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ANSWERS TO QUESTIONS FOR CHAPTER 1
(Questions are in bold print followed by answers.)
1. What is the difference between a financial asset and a tangible asset?
A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital
equipment and machines. A financial asset, which is an intangible asset, represents a legal claim to
some future benefits or cash flows. The value of a financial asset is not related to the physical form
in which the claim is recorded.
2. What is the difference between the claim of a debtholder of General Motors and an
equityholder of General Motors?
The claim of the debt holder is established by contract, which specifies the amount and timing of
periodic payments in the form of interest as well as term to maturity of the principal. The debt
holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-
holder.
The equity holder has a residual claim to assets and income. He can receive funds only after
other claimants are satisfied. Income is in terms of dividends, the amount and timing of which are
not certain.
3. What is the basic principle in determining the price of a financial asset?
The price of any financial asset is the present value of the expected cash flows or a stream of
payments over time. Thus, the basic variables in determining the price are: expected cash flows,
discount rate and the timing of these cash flows.
4. Why is it difficult to determine the cash flow of a financial asset?
The estimation and determination of cash flows is difficult because of several reasons. These
include accounting measures, possibility of default of the issuer, and embedded options in the
security. Interest payments can also change over time. There is uncertainty as to the amount and the
timing of these payments.
5. Why are the characteristics of an issuer important in determining the price of a financial
asset?
The characteristics of the issuer are important because these determine the riskiness or uncertainty of
the expected cash flows. These characteristics, which determine the issuer’s creditworthiness or
default risk, have an impact on the required rate of return for that particular financial asset.
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6. What are the two principal roles of financial assets?
The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or
institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to
invest in tangible assets).
The second role is to redistribute risk among persons or institutions seeking and providing
funds. Funds providers share the risks of expected cash flows generated by tangible assets.
7. In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled
“Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included
this statement:
Securities markets have five basic functions in a capitalistic economy:
a. They make it possible for corporations and governmental units to raise capital.
b. They help to allocate capital toward productive uses.
c. They provide an opportunity for people to increase their savings by investing in
them.
d. They reveal investors’ judgments about the potential earning capacity of
corporations, thus giving guidance to corporate managers.
e. They generate employment and income.
For each of the functions cited above, explain how financial markets (or securities markets, in
the parlance of this Congressional study) perform each function.
The five economic functions of a financial market are: (1) transferring funds from those who have
surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in
such a way that redistributes the unavoidable risk associated with the cash flow generated by
tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a
mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of
transactions.
The five economic functions stated in the Congressional Study can be classified according to
the above five functions:
1. “they make it possible for corporations and governmental units to raise capital” --
functions 1 and 2;
2. “they help to allocate capital toward productive uses” -- function 3;
3. “they provide an opportunity for people to increase their savings by investing in them” --
functions 1 and 5;
4. “they reveal investors’ judgments about the potential earning capacity of corporations,
thus giving guidance to corporate managers” --function 3;
5. “they generate employment and income” -- follows from functions 1 and 2 allowing
those who need funds to use these funds to create employment and income opportunities.
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8. Explain the difference between each of the following:
a. money market and capital market
b. primary market and secondary market
c. domestic market and foreign market
d. national market and Euromarket
a. The money market is a financial market of short-term instruments having a maturity of one year
or less. The capital markets contain debt and equity instruments with more than one year to
maturity;
b. The primary market deals with newly issued financial claims, whereas the secondary market
deals with the trading of season issues (ones previously issued in the primary market);
c. The domestic market is the national market wherein domestic firms issue securities and where
such issued securities are traded. Foreign markets are where securities of firms not domiciled in
the country are issued and traded;
d. In a national market securities are traded in only one country and are subject to the rules of that
country. In the Euromarket, securities are issued outside of the jurisdiction of any single
country. For example, Eurodollars are dollar-denominated financial instruments issued outside
the United States.
9. Indicate whether each of the following instruments trades in the money market or the
capital market:
a. General Motors Acceptance Corporation issues a financial instrument with four
months to maturity.
b. The U.S. Treasury issues a security with 10 years to maturity.
c. Microsoft Corporation issues common stock.
d. The State of Alaska issues a financial instrument with eight months to maturity.
a. GMAC issue trades in the money market.
b. U.S. security trades in the capital market.
c. Microsoft stock trades in the capital market.
d. State of Alaska security trades in the money market.
