FIN3400 Quiz 2 practice

The NYSE is an example of: A. an organized exchange. B. all of the above. C. a commodities exchange. D. an over-the-counter market exchange.

A. an organized exchange.

The two methods by which funds are transferred from savers to borrowers within an economy's financial system include A. direct and indirect transfers. B. primary and secondary transfers. C. short-term and long-term transfers. D. wholesale and retail transfers.

A. direct and indirect transfers.

Within a financial system, money flows indirectly through: A. financial institutions. B. financial markets. C. stock exchanges. D. the SEC.

A. financial institutions.

Interest rates increase when A. the demand for money increases. B. the supply of money increases. C. the supply and demand for money are equal. D. the inflation rate decreases.

A. the demand for money increases.

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?

0.98%; increase r = (1 +0.03)/(1 +0.02) - 1 = 0.0098

What are some of the ways in which a financial institution or intermediary can raise money?

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.

What is a primary market? What does IPO stand for?

A primary market is where new securities are sold for the first time. IPO stands for Initial Public Offering.

According to the Fisher equation, if the real rate of interest is 2.5% and the nominal rate of interest is 5.3%, the rate of inflation is forecast to be approximately A. 2.8%. B. 2.7%. C. 5.3%. D. 7.8%.

A. 2.8%. (5.3% - 2.5% = 2.8%)

Which of the following is a financial institution involved in indirect financing in a financial system? A. Commercial banks B. Capital markets C. Futures and options markets D. Investment banks

A. Commercial banks

Which of the following services does an investment banker provide? A. Distribution B. Auditing C. Money lending D. Insurance

A. Distribution

You loaned $100 to a friend for one year at a nominal rate of interest of 3 percent. Inflation during that year was 2 percent. How much did the purchasing power of your money change (an increase is positive and a decrease is negative)? A. Increased by 1 percent B. Decreased by 1 percent C. Increased by 5 percent D. Decreased by 5 percent

A. Increased by 1 percent

Which of the following is responsible for rolling back many of the rules against commercial banks offering investment banking activities? A. The Financial Services Modernization Act of 1999 B. The Securities Act of 1933 C. The Securities Exchange Act of 1934 D. The Glass-Steagall Act of 1933

A. The Financial Services Modernization Act of 1999

If your investment increased 12% this year and inflation for that period was 4%, what was your real rate of return? Please use the simplified (or approximate) Fisher equation for this question. A. 7.7% B. 8.0% C. 9.3% D. 12.0%

B. 8.0% (12% - 4% = 8%)

Economic units that need to borrow money are said to be: A. Lender-savers. B. Borrower-spenders. C. Balanced budget keepers. D. None of these options.

B. Borrower-spenders.

You just purchased a share of IBM stock on the New York Stock Exchange. What kind of transaction was this? A. Primary market transaction. B. Secondary market transaction. C. Futures market transaction. D. Private placement.

B. Secondary market transaction.

Which form of the efficient market hypothesis states that security prices reflect all public information, but not all private information? A. Strong B. Semistrong C. Weak D. Very weak

B. Semistrong

Which of the following statements is INCORRECT? A. Hedge funds are major buyers and sellers of securities in the direct financial markets B. The retail individual investor is a common direct participant in the direct financial markets C. Life insurance companies are major buyers of securities in the direct financial markets D. Direct transactions in wholesale markets have a typical minimum transaction size of $1 million

B. The retail individual investor is a common direct participant in the direct financial markets

Underwriting is the process by which an investment banker A. markets and resells a company's securities to investors. B. helps a company sell its new security issue. C. lends funds to new companies. D. provides seed capital to new start-ups.

B. helps a company sell its new security issue.

Money markets are markets where A. stocks are sold for immediate delivery of cash. B. short-term financial instruments are traded. C. futures and options are traded. D. foreign currencies are traded.

B. short-term financial instruments are traded.

How does the business cycle affect the nominal interest rate and inflation rate?

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.

