Chapter 02: The Financial System and the Level of Interest Rates

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Directly through financial markets and indirectly through financial institutions.

What are the two basic mechanisms by which funds flow through the financial system?

Businesses.

Among the following, who borrows the most in the economy?

By gathering excess funds and redistributing them to those with financial needs.

How does the financial system contribute to economic growth?

The financial system consists of financial markets, financial institutions, and intermediaries that help channel funds.

Which statement best explains the structure of the financial system?

Buyers would need to pay for homes entirely in cash, as loans would be unavailable.

How would the absence of a financial market affect the ability to purchase a home?

The direct financial markets are wholesale markets with a typical minimum transaction size of $1 million.

It is difficult for individuals to participate in the direct financial markets for the following reason:

an efficient financial system.

An economy with a large flow of funds requires:

the financial system.

Financial markets and financial institutions are both parts of:

households.

Savings provided by in small dollar amounts is the origin of much of the money that funds business loans in an economy.

lender-savers to borrower-spenders.

The primary function of a financial system is to funnel funds from:

Households.

are the principal lender-savers in the economy.

to convert financial securities with one set of characteristics into securities with a different set of characteristics.

An important function of financial intermediation is:

to direct funds from savers to the best investment opportunities in the economy.

An important function of the financial system is:

a borrower-spender borrows directly from a lender-saver.

Direct financing occurs when:

Wholesale markets with a typical minimum transaction size of at least $1 million.

Which of the following best describes the financial markets where direct transactions take place?

Major corporations, commercial banks, hedge funds, and the federal government.

Who are the major participants in direct financial markets?

helping companies sell new debt or equity issues in the financial markets.

One of the main services provided by investment banks to companies is:

Wholesale markets involving large transactions between lender-savers and borrower-spenders.

What is a key characteristic of direct financial markets?

The difference between the price at which securities are sold and the original price paid to the issuing company.

What is the underwriting spread in an investment banking transaction?

Financial Services Modernization Act.

Which law repealed the Glass-Steagall Act, allowing commercial banks to engage in investment banking activities?

Allows major money center banks in the U.S. to provide investment banking services.

The Financial Services Modernization Act:

Large corporations.

Which of the following is a major participant in the direct financial markets?

both investment banks and money center banks.

The major players in the direct financial markets are:

$1,000,000.

What is the typical minimum denominated transaction size in the direct financial markets?

The Financial Services Modernization Act of 1999.

Which of the following Acts is responsible for rolling back many of the rules prohibiting commercial banks from engaging in investment banking activities?

Underwriting.

Which of the following is a process by which investment bankers purchase new securities directly from the issuing company and resell them to the investors?

An initial public offering.

Which of the following terms relates to the process in which a firm sells common stocks to the public for the very first time?

Primary market.

When a company raises capital by issuing shares for the first time, where does the selling of newly issued stocks occur?

to adjust their liquidity position.

Large firms are most likely to use money markets:

Secondary.

The New York Stock Exchange facilitates transactions in which market?

Higher degree of price stability in the primary market.

An active secondary market typically leads to:

They offer speed in raising funds and low transaction costs.

Which of the following is an advantage of private placement transactions?

Brokers do not take on the risk of owning securities.

What distinguishes brokers from dealers in terms of risk?

Easily converted into cash.

Which of the following describes money market instruments?

The New York Stock Exchange (NYSE) and the London Stock Exchange.

Which of the following markets are considered capital markets?

over-the-counter markets.

Stocks that are traded in the firms.

a primary market.

The financial market where a new security is sold for the first time is called:

used-car markets.

Secondary financial markets are similar to:

a secondary market transaction.

If you just purchased a share of IBM through a New York Stock Exchange-based transaction, you participated in:

liquidity.

The ease with which a security can be sold and converted into cash is called:

reducing the transaction costs from selling the security.

The presence of a secondary market increases the marketability of a financial security by:

It results in new money going into the firm.

What is a key characteristic of a primary market?

By allowing conversion of securities into cash.

How do secondary markets benefit investors?

an organized exchange.

The NYSE is an example of:

An over-the-counter market.

Which of the following markets has no central trading location?

the money market.

A highly liquid financial instrument with a maturity of 90 days would be traded in:

firms with the highest credit rating.

Money market instruments are issued by:

the instruments traded in this market are close substitutes for cash.

The term money market is used because:

the money market.

If a firm needs to adjust its liquidity position, then it would participate in:

capital market.

If a firm needs to finance a new corporate headquarters building, then it would seek the funds in the:

Securities that are not listed on an organized exchange are bought and sold on the OTC market.

Which of the following statements about the OTC market is true?

hedge risk.

