FNM106 - Capital Market Prelim

Question 1

are the key intermediaries in financial markets because they transfer funds from savers to individuals, firms and government.

Answer 1

Financial institutions

Question 2

It is very important to recognize that at the most fundamental well-functioning markets and institutions are based heavily on TRUST

Answer 2

TRUE

Question 3

is capable of efficiently allocating resources, assessing and managing financial risks, maintaining employment levels close to the economy’s natural rate, and eliminating relative price movements of real or financial assets will affect monetary stability or employment levels

Answer 3

stable financial system

Question 4

The net benefit to GDP that outweigh costs. Cost includes capital requirements, increased liquidity requirements, increased compliance.

Answer 4

TRUE

Question 5

has the effect of decreasing bank ability to make loans.

Answer 5

Increasing equity

Question 6

They can go out and borrow money from other banks, which they can in turn loan to customers, this is called

Answer 6

taking on leverage

Question 7

Banks don’t rely on deposits alone to fund loans

Answer 7

TRUE

Question 8

Leverage increases return but also increase risk.

Answer 8

TRUE

Question 9

Banks responds to higher capital minimums in two ways:

Answer 9

1. Making fewer loans

2. Rising additional equity

Question 10

is important ingredient in consumption and business investment.

Answer 10

Lending

Question 11

So if lending slows down and gets more expensive, GDP takes hit.

Answer 11

TRUE

Question 12

The Central Bank can encourage lending by keeping interest low.

Answer 12

TRUE

Question 13

One of the most difficult part about running a bank is managing

Answer 13

cash flow

Question 14

government requires banks to stash away reserves. It’s hard enough to predict how many customers will withdraw funds from their personal account on a given day or during crisis and even more complicated with large investment accounts.

Answer 14

TRUE

Question 15

push banks to consider not just how much cash they need to get by on a day-to-day basis. Similar to capital requirements, it slow down lending because they increase the amount of cash that bank must set aside rather than lend out

Answer 15

Liquidity Requirements

Question 16

Financial institutions depletes liquidity so quickly that it may not be able to open the next day

Answer 16

TRUE

Question 17

Banks submit annual and quarterly reporting to industry regulators to disclose their financial position. Costs associated with regulation should be reflected on bank’s financial statements as increased noninterest expense, which include many expenses like employee wages.

Answer 17

TRUE

Question 18

as the management of cash or funds. would view all transactions similar to cash management.

Answer 18

FINANCE

Question 19

While accounting and finance deal with the same account titles in the preparation of the Balance Sheet, the Income Statements, and all other financial statements, they differ in perspective.

Answer 19

TRUE

Question 20

view all transactions in the accrual method.

Answer 20

Accounting

Question 21

is an accounting method that recognizes income when earned and expenses when incurred regardless of when cash is received or disbursed

Answer 21

Accrual

Question 22

This means that no income can be recognized until such time that the accounts receivables have been collected and converted into cash

Answer 22

FINANCE PERSPECTIVE

Question 23

, it should be noted that the accounting system of recording of transactions should always be used in the development of the financial statements.

Answer 23

TRUE

Question 24

is concerned with financial statements preparation and reporting, and managing the financial affairs of the company.

Answer 24

FINANCE

Question 25

is responsible for managing the company’s funds. The cashier’s office, which deals with receipt of payments, and the disbursement unit of the company, are part of this group. Financial planning, company investment section, foreign exchange section, credit and collection department, and even pension administration are under this group.

Answer 25

Treasury group

Question 26

is responsible for the preparation of the financial statements and all other accounting-related activities. This include tax planning, business unit financial statement group, and the cost accounting group. The Controller heads this group.

Answer 26

Accounting group

Question 27

refer to bank activities, insurance products, investment and other services provided by different financial institutions

Answer 27

Financial services

Question 28

refers to day to day activities of an organization

Answer 28

managerial finance

Question 29

The primary activities of a ________are investing, financing and financial statement analysis and planning.

Answer 29

financial manager

Question 30

External sources of funds include borrowing from banks or creditors, obtaining funds though financial markets, or sourcing funds through direct transactions (without using middlemen)

Answer 30

TRUE

Question 31

The third major activity of a finance manager is to analyze the financial statement and to provide financial planning or forecasting.

Answer 31

TRUE

Question 32

concentrates more on the past and present performances of the firm

Answer 32

financial statement analysis

Question 33

looks into the financial outlook of the company one or more years to the future.

Answer 33

, financial planning

Question 34

The output of all the plans is summarized for the preparation of the balance sheet, income statement, cash budget, and cash flows.

