EoCB_ch2_B4 uGo Flashcards
Section 2.1
1. What critical economic role does the financial system play in the economy?
The financial system is in place to gather money from people and businesses and then channel these funds to those who need it. An efficient financial system is essential for a healthy economy. The major players in the U.S. financial system are big institutions such as the New York Stock Exchange, Citigroup, or State Farm Insurance.
Section 2.1
2. What are the two basic ways in which funds flow through the financial system from lender–savers to borrower–spenders?
The financial markets where direct transactions take place are wholesale markets with a typical minimum transaction size of $1 million. Major buyers and sellers of securities in direct financial markets include commercial banks, large corporations, the federal government, hedge funds, and some wealthy individuals.
Section 2.2
1. Why is it difficult for individuals to participate in the direct financial markets?
The financial markets where direct transactions take place are wholesale markets with a typical minimum transaction size of $1 million. Major buyers and sellers of securities in direct financial markets include commercial banks, large corporations, the federal government, hedge funds, and some wealthy individuals.
Section 2.2
2. Why might a firm prefer to have a security issue underwritten by an investment banking firm?
In the most common type of underwriting arrangement, called firm-commitment underwriting, the investment banker assumes the risk of buying the new securities from the issuing company and reselling them to investors. The investment banker guarantees to buy the entire security issue from the company at a fixed price.
Section 2.3
1. What is the difference between primary and secondary markets?
Primary markets are markets where new securities are sold for the first time. Secondary markets are where the owners of outstanding securities can sell them to other investors. They provide the means for investors to sell their securities and get cash.
Section 2.3
2. How and why do large business firms use money markets?
Large businesses use money markets to adjust their liquidity positions. If a firm has idle cash sitting around, it can invest it in negotiable CDs, Treasury bills, or other money market instruments. On the other hand, if a company has a temporary cash shortage, it can borrow in the money markets by selling commercial paper at lower interest rates than it could borrow through a commercial bank.
Section 2.3
3. What are capital markets, and why are they important to corporations?
Capital markets refer to the segment of the marketplace where capital goods are financed with long-term debt or equities. The most important capital market instruments are common stocks and corporate bonds. Capital markets are important to corporations because they allow them to obtain necessary financing.
Section 2.4
1. How does information about a firm’s prospects get reflected in its share price?
Investors act upon the expectations of a firm’s prospects through trading of the securities. The buying and selling then causes the price of the security to reflect their assessment of its value.
Section 2.4
2. What is strong-form market efficiency? Semistrong-form market efficiency? Weak-form market efficiency?
Strong-form market efficiency is a market in which all information, private and public, is reflected in the price of the security. The semistrong-form of market efficiency suggests that only public information is reflected in a security’s price, while the weak-form of market efficiency holds that only information contained in the past price of a security is reflected in its current price (it does not reflect public or private information).
Section 2.5
1. What is financial intermediation, and why is it important?
Financial intermediation is the process of converting financial securities with one set of characteristics into securities with another set of characteristics. For example, commercial banks use consumer CD deposits to make loans to small businesses.
Section 2.5
2. What are some services that commercial banks provide to businesses?
Commercial banks are the largest financial intermediaries in the economy and offer the widest range of financial services to businesses. Nearly every business has a significant relationship with a commercial bank – usually a checking or transaction account and some type of credit or loan arrangement. In addition, banks do a significant amount of equipment lease financing.
Section 2.5
3. What is an IPO, and what role does an investment banker play in the process?
Investment bankers specialize in helping firms to sell their new debt or equity issues in financial markets. In an initial public offering (IPO), the investment banker prepares the new issue for sale and then underwrites the deal. Other functions of the investment banker in an IPO process include preparing the prospectus, registering the documentation with the SEC, and providing general financial advice to the issuer.
Section 2.6
1. Explain how the real rate of interest is determined.
The real rate of interest depends on interaction between the rate of return that businesses can expect to earn on investments in capital goods and savers’ time preference for consumption today versus willingness to save. Therefore, the real rate of interest is determined when the desired saving level equals the desired level of investment.
Section 2.6
2. How are inflationary expectations accounted for in the nominal rate of interest?
The nominal interest rate is the rate that is actually observed in the financial markets, and it is equal to the real interest rate plus the expected annualized changes in commodity prices, or inflation premium. This is commonly referred to as the Fisher effect.
Section 2.6
3. Explain why interest rates follow the business cycle.
Interest rates tend to follow the business cycle to rise during economic expansion and decline during recession. On the one hand, during an expansion, there is upward pressure on interest rates as businesses begin to grow and borrow more money. On the other hand, during a recession, the demand for goods and services is lower, businesses borrow less, and as a result the economy slows down and the interest rates decline. Typically, the Fed also loosens credit to stimulate the economy, which puts further downward pressure on the interest rates.
