Page 33
Private placements are A) limited to debt securities. B) limited to equity securities. C) available for both debt and equity securities, but the market is dominated by equity issues. D) especially appealing to new, small, and medium-sized companies.
D) especially appealing to new, small, and medium-sized companies. Page 31, 32
The Sarbanes-Oxley Act of 2002 holds all of the following groups strictly accountable in a legal sense for any instances of misconduct EXCEPT A) company officers. B) outside members of the board of directors. C) lawyers. D) investors.
D) investors. Page 34
Money-market transactions include which of the following? A) any security that is paid for with cash B) 30-year U.S. Treasury bonds C) all securities paid for with the proceeds of a money-market account D) securities that have a maturity of less than one year
D) securities that have a maturity of less than one year Page 27
Which of the following is NOT a benefit provided by the existence of organized security exchanges? A) providing a continuous market B) establishing and publicizing fair security prices C) helping businesses raise new capital D) standardization of all debt agreements
D) standardization of all debt agreements Page 28
Which of the following is NOT a valid theory that attempts to explain the shape of the term structure of interest rates? A) the unbiased expectations theory B) the liquidity preference theory C) the market segmentation theory D) the Fisher Effect theory
D) the Fisher Effect theory Page 45
All of the following are typically advantages of private placements EXCEPT A) speed. B) reduced flotation costs. C) financial flexibility. D) the possibility of future SEC registration.
D) the possibility of future SEC registration. Page 32, 33
An example of a secondary market transaction involving a capital market security is A) a new issue of a security with a very short maturity. B) a new issue of a security with a very long maturity. C) the transfer of a previously-issued security with a very short maturity. D) the transfer of a previously-issued security with a very long maturity.
D) the transfer of a previously-issued security with a very long maturity. Page 26
A corporation sells securities to an investment banking firm on January 1st. The next day an international oil crisis causes stock prices to drop dramatically. The corporation is immune from the drop in price of its stock due to which function of the investment banking firm? A) hedging B) distributing C) reinsurance D) underwriting
D) underwriting, Page 29
Learning Objective 2.1 Common stock is considered a short-term security because it has no maturity date and a long-term security is one with a maturity date of more than one year. TRUE or FALSE
FALSE Page 23
Saving surplus units include individuals and governments, but not corporations. TRUE or FALSE
FALSE Page 24
6) Venture capitalists typically provide funds to high-risk startup companies but take no active role in their management. TRUE or FALSE
FALSE Page 25, 26
A corporation needing cash sells securities to investors in the secondary market. TRUE or FALSE
FALSE Page 26
Each purchase occurring in the secondary markets increases the total stock of financial assets that exist in the economy. TRUE or FALSE
FALSE Page 26
Seasoned secondary offerings occur in the secondary market. TRUE or FALSE
FALSE Page 26
Primary market transactions cannot be undertaken in over the counter markets. TRUE or FALSE
FALSE Page 26, 27
Flotation costs are typically greater in the secondary market than in the primary market. TRUE or FALSE
FALSE Page 26, 33
Transactions in common stock occur in the money market, due to the large amount of money involved in such transactions. TRUE or FALSE
FALSE Page 27
Transactions in the futures markets involve current payments for goods which will be delivered at some future agreed upon date. TRUE or FALSE
FALSE Page 27
One advantage of being listed on the NYSE is that all trades are made in an auction setting with face-to-face trading between individuals on the floor of the stock exchange. TRUE or FALSE
FALSE Page 28
One advantage of organized stock exchanges is increased stock price volatility resulting from the efficient exchange of pricing information. TRUE or FALSE
FALSE Page 28
Registration of securities by the SEC indicates to investors that the risk of those securities is reasonable. TRUE or FALSE
FALSE Page 28
Stocks listed on the New York Stock Exchange must be traded exclusively on the NYSE in order to maintain the high standards set by the exchange. TRUE or FALSE
FALSE Page 28
Investment banking firms are prohibited from selling securities due to conflicts of interest. TRUE or FALSE
FALSE Page 29
It is common practice among the largest corporations to sell their securities directly to investors. TRUE or FALSE
FALSE Page 29
Learning Objective 2.2 1) The difference between the price the corporation gets and the public offering price is called the broker-dealer spread. TRUE or FALSE
FALSE Page 29