Answer 34

TRUE

Question 35

It has always been widely believed that the highest goal of finance is _____. This can immediately be obtained by looking at the net income account of the income statement.

Answer 35

profit maximization

Question 36

However the highest goal of finance is _______

Answer 36

maximizing the value of the firm

Question 37

Under normal circumstances, the company will first take the option of financing its long-term projects with the profits it has generated.

Answer 37

TRUE

Question 38

In corporations, the ____is classified as appropriated or restricted to mean that such earnings will be used for specific purposes.

Answer 38

PROFIT

Question 39

However if funds are not sufficient to cover for the financial requirements, the enterprise or corporation may resort to two possible external financing option, borrowing through financial institution and or/selling equity through financial market.

Answer 39

TRUE

Question 40

they facilitate in bringing the funds from the providers to the users.

Answer 40

Financial intermediaries like banks are entities that convert funds supplied by depositors (individuals, businesses and government)

Question 41

carry an interest which the borrowers will pay for the use of money, together with the principal amount.

Answer 41

loanable funds

Question 42

Upon repayment, part of the interest earned by the bank will be retained for their operations, while the rest are shared to the depositors (interest income from bank deposits)

Answer 42

TRUE

Question 43

are places or organizations where demanders and suppliers of funds (money) can transact business.

Answer 43

Financial markets

Question 44

Under a complete transaction, money will change hands between those who have the funds (money) and those who are in need of funds.

Answer 44

TRUE

Question 45

Private corporations which would like to raise funds through capital infusion (equity) will go public by having it listed at

Answer 45

PSE

Question 46

enables the public corporations to raise funds, the buyer will now become stockholders of the corporations for buying and selling of shares of stock.

Answer 46

sales of the stock

Question 47

(first time the stock is offered in the market

Answer 47

initial public offering

Question 48

There are two types of Financial Markets

Answer 48

money market and capital market

Question 49

is the forum where short term (maturities are usually one year or less) financial transactions occur. Example of Financial instruments transacted in this market are the treasury bills (government securities), and commercial papers.

Answer 49

Money Market

Question 50

are debt instruments issued by the government in order to raise funds (borrowing) in the short term horizon. Individuals and businesses can purchase or invest in the securities at a discounted value (interest is collected in advance) and the government in turn return the principal amount at the specified maturity date. Such financial instrument is deemed to be practically no risk (as the government guarantees repayment) but also earns low interest rate.

Answer 50

Treasury bills

Question 51

The usual maturity dates for a Treasury bills are

Answer 51

91 days, 182 days, and 364 days.

Question 52

are documents of indebtedness issued by a private company to raise short term funds for their projects. Similar to resorting to bank loans, also carry interest to entice investors to buy such papers.

Answer 52

Commercial papers

Question 53

Not all company can issue this type of debt security. Only those companies with high credit standing and financial status are successful in issuing commercial papers. In addition, these papers have slightly higher risk than the treasury bills. Maturity of these papers may range from 3 days to 270 days.

Answer 53

TRUE

Question 54

the forum where long term financial transactions take place (perspective is more than one year). Corporate shares of stocks and bonds (long term debt securities) are examples of transactions that take place

Answer 54

Capital market

Question 55

is a multi-asset pricing model based on the idea that an asset returns can be predicted using a linear relationship between the asset’s expected return and a number of macroeconomic variables that captures systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in order to identify securities that maybe temporarily mispriced

Answer 55

Arbitrage Pricing Theory

Question 56

The APT was developed by the economist ____in 1976 as alternative to the Capital Asset pricing model (CAPM) which assumes market re perfectly efficient, APM sometimes assumes markets sometimes misprice securities, before the market eventually corrects securities move back to fair value.

Answer 56

Stephen Ross

Question 57

The CAPM only takes one factor-market risk- while the APT formula has more factors to determine how sensitive a security is to various macroeconomic risk.

Answer 57

TRUE

Question 58

The macroeconomic factors that have proven most reliable as price predictors include

Answer 58

unexpected changes in inflation, Gross National Product, corporate bond spreads. Other commonly used factors are Gross Domestic Product, commodities Prices, market indexes, and exchange rates.

Question 59

helps keep market efficient because it draws attention to price discrepancies between different markets which can equilibrate prices.

Answer 59

Arbitrage trading

Question 60

The principle of arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the assets listed price.

Answer 60

TRUE

Question 61

Arbitrage funds work on the mispricing of equity shares in spot and futures market. Mostly it takes advantage of the price between current and future securities to generate maximum returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives market. The difference in the cost price and the selling price is the return you earn.

