502- 1 Security Markets and Economic Environment Flashcards Preview

CFP 502- Investment planning > 502- 1 Security Markets and Economic Environment > Flashcards

Flashcards in 502- 1 Security Markets and Economic Environment Deck (138):
1

What security does the intermediary: Banks, Credit Unions, etc. offer, and who is the typical ultimate user of funds?

Typical investment: Savings accounts, checking accounts, CD's.

Typical ultimate user of funds: Business borrowers, car purchasers, homeowners.

2

What security does the intermediary: brokers, dealers, investment bankers and mutual funds offer, and who is the typical ultimate user of funds?

Typical Investment: Bonds, stocks, commodities, and mutual funds.

Typical ultimate user of funds: Businesses, entrepreneurs, investment managers, farmers.

3

What security does the intermediary: insurance companies offer, and who is the typical ultimate user of funds?

Typical Investment: Bonds, stock, real estate

Typical ultimate user of funds: Businesses

4

In addition to being a middleman between savers, investors, and users of money, what else does an intermediary do?

They help businesses raise capital by issuing either debt or equity securities

5

Public offerings are made with the assistance of lawyers, accountants, appraisers, and investment bankers. What is the role of the investment banker?

Investment bankers take the lead and hire other professionals to assist with the technical details of a public offering.

6

What is the investment banker who agrees to lead the offering process is known as?

Originating house or lead underwriter.

7

What are securities firms that agree to assist with marketing the offering, but not the lead underwriter, known as?

The syndicate.

8

What two types of underwriting agreements are the selling syndicates generally undertaking?

Best effort agreement: No guarantees from the investment banker to the company going public - they will sell as many shares as possible.

Firm commitment: Investment bankers guarantee company that entire issue will be purchased; investment bankers absorb loss if they fail to sell entire issue to investors

9

Red herring

preliminary prospectus; it is called a red herring because of the statement printed in red ink on the front of the prospectus that states “A Registration Statement relating to these securities has been filed with the Securities and Exchange Commission but has not yet become effective.

10

Registration

the process of filing the prospectus with the SEC.

11

Green shoes

the right to increase the size of an offering.

12

Initial public offering (IPO)

a company’s first public offering of securities.

13

Secondary offering

a sale of securities to the public by insiders or other affiliated persons.

14

Dealers

Principals who buy and sell securities for their own accounts

15

What is a dealer called in the over the counter market, and the securities exchange market?

Over the counter- Market Maker
Securities exchange- Specialist

16

What is the definition of the dealer bid and ask price?

The bid price is the price at which the dealer will buy, and the ask price is the price at which the dealer will sell.

17

How does the dealer work with the equilibrium price.

The equilibrium price would be one that equates supply and demand. A price quoted above the equilibrium price would require the dealer to absorb the excess supply of securities offered but not purchased (the dealer would accumulate an increasing number of shares), and a price below the equilibrium price would require the dealer to sell more securities in order to meet demand (the dealer would have an increasing short position).

18

How does a dealer maintain an orderly market?

-The dealer does so by offering to buy and sell at the quoted bid and ask prices, while guaranteeing only one round lot transaction at these prices
-If circumstances warrant (e.g., a large quantity is demanded by investors or a large quantity is supplied by sellers), the dealer can increase or lower the bid and ask prices after the one round lot transaction.

19

seed capital

provided to new companies without any products for product development and market research

20

start-up capital

cash provided for initial marketing

21

first-stage financing

cash provided for manufacturing and sales

22

second-stage financing

cash provided for working capital

23

mezzanine financing

cash provided for expansion and new products

24

bridge financing

capital for expected initial public offering

25

acquisition financing

capital, including high-yield bonds, provided to acquire other companies

26

LBO (leveraged buyout) financing

capital to allow management to buy all or part of a company

27

Limit order

an order used when investors want to specify the price they will receive (minimum) or pay (maximum) for an investment; the specifying of a minimum price at which the investment may be sold or a maximum price that may be paid for it (sure of price, but not of execution)

28

Odd lot

a unit of trading that is smaller than the general unit of trading

29

Market order

an order to buy or sell immediately at the current price (sure of execution, but not of price)