The investment banker prefers to avoid a negotiated purchase because it tends to be the least profitable arrangement for the investment banker. TRUE or FALSE
FALSE Page 30
The investment banking business is dominated by a few very large, stand-alone investment banking firms. TRUE or FALSE
FALSE Page 30
When the corporation sells securities directly to the investment public without involving an investment banker, it is called a privileged subscription. TRUE or FALSE
FALSE Page 30, 31
Only individual investors participate in public offerings, while institutional investors participate in private placements. TRUE or FALSE
FALSE Page 31
Because they occur in private, stricter regulations are placed on the private placement of securities. TRUE or FALSE
FALSE Page 32
Preferred stock is traded in the money market, while common stock is traded in the capital market. TRUE or FALSE
FALSE Page 32
In a private placement, the securities are offered and sold to a limited number of investors. TRUE or FALSE
FALSE Page 33, 34
The need for extensive regulation of investment banking firms is due to the highly competitive nature of that industry. TRUE or FALSE
FALSE Page 34
Investors expect to receive the highest returns from government-issued securities because the government will not default on securities that it has issued. TRUE or FALSE
FALSE Page 35
A liquidity-risk premium is the additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuation on those securities caused by interest rate changes. TRUE or FALSE
FALSE Page 38
A real interest rate is the interest rate on a fixed-income security that has no risk in an economic environment of high inflation. TRUE or FALSE
FALSE Page 39
In response to the banking crisis and economic collapse of 2007 and 2008, the U.S. government moved to increase interest rates in order to attract foreign capital seeking high returns in U.S. banks. TRUE or FALSE
FALSE Page 44
61) Explain the difference between (a) public offerings and private placements (b) primary markets and secondary markets (c) the money market and the capital market (d) organized security exchanges and over-the-counter markets.
In a public offering securities are usually made available to the public at large by an investment-banking firm, which is a firm that specializes in helping other firms raise money. In a private placement, also called a direct placement, the securities are offered and sold directly to a limited number of investors. The firm will usually deals directly with the prospective buyers. In this setting, the investment-banking firm may act as a finder by bringing together potential lenders and borrowers. A primary market is a market in which new, as opposed to previously issued, securities are traded. The secondary market is where currently outstanding securities are traded. The money market refers to transactions in short-term debt instruments, with "short-term" meaning maturity periods of 1 year or less. The capital market refers to the market for long-term financial instruments. "Long-term" here means having maturity periods that extend beyond 1 year. Organized security exchanges are tangible entities; that is, they physically occupy space (such as a building or part of a building), and financial instruments are traded on their premises. The over-the-counter markets include all security markets except the organized exchanges. Page 25, 26, 27, 28
The yield curve in 2009 was very low, with short-term rates close to zero and long-term rates below 5 percent. What factors contributed to such low interest rates?
In response to the banking and economic crises, the U.S. Government undertook policies to reduce interest rates in an attempt to stimulate economic activity. In addition, the recession caused a decrease in the demand for borrowed funds, and investors, scared off by large declines in the stock market, moved money into safer U.S. Treasury securities. Increasing Treasury prices mean lower yields. Page 43, 44, 45
Distinguish between the concepts of the inflation premium and the default-risk premium.
Inflation premium is a premium to compensate for anticipated inflation that is equal to the price change expected to occur over the life of the bond or investment instrument. Default-risk premium is the additional return required by investors to compensate them for the risk of default. It is calculated as the difference between a U.S. Treasury bond and a corporate bond of the same maturity and marketability. Page 37
Distinguish between the concepts of the maturity-risk premium and the liquidity-risk premium.
Maturity-risk premium is the additional return required by investors in longer-term securities to compensate them for greater risk of price fluctuations on those securities caused by interest rate changes. Liquidity-risk premium is the additional return required by investors for securities that cannot be quickly converted into cash at a reasonably predictable price. Page 37
Within the financial markets, explain what we mean by "private placements" and name the advantages and disadvantages.
