mbf chapter2

Given the following business plan​ information:

I need to borrow​ $5,000 for a car because it enables me to get a job as a traveling anvil seller. Larry the Loan Shark will loan me the​ $5,000 at an interest rate of​ 90%. Principle and interest are due in exactly 12 months. With the​ car, I will be able to earn​ $10,000 in extra income over the next 12 months. What is the net cash flow by taking out the​ loan?

The net cash flow is $500.

In which of the following situations do financial markets allow consumers to better time their​ purchases?

A.

Paying the cost of repairing a flooded basement.

B.

Buying groceries.

C.

Paying for tuition

D.

Purchasing a car or furniture.

A.

Paying the cost of repairing a flooded basement.

C.

Paying for tuition

D.

Purchasing a car or furniture.

A financial market in which only​ short-term debt instruments​ (generally those with original maturity of less than one​ year) are traded.

Money Market

A financial market in which securities that have been previously issued can be resold.

Secondary Market

A financial market in which new issues of a​ security, such as a bond or a​ stock, are sold to initial buyers by the corporation or government agency borrowing the funds.

Primary Market

A market in which​ longer-term debt​ (generally those with original maturity of one year or​ greater) and equity instruments are traded.

Capital Market

A market where bonds or​ mortgages, which are contractual agreements by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date when a final payment is​ made, are traded.

Debt Market

What is the difference between a mortgage and a ​mortgage-backed security​?

A.

Mortgages are provided to households or​ firms, whereas​ mortgage-backed securities are provided mainly to financial institutions.

B.

No interest is paid on​ mortgage-backed securities, whereas interest and principal payments are paid on mortgages.

C.

Mortgages are usually used to create a​ portfolio, whereas​ mortgage-backed securities are held separately.

D.

Mortgages are​ loans, whereas​ mortgage-backed securities are​ bond-like debt instruments.

D.

Mortgages are​ loans, whereas​ mortgage-backed securities are​ bond-like debt instruments.

These​ long-term bonds are issued by institutions such as Ginnie​ Mae, the Federal Farm Credit​ Bank, and the TVA. Many of these securities are guaranteed by the federal government.

Agency Securities

These​ long-term debt instruments are issued by the U.S. Treasury to finance the deficits of the federal government.

Government Security

These are loans to households or firms to purchase​ housing, land, or other real​ structures, where the structure or land itself serves as collateral for the loans.

Mortgages

These are equity claims on the net income and assets of a corporation.

Stocks

These​ long-term bonds are issued by corporations with very strong credit ratings.

Corporate Bonds

US dollars deposited in foreign banks outside the United States or in foreign branches of US banks.

Eurodollars

Bonds sold in a foreign country and denominated in that​ country's currency.

Eurodollars

A bond denominated in a currency other than that of the country in which it is sold—for ​example, a bond denominated in US dollars sold in London.

Eurobonds

Foreign currencies deposited in banks outside the home country.

Eurocurrency

Suppose that you​ buy, and one year later​ sell, a foreign​ (British) bond under the following​ circumstances:

When you buy the bond the exchange rate is ​$2.00 ​= pound1.

You pay £45 ​($90.00​) for the British bond.

You sell the bond for £50. No interest payment was expected or received.

When you sell the​ bond, the exchange rate is​ $1.70 ​= £1.

What is your gain or loss in​ dollars? ​

-5

How do financial intermediaries benefit by providing​ risk-sharing services?

A.

Customers pay a fee to financial intermediaries for being able to invest in safer assets

B.

A collection of riskier assets is always more profitable for a bank or intermediary

C.

They are able to turn safe assets into​ high-risk, high-return investments

D.

They are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold

D.

They are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold

Financial intermediaries have a role to play in matching savers and borrowers for all of the following reasons

A.

minimising transaction costs

B.

information symmetries

C.

risk sharing

D.

economies of scale

B.

information symmetries

How do conflicts of interest make the asymmetric information problem​ worse?

A.

Competing interests may limit a financial​ institution's economies of​ scope, which lowers overall economy efficiency and profits.

B.

Competing interests may lead a financial institution to conceal information or disseminate misleading​ information, which prevents financial markets from channeling funds into the most productive investment opportunities.

C.

Conflicts of interest tend to lead financial institutions to lend money to the most risky​ borrowers, deepening the asymmetric information problem.

D.

Conflicts of interest create an adverse selection​ problem, which prevents financial markets from channeling funds into the most productive investment opportunities.

B.

Competing interests may lead a financial institution to conceal information or disseminate misleading​ information, which prevents financial markets from channeling funds into the most productive investment opportunities.

A situation where the borrower might engage in activities that are undesirable from the​ lender's point of​ view, because they make it less likely that the loan will be paid back.

Moral Hazard

Occurs when the potential borrowers who are the most likely to produce an undesirable​ (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected.

Adverse Selection

A situation where one party often does not know enough about the other party to make accurate decisions.

Asymmetric Information

Why would a life insurance company be concerned about the financial stability of major corporations or the health of the housing​ market?

A.

Today life insurance companies are the largest holders of corporate stocks and​ mortgage-backed securities.

B.

When there are negative changes in financial or housing​ markets, people have no money for life insurance payments.

C.