Which of the following is LEAST likely to be included in a pension fund's investment portfolio? A. Stocks B. Government securities C. Commercial paper D. Long-term corporate bonds

C. Commercial paper

Which of the following transactions is a secondary market transaction? A. IBM issuing 100,000 shares on the NYSE for the first time B. MicroChip Computers selling $1,000,000 worth of bonds directly to AIG Corp. C. Johnny Appleseed buying 1,000 shares of Dell through NYSE D. Mary receiving dividends from IBM

C. Johnny Appleseed buying 1,000 shares of Dell through NYSE

Brokers A. "make markets" for securities. B. buy and sell securities from their own inventory. C. bring buyers and sellers together, usually for a commission. D. bear the risk of loss from trading securities.

C. bring buyers and sellers together, usually for a commission.

A primary market is a market for A. companies to buy back their own previously issued shares. B. investors to sell stocks to other investors. C. companies to sell new securities directly to investors. D. companies to trade the financial derivatives such as futures and options.

C. companies to sell new securities directly to investors.

Financial markets and financial institutions are both part of: A. the SEC. B. none of the above. C. the financial system. D. the U.S. Treasury.

C. the financial system.

An important function of the financial system is: A. to help state governments to coordinate state tax levies. B. to allow the federal government to view all financial transactions. C. to direct money to the best investment opportunities in the economy. D. to direct the money from borrower-lenders to lender-savers.

C. to direct money to the best investment opportunities in the economy.

How do capital market instruments differ from money market instruments?

Capital market instruments are less liquid or marketable, they have longer maturities, usually between 1 and 30 years, and they carry more financial risk.

Which of the following is a process by which investment bankers purchase new securities directly from the issuing company and resell them to the investors? A. Distribution B. Private placement C. Agency marketing D. Underwriting

D. Underwriting

The major players in the direct financial markets are: Group of answer choices A. money center banks. B. investment banks. C. regional banks. D. both A and B.

D. both A and B.

If a firm needs to finance a new corporate headquarters building, then it would most likely seek the funds in the: A. money market. B. all of the above. C. futures market. D. capital market.

D. capital market.

Investment banking firms provide A. auditing services. B. insurance. C. overdraft facility. D. underwriting services.

D. underwriting services.

Assets that are claims on the cash flows from other assets, business loans, stocks, and bonds, are real assets. True or False?

False; those would be financial assets Real assets: plant and equipment; productive assets

List the two ways in which a transfer of funds takes place in an economy. What is the main difference between these two?

Funds can flow directly through financial markets or indirectly through intermediation markets where funds flow through financial institutions first.

What does a competitive financial system imply about interest rates?

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.

What is the main difference between money markets and capital markets?

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 sold.

What is the primary role of money markets? Explain how the money markets work.

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.

What are over-the-counter markets (OTCs), and how do they differ from organized exchanges?

Securities that are not listed on an organized exchange are sold OTC. An OTC market differs from an organized exchange in that there is no central trading location. OTC security transactions are made via phone or computer as opposed to on the floor of an exchange.

Why are direct financial markets also called wholesale markets?

The financial markets are also called wholesale markets because the minimum transaction or security denomination is $1 million or more.

How does the nominal rate of interest vary over time?

The nominal rate is the rate that we observe in the marketplace. It is determined by both the real rate as well expected inflation. Therefore, the nominal rate will fluctuate according the changes in the real rate as well as changes in expected inflation.

When are the nominal and real interest rates equal?

The only time the nominal and real interest rates are equal is when the expected rate of inflation over the contract period is zero.

Which financial institution is usually the most important to businesses?

The primary financial intermediaries are commercial banks, life insurance companies, casualty insurance companies, pension funds, investment funds, and business finance companies. Commercial banks are the largest and most prominent financial intermediaries in the economy and offer the widest range of financial services to businesses.

What is the role of the financial system, and what are the two major components of the financial system?

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 main types of securities in the money markets?

Treasury bills, bank negotiable CDs, and commercial paper.

Nominal interest rates tend to rise and fall with changes in the rate of inflation. True or False?

