Chapter 2: Overview of the Financial System

Question 1

Adverse Selection

Answer 1

The problem created by asymmetric information before a transaction occurs: the people who are the most undesirable from the other party’s point of view are the ones who are most likely to want to engage in the financial transaction.

Question 2

Asset Transformation

Answer 2

The process by which financial intermediaries turn risky assets into safer assets for investors by creating and selling assets with risk characteristics that people are comfortable with and then use the funds they acquire by selling these assets to purchase other assets that may have far more risk.

Question 3

Assymetric Information

Answer 3

The inequality of knowledge that each party to a transaction has about the other party.

Question 4

Capital

Answer 4

Wealth, either financial or physical, that is employed to produce more wealth.

Question 5

Capital Market

Answer 5

Wealth, either financial or physical, that is employed to produce more wealth.

Question 6

Eurobond

Answer 6

Bonds denominated in a currency other than that of the country in which they are sold.

Question 7

Eurocurrencies

Answer 7

Foreign currencies deposited in banks outside the home country.

Question 8

Eurodollars

Answer 8

U.S. dollars that are deposited in foreign banks outside of the United States or in foreign branches of U.S. banks.

Question 9

Intermediate Term

Answer 9

With reference to a debt instrument, having a maturity of between one and 10 years.

Question 10

Investment Bank

Answer 10

Firms that assist in the initial sale of securities in the primary market.

Question 11

Long Term

Answer 11

With reference to a debt instrument, having a maturity of 10 years or more.

Question 12

Money Market

Answer 12

A financial market in which only short-term debt instruments (maturity of less than one year) are traded.

Question 13

Over-the-Counter (OTC) Market

Answer 13

A secondary market in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities to anyone who comes to them and is willing to accept their prices.

Question 14

Thrift Institutions

Answer 14

Savings and loan associations, mutual savings banks, and credit unions.

Question 15

Underwriting

Answer 15

Investment banks that guarantee prices on securities to corporations and then sell the securities to the public.

Question 16

3. Simple Present Value

Answer 16

Question 17

3. Fixed Payment Loan

Answer 17

Question 18

3. Coupon Bond

Answer 18

Question 19

3. Perpetuity/Consol

Answer 19

Question 20

3. Discount Bond

Answer 20

Question 21

3. Fisher Equation

Answer 21

Question 22

3. Yield to Maturity

Answer 22

The interest rate that equates the present value of payments received from a credit market instrument with its value today.

Question 23

3. Rate of Return

Answer 23

The payments to the owner of a security plus the change in the security’s value, expressed as a fraction of its purchase price.

Question 24

3: Return

Answer 24

Question 25

3: Rate of Captal Gain

Answer 25

The change in a security’s price relative to the initial purchase price.

Question 26

3. Calculating Duration

Answer 26

Question 27

3. Interest-Rate Risk

Answer 27

The possible reduction in returns that is associated with changes in interest rates. Long term bonds have a higher interest-rate risk than short term bonds.

Question 28

3. Reinvestment Risk

Answer 28

The interest-rate risk associated with the fact that the proceeds of short-term investments must be reinvested at a future interest rate that is uncertain.

Question 29

3. Duration and Interest-Rate Risk

Answer 29

Question 30

3. Porfolio Duration

Answer 30

Question 31

4. Expected Returns

Answer 31

Question 32

4. Standard Deviation of Rate of Return on Assets

Answer 32

Question 33

4: Factors that Affect Demand for Bonds

Answer 33

Question 34

4: Factors that Affect Supply for Bonds

Answer 34

Question 35

4: The Fisher Effect

Answer 35

The outcome that when expected inflation occurs, interest rates will rise.

Question 36

5: Three Factors of Risk Premium

Answer 36

Question 37

5: Expectations Theory

Answer 37

Question 38

5: Market Segmentation Theory

Answer 38

A theory of the term structure that sees markets for differentmaturity bonds as completely separated and segmented such that the interest rate for bonds of a given maturity is determined solely by supply and demand for bonds of that maturity.

Question 39

5: Liquidity Premium Theory

Answer 39

Question 40

5: Forward Rate

Answer 40

Question 41

5: Spot Rate

Answer 41

The interest rate at a given moment.

Question 42

6: Efficient Market Hypothesis

Answer 42

Question 43

6: Short Selling

Answer 43

An arrangement with a broker to borrow and sell securities. The borrowed securities are replaced with securities purchased later. Short sales let investors earn profits from falling securities prices

Question 44

6: Evidence Against the Efficient Market Hypothesis

Answer 44

Question 45

7: Principle Agent Problem

Answer 45

The managers in control (the agents) act in their own interest rather than in the interest of the owners (the principals) due to differing sets of incentives.

Question 46

7: 8 Facts/Consequences of Financial Markets

Answer 46

1. Stocks are not the most important source of external financing.
2. Marketable securities are not the primary source of finance.
3. Indirect finance is more important than direct finance.
4. Banks are the most important source of external funds.
5. The financial system is heavily regulated.
6. Only large, well-established firms have access to securities markets.
7. Collateral is prevalent in debt contracts.
8. Debt contracts have numerous restrictive covenants.

Question 47

7: Solutions for the Adverse Selection Problem

Answer 47

Question 48

7: Spinning

Answer 48

When an investment bank allocates hot, but underpriced, initial public offerings (IPOs), shares of newly issued stock, to executives of other companies in return for their companies’ future business with the investment banks.

Question 49

4.1: Discrete and Continuous Mean for a Random Variable

Answer 49