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Market analysis- 220 > chapter 9 book: an economic analysis of financial future > Flashcards

chapter 9 book: an economic analysis of financial future Flashcards

1
Q

eight basic facts that we need to explain in order to understand how the financial system works

A
  1. Stocks are not the most important source of external financing for businesses
  2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
  3. Indirect finance is many times more important than direct finance
  4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses
  5. The financial system is among the most heavily regulated sectors of the economy
  6. Only large, well-established corporations have easy access to securities markets to finance their activities
  7. Collateral is a prevalent feature of debt contracts for both households and businesses
  8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower
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2
Q

indirect finance

A

involves the activities of financial intermediaries

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3
Q

direct finance

A

businesses raise funds directly from lenders in financial markets

involves the sale to households of marketable securities such as stocks and bonds

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4
Q

the most important source to finance business

A

Financial intermediaries

particularly banks

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5
Q

the role of financial intermediaries is more important in industrialized or countries industrializing?

A

countries industrializing

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6
Q

why do governments regulate financial markets?

A

to promote the provision of information

to ensure the stability of the financial system

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7
Q

collateral

A

property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments

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8
Q

secured debt

A

Collateralized debt

predominant form of household debt

is widely used in business borrowing as well

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9
Q

unsecured debt

A

not collateralized

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10
Q

restrictive covenants

A

provisions on bond or loan contracts (debt contracts)

restrict and specify certain activities that the borrower can engage in

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11
Q

how transactions costs are wack if you have almost no funds available

A

Because you have only a small amount of funds available, you can make only a restricted number of investments

a large number of small transactions would result in very high transaction costs.

That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk

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12
Q

solutions to transaction costs

A

bundle the funds of many investors together so that they can take advantage of economies of scale

expertise

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13
Q

economies of scale

A

the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases

reduces transaction costs for each individual investor

also important in lowering the costs of things such as computer technology that financial institutions need to accomplish their tasks

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14
Q

The clearest example of a financial intermediary that arose because of economies of scale

A

A mutual fund

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15
Q

A mutual fund

A

a financial intermediary that sells shares to individuals

invests the proceeds in bonds or stocks

take advantage of lower transaction costs

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16
Q

benefits of financial intermediaries expertise

A

expertise lowers transaction costs

provides its customers with liquidity services

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17
Q

liquidity services

A

services that make it easier for customers to conduct transaction

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18
Q

Asymmetric information

A

one party s having insufficient knowledge about the other party involved in a transaction to make accurate decisions

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19
Q

Adverse selection

A

asymmetric information problem that occurs before the transaction occurs

the parties who are the most likely to produce an undesirable outcome are the ones most likely to want to engage in the transaction

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20
Q

Moral hazard

A

arises after the transaction occurs

the lender runs the risk that the borrower will engage in activities that are undesirable from the lender s point of view because they make it less likely that the loan will be paid back

lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan

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21
Q

agency theory

A

The analysis of how asymmetric information problems affect economic behaviour

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22
Q

why marketable securities are not the primary source of financing for businesses and why are stocks not the most important source of financing for Canadian businesses?

A

The presence of the lemons problem

stock and bond markets far from being effective in channelling funds from savers to borrower

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23
Q

what makes the lemon problem go away?

A

the absence of asymmetric information

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24
Q

The solution to the adverse selection problem in financial markets

A

to eliminate asymmetric information by furnishing people supplying funds with full details about the individuals or firms seeking to finance their investment activities

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25
Q

free-rider problem

A

occurs when people who do not pay for information take advantage of the information that other people have paid for

suggests that the private sale of information will be only a partial solution to the lemons problem

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26
Q

independent audits

A

In Canada, government regulation exists that requires firms selling securities to have independent audits

accounting firms certify that the firm adheres to standard accounting principles and discloses information about sales, assets, and earnings

27
Q

what explains why financial markets are among the most heavily regulated sectors in the economy (fact 5)?