Answer 61

TRUE

Question 62

The formula for the Arbitrage Pricing Theory Model

Answer 62

E(R) I = E(R)z + (E(I) – E (R)z) x βn

Question 63

E(R)i = Expected return on the asset

Rz = Risk free rate of return

βn = sensitivity of the asset price to macroeconomic factor n

Ei = Risk premium associated with factor i

Answer 63

TRUE

Question 64

describes the relationship between systematic risk and expected return for assets, particularly stocks. is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost capital.

Answer 64

CAPM (Capital Asset Pricing Model)

Question 65

Investors expect to be compensated for risk and the time value of money. The risk free rated in the CAPM formula account for the investor taking additional risk.

Answer 65

TRUE

Question 66

is used to help investors understand whether a stock moves in the same direction as the rest of the market.

Answer 66

beta calculation

Question 67

an measure the volatility of an individual stock compared to the systematic risk of the entire market.

Answer 67

beta coefficient

Question 68

The goal of the _____formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared to its expected return.

Answer 68

CAPM

Question 69

EXAMPLE PROBLEM CAPM

Answer 69

imagine an investor is contemplating a stock worth $100 per share today that pays a 3% annual dividend. The stock has a beta compared to the market of 1.3, which means its riskier than a market portfolio. Also assume that the risk-free rate is 3% and this investor expect the market to rise in value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%:

9.5% =3% + 1.3% x (8% -3%)

Question 70

Functions of Business Finance

Answer 70

1. The allocation of an adequate supply of capital for business needs, both short term and long term
2. The procurement of funds at the most favorable terms at least cost to the business.
3. The efficient management of capital for profit maximization and increasing the value of the firm

Question 71

refer to the means of payment, whether in cash or credit, for goods and services.

Answer 71

FUNDS

Question 72

The need of funds which is synonymous to capital, remains a foremost concern of a business entity from its organization to its dissolution. No business activity is planned without fund raising problems, regardless of size r nature, firms financial needs can be classified into the long term and short term.

Answer 72

TRUE

Question 73

usually supports expansion expenditures where the payback period of investment takes several years. The payback period is the period from the time the sum of money spent on the project was first used to the time this amount is fully recovered.

Answer 73

Long term-capital financing,

Question 74

as allocations for expansion expenditures are called investment in fixed assets requiring a large outlay of funds, it takes longer time to recover investments.

Answer 74

Capital expenditures

Question 75

Capital expenditures do not usually come the other. Plant facilities may have to be replaced or may need major repairs. New branches may have to be established. New product line may have to be adopted. A firm should choose between these projects with their limited capital availability. It resorts to capital budgeting, a process of ranking projects in the order of their urgency, feasibility and profitability.

Answer 75

TRUE

Question 76

is concerned with estimating capital needs, strategies for capital procurement and projecting the profitability of and particular uses of capital in each project.

Answer 76

Financial Management

Question 77

provides working capital where there is an expectation of investment flowback within one year or less than a year. Short term funds provide working capital which finances day-to-day operations.

Answer 77

Short-term capital financing

Question 78

are invested in current assets such as the stock of goods intended either for processing or for sale. Planning for the adequacy of funds for maintaining required inventory levels and for the payment of taxes, salaries, insurance premiums and interest on borrowed capital is a continuing challenge to the expertise of finance officers

Answer 78

short term funds

Question 79

Receivables and inventories must be kept moving towards cash. Efficient management of money position requires avoiding shortage of funds or keeping capital idle. Delays in the flow of funds in the form of slow-moving inventories or gaps in receivables collections are common headache that plaque even the most affluent business firm.

Answer 79

TRUE

Question 80

The synchronization of operating and long term capital requirements is one of the imperatives of financial planning. Traditionally, working capital needs are financed by tapping such sources as commercial banks, financing companies and the money market, or by availing trade credits to minimize interest charges. Capital expenditures are financed from long-term borrowings, the issuance of bonds or stocks, or purchases of fixed assets in installment basis.

Answer 80

TRUE

Question 81

is concerned with choosing the best source and employing the most effective financing scheme at the least cost possible. There maybe a combination of sources, a consortium of leaders, or a combination of financial schemes to get the best terms of the user.

Answer 81

Business Finance

Question 82

should be obtained at the least cost of capital, with convenient terms of payment and the least burden of the company assets

Answer 82

FUNDS

Question 83

is of prime importance. This refers to aggregate expenses incurred in obtaining the funds, including but not limited to: interest expense, service charges, selling expenses and underwriting commission in the case of security issues, anticipated increase in relevant taxes, printing costs of documents and certificates, and legal and government fees.

Answer 83

cost of capital

Question 84

Procuring the capital is just the means, the end is maximum profit.