True

One of the major advantages of private placements is the speed at which funds can be raised. True or False?

True

The New York Stock Exchange is an example of an organized market that provides a physical meeting place. True or False?

True

Zippy Computers announced strong fourth quarter results. Sales and earnings were both above analysts' expectations. You notice in the newspaper that Zippy's stock price went up sharply on the day of the announcement. If no other information about Zippy became public on the day of the announcement and the overall market was down, is this evidence of market efficiency?

Yes, if no other information became public and the market was down, the increase in Zippy's price most likely reflects the effects of investors trading on the good news. Investors, believing that Zippy is now more valuable than they had thought, are willing to pay a higher price for the shares.

Identify whether the following transactions are primary market or secondary market transactions. a. Jim Hendry bought 300 shares of IBM through his brokerage account. b. Peggy Jones bought $5,000 of General Motors bonds from another investor. c. Hathaway Insurance Company bought 500,000 shares of Trigen Corp. when the company issued stock.

a. secondary b. secondary c. primary

Cranjet Inc. is issuing 10,000 bonds, and its investment banker has guaranteed a price of $985 per bond. If the investment banker sells the entire issue to investors for $10,150,000. a. What is the underwriting spread for this issue? b. What is the percentage underwriting cost? c. How much will Cranjet raise?

a. • Underwriting spread = Proceeds from sale - Price paid for issue ◦ $10,150,000 - (10,000 x $985) = $300,000 b. • Percentage underwriting cost = Underwriting spread / Amount raised ◦ $300,000/(10,000 x $985) = 0.0305 = 3.05% c. • Money raised from issue = Number of bonds issues x Amount received per bond ◦ 10,000 x $985 =$9,850,000

What are the two risk-hedging instruments discussed in the chapter?

futures and options markets

You lent $ 300 to a friend for one year at a nominal rate of interest of 4 percent. Inflation during that year was 3 percent. Did you experience an increase or decrease in the purchasing power of your money? How much did it increase or decrease? (Round answer to 2 decimal places, e.g. 52.75%.) The purchasing power________(inc or dec) by ___________%.

increased; 0.97% ------>( 1 + 0.04)/(1 + 0.03) - 1 = 0.0097

What effect does an increase in demand for business goods and services have on the real interest rate? What other factors can affect the real interest rate?

• An increase in the demand for business goods and services will cause the borrowing schedule in Exhibit 2.4 to shift to the right, thus increasing the real rate of interest. Other factors that can affect the real interest rate include increases in productivity, changes in technology, or changes in the corporate tax rate. Demographic factors, such as growth or age of the population, and cultural differences can also affect the real rate of interest.

How are brokers different from dealers?

• Broker: brings a seller and buyer together but does no buy or sell in the transaction ◦ Broker = NO RISK! • Dealer: participates in trades as a buyer or seller using his/her own inventory of securities ◦ Dealer = TAKES RISK

How do financial institutions act as intermediaries to provide services to small businesses?

• Financial intermediaries allow smaller companies to access the financial markets. They do this by converting securities with one set of characteristics into securities with another set of characteristics that meets the needs of smaller companies. By repackaging securities, they are able to meet the needs of different clients.

What are the two basic mechanisms through which funds flow through the financial system, and how do they differ?

• 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.

What is the relation between business cycles and the general level of interest rates?

• Interest rates tend to follow the business cycle • Interest rates tend to increase during an economic expansion • Interest rates tend to decrease during an economic contraction

Explain what the marketability of a security is and how it is determined.

• 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.

What are the major differences between public and private markets?

• Public markets are organized financial markets where the public buys and sells securities through their stockbrokers or other brokers or dealers. The SEC regulates public securities markets in the United States. • In contrast, private markets involve direct transactions between two parties. These transactions lack SEC regulation.

What is the difference between saver-lenders and borrower-spenders, and who are the major representatives of each group?

• 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 and the federal government.

List the three forms of the efficient market hypothesis, and describe what information is assumed to be reflected in security prices under each of these hypotheses.