30

Spread

The difference between the bid and ask prices

31

Thin issue

an issue of securities with a small volume of transactions

32

Short position

the sale of a borrowed security or commodity, generally with the expectation that its price will fall—at which time the investor would purchase at the lower price and make a profit

33

Margin

the portion of the total value of a transaction that must be paid in cash to purchase a security; for stock, the portion of the value of the stock being purchased that is not being borrowed from the broker

34

Round lot

the general unit of trading (for stock, generally 100 shares)

35

Good-til canceled order

an order placed with a broker that remains in effect until it is executed by the broker or canceled by the investor

36

Long position

ownership of a security or commodity, generally for income and price appreciation potential (if the security’s price increases, the investor profits)

37

Margin requirement

the minimum percentage of the total price that an investor must pay in cash (set by the Federal Reserve, although brokerage firms can require a higher percentage)

38

Stop order

a buy or sell order that carries a specific price and becomes a market order when the market touches that price (i.e., when one trade has occurred at the specified price); generally used to limit loss if a security drops in price

39

Day order

an order to buy or sell securities that is good only for that day

40

New York Stock Exchange (NYSE)

The NYSE is the largest exchange in the United States. To have their securities listed on the exchange, firms must meet specific initial (and continuing) listing requirements. The NYSE, which lists securities of companies of national interest, currently has more than 2,400 stocks listed. (Some bonds and options are traded on the NYSE.)

For a co. to be listed:
 at least 400 round-lot holders and
 at least 1.1 million public shares outstanding (and other financial standards for listing, such as certain earnings or valuation/revenue tests that must be met).

41

Regional exchanges

Regional exchanges, such as the Philadelphia, Chicago, and Pacific exchanges, list small companies of particular interest to their geographic areas. These companies frequently have dual listings (also on a national exchange) because it enhances a security’s trading activity. Listing requirements of the regional exchanges are more lenient than those of the national exchanges

42

primary market

The “primary market” refers to new issues, which are called IPO’s, initial public offerings

43

secondary market

The term “secondary market” refers to securities trading in the open market after they have been issued. These trades can be on an exchange or in the over-the-counter market.

Any proceeds from the sale of stock would go to the seller and not the company.

44

third market

The “third market” is a term used to describe over-the-counter transactions made in securities that are listed on an exchange. Brokers organize and exercise these trades for large institutional investors, such as pension plans, mutual funds, and insurance companies.

An example would be IBM, which is listed on the NYSE, trading in the OTC market. These are large block trades between non-exchange broker-dealers and institutional investors.

45

fourth market

The “fourth market” is a term referring to transactions made directly between large institutional buyers and sellers through a computerized system called Instinet. This system provides bid and ask quotations and executes orders. (The third market and the fourth market allow for lower commissions and quicker trade executions for financial institutions.)

46

What is a margin account?

A margin account is one in which an investor can pay for securities with a combination of cash and borrowed funds.

47

How is the amount of the initial margin loan determined?

The initial amount of the loan from the broker is based on the market price of the stock at the time that the loan was made. It is 100% of the market price of the stock minus the initial margin percentage (generally 50%).

48

What happens if the market price of a stock declines after the stock is purchased on margin?

If the market price of the stock declines, the value of the investor’s shares declines, but the amount owed to the broker remains the same. If the amount owed to the broker becomes too large a portion of the value of the shares owned by the investor, the investor will be required to deposit more margin money. If the investor fails to meet this “margin call,” the broker will sell some securities in the account to raise the money needed to protect the loan. The NYSE has set the minimum maintenance margin at 25%, although firms may use a higher level.

49

How are risk and return affected by a margin transaction?

Buying securities on margin increases the risk borne by the investor because the potential loss is greater than it would be if the transaction were a cash purchase. The use of margin increases the investor’s return on the invested funds if the stock price rises; however, the potential loss is greater if the stock price falls.

50

List two benefits for investors of the conversion from fractional to decimal- based pricing for stocks:

- Spreads are narrower, which results in reduced transaction costs for investors.
- It is easier to understand decimal pricing than fractional pricing.

