Chapter 13: The Basics of Finance

Question 1

Define ‘Financial market’.

Answer 1

A market in which people trade future claims on funds or goods.

Question 2

Define ‘Market for loanable funds’.

Answer 2

A market in which savers supply funds to those who want to borrow.

Question 3

Define ‘Savings’.

Answer 3

The portion of income that is not immediately spent on consumption of goods and services.

Question 4

Define ‘Investment’.

Answer 4

Spending on productive inputs, such as factories, machinery, and inventories.

Question 5

Define ‘Interest rate’.

Answer 5

The price of borrowing money for a specified period of time, expressed as a percentage per dollar borrowed and per unit of time.

Question 6

Define ‘Crowding out’.

Answer 6

The reduction in private borrowing caused by an increase in government borrowing.

Question 7

Define ‘Default’.

Answer 7

The failure of a borrower to pay back a loan according to the agreed-upon terms.

Question 8

Define ‘Risk-free rate’.

Answer 8

The interest rate at which money would be loaned if there were no risk of default; usually approximated by interest rates on government debt.

Question 9

Define ‘Financial system’.

Answer 9

The group of institutions that bring together savers, borrowers, investors, and insurers in a set of interconnected markets where people trade financial products.

Question 10

Define ‘Financial intermediaries’.

Answer 10

Institutions that channel funds from people who have them to people who want them.

Question 11

Define ‘Liquidity’.

Answer 11

A measure of how easily a particular asset can be converted quickly to cash without much loss of value.

Question 12

Define ‘Diversification’.

Answer 12

The process by which risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual.

Question 13

Define ‘Stock’.

Answer 13

A financial asset that represents partial ownership of a company.
Stockholders are entitles to receive a portion of a company’s profits, in the form of dividends, in proportion to the size of their ownership.

Question 14

Define ‘Dividend’.

Answer 14

A payment made periodically, typically quarterly or annually, to all shareholders of a company.

Question 15

Define ‘Loan’.

Answer 15

An agreement in which a lender gives money to a borrower in exchange for a promise to repay the amount loaned (principle) plus an agreed-upon amount in interest,

Question 16

Define ‘Bond’.

Answer 16

A form of debt that represents a promise by the bond issuer to repay the face value of the loan, at a specified maturity date, and to pay periodic interest at a specific percentage rate.

Question 17

Define ‘Derivative’.

Answer 17

An asset whose value is based on the value of another asset. The best example of a derivative is a futures contract.

Question 18

Define ‘Mutual fund’.

Answer 18

A portfolio of stocks and other assets, managed by a professional who makes decisions on behalf of clients.

Question 19

Define ‘Pension fund’.

Answer 19

A professionally managed portfolio of assets intended to provide an income to retirees.

Question 20

Define ‘Market (systemic) risk’.

Answer 20

Any risk that is broadly shared by the entire market or economy.

Question 21

Define ‘Idiosyncratic risk’.

Answer 21

Any risk that is unique to a particular company or asset.

Question 22

Define ‘Standard deviation’.

Answer 22

A measure of how spread out a set of numbers is.

Question 23

Define ‘Net present value (NPV)’.

Answer 23

A measure of the current value of a stream of cash flows expected in the future.

Question 24

Define ‘Efficient-market hypothesis’.

Answer 24

The idea that market prices always incorporate all available information, and therefore represent true value as correctly as possible.

Question 25

Define ‘Arbitrage’.

Answer 25

The process of taking advantage of market inefficiencies to earn profits.

Question 26

Define ‘Private savings’.

Answer 26

The savings of individuals or corporations within a country.

Question 27

Define ‘Public savings’.

Answer 27

The difference between government tax revenue and government spending.

Question 28

Define ‘National savings’.

Answer 28

The sum of the private savings of individuals and corporations plus the public savings of the government.

Question 29

Define ‘Closed economy’.

Answer 29

An economy that does not interact with other counties’ economies.

Question 30

Define ‘Open economy’.

Answer 30

An economy that interacts with other countries’ economies.

Question 31

Define ‘Net capital flow’.

Answer 31

The difference between capital inflows (investment financed by savings from another country) and capital outflows (domestic savings invested abroad).

Question 32

What are the 3 functions of a financial market?

Answer 32

1. Act as intermediaries between savers and borrowers
2. Provide the benefits of liquidity - having cash easily available
3. Help savers and borrowers diversify risk by providing funds to a big pool of borrowers

Question 33

The markets for loanable funds clears at a price where supply and demand meet. This price is known as the ___ ___.

Answer 33

Interest rate.

Question 34

What are some factors that affect the supply and demand for loanable funds?

Answer 34

• A key determinant of the supply curve for loanable funds is how much people decide to save.
• Many factors influence the demand curve for loanable funds, including the strength of capital flows within a country and the overall strength of an economy.

Question 35

What are the major types of financial assets?

Answer 35

Debt: Loan is most basic type. Bond is a loan that has been standardized into a more easily tradable and liquid asset; issued by corporations or governments, as a way to borrow large sums of money.
Equity: Ownership in a company, and the most common form of such ownership is stock.

Question 36

___ and ___ are liquid assets that are easily bought and sold in financial markets.

Answer 36

Stocks and bonds.

Question 37

What are the main institutions in financial markets?

Answer 37

Commercial banks and investment banks (provide liquidity to the financial markets themselves, by acting as market makers, helping companies to issue stocks and bonds (process known as underwriting).
Individual actors in the financial market have to operate through a proxy, such as mutual funds, pension funds, and life insurance policies.
Entrepreneurs and businessmen are also major players, as are speculators.

Question 38

In general, there is a direct relationship between risk and reward in the financial market. What are some examples?

Answer 38

Typically, the investment with the lowest risk and return are government bonds.
Stocks are considerably more risky with possibility of higher returns.

Question 39

A portfolio of assets can help diversify away ___ risk; a certain amount of ___ risk remains in all portfolios.

Answer 39

Idiosyncratic and market.

Question 40

In financial markets, what is the most commonly used method of measuring risk?

Answer 40

SD.

Question 41

What are arguments for and against the assumption that markets are efficient?

Answer 41

For: Expected movement of stock as a random walk.
Against: Some people simply have better info than others or a better ability to put all the complex pieces together to predict stock price.
Occasionally markets have certain info efficiencies that savvy investors, through arbitrage, can exploit to profit from the differences between prices in different markets.

Question 42

In a closed economy, one with no international trade, ___ equals ___.

Answer 42

Savings equals investment.