Chapter 1 Introduction

True/Falqe Questions
1. Primary markets are markets where users of funds raise cash by sehling securities to
funds suppliers.
Answer: True Page: 4 Leveh !asy
. "econdary markets are markets used by ckrpnrations to raise cash by issuing securities
for a short time period.
Answer: #alse Page: $ Level: !asy
%. &n a private placement' the is(uar typically sells the entire issue to one or only a few
institutional buyerc.
Answer: True Page: 4 Level !asy
4. The )*"! is an e+ample of a secondary market.
,nswer: True Page: - Level: !asy
$. The )A".A/ market is an e+ample of an over the counter market'
Answer: True Page: -
-. 0oney markets are the markets for securities with an original maturit+ of 1 year or
less.
Answer: True Page: 1 Level: !asy
1. !urgdollar bonds are dollar denominated bonds issued outcide the 2nited "tates.
Answer: True Page: 3 Level: !asy
4. #inancial intermediaries such as banks dypically have assets that are riskier than their
liabilities.
Answer: Trua Page: 1- Level: !asy
1
5. "pinning is dhe process of alhocating shares in a 6hot6 &P7 to certain favored clients of
investment banking firms in e+change for receiving additional investment banking
business.
Answer: True Page: $ Level: !asy
13. 0any stock research analysts of investment banking firms have baen accused of
icsuing overly optimistic stock research reports on firms in order to help support the
investment bankers6 underwriting business.
Answer: True Page: - Level: 0edium
11. An individual buying an AT8T corporate bond in the secondary market is an e+ample
of direct finance.
Answer: True Page: 1% Level: 0edium
1. A derivative security is a security that has a maturity of greater than one year.
Answer: #alse Page: 13 Level: !asy
Multiple Choice Questions
1%. 9hat factors are encouraging financial institutions to offer overlapping financial
services such as banking' investment banking' brokerage' etc:
&. ;egulatory changes allowing institutions to offer more services
&&. Technological improvements reducing the cost of providing financial services
&&&. &ncreasing competition from full service global financial institutions
&<. ;eduction in the need to manage risk at financial institutions
A= & only
>= && and &&& only
?= &' && and &&& only
.= &' && and &< only
!= &' &&' &&& and &<
Answer: ? Page: % Level: !asy
2se the following to answer (uestions 14@1$:
&>0 creates and sells additional stock to the investment banker' 0organ "tanley. 0organ
"tanley then resells the issue to the 2.". public.

14. This transaction is an e+ample of aAn=

A= Primary market transaction
>= Asset transformation by 0organ "tanley
?= 0oney market transaction
.= #oreign e+change transaction
!= #orward transaction
Answer: A Page: 4 Level: !asy
1$. 0organ "tanley is acting as aAn=
A= Asset transformer
>= Asset broker
?= Bovernment regulator
.= #oreign service representative
Answer: > Page: 4 Level: 0edium
1-. A corporation seeking to sell new e(uity securities to the public for the first in order to
raise cash for capital investment would most likely
A= conduct an &P7 with the assistance of an investment banker
>= engage in a secondary market sale of e(uity
?= conduct a private placement
.= place an ad in the 9all "treet Cournal soliciting retail suppliers of funds
!= none of the above
Answer: A Page: 4 Level: 0edium
11. Advantages of putting your money in a bank deposit instead of directly buying capital
market securities typically include
A= .elegated monitoring
>= >etter li(uidity
?= Less price risk
.= All of the above
!= )one of the above
Answer: . Page: 14 Level: !asy
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14. The process of allocating shares of hot &P7 issues to directors andDor e+ecutives of
potential investment banking clients in e+change for subse(uent investment banking
business is called
A= "pinning
>= Laddering
?= 0oney laundering
.= #ront running
!= Pegging
Answer: A Page: $ Level: !asy
15. A market that trades financial instruments only after the instruments have been issued
is called aDan
A= secondary market
>= primary market
?= money market
.= derivatives market
!= 7T? market
Answer: A Page: - Level: !asy
3. EEEEEEEEE and EEEEEEEEEE allow a financial intermediary to offer safe' li(uid
liabilities such as deposits while investing the depositors money in riskier' illi(uid
assets.
A= .iversification F high e(uity returns
>= Price risk F collateral
?= #ree riders F regulations
.= 0onitoring F diversification
!= Primary markets F foreign e+change markets
Answer: . Page: 1- Level: 0edium
1. .epository institutions include:
A= >anks
>= Thrifts
?= #inance companies
.= All of the above
!= A and > only
Answer: ! Page: 11 Level: 0edium
4
. 0atch the intermediary with the characteristic that best describes its function.
