Finance- Ch. 2 Financial Markets

What is a capital market? A.) A market for long-term capital B.) A market for short-term debt instruments C.) A market for physical capital, such as machines D.) A market for cash

A.) A market for long-term capital Capital markets are financial markets that allow companies to raise long-term capital, i.e., to issue securities with maturities longer than one year, and investors to trade those securities with each other.

Which of the following statements is correct? A.) If expected inflation increases, interest rates are likely to increase. B.) If individuals save more, interest rates are likely to increase. C.) If companies borrow more money, interest rates are likely to decrease. D.) If companies are more likely to default on their bonds, interest rates are likely to decrease.

A.) If expected inflation increases, interest rates are likely to increase. If expected inflation increases, interest rates are likely to increase, as new investors want to be compensated for the erosion of purchasing power.

_____ are the markets for short-term debt securities, while _____ are the markets for long-term debt securities and stocks. A.) Money markets; capital markets B.) Credit markets; capital markets C.) Credit markets; stock markets D.) Money markets; stock markets

A.) Money markets; capital markets Short-term debt securities, such as treasury bills and certificates of deposit, are said to trade in the money market. Long-term debt securities, such as treasury notes and bonds, commercial and municipal bonds, and stocks trade in the capital market. Securities with a time to maturity of up to one year are considered money market instruments, while securities with a time to maturity of more than one year, or no maturity date at all (like stocks), are considered capital market instruments.

Which are costs of issuing new securities (flotation costs)? (pick 3) Check all that apply: A.) Underwriter's spread B.) Accounting fees C.) Dividends D.) Legal fees

A.) Underwriter's spread B.) Accounting fees D.) Legal fees Dividends are not related to the issue of new equity. In fact, a company may issue new stocks and decide never to pay any dividends.

You just logged into your online brokerage account and bought 100 shares of Apple stock. This is an example of _____. A.) a secondary market transaction B.) a money market transaction C.) an over-the-counter transaction D.) a primary market transaction

A.) a secondary market transaction One investor buying shares from another investor is a secondary market transaction.

What are common risk premiums? Check all that apply: A.) Real risk premium B.) Default risk premium C.) Liquidity premium D.) Term (maturity risk) premium

B.) Default risk premium C.) Liquidity premium D.) Term (maturity risk) premium Nominal rate = real rate + inflation premium + risk premium Risk premiums: Default risk premium: return component to compensate investors for the risk that the issuer will not pay the promised interest or principal Liquidity premium: return component to compensate investors for the risk that some assets cannot be sold (converted to cash) at a fair price on short notice Maturity risk premium: return component to compensate investors for the risk that increases in market interest rates will lead to large price drops for existing debt securities. The longer the time to maturity, the greater the interest rate (or price) risk.

What are determinants of market interest rates? (pick 3) Check all that apply: A.) Demand premium B.) Inflation premium C.) Risk premium D.) Real rate of interest

B.) Inflation premium C.) Risk premium D.) Real rate of interest Nominal rate = real rate + inflation premium + risk premium Real rate of interest: The interest rate on a risk-free security in a world without inflation (not directly observable) Inflation premium: return component to compensate investors for the erosion of purchasing power due to inflation Risk premium: return component to compensate investors for various risks, such as default or limited liquidity

Which of the following statements is correct? A.) If a company issues new shares of stock for the first time, it is a secondary market transaction. B.) The New York Stock Exchange is an organized market. C.) Mortgage-backed securities are traded in the money market. D.) Capital markets are for trading common and preferred stocks only.

B.) The New York Stock Exchange is an organized market. The New York Stock Exchange is an organized market, with a set system of rules in place i.e., all orders are routed to a central auctioneer (the specialist on the trading floor or a computer algorithm for electronic trading) that matches buy and sell orders, with the highest bid and lowest ask getting priority.

