Exam 1 (Ch 1 - Partial 4) Flashcards
Markets and institutions are the ____ ____ through which capital is allocated in our society
Primary channels
Investment and financing decisions require managers and individual investors to understand
The flow of funds throughout the economy
Financial markets
Structures through which funds flow
Two major dimensions of financial markets
- Primary versus secondary markets
- Money versus capital markets
Primary markets
Markets in which users of funds (e.g. corporations) raise funds through new issues of financial instruments, such as stocks and bonds
Initial public offerings (IPOs)
Issues of equity by firms initially going public
Secondary markets
Markets that trade financial instruments once they are issued
When was the Wall Street Crash
1929
What happened on Oct 24, 1929
29% decline, Black Thursday
What happened on oct 28, 1929
13% decline, black Tuesday
When was the Great Depression
1937-1938
When was black Monday
Oct 19, 1987
Black Monday
First financial crisis of the modern era, DJIA declined by 22.6%
3 things secondary markets offer
- Liquidity, or the ability to turn an asset into cash quickly at its fair market value
- Information about the prices or the value of investments
- Trading with low transaction costs
(P/S) IBM issues $200 million of new common stock
Primary
(P/S) The New Company issues $50 million of common stock in an IPO
Primary
(P/S) IBM sells $5 million of GM preferred stock out of its marketable securities portfolio
Secondary
(P/S) The Magellan Fund buys $100 million of previously issued IBM bonds
Secondary
(P/S) Prudential Insurance Co. sells $10 million of GM common stock
Secondary
Money markets
Trade debt securities or instruments with maturities of one year or less
Most U.S. money markets are what markets
Over the counter (OTC)
Capital markets
Trade debt (bonds) and equity (stocks) instruments with maturities of more than one year
Do money markets or capital markets have wider price fluctuations
Capital markets
Foreign exchange risk
The sensitivity of the value of cash flows on foreign investments to changes in the foreign currency’s price in terms of dollars
What happens to the profitability of a company with significant overseas revenues due to a strong USD?
You would want to be an importer with a stronger USD and can buy more domestic currencies, exporter prefers a weaker USD because demand decreases for high market power
Derivative security
A financial security (e.g., future, option, swap, or mortgage-backed security) whose payoff is linked to another, previously-issued security, such as a security traded in capital or foreign exchange markets
Where are derivatives traded
Derivative security markets
What is the newest and riskiest security market and the potential riskiest security
Derivative markets
Commercial paper
Short-term unsecured promissory nite issued by a company to raise funds for a short time period
SEC regulation emphasis
On full and fair disclosure of information on securities issues to actual and potential investors
Why, in a world without FIs, would the level of funds flowing between suppliers and users be quite low
- Monitoring costs
- Liquidity costs
- Price risk
Why is monitoring extremely costly
Requires considerable time, expense, and effort to collect information
Price risk
The risk that an asset’s sale price will be lower than it’s purchase price
Benefits FIs provide to suppliers of funds
- Reduced transaction cost
- Maturity intermediation - assets have different maturity periods
- Denomination intermediation
4 economic functions FIs provide to the financial system as a whole
- Transmission of monetary policy
- Credit allocation
- Inter generational wealth transfers or time intermediation
- Payment services
8 types of risks for FIs
- Default risk (ie credit risk)
- Foreign exchange risk and country (ie sovereign) risk
- Interest rate risk
- Market risk, or asset price risk
- Off-balance sheet risk
- Liquidity risk
- Technology and operational risk
- Insolvency risk
Why are financial institutions heavily regulated
Failures can cause widespread panic and withdrawals on institutions
Enterprise risk management
Recognizes the importance of prioritizing and managing the combined impact of the full spectrum of risks as an interrelated risk portfolio
Fintech
Refers to the use of technology to deliver financial solutions in a manner that competes with traditional financial methods
Examples of fintech
Cryptocurrencies (bitcoin) and blockchain
Why have international markets seen rapid growth
- Pool of savings in foreign countries has increased
- International investors have turned to U.S. and other markets to expand their investment opportunities
- Information on foreign investments and markets is now more accessible and thorough
- Some U.S. FIs offer their customers opportunities to invest in foreign securities and emerging markets at relatively low transaction costs
- The euro is having a notable impact on the global financial system
- Economic growth in pacific basin countries, China and other emerging countries has resulted in significant growth in their stock markets
- Deregulation in many foreign countries has allowed international investors greater access and allowed the deregulating countries to expand their investor base
Interest rates
Rental price for money, positive time preference of consumption, opportunity cost of giving up investment
Nominal interest rates
