Chapter 03 Financial Instruments, Financial Markets, and Financial Institutions

Transcription

1 Chapter 03 Financial Instruments, Financial Markets, and Financial Institutions Multiple Choice Questions 1. (p. 56) A financial intermediary: a. Is an agency that guarantees a loan? B. Is involved in indirect finance c. Would be used in direct finance d. Must be a depository institution 2. (p. 39) Most individuals borrow: a. Directly without the use of a financial intermediary B. Using a financial intermediary because it lowers the cost of borrowing c. Using a financial intermediary, but would save money if they financed directly d. Without using financial intermediaries, preferring credit cards 3. (p. 39) Tom obtains a car loan from Old Town Bank. a. The car loan is Tom's asset and the bank's liability b. The car loan is Tom's asset, but the liability belongs to the bank's depositors C. The car loan is Tom's liability and an asset for Old Town Bank d. The car loan is Tom's liability and a liability of the bank until Tom pays it off 3-1

2 4. (p. 39) The U.S. government finances its budget deficits: A. Using direct finance b. By using a financial intermediary c. Using indirect finance d. Both through direct and indirect finance 5. (p. 39) The ultimate role of the financial system of a country is to: a. Provide a place for wealthy households to save b. Be a low-cost source of funds for government C. Facilitate production, employment, and consumption d. Provide jobs in the financial sector 6. (p. 39) Loans made between borrowers and lenders: a. Are liabilities to the lenders and assets to the borrowers since the borrower obtains the funds B. Are assets to the lenders and liabilities of the borrowers since the promises are made to the lenders c. Are not part of either parties' assets or liabilities until the loans are repaid? d. Are liabilities to both the lenders and the borrowers? 3-2

3 7. (p. 40) Financial instruments are used to channel funds from: A. Savers to borrowers in financial markets and via financial institutions b. Savers to borrowers in financial markets but not through financial institutions c. Borrowers to savers in financial markets but not through financial institutions d. Borrowers to savers through financial institutions, but not in financial markets 8. (p. 39) Kate buys a share of Google. Google uses the funds raised from selling its stock to expand its operations into Asia. This is an example of: A. Direct finance b. Indirect finance c. Use of a financial institution d. A loan 9. (p. 39) Loans made between borrowers and lenders are: a. Usually not taxable at the federal level b. Legal only in the state of origination C. Assets of the lenders d. Assets of the borrowers 3-3

4 10. (p. 39) Loans made between lenders and borrowers: a. Are assets to the borrowers? B. Are assets of the lenders? c. Are not taxable in the state of origination d. Are liabilities of the borrowers? 11. (p. 56) The process of financial intermediation: a. Creates a net cost to an economy B. Increases the economy's ability to produce c. Is always used when a borrower needs to obtain funds d. Is used primarily in underdeveloped countries 12. (p. 56) Which of the following statements is most correct? a. Financial intermediaries are banks B. A bank is a financial intermediary c. Financial intermediaries are insurance companies d. Financial intermediaries are essential to direct finance 13. (p. 56) Which of the following statements is most correct? A. All banks are financial intermediaries, but not all financial intermediaries are banks b. Financial intermediaries must be public corporations c. All financial intermediaries are insurance companies d. Financial intermediaries are government agencies 3-4

5 14. (p. 56) Which of the following is not a financial intermediary? a. A bank b. An insurance company C. The New York Stock Exchange d. A mutual fund 15. (p. 39) Mary purchases a U.S. Treasury bond; the bond is: a. An asset of the U.S. government as well as an asset for Mary B. A liability of the U.S. government and an asset for Mary c. An asset for Mary but not a liability of the U.S. Government d. An asset for the government but a liability for Mary 16. (p. 41) A financial instrument would include: a. Only a written obligation and a transfer of value b. Only a written obligation and a specified date C. A written obligation, a transfer of value, a future date, and certain conditions d. A written obligation, a transfer of value, a specific date for payment, uncertain conditions 17. (p. 41) Which of the following is not a financial instrument? a. A share of Microsoft stock b. A U.S. Treasury Bond C. An electric bill d. A life insurance policy 3-5

6 18. (p. 39) Sue has a checking account at the First National Bank; her checking account: a. Is an asset to the bank and a liability to Sue? B. Is an asset to Sue and a liability to the bank? c. Is an asset to Sue but actually a liability to the Federal Reserve? d. Is a liability to Sue until she spends the funds? 19. (p. 41) Financial instruments and money share which of the following characteristics? A. Both can function as a means of payment and a store of value b. Both can function as a store of value and allow for trading of risk c. Both can function by acting as a means of payment and allow for trading of risk d. Both can function as a store of value even though they do not allow for trading of risk BLOOMS: Synthesis 20. (p. 41) Financial instruments are different from money because: a. They can act as a store of value and money cannot b. They can't be a means of payment but money can C. They can allow for the transfer of risk d. They have greater liquidity BLOOMS: Synthesis 21. (p. 41) Juan purchases automobile insurance; the insurance contract is: A. A financial instrument b. A form of money c. A transfer of risk from the insurance company to Juan d. A financial intermediary 3-6

