DOC Chapter 1



Chapter 1

Role of Financial Markets and Institutions

Specific Objectives

• Describe the types of financial markets that accommodate various transactions

• Describe the role of financial institutions within financial markets

• Introduce the concept of security valuation within financial markets

• Identify the types of financial institutions that facilitate transactions in financial markets

Key Terms Matching

In the following exercise, place a letter from the right column with the correct number in the left column.

|Key Term |Definition |

|Bid-ask spread |the sale of government-owned firms to individuals |

|Bonds |the fee charged by a broker |

|Broker |financial contracts whose values are derived from the values of underlying assets |

|Capital market |a visible marketplace for secondary market transactions |

|Dealer |a person making a market in specific securities by adjusting his inventory of |

|Derivative securities |securities |

|Financial market |a telecommunications network facilitating financial market transactions |

|Liquidity |a person or institution executing securities transactions between two parties |

|Money market |a mutual fund concentrating in money market securities |

|Money market mutual fund |long-term debt obligations issued by corporations and government agencies to support |

|Organized exchange |their operations |

|Over-the-counter (OTC) market |a market that facilitates the issuance of new securities |

|Perfect market |a market that facilitates the trading of existing securities |

|Primary market |a market that facilitates the flow of short-term funds with maturities of less than |

|Privatization |one year |

|Secondary market |a market that facilitates the flow of long-term funds |

|Stocks |a market in which financial assets (securities) can be bought or sold |

| |the degree to which securities can easily be sold without a loss of value |

| |a market in which all information about any securities for sale in primary and |

| |secondary markets is continuously and freely available to investors |

| |q. certificates representing partial ownership in a firm |

Definitional Problems

1. Financial market participants that provide funds are called ________________, while participants that need to obtain funds are called __________________.

2. A market in which financial assets (securities) such as stocks and bonds can be purchased or sold is a(n) ____________ market.

3. ________________ securities are securities with maturities of more than one year; ________________ securities are securities with maturities of one year or less.

4. In general, money market securities have a higher degree of _____________ than capital market securities.

5. A market in which existing securities are traded is called a _____________ market, while a market that facilitates the issuance of new securities is called a ______________ market.

6. Two primary uses of derivative securities are ___________ and __________.

7. A visible marketplace for secondary market transactions is known as a(n) _______________.

8. The _________________ is an example of an organized exchange.

9. The _________________ is an example of the over-the-counter (OTC) market.

10. The ______________ market facilitates the exchange of currencies.

11. __________ are long-term debt obligations issued by corporations and government agencies to support their operations.

12. Long-term debt securities tend to have a higher expected return than money market securities, but they have ____________ risk as well.

13. Derivative securities are ___________ whose values are derived from the values of underlying assets.

14. When particular securities are perceived to be overvalued by the market, their prices ____________ as these securities are sold.

15. The valuation of a security is measured as the _________ of its expected cash flows.

16. When security prices fully reflect all available information, the market for these securities is said to be _______________.

17. The sale of government-owned firms to individuals is commonly referred to as _________________.

18. If buyers and sellers do not have full access to information and cannot always break down securities to the precise size they desire, the markets for these securities are ____________.

19. Savings institutions, sometimes also referred to as ______ institutions, are a type of depository financial institution.

20. The fee charged by a(n) ________ is reflected in the difference between her bid and ask quotes.

21. In addition to brokerage services, securities firms often act as _____________, making a market in specific securities by adjusting their inventory of securities.

22. Many of the transactions between financial institutions and deficit units are executed by ______________________.

23. In recent years, financial institutions have consolidated to capitalize on both ______________________ and ______________________.

24. The introduction of the _______, a single European currency, has reduced concerns about exchange rate risk for European firms.

True/False Problems

1. A financial market is a market in which financial assets can be purchased or sold.

2. The federal government commonly acts as a surplus unit.

3. Households are the main providers of funds.

4. Those financial markets that facilitate the flow of short-term funds (with maturities of less than one year) are known as capital markets, while those that facilitate the flow of long-term funds are known as money markets.

5. Primary markets facilitate the trading of existing securities.

6. An organized exchange is a telecommunications network.

7. Bonds are long-term debt obligations issued by corporations and government agencies to support their operations.

8. Long-term debt securities tend to have lower risk but a higher return than money market securities.

9. Derivative securities are financial contracts whose values are derived from the values of underlying assets.

10. While all investors rely on valuation to make investment decisions, they derive different valuations of a security based on the existing set of information.

