chapter 03 financial instruments, financial markets, and ... · chapter 03 - financial instruments,...

Chapter 03 - Financial Instruments, Financial Markets, and Financial Institutions

Chapter 03Financial 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 financec. Would be used in direct financed. Must be a depository institution

AACSB: AnalyticBLOOMS: KnowledgeLOD: 1

2. (p. 39) Most individuals borrow: a. Directly without the use of a financial intermediaryB. Using a financial intermediary because it lowers the cost of borrowingc. Using a financial intermediary, but would save money if they financed directlyd. 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 liabilityb. The car loan is Tom's asset, but the liability belongs to the bank's depositorsC. The car loan is Tom's liability and an asset for Old Town Bankd. The car loan is Tom's liability and a liability of the bank until Tom pays it off

AACSB: Reflective ThinkingBLOOMS: ComprehensionLOD: 2

3-1


4. (p. 39) The U.S. government finances its budget deficits: A. Using direct financeb. By using a financial intermediaryc. Using indirect financed. 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 saveb. Be a low-cost source of funds for governmentC. Facilitate production, employment, and consumptiond. 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 fundsB. Are assets to the lenders and liabilities of the borrowers since the promises are made to the lendersc. Are not part of either parties' assets or liabilities until the loans are repaid?d. Are liabilities to both the lenders and the borrowers?

AACSB: AnalyticBLOOMS: ComprehensionLOD: 1

3-2


7. (p. 40) Financial instruments are used to channel funds from: A. Savers to borrowers in financial markets and via financial institutionsb. Savers to borrowers in financial markets but not through financial institutionsc. Borrowers to savers in financial markets but not through financial institutionsd. 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 financeb. Indirect financec. Use of a financial institutiond. A loan


9. (p. 39) Loans made between borrowers and lenders are: a. Usually not taxable at the federal levelb. Legal only in the state of originationC. Assets of the lendersd. Assets of the borrowers

AACSB: AnalyticBLOOMS: ComprehensionBLOOMS: KnowledgeLOD: 1

3-3


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 originationd. Are liabilities of the borrowers?


11. (p. 56) The process of financial intermediation: a. Creates a net cost to an economyB. Increases the economy's ability to producec. Is always used when a borrower needs to obtain fundsd. Is used primarily in underdeveloped countries


12. (p. 56) Which of the following statements is most correct? a. Financial intermediaries are banksB. A bank is a financial intermediaryc. Financial intermediaries are insurance companiesd. 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 banksb. Financial intermediaries must be public corporationsc. All financial intermediaries are insurance companiesd. Financial intermediaries are government agencies


3-4


14. (p. 56) Which of the following is not a financial intermediary? a. A bankb. An insurance companyC. The New York Stock Exchanged. 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 MaryB. A liability of the U.S. government and an asset for Maryc. An asset for Mary but not a liability of the U.S. Governmentd. 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 valueb. Only a written obligation and a specified dateC. A written obligation, a transfer of value, a future date, and certain conditionsd. 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 stockb. A U.S. Treasury BondC. An electric billd. A life insurance policy


3-5


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 valueb. Both can function as a store of value and allow for trading of riskc. Both can function by acting as a means of payment and allow for trading of riskd. Both can function as a store of value even though they do not allow for trading of risk

AACSB: Reflective ThinkingBLOOMS: SynthesisLOD: 2

20. (p. 41) Financial instruments are different from money because: a. They can act as a store of value and money cannotb. They can't be a means of payment but money canC. They can allow for the transfer of riskd. They have greater liquidity


21. (p. 41) Juan purchases automobile insurance; the insurance contract is: A. A financial instrumentb. A form of moneyc. A transfer of risk from the insurance company to Juand. A financial intermediary


3-6


22. (p. 39) Most funds that flow between lenders and borrowers: a. Flow directly through financial intermediariesb. Flow through government agenciesc. Flow directly through financial instrumentsD. 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 borrowerb. People seeking loans from the bank are the ultimate spenders while the bank is the ultimate lenderC. The bank's depositors are the ultimate lenders, while those seeking loans from the bank are the ultimate spendersd. 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 risksB. Financial instruments are created to transfer risks that are relatively easy to predictc. Financial instruments require certainty of an event to be able to transfer riskd. Financial instruments eliminate the risk from uncertainty, they do not transfer it


3-7


25. (p. 42) Standardization of financial instruments has occurred as a result of: a. The rule of 70b. The law of demandC. Economies of scaled. The law of supply