7 22. (p. 39) Most funds that flow between lenders and borrowers: a. Flow directly through financial intermediaries b. Flow through government agencies c. Flow directly through financial instruments D. Flow indirectly through financial intermediaries 23. (p. 56) A bank is a financial intermediary. Which of the following statements is most accurate? a. The bank's depositors are the ultimate lenders and the bank is the ultimate borrower b. People seeking loans from the bank are the ultimate spenders while the bank is the ultimate lender C. The bank's depositors are the ultimate lenders, while those seeking loans from the bank are the ultimate spenders d. Those seeking loans from the bank are the ultimate spenders; the bank's stockholders are the ultimate lenders 24. (p. 41) Which of the following statements is most correct? a. When a risk is difficult to predict, financial instruments are created to transfer these risks B. Financial instruments are created to transfer risks that are relatively easy to predict c. Financial instruments require certainty of an event to be able to transfer risk d. Financial instruments eliminate the risk from uncertainty, they do not transfer it 3-7

8 25. (p. 42) Standardization of financial instruments has occurred as a result of: a. The rule of 70 b. The law of demand C. Economies of scale d. The law of supply 26. (p. 42) More detailed financial instruments tend to be: a. Less costly because all possible contingencies are covered B. More costly because it will cost more to create c. More desirable than less detailed ones, no matter what the price d. Less costly because they can be standardized more easily BLOOMS: Analysis 27. (p. 42) Many financial instruments are standardized because: a. It is believed that most parties to a contract do not read them anyway B. Complexity is costly, the more complex a contract, the more it costs to create c. The standardization of contracts makes them harder to understand d. It is required by the government 28. (p. 42) A share of Ford Motor Company stock is an example of: a. A non-standardized financial instrument B. A standardized financial instrument c. A non-standardized financial instrument since their prices can differ over time d. A financial instrument without risk BLOOMS: Application 3-8

9 29. (p. 43) A counterparty to a financial instrument is always: a. The issuer of the financial instrument b. The government agency guaranteeing the value of the instrument c. The person or institution that purchases the financial instrument D. The person or institution that is on the other side of the financial contract 30. (p. 44) The information concerning the issuer of a financial instrument: a. Needs to be complete and closely monitored by the buyers of the instrument for change b. Is somewhat non-standardized to minimize the cost of the instrument C. Is usually standardized to the essential information required by the buyers d. Is closely monitored by the buyers of these instruments for change BLOOMS: Analysis 31. (p. 44) Asymmetric information in financial markets is a potential problem usually resulting from: A. Borrowers having more information than the lenders, and not disclosing this information b. Lenders having more information than borrowers and not disclosing this information c. The fact that people are basically dishonest d. The uncertainty about Federal Reserve monetary policy 3-9

10 32. (p. 44) Agencies exist which rate bonds based on characteristics of the borrower. Such bond rating agencies are an example of a financial market response designed to: a. Increase information asymmetry b. Decrease the real return to bondholders C. Provide a lower cost solution to the high cost of information d. Transfer risk from the buyer to the rating agency BLOOMS: Synthesis LOD: (p. 43) The better the information provided to financial markets: a. The less the amount of funds transferred between savers and borrowers b. The greater the amount of funds transferred between savers and borrowers, though risk increases c. The higher the return required by lenders D. The greater will be the flow of funds in these markets 34. (p. 45) Financial markets enable the transfer of risk by: a. Requiring that risk-averse investors have access to U.S. Treasury bond markets B. Allowing individuals and firms less willing to bear risk to transfer risk to other individuals and firms more willing to bear risk c. Making sure that higher default risk is offset by greater liquidity d. Enabling even unsophisticated investors to purchase highly complex financial instruments 3-10

11 35. (p. 44) A borrower has information that it does not make available to a prospective lender; this is an example of: a. A wise borrower and an unwise lender b. A transfer of risk C. Information asymmetry d. Liquidity risk BLOOMS: Application 36. (p. 47) Disability Income Insurance is: a. Insurance borrowers can take out in case the company they invest in defaults b. Insurance that makes payments of wages to workers when the company they work for is disabled due to a natural disaster C. Is insurance that makes payments to workers when they are unable to work due to an injury? d. Is only available through the government as part of the Social Security System 37. (p. 47) Disability Income Insurance: a. Is available only to people who have been at their jobs for more than 5 years B. Is provided by the government through Social Security c. Is not that critical since the odds are less than 1 in 10 working adults will be disabled for a period exceeding 90 days d. Is not a transfer of risk since it seeks to replace wages 3-11