51

List the advantages and disadvantages of leaving securities registered in “street name."

Advantages:
 Convenience
 Ease of sale
 Accrual of dividends and interest
 Monthly statements indicating beginning and closing cash balances, dividends and interest received to date, activity during the month, and price information

Disadvantages:
 Possible loss if the brokerage firm fails
 Interim reports are sent to the broker rather than the investor; the investor may have to wait longer to receive his or her report

52

Describe how a short sale works:

The idea behind a short sale is to sell the security first (with the intention of buying it later at a lower price). The short seller borrows the security to sell to another investor. The security usually is borrowed from a broker, as the short seller deposits an amount with the broker that is equal to the margin requirement for the security. This money is the short seller’s collateral and is returned (plus any profits or minus any losses) when the short seller buys the security (covers the short position) for return to the broker.

53

What is a money market instrument?

A money market instrument is a short-term (one year or less) debt instrument issued by corporations, financial institutions, or governments.

54

negotiable CD

Negotiable CDs, also called “jumbo” CDs, are large (minimum $100,000) time deposits. The yield and term of the certificate are agreed upon (i.e., negotiated) by the investor and the institution. These jumbo CDs cannot be redeemed prior to maturity, but there is a secondary market for them.

55

commercial paper

Commercial paper is short-term, unsecured debt issued by firms with excellent credit ratings. Minimal default risk is associated with commercial paper, but the possibility of a loss of purchasing power exists. Typically, only large institutions, such as money market mutual funds, deal directly in commercial paper.

56

bankers’ acceptances (BAs)

Issued at a discount, BAs are time drafts primarily used to facilitate international trade. When a BA is presented to the importer’s bank, if all import documents are in order, the bank stamps “accepted” on the draft, thereby making that bank liable for the payment of the face amount of the draft when it becomes due (the importer is expected to pay the BA at maturity, but if the importer does not, the bank will pay it). This acceptance makes BAs marketable because any owners of them have the bank’s guarantee of payment. Maturities are usually between 30 and 180 days, issued at a discount to face value, and face value is generally in multiples of $100,000.

57

repurchase agreement

A repurchase agreement (RP) is an agreement between a borrower and a lender whereby the borrower agrees to sell and subsequently repurchase a security (usually a U.S. government security) at a prespecified price on a stated date. The holder of the security (i.e., the lender) receives a higher price at the time of the repurchase by the borrower. RPs are not marketable, but they are liquid (with very short maturities), which minimizes market risk, interest rate risk, and purchasing power risk. Depending upon the issuer, there is a possibility of default.

58

Eurodollar CDs

Eurodollars are U.S. dollar deposits held in overseas banks. These banks may be foreign banks or foreign branches of U.S. banks. Eurodollar CDs are not subject to U.S, banking regulations. Interest is paid at a fixed rate and usually tied to the London Interbank Offer Rate (LIBOR). Maturities of Eurodollar CDs are usually 180 days or less, but they can be up to one year.

59

taxable money market funds

These funds seek to maintain a stable net asset value of $1.00 by investing in taxable short-term money market instruments. They limit their average dollar-weighted maturity to 90 days or less. Some funds own Treasury securities only, which provide greater safety of principal and interest that is free from state income tax.

60

What is LIBOR?

LIBOR stands for “London Interbank Offered Rate” and is the rate at which large banks and institutions in London are willing to lend money to each other on a short-term basis.

61

John Johnson has a single account with his local FDIC-insured savings and loan that has a balance of $150,000, as well as a joint account with his spouse, Heather, that has a balance of $600,000. He also has an IRA with a $300,000 CD. What amount of FDIC insurance does John have?

John has up to $250,000 of coverage in each of the following ownership categories: single, joint, and retirement accounts. So his $150,000 in the single account is fully covered. In the joint account each owner is considered to own half of the account, so John’s share is $300,000, of which $250,000 is covered. In the IRA, $250,000 of the $300,000 is covered. This brings the total amount of coverage that John has to $650,000.

62

What were three main changes that the SEC announced in 2010 regarding money market funds?