A

The asymmetric information problem of adverse selection in financial markets

28
Q

the role of financial intermediaries to combat adverse selection and asymmetric information

A

financial intermediary such as a bank becomes an expert in producing information about firms

it can sort out good credit risks from bad ones

it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market

29
Q

facts 3 and 4: why indirect finance is so much more important than direct finance and why banks are the most important source of external funds for financing businesses?

A

financial intermediary such as a bank becomes an expert in producing information about firms

it can sort out good credit risks from bad ones

it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market

30
Q

why are large firms more likely to obtain funds from securities markets, a direct route, rather than from banks and financial intermediaries, an indirect route? (fact 6)

A

improvements in information technology

lending role of financial institutions such as banks have declined

The better known a corporation is, the more information about its activities is available in the marketplace

easier for investors to evaluate the quality of the corporation and determine whether it is a good firm or a bad one

31
Q

why is collateral an important feature of debt contracts (fact 7)?

A

Adverse selection interferes with the functioning of financial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults

Collateral reduces the consequences of adverse selection because it reduces the lender s losses in the event of a default

32
Q

Net worth (also called equity capital)

A

the difference between a firm’s assets and its liabilities

can perform a similar role to collateral

33
Q

Equity contracts

A

such as common stock

claims to a share in the profits and assets of a business

34
Q

the principal agent problem

A

moral hazard that affects equity contracts

separation of ownership between stockholders and managers

managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals)

35
Q

why does the the principal agent problem arise?

A

because managers have more information about their activities and actual profits than stockholders do

36
Q

costly state verification

A

auditing the firm frequently and checking on what the management is doing

goal is to reduce moral hazard problems by engaging in a particular type of information production and monitoring of the firm’s activities

this shit is costly to do and makes the equity contract less desirable

37
Q

One financial intermediary that helps reduce the moral hazard arising from the principal agent problem

A

venture capital firm

38
Q

venture capital firm

A

pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses

does not allow stock traders to free ride

they let their own people monitor stuff

39
Q

a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals

A

debt contract

40
Q

benefits of a debt contract to the lender when it comes to moral hazard

A

they don’t really care as long as the firm can make the payments they owe

it is less risky than being a shareholder

they have priority in receiving their share of funds

41
Q

when is the risk of moral hazard or the temptation of do some dumb shit greatly reduced as a borrower?

A

When borrowers have more at stake because their net worth in the business or the collateral they have pledged to the lender is high

they have a lot to lose

42
Q

incentive-compatible debt contract

A

it aligns the incentives of the borrower with those of the lender

including collaterals

43
Q

four types of restrictive covenants that achieve moral hazard reduction

A

Covenants to discourage undesirable behaviour

Covenants to encourage desirable behaviour

Covenants to keep collateral valuable

Covenants to provide information about its activities periodically in the form of quarterly financial statements

44
Q

problems with restrictive covenants?

A

they will never be 100% effective

they must be monitored and enforced

45
Q

which tools solve adverse selection and which fact do they explain?

List of facts:

  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 easy access to securities markets.
  7. Collateral is prevalent in debt contracts.
  8. Debt contracts have numerous restrictive covenants.
A

Private production and sale of information (facts 1 and 2)

Government regulation to increase information (fact 5)

Financial intermediation (facts 3,4 and 6)

Collateral and net worth (fact 7)

46
Q

which tools solve Moral hazard in equity contracts (principal agent problem) and which fact do they explain?

List of facts:

  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 easy access to securities markets.
  7. Collateral is prevalent in debt contracts.
  8. Debt contracts have numerous restrictive covenants.
A

Production of information: monitoring (fact 1)

Government regulation to increase information (fact 5)

Financial intermediation (fact 3)

Debt contracts (fact 1)

47
Q

which tools solve Moral hazard in debt contracts and which fact do they explain?