&. Provide protection from adverse events
&&. Pool funds of small savers and invest in either money or capital markets
&&&. Provide consumer loans and real estate loans funded by deposits
&<. Accumulate and transfer wealth from work period to retirement period
<. 2nderwrite and trade securities and provide brokerage services
1. Thrifts
. &nsurers
%. Pension funds
4. "ecurities firms and investment banks
$. 0utual funds
A= 1' %' ' $' 4
>= 4' ' %' $' 1
?= ' $' 1' %' 4
.= ' 4' $' %' 1
!= $' 1' %' ' 4
Answer: ? Page: 11 Level: 0edium
%. "econdary markets help support primary markets because secondary markets
&. offer primary market purchasers li(uidity for their holdings
&&. update the price or value of the primary market claims
&&&. reduce the cost of trading the primary market claims
A= & only
>= && only
?= & and && only
.= && and &&& only
!= &' && and &&&
Answer: ! Page: 1 Level: 0edium
$
4. #inancial intermediaries A#&s= can offer savers a safer' more li(uid investment than a
capital market security' even though the intermediary invests in risky illi(uid
instruments because:
A= #&s can diversify away some of their risk
>= #&s closely monitor the riskiness of their assets
?= The federal government re(uires them to do so
.= >oth a= and b=
!= >oth a= and c=
Answer: . Page: 1- Level: !asy
$. Gouseholds are increasingly likely to both directly purchase securities Aperhaps via a
broker= and also place some money with a bank or thrift to meet different needs.
0atch up the given investor6s desire with the appropriate intermediary or direct
security.
&. 0oney likely to be needed within - months
&&. 0oney to be set aside for college in 13 years
&&&. 0oney to provide supplemental retirement income
&<. 0oney to be used to provide for children in the event of death
1. .epository institutions
. &nsurer
%. Pension fund
4. "tocks or bonds
A= ' %' 4' 1
>= 1' 4' ' %
?= %' ' 1' 4
.= 1' 4' %'
!= 4' ' 1' %
Answer: . Page: 11 Level: 0edium
-. As of 334' which one of the following 2.". capital market instruments had the
greatest amount outstanding:
A= mortgages
>= common stock
?= corporate bonds
.= Treasury securities
!= 2.". government agency securities
Answer: > Page: 5 Level: !asy
-
1. 9hich of the following are money market instruments:
A= )egotiable ?.s
>= ?ommon stock
?= T@bonds
.= 4 year maturity corporate bond
!= A' > and ? are money market instruments
Answer: A Page: 4 Level: !asy
4. The "ecurities !+change ?ommission A"!?= does not
A= .ecide whether a public issue is fairly priced
>= .ecide whether a firm making a public issue has provided enough information for
investors to decide whether the issue cs fairly priced
?= ;e(uire e+changes to monitor trading to prevent insider trading
.H Attempt to reduce e+cessite price fluctuations
!= 0onitor the maIor securities e+changes
Ansser: A Page: 13 Level: 0edium
5. 0any households place funds with financial intermediaries A#&r= because many #&
acaounts provide
A= Lower denominations than mone+ market securities
>= >etter li(uidity and less price risk than direct securities
?= "horter maturities than direct securities
.= All of the above
!= )one of the above
Answer: . Page: 1$ Level: !asy
%3. 0arkets that do not have a specific location' but conduct trades over computer or other
telecommunication networks are called
A= mortgage markets
>= money markets
?= over@the@counter markets
.= derivative markets
!= capital markets
Answer: ? Page: 1 Level: !asy
1
%1. .epository institutions A.&s= play an important role in the transmission of monetary
policy from the #ederal ;eserve to the rest of the economy because
A= Loans to corporations are part of the money supply
>= >ank and thrift loans are tightly regulated
?= 2.". .&s compete with foreign financial institutions
.= .& deposits are a maIor portion of the money supply
!= Thrifts provide a large amount of credit to finance residential real estate
Answer: . Page: 11@14 Level: .ifficult
%. As a percentage of total assets EEEEEEEEEEEEEEEEEEEE have declined while
EEEEEEEEEEEEEEEEE have increased over the last twenty to thirty yearc.
A= insurance and finance companiesFbanks and thriftJ
>= banks and thriftsF investment companies and pension funds
?= pension funds and ;!&TsF insurance companies and thrifts
.= secubities brokers and dealersF investment companies and banks
!= banks and finance companiesF thrifts and pension funds
Answer > Page: 1 Level: .ifficult
Qhort Ancwer Questions
%%. .iscuss how secondary markets benefit funds issuers.