The most common reason that corporate firms use the futures and options markets is to:

Secondary markets provide liquidity to the buyers of securities. They facilitate the sale of securities because they enable investors to buy and sell securities as frequently as they want. Secondary markets are important to corporations because investors are willing to pay higher prices for securities in primary markets if the securities are expected to have active secondary markets. This lowers the cost of capital for the corporations that issue securities.

Explain why secondary markets are so important to businesses that need to raise capital.

Semi strong-form efficiency.

Which of the following theories states that security prices reflect all public information, but not all private information?

Strong-form efficiency.

Which of the following theories states that security prices reflect all information, whether public or private?

indirect financing.

If your firm obtains most of its financing from commercial banks, then it primarily accesses the capital markets through:

financial intermediation.

The process of converting financial securities with one set of characteristics into securities with another set of characteristics is called:

a credit card.

A line of credit to a corporation is like to an individual.

Both equity securities and long-term corporate bonds.

Which of the following can be a primary investment vehicle(s) for the funds in which life insurance companies must invest?

protection against loss of property from fire, theft, accidents, and other predictable causes.

Casualty insurance companies sell:

Commercial paper.

Which of the following is least likely to be included in a pension fund's investment portfolio?

an investment fund.

A mutual fund is an example of:

A business finance company.

If a small business chooses not to borrow funds from a commercial bank, then what will be its next best alternative source of capital?

They are too small to raise capital directly from investors through wholesale channels.

Why do many companies use indirect market funding from financial institutions?

Most companies finance through selling equity as a primary source.

What is a common misconception about how companies finance their business investments?

The interest rate observed in the marketplace.

What does the nominal interest rate represent?

they are adjusted for inflation and all economies have some degree of inflation.

Real rates of interest are not easily observable in financial markets because:

When deflation occurs.

Under what condition can the nominal rate of interest be lower than the real rate of interest?

interest.

The cost of borrowing money is called:

Interest rates tend to rise during economic expansion and decline during economic contraction.

Which of the following statements best describes the relationship between interest rates and the business cycle?

both the real rate of interest and inflation expectation.

The nominal rate of interest is comprised of:

compensation for deferring consumption.

The real rate of interest can be fundamentally determined by:

A level of inflation that is higher than that anticipated at the outset of the loan.

If you are a borrower, which would you prefer to occur during the life of your loan?

11%.

If inflation is anticipated to be 6 percent during the next year, while the real rate of interest for a one-year loan is 5 percent, then what should the nominal rate of interest be for a risk-free one-year loan?

5%

If inflation is anticipated to be 5 percent during the next year, while the nominal rate of interest for a risk-free one-year loan is 10 percent, then what should the real rate of interest for a one-year loan be?

the business cycle.

The general level of interest rates tends to follow:

interest rates to increase.

During an economic expansion, we would expect:

3 percent.

In the United States, the real rate of interest has historically been around:

Increased by 1%

You loaned $100 to a friend for one year at a nominal rate of interest of 3 percent. Inflation during that year was 2 percent. Has the purchasing power of your money increased or decreased and by how much?

Decreased by approximately 3 percent.

You loaned $100 to a friend for one year at a nominal rate of interest of 5 percent. Inflation during that year was 8 percent. Has the purchasing power of your money increased or decreased and by how much?

interest rates to increase.

If the supply of loanable funds decreases relative to the demand for those loanable funds, then we would expect:

The retail individual investor is a common direct participant in the direct financial markets

Which of the following statements is incorrect?

Semistrong

Which form of the efficient market hypothesis states that security prices reflect all public information, but not all private information?

direct and indirect transfers

The two methods by which funds are transferred from savers to borrowers within an economy’s financial system include

The expected rate of inflation = The real rate of interest − The nominal rate of interest = 5.3% − 2.5% = 2.8%

According to the Fisher equation, if the real rate of interest is 2.5% and the nominal rate of interest is 5.3%, the rate of inflation is forecast to be approximately

False

Assets that are claims on the cash flows from other assets, business loans, stocks, and bonds, are real assets.

helps a company sell its new security issue.

Underwriting is the process by which an investment banker

companies to sell new securities directly to investors.

A primary market is a market for

True

The New York Stock Exchange is an example of an organized market that provides a physical meeting place.

Johnny Appleseed buying 1,000 shares of Dell through NYSE.

Which of the following transactions is a secondary market transaction?

False

Companies receive funds when their securities are sold by an investor in a secondary market.

True

Nominal interest rates tend to rise and fall with changes in the rate of inflation.

underwriting services

Investment banking firms provide

gather money from savers and channel it to borrowers.

The critical role of the financial system in an economy is to