-a fund can have no more than 3% of its assets in second tier securities (down from 5% allowed previously).
-Also, no more than 1⁄2 of 1% of the fund can be invested in a second tier security of the same issuer (this is down from 1% allowed previously).
-a fund cannot buy any second tier securities that have a maturity of more than 45 days (much lower than the limit of 397 days allowed previously).
-Daily requirement. For all taxable money market funds, at least 10% of assets must be in cash, U.S. Treasuries, or securities that convert into cash (mature) within one day.
-Weekly requirement. For all money market funds, at least 30% of assets must be in cash, U.S. Treasuries, certain other government securities with remaining maturities of 60 days or less, or securities that convert into cash within one week.

---
In essence:
1. improved liquidity,
2. higher credit quality, and
3. shorter maturity limits.

63

Identify Law that governs listed activity:
Ben Graham has decided to become a financial planner and to manage clients’ money for an annual retainer fee.

Investment Advisers Act of 1940

64

Identify Law that governs listed activity:
Roger Dodger is a financial consultant at a regional brokerage firm. At his firm, he sells mutual funds, stocks, and bonds.

Securities Exchange Act of 1934

65

Identify Law that governs listed activity:
Marie Wells has a small computer company, and she wants to incorporate her company and sell shares to the public.

Securities Act of 1933

66

Identify Law that governs listed activity:
Ben Graham also wants to create a mutual fund that allows people with only $1,000 to invest to have the benefit of his investment expertise.

Investment Company Act of 1940 and Securities Act of 1933

67

Identify Law that governs listed activity:
Walter Wish had a $300,000 account with Good Times Brokerage Firm. Good Times recently had to close because of financial improprieties.

Securities Investors Protection Act of 1970

68

Identify Law that governs listed activity:
Excell Corporation annually files a Form 10–K with the SEC

Securities Exchange Act of 1934

69

Identify Law that governs listed activity:
Excell Corporation plans to issue bonds next year to finance construction of a new building.

Securities Act of 1933

70

Identify the applicable law that is described by the features:
allows the SEC to regulate the management and capital structure of publicly owned investment companies

Investment Company Act of 1940

71

Identify the applicable law that is described by the features:
provides insurance coverage of up to $500,000 for a client’s cash and securities when a brokerage firm gets into financial difficulty

Securities Investors Protection Act of 1970

72

Identify the applicable law that is described by the features:
regulates initial public offerings of securities to prevent fraud, deceit, and misrepresentation in the sale

Securities Act of 1933

73

Identify the applicable law that is described by the features:
requires registration and regulation of investment advisers

Investment Advisers Act of 1940

74

Identify the applicable law that is described by the features:
requires registration of brokers and dealers; requires publicly held companies to file periodic reports with the SEC

Securities Exchange Act of 1934

75

Identify the applicable law that is described by the features:
authorizes the SEC to regulate the management of mutual funds

Investment Company Act of 1940

76

Identify the applicable law that is described by the features:
provides tougher regulation of auditors and imposes stiff penalties on corporate officers who submit false financial reports

The Sarbanes-Oxley Act

77

Identify the applicable law that is described by the features:
requires broker-dealers to have an anti-money laundering compliance program

USA Patriot Act

78

List the two principal purposes of full disclosure laws.

 to protect investors by ensuring honest and fair practices
 to prevent fraud and manipulation of securities prices

79

What are the objectives of the SEC.

 to regulate investment advisers
 to regulate investment companies
 to regulate hedge funds
 to supervise regulation of FINRA member firms, brokers, and security dealers
 to ensure that investors have sufficient information to make informed decisions
 to prevent manipulation of security prices
 to work with the Federal Reserve to regulate the use of credit to
acquire securities

80

What were some of the major changes in 2011 with Form ADV Part 2, the form that must be filed by all registered investment advisers?