Answer: The secondary markets provide li(uidity to investors after their initial
purchase of the security. This li(uidity encourages them to purchase the security at
the initial offer. The current market price also reflects current prospects for the firm
and the competitiveness of the issue relative to similar securities. ?orporate treasurers
follow their stock6s price closely because the stock price reflects how well their firm
and the market is performing. The current security price also provides information
about the cost of obtaining any additional funds. Page: $@- Level: 0edium
4
%4. Gow can brokers and dealers make money: 9hich activity is riskier: 9hy:
Answer: An asset broker assists buyers and sellers of securities by providing a
mechanism for a buyer or seller to process their order. &f the broker simply assists one
party in finding another party' the broker charges a small fee called a commission. An
asset dealer buys Asells= the security for their own account at the bid price and then
sells Abuys= the security at a higher ask price. The dealer profits by earning the bid@ask
spread or the difference between the buy and sell price. The dealer function is riskier
because the dealer must maintain an inventory of the asset and honor (uotes posted to
buy and sell. &f the security is risky the value of the inventory can fluctuate with
market prices. The broker takes less risk because they do not own the security.
Page: 14 Level: .ifficult
%$. 9hat does an asset transformer do: 9hy is this a risky activity:
Answer: An asset transformer buys one security from a customer or makes and creates
a separate claim in order to raise funds. This is normally a risky activity because the
asset ac(uired will be riskier than the security Aor deposit= used to raise funds because
the intermediary hopes to profit on the spread between the rate earned on the asset
claim and the rate paid on the liability claim. &n order for this spread to be positive'
generally speaking the asset must be riskier than the liability.
Page: 1- Level: 0edium
%-. Gow can using indirect finance rather than direct finance reduce agency costs
associated with monitoring funds demanders:
Answer: A large #& has a greater incentive to monitor the behavior of funds demanders
in an indirect financing. The #& supposedly hires and trains e+perts who know how to
collect information about a funds demander and evaluate whether the funds demander
is acting appropriately. &n direct finance' a funds demander sells claims to the public
at large. &n this case there is little incentive for an individual claim holder to monitor
and attempt to enforce good behavior on the part of the funds user. The benefit of
monitoring and enforcement is shared among all claimholders' but the cost would be
borne by only the sole individual. This is termed the free rider problem. &f there is
improved monitoring of borrower behavior' the problem of agency costs is likely to be
reduced. Page: 1$ Level: .ifficult
5
%1. 9hat have been the maIor factors contributing to growth in the foreign financial
markets:
Answer:
1. &ncrease in the amount of savings available for investment
in foreign countries.
. &nternational investors have looked to the 2.". for better
investment opportunities.
%. The &nternet has helped provide additional information on
foreign markets and overseas investment opportunities.
4. "pecialiKed intermediaries such as country specific mutual
funds and A.;s have been developed to facilitate overseas investments.
$. .eregulation of foreign markets has allowed many new
investors to participate in international investing.
Page: 1 Level: 0edium
%4. *ou are a corporate treasurer seeking to raise funds for your firm. 9hat are some
advantages of raising funds via a financial intermediary A#&= rather than by selling
securities to the public:
Answer:
Advantages include:
"peed: funds can normally be raised more (uickly through #&s.
;egistration processDcost: The registration process can be (uite costly and time
consuming in terms of person hours' audit fees and fees to investment bankers.
;aising funds via a #& can be less e+pensive' particularly for smaller capital needs
or when funds are needed for only a short time period. A0aturities of 13 days or
less do not re(uire registration' nor do private placements=.
)onstandard terms can be negotiated with #&s but are difficult to sell to the public.
!.B. if a borrower can only begin paying interest after years' they would have a
difficult time selling bonds to the public.
There is a greater ability to renegotiate terms if necessary. Terms of public issue
generally cannot be changed outside of court.
Less information made public.
Page: )one Level: .ifficult
13
%5. Gow can a depository intermediary afford to purchase long term risky direct claims
from fund6s demanders and finance these purchases with safe' li(uid' short term' low
denomination deposits: 9hat can go wrong in this process:
Answer: .&s can afford to do so because the rate they must pay to attract funds is
lower than the rate they can charge on their riskier assets. A lot can go wrong
however.
&f the money lent is not repaid' the .& may not be able to repay its depositors
on demand Acredit and li(uidity risk=. .iversification of the credit risk is a key
way .&s limit credit risk.
