Chapter 1 Role of Financial Markets and Institutions Specific Objectives Describe the types of financial markets that accommodate various transactions Describe the role of financial institutions within financial markets Introduce the concept of security valuation within financial markets Identify the types of financial institutions that facilitate transactions in financial markets Key Terms Matching In the following exercise, place a letter from the right column with the correct number in the left column. Key Term ____ 1. Bid-ask spread ____ 2. Bonds ____ 3. Broker ____ 4. Capital market ____ 5. Circuit breakers ____ 6. Dealer ____ 7. Derivative securities ____ 8. Financial market ____ 9. Liquidity ____ 10. Money market ____ 11. Money market mutual fund ____ 12. Organized exchange ____ 13. Over-the-counter (OTC) market ____ 14. Perfect market ____ 15. Primary market ____ 16. Privatization ____ 17. Secondary market ____ 18. Stocks Definition a. the sale of government-owned firms to individuals b. the fee charged by a broker c. financial contracts whose values are derived from the values of underlying assets d. a visible marketplace for secondary market transactions e. a person making a market in specific securities by adjusting his inventory of securities f. a telecommunications network facilitating financial market transactions g. a person or institution executing securities transactions between two parties h. a mutual fund concentrating in money market securities i. long-term debt obligations issued by corporations and government agencies to support their operations j. a market that facilitates the issuance of new securities k. a market that facilitates the trading of existing securities l. a market that facilitates the flow of short-term funds with maturities of less than one year m. a market that facilitates the flow of long-term funds n. a market in which financial assets (securities) can be bought or sold o. the degree to which securities can easily be sold without a loss of value p. a market in which all information about any securities for sale in primary and secondary markets is continuously and freely available to investors q. a device used to temporarily halt the trading of some securities or contracts r. certificates representing partial ownership in a firm 1 2 Chapter 1/Role of Financial Markets and Institutions Definitional Problems 1. Financial market participants that provide funds are called ________________, while participants that need to obtain funds are called __________________. 2. A market in which financial assets (securities) such as stocks and bonds can be purchased or sold is a(n) ____________ market. 3. ________________ securities are securities with maturities of more than one year; ________________ securities are securities with maturities of one year or less. 4. In general, money market securities have a higher degree of _____________ than capital market securities. 5. A market in which existing securities are traded is called a _____________ market, while a market that facilitates the issuance of new securities is called a ______________ market. 6. Two primary uses of derivative securities are ___________ and __________. 7. A visible marketplace for secondary market transactions is known as a(n) _______________. 8. The _________________ is an example of an organized exchange. 9. The _________________ is an example of the over-the-counter (OTC) market. 10. The ______________ market facilitates the exchange of currencies. 11. __________ are long-term debt obligations issued by corporations and government agencies to support their operations. 12. Long-term debt securities tend to have a higher expected return than money market securities, but they have ____________ risk as well. 13. Derivative securities are ___________ whose values are derived from the values of underlying assets. 14. When particular securities are perceived to be overvalued by the market, their prices ____________ as these securities are sold. 15. The valuation of a security is measured as the _________ of its expected cash flows. 16. When security prices fully reflect all available information, the market for these securities is said to be _______________. 17. The sale of government-owned firms to individuals is commonly referred to as _________________. 18. If buyers and sellers do not have full access to information and cannot always break down securities to the precise size they desire, the markets for these securities are ____________. Chapter 1/Role of Financial Markets and Institutions 3 19. Savings institutions, sometimes also referred to as ______ institutions, are a type of depository financial institution. 20. The fee charged by a(n) ________ is reflected in the difference between her bid and ask quotes. 21. In addition to brokerage services, securities firms often act as _____________, making a market in specific securities by adjusting their inventory of securities. 22. Many of the transactions between financial institutions and deficit units are executed by ______________________. 23. In recent years, financial institutions have consolidated to capitalize on both ______________________ and ______________________. 