List of facts

  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 easy access to securities markets.
  7. Collateral is prevalent in debt contracts.
  8. Debt contracts have numerous restrictive covenants.
A

Net worth and collateral (fact 7

Monitoring and enforcement of restrictive covenants (fact 8)

Financial intermediation (facts 3 and 4)

48
Q

financial repression

A

many developing countries or ex-communist countries experiencing very low rates of growth because their financial systems are underdeveloped

49
Q

state owned banks

A

bank owned by their government

in many developing and transition countries, there is absence of profit motive

50
Q

how can financial institutions obtain economies of scope? how will it be beneficial to these institutions?

A

By providing multiple financial services to their customers

they can lower the cost of information production for each service by applying one information resource to many different services

51
Q

downsides of economies of scope made from financial institutions

A

it also creates potential costs in terms of conflicts of interests

The potentially competing interests of those services may lead an individual or firm to conceal information or disseminate misleading information

52
Q

Why Do We Care About Conflicts of Interest?

A

because a substantial reduction in the quality of information in financial markets increases asymmetric information problems

prevents financial markets from channelling funds into productive investment opportunities

financial markets and the economy become less efficient

53
Q

which types of financial service activities have led to prominent conflict-of-interest problems in financial markets in recent years

A

underwriting and research in investment banks

auditing and consulting in accounting firms

credit assessment and consulting in credit-rating agencies

54
Q

the two tasks performed by investment banks

A

They research companies issuing securities

they underwrite these securities by selling them to the public on behalf of the issuing corporations

55
Q

why does underwriting and research in investment banks lead to conflicts of interest?

A

A conflict of interest arises between the brokerage and underwriting services the banks want serve the security-issuing firms and the security-buying investors at the same time

these have difference information needs but often get the same info

Issuers benefit from optimistic research, whereas investors desire unbiased research

also, there is Spinning

56
Q

Spinning

A

occurs when an investment bank allocates hot, but underpriced, initial public offerings (IPOs) to executives of other companies in return for their companies future business with the investment bank

is a form of kickback meant to persuade executives to use that investment bank because hot IPOs typically immediately rise in price after they are first purchased

57
Q

initial public offerings (IPOs)

A

shares of newly issued stock

58
Q

when does auditing arise in conflicts of interest? why?

A

when an accounting firm provides its client with both auditing services and non-audit consulting services

auditors may be willing to skew their judgements and opinions to win consulting business from these same clients

auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts within the firm,

these may be not down to criticize the systems or advice

59
Q

how can credit ratings give rise to conflicts of interests?

A

when multiple users with divergent interests depend on the credit ratings

investors and regulators worry that the agency may bias its ratings upward to attract more business from the issuer

60
Q

how can credit ratings AGENCIES give rise to conflicts of interests?

A

conflict of interest may arise when credit-rating agencies also provide ancillary consulting services

if debt issuers often ask rating agencies to advise them on how to structure their debt issues, the credit-rating agencies would experience a conflict of interest similar to the one found in accounting firms that provide both auditing and consulting services

the credit-rating agencies would be audit- ing their own work

61
Q

Two major policy measures implemented in the United States to deal with conflicts of interest

A

the Sarbanes-Oxley Act

the Global Legal Settlement

62
Q

the Sarbanes-Oxley Act

A

This act increased supervisory oversight to monitor and prevent conflicts of interest

established a Public Company Accounting Oversight Board (PCAOB) to supervise accounting firms and ensure that audits are independent and controlled for quality

increased the SEC s budget to supervise securities markets

beefed up criminal charges for white-collar crime and obstruction of official investigations

CEOs, CFOs, and auditors must certify the accuracy of periodic financial statements and disclosures of the firm

members of the audit committee cannot be managers in the company or receive any consulting or advisory fee from the company

63
Q

GLOBAL LEGAL SETTLEMENT OF 2002

A

this settlement directly reduced conflicts of interest

It required investment banks to sever the links between research and securities underwriting

It banned spinning

It required investment banks to make their analysts recommendations public

Market analysis- 220 (41 decks)

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