Chapters 2: The Financial Market Environment

Question 1

Commercial Banks

Answer 1

Institutions that provide savers with a secure place to invest their funds and that offer loans to individual and business borrowers.

Question 2

Investment Bank

Answer 2

Institutions that assist companies in raising capital, advise firms on major transactions such as mergers or financial restructurings, and engage in trading and market making activities.

Question 3

Shadow Banking System

Answer 3

A group of institutions that engage in lending activities, much like traditional banks, but do not accept deposits and therefore are not subject to the same regulations as traditional banks.

Question 4

Financial Markets

Answer 4

Forums in which suppliers and demanders of funds can transact business directly.

Question 5

Private Placement

Answer 5

The sale of new security directly to an investor or group of investors.

Question 6

Public Offering

Answer 6

The sale of either bonds or stocks to the general public.

Question 7

Primary Market

Answer 7

Financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction.

Question 8

Secondary Market

Answer 8

Financial market in which preowned securities (those that are not new issues) are traded.

Question 9

Money Market

Answer 9

A financial relationship created between suppliers and demanders of short term funds.

Question 10

Marketable Securities

Answer 10

Short-term debt instruments, such as US Treasury Bills, commercial paper, and negotiable certificates of deposit issued by the government, business, and financial institutions, respectively.

Question 11

Capital Market

Answer 11

A market that enables suppliers and demanders of long-term fund to make transactions.

Question 12

Bond

Answer 12

Long-term debt instrument used by business and government to raise large sums of money, generally from a diverse group of lenders.

Question 13

Preferred Stock

Answer 13

A special form of ownership having a fixed periodic dividend that must be paid prior to payment of any dividends to common stock holders.

Question 14

Broker Market

Answer 14

The securities exchanges on which two sides of a transaction, the buyer and seller, are brought together to trade securities.

Question 15

Securities Exchanges

Answer 15

Organizations that provide the marketplace in which firms can raise funds through the sale of new securities and purchasers can resell securities.

Question 16

Dealer Market

Answer 16

The market in which the buyer and seller are not brought together directly but instead have their orders executed by securities dealers that “make markets” in the given security.

Question 17

Market Makers

Answer 17

Securities dealers who “make markets” by offering to buy or sell certain securities at stated prices.

Question 18

Nasdaq Market

Answer 18

An all-electronic trading platform used to execute securities trades.

Question 19

Over-The-Counter Market

Answer 19

Market where smaller, unlisted securities are traded.

Question 20

Bid Price

Answer 20

The highest price offered to purchase a security.

Question 21

Ask Price

Answer 21

The lowest price at which a security is offered for sale.

Question 22

Efficient Market

Answer 22

Establishes correct prices for the securities that firms sell and allocates funds to their most productive uses.

Question 23

Securitization

Answer 23

The process of pooling mortgages or other types of loans and selling claims or securities against that pool in the secondary market.

Question 24

Mortgage-Backed Securities

Answer 24

Represent claims on the cash flows generated by a pool of mortgages.

Question 25

Marginal Tax Rate

Answer 25

The rate at which additional income is taxed.

Question 26

Average Tax Rate

Answer 26

A firm’s taxes divided by its taxable income.

Question 27

Double Taxation

Answer 27

Situation that occurs when after-tax corporate earnings are distributed as cash dividends to stockholders, who then must pay personal taxes on the dividend aount.

Question 28

Capital Gain

Answer 28

The amount by which the sale price of an asset exceeds the asset’s purchase price.

Question 29

Financial Institution

Answer 29

An intermediary that channels the savings of individuals, businesses, and governments into loans or investments.

Question 30

Understand the role that financial institutions play in managerial finance.

Answer 30

Financial institutions bring net suppliers of funds and net demanders together to help translate the savings of individuals, businesses, and governments into loans and other types of investments.
The net suppliers of funds are generally individuals or households who save more money than they borrow. Businesses and governments are generally net demanders of funds, meaning that they borrow more then they save.

Question 31

Contrast the functions of financial institutions and financial markets.

Answer 31

Both financial institutions and financial markets help markets businesses raise the money that they need to fund new investments for growth. Financial institutions collect the savings of individuals and channel those funds to borrows such as businesses and governments. Financial markets provide a forum in which savers and borrowers can transact business directly.
Businesses and governments issue debt and equity to securities directly to the public in the primary market. Subsequently trading of these securities between investors occurs in the secondary market.

Question 32

Describe the differences between the capital markets and the money markets.

Answer 32

In the money market, savers who want a temporary place to deposit funds where they can earn interest interact with borrowers who have short term need for funds. Marketable securities, including treasury bills, commercial paper, and other instruments, are the primary securities traded in the money market.
In contrast the capital market is the forum in which savers and borrowers interact on a long term basis. Firms issue debt (Bonds) or equity (Stock) securities in the capital market. Once issued, these securities trade on a secondary markets that are either broker markets or dealer markets.
An important function of the capital market is to determine the underlying value of the securities issued by businesses.

Question 33

Explain the root causes of the 2008 financial crisis and recession.

Answer 33

The financial crisis was caused by several factors related to investments in real estate. Financial institutions lowered their standards for lending to prospective homeowners, institutions also invested heavily in mortgage backed securities.
When home prices fell and mortgage delinquencies rose, the value of the mortgage backed securities held by banks plummeted, causing some banks to fail and many others to restrict the flow of credit to business. That in turn, contributed to the severe recession in the USA and abroad.

Question 34

Gramm Leach Bliley Act 1999.

Answer 34

An act that allows business combinations (that is, mergers) between commercial banks and investment banks, and insurance companies and thus permit these institutions to compete in markets that prior regulations prohibited them from entering.

Question 35

Securities Act of 1933.

Answer 35

An act that regulates the sale of securities to the public via the primary market

Question 36

Securities exchange act of 1934.

Answer 36

An act that regulates the trading of securities such as stocks and bonds in the secondary market.

Question 37

Securities and exchange commission (SEC)

Answer 37

The primary government agency responsible for enforcing federal securities laws.

Question 38

The Glass Steagall Act.

Answer 38

Imposed the separation between commercial and investment banks. The act was designed to limit the risks that banks could take and to protect depositors.

Question 39

Discuss Business taxes and their importance in financial decisions.

Answer 39

Corporate income is subject to corporate taxes. Corporate tax rates apply to both ordinary income (after deduction of allowable expenses) and capital gains. The average tax rate paid by a corporation ranges from 15 to 35 percent.

Corporate taxpayers can reduce their taxes through certain provisions in the tax code: dividend income exclusions and tax deductible expenses.

A capital gain occurs when an asset is sold for more then its initial purchase price; gains are added to ordinary corporate income and taxed at regular corporate tax rates. (For convenience, we assume a 40 percent marginal tax rate throughout.)