Unit 3:Financial market

Question 1

What is money market

Answer 1

Money markets trade debt securities with maturities of less than 1 year
dealer-driven markets
Money market securities are generally short-term and marketable.

Question 2

Money market securities include

Answer 2

Money market securities include

a) Government Treasury bills
b) Government Treasury notes and bonds
c) Federal agency securities
d) Short-term tax-exempt securities
e) Commercial paper
f) Certificates of deposit
g) Repurchase agreements
h) Eurodollar CDs
i) Bankers’ acceptances

Question 3

Capital markets

Answer 3

trade:
long-term debt and
equity securities

Question 4

primary markets

Answer 4

-Primary markets are the markets in which corporations and governmental units raise new
capital by making #initial offerings of their securities.
-The issuer receives the proceeds of sale in a primary market.

Question 5

Secondary markets

Answer 5

Secondary markets provide for trading of previously issued securities among investors.
Examples of secondary markets include
auction markets and dealer markets.

Question 6

Auction Market: how it function

Answer 6

-like the New York Stock Exchange, the American Stock Exchange,
and regional exchanges conduct trading at particular physical sites
-the profit made from the auction market is called “the spread” is the excess of the asked over the bid price
-Derivatives are also traded in Auction market
-2 types of derivatives :
Commodity futures and financial futures
* governing by SEC

Question 7

OTC

Answer 7

*OTC is dealer market includes brokers and dealers who r linked by telecommunications equipment
*The OTC market conducts transactions in securities not
traded on the stock exchanges.
Governing by NASDAQ
-The majority of stocks are traded in the OTC market, but the dollar volume of
trading on the exchanges is greater because they list the largest companies.

Question 8

Financial Intermediaries

Answer 8

Financial intermediaries are specialized firms that help create and exchange the instruments
of financial markets. Financial intermediaries increase the efficiency of financial markets
through better allocation of financial resources.

b. Financial intermediaries include
1) Commercial banks
2) Life insurance companies
3) Private pension funds
4) Nonbank thrift institutions, such as savings banks and credit unions
5) State and local pension funds
6) Mutual funds
7) Finance companies
8) Casualty insurance companies
9) Money market funds
10) Mutual savings banks
11) Credit unions
12) Investment bankers

Question 9

Insider Trading

Answer 9

Insider trading is the trading of securities while possessing nonpublic information about the
securities.
-This type of trading is illegal

Question 10

Efficient Markets Hypothesis

Answer 10

1-states that current stock prices immediately and fully reflect all relevant information. Hence, the market is continuously adjusting to new information and
acting to correct pricing errors.
>securities prices are always in equilibrium.
2-states that it is impossible to obtain abnormal returns
consistently with either fundamental or technical analysis.
3-the expected return of each security is equal to the
return required by the marginal investor given the risk of the security

Question 11

Fundamental analysis

Answer 11

is the evaluation of a security’s future price movement based upon
sales, internal developments, industry trends, the general economy, and
expected changes in each factor.

Question 12

technical analysis.

Answer 12

is the evaluation of a security’s future price based on

the sales price and number of shares traded in a series of recent transactions.

Question 13

The efficient markets hypothesis has three forms

Answer 13

1-Strong Form
a) All public and private information is instantaneously reflected in securities’ prices.
Thus, insider trading is assumed not to result in abnormal returns.
2-Semi Strong
All publicly available data are reflected in security prices, but private or insider
data are not immediately reflected. Accordingly, insider trading can result in
abnormal returns.
3-Weak
Current securities prices reflect all recent past price movement data, so technical
analysis will not provide a basis for abnormal returns in securities trading.

Question 14

Rating Agencies

Answer 14

-Ratings are based upon the probability of default and the protection for investors in case of default.
-A decrease in the rating may increase the firm’s cost of
capital or reduce its ability to borrow long-term

**Simply More Risk lead to Increase the cost of Capital

**The ratings are significant because higher ratings reduce interest costs to issuing firms.
Lower ratings incur higher required rates of return

• *High Rate: Low Risk, Low Interest Paid
• *Low Rate: High Risk, High Interest Paid, High Required Rate of Return by investors to buy this type of debt

-The lower the risk of default, the lower the interest rate the market will demand.

