A financial intermediary:
A. is an agency that guarantees a loan.
B. is a third-party that facilitates a transaction between a borrower and a lender.
C. would be used in direct finance.
D. must be a depository institution.
answer
B
question
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.
answer
B
question
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.
answer
C
question
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.
answer
C
question
Loans made between borrowers and lenders are:
A.
liabilities to the lenders and assets to the borrowers since the borrower obtains the funds.
B.
assets to the lenders and liabilities of the borrowers since the promises are made to the lenders.
C.
not part of either parties' assets or liabilities until the loans are repaid.
D.
liabilities to both the lenders and the borrowers.
answer
B
question
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.
answer
A
question
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.
answer
C
question
Loans made between lenders and borrowers are:
A.
assets to the borrowers.
B.
liabilities of the lenders.
C.
not taxable in the state of origination.
D.
liabilities of the borrowers.
answer
D
question
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.
answer
B
question
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.
answer
B
question
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.
answer
A
question
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
answer
C
question
Mary purchases a U.S. Treasury bond; the bond is a(n):
A.
asset of the U.S. government as well as an asset for Mary.
B.
liability of the U.S. government and an asset for Mary.
C.
asset for Mary but not a liability of the U.S. Government.
D.
asset for the government but a liability for Mary.
answer
B
question
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.
answer
C
question
15.
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
answer
C
question
Sue has a checking account at the First National Bank; her checking account is a(n):
A.
asset to the bank and a liability to Sue.
B.
asset to Sue and a liability to the bank.
C.
asset to Sue but actually a liability to the Federal Reserve.
D.
liability to Sue until she spends the funds.
answer
B
question
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.
answer
A
question
Financial instruments are different from money because they:
A.
can act as a store of value and money cannot.
B.
can't be a means of payment but money can.
C.
can allow for the transfer of risk.
D.
have greater liquidity.
answer
C
question
Juan purchases automobile insurance; the insurance contract is a:
A.
financial instrument.
B.
form of money.
C.
transfer of risk from the insurance company to Juan.
D.
financial intermediary.
answer
A
question
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.
answer
C
question
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.
answer
B
question
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.
answer
C
question
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.
answer
B
question
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.
answer
B
question
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.
answer
B
question
A counterparty to a financial instrument is always the:
A.
issuer of the financial instrument.
B.
government agency guaranteeing the value of the instrument.
C.
person or institution that purchases the financial instrument.
D.
person or institution that is on the other side of the financial contract.
answer
D
question
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.
answer
C
question
Asymmetric information in financial markets is a potential problem usually resulting from:
A. borrowers having more information than the lenders.
B. lenders having more information than borrowers.
C. the fact that people are basically dishonest.
D. the uncertainty about Federal Reserve monetary policy.
answer
A
question
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.
answer
C
question
The better the information provided to financial markets the:
A.
less the amount of funds transferred between savers and borrowers.
B.
greater the amount of funds transferred between savers and borrowers though risk increases.
C.
higher the return required by lenders.
D.
greater will be the flow of funds in these markets.
answer
D
question
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.
answer
B
question
A borrower has information that is not 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.
answer
C
question
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.
insurance that makes payments to workers when they are unable to work due to an injury.
D.
only available through the government as part of the Social Security System.
answer
C
question
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.
answer
D
question
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
answer
C
question
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.
answer
C
question
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.
answer
A
question
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.
answer
B
question
Considering the value of a financial instrument, the bigger the size of the promised payment the:
A.
less valuable the financial instrument because risk must be greater.
B.
longer an investor has to wait for the payment.
C.
more valuable the financial instrument.
D.
greater the risk.
answer
C
question
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.
answer
C
question
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.
answer
A
question
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.
answer
B
question
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.
answer
C
question
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.
answer
B
question
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 shorter 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.
answer
C
question
Financial instruments used primarily as stores of value include each of the following, except:
A.
bonds.
B.
futures contracts.
C.
stocks.
D.
home mortgages.
answer
B
question
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.
answer
A
question
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.
answer
D
question
Which of the following financial instruments is used mainly to transfer risk?
A.
Asset-backed securities
B.
Bonds
C.
Options
D.
