Financial Markets and the Economy

Question 1

What is a security or financial instrument?

Answer 1

Claim on the issuer’s future income or assets. Assets for the person who buys them but liabilities for the individual or firm who issues (sells) them.

Question 2

What is a bond?

Answer 2

A bond is a debt security that promises to make payments periodically for a specified period.

Question 3

What are the different types of bonds?

Answer 3

1. Treasury Bills (T-bills): Short-term federal government bonds that don’t provide interest but are sold at a discount.
2. Treasury Bonds: Federal government bonds.
3. Canada Savings Bonds: A type of bond issued by the government of Canada.
4. Coupon Bond: Pays fixed amounts (coupons) at fixed dates, plus a final payment (face value) at maturity.
5. Discount Bond: A bond that pays zero coupons and only a final payment at maturity. It is called a “discount” bond because its price is typically less than its face value.
6. Consol or Perpetuity: A bond with no maturity date that doesn’t repay the principal but makes fixed coupon payments forever.

Question 4

What is an interest rate?

Answer 4

Cost of borrowing or the price paid for the rental of funds.

Question 5

What is the difference between a long position and short selling in a stock market?

Answer 5

Long position: Buying a security with the expectation that its value will increase.
Short selling: Selling a security that the seller does not own. The seller borrows the security and sells it, hoping to buy it back at a lower price later to make a profit.

Question 6

What are financial intermediaries/institutions?

Answer 6

Entities that borrow funds from savers and make loans for borrowers.
Examples:
Banks: Borrow funds by accepting deposits.
Insurance companies: Provide financial protection against risks.
Finance companies: Offer various financial services, including loans and credit.
Pension funds: Manage retirement savings.
Mutual funds: Pool money from multiple investors to invest in a diversified portfolio of assets.
Investment banks: Help companies raise capital and provide financial advisory services.

Question 7

What is the difference between the primary market and the secondary market?

Answer 7

Primary market: New security issues are sold to initial buyers.
Not well-known to the public, typically private. Investment banks guarantee prices in the primary market, a process known as underwriting.

Secondary market: Previously issued securities are bought and sold in the secondary market. Brokers match buyers and sellers, while dealers offer to buy and sell securities at stated prices.

Question 8

How are secondary markets organized?

Answer 8

Exchanges: Buyers and sellers meet in one central location in an exchange. Like the Toronto Stock Exchange for stocks and the ICE Futures Canada for commodities like wheat and oats.

Over-the-Counter (OTC) markets: Dealers in OTC markets have an inventory of securities and are ready to buy or sell at stated prices. Many stocks are traded OTC, although most are on exchanges.
The Canadian government bond market is an OTC market.

Question 9

What is the difference between money markets and capital markets?

Answer 9

Based on the maturity of their securities:

Money markets: Only short-term debt instruments with maturities < one year traded.
Corporations and banks actively use them to earn interest on temporary surplus funds.
Considered to be more liquid than capital markets.

Capital Markets: Markets where debt instruments with maturities > one year are traded.

Question 10

What is the formula for Simple Present Value?

Question 11

What are the four types of credit market instruments?

Answer 11

1. Simple loan: One payment at the maturity date.
2. Fixed payment loan: Multiple fixed payments at pre-specified dates.
3. Coupon bond: A bond that pays fixed amounts (the coupons) at fixed dates, plus a final payment (the face value) at maturity.
4. Discount bond: A bond that pays zero coupons, only a final payment at maturity. “Discount” because the price is typically less than the face value.

Question 12

What is the formula to calculate fixed payments for a loan?

Question 13

What is the formula to calculate the yield to maturity of a simple loan?

Question 14

What is the formula to calculate the yield to maturity of a coupon bond?

Question 15

What is the formula to calculate the yield to maturity of a consol or perpetuity?

Question 16

What is the formula to calculate the yield to maturity of a discount bond?

Question 17

What are the three important facts about coupon bonds?

Answer 17

1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
2. The price of a coupon bond and the yield to maturity are negatively related. As the yield to maturity increases, the price of the bond decreases.
3. The yield to maturity is greater than the coupon rate when the bond price is below its face value.

Question 18

What is the rate of return?

Answer 18

Measure of how well a person does financially by holding a bond over some time.

Question 19

What is the formula for the rate of return?

Question 20

What is the relationship between the rate of return and the yield to maturity?

Answer 20

The return = yield to maturity
ONLY if the holding period is equal to the time to maturity.

Question 21

What is the formula to calculate the current yield?

Question 22

What is the formula to calculate the rate of capital gain?

Question 23

What is the distinction between interest rates and returns?

Answer 23

A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if the time to maturity is longer than the holding period.

The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest rate change.

The more distant a bond’s maturity, the lower the rate of return that occurs due to an increase in the interest rate.

Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise.

Question 24

How do you annualize a T-bill interest rate?

Answer 24

1. Calculate the discount yield:
2. Identify the T-bill’s maturity period:
3. Convert the yield to an annualized rate:

Question 25

What is the difference between the nominal interest rate and the real interest rate?

Answer 25

Nominal interest rate: This is the interest rate that does not consider inflation. It is the stated interest rate on a loan.

Real interest rate: The interest rate that has been adjusted for inflation. It reflects the true cost of borrowing and the real return on lending.

Question 26

What is the formula for the real interest rate?

Answer 26

Real interest rate = Nominal i.r - Inflation

Question 27

What are the two ways of obtaining funds in a financial market?

Answer 27

Issuing debt instruments or equities.

Question 28

What are equities?

Answer 28

Claims in net income and assets of a business (stock/shares).
- No maturity date (long-term securities).
- Residual claimants: Will get dividends (periodic payments to holders) only if all debt holders have been paid off.
- Pro: Benefit directly from increases of profitability/value.

Question 29

Which is bigger, the size of the debt market or the equity market (stocks)?

Answer 29

Debt!

Question 30

What are the agents in secondary markets?

Answer 30

Dealers: Buy at stated prices, then sell.
Brokers: Match buyers with sellers.

Question 31

What are the 2 important functions of secondary markets?

Answer 31

Make securities more liquid, more desirable ∴ easier to sell in primary market.
Determine WTP for security ∴ the max price in the primary market.
Por eso nos concentramos en el secondary market.