Which of the following is a primary market transaction? A.) You buy 100 shares of Twitter stock, with your broker routing the order to the NYSE. B.) You buy 100 shares of Twitter stock from your friend, exchanging cash for shares. C.) A pension fund buys 80,000 shares of Facebook stock from another fund with the help of an investment bank. D.) Apple issues one million shares of new stock and sells them to the public with the help of an investment bank.

D.) Apple issues one million shares of new stock and sells them to the public with the help of an investment bank. In a primary market transaction, a company issues (creates) new securities by selling them to investors for the first time.

_____ are markets in which financial securities are issued for the first time, while _____ are markets where already existing securities are traded. A.) Issue markets; liquidity markets B.) Issue markets; secondary markets C.) Primary markets; liquidity markets D.) Primary markets; secondary markets

D.) Primary markets; secondary markets Primary markets are used by companies to raise new capital. They issue (create) new stocks or bonds and sell them to investors. If these securities are offered to everyone (a public offering), the transaction is called an initial public offering (IPO). Secondary markets allow investors to trade existing securities with each other. The New York Stock Exchange and NASDAQ are examples of a secondary market. The issuer of the security does not receive any money from secondary market transactions.

_____ are markets where assets are traded for immediate delivery, while _____ are markets where assets are traded for future delivery. A.) Instant markets; delayed markets B.) Spot markets; delayed markets C.) Instant markets; future markets D.) Spot markets; future markets

D.) Spot markets; future markets In spot markets, assets are sold at the current market price (or spot price) for immediate delivery (in practice, for delivery within a few days). In future markets, assets are sold at a prearranged price (the future price) to be paid when the asset is delivered at some future date, which may be days to months away.

Selling stocks to the investing public for the first time is called a/an _____, while selling additional shares at a later date is called a/an _____. A.) public sale; follow-up sale B.) first-time offering; follow-up offering C.) private placement; public offering D.) initial public offering; seasoned equity offering

D.) initial public offering; seasoned equity offering Selling stocks to the investing public for the first time is called an initial public offering (IPO), while selling additional shares at a later date is called a seasoned equity offering (SEO).

Money markets are markets for _____. A.) long-term bonds, such as corporate bonds and Treasury bonds B.) derivatives, such as options and swaps C.) stocks D.) short-term debt securities such as Treasury bills E.) money

D.) short-term debt securities such as Treasury Bills Money markets are markets for short-term debt securities such as Treasury bills and commercial paper. Practice again

Companies issue new shares with the help of _____. A.) investment companies B.) private equity funds C.) mutual funds D.) underwriters

D.) underwriters Underwriting a new stock issue involves determining the initial offering price, often buying them from the issuer, and selling them to investors. Nearly all underwriters are investment banks.

The NYSE is an _____ and NASDAQ is a _____. A.) exchange; dealer market B.) over-the-counter market; dealer market C.) over-the-counter market; broker market D.) exchange; broker market

A.) exchange; dealer market The New York Stock Exchange is a physical location exchange, where traders trade on a trading floor. However, these days most of the trading in NYSE-listed stocks is done electronically off the trading floor. NASDAQ is a dealer market, where dealers (financial companies) hold an inventory of stocks and quote prices to buy and sell the stocks in which they make a market.

Which of the following trade in the capital market? (pick 2) Check all that apply: A.) Commercial paper B.) Stocks C.) Treasury bills D.) Bonds

B.) Stocks D.) Bonds Stocks and bonds have long maturities (in fact, stocks have an infinite maturity date) and are thus traded in the capital market.

Investment banks help their clients by _____. (pick 3) Check all that apply: A.) lending them money B.) advising them about issuing new securities, M&A and restructuring C.) underwriting a new security issue D.) making a market for a newly issued security

B.) advising them about issuing new securities, M&A and restructuring C.) underwriting a new security issue D.) making a market for a newly issued security Pure investment banks do not take deposits and do not make loans. Instead, they advise clients about mergers and acquisitions and new issues, or take a more active role in the process (underwriting).

real interest rate formula (R)

Nominal interest rate (r) - Inflation rate (i)

Fisher Equation

real interest rate = nominal interest rate - inflation rate