11. Since markets are efficient, institutional and individual investors should ignore the various investment instruments available.

12. Speculating with derivative contracts on an underlying asset typically results in both higher risk and higher returns than speculating in the underlying asset itself.

13. The Internet expedites the adjustment in security prices to new information.

14. When security prices fully reflect all available information, the markets for these securities are said to be perfect.

15. Securities that are not as safe and liquid as other securities are never considered for investment by anyone.

16. By requiring full disclosure of information, securities laws prevent investors from making poor investment decisions.

17. When financial information is fully disclosed, the asymmetric information problem is completely eliminated.

18. Circuit breakers are used to temporarily halt the trading of some securities or contracts in order to reduce market volatility.

19. Even with regulatory oversight, there continue to be cases in which some investors have an unfair advantage over others because they have better access to information.

20. An efficient financial market is one in which all information about any securities for sale in primary and secondary markets is continuously and freely available to investors.

21. If markets are imperfect, securities buyers and sellers to not have full access to information and cannot always break down securities to the precise size they desire.

22. When a depository institutions offers a loan, it is acting as a creditor.

23. Savings institutions are the most dominant financial institution.

24. While commercial banks concentrate on commercial loans, credit unions have concentrated on residential mortgage loans.

25. Most mutual funds obtain funds by issuing securities, then lend the funds to individuals and small businesses.

26. A broker executes securities transactions between two parties and charges a fee reflected in the bid-ask spread.

27. Many corporations and government agencies offer their employees pension plans that are entirely funded by the employer.

28. Economies of scope represent a reduction in the average cost per unit due to increased volume.

29. Among others, deficit units receive funding from insurance companies and pension funds.

30. Many of the transactions between financial institutions and deficit units are executed by securities firms.

31. Institutional investors not only provide financial support to companies but exercise some degree of corporate control over them.

32. In recent years, financial institutions have consolidated to capitalize on economies of scale and on economies of scope.

33. The euro increased business between European countries and created a less competitive environment in Europe.

34. Many financial institutions engage in international mergers so that they can serve clients throughout Europe and provide a wider variety of services.

Multiple Choice Problems

1. According to your text, which of the following are not main participants in financial market transactions?

a. households

b. financial institutions

c. governments

d. businesses

e. all of the above are main participants in financial market transactions

2. Financial markets

a. facilitate the flow of funds from deficit to surplus units.

b. facilitate the flow of funds from surplus to deficit units.

c. are markets in which financial assets such as stocks and bonds can be purchased and sold.

d. None of the above are true.

e. Only answers b and c are correct.

3. Financial markets facilitating the flow of short-term funds with maturities of less than one year are known as

a. money markets.

b. capital markets.

c. primary markets.

d. secondary markets.

e. none of the above.

4. Financial markets facilitating the trading of existing securities are known as

a. money markets.

b. capital markets.

c. primary markets.

d. secondary markets.

e. none of the above.

5. Which of the following is not an organized exchange?

a. New York Stock Exchange

b. American Stock Exchange

c. Nasdaq

d. All of the above are organized exchanges.

6. Which of the following transactions would not be considered a secondary market transaction?

a. An individual investor purchases some existing shares of IBM stock through his broker.

b. An institutional investor sells some Disney stock through his broker.

c. Microsoft issues new shares of common stock using its investment bank.

d. All of the above would occur in the secondary market.

7. According to your text, which of the following is not considered a money market security?

a. Treasury bills

b. Treasury notes

c. retail CD

d. banker’s acceptance

e. commercial paper

8. ________________ are not considered capital market securities.

a. Repurchase agreements

b. Municipal bonds

c. Corporate bonds

d. Equity securities

e. Mortgages

9. ____________ are long-term debt obligations issued by corporations and government agencies to support their operations.

a. Common stock

b. Derivative securities

c. Bonds

d. None of the above

10. Long-term debt securities tend to have a ___________ expected return and _________ risk than money market securities.

a. lower; lower

b. lower; higher

c. higher; lower

d. higher; higher

11. If investors speculate in derivative contracts rather than the underlying asset, they will probably achieve ____________ returns, and they are exposed to relatively ___________ risk.

a. lower; lower

b. lower; higher

c. higher; lower

d. higher; higher

12. When security prices fully reflect all available information, the markets for these securities are said to be

a. inefficient.

b. efficient.

c. perfect.

d. imperfect.

e. none of the above.