24. The introduction of the _______, a single European currency, has reduced concerns about exchange rate risk for European firms. True/False Problems ____ 1. A financial market is a market in which financial assets can be purchased or sold. ____ 2. The federal government commonly acts as a surplus unit. ____ 3. Households are the main providers of funds. ____ 4. Those financial markets that facilitate the flow of short-term funds (with maturities of less than one year) are known as capital markets, while those that facilitate the flow of long-term funds are known as money markets. ____ 5. Primary markets facilitate the trading of existing securities. ____ 6. An organized exchange is a telecommunications network. ____ 7. Bonds are long-term debt obligations issued by corporations and government agencies to support their operations. ____ 8. Long-term debt securities tend to have lower risk but a higher return than money market securities. ____ 9. Derivative securities are financial contracts whose values are derived from the values of underlying assets. ____ 10. While all investors rely on valuation to make investment decisions, they derive different valuations of a security based on the existing set of information. ____ 11. Since markets are efficient, institutional and individual investors should ignore the various investment instruments available. 4 Chapter 1/Role of Financial Markets and Institutions ____ 12. Speculating with derivative contracts on an underlying assets typically results in both higher risk and higher returns than speculating in the underlying asset itself. ____ 13. When security prices fully reflect all available information, the markets for these securities are said to be perfect. ____ 14. Securities that are not as safe and liquid as other securities are never considered for investment by anyone. ____ 15. By requiring full disclosure of information, securities laws prevent investors from making poor investment decisions. ____ 16. Circuit breakers are used to temporarily halt the trading of some securities or contracts in order to reduce market volatility. ____ 17. Even with regulatory oversight, there continue to be cases in which some investors have an unfair advantage over others because they have better access to information. ____ 18. An efficient financial market is one in which all information about any securities for sale in primary and secondary markets is continuously and freely available to investors. ____ 19. If markets are imperfect, securities buyers and sellers to not have full access to information and cannot always break down securities to the precise size they desire. ____ 20. When a depository institutions offers a loan, it is acting as a creditor. ____ 21. Savings institutions are the most dominant financial institution. ____ 22. While commercial banks concentrate on commercial loans, credit unions have concentrated on residential mortgage loans. ____ 23. Most mutual funds obtain funds by issuing securities, then lend the funds to individuals and small businesses. ____ 24. A broker executes securities transactions between two parties and charges a fee reflected in the bid-ask spread. ____ 25. Many corporations and government agencies offer their employees pension plans that are entirely funded by the employer. ____ 26. Economies of scope represent a reduction in the average cost per unit due to increased volume. ____ 27. Among others, deficit units receive funding from insurance companies and pension funds. ____ 28. Many of the transactions between financial institutions and deficit units are executed by securities firms. ____ 29. Institutional investors not only provide financial support to companies but exercise some degree of corporate control over them. Chapter 1/Role of Financial Markets and Institutions 5 ____ 30. In recent years, financial institutions have consolidated to capitalize on economies of scale and on economies of scope. ____ 31. The euro increased business between European countries and created a less competitive environment in Europe. ____ 32. Many financial institutions engage in international mergers so that they can serve clients throughout Europe and provide a wider variety of services. Multiple Choice Problems 1. According to your text, which of the following are not main participants in financial market transactions? a. households b. financial institutions c. governments d. businesses e. all of the above are main participants in financial market transactions. 2. Financial markets a. facilitate the flow of funds from deficit to surplus units. b. facilitate the flow of funds from surplus to deficit units. c. are markets in which financial assets such as stocks and bonds can be purchased and sold. d. None of the above are true. e. Only answers b and c are correct. 3. Financial markets facilitating the flow of short-term funds with maturities of less than one year are known as a. money markets. b. capital markets. c. primary markets. d. secondary markets. e. none of the above. 4. Financial markets facilitating the trading of existing securities are known as a. money markets. b. capital markets. c. primary markets. d. secondary markets. e. none of the above. 5. Which of the following is not an organized exchange? a. New York Stock Exchange b. American Stock Exchange c. Nasdaq d. All of the above are organized exchanges. 6 Chapter 1/Role of Financial Markets and Institutions 6. Which of the following transactions would not be considered a secondary market transaction? a. An individual investor purchases some existing shares of IBM stock through his broker. b. An institutional investor sells some Disney stock through his broker. c. Microsoft issues new shares of common stock using its investment bank. d. All of the above would occur in the secondary market. 