Question 15

Rating types

Answer 15

1- AAA to AA High quality and Little Chance of Default.
2- A- to BBB- are Investment Bond Grade
3- BB and below is speculative, high risk, high yield
4- CCC to D : Significant default risk

Question 16

Investment Banking: Function

Answer 16

a. Investment bankers serve as intermediaries between businesses and the providers of
capital.
1) They not only help to sell new securities but also assist in business combinations, act as brokers in secondary markets, and trade for their own accounts.
b. In their traditional role in the sale of new securities, investment bankers help determine
the method of issuing the securities and the price to be charged, distribute the securities,
provide expert advice, and perform a certification function.

Question 17

Investment Banking :Options

Answer 17

An investment banker issues securities through
best efforts sales and underwriting deals.

in Best effort method,
sales of securities provide no guarantee that the securities will be sold or that enough cash will be raised.

An underwritten deal,
or a firm commitment provides a guarantee.
i) The investment banker agrees to purchase the entire issue and resell it.
Thus, the issuer does not bear the risk of not being able to sell the issue,

Question 18

Investment Banking

Answer 18

Determining the offering price of the securities is crucial. For a seasoned issue, the offering
price may be pegged to the price of the existing securities,

single investment banker ordinarily does not underwrite an entire issue of securities
unless the amount is relatively small.

To share the risk of overpricing the issue or of a market decline during the offering
period, the investment banker (the lead or managing underwriter) forms an
underwriting syndicate with other firms.

The members of the syndicate share in the underwriting commission, but their risk is
limited to the percentage of their participation.

Question 19

Q. for Investment Bank View, To Minimize the risk of Overpricing or Market decline, it has to ?

Answer 19

form an underwriting syndicate with other firms

Question 20

Flotation costs

Answer 20

the costs of issuing new securities, are relatively lower for large issues
than those for small issues.

It include

1- The underwriting spread is the difference between the price paid by purchasers and
the net amount received by the issuer

2-The issuer incurs expenses for filing fees, taxes, accountants’ fees, and attorneys’
fees. These costs are essentially fixed.

3-The issuer incurs indirect costs because of management time devoted to the issue.

4-Announcement of a new issue of seasoned securities usually results in a price decline.
**Increase stocks traded in the market(supply) decrease the price of the stock

Question 21

Initial Public Offerings (IPOs)

Answer 21

A firm’s first issuance of securities to the public is an initial public offering.
1) The process by which a closely held corporation issues new securities to the public
is called going public.

In a subsequent offering, the company offers additional shares which are usually issued from the company’s treasury.
**Such as Treasury stock

In a secondary offering, the company issues new stock for public sale.

Question 22

Advantages of going public include

Answer 22

1) The ability to raise additional funds (Equity Financing)
2) The establishment of the firm’s value in the market
3) An increase in the liquidity of the firm’s stock

Question 23

Disadvantages of going public include

Answer 23

1) Costs of the reporting requirements of the SEC and other agencies
2) Access to the company’s operating data by competing firms
3) Access to net worth information of major shareholders
4) Limitations on self-dealing by corporate insiders, such as officers and major
shareholders
5) Pressure from outside shareholders for earnings growth
6) Stock prices that do not accurately reflect the true net worth of the company
7) Loss of control by management as ownership is diversified
8) Need for improved management control as operations expand
9) Increased shareholder servicing costs

Question 24

A public issue of securities may be sold through a cash offer or a rights offer.

Answer 24

.
1) A cash offer: in cash dealing
2) A rights offer gives existing shareholders an option to purchase new shares before
they are offered to the public. If the corporate charter provides for a preemptive right,
a rights offer is mandatory.
Right offer like Preemptive Right on common stock

Question 25

Return on Investment

Answer 25

ROI= Amount Received - Amount Invested
RoR= ROI\ Amount Invested

Question 26

Basic Types of Investment Risk: Systematic Risk

Answer 26

Systematic risk, also called market risk, is the risk faced by all firms. Changes in the
economy as a whole, such as the business cycle, affect all players in the market.

systematic risk is sometimes referred to as undiversifiable risk.

Since
all investment securities are affected, this risk cannot be offset through portfolio
diversification.

Question 27

Basic Types of Investment Risk: UnSystematic Risk

Answer 27

Unsystematic risk, also called nonmarket or company risk,
is the risk inherent in a particular investment security.

