Fin 3403 Ch.2
What are two basic services that investment banks provide in the economy? (2.5 discussion question)
Investment banks specialize in helping companies sell new debt or equity as well as provide other services such as broker and dealer services.
Money Center banks (book 2.5)
Large commercial banks that provide both traditional and investments banking services throughout the world.
Real assets (book 2.1)
Non-financial assets such as plant and equipment; productive assets are claims on cash flows from real assets.
true (intrinsic) value (book 2.10)
for a security, the present value of the cash flows an investor who owns that security can expect to receive in the future.
public information (book 2-11)
information that is available to all investors.
efficient market (book 2-11)
market where prices reflect the knowledge and expectations of all investors.
Liquidity (book 2.8)
the ability to convert an asset into cash quickly without loss of value.
marketability (book 2.8)
the ease with which a security can be sold and converted into cash.
private placement (book 2.9)
the sale of an unregistered security directly to an investor, such as an insurance company or wealthy individual.
weak-form of the efficient market hypothesis (book 2-12)
the theory that security prices reflect all information in past prices but do not reflect all private or all public information
Strong-form of the efficient market hypothesis (book 2-11)
the theory that security prices reflect all public information but not all private information
Money Markets: What are the main types of securities in the money markets? (2.12 questions & answers)
Treasury bills, bank negotiable CDs, and commercial paper.
Why might a firm prefer to have a security issue underwritten by an investment banking firm? (2.2 questions &answers)
- In the most common type of underwriting arrangement, called firm-commitment underwriting, the investment banker assumes the risk of buying the new securities from the issuing company and reselling them to investors. The investment banker guarantees to buy the entire security issue from the company at a fixed price.
What are capital markets, and why are they important to corporations? (2.3 questions and answers)
-Capital markets refer to the segment of the marketplace where capital goods are financed with long-term debt or equities. The most important capital market instruments are common stocks and corporate bonds. Capital markets are important to corporations because they allow them to obtain necessary financing.
What is financial intermediation, and why is it important? (questions 2.5& answers)
-Financial intermediation is the process of converting financial securities with one set of characteristics into securities with another set of characteristics. For example, commercial banks use consumer CD deposits to make loans to small businesses.
What is an IPO, and what role does an investment banker play in the process?(2.5 questions and answers)
-Investment bankers specialize in helping firms to sell their new debt or equity issues in financial markets. In an initial public offering (IPO), the investment banker prepares the new issue for sale and then underwrites the deal. Other functions of the investment banker in an IPO process include preparing the prospectus, registering the documentation with the SEC, and providing general financial advice to the issuer.
How and why do large business firms use money markets?(2.3 questions answers)
-Large businesses use money markets to adjust their liquidity positions. If a firm has idle cash sitting around, it can invest it in negotiable CDs, Treasury bills, or other money market instruments. On the other hand, if a company has a temporary cash shortage, it can borrow in the money markets by selling commercial paper at lower interest rates than it could borrow through a commercial bank.
What is the difference between primary and secondary markets?(section 2.3 questions and answers)
-Primary markets are markets where new securities are sold for the first time. Secondary markets are where the owners of outstanding securities can sell them to other investors. They provide the means for investors to sell their securities and get cash.
Primary Markets: Identify whether the following transactions are primary market or secondary market transactions. (2.7 questions and answers)
-Secondary market transactions. - Secondary market transactions. -Primary market transactions
Why is it difficult for individuals to participate in the direct financial markets? (2.2 questions and answer)
-The financial markets where direct transactions take place are wholesale markets with a typical minimum transaction size of $1 million. Major buyers and sellers of securities in direct financial markets include commercial banks, large corporations, the federal government, hedge funds, and some wealthy individuals
What critical economic role does the financial system play in the economy? (2.1 questions and answers)
-The financial system is in place to gather money from people and businesses and then channel these funds to those who need it. An efficient financial system is essential for a healthy economy. The major players in the U.S. financial system are big institutions such as the New York Stock Exchange, Citigroup, or State Farm Insurance.
What are the two basic ways in which funds flow through the financial system from lender-savers to borrower-spenders? (2.1 questions and answers)
-There are two basic mechanisms by which funds flow through the financial system: 1) Funds can flow directly through financial markets, and (2) funds can flow indirectly through financial institutions.