The interest rates actually observed in financial markets (APR, discount rate)
Real interest rates
Interest rates after adjusting for inflation
Time value of money
The basic notion that a dollar received today is worth more than a dollar received at some future date
Two forms of time value of money calculations
Value of a lump sum, value of annuity payments
Lump sum payment
A single cash payment received at the beginning or end of some investment horizon
Value of annuity payments
A series of equal cash flows received at fixed intervals over the entire investment horizon
Future value of lump sum
The value of a sum invested today at a given interest rate
Present value of lump sum
The value today of a sum received at a future date discounted at the required rate of return
Loanable funds theory
A model that is commonly used to explain interest rates and interest rate movement over time
Demand for loanable funds
Describes the total net demand for funds by fund users
(Supply) As wealth of fund suppliers increases, the supply of loanable funds
Increases
(Supply) As risk of the financial security increases, the supply of loanable funds
Decreases because investment becomes riskier
(Supply) As near term spending needs increases, the supply of loanable funds
Increases
(Supply) When monetary policy objectives allow the economy to expand, the supply of loanable funds
Increases
(Supply) As economic conditions improve in a domestic country, the supply of funds
Increases
(Demand) as the utility derived from an asset purchased with borrowed funds increases, the demand for loanable funds
Increases
(Demand) as the restrictiveness of no price conditions on borrowed funds decreases, the demand for loanable funds
Increases
(Demand) when domestic economic conditions result in a period of growth, the demand for funds
Increases
6 determinants of interest rates for individual securities
- Inflation
- Real risk free rate
- Default risk
- Liquidity risk
- Special provisions or covenants
- Term to maturity
Inflation
The continual increase in the price level of a basket of goods and services
Consumer price index (CPI)
Price you as a consumer pay and compare it month to month
Producer price index (PPI)
Price you as a consumer receive, can determine whether increasing or not
Real risk free rate
The interest rate that would exist on a risk free security if no inflation were expected over the holding period of a security
The fisher effect
Relationship among the real risk free rate, the expected rate of inflation and the nominal interest rate
Default risk
The risk that a security issuer will fail to make its promises interest and principal payments to the buyer of a security
Default or credit risk premium
Difference between a quoted interest rate on a security and a treasury security with similar maturity, liquidity, tax and other features
Liquidity risk
The risk that a security can be sold at a predictable price with low transaction costs on short notice
The term structure of interest rates
A comparison of market yields on securities, assuming all characteristics except maturity are the same
Maturity premium (mp)
Change in required interest rates as the maturity of a security changes
3 explanations for the shape of the yield curve
- Unbiased expectations theory
- Liquidity premium theory
- Market segmentation theory
Unbiased expectations theory
At a given point in time, the yield curve reflects the market’s current expectations of future short-term rates
Liquidity premium theory
Investors will hold long term maturities only if they are offered at a premium to compensate for future uncertainty in a security’s value, which increases with an asset’s maturity
Market segmentation theory
Argues that individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium)
Required rate of return (r)
The interest rate used to find the fair present value of a financial security
Expected rate of return E(r)
The interest rate a market participant expects to earn by buying the security at its current market price, receiving all projected cash flow payments on the security and selling the security at the end of the participant’s investment horizon
Market efficiency
The speed with which financial security prices adjust to unexpected news, to maintain equality with the fair present value of the security
Realized rate of return (r)
The interest rate actually earned on an investment in a financial security
Coupon rate
Interest rate used to calculate the annual cash flow the bond issuer promises to pay to the bond holders
Where do promises cash flows on bonds come from
- Interest or coupon payments paid over the life of the bond
- Lump sum payment (face or par value) when a bond matures
Coupon rate
Interest rate used to calculate the annual cash flow the bond issuer promises to pay to the bond holders
Zero coupon bonds
Do not pay coupon interest
Face or par value
A lump sum payment received by the bond holder at maturity
Yield to maturity (YTM)
The yield or return a bond holder earns if they buy the bond at its market price, receives all coupon and principal payments as promised and holds it until maturity
Premium bond
Price > par, C > YTM
Discount bond
Price < par, C < YTM
Par bond
Price = par, C = YTM
If interest rate changes are measured using required rates of return, what is the price sensitivity being measured
Fair present value
If interest rate changes are measured using expected rates of return, what is the price sensitivity being measured?