26. (p. 42) More detailed financial instruments tend to be: a. Less costly because all possible contingencies are coveredB. More costly because it will cost more to createc. More desirable than less detailed ones, no matter what the priced. Less costly because they can be standardized more easily

AACSB: Reflective ThinkingBLOOMS: AnalysisBLOOMS: ComprehensionLOD: 2

27. (p. 42) Many financial instruments are standardized because: a. It is believed that most parties to a contract do not read them anywayB. Complexity is costly, the more complex a contract, the more it costs to createc. The standardization of contracts makes them harder to understandd. 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 instrumentB. A standardized financial instrumentc. A non-standardized financial instrument since their prices can differ over timed. A financial instrument without risk

AACSB: Reflective ThinkingBLOOMS: ApplicationLOD: 1

3-8


29. (p. 43) A counterparty to a financial instrument is always: a. The issuer of the financial instrumentb. The government agency guaranteeing the value of the instrumentc. The person or institution that purchases the financial instrumentD. 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 changeb. Is somewhat non-standardized to minimize the cost of the instrumentC. Is usually standardized to the essential information required by the buyersd. Is closely monitored by the buyers of these instruments for change

AACSB: Reflective ThinkingBLOOMS: AnalysisLOD: 2

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 informationb. Lenders having more information than borrowers and not disclosing this informationc. The fact that people are basically dishonestd. The uncertainty about Federal Reserve monetary policy


3-9


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 asymmetryb. Decrease the real return to bondholdersC. Provide a lower cost solution to the high cost of informationd. Transfer risk from the buyer to the rating agency


33. (p. 43) The better the information provided to financial markets: a. The less the amount of funds transferred between savers and borrowersb. The greater the amount of funds transferred between savers and borrowers, though risk increasesc. The higher the return required by lendersD. 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 marketsB. Allowing individuals and firms less willing to bear risk to transfer risk to other individuals and firms more willing to bear riskc. Making sure that higher default risk is offset by greater liquidityd. Enabling even unsophisticated investors to purchase highly complex financial instruments


3-10


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 lenderb. A transfer of riskC. Information asymmetryd. Liquidity risk


36. (p. 47) Disability Income Insurance is: a. Insurance borrowers can take out in case the company they invest in defaultsb. Insurance that makes payments of wages to workers when the company they work for is disabled due to a natural disasterC. 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 yearsB. Is provided by the government through Social Securityc. Is not that critical since the odds are less than 1 in 10 working adults will be disabled for a period exceeding 90 daysd. Is not a transfer of risk since it seeks to replace wages


3-11


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 riskb. Default riskc. A lack of diversification for the bankD. Information asymmetry

AACSB: AnalyticBLOOMS: ApplicationLOD: 2

39. (p. 44) A share of Microsoft stock would best be described as which of the following? a. A derivative instrumentb. A means of paymentC. An underlying instrumentd. A debt instrument


40. (p. 44) A derivative instrument: a. Comes into existence after the underlying instrument is in defaultb. Is a low-risk financial instrument used by highly risk-averse savers?C. Gets its value and payoff from the performance of the underlying instrumentd. Should be purchased prior to purchasing the underlying security


3-12


41. (p. 44) One of the advantages of the financial system is: A. It gathers information about borrowers both before and after they obtain resourcesb. It communicates more information to lenders than borrowersc. It eliminates information asymmetryd. It makes sure that all information communicated is truthful


42. (p. 47) A futures contract is an example of: A. A derivative instrumentb. An instrument used solely by financial institutionsc. A high-risk security that will only have value if certain events occurd. 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 futureB. To shift risk among investorsc. For investors seeking a greater return by taking greater riskd. 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 marketb. The size of the payment that is promisedc. When the promised payment will be maded. The likelihood that the promised payment will be made


3-13


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 ratesb. The size of the promised payment to be madec. The likelihood that the payment will be maded. 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 greaterb. The longer an investor has to wait for the paymentC. The more valuable the financial instrumentd. 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 valuableb. The greater the risk, therefore the promise has greater valueC. The more valuable is the promise to make itd. The less relevant is the likelihood that the payment will be made


3-14


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 instrumentb. The less valuable is the instrument because risk is lowerc. The less valuable is the financial instrument because it is highly liquidd. 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 returnB. Payments that are made when we need them the most are more valuablec. The sooner the payment is to be made the betterd. 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 promisedb. When the promised payment will be madeC. Where the instrument is tradedd. The likelihood of payment


