Question 1

Explain the main functions of the financial system

Accepted Answer

The three main functions of the financial system are to: 1. Allow entities to save, borrow, issue equity capital, manage risks, exchange assets, and utilize information 2. Determine the return that equates aggregate savings and borrowing 3. Allocate capital efficiently

Question 2

Describe classifications of assets and markets

Accepted Answer

Assets and markets can be classified as: financial assets (e.g. securities, currencies, derivatives) verus real assets (e.g. real estate, equipment) debt securities versus equity securities public serucrities that trade on exchanges or through dealers versus private securities physical derivative contracts (e.g. on grains or metals) versus financial derivative contracts (e.g. on bonds or equity indexes) spot versus future delivery markets primary markets (issuance of new securities) versus secondary markets (trading of previously issued securities) money markets (short-term debt instruments) versus capital markets (longer-term debt instruments and equities) traditional investment markets (bonds, stocks) versus alternative investment markets (e.g. real estate, hedge funds, fine art).

Question 3

Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes

Accepted Answer

The major types of assets are securities, currencies, contracts, commodities, and real assets Securities include _fixed income_ (e.g. bonds, notes, commercial paper), _equity_ (common stock, preferred stock, warrants), and _pooled investment vehicles_ (mutual funds, exchange-traded funds, hedge funds, asset-backed securities) Contracts include futures, forwards, options, swaps, and insurance contracts Commodities include agricultural products, industrial and precious metals, and energy products and are traded in spot, forward, and futures markets Most national currencies are traded in spot markets and some are also traded in foward and futures markets

Question 4

Describe types of financial intermediaries and services that they provide

Accepted Answer

Financial intermediaries perform the following roles: brokers, exchanges, and alternative trading systems connect buyers and sellers of the same security at the same location and time. They provide a centralized locations for trading dealers match buyers and sellers of the same security at different points in time arbitrageurs connect buyers and sellers of the same security at the same time but in different venues. They also connect buyers and sellers of non-identical securities of similar risk securitizers and depository institutions package assets into a diversified pool and sell interests in it. investors obtain greater liquidity and choose their desired risk level Insurance companies create a diversified pool of risks and manage the risk inherent in providing insurance Clearinghouses reduce couterparty risk and promote market integrity

Question 5

Compare positions an investor can take in an asset

Accepted Answer

A long position in an asset represents current or future ownership. A long position benefits when the assets increases in value. A short position represents an agreement to sell or deliver an asset or results from borrowing an asset and selling it (i.e. a short sale). A short position benefits when the asset decreases in value When an investor buys a security by borrowing from a broker, the investor is said to buy on margin and has a leveraged position. The risk of investing borrowed funds is referred to as financial leverage. More leverage results in greater risk.

Question 6

Calculate and intepret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call

Accepted Answer

The leverage ratio is the value of the asset divided by the value of the equity position. Higher leverage ratios indicate greater risk. The return on margin transaction is the increase in the value of the position after deducting selling commissions and interest charges, divided by the amount of funds initially invested including purchase commissions The maintenance margin is the minimum percentage of equity that a margin investor is required to maintain in his account. If the investor's equity falls below the maintenance margin, the investor will receive a margin call. The stock price that will result in a margin call is: margin call = P0(1-initial margin / 1-maintenance margin) where P0 = initial purchase price

Question 7

Given the following information: Shares purchased 1,000 Purchase price per share $100 Annual dividend per share $2.00 Initial margin requirement 40% Call money rate 4% Commision per share $0.05 Stock price after one year $110 Calculate (1) the leverage ratio and (2) the investor's return on th emargin transaction (return on equity) if the stock is sold at the end of one year.