12 38. (p. 45) The owner of a small business applies for a bank loan and tells the loan officer that the funds will be used to expand inventory for the upcoming holiday season. The small business finds itself in need of additional funds to meet the monthly rent for the next quarter and the owner uses the loan proceeds to pay the rent. This is an example of: a. Liquidity risk b. Default risk c. A lack of diversification for the bank D. Information asymmetry BLOOMS: Application 39. (p. 44) A share of Microsoft stock would best be described as which of the following? a. A derivative instrument b. A means of payment C. An underlying instrument d. A debt instrument 40. (p. 44) A derivative instrument: a. Comes into existence after the underlying instrument is in default b. Is a low-risk financial instrument used by highly risk-averse savers? C. Gets its value and payoff from the performance of the underlying instrument d. Should be purchased prior to purchasing the underlying security 3-12

13 41. (p. 44) One of the advantages of the financial system is: A. It gathers information about borrowers both before and after they obtain resources b. It communicates more information to lenders than borrowers c. It eliminates information asymmetry d. It makes sure that all information communicated is truthful 42. (p. 47) A futures contract is an example of: A. A derivative instrument b. An instrument used solely by financial institutions c. A high-risk security that will only have value if certain events occur d. A contract that is traded but is not a financial instrument 43. (p. 45) The primary use of derivative contracts is: a. For IRA and other pension plans since they only have value well into the future B. To shift risk among investors c. For investors seeking a greater return by taking greater risk d. To add to the profits an investor obtains through information asymmetry 44. (p. 45) The value of a financial instrument is influenced by each of the following, c: A. The identity of the seller of the instrument in a secondary market b. The size of the payment that is promised c. When the promised payment will be made d. The likelihood that the promised payment will be made 3-13

14 45. (p. 45) Which of the following is not one of fundamental characteristics that influence the value of a financial instrument? A. The current income tax rates b. The size of the promised payment to be made c. The likelihood that the payment will be made d. When the promised payment is to be made 46. (p. 45) Considering the value of a financial instrument, the bigger the size of the promised payment: a. The less valuable the financial instrument because risk must be greater b. The longer an investor has to wait for the payment C. The more valuable the financial instrument d. The greater the risk 47. (p. 45) Considering the value of a financial instrument, the sooner the promised payment is made: a. The less valuable is the promise to make it since time is valuable b. The greater the risk, therefore the promise has greater value C. The more valuable is the promise to make it d. The less relevant is the likelihood that the payment will be made 3-14

15 48. (p. 45) Considering the value of a financial instrument, the more likely it is the payment will be made: A. The more valuable the financial instrument b. The less valuable is the instrument because risk is lower c. The less valuable is the financial instrument because it is highly liquid d. The greater the uncertainty; therefore the less valuable is the financial instrument 49. (p. 45) Considering the value of a financial instrument, the circumstances under which the payment is to be made influence the value because: a. We like uncertain payoffs because this adds to the return B. Payments that are made when we need them the most are more valuable c. The sooner the payment is to be made the better d. We know when certain events are going to occur and that is when we want the payment 50. (p. 45) The fundamental characteristics influencing the value of a financial instrument: include each of the following except: a. The size of the payment promised b. When the promised payment will be made C. Where the instrument is traded d. The likelihood of payment 3-15

16 51. (p. 45) The value of a financial instrument rises as: a. The size of the payment promised decreases B. The promised payment is made sooner rather than later c. It is less likely the payment will be made d. The payments are made when the prospective investor needs them least 52. (p. 45) Consider the price paid for debt issued by the State of California. Which of the following would lead to a decrease in the value of State of California bonds? a. The State of California bonds are in small dollar amounts b. The State of California bonds have a longer maturity C. The State of California experiences a fiscal crisis that makes it less likely it will be able to honor its interest payments d. The State of California pays back its previous bonds ahead of schedule BLOOMS: Analysis LOD: (p. 46) Financial instruments used primarily as stores of value include each of the following, except: a. Bonds B. Futures contracts c. Stocks d. Home mortgages 3-16

17 54. (p. 46) Financial instruments used primarily as stores of value would not include: A. A car insurance policy b. A U.S. Treasury bond c. Shares of General Motors stock d. A home mortgage 55. (p. 47) Financial instruments used primarily to transfer risk would include all of the following, except: a. An insurance contract b. A futures contract c. Options D. A bank loan BLOOMS: Application 56. (p. 47) Financial instruments used primarily to transfer risk would not include: A. A bank loan b. Options c. An insurance policy d. Home mortgages 3-17

18 57. (p. 47) Which of the following financial instruments is used mainly to transfer risk? a. Asset-backed securities b. Bonds C. Options d. Stocks 58. (p. 46) Financial instruments used primarily as stores of value do not include: a. Asset backed securities b. U.S. Treasury bonds C. A car insurance policy d. A bank loan 59. (p. 46) The most prominent of asset-backed securities is: a. Shares of stock in corporations since stockholders own the assets B. Securities backed by home mortgages c. U.S. Treasury bonds since they are backed by all public assets d. Movie box-office receipts 60. (p. 48) Roles served by financial markets include the following, except: A. Eliminating risk b. Providing liquidity c. Pooling and communicating information d. Sharing of risk 3-18