-Form ADV Part 2 must now be filled out in a narrative form, and must be in “plain English.”
-The SEC does not want, and will not tolerate, ambiguous or confusing language, or the use of industry jargon and phrases that hide or obscure disclosure.
-There are 19 sections, primarily dealing with full disclosure of the adviser’s background, how he or she does business and is compensated, and disclosure of any conflicts of interest.
-Any material changes must now be summarized at the beginning of the document so that clients do not have to read through the entire Form ADV Part 2 in order to find any changes made since the last form was filed.

81

All registered investment advisers are considered to be fiduciaries. What are the five main responsibilities of a fiduciary?

 to put client’s interests first
 to act with utmost good faith
 to provide full and fair disclosure of all material facts  to not mislead clients
 to expose all conflicts of interest to clients

82

What are the major features of:
Securities Act of 1933

Requires registration of initial public offerings

83

What are the major features of:
Securities Exchange Act of 1934

Requires companies with previously issued securities to keep information current
Created the SEC to enforce securities laws
Requires brokers and dealers to register with the SEC

84

What are the major features of:
Investment Company Act of 1940

Extended securities laws to investment companies (mutual funds)

85

What are the major features of:
Investment Advisers Act of 1940

Requires registration for and regulates activities of investment advisers

86

What are the major features of:
Security Investors Protection Act of 1970

- Established the Security Investor Protection Corporation (SIPC)

- Insures customers’ accounts, up to $500,000 in securities and cash, with a limit of $250,000 of cash coverage (in the event of the failure of a brokerage firm)

87

What are the major features of:
Sarbanes-Oxley Act of 2002

Toughens the accountability for accuracy of financial information released by corporations; requires independence on corporate boards and sets stricter rules for auditors

88

What are the major features of:
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Created the Consumer Financial Protection Bureau and the Financial Stability Oversight Council; also addresses transparency and accountability for derivatives

89

The USA Patriot Act of 2001

This act requires broker-dealers, among others, to have internal policies, procedures, and controls to meet the “know your customer” mandate to combat terrorism and money laundering.

90

Gramm-Leach-Bliley Act of 1999

This act is also known as the Financial Services Modernization Act, and it dealt with ways that financial institutions handle the private information of individuals. It also repealed part of the Glass-Steagall Act of 1933 that prohibited financial institutions from consolidating and offering any combination of traditional commercial banking, investment banking (brokerage firms), and insurance.

91

The Commodity Futures Modernization Act of 2000

essentially exempted derivatives such as credit default swaps from regulation.

92

Securities Acts Amendments of 1975

This act directed the SEC to supervise the development of a national securities market and a system for nationwide clearing and settlement of securities transactions. The assumption behind this act was that any national market would extensively use computers and electronic communications. This act also enabled the SEC to create the Municipal Securities Rulemaking Board (MSRB).

93

May Day

May Day” also occurred in 1975. On May 1, 1975, fixed rate commissions were abolished. Prior to May Day, commission rates had been set by the stock exchange, and for about 183 years it had cost the same amount per share to trade stock, whether it was 100 shares or 100,000 shares, and brokers typically made 2% or more per trade. Charles Schwab, who opened up his discount brokerage firm in 1975, stated “Deregulation provided the window for people to begin to innovate. It turned the whole industry upside down, and led to this great mass flourishing of services and pricing and technology.”

94

Sarbanes-Oxley Act of 2002 (called “Sox”)

This board consists of five financially literate members, two of whom must be or have been certified public accountants. The board is to establish, or adopt, by rule, “auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports for issuers.” It also must conduct inspections of accounting firms, conduct investigations and disciplinary proceedings, and impose appropriate sanctions. At least one member of the audit committee must be a “financial expert.” The lead auditing or coordinating partner and the reviewing partner of the company’s CPA firm must rotate off the audit every five years.

95

The Investment Advisers Act of 1940 defines an investment adviser as

1. Advice: The adviser must give advice concerning securities.
2. Business: He or she must be engaged in the business of giving advice about securities.
3. Compensation: He or she must receive compensation for such advice.

96

How much in assets under management must a Registered Investment Advisor have in order to register with the SEC instead of the state?

Updated with Dodd Frank act to be 100 million under management. +-10 MM (90-110 MM flexibility)

97

Investment advisers must file Form ADV, Parts 1 and 2 with the Investment Adviser Registration Depository (IARD). Form ADV Part 2 must be provided to all clients by an investment adviser (this requirement is called the “Brochure Rule”). What must be disclosed in the ADV document?