This type of risk is determined by
the issuer’s industry, products, customer loyalty, degree of leverage, management competence, etc.

** For this reason, unsystematic risk is sometimes referred to as diversifiable risk.

Since
individual securities are affected differently by economic conditions, this risk can be
offset through portfolio diversification.

Question 28

Other types of Investment Risk

Answer 28

a. Credit risk(Default Risk): is the risk that the issuer of a debt security will default. This risk can be gauged
by the use of credit-rating agencies.

b. Foreign exchange risk is the risk that a foreign currency transaction will be affected by
fluctuations in exchange rates.

c. Interest rate risk is the risk that an investment security will fluctuate in value due to
changes in interest rates. In general, the longer the time until maturity, the greater the
degree of interest rate risk.

**The interest rate is also affected by inflation expectations, among other factors. The
lower (higher) the expected inflation, the lower (higher) the interest rate.

d. Industry risk is the risk that a change will affect securities issued by firms in a particular
industry. For example, a spike in fuel prices will negatively affect the airline industry.

e. Political risk is the probability of loss caused by such government actions as expropriation
of assets or changes in laws (e.g., tax or environmental). Political risk can be reduced by
making foreign operations dependent on the domestic parent for technology, markets, and
supplies.

f. Liquidity risk is the risk that a security cannot be sold on short notice for its market value.

g. Financial risk is the risk of an adverse outcome based on a change in the financial markets,
such as changes in interest rates or changes in investors’ desired rates of return.

h. Purchasing-power risk is the risk that a general rise in the price level will reduce the
quantity of goods that can be purchased with a fixed sum of money.

Question 29

The following is a short list of widely available long-term financial instruments ranked from
the lowest rate of return to the highest (and thus the lowest risk to the highest):

Answer 29

1) U.S. Treasury bonds
2) First mortgage bonds
3) Second mortgage bonds
4) Subordinated debentures
5) Income bonds
6) Preferred stock
7) Convertible preferred

Question 30

Short term Securities

Answer 30

Short-term financial instruments increase the liquidity of an entity.
1) Commercial paper of an AAA-rated company is the least risky among short-term
financial instruments. It is very short-term debt and has priority over equities. its maturity within 270 days

c) Federal agency securities
d) Short-term tax-exempt securities
e) Commercial paper
f) Certificates of deposit
g) Repurchase agreements
h) Eurodollar CDs
i) Bankers’ acceptances

Question 31

Bonds

Answer 31

Bonds are the principal form of long-term debt financing for corporations and governmental
bodies.

A bond is a formal contractual obligation to pay an amount of money (called the par
value, maturity amount, or face amount) to the holder at a certain date, plus interest called the stated rate or coupon rate)

In general, the longer the term of a bond, the higher will be the return (yield) demanded by
investors to compensate for increased risk.

**Increase duration of the bond, Increase the interest risk, Increase the required return

Question 32

indenture.

Answer 32

All of the terms of the agreement are stated in a document called an indenture.

Question 33

Advantages of bonds to Issuer

Answer 33

1) Interest paid on debt is tax deductible.
a) This is by far the most significant advantage of debt. For a corporation facing
a 40%-50% marginal tax rate, the tax savings produced by the deduction of
interest can be substantial.
2) Basic control of the firm is not shared with debtholders.

Question 34

Disadvantages of Bonds to the Issuer

Answer 34

1) Unlike returns on equity investments, the payment of interest and principal on debt is a
legal obligation.
a) If cash flow is insufficient to service debt, the firm could become insolvent.
2) The legal requirement to pay debt service raises a firm’s risk level.
a) Shareholders will demand higher capitalization rates on retained earnings, which
may result in a decline in the market price of the stock.
3) The long-term nature of bond debt also affects risk profiles.
a) Debt originally appearing to be profitable may become a burden if interest rates
fall and the firm is unable to refinance.
4) Certain managerial prerogatives are usually given up in the contractual relationship
outlined in the bond’s indenture contract.
a) For example, specific ratios must be kept above a certain level during the term of
the loan.
5) The amount of debt financing available to the individual firm is limited.