3-15


51. (p. 45) The value of a financial instrument rises as: a. The size of the payment promised decreasesB. The promised payment is made sooner rather than laterc. It is less likely the payment will be maded. 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 amountsb. The State of California bonds have a longer maturityC. The State of California experiences a fiscal crisis that makes it less likely it will be able to honor its interest paymentsd. The State of California pays back its previous bonds ahead of schedule


53. (p. 46) Financial instruments used primarily as stores of value include each of the following, except: a. BondsB. Futures contractsc. Stocksd. Home mortgages


3-16


54. (p. 46) Financial instruments used primarily as stores of value would not include: A. A car insurance policyb. A U.S. Treasury bondc. Shares of General Motors stockd. A home mortgage


55. (p. 47) Financial instruments used primarily to transfer risk would include all of the following, except: a. An insurance contractb. A futures contractc. OptionsD. A bank loan

AACSB: AnalyticBLOOMS: ApplicationBLOOMS: ComprehensionLOD: 1

56. (p. 47) Financial instruments used primarily to transfer risk would not include: A. A bank loanb. Optionsc. An insurance policyd. Home mortgages


3-17


57. (p. 47) Which of the following financial instruments is used mainly to transfer risk? a. Asset-backed securitiesb. BondsC. Optionsd. Stocks


58. (p. 46) Financial instruments used primarily as stores of value do not include: a. Asset backed securitiesb. U.S. Treasury bondsC. A car insurance policyd. A bank loan


59. (p. 46) The most prominent of asset-backed securities is: a. Shares of stock in corporations since stockholders own the assetsB. Securities backed by home mortgagesc. U.S. Treasury bonds since they are backed by all public assetsd. Movie box-office receipts


60. (p. 48) Roles served by financial markets include the following, except: A. Eliminating riskb. Providing liquidityc. Pooling and communicating informationd. Sharing of risk


3-18


61. (p. 49) If financial markets didn't exist: a. Required returns would be lower since fewer instruments would tradeb. Liquidity would diminish and returns would be lowerc. More funds would flow directly between borrowers and saversD. Liquidity would diminish, reducing the flow of funds between borrowers and savers

AACSB: Reflective ThinkingBLOOMS: AnalysisBLOOMS: ComprehensionLOD: 2

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 marketsB. The low transaction costs and high liquidity associated with these marketsc. The low transaction costs and low liquidity associated with these marketsd. 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 lendersB. Summarized in the form of a pricec. Valuable and not made available until the parties pay for itd. More than a borrower needs to make a loan


3-19


64. (p. 48) Financial markets: a. Enable buyers and sellers to exchange financial instruments but not riskB. Enable buyers and sellers to exchange risk by buying and selling financial instrumentsc. Only allow the transfer of risk through derivative securitiesd. 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 transferB. Transaction costsc. Information asymmetryd. Liquidity


66. (p. 48) Brokerage commissions: a. Are set by government regulators so they cannot vary across firms for the same servicesb. Can vary but typically don't because firms tend to set them at the same levelsc. Can differ reflecting the different services being offeredD. Are always a percentage of the amount of the trade?


67. (p. 49) A primary financial market is: a. A market just for corporate stocksb. A market only for AAA rated Securitiesc. The New York Stock ExchangeD. Is one in which newly issued securities are sold


3-20


68. (p. 49) A primary financial market is: a. Located only in New York, London, and Tokyo but can handle transactions anywhere in the worldB. One where the borrower obtains funds directly from the lender for newly issued securitiesc. A market where U.S. Treasury bonds are tradedd. 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 marketb. Only to the Federal Reserve who then resells themc. The secondary market since bonds cannot be sold in the primary marketd. 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 viewb. Is highly transparent and closely monitored by the SECC. Involve an investment bankd. Is done by the Federal Reserve

AACSB: Reflective ThinkingBLOOMS: KnowledgeLOD: 2

71. (p. 50) Secondary financial markets: a. Are financial markets for all financial instruments rated less than investment gradeB. Are financial markets where existing securities are bought and sold?c. Eliminate the transaction costs for buyers and sellersd. Are only for stock


3-21


72. (p. 49) A primary financial market is a market: a. Where only corporate bonds are soldb. Where only corporate and government bonds are soldc. Where newly issued securities are sold by savers to borrowersD. Where investment banks assist companies in raising cash