Private placements are an alternative to the sale of securities to the public or to a restricted group of investors through a privileged subscription. Any type of security can be privately placed (directly placed). The major investors in private placements are large financial institutions. Based on the volume of securities purchased, the three most important investor groups are (1) life insurance companies, (2) state and local retirement funds, and (3) private pension funds. Private placements have advantages and disadvantages compared with public offerings. The advantages associated with private placements are: 1. Speed: The firm usually obtains funds more quickly through a private placement than a public offering. The major reason is that registration of the issue with the SEC is not required. 2. Reduced costs: These savings result because the lengthy registration statement for the SEC does not have to be prepared, and the investment-banking underwriting and distribution costs do not have to be absorbed. 3. Financing flexibility: In a private placement, the firm deals on a face-to-face basis with a small number of investors. This means that the terms of the issue can be tailored to meet the specific needs of the company. The following disadvantages of private placements must be evaluated. 1. Interest costs: It is generally conceded that interest costs on private placements exceed those of public issues. Whether this disadvantage is enough to offset the reduced costs associated with a private placement is a determination the financial manager must make. 2. Restrictive covenants: A firm's dividend policy, working capital levels, and the raising of additional debt capital may all be affected by burdensome provisions especially in the private placement debt contract. 3. The possibility of future SEC registration: If the lender (investor) should decide to sell the issue to a public buyer before maturity, the issue must be registered with the SEC. Some lenders, then, require that the issuing firm agree to a future registration at their option. Page Ref: 31, 32, 33
Name the benefits derived from the existence of stock exchanges.
Providing a continuous market: it may be the most important function of an organized security exchange. A continuous market provides a series of continuous security prices. Establishing and publicizing fair security prices: An organized exchange permits security prices to be set by competitive forces. The bidding process flows from the supply and demand underlying each security. This means the specific price of a security is determined in the manner of an auction. In addition the security prices determined at each exchange are widely publicized. Helping business raise new capital: Because a continuous secondary market exists, it is easier for firms to float, or issue, new security offerings at competitively determined prices. Page 28
Part of the U.S. Government's huge deficit is financed by foreign countries, such as China, which is a savings surplus unit. TRUE or FALSE
TRUE Page 24, 25
Three ways that savings can be transferred through the financial markets to those in need of funds include direct transfers, indirect transfers using the investment banker, and indirect transfers using the financial intermediary. TRUE or FALSE
TRUE Page 24, 25
Financial intermediaries issue their own indirect securities and use the proceeds to purchase the direct securities of other economic units. TRUE or FALSE
TRUE Page 25
Financial markets exist in order to allocate savings in the economy to the demanders of those savings. TRUE or FALSE
TRUE Page 25
A seasoned equity offering is the sale of additional shares by a company whose shares are already publicly traded. TRUE or FALSE
TRUE Page 26
Cash markets are often referred to as spot markets. TRUE or FALSE
TRUE Page 27
On the basis of number of shares traded, more stocks are traded over the counter than on organized exchanges. TRUE or FALSE
TRUE Page 27
Over-the-counter markets include all security markets, with the exception of organized exchanges. TRUE or FALSE
TRUE Page 27
The money market includes transactions in short-term financial instruments. TRUE or FALSE
TRUE Page 27
The vast majority of corporate bond business takes place over the counter. TRUE or FALSE
TRUE Page 27
For a firm to have its securities listed on an exchange, it must meet certain requirements. These usually include measures of profitability, size, market value, and public ownership. TRUE or FALSE
TRUE Page 28
Organized stock exchanges provide the benefits of a continuous market, fair security pricing, and helping businesses raise new capital. TRUE or FALSE
TRUE Page 28
A group of investment bankers organized to distribute large securities issues is known as a syndicate. TRUE or FALSE
TRUE Page 29
The investment banker performs three basic functions: (1) underwriting, (2) distributing, and (3) advising. TRUE or FALSE
TRUE Page 29
The syndicate can be thought of as a wholesaler of securities and the dealer organization as a retailer of securities. TRUE or FALSE
TRUE Page 29
The competitive bid purchase is largely confined to railroad, public utility, and municipal bond issues. TRUE or FALSE
TRUE Page 30
The negotiated purchase is the most prevalent method of securities distribution in the private sector. TRUE or FALSE
TRUE Page 30
13) The bid price is the price that a dealer will pay for a security; the asked price is the price at which she will sell a security. TRUE or FALSE
TRUE Page 32
The rate of return available on the next best investment alternative for the saver refers to the opportunity cost of funds. TRUE or FALSE
TRUE Page 34
Learning Objective 2.3 Over time, there has been a high correlation between actual rates of return on securities and the securities' standard deviations of returns. TRUE or FALSE
TRUE Page 35
A liquidity-risk premium is the additional return required by investors for securities that cannot quickly be converted into cash at a reasonably predictable price. TRUE or FALSE
TRUE Page 38
Learning Objective 2.4 The term structure of interest rates usually indicates that longer terms to maturity have higher expected returns. TRUE or FALSE
TRUE Page 44
Examine the securities below and identify the security with the highest liquidity premium, the highest default risk premium, and the highest maturity premium. a. 30-year U.S. Government Treasury bond maturing in 2025 b. 25-year Bbb-rated corporate bond maturing in 2030, actively traded on the New York Exchange c. 10-year Aaa-rated corporate bond maturing in 2020, thinly traded on a regional exchange d. 3-month U.S. Treasury bill
The 10-year Aaa-rated corporate bond has the highest liquidity premium because it is not actively traded and may be difficult to turn into cash on short notice. The Bbb-rated corporate bond has the highest default risk premium. The U.S. Government securities are virtually default risk free, and the other corporate bond is Aaa rated. The 25-year Bbb-rated corporate bond maturing in 2030 has the highest maturity premium. Although the Treasury bond had a longer maturity when issued, currently the 25-year Bbb bond has the longest time left to maturity. Page 37
What are the three major functions of an investment banker?
