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Chapter 1 Assignment
1. Interactions between financial market participants Financial markets facilitate the transfer of excess funds from those who have them to those who need them. In the following table, determine whether each financial market participant is a surplus unit or deficit unit. Financial Market Participant Surplus Unit Deficit Unit A firm that issues equity securities to expand operations
A state that is constantly running a budget deficit ✔ A firm that purchases debt securities ✔ A bank that lends money at a rate faster than it borrows it
Suppose Proton Lighting needs to raise money to finance its new manufacturing facility, but their CFO does not want to part with any of the firm’s equity. In this case, Proton Lighting would likely issue (choices: debt / equity) securities to obtain the funding. Which of the following are ways that Proton Lighting could obtain funds to finance the expansion of its operations, given its stated preference in the previous question? Check all that apply. ✘ Issue preferred stocks ✘ Issue common stocks ✔ Issue commercial paper ✔ Issue corporate bonds
2. Primary markets, secondary markets, and their roles Which of the following are key roles of financial markets? Check all that apply. ✔ Facilitating the exchange of currencies between market participants in the foreign exchange market ✔ Facilitating the creation of new securities ✔ Serving as a mechanism for deficit units to obtain funding from investors ✘ Preventing one country’s economic problems from spilling over into other countries during economic downturns In the following table, indicate whether each transaction is traded in a primary or secondary financial market: Transaction Primary Market Secondary Market Former Enron CEO Jeff Skilling sold 500,000 shares of Enron.
In 2018, CVS Health Corp. issued $27 million in bonds to help fund its acquisition of Aetna Inc.
You sell your savings bonds to an investor willing to pay 15% more than you originally paid.
Spotify filed its initial public offering worth $9.2 billion in April of 2018.
3. Securities in financial markets Financial market participants have a variety of securities they can choose to issue or purchase in order to support their financial needs. Such securities are money market securities, capital market securities, and derivative securities. Use the following table to determine whether each definition describes money market, capital market, or derivative securities. Definition Security Type Short-term securities that have a maturity of one year or less. money market Long-term securities that have a maturity greater than one year. capital market Financial contracts whose values are derived from the values of the underlying assets. derivative securities Use the following table to determine whether each example is a money market, capital market, or derivative security. Example Security Type Securities that enable investors to speculate on movements in the value of underlying assets without having to purchase them. derivative security U.S. Treasury bills. money market An option to buy Slack stock. derivative security Securities that are commonly used to finance the purchase of capital assets. capital market 4. Determinants of security values For decades in the U.S., street vendors have popped up in densely populated areas, such as major cities, beaches, and festivals. These businesses sell things from hamburgers and hot dogs to tacos and Mexican street corn. After the recession hit between 2008 and 2009, the U.S. saw an increase in the number of mobile food businesses, namely an increase in the number of food trucks. Because this is the first time this industry has seen this much growth, suppose investors look carefully at historical food truck financial records, customer feedback, and any other information they can get their hands on to give them better insight into the industry’s potential performance. After investors review this information, suppose they determine that there is a high likelihood of the businesses generating high cash flows, and thus a high return on their investment, and they revise their valuations of the stocks accordingly. True or False: Given the scenario, the investors are using firm-specific information to take their positions on the security. ✔ True ✘False Use the graph to show what happens to the supply, demand, and equilibrium price in the market for food truck stocks in the short run, assuming that if supply and demand change, they do so simultaneously.
✔They take on riskier loans, knowing they could default. ✔They repackage depositor funds to fit the size and maturity length needs of deficit units. ✔They serve as activist shareholders which allows them to monitor publicly traded firms. ✘They provide surplus units with full information within markets, completely removing information asymmetry from financial markets. In the following table, indicate which financial institution each description best represents and whether it is a depository or nondepository financial institution. Description Financial Institution Institution Type They are nonprofit financial institutions owned by their members so that they can share funds among themselves. The members have a common bond, such as an employer, and act as the surplus units for the institution. Funds deposited by surplus units are then loaned to deficit unit members who need the funds. Credit Unions Depository They are established by an employer to facilitate and organize employee retirement funds. They are asset pools that invest in securities and manage the assets until individuals withdraw the money from their retirement accounts. Pension Funds Nondepository They accept deposits from surplus units and make loans to and purchase debt securities from deficit units. They utilize the federal funds market to loan funds to other financial institutions and are regulated by the Federal Reserve. They are known for concentrating on business loans. Commercial Banks Depository They collect a pool of funds from surplus units to purchase a portfolio of securities. They allow small savers, with limited funds, to invest in a widely diversified portfolio of securities. Mutual Funds Nondepository
6. Systemic risk in the financial system Which of the following best defines systemic risk? ✔The idea that due to the high amounts of business transactions between financial institutions, financial instabilities that occur in just a few financial institutions can very easily spread to others. ✘The degree to which securities can easily be sold without a loss of value ✘The idea that the failure of one institution is an isolated event and will not affect other institutions and markets in the financial system ✘The idea that in a financial transaction, one party has more information than the other party Which of the following scenarios represent(s) a major source of systemic risk? Check all that apply. ✘The Financial Reform Act was passed in 2010 to provide stability to the financial system, and it mandated that financial institutions granting mortgages must conduct more thorough financial checks on lendees in an attempt to improve on standards that caused the credit crisis of 2008–2009. ✔Origin Savings and Loan Association originate thousands of subprime mortgages that are then sold to commercial banks, securities firms, and other savings institutions. ✘Smallwood Bank, which is a fictional bank with only 100 deposit accounts among its members, fails one day and is unable to meet its obligations.
✔New Leaf Investment Bank relies heavily on short-term debt to finance their operations and uses their holdings of mortgage-backed securities as collateral. Suddenly the prices of mortgage backed securities plummet, and they can no longer issue short-term debt to pay off the principal on maturing debt.