Financial Markets: List the two ways in which a transfer of funds takes place in an economy. What is the main difference between these two? (2.4 questions and answers )
: Funds can flow directly through financial markets or indirectly through intermediation markets where funds flow through financial institutions first.
What is the relation between business cycles and the general level of interest rates? (2.6 sample test problems)
: Interest rates tend to follow the business cycle. The level of interest rates tends to rise during periods of economic expansion and decline during periods of economic contraction.
Financial System: What is the difference between saver-lenders and borrower-spenders, and who are the major representatives of each group? (2.3 questions and answers)
: Saver-lenders are those who have more money than they need right now. The principal saver-lenders in the economy are households. Borrower-spenders are those who need the money saver-lenders are offering. The main borrower-spenders in the economy are businesses followed by the federal government, although households are important mortgage borrowers.
Financial Institutions: What are some of the ways in which a financial institution or intermediary can raise money?(2.9 quests and answers)
A financial intermediary can raise money through the sale of financial products that individuals or businesses will purchase, such as checking and savings accounts, life insurance policies, pension or retirement funds.
Primary market (book 2.7)
A financial market in which new security issues are sold by companies directly to investors.
Secondary Market (book 2.7)
A financial market in which the owners of outstanding securities can sell them to other investors.
Primary Markets: What is a primary market? What does IPO stand for? (2.6 questions and answers)
A primary market is where new securities are sold for the first time. IPO stands for Initial Public Offering.
Efficient Market Hypothesis (book 2-11)
A theory concerning the extent to which information is reflected in security prices and how information gets incorporated into security prices.
Financial Markets: Suppose you own a security that you know can be easily sold in the secondary market, but the security will sell at a lower price than you paid for it. What does this imply for the security's marketability and liquidity? (2.5 questions and answers)
As the price of the security is lower than that you paid for it, it has a lower degree of liquidity to you, the owner. That is because the security cannot now be sold without a loss in value to the owner. Marketability refers to the ease with which a security can be sold or converted to cash. The information in the problem mentions that the security could be easily sold in secondary market, which implies it has high degree of marketability to you.
Financial assets (book 2.1)
Assets that new claims in the cash flows from other assets, business loans, stocks, and bonds are financial assets.
Economic units that need to borrow money are said to be (2.1 self study )
Borrower-spenders
How does the business cycle affect the nominal interest rate and inflation rate? (2.3 self study& problems)
Both the nominal interest and inflation rates tend to follow the business cycle; that is, they rise with economic expansion and fall during a recession.
Explain the economic role of brokers and dealers. How does each make a profit? (discussion 2.3)
Brokers and dealers play a similar economic role in that they both bring buyers and sellers of a commodity together in a market. However, brokers only facilitate a transaction by helping the two parties make a transaction and brokers are therefore only compensated for taking on that role. They bear no risk of ownership of securities during the transaction. Dealers on the other hand, take risk in that they will purchase (sell) a commodity from a seller (buyer) without another buyer (seller) necessarily being available. In other words, a dealer will take the risk of purchasing (selling) a commodity and will therefore be compensated for taking that risk.
How are brokers different from dealers? (2.3 sample test problems)
Brokers bring buyers and sellers together. They execute a transaction for their client and are compensated with a commission fee. Brokers never own the securities being sold and therefore do not bear any risk of ownership. In contrast, dealers purchase securities and sell them from an inventory that they own. Dealers profit if they are able to sell securities for a price greater than they paid for them. Because they own the securities, dealers face the risk that the prices of the securities in their inventory will fall below what they paid for those securities.
Capital Markets: How do capital market instruments differ from money market instruments? (2.13 questions & answers)
Capital market instruments are less liquid or marketable, they have longer maturities, usually between 1 and 30 years, and they carry more financial risk.
Why were commercial banks prohibited from engaging in investment banking activities until 1999? (discussion 2.4)
Commercial Banks had been barred from investment banking following the Great Depression because it was believed that these activities were too risky for banks. They became greedy and diverted funds to speculative stock market investment. At the time, it was believed that excessive risk taking by banks had resulted in a large number of bank failures, which precipitated the Great Depression. For instance, a commercial bank could issue risky loans to an underperforming company because of the reason that it had invested in the company. Moreover, such a bank have an incentive to conceal the actual risk of the loan and encourage its clients to participate in investing in the company. Recent research has exonerated the banking system of this charge.
