Chapter 3 Financial Principles

Question 1

The desirability of one’s entire portfolio depends on what two factors?

Answer 1

its yield and its riskiness

Question 2

What are the three types of risk that a supplier of funds takes?

Answer 2

default risk, purchasing-power risk, interest-rate risk (market risk)

Question 3

the risk that a borrower will not repay a loan or make the required interest payments

Answer 3

default risk

Question 4

the risk that inflation will reduce the real value of a debt by more than what was expected

Answer 4

purchasing-power risk

Question 5

the risk that the value of a security will change due to a change in interest rates

Answer 5

interest-rate risk (market risk)

Question 6

combining assets (or assets and debts) that respond in opposite ways to certain risks, so that the combination is less risky than each of the assets individually

Answer 6

hedging

Question 7

claims that become effective only if a certain event occurs such as fire, life, and property claims

Answer 7

contingent claims

Question 8

the type of risk that can be eliminated by diversification of particular assets

Answer 8

diversifiable risk

Question 9

a risk you can not avoid by diversifying and buying many different stocks

Answer 9

undiversifiable risk

Question 10

to induce one to take on undiversifiable risk, the average yield on stocks must ____ the yield on, say, savings deposits

Answer 10

exceed

Question 11

a model of asset pricing that has the price of an asset depend on its expected return and its undiversifiable risk; this risk is measured by the beta coefficient (b) which shows how volatile the stock is relative to the average stock on the market

Answer 11

CAPM capital assets pricing model

Question 12

What entities are on the demand side of the market?

Answer 12

households, firms, and governments

Question 13

Households and governments can only obtain funds by borrowing. However, what is the second choice that firms have?

Answer 13

firms can issue equity

Question 14

What are the two ways that corporations can obtain equity capital?

Answer 14

1) issue equity; 2) through retained earnings

Question 15

when corporations do not distribute all the earnings to the stockholders and plough some of them back into the business
**in doing so, corporations are, in effect, “selling” additional equity to their stockholders, since the shares each stockholder owns are now more valuable

Answer 15

retained earnings

Question 16

this theorem asserts that, under certain circumstances, it makes no difference to the firm’s stockholders whether the firm finances itself by borrowing (bonds) or by selling stock (equity)

Answer 16

Modigliani-Miller theorem

Question 17

the theory that markets make efficient use of all the available information, so that asset prices are set at their equilibrium values

Answer 17

efficient-markets theory

Question 18

Which theory tells us that opportunities for excess profits, that is, profits in excess of the normal rate of return for the specific degree of risk, are quickly competed away?

Answer 18

efficient-markets theory

Question 19

the process of issuing securities backed by mortgages

Answer 19

securitization

Question 20

the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or collateralized mortgage obligation (CMOs), to various investors. (wikipedia.org)

Answer 20

securitization

Question 21

dividing the ownership rights of a security into parts (such as the right to obtain interest or dividends and the right to obtain any capital gains) that can be sold separately

Answer 21

stripping

Question 22

securities whose values are derived from the values of other securities that collateralize them; the term is sometimes used more broadly to denote exotic and risky financial instruments

Answer 22

derivatives

Question 23

an arrangement under which borrowers swap their loan liabilities; (ex: a firm may swap its liability under a fixed-rate loan for another firms liability under a variable-rate loan)

Answer 23

interest-rate swap(s)

Question 24

the problem created by one party to a contract knowing something that the other party does not

Answer 24

asymmetric information

Question 25

the hazard that results from a contract changing the behavior of one of the parties to it; (ex: insuring one’s car against theft reduces one’s incentive to lock the car)

Answer 25

moral hazard

Question 26

the idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal) (wikipedia.com)

Answer 26

signaling