The investment banker performs three basic functions: (1) underwriting, (2) distributing, and (3) advising. Underwriting: The term underwriting is borrowed from the field of insurance. It means assuming a risk. The investment banker assumes the risk of selling a security issued at a satisfactory price. A satisfactory price is one that generates a profit for the investment-banking house. A syndicate is a group of other investment bankers that is invited to help buy and resell the issue. Distributing: Once the syndicate owns the new securities, it must get them into the hands of the ultimate investors. This is the distribution or selling function of investment banking. The investment banker may have branch offices across the United States, or it may have an informal arrangement with several security dealers who regularly buy a portion of each new offering for final sale. It is not unusual to have 300 to 400 dealers involved in the selling effort. The syndicate can properly be viewed as the security wholesaler, and the dealer organization can be viewed as the security retailer. Advising: The investment banker is an expert in the issuance and marketing of securities. A sound investment-banking house will be aware of prevailing market conditions and can relate those conditions to the particular type of security and the price at which it should be sold at a given time. Page 29, 30
Identify three prominent theories that attempt to explain the term structure of interest rates.
Three possible theories may explain the shape of the term structure of interest rates at any point in time: The Unbiased Expectations Theory: The theory says that the term structure is determined by an investor's expectations about future interest rates. The Liquidity Preference Theory: According to the theory, investors require maturity-risk premiums to compensate them for buying securities that expose them to the risks of fluctuating interest rates. The Market Segmentation Theory: The theory implies that the rate of interest for a particular maturity is determined solely by demand and supply for a given maturity and that it is independent of the demand and supply for securities having different maturities. Page 45
Given the rate information in the table below, estimate the nominal rate for a AA-rated corporate bond. Assume a liquidity premium of 8 basis points. Identify as part of your answer the inflation risk premium, the default risk premium, the maturity premium, and the liquidity premium. 3-month T-bills 2.0% 30-year Treasury bonds 5.0% AA-rated corp. bonds 8.0% Inflation Rate 1.0%
k* = 2.0% - 1.0% = 1.0% IRP = 1.0% DRP = 8.0% - 5.0% = 3.0% MP = 5.0% - 2.0% = 3.0% LP = .08% (given) K = 1.0% + 1.0% + 3.0% + 3.0% + .08% = 8.08% Page 40
An investor buys a 20-year Bbb-rated corporate bond with a nominal annual rate of return of 10%. The average inflation rate is expected to be 2%. The default risk premium is expected to be 5% and the maturity premium is 4%. Calculate the real rate of interest.
krf = k* + IRP + (k* × IRP) 10% = k* + 2% + (k* × 2%) 8% = 1.02 k* 7.84% = k* Page 41
If provided the nominal rate of interest (r) of 7.4% and the anticipated rate of inflation (i) of 4.5%, what is the real rate of interest (R)?
r = R + i + Ri .074 = R + .045 + (.045)(R) .074 - .045 = 1.045R .029 = 1.045R R = .02775 = 2.78% Page 44
Given the anticipated rate of inflation (i) of 1.7% and the real rate of interest (R) of 1.4%, find the nominal rate of interest (r).
r = R + i + Ri r = .014 + .017 + (.014)(.017) r = .031 + .000238 = .031238 r = 3.12% Page 44
Given the anticipated rate of inflation (i) of 2.13% and the real rate of interest (R) of 3.1%, find the nominal rate of interest (r).
r = R + i + Ri r = .031 + .0213 + (.031)(.0213) r = .0523 + .0006603 r = .05296 = 5.3% Page 44