What are some services that commercial banks provide to businesses? (2.5 questions & answers)
Commercial banks are the largest financial intermediaries in the economy and offer the widest range of financial services to businesses. Nearly every business has a significant relationship with a commercial bank - usually a checking or transaction account and some type of credit or loan arrangement. In addition, banks do a significant amount of equipment lease financing.
Financial intermediation (book 2-12)
Conversion of securities with one set of characteristics into securities with another set of characteristics.
Why don't small businesses make greater use of the direct credit markets since these markets enable firms to finance their activities at a very low cost? (2.2 Discussion question)
Direct credit markets are geared toward big, established companies since they are wholesale in nature and the minimum transaction size is far beyond the needs of a small business. Small businesses are better off borrowing money from financial intermediaries, such as commercial banks.
Explain why total financial assets in the economy must equal total financial liabilities. (2.1 discussion question)
Every financial asset must be financed with some type of a claim or liability. Since all of an economy's financial assets are just a collection of the individual financial assets, then they should also sum to the collective claims on those assets in the economy.
Investment banks (book 2.5)
Firms that specialize in helping companies sell new security issues.
Financial System: What does a competitive financial system imply about interest rates? (2.2 questions and problems)
If the financial system is competitive, one will receive the highest possible rate for money invested with a bank and the lowest possible interest rate when borrowing money. Also, only firms with good credit ratings and projects with high rates of return will be financed.
Explain why interest rates follow the business cycle. (2.6 questions & answers)
Interest rates tend to follow the business cycle to rise during economic expansion and decline during recession. On the one hand, during an expansion, there is upward pressure on interest rates as businesses begin to grow and borrow more money. On the other hand, during a recession, the demand for goods and services is lower, businesses borrow less, and as a result the economy slows down and the interest rates decline. Typically, the Fed also loosens credit to stimulate the economy, which puts further downward pressure on the interest rates.
How do large corporations adjust their liquidity in the money markets? (2.6 discussion questions)
Large corporations can take advantage of money markets to adjust for their liquidity by selling or buying short-term financial instruments such as commercial paper, CDs, or Treasury bills. Large corporations with cash surplus can invest in short-term securities, while corporations with cash shortfalls can sell securities or borrow funds on a short-term basis. Money market instruments have a maturity anywhere between one day and one year and therefore are very liquid and less risky than long-term debt.
Brokers (book 2.8)
Market specialist who bring buyers and sellers together, usually for a commission.
Dealers (book 2.8)
Market specialist who make markets for securities by buying and selling from there own inventories.
Explain what the marketability of a security is and how it is determined.(2.2 self study)
Marketability refers to the ease with which a security can be sold and converted into cash. The level of marketability depends on the cost of trading the security and the cost of searching for information. The lower these costs are, the greater the security's marketability.
Money markets (books 2.8)
Markets where short- term debt instruments are traded.
Financial Markets: What is the main difference between money markets and capital markets?(2.10 questions and answers)
Money markets are markets in which short-term debt instruments with maturities of less than one year are bought and sold. Capital markets are markets in which equity securities and debt instruments with maturities of more than one year are bought and sold.
Money Markets: What is the primary role of money markets? Explain how the money markets work. (questions and answers 2.11)
Money markets provide an option for large corporations to adjust their liquidity positions. Since only seldom are cash receipts and cash expenditures perfectly synchronized, money markets allow companies to temporarily invest idle cash in Treasury bills or negotiable CDs. If a company is short on cash, it can borrow the money from money markets by selling commercial paper at lower interest rates than through commercial banks.
Initial Public Offering (IPO). (book 2-14)
The first offering of a corporation stock to the public.
2.6.1 You lent $100 to a friend for one year at a nominal rate of interest of 3 percent. Inflation during that year was 2 percent. Did you experience an increase or decrease in the purchasing power of your money? How much did it increase or decrease?
Since the interest rate that you received (3 percent) exceeded the rate of inflation, the amount that you received from your friend when the loan was repaid had greater purchasing power than $100. The amount by which the purchasing power increased can be calculated using Equation 2.1: 1 + i = (1 + r) × (1+ ΔPe) Solving for r yields: r = (1 + i)/(1 + ΔPe) - 1 r = (1 + 0.03)/(1 + 0.02) - 1 r = 0.0098, or 0.98% Therefore, the purchasing power increased by slightly less than 1 percent
Market informational efficiency (book 2-11)
The degree to which current market prices reflect relevant information and, therefore, the true value of the security.