10. A U.S. investor who purchases the bonds issued by the government of France made the
following comment: “Assuming that the French government does not default, I know what the
cash flow of the bond will be.” Explain why you agree or disagree with this statement.
One would tend to disagree with this statement. Even though there is no default risk with French
bonds issued by the government, some other risks include price risk and foreign exchange risk.
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11. A U.S. investor who purchases the bonds issued by the U.S. government made the following
statement: “By buying this debt instrument I am not exposed to default risk or purchasing
power risk.” Explain why you agree or disagree with this statement.
This is not true. There is no default (credit) risk of U.S. government securities. However, it is not
free of purchasing power or inflation risk. There is also price risk, which is related to maturity of
any bond.
12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250
million of bonds in the United States. From the perspective of the U.S. financial market,
indicate whether this issue is classified as being issued in the domestic market, the foreign
market, or the offshore market.
The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can
also be from foreign markets.
13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United
States. From the perspective of the U.S. financial market, indicate whether this issue is
classified as being issued in the domestic market, the foreign market, or the offshore market.
This issue can be classified as a domestic issue.
14. 14. Give three reasons for the trend toward greater integration of financial markets
throughout the world.
There are several reasons. These include:
a. Deregulation and/or liberalization of financial markets to permit greater participants from other
countries;
b. Technological innovations to provide globally-available information and to speed transactions;
c. Institutionalization -- financial institutions are better able to diversify portfolio and exploit mis-
pricings than are individuals.
15. What is meant by the “institutionalization” of capital markets?
The term “institutionalization” refers to the dominance of large institutional investors such as
pension funds, investment companies, banks, insurance companies, etc. in the money and capital
markets.
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16.a. What are the two basic types of derivative instruments?
b. “Derivative markets are nothing more than legalized gambling casinos and serve no
economic function.” Comment on this statement.
a. The two basic types of derivative instruments are futures and options contracts. They are called
derivatives because their values are derived from the values of their underlying stocks or bonds.
b. The statement implies that derivative instruments can be used only for speculative purposes.
Actually, derivatives serve an important economic function by permitting hedging, which
involves shifting risks on those individuals and institutions (speculators) that are willing to bear
them.
17. What is the economic rationale for the widespread use of disclosure regulation?
The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically,
there information asymmetry between the issuer (management) and the investors, and disclosure
regulation mitigates the harm to investors that could result from this informational disadvantage. As
a result, there is confidence in the market and the pricing mechanism of the market.
18. What is meant by market failure?
Market failure occurs when the market cannot produce its goods or services efficiently. In the
context of financial market failure, it occurs when the pricing mechanism fails and thus the supply
and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced
liquidity.
19. What is the major long-term regulatory reform that the U.S. Department of the Treasury
has proposed?
The long-term proposal is to replace the prevailing complex array of regulators with a regulatory
system based on functions. Specifically, there would be three regulators: (1) market stability
regulator, (2) prudential regulator, (3) business conduct regulator.
20. Why does increased volatility in financial markets with respect to the price of financial
assets, interest rates, and exchange rates foster financial innovation?
Increased volatility of the prices of financial assets has fostered innovation as investors and
institutions seek ways to mitigate financial risk. Among other things, these innovations include the
advancement of the modern derivatives markets.
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Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 2-6
ANSWERS TO QUESTIONS FOR CHAPTER 2
(Questions are in bold print followed by answers.)
1. Why is the holding of a claim on a financial intermediary by an investor considered an
indirect investment in another entity?
An individual’s account at a financial intermediary is a direct claim on that intermediary. In turn, the
intermediary pools individual accounts and lends to a firm. As a result, the intermediary has a direct
contractual claim on that firm for the expected cash flows. Since the individual’s funds have in
essence been passed through the intermediary to the firm, the individual has an indirect claim on the
firm. Two separate contracts exist. Should the individual lend to the firm without the help of an
intermediary, he then has a direct claim.
2. The Insightful Management Company sells financial advice to investors. This is the only
service provided by the company. Is this company a financial intermediary? Explain your
answer.
Strictly speaking, the Insightful Management Company is not a financial intermediary, because it
lacks the function of deposit taking and creating liabilities.
3. Explain how a financial intermediary reduces the cost of contracting and information
processing.
Financial intermediaries can reduce the cost of contracting by its professional staff because investing
funds is their normal business. The use of such expertise and economies of scale in contracting about
financial assets benefits both the intermediary as well as the borrower of funds. Risk can be reduced
through diversification and taking advantage of fund expertise.