Current market price
Duration
The weighted-average time to maturity on an investment using the relative present values of the cash flows as weights
What relationship is between duration and coupon interest
Indirect
What relationship is between duration and rate of return
Indirect
What relationship is between duration and maturity
Direct
Central banks
Determine, implement and control the monetary policy in their home countries
Four major functions of Fed
- Conducting monetary policy
- Supervising and regulating depository institutions
- Maintaining the stability of the financial system
- Providing payment and other financial services to the US government, the public, financial institutions and foreign official institutions
Federal open market committee (FOMC)
The major monetary policy making body of the federal reserve system (12 members)
Federal open market committee (FOMC)
Set guidelines regarding open market operations, the purchase and sale of US government and federal agency securities; as the main policy tool to achieve monetary targets
8 functions performed by federal reserve banks (FRBs)
- Assistance in the conduct of monetary policy
- Supervision and regulation
- Consumer protection and community affairs
- Government services
- New currency issue
- Check clearing
- Wire transfer services
- Research services
Two categories of total reserves
Required reserves and excess reserves
IBM creates and sells additional stock to the investment banker Morgan Stanley. Morgan Stanley then resells the issue to the U.S. public through its mutual funds. This transaction is an example of a(n):
A. Primary market transaction
B. Asset transformation by Morgan Stanley
C. Money market transaction
D. Foreign exchange transaction
E. Forward transaction
A primary market transaction
A corporation seeking to sell new equity securities to the public for the first time in order to raise cash for capital investment would most likely:
A. Conduct an IPO with the assistance of an investment banker
B. Engage in a secondary market sale of equity
C. Conduct a private placement to a large number of potential buyers
D. Place an ad in the Wall Street Journal soliciting retail suppliers of funds
E. Issue bonds with the assistance of a dealer
A. Conduct an IPO with the assistance of an investment banker
The largest capital market security outstanding in 2019 measured by market value was:
A. Securitized mortgages
B. Corporate bonds
C. Municipal bonds
D. Treasury bonds
E. Corporate stocks
E corporate stocks
Depository institutions include:
A. Banks only
B. Thrifts only
C. Finance companies only
D. Banks and thrifts
E. All of these choices are correct
D. Banks and thrifts
Match the intermediary with the characteristic that best describes its function
I. Provide protection from adverse events
II. Pool funds of small savers and invest in either money or capital markets
III. Provide consumer loans and real estate loans funded by deposits
IV. Accumulate and transfer wealth from work period to retirement period
V. Underwrite and trade securities and provide brokerage services
- Thrifts
- Insurers
- Pension funds
- Securities firms and investment banks
- Mutual funds
A. 1, 3, 2, 5, 4
B. 4, 2, 3, 5, 1
C. 2, 5, 1, 3, 4
D. 2, 4, 5, 3, 1
E. 5, 1, 3, 2, 4
C. 2, 5, 1, 3, 4
Financial intermediaries can offer savers a safer, more liquid investment than a capital market security, even though intermediary invests in risky illiquid instruments because:
A. FIs can diversify away some of their risk
B. FIs closely monitor the riskiness of thei assets
C. The federal government requires them to do so
D. FIs can diversify away some of their risk and closely monitor the riskiness of their assets
E. FIs can diversify away some of their risk and the federal government requires them to do so
D. FIs can diversify some of their risk and closely monitor the riskiness of their assets
As of 2019, which one of the following derivatives instruments had the greatest amount of notional principal outstanding?