Stocks
answer
C
question
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.
answer
C
question
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.
answer
B
question
Roles served by financial markets include the following, except:
A.
eliminating risk.
B.
providing liquidity.
C.
pooling and communicating information.
D.
sharing of risk.
answer
A
question
Which of the following is not a reason why interbank lending dried up during the financial crisis of 2007-2009?
A.
Banks preferred to hold on to their liquid assets in case their own need for them increased.
B.
Banks grew increasingly concerned about the ability of their trading partners to repay the loans.
C.
The increased cost of loans.
D.
The Fed grew increasingly wary of making liquidity available to banks.
answer
D
question
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.
answer
D
question
The high volume of shares of stock that are traded on a normal day on stock markets reflects the:
A.
high transaction costs associated with these financial markets.
B.
low transaction costs and high liquidity associated with these markets.
C.
low transaction costs and low liquidity associated with these markets.
D.
high transactions costs and low liquidity associated with these markets.
answer
B
question
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.
answer
B
question
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.
answer
B
question
Commissions paid to a stock broker are an example of:
A.
risk transfer.
B.
transaction costs.
C.
information asymmetry.
D.
liquidity.
answer
B
question
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.
answer
C
question
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.
one in which newly issued securities are sold.
answer
D
question
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.
answer
B
question
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.
answer
A
question
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.
answer
C
question
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.
answer
B
question
A collection of assets is known as a(n):
A.
asset-backed security.
B.
derivative.
C.
futures contract.
D.
portfolio.
answer
D
question
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.
answer
B
question
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.
answer
C
question
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.
answer
D
question
The New York Stock Exchange (NYSE) originated as:
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.
answer
B
question
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.
answer
D
question
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.
answer
B
question
Equity markets are markets:
A.
of U.S. Treasury bonds.
B.
for AAA rated bonds.
C.
for stocks.
D.
for either stocks or bonds.
answer
C
question
Debt instruments that have maturities less than one year are traded in the:
A.
primary market exclusively.
B.
bond markets exclusively.
C.
bond market if they are already in existence.
D.
money market.
answer
D
question
Money markets are where trades occur for:
A.
stocks.
B.
bonds of all maturities.
C.
derivatives.
D.
short-term bonds issued by both governments and private companies.
answer
D
question
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
answer
C
question
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.
answer
B
question
Financial institutions:
A.
raise the level of transaction costs relating to borrowing/lending.
B.
can lower the information asymmetry involved with borrowing/lending.
C.
decrease the liquidity to savers.
D.
are required for all financial transactions.
answer
B
question
An insurance company is an example of a financial institution that:
A.
transfers risk.
B.
acts as a broker.
C.
serves as a depository institution.
D.
sells derivative securities.
answer
A
question
All of the following are depository institutions, except:
A.
commercial banks.
B.
credit unions.
C.
insurance companies.
D.
savings banks.
answer
C
question
Which of the following are depository institutions?
A.
Credit unions
B.
Mutual funds
C.
Pension funds
D.
Insurance companies
answer
A
question
Nondepository institutions:
A.
do not serve as intermediaries.
B.
only serve as brokers.
C.
only transform assets.
D.
do not accept deposits.
answer
D
question
Non-depository institutions would include all of the following except:
A.
finance companies.
B.
pension funds.
C.
insurance companies.
D.
credit unions.
answer
D
question
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.
it allows them to diversify risk.
D.
the liquidity is lower with financial institutions but the return is higher.
answer
C
question
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.
answer
D
question
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.
answer
C
question
Derivative markets exist to allow for:
A.
allow for the transfer of risk.
B.
direct transfers of common stocks for bonds.
C.
cash receipts from the sale of bonds.
D.
reduced information asymmetry.
answer
A
question
Financial intermediaries include each of the following, except:
A.
the New York Stock Exchange.
B.
credit unions.
C.
savings banks.
D.
commercial banks.
answer
A
question
Which of the following is not considered to be a shadow bank?
A.
Credit unions
B.
Brokerages
C.
Insurers
D.
Money-market mutual funds
answer
A
question
Today the primary distinction between direct and indirect finance is in:
A.
direct finance the asset holder has a claim on a financial institution while in indirect finance the asset holder has a direct claim on the borrower.