Part 1 of Form ADV asks general information about the adviser, such as name and location, the form of the operation (e.g., sole proprietorship, corporation), background of the adviser and his or her associates, and whether the adviser has any felony convictions or specified types of current injunctions.

Part 2 asks for fairly detailed information such as what kind of fee structure the adviser has in place, what services are offered, whether the adviser is potentially involved with any client securities transactions, and who the adviser’s business associates are.
- due to update in 2011- Firms must write a “narrative” in “plain English” in their Form ADV Part II.

98

What is form ADV part 2b?

A brochure supplement must be prepared for the following supervised persons:
1. any supervised person who formulates investment advice for a client and has direct client contact; and
2. any supervised person who has discretionary authority over a client’s assets, even if the supervised person has no direct client contact.

99

Gross Domestic Product Formula

GDP = C + I + G + NE
where
C= Consumption, generally spending by individuals on durable and
nondurable goods and services
I= Investment, generally business spending on inventory, plant, and equipment, but including new housing purchases by consumers
G= Government spending, including federal, state, and local NE= Net exports (total exports less total imports)

100

Expansion Phase: Economic Features

- Investment leads GDP equation
- Moderate GDP increases
-Low unemployment
- Labor productivity declines, wages increase
- Business profits peak and begin to decline
- Business capacity utilization nears high
- Businesses increase investment in plants and equipment
- Loan demand strong
- Inflation rises and then peaks
- Fed tightens money supply
- Interest rates rise

101

Expansion Phase: Financial Assets

- Prices of fixed-income securities decline
- Fixed-income investors switch from long-term bonds to short-term bonds and adjustable-rate bonds
- Stocks rise, but process is more selective
- P/E ratios relatively high
- New issues proliferate
- Investors move from growth stocks to value stocks, defensive stocks, and quality issues with low volatility

102

Expansion Phase: Real Assets

Prices for commodities, real estate, collectibles, and natural resources rise

103

Contraction/Recession Phase: Economic Features

- Government spending leads GDP equation to offset decline in private sector
- GDP slows and may decline
- Unemployment rises
- Consumer spending declines
- Businesses cut costs to maintain
profit margins
- Business capacity utilization declines
- Business investment declines
- Business and consumer lending decline
- Inflation declines
- Fiscal and monetary policy expansionary
- Interest rates peak and then decline
- A recession is considered to occur when the GDP declines for two successive quarters

104

Contraction/Recession Phase: Financial Assets

- Prices of fixed-income securities rise
- Fixed-income investors switch from short-term bonds to long-term bonds to lock in high coupons; buy convertible bonds
- Stocks decline, build a base, and move off lows

105

Contraction/Recession Phase: Real Assets

- Prices for commodities, real estate, natural resources, and securities become stable or decline

106

Recovery Phase: Economic Features

- Consumer spending leads GDP equation
- Rapid GDP increases
- Unemployment high, but slowly declining
- Labor productivity rises rapidly
- Business profits recover sharply
- Business capacity utilization begins to rise
- Credit demand rises
- Inflation low
- Fed holds monetary policy steady
- Interest rates low

107

Recovery Phase: Financial Assets

- Fixed-income prices relatively stable
- Investors buy bonds for yield, not for price appreciation
- Investors switch from long- term bonds to intermediate- term bonds
- Investors buy high-yield bonds
- P/E ratios relatively low
- Stocks rebound briskly from lows
- Investors switch from value and defensive stocks to growth stocks
- Investors buy cyclical stocks