Answer 84

TRUE

Question 85

When the cost of capital exceeds or is at par with the expected income, the firm may completely abandon the project. Or defer its implementation to a more opportune time, when the cost of capital is less or when expected earnings are higher.

Answer 85

TRUE

Question 86

is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying and selling is undertaken by participants such as individuals and institutions, this market trades mostly long term securities. plays a vital role in the mobilization of savings and making them available to the investors

Example of highly organized capital market are the New York Stock Exchange, American Stock Exchange, London Stock Exchange, in the Philippine we have the PSE.

Answer 86

Capital Market

Question 87

Security market or Capital market is an essential prerequisite for faster industrial growth.

It channels the savings of masses who does not venture to manage enterprise but merely want to be an investor.

Capital market acts as a link between economic deficit unit and economic surplus unit

Healthy and efficient security market is imperative for industrialization and economic development

Answer 87

Importance of Capital Market

Question 88

1. To promote the financial welfare of the investors through
   - adequate returns of investments through dividends to stockholders, profit shares to partners and proprietors and interest payments to creditors.
   - increasing the value of proprietary interest of the investor in business through accumulation of assets and increases in the market value of shares.
2. The fulfillment of its civic and social responsibilities to improve the quality of life of the people through
   - better working conditions, hikes in wage and salary scale, fringe benefits, bonuses, sick and vacation leaves
   - direct participation in civic and community affairs, providing scholarships donations to worthy causes, financial assistance during calamities etc.

Answer 88

Primary Goals of Business

Question 89

In this function, money is effectively transferred from savers to borrowers

Answer 89

Economic Function

Question 90

This function indicates that the prices in the market are moment by moment which benefit the investors. The participants get up-to-date and accurate price information with the continuous price function of the capital market.

Answer 90

Continuous Price Function

Question 91

An investor can say to his broker to sell his stock of particular company at the prevailing price and he is confident about getting a fair price. The high number of players is the main reason of the fair pricing of the capital market.

Answer 91

Fair Pricing Function

Question 92

The function of financial market is to facilitate the transfer of savings from those economic units with a surplus to those with deficit. Financial market exist in order to allocate the supply or savings to the economy to the demanders of those savings. The central characteristics of financial market is that it acts as vehicle through which the forces of demand and supply for a specific type of financial claim (such as bond) are brought together.

Answer 92

Why Financial Markets Exist?

Question 93

The wealth of the economy would be less without the financial market. The rate of capital formation would not be as high if financial market did not exist. It means that at some period of time of stocks the net additions to: 1. Dwellings (houses), 2. Productive plant equipment, 3. Inventory and 4. Consumer durable goods would occur at lower rates

Answer 93

Why would the economy suffer without a developed financial market system?

Question 94

The Mix of Corporate Securities Sold in the Capital Market

What type of financing vehicle is most favored when corporations decide to raise cash in the capital market? Common stock is the answer of most individual but the answer to the question is corporate bond. The corporate debt markets dominate the corporate equity market when new funds are being raise, this is a long-term relationship.

Financial executives are responsible for raising corporate cash. When they have a choice between marketing new bonds and marketing new preferred stock, the outcome is usually in favor of bonds. The after-tax cost of capital on the debt is less than that incurred on the preferred stock. Likewise if the firm has unused debt capacity and the general level of equity prices is depressed, financial executives favor the issuance of debt securities over the issuance of new common stock.

Answer 94

FINANCIAL MARKETS AND INTEREST RATES

Question 95

1. Market Risk – The risk of investments declining in value because of economic developments or other events that affect the entire market. The main type of market risk are:

Equity risk – applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares.

Interest Rate Risk – applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate. For example if the interest rate goes up, the market value of bonds will drop.

Currency Risk – applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable relative to Canadian dollar, US stocks will be worth less in Canadian dollars.

2. Liquidity Risk – The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price.
3. Concentration Risk – The risk of loss because your money is concentrated in one investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.
4. Credit Risk – The risk that government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For example, long term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk.
5. Reinvestment Risk – The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bonds paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest at 4%.

Reinvestment risk also applies when the bond matures and you have to reinvest the principal at less than 5%

6. Inflation Risk – The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time- the same amount will buy fewer goods and services.

Inflation risk is particularly relevant if you own cash or debt investments like bonds.

7. Horizon Risk – The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the market are down, you may lose money.
8. Longevity Risk – The risk of outliving your savings. The risk is particularly relevant for people who are retired, or are nearing retirement.
9. Foreign Investment Risk – The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the share of companies in emerging markets, the risk of nationalization.

Answer 95

TYPES OF RISK IN THE CAPITAL MARKET