7. According to your text, which of the following is not considered a money market security? a. Treasury bills b. Treasury notes c. retail CD d. banker’s acceptance e. commercial paper 8. ________________ are not considered capital market securities. a. Repurchase agreements b. Municipal bonds c. Corporate bonds d. Equity securities e. Mortgages 9. ____________ are long-term debt obligations issued by corporations and government agencies to support their operations. a. Common stock b. Derivative securities c. Bonds d. None of the above 10. Long-term debt securities tend to have a ___________ expected return and _________ risk than money market securities. a. lower; lower b. lower; higher c. higher; lower d. higher; higher 11. If investors speculate in derivative contracts rather than the underlying asset, they will probably achieve ____________ returns, and they are exposed to relatively ___________ risk. a. lower; lower b. lower; higher c. higher; lower d. higher; higher 12. When security prices fully reflect all available information, the markets for these securities are said to be a. inefficient. b. efficient. c. perfect. d. imperfect. e. none of the above. Chapter 1/Role of Financial Markets and Institutions 7 13. When particular securities are perceived to be ______________ by the market, their prices decrease when they are sold by investors. a. undervalued b. overvalued c. fairly priced d. efficient e. none of the above 14. According to your text, the most pronounced changes in international integration have occurred in a. Latin America. b. Asia. c. Europe. d. Africa. 15. If financial markets were _____________, all information about any securities for sale in primary and secondary markets would be continuously and freely available to investors. a. inefficient b. efficient c. perfect d. imperfect e. none of the above 16. Which of the following is not a reason why depository institutions are popular financial institutions, according to your text? a. They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units. b. They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units. c. They accept the risk on loans provided. d. They have more expertise than individual deficit units in evaluating the creditworthiness of surplus units. e. All of the above are reasons why depository institutions are popular financial institutions. 17. Which of the following are not considered depository financial institutions? a. finance companies b. commercial banks c. savings institutions d. credit unions e. All of the above are depository financial institutions. 18. According to your text, credit unions differ from commercial banks and savings institutions because they a. are profit-oriented. b. concentrate on residential mortgage loans. c. restrict their business to credit union members. d. are larger than commercial banks and savings institutions. 8 Chapter 1/Role of Financial Markets and Institutions 19. Which of the following are considered depository financial institutions? a. credit unions b. mutual funds c. securities firms d. pension funds 20. Securities firms a. sometimes act as a broker. b. provide investment banking services. c. often act as a dealer. d. sometimes provide advisory services. e. all of the above 21. Many corporations offer their employees pension plans in which funds are periodically contributed by a. the employers. b. the employees. c. both employers and employees. d. the U.S. government. e. Answers a, b, and c can be correct. 22. _________________ maintain a larger amount of assets than the other types of depository institutions. a. Finance companies b. Commercial banks c. Life insurance companies d. Savings institutions e. Credit unions 23. ________________ accept deposits from households, businesses, and government agencies and purchase government and corporate securities. a. Commercial banks b. Savings institutions c. Finance companies d. Money market funds e. Answers a and b are correct. 24. The main source of funds for ________________ is proceeds from selling securities to households and businesses, while their main use of funds is providing loans to households and businesses. a. savings institutions b. commercial banks c. mutual funds d. finance companies e. pension funds Chapter 1/Role of Financial Markets and Institutions 9 25. According to your text, which of the following is not a financial service provided by Citigroup? a. commercial loans b. advisory services for corporations planning to restructure c. consumer loans d. credit cards e. All of the above are financial services provided by Citigroup. 26. Which of the following is not a reason why depository financial institutions are popular? a. They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units. b. They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units. c. They accept the risk on loans provided. d. They use their information resources to act as a broker, executing securities transactions between two parties. e. They have more expertise than individual surplus units in evaluating the creditworthiness of deficit units. Answers to Key Terms Matching 1. 2. 3. 4. 5. 6. 7. 8. 9. b i g m q e c n o 10. 11. 12. 13. 14. 15. 16. 17. 18. l h d f p j a k r Answers to Definitional Problems 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. surplus units; deficit units financial capital market; money market liquidity secondary; primary speculation; hedging organized exchange New York Stock Exchange (NYSE) Nasdaq foreign exchange bonds more 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. financial contracts decrease present value efficient privatization imperfect thrift broker dealers securities firms economies of scale; economies of scope euro 10 Chapter 1/Role of Financial Markets and Institutions Answers to True/False Problems 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. T F T F F F T F T T F T F F F T 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. T F T T F F F T F F T T F T F T Answers to Multiple Choice Problems 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. e e a d c c b a c d d b b 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. c c d a c a e e b e d e d