4. “All financial intermediaries provide the same economic functions. Therefore, the same
investment strategy should be used in the management of all financial intermediaries.”
Indicate whether or not you agree or disagree with this statement.
Disagree. Although each financial intermediary more or less provides the same economic functions,
each has a different asset-liability management problem. Therefore, same investment strategy will
not work.
5. A bank issues an obligation to depositors in which it agrees to pay 8% guaranteed for one
year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is
the risk if the bank uses the funds to invest in common stock?
Practically, it is not a valid statement as banks are not allowed to hold stocks. The bank has a
funding risk. On the liability side, amount of cash outlay and timing are known with certainty (Type
I). However, on the asset side, both factors are unknown. Thus, there is liquidity risk and price risk.
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6. Look at Table 2-1 again. Match the types of liabilities to these four assets that an individual
might have:
a. car insurance policy
b. variable-rate certificate of deposit
c. fixed-rate certificate of deposit
d. a life insurance policy that allows the holder’s beneficiary to receive $100,000 when
the holder dies; however, if the death is accidental, the beneficiary will receive
$150,000
a. Car insurance: neither the time nor the amount of payoffs are certain, which is Type IV liability
b. Variable rate certificates of deposit: times of payments are certain, the amounts are not, which is
Type II liability.
c. Fixed-rate certificate of deposit: both times of payments and cash outflows are known, which is
Type I liability.
d. Life insurance policy: time of payout is not known, but the amount is certain, which is Type III
liability.
7. Each year, millions of American investors pour billions of dollars into investment
companies, which use those dollars to buy the common stock of other companies. What do the
investment companies offer investors who prefer to invest in the investment companies rather
than buying the common stock of these other companies directly?
In investing funds with the investment companies, investors are reducing their risk via
diversification and the cost of contracting and information. These companies also provide liquidity
to the investor.
8. In March 1996, the Committee on Payment and Settlement Systems of the Bank for
International Settlements published a report entitled “Settlement Risk in Foreign Exchange
Transactions” that offers a practical approach that banks can employ when dealing with
settlement risk. What is meant by settlement risk?
Counterparty risk is that risk that a counterparty to a transaction cannot fulfill its obligation. It is
related to settlement risk in that counterparty party risk bears on the question of whether settlement
can take place or not.
9. The following appeared in the Federal Reserve Bank of San Francisco’s Economic Letter,
January 25, 2002:
Financial institutions are in the business of risk management and reallocation, and they
have developed sophisticated risk management systems to carry out these tasks. The
basic components of a risk management system are identifying and defining the risks
the firm is exposed to, assessing their magnitude, mitigating them using a variety of
procedures, and setting aside capital for potential losses. Over the past twenty years or
so, financial institutions have been using economic modeling in earnest to assist them in
these tasks. For example, the development of empirical models of financial volatility led
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to increased modeling of market risk, which is the risk arising from the fluctuations of
financial asset prices. In the area of credit risk, models have recently been developed
for large-scale credit risk management purposes.
Yet, not all of the risks faced by financial institutions can be so easily categorized and
modeled. For example, the risks of electrical failures or employee fraud do not lend
themselves as readily to modeling.
What type of risk is the above quotation referring to?
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and
systems, or from external events.
10. What is the source of income for an asset management firm?
The sources of income are a fee based on assets under management, and sometimes a performance
fee based on returns that meet certain benchmarks or targets.
11. What is meant by a performance-based management fee and what is the basis for
determining performance in such an arrangement?
Performance based management fees are typically seen in hedge funds. Increasingly, they are also
used by managers of asset management firms. These fees are fees based on performance that meet
specified criteria.
12. a. Why is the term hedge to describe “hedge funds” misleading?
b. Where is the term hedge fund described in the U.S. securities laws?
a. Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and
these funds take significant risk in their attempt to achieve abnormal returns.
b. The term is not described in US securities laws, and hedge funds are not regulated by the SEC.
13. How does the management structure of an asset manager of a hedge fund differ from that
of an asset manager of a mutual fund?
Asset management firms are compensated by a fee on asset under management. Hedge funds are
compensated by a combination of assets under management and a performance fees. Clearly,
investment strategies of these firms will be different since hedge funds seek to generate abnormal
returns.
14. Some hedge funds will refer to their strategies as “arbitrage strategies.” Why would this be
misleading?
Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great
risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such
as pricing disp
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