19 61. (p. 49) If financial markets didn't exist: a. Required returns would be lower since fewer instruments would trade b. Liquidity would diminish and returns would be lower c. More funds would flow directly between borrowers and savers D. Liquidity would diminish, reducing the flow of funds between borrowers and savers BLOOMS: Analysis 62. (p. 48) The high volume of shares of stock that are traded on a normal day on stock markets reflects: a. The high transaction costs associated with these financial markets B. The low transaction costs and high liquidity associated with these markets c. The low transaction costs and low liquidity associated with these markets d. The high transactions costs and low liquidity associated with these markets 63. (p. 49) The pool of information collected by financial markets is usually: a. Only available to lenders B. Summarized in the form of a price c. Valuable and not made available until the parties pay for it d. More than a borrower needs to make a loan LOD:

20 64. (p. 48) Financial markets: a. Enable buyers and sellers to exchange financial instruments but not risk B. Enable buyers and sellers to exchange risk by buying and selling financial instruments c. Only allow the transfer of risk through derivative securities d. Do not allow for the transfer of risk but do help reduce it 65. (p. 48) Commissions paid to a stock broker are an example of: a. Risk transfer B. Transaction costs c. Information asymmetry d. Liquidity 66. (p. 48) Brokerage commissions: a. Are set by government regulators so they cannot vary across firms for the same services b. Can vary but typically don't because firms tend to set them at the same levels c. Can differ reflecting the different services being offered D. Are always a percentage of the amount of the trade? 67. (p. 49) A primary financial market is: a. A market just for corporate stocks b. A market only for AAA rated Securities c. The New York Stock Exchange D. Is one in which newly issued securities are sold 3-20

21 68. (p. 49) A primary financial market is: a. Located only in New York, London, and Tokyo but can handle transactions anywhere in the world B. One where the borrower obtains funds directly from the lender for newly issued securities c. A market where U.S. Treasury bonds are traded d. One that can only deal in the highest investment grade securities 69. (p. 49) Newly issued U.S. Treasury Securities are sold in: A. The primary financial market b. Only to the Federal Reserve who then resells them c. The secondary market since bonds cannot be sold in the primary market d. Secondary markets but only using registered bond dealers 70. (p. 50) Most of the buying and selling in primary markets: a. Is in the public view b. Is highly transparent and closely monitored by the SEC C. Involve an investment bank d. Is done by the Federal Reserve 71. (p. 50) Secondary financial markets: a. Are financial markets for all financial instruments rated less than investment grade B. Are financial markets where existing securities are bought and sold? c. Eliminate the transaction costs for buyers and sellers d. Are only for stock 3-21

22 72. (p. 49) A primary financial market is a market: a. Where only corporate bonds are sold b. Where only corporate and government bonds are sold c. Where newly issued securities are sold by savers to borrowers D. Where investment banks assist companies in raising cash 73. (p. 49) A collection of assets is known as a(n): a. Asset-backed security b. Derivative c. Futures contract D. Portfolio 74. (p. 50) One benefit of centralized exchanges compared to over-the-counter (OTC) markets is that: a. OTC markets require specialists, whereas centralized exchanges do not B. Mistakes in placing orders are more likely in OTC markets c. Centralized exchanges do not require physical access, whereas OTC markets do d. Centralized exchanges make use of electronic communications networks (ECNs), whereas OTC markets do not 3-22

23 75. (p. 50) Which of the following would not be an example of a secondary financial market transaction? a. You call a broker and purchase 100 shares of McDonalds Corp. stock B. You go to the bank and purchase a $5000 certificate of deposit c. You call a broker and purchase a U.S. Treasury bond d. You call a broker and purchase a bond issued by General Motors BLOOMS: Application 76. (p. 49) Which of the following is likely to be a primary financial market transaction? a. You cash the check your grandmother sent you for your birthday b. You call a broker and purchase bonds for your retirement fund C. A city issues bonds to finance new road construction d. A supermarket needs to borrow the funds for a second location and takes out a loan from a commercial bank to pay for it BLOOMS: Application 77. (p. 52) An over-the-counter (OTC) market is: a. Made up of dealers who only sell government bonds b. An example of a centralized market c. Made up of dealer who buy and sell only for their own accounts D. Made up of dealers who buy and sell for their customers and for their own accounts 3-23

