Chapter 8 - Answer

Solutions Manual

CHAPTER 8 UNDERSTANDING THE ROLE OF THE FINANCIAL MARKETS AND INSTITUTIONS SUGGESTED ANSWERS TO THE REVIEW QUESTIONS I. Questions 1. 

Spot markets – the markets in which assets are bought or sold for “on-the-spot” delivery; Future markets – the markets in which participants agree today to buy or sell an asset at some future date.

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Money markets – the financial markets in which funds are borrowed or loaned for short periods (less than one year); Capital markets – the financial markets for stocks and for intermediate or long-term debt (one year or longer).

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Primary markets – markets in which corporations raise capital by issuing new securities; Secondary markets – markets in which securities and other financial assets are traded among investors after they have been issued by corporations.

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Private markets – markets in which transactions are worked out directly between two parties; Public markets – markets in which standardized contracts are traded on organized exchanges.

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Derivatives – any financial asset whose value is derived from the value of some other “underlying” asset.

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Investment banks – an organization that underwrites and distributes new investment securities and helps businesses obtain financing; Commercial banks – the traditional department store of finance serving a variety of savers and borrowers; Financial services corporations – a firm that offers a wide range of

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financial services, including investment banking, brokerage operations, insurance and commercial banking. 

Mutual funds – organizations that pool investor funds to purchase financial instruments and thus reduce risks through diversification; Money market funds – mutual funds that invest in short-term, low-risk securities and allow investors to write checks against their accounts.

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Physical location exchanges – formal organizations having tangible physical locations that conduct auction markets in designated (listed) securities; Over-the-Counter (OTC) market – a large collection of brokers and dealers connected electronically by telephones and computers that provides for trading in unlisted securities; Dealer market – includes all facilities that are needed to conduct security transactions not conducted on the physical location exchanges.

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Closely held corporation – a corporation that is owned by a few individuals who are typically associated with the firm’s management; Publicly owned corporation – a corporation that is owned by a relatively large number of individuals who are not actively involved in the firm’s management.

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Going public – the act of selling stock to the public at large by a closely held corporation or its principal stockholders; Initial public offering (IPO) market – the market for stocks of companies that are in the process of going public.

2. In a well-functioning economy, capital will flow efficiently from those who supply capital to those who demand it. This transfer of capital can take place in three different ways: a. Direct transfers of money and securities occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. The business delivers its securities to savers, who in turn give the firm the money it needs. b. Transfers may also go through an investment banking house which underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The 8-2

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company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses’ securities and the savers’ money merely “pass through” the investment banking house. c. Transfers can also be made through a financial intermediary. Here, the intermediary obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy and hold businesses’ securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly increases the efficiency of money and capital markets. 3. A money market transaction occurs in the financial market in which funds are borrowed or loaned for short periods (less than one year). A capital market transaction occurs in the financial market in which stocks and intermediate or long-term debt (one year or longer) are issued. a. A BSP Treasury bill is an example of money market securities. b. Long-term corporate bonds are examples of capital market securities. c. Common or ordinary stocks are examples of capital market securities. d. Preferred stocks are examples of capital market securities. e. Dealer commercial paper is an example of money market securities. 4. If people lost faith in the safety of financial institutions, it would be difficult for firms to raise capital. Thus, capital investment would slow down, unemployment would raise, the output of goods and services would fall, and in general, our standard of living would decline. 5. Financial markets have experienced many changes during the last two decades. Technological advances in computers and telecommunications, along with the globalization of banking and commerce, have led to deregulation and this has increased competition throughout the world. The result is a much more efficient, internationally linked market, but one that is far more complex than existed a few years ago. While these 8-3

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developments have been largely positive, they have also created problems for policy makers. Large amounts of capital move quickly around the world in response to changes in interest and exchange rates, and these movements can disrupt local institutions and economies. The subprime mortgage crisis illustrates how problems in one country quickly affect the economies of other nations. Globalization has exposed the need for greater cooperation among regulators at the international level. Factors that complicate coordination include (1) the differing structures among nations’ banking and securities industries, (2) the trend in Europe toward financial services conglomerates, and (3) reluctance on the part of individual countries to give up control over their national monetary policies. Regulators are unanimous about the need to close the gaps in the supervision of worldwide markets. Another important trend in recent years has been the increased use of derivatives. The market for derivatives has grown faster than any other market in recent years, providing corporations with new opportunities but also exposing them to new risks. Derivatives can be used either to reduce risks or to speculate. It’s not clear whether recent innovations have “increased or decreased the inherent stability of the financial system”. 6. Money markets refer to those markets dealing with short-term securities that have a life of one year or less. Capital markets refer to securities with a life of more than one year. 7. A primary market refers to the use of the financial markets to raise new funds. After the securities are sold to the public (i.e., institutions and individuals), they trade in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell securities based on the expectations of corporate prospects. 8. Given companies with equal risk, those companies with expectations of high return will have higher common stock prices relative to those companies with poor expectations. 9. Restructuring can result in changes in the capital structure (liabilities and owners’ equity on the balance sheet). It can also result in the selling of low-profit-margin divisions with the proceeds reinvested in better 8-4

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investment opportunities, and sometimes restructuring results in the removal of the current management team or large reductions in the work force. Restructuring has also included mergers and acquisitions. II. Multiple Choice Questions 1. 2. 3. 4.

A B D B

5. 6. 7. 8.

D D A D

III. Matching Quiz 1. 2. 3. 4. 5. 6. 7. 8. 9.

i. e. f. c. a. h. b. g. d.

financial capital inflation primary market money market restructuring disinflation capital market secondary market real capital

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