The three primary ways that capital can be transferred between savers and borrowers are: (1) direct

transfers, (2) indirect transfers through investment bankers, and (3) indirect transfers through a financial
intermediary (Brigham & Houston, 2009, p. 28). In a direct transfer, a company sells its stocks or bonds
directly to savers. The money provided by the saver is received directly by the company. This type of
transfer is generally found among smaller firms. In an indirect transfer through an investment banker,
the investment banker acts as a “middleman.” The company sells its stocks or bonds to the investment
banker, and the investment banker resells the securities to savers. Financial intermediaries include such
entities as banks, insurance companies and mutual funds (Brigham & Houston, 2009, p. 29). A financial
intermediary takes funds provided by savers and invests the money or uses it to make loans to
borrowers.

A. What are the three primary ways in which capital is transferred between savers and borrowers?
Describe each one.

The three primary ways that capital can be transferred between savers and borrowers are: (1) direct
transfers, (2) indirect transfers through investment bankers, and (3) indirect transfers through a financial
intermediary (Brigham & Houston, 2009, p. 28). In a direct transfer, a company sells its stocks or bonds
directly to savers. The money provided by the saver is received directly by the company. This type of
transfer is generally found among smaller firms. In an indirect transfer through an investment banker,
the investment banker acts as a “middleman.” The company sells its stocks or bonds to the investment
banker, and the investment banker resells the securities to savers. Financial intermediaries include such
entities as banks, insurance companies and mutual funds (Brigham & Houston, 2009, p. 29). A financial
intermediary takes funds provided by savers and invests the money or uses it to make loans to
borrowers.

B. What is a market? Differentiate between the following types of markets: physical asset markets
versus financial asset markets, spot markets versus futures markets, money markets versus capital
markets, primary markets versus secondary markets, and public markets versus private markets.

The term “market” refers to a system in which assets can be bought, sold or traded. In a physical asset
market, tangible goods are bought and sold. Tangible goods include such things as products and
machinery. A financial asset market is concerned with the buying and selling of stocks, bonds, notes and
mortgages (Brigham & Houston, 2009, p 30). In a spot market, assets are bought for “on-the-spot”
delivery. In a futures market, an agreement is made to buy or sell an asset at some point in time in the
future. Money markets involve the buying and selling of “short-term, highly liquid debt securities,” such
as treasury bills (Brigham & Houston, 2009, p. 30). Capital markets are concerned with trade in long-
term debt securities, such as shares of a company’s stock. In a primary market, companies issue new
shares of stock to sell to the public. A secondary market is found when outstanding shares, which were
previously purchased by investors, are resold. In a private market, transactions are made directly
between investors and borrowers. In a public market, standardized contracts are used to facilitate
transactions among numerous buyers and sellers. A bank loan is an example of a private market
transaction and the exchange of stocks and bonds is an example of a public market transaction (Brigham
& Houston, 2009, p. 31).

C. Why are financial markets essential for a healthy economy and economic growth?

Businesses, governments and individuals need to have access to capital in order to expand and grow.
Capital is used for such things as building factories, expanding operations, and developing new products
to meet changes in consumer needs and demands. These kinds of developments cannot be made with
the money that is already tied up in running operations. New capital needs to be raised through the use
of financial markets. In the words of Brigham & Houston (2009), “a healthy economy is dependent on
efficient funds transfers from people who are net savers to firms and individuals who need capital” (p.
31). Without the transfer of funds from savers to borrows, an efficient economy cannot exist.

D. What are derivatives? How can derivatives be used to reduce risk? Can derivatives be used to
increase risk? Explain.

A derivate is “any financial asset whose value is derived from the value of some other ‘underlying’ asset”
(Brigham & Houston, 2009, p. 33). For example, the value of a contract to buy a nation’s currency
depends on the exchange rate between the foreign currency and the U.S. dollar. An example of how
derivatives can be used to reduce risk is provided by Brigham & Houston (2009). A wheat processor is
negatively impacted whenever the price of wheat goes up in the market. To reduce this kind of risk, the
processor can buy derivatives in the form of wheat futures. Although the wheat processor’s net income
will drop when wheat prices go up, the value of the wheat futures will go up at the same time.
Derivatives result in increased risk when they are used for the purpose of speculation. Speculation
occurs when an individual or institution buys derivatives in the hope that their value will increase in the
future. However, it is possible that the value of the derivatives will decline instead.

E. Briefly describe each of the following financial institutions: commercial banks, investment banks,
mutual funds, hedge funds, and private equity companies.

A commercial bank is the traditional “department store of finance” (Brigham & Houston, 2009, p. 34). It
provides various services to consumers and businesses in the process of saving or borrowing money. An
investment bank is an organization that helps busibusinesses get the financing they need to fund new
projects. It does this by underwriting and distributing new investment securities (p. 34). Mutual funds
are organizations that invest the money of savers in stocks, bonds and other financial instruments. This
is done to diversify the funds and thus reduce risk. Hedge funds, like mutual funds, are designed to
invest savings. However, hedge funds are different from mutual funds because they are not strictly
regulated and they appeal to individuals and institutions with high net worth (p. 35). Private equity
companies are similar to hedge funds; however, rather than invest savings by buying company stocks,
private equity companies buy out companies and then take over their operations.