B.
indirect finance the lender has a direct claim on the borrower while in direct finance the lender has a claim on a financial institution.
C.
direct finance the asset holder has a direct claim on the borrower while in indirect finance the asset holder has a claim on a financial institution.
D.
indirect finance the asset holder has a claim on the government while in direct finance the asset holder has a direct claim on a private sector corporation.
answer
C
question
Derivatives would include all of the following except:
A.
options.
B.
U.S. Treasury securities.
C.
swaps.
D.
futures.
answer
B
question
Reasons for the rapid structural change in financial markets in recent years include all of the following except:
A.
globalization.
B.
technological advances in computing.
C.
technological advances in communication.
D.
high real interest rates.
answer
D
question
What is the relationship between financial market development and economic growth?
answer
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.
question
What are the four characteristics of a financial instrument?
answer
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.
question
Briefly explain one function of financial instruments that can make them very different from money.
answer
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).
question
Explain why most financial instruments are fairly complex, while at the same time quite standardized.
answer
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.
question
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?
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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.
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Why might a life insurance company insist on an individual having a physical exam before agreeing to provide life insurance to the individual?
answer
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.
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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?
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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.
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Why are options referred to as derivative instruments?
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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.
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What are the four fundamental characteristics that determine the value of a financial instrument?
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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.
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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
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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.
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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.
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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.
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What evidence is there that the transaction costs involved with the buying and selling of stocks is low?
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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.
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Standard & Poor's sells information to investors; this is their primary business. Is this an example of a financial intermediary? Explain.
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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.
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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?
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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.
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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.
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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.
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How do financial markets pool and communicate the information regarding issuers of financial instruments in a convenient way?
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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.
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Can a financial instrument be bought and sold in both a primary and secondary financial market? Explain.
answer
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.
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Is the obtaining of a car loan a primary or secondary market transaction?
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The obtaining of a car loan is a primary market transaction since the loan represents a newly-issued instrument by the bank.
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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?
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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.
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What is the primary distinction between debt/equity markets and derivative markets?
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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.
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What is meant by the "paradox of leverage?"
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The paradox of leverage occurs when all financial institutions try to deleverage at once. This will prove counterproductive as falling asset prices will mean more losses, diminishing their net worth still more, raising leverage and making the assets they hold seem riskier, compelling further sales, and so on.
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Why has the pace of structural change in financial markets accelerated in recent years?
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The pace of structural change has accelerated dramatically in the past few years, driven by (1) ongoing technological advances in computing and communications and (2) increasing globalization. The former dramatically lowered the importance of a physical location of an exchange—as new technology allowed the rapid low-cost transmission of orders across long distances—while the latter encouraged unprecedented cross-border mergers of exchanges, integrating larger pools of providers and users of funds.
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What are some of the advantages of trading in decentralized electronic exchanges?
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Customers can see the orders, the orders are executed quickly, trading occurs 24 hours a day, and costs are low.
question
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.
answer
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.
question
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.
answer
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.
question
Explain the various ways that financial intermediaries increase the efficiency of an economy.
answer
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.
question
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.
answer
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.
question
Trading in electronic exchanges has grown tremendously in recent years, what are some of the disadvantages of trading in decentralized electronic exchanges?
answer
Electronic operations have proven prone to errors that threaten the existence of brokers. In addition, amid the complex system of multiple, imperfectly linked exchanges, new trading patterns have arisen that render the entire system fragile, raising serious worries among investors about the liquidity and value of their stocks. Efforts to speed up electronic trading drain resources from more efficient uses. To see this point, imagine that an HFT firm relocates its computing facilities closer to an exchange so that it can cut the transmission time for orders by a few microseconds (millionths of a second). The goal of the move is to profit by trading an instant faster than competitors when new information becomes available, such as a stock issuer's quarterly profit statement or the nation's monthly employment report. Yet microsecond gains in trading speed likely diminish the willingness of market makers to provide liquidity because they don't wish to be "picked off" by well-equipped HFTs. Over time, market makers also may be forced to invest heavily to keep up with the faster turnover of stocks, with little gain to the broader economy. Finally, the advent of multiple electronic exchanges and ECNs has not resulted in a single, integrated, and transparent U.S. stock market.
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