Accepted Answer

1. The leverage ratio = 1/0.40 = 2.5 2. The total purchase price is 1,000 \ $100 = $100,000. The investor must post initial margin of 40% \ $100,000 = $40,000. The remaining $60,000 is borrowed. The commission on the purchase is 1,000 \ $0.05 = $50. Thus, the total initial equity investment is $40,050 At the end of one year, the stock value is 1,000 \ $110 = $110,000 for a gain of $9,950. Dividends received are 1,000 \ $2.00 = $2,000. Interest paid is $60,000 \ 4% = $2,400. The commission on the sale is 1,000 \ 0.05 = $50. The gain on the transaction in one year is $9,950 + $2,000 - $2,400 - $50 = $9,500. The return on the equity investment is $9,500 / $40,050 = 23.72%. The investor's net return is less than the asset total return (10% price appreciation + 2% dividend = 12%) multiplied by the leverage ratio (12% \ 2.5 = 30%) because of the loan interest and commissions. We can also solve for the return on the margin transaction with the cash flow functions on a financial calculator. CF0 = -40,050; CF1 = 49,550; CPT IRR = 23.72%

Question 8

If an investor purchases a stock for $40 per share with an initial margin requirement of 50% and the maintenance margin requirement is 25%, at what price will the investor get a margin call?

Accepted Answer

$40(1-0.5) / 1-0.25 = $26.67

Question 9

Compare execution, validity, and clearing instructions Compare market orders with limit orders

Accepted Answer

Execution instructions speficy how to trade. Market orders and limit orders are examples of execution instructions Validity instructions specify when an order can be filled. Day orders, good-til-cancelled orders, and stop orders are examples of validity instructions Clearning instructions specify how to settle a trade A market order is an order to execute the trade immediately at the best possible price. A market order is appropriate when the trader wants to execute a transaction quickly. The disadvantage of a market order is that it may execute at an unfavorable price. A limit order is an order to trade at the best possible price, subject to the price satisfying the limit condition. A limit order avoids price execution uncertainty. The disadvantage of a limit order is that it may not be filled. A buy (sell) order with a limit of $18 will only be executed if the security can be bought (sold) at a price of $18 or less (more).

Question 10

Define primary and secondary markets and explain how secondary markets support primary markets

Accepted Answer

New issues of securities are sold in primary capital markets. Secondary financial markets are where securities trade after their initial issuance. In an underwritten offering, the investment bank guarantees that the issue will be sold at a price that is negotiated between the issuer and bank. In a best efforts offering, the bank acts only as a broker. In a private placement, a firm sell securities directly to qualified investors, without the disclosures of a public offering A liquid secondary market makes it easier for firms to raise external capital in the primary market, which results in a lower cost of capital for firms.

Question 11

Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets

Accepted Answer

The three main categories of securities markets: 1. Quote-driven markets: investors trade with dealers that maintain inventories of securities, currencies, or contracts 2. Order-driven markets: Order-matching and trade-pricing rules are used to match the orders of buyers and sellers 3. Brokered markets: Brokers locate a counterparty to take the other side of a buy or sell order In call markets, securities are only traded at specific times. In continuous markets, trades occur at any time the market is open.

Question 12

Describe characteristics of a well-functioning financial system

Accepted Answer

A well-functioning financial system has the following characteristics: complete markets: savers receive a return, borrowers can obtain capital, hedgers can manage risks, and traders can acqure needed assets operational efficiency: trading costs are low informational efficiency: prices reflect fundamental information quickly allocational efficiency: capital is dierected to its highest valued use

Question 13

Describe objectives of market regulation

Accepted Answer

The objectives of market regulation are to: protect unsophisticated investors establish minimum standards of competency help investors to evaluate performance prevent insiders from exploiting other investors promote common financial reporting requirements so that information gathering is less expensive require minimum levels of capital so that market participants will be able to honor their commitments and be more careful about their needs

Question 14

Describe a security market index

Accepted Answer

A security market index represents th performance of an asset class, security market, or segment of a market. The performance of the market or segment over a period of time is represented by the percentage change in (i.e. the return on) the value of the index.

Question 15

Calculate and interpret the value, price return, and total return of an index

Accepted Answer

A price index uses only the prices of the cinstituent securities in the return calculation. The rate of return is called a price return. A total return index uses both the price of and the income from the index securities in the return calculation

Brainscape's Knowledge GenomeTM

Equity: Market organization, market indices, market efficiency (10%) Flashcards

Brainscape's Knowledge Genome^TM