A. Futures
B. Swaps
C. Options
D. Bonds
E. Forwards
B. Swaps
Insolvency risk at a financial intermediary is the risk:
A. That promised cash flows from loans and securities held by FIs may not be paid in full
B. Incurred by an FI when the maturities of its assets and liabilities do not match
C. That a sudden surge in liability withdrawals may require an FI to liquidate assets quickly at fire sale prices
D. Incurred by an FI when it’s investments in technology do not result in cost savings or revenue growth
E. That an FI may not have enough capital to offset a sudden decline in the value of its assets
E. That an FI may not have enough capital to offset a sudden decline in the value of its assets
Depository institutions play an important role in the transmission of monetary policy from the federal reserve to the rest of the economy because:
- Loans to corporations are part of the money supply
- Bank and thrift loans are rightly regulated
- US DIs compete with foreign financial institutions
- DI deposits are a major portion of the money supply
- Thrifts provide a large amount of credit to finance residential real estate
- DI deposits are a major portion of the money supply
The Securities Exchange Commission (SEC) does not:
A. Decide whether a public issue is fairly priced
B. Decide whether a firm making a public issue has provided enough information for investors to decide whether the issue is fairly priced
C. Require exchanges to monitor trading to prevent insider trading
D. Attempt to reduce excessive price fluctuations
E. Monitor the major securities exchanges
A. Decide whether a public issue is fairly priced
Money markets trade securities that:
I. Mature in one year or less
II. Have little chance of loss of principal
III. Must be guaranteed by the federal government
A. I only
B. II only
C. I and II only
D. I and III only
E. I, II, and III
C. I and II only
Commercial paper is a:
A. Time draft payable to a seller of goods, with payment guaranteed by a bank
B. Loan to an individual or business to purchase a home, land or other real property
C. Short term fund transferred between financial institutions usually for no more than one day
D. Marketable bank issued time deposit that specifies the interest rate earned and a fixed maturity date
E. Short term unsecured promissory note issued by a company to raise funds for a short time period
E. Short term unsecured promissory note issued by a company to raise funds for a short time period
What factors are encouraging financial institutions to offer overlapping financial services such as banking, investment banking, brokerage, etc?
I. Regulatory changes allowing institutions to offer more services
II. Technological improvements reducing the cost of providing financial services
III. Increasing competition from full service global financial institutions
IV. Reduction in the need to manage risk at financial institutions
A. I only
B. II and III only
C. I, II and III only
D. I, II, and IV only
E. I, II, III, and IV only
C. I, II and III only
Financial intermediaries ability to reduce the average cost of collecting information because of their efficient operations allows them to take advantage of:
A. Asset transformation
B. Economies of scale
C. Economies of scope
D. Transformational trading
E. Standardization
B. Economies of scale
A corporate bond has a coupon rate of 10 percent and a required return of 10 percent. This bond’s price is:
A. $924.18
B. $1,000.00
C. $879.68
D.$1,124.83
E. Not possible to determine from the information given
B. $1,000.00
A decrease in interest rates will:
A. Decrease the bond’s present value
B. Increase the bond’s duration
C. Lower the bond’s coupon rate
D. Change the bond’s payment frequency
E. Not affect the bond’s duration
B. Increase the bond’s duration
Duration is:
A. The elasticity of a security’s value to small coupon changes
B. The weighted average time to maturity of the bonds cash flows
C. The time until the investor recovers the price of the bond in todays dollars
D. Greater than maturity for deep discount bonds and less than maturity for premium bonds
E. The second derivative of the bond price formula with respect to the yield to maturity
B. The weighted average time to maturity of the bonds cash flows