108

Recovery Phase: Real Assets

- Investors buy real estate at low prices and at low mortgage rates

109

Index of Leading Economic Indicators

1. Average workweek of production workers in manufacturing. When workers get less overtime, output may be declining.
2. Average initial weekly claims for state unemployment insurance. When first- time claims for unemployment insurance benefits rise, employment may be falling.
3. New orders for consumer goods and materials. When manufacturers receive smaller orders, they may cut back on output.
4. Vendor performance, or deliveries times index. Better on-time delivery by suppliers means that they have a smaller backlog of orders.
5. New orders for capital goods. If these orders drop, then businesses are planning less output.
6. New building permits issued. This provides a good indication of how much construction activity there will be three or four months from now.
7. Index of stock prices. Declining stock prices may reflect declining prospects for corporate sales and profits.
8. Money supply. If the Federal Reserve slows the growth of the money supply, interest rates will rise, and it will be harder for businesses and individuals to borrow money.
90  Security Markets and the Economic Environment
© 1983, 1986, 1989, 1996, 2002–2017, College for Financial Planning, all rights reserved.

9. Spread between rates on 10-year Treasury bonds and federal funds. Long- term interest rates are usually higher than short-term interest rates. Federal Reserve policies designed to slow the economy raise short-term interest rates with little effect on long-term rates. So a smaller spread between short-term and long-term interest rates implies a restrictive monetary policy and a decline in output.
10. Index of consumer expectations. As consumers grow less confident about the future, they plan to make fewer major purchases.

110

Evaluate the probable cause or effect of the following economic activities: increase or decrease in the demand for or quantity demanded of a product

Possible causes or effects include changes in the product’s price or the prices of substitute goods, and changes in consumer income and consumer tastes.

111

Evaluate the probable cause or effect of the following economic activities: increase or decrease in the supply or quantity supplied of a product

Possible causes or effects include changes in the product’s price, the cost of production, or the level of production technology.

112

Evaluate the probable cause or effect of the following economic activities: increase in personal incomes

This would cause demand to increase, with consumers willing to pay higher prices for goods and services; new equilibrium levels would then be established at higher prices and increased quantities.

113

Evaluate the probable cause or effect of the following economic activities: decrease in consumer tastes for a particular product

This would cause demand for that product to decrease permanently, so the demand curve would shift to the left; a lower price and quantity equilibrium level would be established as producers lower prices in an attempt to retain market share.

114

Evaluate the probable cause or effect of the following economic activities: decrease in the cost of production due to productivity improvements of the producer

The producer would be able to produce a greater quantity of goods for the same total dollar cost—resulting in a lower cost per unit. The producer would lower prices until demand increases to a point where supply would be in equilibrium with demand.

115

Indicate how the following indices relate to economic activity: consumer price index (CPI)

The CPI measures change in prices at the retail level. CPI changes give some indication of the current direction and the rate of change for inflation. Although regional changes in inflation may vary significantly, the CPI does provide some indication of national trends.

116

Indicate how the following indices relate to economic activity: gross domestic product (GDP)

The GDP is the dollar value of all final goods and services produced with domestic factors of production. The rate of growth of the GDP provides an indication of which phase of the business cycle the economy is currently in. A decline in GDP leads to recession; high growth may lead to increased inflation and higher interest rates; moderate growth is generally the goal of the Fed.

117

Indicate how the following indices relate to economic activity: consumer sentiment index (CSI)

The CSI measures consumers’ confidence about future business conditions, their level of security regarding their own employment and finances, and their willingness to purchase durable goods. As the level of consumer confidence changes, the willingness of consumers to spend money changes, resulting in changes in demand, supply, and prices of goods and services. These changes cause security analysts to alter their earnings forecasts to reflect the impact of the changes on corporate profits.

118

Relate the importance of the leading economic indicators to forecasting security prices.

-The leading economic indicators reflect economic activity and thus are used to forecast the direction of the economy.
-Their usefulness in forecasting security price movements is suspect for many reasons, one of which is that stock prices are one of the components of the index. In general, stock prices tend to be a leading indicator of changes in economic activity, leading such changes by an average of six months.
-However, the leading indicator sometimes gives false signals, and individual components may lead one change in direction but lag a different change in direction.

119

How do business cycles, economic forecasts, and other economic events relate to and influence security prices?

- Increases in the money supply tend to decrease interest rates, whereas decreases in the money supply tend to increase interest rates.
- Rising interest rates decrease bond prices, and falling interest rates increase bond prices.
-Stock prices also generally increase during easy money periods. Increased availability of money and credit increases the demand for securities, and decreased availability decreases the demand and causes stock prices to fall.
-If, however, a large increase in the money supply occurs too quickly, then stock prices may fall because of a fear that the large increase in the money supply will be inflationary.

120

Indicate during which phase of the business cycle the following economic features occur: Inflation and interest rates are high; business profits are declining; unemployment is rising.

Contraction

121

Indicate during which phase of the business cycle the following economic features occur: Inflation and interest rates peak and then decline; the yield curve is inverted; real assets underperform the market.

Recession

122

Indicate during which phase of the business cycle the following economic features occur: Inflation and interest rates are leveling off; unemployment is declining; capacity utilization, business expenditures, and money supply are all increasing.

Recovery

123

Indicate during which phase of the business cycle the following economic features occur: Inflation and interest rates are high; business profits are increasing; productivity is decreasing; the yield curve is leveling out.

Expansion

124

Define each of the following terms: required reserves

The percentage of total deposits that banks must hold in reserve with the Fed to back their transaction and time deposits

125

Define each of the following terms: discount rate

the interest rate that the Fed charges banks to borrow the reserves needed to meet their reserve requirements

126

Define each of the following terms: monetary policy

decisions by the Fed that cause changes in money supply and interest rates

127

Define each of the following terms: fiscal policy

the federal government’s policy regarding taxation, government spending, and debt management

128

Define each of the following terms: equilibrium price

the price at which the quantity supplied is equal to the quantity demanded

129

Explain how each of the following fiscal policy actions affects security prices: taxation

- Corporate income taxes reduce corporate earnings, and this reduction in earnings reduces a firm’s ability to pay dividends and to retain earnings for growth.
- Personal income taxes reduce disposable income, and this reduction in income reduces consumer demand and savings (funds that otherwise could be invested in assets). Increases in both types of taxes tend to cause stock prices to decline.

130

Explain how each of the following fiscal policy actions affects security prices: government spending

-Government spending is one component of aggregate demand.
-When government spending increases (decreases), earnings of the firms affected by the change increase (decrease), and this can affect their stock prices positively (negatively).

131

Explain how each of the following fiscal policy actions affects security prices: debt management (deficit spending)

-When the federal government spends more than it receives, it runs a deficit, which must be financed. The government issues new debt securities, which are bought by the general public, banks, and the Federal Reserve.
-When investors buy Treasury securities rather than the securities of other issuers, the "ignored” securities (e.g., corporate bonds) usually decline in price. In addition, when banks purchase government debt, they make fewer loans, and the resulting increase in the cost of borrowing reduces security prices.
-If the Fed finances the deficit, the money supply increases, initially causing security prices to rise. However, if the money supply expansion is considered inflationary, investors’ required returns may increase, which would drive security prices down.

132

The Fed is the central bank of the United States and has four major responsibilities, what are they?

1. conducting the nation’s monetary policy
2. supervising and regulating banking institutions
3. maintaining the stability of the financial system and containing market risk in the financial markets
4. providing financial services to the U.S. government

133

What is the difference between the Fed and the Treasury?

The Treasury is a budgetary agency of the executive branch that is concerned with financing federal government operations (e.g., issuing Treasury securities). The Fed is an independent government agency that manages the nation’s money supply.

134

The Fed has three tools, what are they?

1. setting reserve requirements of banks,
2. setting the federal funds rate and the discount rate (the rate at which the Fed loans money to depository institutions), and
3. buying and selling U.S. government securities in the open market.

135

What are the expansionary monetary policies?

- Lower reserve requirement
- Lower discount rate
- Purchase government securities

136

What happens to interest rates, bond prices and stock prices when expansionary monetary policies are implemented?

- Interest Rates Fall
- Bond prices increase
- Stock prices increase

137

What are the contractionary monetary policies?

- Increase reserve requirement
- Increase discount rate
- Sell government securities

138

What happens to interest rates, bond prices and stock prices when contractionary monetary policies are implemented?

- Interest Rates Rise
- Bond Prices Fall
- Stock Prices Fall