Chapter 2 Flashcards
Capital Markets
All institutions and procedures that facilitate transactions in long-term financial institutions.
-all the financial institutions that help a business raise long-term capital.
Saving-surplus units
Those who spend less money than they take in.
Savings-deficit units
those who have a need for additional funding.
Direct Transfer of Funds
The firm seeking cash sells its securities directly to savers (investors) who are willing to purchase them in hopes of earning a large return.
Angel Investor
a wealthy private investor who provides capital for a business start-up.
Venture Capitalist
an investment firm (or individual investor) that provides money to business start-ups.
Indirect Transfer using an Investment-baking Firm
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Indirect Transfer using the Financial Intermediary
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Public Offering
a security offering where all investors have the opportunity to acquire a portion of the financial claims being sold.
Private Placement
a security offering limited to a small number of potential investors.
Primary Market
a market in which securities are offered for the first time for sale to potential investors.
Initial Public Offering (IPO)
the first time a company issues its stock to the public.
Seasoned Equity Offering (SEO)
the sale of additional stock by a company whose shares are already publicly traded.
(also called a secondary share offering)
Secondary Market
a market in which currently outstanding securities are traded.
Money Market
all institutions and procedures that facilitate transactions for short-term instruments issued by borrowers with very high credit ratings.
Spot Market
Cash market
Futures Markets
Markets where you can buy or sell something at a future date.
Organized Security Exchanges
formal organizations that facilitate the trading of securities.
Over-the-counter Markets
all security markets except organized exchanges. The money market is an over-the-counter market. Most corporate bonds also are traded in the over-the-counter market.
Investment Banker
A financial specialist who underwrites and distributes new securities and advises corporate clients about raising new funds.
Underwriting
the purchase and subsequent resale of a new security issue. The risk of selling the new issue at a satisfactory (profitable) price is assumed (underwritten) by the investment banker.
Underwriter’s spread
the difference between the price the corporation raising money gets and the public offering price of a security.
Syndicate
a group of investment bankers who contractually assist in the buying and selling of a new security issue.
Privileged Subscription
the process of marketing a new security issue to a select group of investors.
Dutch Auction
a method of issuing securities (common stock) by which investors place bids indicating how many shares they are willing to buy and at what price. The price the stock is then sold for becomes the lowest price at which the issuing company can sell all the available shares.
Flotation Costs
the transaction cost incurred when a firm raises funds by issuing a particular type of security.
Opportunity cost of funds
the next-best rate of return available to the investor for a given level of risk.
Nominal (or quoted) Rate of Interest
the interest rate paid on debt securities without an adjustment for any loss in purchasing power.
Inflation Premium
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
the additional return required by investors to compensate them for the risk of default. It is calculated as the difference in rates between a U.S. Treasury bond and a corporate bond of the same maturity and marketability.
Maturity-Risk Premium
the additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuations on those securities caused by interest rate changes.
Liquidity-Risk Premium
the additional return required by investors for securities that cannot be quickly converted into cash at a reasonably predictable price.
Real Risk-Free Interest Rate
the required rate of return on a fixed-income security that has no risk in an economic environment of zero inflation.
Real Rate of Interest
the nominal (quoted) rate of interest less any loss in purchasing power of the dollar during the time of the investment.
Term Structure of Interest Rates
the relationship between interest rates and the term to maturity, where the risk of the default is held constant.
Yield to Maturity
the rate of return a bondholder will receive if the bond is held to maturity.
Unbiased Expectations Theory
the theory that the shape of the term structure of interest rates is determined by an investor’s expectations about future interest rates.
Liquidity Preference Theory
the theory that the shape of the term structure of interest rates is determined by an investor’s additional required interest rate in compensation for additional risks.
Market Segmentation Theory
the theory that the shape of the term structure of interest rates implies that the rate of interest for a particular maturity is determined solely by demand and supply for a given maturity. This rate is independent of the demand and supply for securities having different maturities.
Nominal Interest Rate=
=Real risk-free interest rate \+ inflation premium \+ default-risk premium \+ maturity-risk premium \+ liquidity-risk premium
Nominal Interest Rate (approximately equals=)
real rate of interest + inflation-risk premium
equation
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equations
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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
Individuals, corporations, and governments can be either savings deficit units or savings surplus units.
True or False
True
A corporation needing cash sells securities to investors in the secondary market.
True or False
False
Venture capitalists typically provide funds to high-risk startup companies but take no active role in their management.
True or False
False
Seasoned secondary offerings occur in the secondary market.
True or False
False
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
Transactions in common stock occur in the money market, due to the large amount of money involved in such transactions.
True or False
False
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
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
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
The term structure of interest rates usually indicates that longer terms to maturity have higher expected returns.
True or False
True
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
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.
Money market instruments include A) common stock. B) preferred stock. C) T-bonds. D) T-bills.
D) T-bills.
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.
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.
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.
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.
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.
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
When a company repurchases its own common stock, it is likely that
A) the stock price will increase because the company views the stock as undervalued.
B) the stock price will decrease because the company is creating artificial demand for its stock.
C) the stock price will remain the same as this is simply an internal transaction.
D) the board of directors will be fired for incompetence.
A) the stock price will increase because the company views the stock as undervalued.
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
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
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
The nominal interest rate is 7% and the expected inflation rate is 2%. Based on the Fisher effect, the exact real rate of interest is A) 5.0%. B) 6.86%. C) 5.1%. D) 4.9%.
D) 4.9%.
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.
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.
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.
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%.
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%
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.
Given the anticipated rate of inflation (i) of 1.7% and the real rate of interest (r) of 1.4%, find the exact nominal rate of interest (R). A) 2.98%. B) 3.59%. C) 3.12%. D) 1.23%.
C) 3.12%.