73. (p. 49) A collection of assets is known as a(n): a. Asset-backed securityb. Derivativec. Futures contractD. 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 notB. Mistakes in placing orders are more likely in OTC marketsc. Centralized exchanges do not require physical access, whereas OTC markets dod. Centralized exchanges make use of electronic communications networks (ECNs), whereas OTC markets do not


3-22


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. stockB. You go to the bank and purchase a $5000 certificate of depositc. You call a broker and purchase a U.S. Treasury bondd. You call a broker and purchase a bond issued by General Motors


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 birthdayb. You call a broker and purchase bonds for your retirement fundC. A city issues bonds to finance new road constructiond. A supermarket needs to borrow the funds for a second location and takes out a loan from a commercial bank to pay for it


77. (p. 52) An over-the-counter (OTC) market is: a. Made up of dealers who only sell government bondsb. An example of a centralized marketc. Made up of dealer who buy and sell only for their own accountsD. Made up of dealers who buy and sell for their customers and for their own accounts


3-23


78. (p. 51) The New York Stock Exchange (NYSE) is: a. A decentralized electronic market made up of dealers all over the worldB. An example of a centralized exchangec. A financial market where nearly 100 million shares of stock are traded every business dayd. The only centralized stock exchange in the world


79. (p. 52) Over-the-counter (OTC) markets: a. Employ specialists to minimize price volatilityb. Are centralized exchanges but you must be a dealer to be part of an exchangec. Only deal in the stocks of companies with over $100 million in capitalD. 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 computerB. Dealers buy and sell only for their customersc. Trading does not take place in one physical locationd. 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 bondsb. Are markets for AAA rated bondsC. Are markets for stocksd. Are markets for either stocks or bonds


3-24


82. (p. 54) Debt instruments that have maturities less than one year are traded in: a. The primary market exclusivelyb. The bond markets exclusivelyc. The bond market if they are already in existenceD. The money market


83. (p. 54) Money markets are where trades occur for: a. Stocksb. Bonds of all maturitiesc. DerivativesD. Bonds issued by both the government and private companies


84. (p. 54) Well-run financial markets: a. Keep transactions costs high to benefit brokersb. Prevent the widespread pooling of informationC. Ensure that resources are allocated efficientlyd. Are usually the result of little or no government regulation


3-25


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 existB. Will not develop as fast economically as counties with clear property rights and a formal legal systemc. Will have much lower transaction costs associated with any level of lendingd. Will not have any financial markets at all


86. (p. 56) Financial institutions: a. Raise the level of transaction costs relating to borrowing/endingB. Can lower the information asymmetry involved with borrowing/endingc. Decrease the liquidity to saversd. Are required for all financial transactions


87. (p. 57) An insurance company is an example of a financial institution that: A. Transforms assetsb. Acts as a brokerc. Serves as a depository institutiond. Sells derivative securities


88. (p. 57) All of the following are depository institutions, except: a. Commercial banksb. Credit unionsC. Insurance companiesd. Savings banks


3-26


89. (p. 57) Which of the following are depository institutions? A. Credit unionsb. Mutual fundsc. Pension fundsd. Insurance companies


90. (p. 57) Nondepository institutions: a. Do not serve as intermediariesb. Only serve as brokersc. Only transform assetsD. Do not accept deposits


91. (p. 57) Non-depository institutions would include all of the following except: a. Finance companiesb. Pension fundsc. Insurance companiesD. Credit unions


3-27


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 borrowersb. Lenders wouldn't want to deal with small saversC. Savers prefer to share riskd. 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 borrowersb. Few large savers and provide it to many small borrowersc. Few large savers a few large borrowersD. 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 monopolyb. Have government-regulated prices, so there is little competitionC. Can lower transaction costs and increase liquidity for saversd. Do not have to worry about information asymmetry


3-28


95. (p. 44) Derivative markets exist to allow for: A. Reduced risk from volatile pricesb. Direct transfers of common stocks for bondsc. Cash receipts from the sale of bondsd. Reduced information asymmetry


96. (p. 57) Financial intermediaries include each of the following, except: A. The New York Stock Exchangeb. Credit unionsc. Savings banksd. 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


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.


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.


100. (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


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


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.


104. (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.


3-32


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.


106. (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.


107. (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


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.


109. (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.


3-34


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.


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.


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.


3-35


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.


114. (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.


115. (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


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.


117. (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 newly-issued instrument by the bank.


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.


3-37


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.


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.


121. (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


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.


123. (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.


3-39


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.


125. (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.


3-40


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.


3-41

chapter 03 financial instruments, financial markets, and ... · chapter 03 - financial instruments,...

Documents