Chapter 2

Question 1

CAP Allocation Process

Answer 1

In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it

Question 2

CAP Allocation Process: Suppliers of Capital

Answer 2

Individuals and institutions with “excess funds.” These groups are saving money and looking for a rate of return on their investment

Question 3

CAP Allocation Process: Demanders or Users of Capital

Answer 3

Individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow

Question 4

What is a Market?

Answer 4

• A venue where goods and services are exchanged
• A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds

Question 5

Investment Bank

Answer 5

Underwrites and distributes new investment securities and helps business obtain financing

Question 6

Commercial Bank

Answer 6

Traditional department store of finance serving a variety of savers and borrowers

Question 7

Financial Services Corporation

Answer 7

A firm that offers a wide range of financial services, including investment banking, brokerage operations, insurance, and commercial banking

Question 8

Mutual Funds

Answer 8

Organizations that pool investor funds to purchase financial instruments and this reduce risks through diversification

Question 9

Money Market Funds

Answer 9

Mutual funds that invest in short-term, low-risk securities and allow investors to write checks against their accounts

Question 10

Types of Financial Markets

Answer 10

• Physical assets vs. Financial assets
• Spot vs. Futures
• Money vs. Capital
• Primary vs. Secondary
• Public vs. Private

Question 11

Physical Assets

Answer 11

• Tangible or real asset markets

- Ex. Wheat, Autos, Real Estate, Computers, and Machinery

Question 12

Financial Assets

Answer 12

Stocks, bonds, notes, and mortgages

Question 13

Spot Markets

Answer 13

Assets are bought or sold “on the spot” delivery

Question 14

Future Markets

Answer 14

Participants agree today to buy or sell an asset at some future date

Question 15

Money Markets

Answer 15

Funds are borrowed or loaned for short periods (less than one year)

Question 16

Capital Markets

Answer 16

For stocks and for intermediate or long term debt (one year or longer)

Question 17

Primary Markets

Answer 17

Corporations raise new capital by issuing new securities

Question 18

Secondary Markets

Answer 18

Securities and other financial assets are traded among investors after they have been issued by corporations

Question 19

Private Markets

Answer 19

Transactions are worked out directly between two or more parties

Question 20

Public Markets

Answer 20

Standardized contracts are traded on organized exchanges

Question 21

Importance of Financial Markets

Answer 21

Well-functioning financial markets facilitate the flow of capital from investors to the users of capital

• Markets provide savers with returns on their money saved/invested, which provide them money in the future
• Markets provide users of capital with the necessary funds to finance their investment projects.Well-functioning markets promote economic growth
• Economies with well-developed markets perform better than economies with poorly-functioning markets

Question 22

Derivatives

Answer 22

• A derivative security’s value is “derived” from the price of another security (e.g., options and futures)
• Can be used to “hedge” or reduce risk. For example, an importer, whose profit fall

Question 23

Types of Financial Institutions

Answer 23

• Investment banks
• Commercial banks
• Financial services corporations
• Pension funds
• Mutual funds
• Exchange traded funds
• Hedge funds
• Private equity funds

Question 24

Initial Public Offering (IPO)

Answer 24

• Occurs when a company issues stock in the public market for the first time
• Enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market
• Public companies are subject to additional regulations and reporting requirements

Question 25

What is meant by stock market efficiency?

Answer 25

• Securities are normally in equilibrium and are “fairly priced”
• Investors cannot “beat the market” except through good luck or better information

Question 26

Behavioral Finance

Answer 26

Borrows insights from psychology to better understand how irrational behavior can be sustained over time