24 78. (p. 51) The New York Stock Exchange (NYSE) is: a. A decentralized electronic market made up of dealers all over the world B. An example of a centralized exchange c. A financial market where nearly 100 million shares of stock are traded every business day d. The only centralized stock exchange in the world 79. (p. 52) Over-the-counter (OTC) markets: a. Employ specialists to minimize price volatility b. Are centralized exchanges but you must be a dealer to be part of an exchange c. Only deal in the stocks of companies with over $100 million in capital D. Are networks of security dealers linked electronically 80. (p. 52) Which of the following is not true of over-the-counter markets? a. Traders are linked by computer B. Dealers buy and sell only for their customers c. Trading does not take place in one physical location d. Traders are willing to buy and sell stocks and bonds at posted prices 81. (p. 53) Equity markets: a. Are markets of U.S. Treasury bonds b. Are markets for AAA rated bonds C. Are markets for stocks d. Are markets for either stocks or bonds 3-24

25 82. (p. 54) Debt instruments that have maturities less than one year are traded in: a. The primary market exclusively b. The bond markets exclusively c. The bond market if they are already in existence D. The money market 83. (p. 54) Money markets are where trades occur for: a. Stocks b. Bonds of all maturities c. Derivatives D. Bonds issued by both the government and private companies 84. (p. 54) Well-run financial markets: a. Keep transactions costs high to benefit brokers b. Prevent the widespread pooling of information C. Ensure that resources are allocated efficiently d. Are usually the result of little or no government regulation 3-25

26 85. (p. 55) Countries that lack well-defined property laws and legal structures: a. Have large secondary financial markets because the primary markets do not exist B. Will not develop as fast economically as counties with clear property rights and a formal legal system c. Will have much lower transaction costs associated with any level of lending d. Will not have any financial markets at all 86. (p. 56) Financial institutions: a. Raise the level of transaction costs relating to borrowing/ending B. Can lower the information asymmetry involved with borrowing/ending c. Decrease the liquidity to savers d. Are required for all financial transactions 87. (p. 57) An insurance company is an example of a financial institution that: A. Transforms assets b. Acts as a broker c. Serves as a depository institution d. Sells derivative securities 88. (p. 57) All of the following are depository institutions, except: a. Commercial banks b. Credit unions C. Insurance companies d. Savings banks 3-26

27 89. (p. 57) Which of the following are depository institutions? A. Credit unions b. Mutual funds c. Pension funds d. Insurance companies 90. (p. 57) Nondepository institutions: a. Do not serve as intermediaries b. Only serve as brokers c. Only transform assets D. Do not accept deposits 91. (p. 57) Non-depository institutions would include all of the following except: a. Finance companies b. Pension funds c. Insurance companies D. Credit unions 3-27

28 92. (p. 57) Small savers would rather use financial institutions than lend directly to borrowers because: a. Financial institutions will offer the savers higher interest rates than the savers could obtain directly from borrowers b. Lenders wouldn't want to deal with small savers C. Savers prefer to share risk d. The liquidity is lower with financial institutions but the return is higher 93. (p. 57) Financial intermediaries pool funds of: a. Many small savers and provide it to a few large borrowers b. Few large savers and provide it to many small borrowers c. Few large savers a few large borrowers D. Many small savers and provide it to many borrowers 94. (p. 57) Financial intermediaries handle a larger flow of funds than do primary markets primarily because financial intermediaries: a. Have a government-provided monopoly b. Have government-regulated prices, so there is little competition C. Can lower transaction costs and increase liquidity for savers d. Do not have to worry about information asymmetry 3-28

29 95. (p. 44) Derivative markets exist to allow for: A. Reduced risk from volatile prices b. Direct transfers of common stocks for bonds c. Cash receipts from the sale of bonds d. Reduced information asymmetry 96. (p. 57) Financial intermediaries include each of the following, except: A. The New York Stock Exchange b. Credit unions c. Savings banks d. Commercial banks Short Answer Questions 97. (p. 39) Provide examples of direct and indirect finance and a brief explanation the difference between the two. An individual going to a bank to obtain an automobile loan is an example of indirect finance. The U.S. Treasury selling bonds directly to the Federal Reserve is an example of direct finance. The key difference is the use of the financial intermediary in obtaining the automobile loan. 3-29

30 98. (p. 39) Stacy needs $5,000 to help with her tuition fees this semester. She is considering two ways to raise the funds she needs. First, she is considering going to her parents for the loan. Second, she could go to a bank for the loan. Discuss these options in the context of direct versus indirect finance. In what sense might her parents pay for the loan either way? If Stacy receives a loan from her parents, this is an example of direct finance because the borrower (Stacy) and her parents (the lenders) are interacting directly. If she receives the loan from a bank, then she is indirectly receiving the funds from her bank's depositors. If the bank's depositors include Stacy's parents, then they are indirectly loaning her the $5,000 through the bank. BLOOMS: Application 99. (p. 39) What is the relationship between financial market development and economic growth? A country's economic growth is linked to financial market development. As the text points out, a country's financial system has to grow as its level of economic activity rises, or the country will stagnate. Economic research has shown that there is strong positive correlation between financial market development and economic growth across countries (p. 41) What are the four characteristics of a financial instrument? (1) A financial instrument is a written legal obligation; (2) A financial instrument transfers something of value to another party; (3) A financial instrument specifies some future date for this transfer to occur; and (4) A financial instrument specifies certain conditions under which payment will be made. 3-30