During financial crises and​ recessions, the number of deaths is much higher than usual and payments of insurance indemnity increase significantly.

D.

Most life insurance companies hold large amounts of corporate bonds and mortgage assets.

D.

Most life insurance companies hold large amounts of corporate bonds and mortgage assets.

These financial institutions are very small cooperative lending institutions organized around a particular​ group: union​ members, employees of a​ firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans

Credit Union

These financial intermediaries raise funds primarily by issuing checkable​ deposits, savings​ deposits, and time deposits. They then use these funds to make​ commercial, consumer, and mortgage loans and to buy U.S. government securities and municipal bonds.

Commercial Bank

These depository institutions obtain funds primarily through savings deposits​ (often called​ shares) and time and checkable deposits. In the​ past, these institutions were constrained in their activities and mostly made mortgage loans for residential housing.

Savings and Loan

These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds.

Mutual Fund

Examines the books of savings and loan associations and imposes restrictions on assets they can hold.

Office of Thrift Supervision

Charters and examines the books of federally chartered commercial banks and imposes restrictions on assets they can hold.

Comptroller of the Currency

Examines the books of commercial banks that are members of the Federal Reserve System and sets reserve requirements for all banks.

Federal Reserve

Provides insurance of at​ $250,000 for each depositor at a​ bank, examines the books of insured​ banks, and imposes restrictions on assets they can hold.

FDIC

Requires disclosure of information of financial instruments traded in organized exchanges.

SEC

In​ 2008, as a financial crisis began to unfold in the United​ States, the FDIC raised the limit on insured losses to bank depositors from​ $100,000 per account to​ $250,000 per account. How would this help stabilize the financial​ system?

A.

It would enable banks to lower interest rates​ (as money is more​ safe) and decrease future interest payments.

B.

It would reassure depositors that their money was safe in banks and prevent a possible bank panic.  

C.

It would attract new foreign depositors and rapidly increase the cash amounts available to banks.

D.

It would decrease​ banks' reserve requirements and thus increase their available assets.

B.

It would reassure depositors that their money was safe in banks and prevent a possible bank panic. 

Financial markets perform the basic function​ of:

A.

providing a​ risk-free means of storing wealth

B.

assuring that governments need never resort to printing money to finance their expenditure

C.

mitigating the business cycle

D.

matching savers with funds to lend to people who want to borrow funds

D.

matching savers with funds to lend to people who want to borrow funds

_______ are debts or financial obligations that must be repaid.

_______ is wealth that is used to produce more wealth.

Liabilities
Capital

	Direct finance	Indirect finance
Savers
Borrowers

	Direct finance	Indirect finance
Savers	Buy securities	Make deposits
Borrowers	Sell securities	Take out loans

If you suspect that an airline will go bankrupt next​ week, which would you rather​ hold, bonds issued by the​ company, or equities issued by the​ company?

You would prefer to hold bonds

A certificate of deposit is​:

A.

an overnight loan between banks.

B.

a short dash term money market instrument issued primarily by banks and funded from corporations and other banks through loans in which Treasury bills serve as collateral, with an explicit agreement to pay off the debt in the near future.

C.
a short dash term debt instrument issued by large banks and well dash known corporations.

D.

a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price.

D.

a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price.

These instruments are typically overnight loans between banks of their deposits at the Federal Reserve.

Federal Funds

A​ short-term debt instrument issued by large banks and​ well-known corporations.

Commercial Paper

These money market instruments are created in the course of carrying out international trade. This is a bank draft​ (a promise of payment similar to a​ check) issued by a​ firm, payable at some future​ date, and guaranteed for a fee by a bank.

Banker’s Acceptances

These​ short-term debt instruments of the US government are issued in​ three-, six-, and​ 12-month maturities to finance the federal government.

Treasury Bills

These instruments are effectively​ short-term loans​ (usually with a maturity of less than two​ weeks) for which Treasury bills serve as​ collateral, which the lender receives if the borrower does not pay back the loan.

Repurchase Agreements

Suppose that Toyota sells​ yen-denominated bonds in Tokyo.

Is this debt instrument considered a​ Eurobond?

A.

No.

B.

Yes.

How would your answer change if the bonds were sold in New​ York?

A.

They would be considered Eurobonds.

B.

They would not be considered Eurobonds.

No
They would be considered Eurobonds

When lenders have inferior knowledge relative to borrowers about the potential returns and risks associated with an investment​ project, it gives rise to the problem known as

A.

financial intermediation.

B.

asset transformation.

C.

asymmetric information.

D.

transaction costs.

C.

asymmetric information.

After a loan is​ made, banks monitor their loan customers to avoid the problem of

A.

moral hazard.

B.

asset transformation.

C.

risk sharing.

D.

adverse selection.

A.

moral hazard.

Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a​ 5% interest rate at the bank and having the bank lend her the funds at a​ 10% interest rate rather than lend her the funds​ yourself?

A.

Your neighbor suffers from information asymmetry.

B.

There is no way to diversify your savings except with the help of a bank.

C.

The costs of writing up the loan contract might exceed the​ 5% difference between your deposit rate and the bank lending rate.

D.

There will always be a moral hazard problem in lending to a friend or neighbor.

C.

The costs of writing up the loan contract might exceed the​ 5% difference between your deposit rate and the bank lending rate.