Question 35

features in bonds

Answer 35

> Call provision allow the bond issuer to exercise an option to redeem the bonds earlier
than the specified maturity date.
1) Since call provisions are undesirable to investors, investors usually demand a higher
rate of return when call provisions are included in the bond issue.

**This increase risk, so the returned (yield) will increase

> Sinking bonds :The objective of making payments into the fund is to segregate and accumulate sufficient
assets to pay the bond principal at maturity.
** make a condition that the return on bond’s money invested to be retained as repay the bonds principle in maturity date

> Convertible Bonds may be converted into equity securities of the issuer at the option
**Less risk and less return required,cuz this time of bonds is somehow secured in case the issuer cant repay the bond amount, he can convert the bond amount into equity securities

Question 36

Type of bonds

Answer 36

a. Maturity Pattern
1) A term bond has a single maturity date at the end of its term.
2) A serial bond matures in stated amounts at regular intervals. Investors can choose
the maturity that suits their needs.
b. Valuation
1) Variable rate bonds pay interest that is dependent on market conditions.
2) Zero-coupon or deep-discount bonds bear no stated rate of interest and thus
involve no periodic cash payments; the interest component consists entirely of the
bond’s discount.
3) Commodity-backed bonds are payable at prices related to a commodity such as
gold.
c. Redemption Provisions
1) Callable bonds may be repurchased by the issuer at a specified price before maturity.
a) A callable bond is not as valuable to investors as a straight bond.
2) Convertible bonds may be converted into equity securities of the issuer at the option
of the holder under certain conditions.
d. Securitization
1) Mortgage bonds are backed by specific assets, usually real estate.
2) Debentures are backed by the issuer’s full faith and credit but not by specific
collateral. Thus, debentures are riskier to investors than secured bonds.
3) Equipment trust bonds are secured by a lien on a specific piece of equipment,
such as an airplane or a railroad car. They are used mostly by companies in the
transportation industry.
e. Ownership
1) Registered bonds are issued in the name of the holder. Only the registered holder
may receive interest and principal payments.
2) Bearer bonds are not individually registered. Interest and principal are paid to
whomever presents the bond.
f. Priority
1) Subordinated debentures and second mortgage bonds are junior securities with
claims inferior to those of senior bonds.
g. Repayment Provisions
1) Income bonds pay interest only if the issuer earns the interest.
2) Revenue bonds are issued by governmental units and are payable from specific
revenue sources.

Question 37

Debt covenants

Answer 37

Debt covenants are restrictions or protective clauses that are imposed on a borrower by the
creditor in a formal debt agreement or an indenture.
1) Examples of debt covenants include the following:
a) Limitations on issuing long-term or short-term debt
b) Limitations on dividend payments
c) Maintaining certain financial ratios
d) Maintaining specific collateral that backs the debt

** The more restrictive the debt covenant, the less risky the investment is for creditors, the lower the
interest rate on the debt

**More restrict in debt, increase the security of the bond, decrease the risk, decrease the return…vice versa

Question 38

Bond Rating

Answer 38

the rating divided into 2 types:
Investment Grade Bond…Have Moderate Risk
Non-Investment Grade Bonds or Speculative Grade Bonds, Have High Yield and High Risk..e.g Junk Bonds

Junk Bonds: A junk bond is a bond that is rated “BB” or lower because of its high default risk.

Question 39

The following is a short list of widely available bonds ranked from the lowest rate of return to
the highest rate of return (and thus the lowest risk to the highest risk):

Answer 39

1) U.S. Treasury bonds
2) Secured bonds (i.e., first mortgage bonds)
3) Second mortgage bonds
4) Investment grade bonds
5) Subordinated bonds (i.e., deep discount bonds)
6) Income bonds
7) Junk bonds

Question 40

term structure of interest rates

Answer 40

is the relationship between yield to maturity and time to
maturity

**Higher interest rates on bonds lead to increased demand for bond investments, which
decreases the demand for common stock, causing the price of common stock to fall.

Since short-term interest rates are
usually lower than long-term rates, the yield curve is usually upward sloping

1) Upward sloping (long-term rates are higher than short-term rates)
2) Flat (long-term rates are equal to short-term rates)
3) Downward sloping (long-term rates are lower than short-term rates)
4) Humped (intermediate-term rates are higher than other rates)