FAQ: Securities and Financial Markets

Transcription

1 Question 1: What is agency relation within the context of a corporation, and what type of problems may arise as a result of such a relation? Answer 1: Agency relation is created whenever a company hires a manager (agent) to manage that company. Despite the legal and ethical responsibilities of an agent, there may be times or circumstances in which the agent may be naturally motivated or tempted to use or abuse the company s resources to fulfill his or her personal needs if left unchecked. Then, agency costs could turn into major draws on the company s resources, and at times may lead to management decisions that are harmful to the welfare of company owners, or stockholders. Question 2: How can companies minimize agency costs? Answer 2: Aside from the threat of firing and legal actions against agents in violation of their fiduciary responsibilities, firms can offer performance-based reward systems, so that managers are encouraged to act in the best interest of their employers and shareholders. Question 3: What is a security? Answer 3: A security is a voucher issued by an entity, such as a corporation. In other words, securities are documents that represent the right to receive funds in the future, such as stocks and bonds. A security certifies that the bearer has a claim to future funds. Securities have value because the bearer has the right to be paid the amount specified. A bearer who wants immediate revenue, therefore, can sell their security to someone else for cash. In fact, business firms, as well as local, state, and national governments, sell securities to the public to raise money. Question 4: What is meant by the term financial market, and how are the markets classified? Answer 4: Financial markets should not be confused with financial institutions. A financial institution is an organization that receives funds from some economic units and makes them available to others. A financial market, on the other hand, is a forum in which financial securities are traded. Financial markets are categorized according to the characteristics of the participants and the securities involved. The following represent the 1

2 classification scheme of financial markets. The Primary Market: When a security is created and sold for the first time in the financial marketplace the transaction takes place in the primary market. In this market the issuing business or entity sells its securities to investors. The Secondary Market: Once a security has been issued, it may be traded from one investor to another. The secondary market is where previously issued securities are traded among investors. The Money Market: Short-term securities, defined as maturities of one year or less, are traded in the money market. Networks of dealers operate in this market to trade Treasury bills, negotiable certificates of deposit, commercial paper, and other short-term debt instruments. The Capital Market: Long-term securities, defined as maturities over one year, trade in the capital market. Federal, state, and local governments, as well as large corporations, raise long-term funds in the capital market. Firms usually invest proceeds from capital market securities sales in long-term assets like buildings, production equipment, and so on. Initial offerings of securities in the capital market are usually large deals put together by investment bankers, although after the original issue, the securities may be traded quickly and easily among investors. The two most widely recognized securities in the capital market are stocks and bonds. Security Exchanges: Security exchanges such as the New York Stock Exchange (NYSE) are organizations that facilitate trading of stocks and bonds among investors. Corporations arrange for their stock or bonds to be listed on an exchange so that investors may trade the company s stocks and bonds at an organized trading location. The Over-the-Counter (OTC) Market: In contrast to the organized exchanges, which have physical locations, the over-the-counter market has no fixed location or, more correctly, it is everywhere. The OTC market is a network of dealers around the world who maintain inventories of securities for sale. Most dealers in the OTC market are connected through a computer network called NASDAQ (National Association of Securities Dealers Automated Quote system). But many others, especially those dealing in securities issued by very small companies, simply buy and sell over the telephone. Question 5: How are interest rates determined? Answer 5: Interest rates are prices of money. Supply and demand, 2

3 therefore, determine such prices at any point in time. There are also fundamental factors that have direct bearing on interest rates. Let s look at each of these separately. Among such factors are expected inflation, default risk, liquidity premium, and maturity risk. Expected Inflation: Inflation erodes the purchasing power of money. If inflation is present, the money that lenders get when their loans are repaid may not be as much as the money they lent to start with. Therefore, lenders who anticipate inflation during the term of a loan will demand additional interest to compensate for it. Default Risk: A default occurs when a borrower fails to pay the interest and principal on a loan on time. The default risk premium is the extra compensation lenders demand for assuming the risk of default. Liquidity Premium: Sometimes lenders sell loans to others after making them. Those that are easily sold are liquid, and those that are not sold easily are considered illiquid. Illiquid loans have a higher interest rate to compensate the lender for the inconvenience of not being able to unload the loan until it matures. Maturity Risk: If interest rates rise, lenders may find themselves with long-term loans paying the original rate prevailing at the time the loans were made while other lenders are able to make new loans at higher rates. Lenders respond to the risk that interest rates may change in one of two ways: o If lenders think interest rates may rise in the future, they may increase the rate they charge on their long-term loans now and decrease the rate they charge on their short-term loans now to encourage borrowers to borrow short term, or o Conversely, if lenders think interest rates might fall in the future, they may decrease the rate they charge on their longterm loans now and increase the rate they charge on their short-term loans now to encourage borrowers to borrow long term. This up or down adjustment that lenders make to their current interest rates to compensate for the uncertainty about future changes in rate is called the maturity risk. Question 6: How does the Federal Reserve (Fed) influence economic activity in the United States? 3

4 Answer 6: The Fed influences economic activity through its Federal Open Market Committee (FOMC) arm. Specifically, FOMC will engage in increasing or decreasing the money supply, and effectively decreasing or increasing interest rates. Lower interest rates are usually good for business and help expansion, as low rates decrease companies cost of doing business. Question 7: What is the main difference between finance companies and financial institutions? Answer 7: Financial institutions, such as banks, receive their funds in the form of deposits; finance companies do not have access to deposits, so they have to borrow their funds and then make new loans to businesses or individuals. This is also one reason that rates charged by finance companies are higher than those by banks and Savings and Loan institutions. Question 8: What is the difference between preferred and common stock, and how do I choose one over another? Answer 8: The owners of a corporation s common stock are the owners of the firm. Common stockholders receive their return in the form of common stock dividends and from capital gains that are realized when the stockholder sells their shares for more than they paid for those shares. Preferred stockholders are paid dividends first, and payments are usually fixed. Since they are always paid before any dividends are declared for common stockholders, preferred stock is therefore less risky. Common stockholders, on the other hand, have a claim on the residual income of the firm, and will earn all profits left after those claims ahead of them are satisfied. Thus, common stockholders have the potential to earn more profits or to suffer more losses. Selection is contingent, therefore, on the level of risk you are willing to assume. Question 9: How does financial intermediation often provide a better alternative to direct financing between surplus and deficit units? Answer 9: Financial intermediaries can help surplus and deficit unions avoid denomination matching problems if one unit needs a large sum of funds, but 4

5 the lending unit has only a small amount to lend, then direct borrowing is difficult. The bank handles the denomination matching problem by acting as an intermediary between units. The same principle applies to maturity matching: the intermediary may assume the risk here, as it has a number of units depositing and borrowing. It is not as difficult for them to accomplish the maturity matching given the large number of units involved. Individual units supplying funds do not need to be as concerned about credit and default. The institution assumes the risk here (of course should the institution fail, the individual unit is at risk depending upon the insurance coverage involved). 5