Market operational efficiency (book 2-11)
The degree to which the transaction costs of bringing buyers and sellers together minimized
Real rate of interest (book 2-16)
The interest rate that would exist in the absence of inflation.
Interest Rates: How does the nominal rate of interest vary over time? (questions & answers 2.21)
The nominal rate is the rate that we observe in the marketplace. It is determined by both the real rate as well as expected inflation. Therefore, the nominal rate will fluctuate with changes in the real rate as well as changes in expected inflation.
Interest Rates: When are the nominal and real interest rates equal? (2.25 questions & answers)
The only time the nominal and real interest rates are equal is when the expected rate of inflation over the contract period is zero.
Nominal rate of interest (book 2-16)
The rate of interest that is unadjusted for inflation.
Financial System: What is the role of the financial system, and what are the two major components of the financial system? (2.1 questions & problems)
The role of the financial system is to gather money from businesses and individuals who have surplus funds and channel funds to those who need them. The financial system consists of financial markets and financial institutions.
What are the two basic mechanisms through which funds flow through the financial system, and how do they differ? (2.1 sample test problems)
The two basic mechanisms are the direct financing mechanism and the indirect financing mechanism. In the direct financing mechanism, issuers of securities (borrower-spenders) sell the securities directly to investors (lender-savers). In the indirect financing mechanism, financial institutions aggregate money from lender-savers and make this capital available through loans to borrower-spenders.
Investment Banking: What does it mean to "underwrite" a new security issue? What compensation does an investment banker get from underwriting a security issue? (2.8 questions and answers)
To underwrite a new security issue means that the investment banker buys the entire issue from the firm at a guaranteed price and then resells the security to individual investors or other institutions at a higher price. The difference between the banker's purchase price and the total resale price is called the underwriting spread, and it is the banker's compensation. In addition to underwriting new securities, investment banks also provide other services, such as preparing the prospectus, preparing legal documents to be filed with the SEC, and providing general financial advice to the issuer.
If the nominal rate of interest is 4.25 percent and the expected rate of inflation is 1.75 percent, what is the real rate of interest? (2.5 sample test problems)
Using the Fisher equation: i = r + ∆Pe + r ∆Pe where i = 0.0425 and ∆Pe = 0.0175 Solving for r, we get r = 0.02457, or 2.457%
Interest Rates: Your parents have given you $1,000 a year before your graduation so that you can take a trip when you graduate. You wisely decide to invest the money in a bank CD that pays 6.75 percent interest. You know that the trip costs $1,025 right now and that the inflation for the year is predicted to be 4 percent. Will you have enough money in a year to purchase the trip? (2.24questions & answers).
Yes. The CD will be worth $1,067.50 at the end of the year ($1,000 x 6.75% + $1,000), and the price of the trip will be $1,066 ($1,025 x 4% + $1,025). The CD will be able to cover the trip.
Interest Rates: Imagine you borrow $500 from your roommate, agreeing to pay her back $500 plus 7 percent nominal interest in one year. Assume inflation over the life of the contract is expected to be 4.25 percent. What is the total dollar amount you will have to pay her back in a year? What percentage of the interest payment is the result of the real rate of interest? (question & answer 2.23)
You will pay her back $535 ($500 × 1.07) in one year. Given an inflation of 4.25 percent, the real rate of interest is approximately 2.368 percent using the Fisher equation: 1 + i = (1 + r) × (1 + ΔPe) 1 + 0.07 = (1 + r) × (1 + 0.0425) r = (1.07/1.0425) - 1 = 0.02638, or 2.638% This means that $13.19 ($500 × 0.02638) will be a result of the real interest rate which is 37.69 percent of the total interest payment. The simplified, or approximate, Fisher equation yields a real interest rate of 2.75 percent: i = r + ΔPe r = 0.07 - 0.0425 = 0.0275, or 2.75% This means that $13.75 ($500 × 0.0275) will be a result of the real interest rate which is 39.29 percent of the total interest payment.
You just purchased a share of IBM stock on the New York Stock Exchange. What kind of transaction was this? (2.2 sample test problem)
b. (The secondary market is the one in which owners of outstanding securities sell their securities to other investors.)