31 101. (p. 42) Briefly explain one function of financial instruments that can make them very different from money. While financial instruments can function as a means of payment and a store of value, similar to money, one function that can make them very different from money is their ability to transfer risk between buyer and seller. A good example of this is the use of a futures contract that guarantees to the seller of the contract a price well into the future. Another common example is an insurance policy that transfers risk from the insured (a homeowner) to the insurer (the insurance company.) 102. (p. 42) Explain why most financial instruments are fairly complex, while at the same time quite standardized. Most financial instruments are complex in the sense that many possible contingencies are identified and both buyer and seller want to avoid problems that can arise from unforeseen events. To write a complete contract, however, would be very time consuming and expensive. As a result, most financial instruments are standardized because over time many common problems have been identified and worked into the contract, and standardization makes it easier to compare contracts and makes the instruments more liquid. 3-31

32 103. (p. 43) Credit cards usually charge higher rates of interest than most other forms of lending. In terms of information, collateral and monitoring, how might these higher rates be explained? When providing credit cards to customers, banks have the ability to obtain information at the time of application and based on this information they decide to issue or not issue the card. Once issued however, the ability of the bank to obtain further information and monitor the behavior of the individual is limited and before the card issuer can respond the cardholder can incur significant debt. Also, these are basically unsecured loans, meaning there is no collateral for the lender to seize if payment is not made. All of these facts and more make credit card loans risky and demanding of the higher rate. BLOOMS: Synthesis LOD: (p. 43) Why might a life insurance company insist on an individual having a physical exam before agreeing to provide life insurance to the individual? The life insurance policy is a contract that transfers risk from the buyer to the seller, in this case from the individual to the company. The price of the contract is based upon certain assumptions regarding the general health of the individual and specific information such as gender, age, etc. The company wants to make sure there is not any information hidden (information asymmetry) or other problem that would significantly alter its decision to provide the coverage or the price of the coverage. BLOOMS: Analysis 3-32

33 105. (p. 43) An annuity is a contract that makes monthly payments as long as someone lives. Explain why an individual would want to purchase such a contract. What risk is being transferred? An annuity transfers the risk that the buyer will live longer than expected. If an individual had certainty regarding his/her life expectancy he/she could plan accordingly and set up a budget that would exhaust his/her wealth at the time of death. We do not usually have such certainty and the risk is that we may live longer than we expect and could run out of funds before we die. With an annuity the individual transfers this risk to a company (for a fee) who is pooling many of these individuals and with the "law of large numbers" is better equipped to take this risk. BLOOMS: Application LOD: (p. 44) Why are options referred to as derivative instruments? Unlike underlying instruments, such as stocks and bonds, derivatives are instruments where the value and the payoff of the instrument are derived from the behavior of the underlying asset. As an example, suppose Tom has a contract allowing him to purchase 100 shares of stock in ABC company at a price of $10 per share six months from now. The value of his option contract will increase as the actual price of the ABC stock (the underlying instrument) rises and exceeds $10 per share (p. 45) What are the four fundamental characteristics that determine the value of a financial instrument? The four fundamental characteristics that determine the value of a financial instrument are (1) The size of the payment that is promised; (2) When the promised payment is to be made; (3) the likelihood that the payment will be made; (4) The conditions under which the payment is to be made. 3-33

34 108. (p. 44) A high school basketball player decides to bypass college and go right into the NBA, (the National Basketball Association). Describe the risk the individual is taking and a contract that might transfer the risk. The risks the individual is taking are numerous; one, he may not be as talented as he thinks and does not perform as well as he thinks he will and his value decreases. Perhaps more important, he could suffer a career-ending injury. In either case by bypassing college he has left himself with fewer options than he might otherwise have. These risks can be transferred through a few different types of contracts. First, he can negotiate a guaranteed contract that will pay him even if he is injured and can't play. The team would likely go along with this if the annual compensation is reduced. The individual could ask for the majority of his first contract to be in a guaranteed upfront payment which can then be used to purchase an annuity to provide income for the rest of his life. The individual could also purchase a disability insurance policy to provide a specified income in the event that he is injured and cannot do his job. BLOOMS: Analysis LOD: (p. 48) Describe what is likely to happen to the average price of a share of stock if the stock markets decide to close every Friday and Monday to provide workers at the exchanges with longer weekends. The average price of stocks would decrease. The fact that the markets are open less decreases the liquidity of stocks and, as a result, their prices would have to be lower in order to entice savers to hold these instruments. BLOOMS: Application 3-34