13. When particular securities are perceived to be ______________ by the market, their prices decrease when they are sold by investors.

a. undervalued

b. overvalued

c. fairly priced

d. efficient

e. none of the above

14. Which of the following statements is incorrect?

a. Much of the information used to value securities issued by firms is provided by the managers of those firms.

b. A firm’s managers possess information about its financial condition that is not necessarily available to investors.

c. Even when information is disclosed, an asymmetric information problem may still exist.

d. The financial statements of firms with closely-held stock must be audited once a year by certified public accountants.

15. According to your text, the most pronounced changes in international integration have occurred in

a. Latin America.

b. Asia.

c. Europe.

d. Africa.

16. If financial markets were _____________, all information about any securities for sale in primary and secondary markets would be continuously and freely available to investors.

a. inefficient

b. efficient

c. perfect

d. imperfect

e. none of the above

17. Which of the following is not a reason why depository institutions are popular financial institutions, according to your text?

a. They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units.

b. They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units.

c. They accept the risk on loans provided.

d. They have more expertise than individual deficit units in evaluating the creditworthiness of surplus units.

e. All of the above are reasons why depository institutions are popular financial institutions.

18. Which of the following are not considered depository financial institutions?

a. finance companies

b. commercial banks

c. savings institutions

d. credit unions

e. All of the above are depository financial institutions.

19. According to your text, credit unions differ from commercial banks and savings institutions because they

a. are profit-oriented.

b. concentrate on residential mortgage loans.

c. restrict their business to credit union members.

d. are larger than commercial banks and savings institutions.

20. Which of the following are considered depository financial institutions?

a. credit unions

b. mutual funds

c. securities firms

d. pension funds

21. Securities firms

a. sometimes act as a broker.

b. provide investment banking services.

c. often act as a dealer.

d. sometimes provide advisory services.

e. all of the above.

22. Many corporations offer their employees pension plans in which funds are periodically contributed by

a. the employers.

b. the employees.

c. both employers and employees.

d. the U.S. government.

e. Answers a, b, and c can be correct.

23. _________________ maintain a larger amount of assets than the other types of depository institutions.

a. Finance companies

b. Commercial banks

c. Life insurance companies

d. Savings institutions

e. Credit unions

24. ________________ accept deposits from households, businesses, and government agencies and purchase government and corporate securities.

a. Commercial banks

b. Savings institutions

c. Finance companies

d. Money market funds

e. Answers a and b are correct.

25. The main source of funds for ________________ is proceeds from selling securities to households and businesses, while their main use of funds is providing loans to households and businesses.

a. savings institutions

b. commercial banks

c. mutual funds

d. finance companies

e. pension funds

26. According to your text, which of the following is not a financial service provided by Citigroup?

a. commercial loans

b. advisory services for corporations planning to restructure

c. consumer loans

d. credit cards

e. All of the above are financial services provided by Citigroup.

27. Which of the following is not a reason why depository financial institutions are popular?

a. They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units.

b. They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units.

c. They accept the risk on loans provided.

d. They use their information resources to act as a broker, executing securities transactions between two parties.

e. They have more expertise than individual surplus units in evaluating the creditworthiness of deficit units.

Answers to Key Terms Matching

1. b

2. i

3. g

4. m

5. e

6. c

7. n

8. o

9. l

10. h

11. d

12. f

13. p

14. j

15. a

16. k

17. q

Answers to Definitional Problems

1. surplus units; deficit units

2. financial

3. capital market; money market

4. liquidity

5. secondary; primary

6. speculation; risk management

7. organized exchange

8. New York Stock Exchange (NYSE)

9. Nasdaq

10. foreign exchange

11. bonds

12. more

13. financial contracts

14. decrease

15. present value

16. efficient

17. privatization

18. imperfect

19. thrift

20. broker

21. dealers

22. securities firms

23. economies of scale; economies of scope

24. euro

25.

Answers to True/False Problems

1. T

2. F

3. T

4. F

5. F

6. F

7. T

8. F

9. T

10. T

11. F

12. T

13. T

14. F

15. F

16. F

17. F

18. T

19. T

20. F

21. T

22. T

23. F

24. F

25. F

26. T

27. F

28. F

29. T

30. T

31. F

32. T

33. F

34. T

Answers to Multiple Choice Problems

35. e

1. e

2. a

3. d

4. c

5. c

6. b

7. a

8. c

9. d

10. d

11. b

12. b

13. d

14. c

15. c

16. d

17. a

18. c

19. a

20. e

21. e

22. b

23. e

24. d

25. e

26. d

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