Study Questions 1

Question 1

direct finance

Answer 1

borrowers borrow funds directly from lenders in financial markets by selling the lenders securities (financial instruments), or claims on the burrowers future income or assets

Question 2

primary market

Answer 2

a financial market in which new issues of a security, such as a bond or stock, are sold to initial buyers by the corporation or government agency borrowing the funds

[investment banks]

Question 3

secondary market

Answer 3

a financial market in which securities that have been previously issued can be resold

[New York Stock Exchange]
[National Association of Securities Dealers Automated Quotation System]
[Foreign exchange markets, futures markets, options markets]

Question 4

security

Answer 4

(also called financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership)

Question 5

investment banks

Answer 5

assists in the initial sale of securities in the primary market by underwriting securities (grantees a price for a corporations securities then sells them to the public)

Question 6

liquid

Answer 6

easily converted to cash

Question 7

exchange

Answer 7

buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades

[New York Stock Exchange/Chicago Board of Trade for Commodities]

Question 8

over the counter (OTC) market

Answer 8

dealers at different locations who have an inventory of securities ready stand ready to buy and sell securities over the counter

Question 9

money market

Answer 9

a financial market in which only short term debt instruments (one year or less of original maturity terms) are traded

Question 10

capital market

Answer 10

a market in which longer term debt instruments (generally those with original maturity terms of one year or greater) and equity instruments are traded

Question 11

money market instruments

Answer 11

• US treasury bills [short term debt instruments]
• negotiable bank certificates of deposit (large denominations) [original purchase price]
• commercial paper [short term debt instrument issued by large banks and well known corporations]
• federal funds [overnight loans between banks at their deposits at the federal reserve]
• security repurchase agreements [effectively short term loans, less than two weeks, use Treasury Bills as a collateral]

Question 12

federal funds rate

Answer 12

the interest rate charged on overnight loans in the federal funds market, a sensitive indicator of the cost to banks of borrowing funds from other banks and the stance of monetary policy

Question 13

capital market instruments

Answer 13

debt and equity instruments with maturities of greater than one year

• corporate stocks [equity claims on the net income and assets of a corporation]
• residential mortgages [loans to households or firms to purchase land, housing, or other real structures]
• corporate bonds [long term bonds issued by corporations with very strong credit ratings]
• us government securities [long term debt instruments are issued by the US treasury to finance the deficits of the government]
• us government agency securities [long term bonds are issued by various government agencies to finance such items as mortgages, farm loans, or power generating equipment]
• state and local government bonds [municipal bonds, long term debt instruments issued by state and local gov to finance expenditures on schools, roads, and other large programs]
• bank commercial loans/ consumer loans [made by banks but by finance companies for consumers]
• commercial and farm mortgages

Question 14

indirect finance

Answer 14

involves a financial intermediary that stand between the lenders-savers and borrowers-spenders and helps transfers funds from one to the other

Question 15

diversification

Answer 15

entails investing in a portfolio of assets whose returns do not always move together , with the result that the overall risk is lower than the individual asset

Question 16

asymmetric information

Answer 16

the unequal knowledge that each party to a transaction has about the other party

Question 17

adverse selection

Answer 17

the problem created by asymmetric information before the transaction occurs (a bad borrower takes a loan)

Question 18

moral hazard

Answer 18

the problem created by asymmetric information after the transaction occurs (risk the borrower might create because of engaging in activities that are undesirable (immoral) from the lenders point of view AKA lying)

Question 19

financial intermediary

Answer 19

DEPOSITORY INSTITUTIONS (Banks), CONTRACTUAL SAVINGS INSTITUTIONS, INVESTMENT INTERMEDIARIES

institutions (such as banks, insurance companies, mutual funds, pension funds, and finance companies) that borrow funds from people who have saved and then make loans to others

Question 20

commercial bank

Answer 20

a financial intermediary who’s sources of funds is deposits and its primary uses of funds is business and consumer loans, mortgages, US government securities, and municipal bonds

Question 21

wealth

Answer 21

the total collection of pieces or property that serve to store value

Question 22

income

Answer 22

flow of earnings per unit of time (a flow concept)

Question 23

medium of exchange (money function)

Answer 23

(money in the form of checks or currency) is used to pay for goods and services

Question 24

unit of account (money function)

Answer 24

money is used to measure value in an economy

Question 25

store of value (money function)

Answer 25

a repository of purchasing power available over time

Question 26

liquidity

Answer 26

the relative ease and speed with which an asset can be converted to a medium of exchange

Question 27

commodity money

Answer 27

money made up of precious metals or another valuable commodity is called commodity money

Question 28

fiat money

Answer 28

paper currency decreed by governments as legal tender (must be accepted as legal payments for debts) but not convertible into coins or precious metal

Question 29

M1

Answer 29

a measure of money that includes currency, travelers checks, and checkable deposits

Question 30

M2

Answer 30

a measure of money that includes M1 plus: money market deposit accounts, money market mutual fund shares, small-denomination time deposits, savings deposits, overnight repurchase agreements, and overnight Euro dollars

Question 31

PDV

Answer 31

present discounted value (see formula)

Question 32

coupon bond (credit market instrument)

Answer 32

pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date when a specified final amount (face value or par value) is repaid

Question 33

coupon rate (part of coupon bonds)

Answer 33

the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond)

Question 34

discount bond

Answer 34

a bond bought at a price below its face value (discount), and the face value is repaid at the maturity rate

Question 35

yield to maturity

Answer 35

(internal rate of return) the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today

Question 36

simple loan

Answer 36

lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date

Question 37

fixed payment loan

Answer 37

lender provides the borrower with an amount of funds the borrower must repay by making the same payment, consisting of part the principal and interest, every period (such as a month) for a set number of years

Question 38

rate of return (one period)

Answer 38

the payment to the owner of a security plus the change in the security’s value, expressed as a fraction of its purchase price