The difference between the rate earned on assets and the rate paid on liabilities
is called the )et &nterest 0argin A)&0=. The )&0 can turn negative if interest
rates rise or if the rates on long@term securities fall below the interest rates risk on
short term securities Aafter adIusting for risk=.
>ecause the assets and liabilities are different claims' it is possible for the
value of the assets to drop resulting in an insolvent institution Ainsolvency risk=.
>ecause the assets are primarily financial their value can be (uite volatile. As a
result risk management is crucial at today6s financial institution.
L.&s attract many savers with a small amount of funds. .&s then invest the
bulk of these savings in investments which cannot be immediately li(uidated. &f
the savers lose confidence in the .& they will seek to withdraw their money which
can precipitate a li(uidity crisis and cause insolvency.
Page: 1- Level: .ifficult
43. .iscuss the benefits to funds suppliers of using a financial intermediary asset
transformer in place of directly purchasing claims such as stocks or bonds. 9hat is
the maIor disadvantage:
Answer:
Potential benefits to funds6 suppliers A""2s=:
Professional risk managers to assess risk of borrowers6 A."26s= claim and
help decide the correct price to pay.
;isk reduction via:
@insurance
@additional diversification
@more fre(uent monitoring
@additional cushion of #& e(uity
@improved li(uidity of ""2 claim on #&
.enomination intermediation.
0aturity intermediation.
The downside of putting your money in an intermediary:
#orego potentially higher returns if you do not purchase the more risky
direct claims. Page: 11 Level: 0edium
11
41. 9hat maIor forces are bringing about change in the financial services industry today:
Answer:
Technological change@@;educed cost of providing financial services to a
growing number of individuals A!conomies of scale= and reduced cost to provide
related financial services to customers A!conomies of scope=. These changes are
pressuring all firms to grow' at the same time technology is allowing individuals to
invest on their own at very low cost and changing the way institutions must
provide financial services to customers.
BlobaliKation@@All financial markets are becoming more closely integrated.
9hat happens in Asia affects 2.". markets and vice versa. All institutional
managers will increasingly need to understand global investing and have an
understanding of global markets and institutions.
;egulations@@;egulations are beginning to allow financial service providers
to overlap functions to a greater degree than ever before' generating more
competition and more pressures on profit margins. After the !nron and
9orld?om scandals we can e+pect tighter regulations in all the financial related
industries.
Page: &ntegrative Level: 0edium
1
4. .iscuss the maIor macro benefits of financial intermediaries. 9hat role does the
government have in the credit allocation process:
Answer:
0oney supply transmission: .epository institutions affect the level of
money supply growth in the economy. The money supply is increased when the
#ed increases money available to banks' but the e+tent of money supply growth is
affected by banks6 decisions to lend the increased supply of funds. &f the banks do
not lend the increased money' the given increase in funds by the #ed will result in
only a small change in the total money supply in the economy.
?redit Allocation: #&s price risk and allocate capital to users who they
believe can generate a high enough rate of return to compensate the lender for the
risk the lender bears in loaning the money. #&s also monitor the borrower6s
condition after the loan is made. A well functioning economy must have sound
mechanisms for allocating capital. &n capitalist countries' #&s and markets allocate
capital to its highest valued uses' thereby ma+imiKing economic growth. The role
of government is to ensure disclosure of risks' and fair practices of all involved. &n
communist and some socialist countries' governments allocate capital according to
a current political agenda and strong' lasting economic growth is rarely if ever
seen in these countries. As the te+t indicates' the government can also channel
credit to socially deserving areas such as housing' farms and small business
development.
L&ntergenerational wealth transfers and risk shifting: Pension funds and
insurance firms allow investors to transfer wealth through time' while avoiding
ta+ation' andDor allow investors the ability to choose which risks in their life they
will bear and which they will insure.
Payment services: The ability to store and (uickly move large sums of
money Aor many small sums= at low cost with little risk encourages greater
investment by market participants and' thus lowers the overall cost of funds in our
economy.
Page: 11@14 Level: .ifficult
4%. 9hat determines the price of financial instruments: 9hich are riskier' capital market
instruments or money market instruments: 9hy:
Answer: The price of any financial instrument is the present value of future cash flows
discounted at an appropriate rate. The longer the maturity of an instrument the greater
the time period of discounting. A small change in interest rates causes a large change
in present value of distant cash flows. Gence' the prices of long@term capital market
instruments are more sensitive to changes in interest rates. &n addition' distant cash
flows for stocks are not known with certainty. ?hanging economic prospects can
cause very large changes in current stock values. 0oney market instruments have
predictable cash flows and mature in one year or less' so they are much less risky.
Page: )one Level: 0edium
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