35 110. (p. 48) What evidence is there that the transaction costs involved with the buying and selling of stocks is low? Probably the best evidence is the volume of trading that occurs on an average day. As an example, on an average day billions of shares of stock may trade in the U.S. alone, and while most of these trades are undertaken using brokers, the fee the broker requires is usually a very small percentage of the overall value of the instruments traded. The volume of trades and the low fees for these trades would not result if transaction costs were high. BLOOMS: Analysis 111. (p. 57) Standard & Poor's sells information to investors; this is their primary business. Is this an example of a financial intermediary? Explain. No. A financial intermediary is involved indirectly in a financial transaction. It matches up the ultimate lenders (savers) with the ultimate spenders (borrowers). The funds flow through the intermediary which is acting as a "middleman." That is not the case with Standard & Poor's. BLOOMS: Application 112. (p. 46) Consider a typical individual who owns the following financial instruments: A life insurance policy for $250,000; a certificate of deposit for $10,000; homeowner's and auto insurance policies; $50,000 in a mutual fund, and $150,000 in her pension fund at work. Which of these are instruments used primarily as stores of value and which are being used to transfer risk? The life insurance policy, the homeowner and auto insurance policies are instruments being used to primarily transfer risk. The cost of an untimely death or loss resulting from an auto accident or damage to her house is a risk the individual prefers to transfer to someone else. The certificate of deposit, the balances in her mutual fund and pension are instruments that are serving primarily as stores of value. In these instruments wealth is being accumulated and stored for use at a later time. BLOOMS: Application 3-35

36 113. (p. 46) Explain how the introduction of asset-backed securities has allowed investors to take advantage of higher returns from loans that most investors could never make on their own. Asset-backed securities are instruments that allow the holder to share in the returns or payments arising from specific assets such as home mortgages or car loans. Investors purchase shares in the revenue that come from the underlying assets. While most investors would not or could not take the risk of making a home mortgage directly, they can purchase these securities and enjoy the higher return offered by home mortgages with less risk than would be the case if they made a home mortgage directly. LOD: (p. 49) How do financial markets pool and communicate the information regarding issuers of financial instruments in a convenient way? Financial markets pool and communicate information about the issuers of financial instruments and summarize this information in the form of a price. For example, any information that says an issuer of a financial instrument is less likely to honor its payment would have the price of the instrument decrease or the required return increases Any information that places the issuer in a more favorable light would have the opposite effect (p. 49) How do financial markets contribute to the process of risk transfer? Financial instruments can be used to transfer risk. This can only happen, however, if these instruments can be traded quickly at relatively low transaction costs. Financial markets are the places that these instruments can be traded for relatively low costs and therefore contribute to the process of risk transfer. 3-36

37 116. (p. 49) Can a financial instrument be bought and sold in both a primary and secondary financial market? Explain. The answer is yes and highly likely. When a financial instrument is new, say a newly issued U.S. Treasury bond, it is initially sold in a primary financial market. Perhaps the bond is purchased directly by the Federal Reserve. At some later time, however, the Federal Reserve may decide to sell the bond and this transaction would be a secondary market transaction since the instrument already exists. LOD: (p. 49) Is the obtaining of a car loan a primary or secondary market transaction? The obtaining of a car loan is a primary market transaction since the loan represents a newlyissued instrument by the bank. BLOOMS: Application 118. (p. 54) Where would you expect prices to be more volatile, on instruments traded in the money market or instruments traded in the bond market? Explain. We learned in previous chapters that prices tend to fluctuate more on instruments with longer maturities. Since the money market deals with instruments that have maturities less than one year, we would expect their prices to be more stable than instruments traded on the bond market where the maturities are longer. BLOOMS: Synthesis 3-37

38 119. (p. 52) Why didn't the over-the-counter (OTC) exchanges suffer the disruption of service that the New York Stock Exchange did after the terrorist attacks of September 11, 2001? The New York Stock Exchange is a centralized exchange, meaning it is one physical location. Since it was located in New York near the World Trade Center it had to close as it was impossible for people to get into the area. The OTC exchange on the other hand is electronic networks where each dealer is linked electronically to other dealers. As a result, the bombing in New York certainly disrupted the ability of some New York dealers to trade, but the remainder of the exchange continued to function. BLOOMS: Application 120. (p. 53) What is the primary distinction between debt/equity markets and derivative markets? The market for equities (stocks) and debt (mainly bonds) are markets where the actual claims are purchased or sold for immediate cash payment. On the other hand, in derivative markets, parties and counterparties make agreements that are settled at a later date (p. 56) From the savers' perspective, what are the benefits of going to a depository institution to obtain accounts in which to hold a portion of wealth, instead of buying securities directly from financial markets? First, the saver does not bear a transaction cost each time he/she makes a deposit. Second, the saver does not need to research potential investment options because the bank invests the funds for him/her. Third, banks grant the saver easy access to his/her funds. Specifically, deposits are more liquid and less risky than securities. 3-38

