EoCB_ch2_discussion_questions Flashcards
2.1 Explain why total financial assets in the economy must equal total financial liabilities.
Every financial asset must be financed with some type of a claim or liability. Since all of an economy’s financial assets are just a collection of the individual financial assets, then they should also sum to the collective claims on those assets in the economy.
2.2 Why don’t small businesses make greater use of the direct credit markets since these markets enable firms to finance their activities at a very low cost?
Direct credit markets are geared toward big, established companies since they are wholesale in nature and the minimum transaction size is far beyond the needs of a small business. Small businesses are better off borrowing money from financial intermediaries, such as commercial banks.
2.3 Explain the economic role of brokers and dealers. How does each make a profit?
Brokers and dealers play a similar economic role in that they both bring buyers and sellers of a commodity together in a market. However, brokers only facilitate a transaction by helping the two parties make a transaction and brokers are therefore only compensated for taking on that role. They bear no risk of ownership of securities during the transaction. Dealers on the other hand, take risk in that they will purchase (sell) a commodity from a seller (buyer) without another buyer (seller) necessarily being available. In other words, a dealer will take the risk of purchasing (selling) a commodity and will therefore be compensated for taking that risk.
2.4 Why were commercial banks prohibited from engaging in investment banking activities until 1999?
Banks had been barred from investment banking following the Great Depression because it was believed that these activities were too risky for banks. At the time, it was believed that excessive risk taking by banks had resulted in a large number of bank failures, which precipitated the Great Depression. Recent research has exonerated the banking system of this charge.
2.5 What are two basic services that investment banks provide in the economy?
Investment banks specialize in helping companies sell new debt or equity as well as provide other services such as broker and dealer services.
2.6 How do large corporations adjust their liquidity in the money markets?
Large corporations can take advantage of money markets to adjust for their liquidity by selling or buying short-term financial instruments such as commercial paper, CDs, or Treasury bills. Large corporations with cash surplus can invest in short-term securities, while corporations with cash shortfalls can sell securities or borrow funds on a short-term basis. Money market instruments have a maturity anywhere between one day and one year and therefore are very liquid and less risky than long-term debt.
2.7 The CFO of a certain company always wears his green suit on a day that the firm is about to release positive information about his company. You believe that you can profit from this information by buying the firm’s shares at the beginning of every day that the CFO shows up wearing this green suit. Describe which form of market efficiency is consistent with your belief.
You believe that the CFO’s decision to wear a green suit indicates that positive information will be announced and that the company’s stock price will increase following that announcement. If you are correct, knowing what the CFO is wearing before any announcement is valuable private information which should enable you to earn abnormally high returns. Therefore, your belief is consistent with the semistrong-form of market efficiency – according to which it is possible to earn abnormally high returns by trading on private information.
2.8 Shouldn’t the nominal rate of interest (Equation 2.1) be determined by the actual rate of inflation (∆Pa), which can be easily measured, rather than by the expected rate of inflation (∆Pe)?
The nominal rate of interest is a forward-looking measure, and therefore it makes sense that it is using the expected rate of inflation as opposed to the actual rate of inflation. The expected rate of inflation is the market’s best estimate of what the inflation rate will be in the future.
2.9 How does Exhibit 2.5 help explain why interest rates were so high during the early 1980s as compared to the relatively low interest rates in the early 1960s?
The nominal rate of interest is determined by the real rate of interest plus the expected rate of inflation, and during the 1980s, the U.S. economy experienced a very high rate of inflation and, thus, high interest rates. Looking at Exhibit 2.5, we can see that the inflation increased from less than 2 percent in the 1960s to almost 13 percent in the 1980s. This was a result of the monetary policy instituted by the U.S. government during this period of time.
2.10 When determining the real interest rate, what happens to businesses that find themselves with unfunded capital projects whose rate of return exceeds the cost of capital?
The real rate of interest reflects a complex set of forces that control the desired level of lending and borrowing in the economy. In this example, businesses are not investing in projects where the rate of return exceeds the cost of capital. This means that there is reduced demand for investment funds at the current real interest rate. This will remain so until either the real interest rate changes or until something changes for the firm such as introducing a new technology that will increase the rate of return on projects for the firm.
Sample Test Problems
2.1 What are the two basic mechanisms through which funds flow through the financial system, and how do they differ?
Solution: The two basic mechanisms are the direct financing mechanism and the indirect financing mechanism. In the direct financing mechanism, issuers of securities (borrower- spenders) sell the securities directly to investors (lender-savers). In the indirect financing mechanism, financial institutions aggregate money from lender-savers and make this capital available through loans to borrower-spenders.
Sample Test Problems
2.2 You just purchased a share of IBM stock on the New York Stock Exchange. What kind of transaction was this?
a. Primary market transaction.
b. Secondary market transaction.
c. Futures market transaction.
d. Private placement.
Solution: b. (The secondary market is the one in which owners of outstanding securities sell their securities to other investors.)
Sample Test Problems
2.3 How are brokers different from dealers?
Solution: Brokers bring buyers and sellers together. They execute a transaction for their client and are compensated with a commission fee. Brokers never own the securities being sold and therefore do not bear any risk of ownership.
In contrast, dealers purchase securities and sell them from an inventory that they own. Dealers profit if they are able to sell securities for a price greater than they paid for them. Because they own the securities, dealers face the risk that the prices of the securities in their inventory will fall below what they paid for those securities.
Sample Test Problems
2.4 List the three forms of the efficient market hypothesis, and describe what information is assumed to be reflected in security prices under each of these hypotheses.
1) Strong-Form Efficiency – all information is reflected in the security prices.
2) Semistrong-Form Efficiency – all public information is reflected in the security prices.
3) Weak-Form Efficiency – all information contained in past prices is reflected in security
prices.
Sample Test Problems
2.5 If the nominal rate of interest is 4.25 percent and the expected rate of inflation is 1.75 percent, what is the real rate of interest?
Using the Fisher equation:
i = r + ∆Pe + r ∆Pe where i = 0.0425 and ∆Pe = 0.0175 Solving for r, we get r = 0.02457, or 2.457%