• Strong-Form Efficiency ◦ Security prices reflect all information, both public and private ◦ Even inside information is reflected in prices • Semistrong-Form Efficiency ◦ Security prices always reflect all public information ◦ Inside, or confidential information, is not reflected in prices • Weak-Form Efficiency ◦ Security prices only reflect historical information

What is the Fisher equation, and how is it used?

• The Fisher equation is an equation that shows how the expected annualized change in prices (ΔPe) is related to the nominal and real rates of interest. It is used to determine the nominal rate that protects the buying power of a lender's money from changes in inflation. It is also used to determine the interest rate, by subtracting ΔPe from the nominal interest rate, that would exist in the absence of inflation.

What is the real rate of interest, and how is it determined?

• The real rate of interest measures the return earned on savings, and it represents the cost of borrowing to finance capital goods. The real rate of interest is determined by the interaction between firms that invest in capital projects and the rate of return they expect to earn on those investments, and individuals' time preference for consumption. The real rate of interest is determined when the desired level of savings equals the desired level of investments in the economy.

Describe the informational differences that distinguish the three forms of market efficiency.

• The strong-form of market efficiency states that all information is reflected in the security's price. In other words, there is no private or inside information that, if released, would potentially change the price. • The semistrong-form of market efficiency holds that all public information available to investors is reflected in the security's price. Therefore, insiders with access to private information could potentially profit from trading on this information before it becomes public. • The weak-form of market efficiency holds that there is both public and private information that is not reflected in the security's price and having access to it can enable an investor to earn abnormal profits.

What does it mean to "underwrite" a new security issue? What compensation does an investment banker get from underwriting a security issue?

• 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.

Trader Inc. is a $300 million company, as measured by asset value, and Horst Corp. is a $35 million company. Both are privately held corporations. Explain which firm is more likely to go public and register with the SEC, and why.

• Trader, Inc., is more likely to go public because of its larger size. Though the cost of SEC registration and compliance is very high, larger firms can offset these costs by the lower funding cost in public markets. Smaller companies find the cost prohibitive for the dollar amount of securities they are likely to sell.

If the market is strong-form efficient, then trading on tips you hear from Jim Cramer (the host of Mad Money on CNBC) will generate no excess returns (i.e., returns in excess of fair compensation for the risk you are bearing). True or False?

• True. If the market is strong-form efficient then all new information gets reflected in stock prices very quickly. In such a market there is nothing you will hear from Jim Cramer on his TV show that will enable you to consistently earn excess returns. The information in his tips will already be reflected in stock prices by the time you can trade on them.

Your parents gave you $1,000 a year before your graduation date 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 inflation for the year is predicted to be 4 percent. Will you have enough money in a year to purchase the trip?

• Yes. The CD will be worth $1,067.50 at the end of the year, and the price of the trip will be $1,066. ◦ To gave enough money to purchase the trip: ‣ CD value in 1 year > Cost of the trip in 1 year • CD Value in 1 year ◦ Interest earned = $1000 x 0.0675 = $67.50 ‣ CD value = 1000 + 67.50 = $1067.50 ‣ Trip Cost in 1 year • Prince increase = Trip costs x Inflation percent ◦ 1025 x 0.04 = $41.00 ‣ Cost in 1 year = 1025 + 41 = $1066 ◦ 1067.50 > 1066

In Problem 2.20, if the market is efficient, would it have been possible for Zippy's stock price to go down in the day that the firm announced the strong fourth quarter results?

• Yes. The last sentence in the Problem 2.20 problem statement suggests why this might happen. If, on the same day of the announcement, some very bad news about the future prospects for Zippy became public or if the market went down substantially, Zippy's stock price might also have gone down despite the positive sales and earnings announcement.

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?

• 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 2.75 percent. This means that $13.75 will be a result of the real interest rate ($500 × 1.0275).

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?

• Your security is marketable, but not liquid. Liquidity implies that when a security is sold, its value will be preserved; marketability does not.

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?

• r = (1+0.0425) / (1 + 0.0175) - 1 ◦ r = 2.46%