Financial Markets and Net Present Value

Question 1

Financial markets facilitate _____ and ______

between participants.

Answer 1

Financial markets facilitate borrowing and lending

between participants.

Question 2

The price of lending or borrowing money is the

______ rate.

Answer 2

The price of lending or borrowing money is the

interest rate.

Question 3

Financial intermediaries (i.e. \_\_\_\_) match borrowers and lenders: 
–Take \_\_\_\_\_ and make \_\_\_\_

Answer 3

Financial intermediaries (i.e. banks) match borrowers and lenders: 
–Take deposits and make loans

Question 4

Financial intermediary: an institution that provides the market function of matching
____ and ____ to ____.

Answer 4

Financial intermediary: an institution that provides the market function of matching
borrowers and lenders to traders.

Question 5

Financial intermediation can take three forms:

• S
• T
• R

Answer 5

Financial intermediation can take three forms:

• Size intermediation
• Term intermediation
• Risk intermediation

Question 6

Size intermediation:
In the example above, the bank took a large loan from
the ____ and made small loans to the ____.

Answer 6

Size intermediation:
In the example above, the bank took a large loan from
the dentist and made small loans to the students.

Question 7

Term intermediation:
Commercial banks finance long term ____ with
short term ____.

Answer 7

Term intermediation:
Commercial banks finance long term mortgages with
short term deposits.

Question 8

Risk intermediation:
Financial intermediaries can tailor the ____ characteristics of securities for borrowers and lenders with different degrees of ____ tolerance.

Answer 8

Risk intermediation:
Financial intermediaries can tailor the risk characteristics of securities for borrowers and lenders with different degrees of risk tolerance.

Question 9

Market Clearing: The job of balancing the _____ of and ____ for loanable funds is taken by the money market.

Answer 9

Market Clearing: The job of balancing the supply of and demand for loanable funds is taken by the money market.

Question 10

Market Clearing: When the quantity supplied by lenders equals the quantity demanded by borrowers, the market is in _____ at the _____ rate of _____.

Answer 10

When the quantity supplied by lenders equals the quantity demanded by borrowers, the market is in equilibrium at the equilibrium rate of interest

Question 11

Market Clearing: At higher rates, lenders will want to supply _____ than is
demanded by borrowers.

Answer 11

At higher rates, lenders will want to supply more than is

demanded by borrowers.

Question 12

Market Clearing: At lower rates, borrowers will demand _____ loans than lenders are willing to supply.

Answer 12

At lower rates, borrowers will demand more loans than lenders are willing to supply.

Question 13

An individual can alter his consumption across time

periods through _____ and _____.

Answer 13

An individual can alter his consumption across time
periods through borrowing and lending.

We can illustrate this by graphing consumption
today versus consumption in the future (shows This graph will show intertemporal consumption opportunities.).

Question 14

In a competitive market:
– Trading is ____.
– Information about borrowing and lending is _____.
– There are many traders who are price takers , i.e. no
_____ can move market prices.

Answer 14

In a competitive market:
– Trading is costless.
– Information about borrowing and lending is available.
– There are many traders who are price takers , i.e. no
individual can move market prices.

Question 15

There can be only __ equilibrium interest rate in

a competitive market otherwise ____ opportunities would arise.

Answer 15

There can be only one equilibrium interest rate in

a competitive market otherwise arbitrage opportunities would arise.

Question 16

The Basic Principle: Savings and consumption decisions depend on the _____ rates.

Answer 16

The Basic Principle: Savings and consumption decisions depend on the interest rates.

Question 17

The Basic Principle: Financial markets provide a benchmark which is used as a standard for _______ investments.

Answer 17

Financial markets provide a benchmark which is used as a standard for comparing investments.

Question 18

The Basic Principle: The market interest rate is the basis for a ___ that any proposed investment must ____.

Answer 18

The Basic Principle: The market interest rate is the basis for a test that any proposed investment must pass.

Question 19

The Basic Principle: This benchmark is used by individuals, corporations, and the government for _____
decision making.

Answer 19

The Basic Principle: This benchmark is used by individuals, corporations, and the government for economic
decision making.

Question 20

The basic financial principle of investment decision making is this:

An investment must be at least as _____ as the opportunities available in the _____ markets.

Answer 20

The basic financial principle of investment decision making is this:

An investment must be at least as desirable as the opportunities available in the financial markets.

If this were not the case, people would use the
financial markets rather than undertaking the
investment.

Question 21

Corporations that invest in positive NPV investments will _____ the value of the firm by the NPV.
– Negative NPV investments should be ____.

Answer 21

Corporations that invest in positive NPV investments will increase the value of the firm by the NPV.
– Negative NPV investments should be rejected.

Question 22

Shareholders will be united in their preference for the firm to undertake ____ net present value decisions, regardless of their personal intertemporal consumption preferences.
–______ markets allow for these personal differences.

Answer 22

Shareholders will be united in their preference for the firm to undertake positive net present value decisions, regardless of their personal intertemporal consumption preferences.
–Financial markets allow for these personal differences.

Question 23

In reality, shareholders do not vote on ____ investment decision faced by a firm and the managers of firms need ____ _____ to operate by.

Answer 23

In reality, shareholders do not vote on every investment decision faced by a firm and the managers of firms need decision rules to operate by.

Question 24

All shareholders of a firm will be made better off if managers follow the _____ rule undertake ____ NPV projects and reject ____ NPV projects.

Answer 24

All shareholders of a firm will be made better off if managers follow the NPV rule undertake positive NPV projects and reject negative NPV projects.

Question 25

The separation theorem in financial markets says that all investors will want to accept or reject the same investment projects by using the ____ ___, regardless of their personal ______.

Answer 25

The separation theorem in financial markets says that all investors will want to accept or reject the same investment projects by using the NPV rule, regardless of their personal preferences.

• Logistically, separating investment decision
  making from the shareholders is a basic requirement
  of the modern corporation.