39 Essay Questions 122. (p. 42) As we saw in the chapter, some financial instruments are used primarily to transfer risk. Explain how a bread maker can use a financial instrument to transfer the following risk: The bread maker has the opportunity to provide bread to a local army base. The base figures they will need 10,000 loaves of bread each week, or roughly 500,000 for a year. The problem is the baker must quote a price for the entire year. The baker would really like to have this contract but he realizes that fluctuating input prices (specifically wheat) could result in significant losses. The baker could quote a price for bread based on today's price and then purchase wheat a futures contract for wheat at today's price, for delivery one year from now. If actual wheat prices do increase the baker will lose money on the actual baking operations but these losses will be offset by the profits he will earn on the wheat futures contract. If wheat prices end up decreasing, he will suffer losses on the futures contract but will offset these by having higher profits from baking. In this case the futures contract accomplishes exactly what it was supposed to do. It transferred the risk of volatile wheat prices from the baker, who otherwise wouldn't accept the opportunity to provide bread at a guaranteed price for a year, to someone who was more willing to accept this risk. BLOOMS: Application LOD: (p. 46) Suppose that an internet-based program, Novus, wants to raise $10 million to expand its business operations. Describe how Novus can raise these funds directly through each of the follow options: issuing stock, issuing bonds, or obtaining a bank loan. Compare and contrast these three options. Novus can issue new stock worth $10 million. Alternatively, it can issue $10 million in bonds. In either of these two cases, Novus will seek out an investment bank to serve as an underwriter (to bring the shares from the primary to the secondary market). If Novus issues stock, it is not obligated to pay dividends to its new stock holders, but if it doesn't it risks reducing the value of its stock. If Novus issues bonds, it must pay interest in regular payments. If Novus goes to a bank for a loan, it will make regular payments that include interest (and possibly parts of the principal amount owed), similar to a bond issue. BLOOMS: Analysis LOD:

40 124. (p. 54) Many countries of the former Soviet Union are finding the transformation to a market-based economy to be quite difficult and economic growth rates for many of these countries are quite low. Explain what role the lack of financial market development may play in these countries. Financial markets really did not exist for many of these countries when they were under a command and control system. As the countries seek to become more market oriented, financial markets will need to develop just like other markets. One problem that will need to be overcome is the creation of a system of property rights and laws on which all markets, especially financial markets, can rely. Many of us in industrialized market economies take the system of property rights and laws that protect investors for granted. It is the extensive system of property rights, laws, and investor protection that has many people quite comfortable placing their funds with financial intermediaries or lending their funds directly to other individuals or firms, knowing that there is legal recourse should the counterparty not do what he/she was supposed to do. In developing market economies it is not surprising that many people who may have funds to invest may be quite reluctant to do so until they are comfortable that there is adequate legal protection, methods to minimize information asymmetry, and the development of financial intermediaries to reduce the risk of lending. Until this happens these economies will not operate as efficiently or grow as rapidly as they otherwise might. BLOOMS: Synthesis LOD: (p. 56) Explain the various ways that financial intermediaries increase the efficiency of an economy. Financial intermediaries increase an economy's efficiency in a number of ways. First, they provide a means for savers to channel funds to borrowers (spenders). This puts otherwise idle resources to use, increasing an economy's output. While savers theoretically could lend directly to borrowers, the transaction costs as well as the risk would be significantly increased, to the point where these funds may not actually flow. Also, financial intermediaries lower the transaction costs of lending. This includes information gathering as well as monitoring costs. These lower transaction costs allow resources to be used to increase the output of goods and services in the economy. BLOOMS: Analysis LOD:

41 126. (p. 56) Compare and contrast financial institutions that act as brokers to those that transform assets. In what sense are both types of institutions financial intermediaries? Provide one example of each type and describe how each functions as a financial intermediary. Financial institutions that act as brokers provide a way for lenders/savers to buy securities from borrowers/spenders. Such institutions make it easier for borrowers and savers direct access financial markets. Financial institutions that transform assets collect deposits (and payments for insurance policies) to raise funds that are then loaned to borrowers/spenders. These institutions allow borrowers and savers to interact indirectly. Depository institutions accept deposits from savers and issue loans to borrowers. Insurance companies accept premiums from policy holders (savers) and invest these funds in securities. When a policy holder makes a claim (borrower), he/she receives compensation in the even of a bad event (accident, illness, theft, etc.). Pension funds invest contributions from savers and provide payments to retirees (borrowers). Securities firms provide brokerage services, allowing investors (savers) the ability to buy securities (issued by borrowers) in financial markets. Investment banks serve as underwriters, easing access to markets by bringing securities issued by borrowers into secondary markets for purchase by savers. Mutual funds mainly transform assets, allowing savers to purchase a diverse group of securities (issued by borrowers) with a small initial investment. Finance companies raise funds from buying securities in financial markets and loan out funds to borrowers. Government-sponsored programs, such as Social Security, provide the same services that pension funds and insurance companies provide privately. BLOOMS: Analysis LOD: