EoCB_ch2_questions&problems

Question 1

2.1 Financial System: What is the role of the financial system, and what are the two major components of the financial system?

Answer 1

Solution: The role of the financial system is to gather money from businesses and individuals who have surplus funds and channel funds to those who need them. The financial system consists of financial markets and financial institutions.

Question 2

2.2 Financial System: What does a competitive financial system imply about interest rates?

Answer 2

Solution: If the financial system is competitive, one will receive the highest possible rate for money invested with a bank and the lowest possible interest rate when borrowing money. Also, only firms with good credit ratings and projects with high rates of return will be financed.

Question 3

2.3 Financial System: What is the difference between saver–lenders and borrower–spenders, and who are the major representatives of each group?

Answer 3

Solution: Saver–lenders are those who have more money than they need right now. The principal saver–lenders in the economy are households. Borrower–spenders are those who need the money saver–lenders are offering. The main borrower–spenders in the economy are businesses followed by the federal government, although households are important mortgage borrowers.

Question 4

2.4 Financial Markets: List the two ways in which a transfer of funds takes place in an economy. What is the main difference between these two?

Answer 4

Solution: Funds can flow directly through financial markets or indirectly through intermediation markets where funds flow through financial institutions first.

Question 5

2.5 Financial Markets: Suppose you own a security that you know can be easily sold in the secondary market, but the security will sell at a lower price than you paid for it. What does this imply for the security’s marketability and liquidity?

Answer 5

Solution: As the price of the security is lower than that you paid for it, it has a lower degree of liquidity to you, the owner. That is because the security cannot now be sold without a loss in value to the owner. Marketability refers to the ease with which a security can be sold or converted to cash. The information in the problem mentions that the security could be easily sold in secondary market, which implies it has high degree of marketability to you.

Question 6

2.6 Financial Markets: Why are direct financial markets also called wholesale markets?

Answer 6

Solution: The financial markets are also called wholesale markets because the minimum transaction or security denomination is $1 million or more.

Question 7

2.7 Financial Markets: Trader Inc.is a $300 million company, as measured by asset value, and Horst Corp. is a $35 million company. Both are privately held corporations. Explain which firm more likely to go public and register with the SEC, and why.

Answer 7

Solution: Trader Inc. is more likely to go public because of its larger size. Though the cost of SEC registration and compliance is very high, larger firms can offset these costs by the lower funding cost in public markets. Smaller companies find the cost prohibitive for the dollar amount of securities they sell.

Question 8

2.8 Primary Markets: What is a primary market? What does IPO stand for?

Answer 8

Solution: A primary market is where new securities are sold for the first time. IPO stands for Initial Public Offering.

Question 9

2.9 Primary Markets: Identify whether the following transactions are primary market or secondary market transactions.

a. Jim Hendry bought 300 shares of IBM through his brokerage account.
b. Peggy Jones bought $5,000 of General Motors bonds from another investor.
c. Hathaway Insurance Company bought 500,000 shares of Trigen Corp. when the
company issued stock.

Answer 9

a. Secondary market transactions.
b. Secondary market transactions.
c. Primary market transactions.

Question 10

2.10 Investment Banking: What does it mean to “underwrite” a new security issue? What compensation does an investment banker get from underwriting a security issue?

Answer 10

To underwrite a new security issue means that the investment banker buys the entire issue from the firm at a guaranteed price and then resells the security to individual investors or other institutions at a higher price. The difference between the banker’s purchase price and the total resale price is called the underwriting spread, and it is the banker’s compensation. In addition to underwriting new securities, investment banks also provide other services, such as preparing the prospectus, preparing legal documents to be filed with the SEC, and providing general financial advice to the issuer.

Question 11

2.11 Investment Banking: Cranjet Inc. is issuing 10,000 bonds, and its investment banker has guaranteed a price of $985 per bond. If the investment banker sells the entire issue to investors for $10,150,000.

a. What is the underwriting spread for this issue?
b. What is the percentage underwriting cost?
c. How much did Cranjet raise?

Answer 11

a. $300,000 ($10,150,000 – $985 x 10,000)
b. 3.05 percent [($1,105-985) /$985]
c. $9,850,000 ($985 x 10,000)

Question 12

2.12 Financial Institutions: What are some of the ways in which a financial institution or intermediary can raise money?

Answer 12

A financial intermediary can raise money through the sale of financial products that individuals or businesses will purchase, such as checking and savings accounts, life insurance policies, pension or retirement funds.

Question 13

2.13 Financial Institutions: How do financial institutions act as intermediaries to provide services to small businesses?

Answer 13

Financial intermediaries allow smaller companies to access the financial markets. They do this by converting securities with one set of characteristics into securities with another set of characteristics that meets the needs of smaller companies. By repackaging securities, they are able to meet the needs of different clients.

Question 14

2.14 Financial Institutions: Which financial institution is usually the most important to businesses?

Answer 14

The primary financial intermediaries are commercial banks, life insurance companies, casualty insurance companies, pension funds, investment funds, and business finance companies. Commercial banks are the largest and most prominent financial intermediaries in the economy and offer the widest range of financial services to businesses.

Question 15

2.15 Financial Markets: What is the main difference between money markets and capital markets?

Answer 15

Money markets are markets in which short-term debt instruments with maturities of less than one year are bought and sold. Capital markets are markets in which equity securities and debt instruments with maturities of more than one year are bought and sold.

Question 16

2.16 Money Markets: What is the primary role of money markets? Explain how the money markets work.

Answer 16

Money markets provide an option for large corporations to adjust their liquidity positions. Since only seldom are cash receipts and cash expenditures perfectly synchronized, money markets allow companies to temporarily invest idle cash in Treasury bills or negotiable CDs. If a company is short on cash, it can borrow the money from money markets by selling commercial paper at lower interest rates than through commercial banks.

Question 17

2.17 Money Markets: What are the main types of securities in the money markets?

Answer 17

Treasury bills, bank negotiable CDs, and commercial paper.

Question 18

2.18 Capital Markets: How do capital market instruments differ from money market instruments?

Answer 18

Capital market instruments are less liquid or marketable, they have longer maturities, usually between 1 and 30 years, and they carry more financial risk.

Question 19

2.19 Market Efficiency: Describe the informational differences that distinguish the three forms of market efficiency.

Answer 19

The strong-form of market efficiency states that all information is reflected in the security prices. In other words, there is no private or inside information, that if released would potentially change the price. The semistrong-form holds that all public information available to investors is reflected in the security’s price. Therefore, insiders with access to private information could potentially profit from trading on this knowledge before it becomes public. Finally, the weak-form of market efficiency holds that there is both public and private information that is not reflected in the security’s price and having access to it can lead to abnormal profits.

Question 20

2.20 Market Efficiency: Zippy Computers announced strong fourth quarter results. Sales and earnings were both above analysts’ expectations. You notice in the newspaper that Zippy’s stock price went up sharply on the day of the announcement. If no other information about Zippy became public on the day of the announcement and the overall market was down, is this evidence of market efficiency?

Answer 20

Yes, if no other information became public and the market was down, the increase in Zippy’s price most likely reflects the effects of investors trading on the good news. Investors, believing that Zippy is now more valuable than they had thought, are willing to pay a higher price for the shares.

Question 21

2.21 Market Efficiency: In problem 2.20, if the market is efficient, would it have been possible for Zippy’s stock price to go down on the day that the firm announced the strong fourth quarter results?

Answer 21

Yes. The last sentence in the statement of problem 2.20 suggests why this might happen. If, on the same day of the announcement, some very bad news about the future prospects for Zippy became public or if the market went down substantially, Zippy’s stock price might also have gone down despite the positive sales and earnings announcement. Zippy’s stock price may also go down if strong results were anticipated and this information was already reflected in the stock price, but the actual results were not as strong as anticipated.

Question 22

2.22 Market Efficiency: If the market is strong-form efficient, then trading on tips you hear from Jim Cramer (the host of Mad Money on CNBC) will generate no excess returns (i.e., returns in excess of fair compensation for the risk you are bearing). True or false?

Answer 22

True. If the market is strong-form efficient then all new information gets reflected in stock prices very quickly. In such a market, there is nothing you will hear from Jim Cramer on his TV show that will enable you to consistently earn excess returns. The information in his tips will already be reflected in stock prices by the time you can trade on them.

Question 23

2.23 Financial Markets: What are the major differences between public and private markets?

Answer 23

Public markets are organized financial markets (also referred to as Exchanges) where the public buys and sells securities through their stock brokers. The SEC regulates public securities markets in the United States. In contrast, private markets involve direct transactions between two parties. These transactions lack SEC regulation.

Question 24

2.24 Financial Instruments: What are the two risk-hedging instruments discussed in the chapter?

Answer 24

Solution: The two risk-hedging instruments discussed are futures and options contracts.

Question 25

2.25 Interest Rates: What is the real rate of interest, and how is it determined?

Answer 25

Solution: The real rate of interest measures the return earned on savings, and it represents the cost of borrowing to finance capital goods. It is the interest rate determined in the absence of inflation. The real rate of interest is determined by the interaction between firms that invest in capital projects and the rate of return businesses can expect to earn on investments in capital goods, and individuals’ time preference for consumption. Graphically, it is that point when the desired saving level equals the desired level of investment in the economy.

Question 26

2.26 Interest Rates: How does the nominal rate of interest vary over time?

Answer 26

Solution: The nominal rate is the rate that we observe in the marketplace. It is determined by both the real rate as well as expected inflation. Therefore, the nominal rate will fluctuate with changes in the real rate as well as changes in expected inflation.

Question 27

2.27 Interest Rates: What is the Fisher equation, and how is it used?

Answer 27

Solution: The Fisher equation reflects the expected, not the reported or actual, annualized change in commodity prices (∆Pe). It is used to protect the buying power from changes in inflation, and it is incorporated into a loan contract by including the real interest rate that would exist in the absence of inflation.

Question 28

2.28 Interest Rates: Imagine you borrow $500 from your roommate, agreeing to pay her back $500 plus 7 percent nominal interest in one year. Assume inflation over the life of the contract is expected to be 4.25 percent. What is the total dollar amount you will have to pay her back in a year? What percentage of the interest payment is the result of the real rate of interest?

Answer 28

Solution: You will pay her back $535 ($500 × 1.07) in one year. Given an inflation of 4.25 percent, the real rate of interest is approximately 2.368 percent using the Fisher equation:
1 + i = (1 + r) × (1 + ΔPe)
1 + 0.07 = (1 + r) × (1 + 0.0425)
r = (1.07/1.0425) – 1 = 0.02638, or 2.638%
This means that $13.19 ($500 × 0.02638) will be a result of the real interest rate which is 37.69 percent of the total interest payment.
The simplified, or approximate, Fisher equation yields a real interest rate of 2.75 percent:
i = r + ΔPe
r = 0.07 - 0.0425 = 0.0275, or 2.75%
This means that $13.75 ($500 × 0.0275) will be a result of the real interest rate which is 39.29 percent of the total interest payment.

Question 29

2.29 Interest Rates: Your parents have given you $1,000 a year before your graduation so that you can take a trip when you graduate. You wisely decide to invest the money in a bank CD that pays 6.75 percent interest. You know that the trip costs $1,025 right now and that the inflation for the year is predicted to be 4 percent. Will you have enough
money in a year to purchase the trip?

Answer 29

Solution: Yes. The CD will be worth $1,067.50 at the end of the year ($1,000 x 6.75% + $1,000), and the price of the trip will be $1,066 ($1,025 x 4% + $1,025). The CD will be able to cover the trip.

Question 30

2.30 Interest Rates: When are the nominal and real interest rates equal?

Answer 30

Solution: The only time the nominal and real interest rates are equal is when the expected rate of inflation over the contract period is zero.