Chapter 02 - Financial Markets and Institutions

Chapter 02 - Financial Markets and Institutions
Chapter 02
Financial Markets and Institutions
True / False Questions
1. The reinvestment of cash back into the firm's operations is an example of a flow of savings
to investment.
True False
2. Smaller businesses are especially dependent upon internally generated funds.

True False
3. An individual can save and invest in a corporation only by lending money to it or by

purchasing additional shares.
True False
4. Apple Computer is well known for its product innovations. Access to financing was not
vital to Apple's growth and profitability.
True False
5. Hedge fund managers, unlike mutual fund managers, do not receive fund-performance-
related fees.
True False
6. In the United States, banks are the most important source of long-term financing for
businesses.
True False
2-1
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7. A financial intermediary invests in financial assets rather than real assets.

True False
8. Only small companies can go through financial markets to obtain financing.

True False
9. Previously issued securities are traded among investors in the secondary markets.
True False
10. Only the IPOs for large corporations are sold in primary markets.
True False
11. The markets for long-term debt and equity are called capital markets.
True False
12. The stocks of major corporations trade in many markets throughout the world on a
continuous or near-continuous basis.
True False
13. The derivative market is also a source of financing.

True False
14. Households hold more than half of U.S. corporate equities.

True False
2-2
15. The key to the banks' ability to make illiquid loans is their ability to pool liquid deposits
from thousands of depositors.
True False
16. For corporate bonds, the higher the credit quality of an issuer, the higher the interest rate.
True False
17. The cost of capital is the interest rate paid on a loan from a bank or some other financial
institution.
True False
18. Like public companies, private companies can also use their stock price as a measure of
performance.
True False
19. The opportunity cost of capital is the expected rate of return that shareholders can obtain
in the financial markets on investments with the same risk as the firm's capital investments.
True False
20. Whenever there is uncertainty, investors might be interested in trading, either to speculate
or to lay off their risks, and a market may rise to meet the trading demand.
True False
21. Financial markets and intermediaries allow investors and businesses to reduce and
reallocate risk.
True False
2-3
22. The cost of capital is the minimum acceptable rate of return for capital investment.
True False
23. The rates of return on investments outside the corporation set the minimum return for
investment projects inside the corporation.
True False
24. Financing for public corporations must flow through financial markets.
True False
25. Financing for private corporations must flow through financial intermediaries.
True False
26. Almost all foreign exchange trading occurs on the floors of the FOREX exchanges in New
York and London.
True False
27. During the Financial Crisis of 2007-2009, the U.S. government bailed out all firms in
danger of failing.
True False
28. From June 2001 to June 2006, housing prices in the United States doubled.
True False
29. The effects of the financial crisis of 2007-2009 were confined to the U.S. and domestic
companies.
True False
2-4
30. One root of the financial crisis of 2007-2009 was the strict money policies promoted by
the U.S. Federal Reserve and other central banks after the technology bubble burst (i.e.,
money was relatively expensive during this time).
True False
Multiple Choice Questions
31. Corporate financing comes ultimately from:

A. savings by households and foreign investors.
B. cash generated from the firm's operations.
C. the financial markets and intermediaries.
D. the issue of shares in the firm.
32. A company can pay for its expansion in all the following ways except:
A. by using the earnings generated from its sale of obsolete equipment.
B. by persuading the director's mother to make a personal loan to the company.
C. by purchasing bonds in the secondary market.
D. by selling stock certificates for a new subsidiary.
33. "Reinvestment" means:

A. new investment in new operations.
B. additional investment in existing operations.
C. new investment by new shareholders.
D. additional investment by existing shareholders.
34. Excess cash held by a firm should be:

A. reinvested by the firm in projects offering the highest rate of return.
B. reinvested by the firm in projects offering rates of return higher than the cost of capital.
C. reinvested by the firm in the financial markets.
D. distributed to bondholders in the form of extra coupon payments.
2-5
35. A financial intermediary provides financing for:

A. individuals.
B. companies.
C. other organizations.
D. all of these.
36. Which of the following statements is not characteristic of mutual funds?

A. They are financial institutions.
B. They raise money by selling shares to investors.
C. They pool the savings of many investors.
D. They offer professional management.
37. Compared to buying stocks and bonds directly, what are the advantages of investing in a
mutual fund?
A. Mutual funds are efficiently diversified and professionally managed.
B. Investment returns are never taxed until withdrawn from the fund.
C. You can buy additional shares in the fund or cash out at any time.
D. All of these.
38. "Balanced" mutual funds:

A. offer mixtures of stocks and bonds.
B. spread their investments equally over a specified geographic area.
C. spread their investments equally over various industries.
D. charge a management fee that is proportionate to the investment return.
39. Which of the following mutual funds have a tax advantage?

A. Balanced funds
B. Pension funds
C. Bond funds
D. Funds that invest in foreign countries
2-6
40. Banks cover the costs of the service they provide primarily via:
A. a management fee.
B. a service charge.
C. an interest rate differential.
D. an operating fee.
41. Which of the following financial intermediaries has shown a preference for investing in
long-term financial assets?
A. Commercial banks
B. Insurance companies
C. Finance companies
D. Savings banks
42. Which of the following financial intermediaries can loan money directly to businesses?
A. Mutual funds
B. Pension funds
C. Insurance companies
D. All of these
43. Insurance companies can usually cover the claims of policyholders because:
A. the incidence of claims normally averages out.
B. they issue thousands of insurance policies.
C. the cost of paying for claims has already been factored into the price of the policies.
D. all of these.
44. Which of the following is not typically considered a function of financial intermediaries?
A. Providing a payment mechanism
B. Investing in real assets
C. Accumulating funds from smaller investors
D. Spreading, or pooling risk among individuals
2-7
45. U.S. bonds and other debt securities are mostly held by:
A. institutional investors.
B. households.
C. foreign investors.
D. state and local governments.
46. Liquidity is important to a mutual fund because:

A. a fund that is less liquid will attract more investors.
B. the fund's shareholders may want to redeem their shares at any time.
C. the fund's managers need liquidity to trade actively.
D. the fund needs to distribute payouts to its shareholders and managers periodically.
47. Property insurance companies protect themselves against the extensive damage caused by
hurricanes and earthquakes by:
A. selling thousands of policies to different homeowners.
B. factoring the cost into the price of the policies.
C. buying reinsurance against such catastrophes.
D. declaring bankruptcy when the need arises.
48. Financing for public corporations flows through:

A. the financial markets only.
B. financial intermediaries only.
C. derivatives markets.
D. the financial markets, financial intermediaries, or both.
49. When corporations need to raise funds through stock issues, they rely on the:
A. primary market.
B. secondary market.
C. tertiary market.
D. centralized NASDAQ exchange.
2-8
50. A primary market would be utilized when:

A. investors buy or sell existing securities.
B. shares of common stock are exchanged.
C. securities are initially issued.
D. a commission must be paid on the transaction.
51. The primary distinction between securities sold in the primary and secondary markets is
the:
A. riskiness of the securities.
B. price of the securities.
C. previous issuance of the securities.
D. profitability of the issuing corporation.
52. Which of the following are both a financial intermediary and a financial institution?
A. Mutual funds
B. Pension funds
D. Hedge funds
53. A share of IBM stock is purchased by an individual investor for $75 and later sold to
another investor for $125. Who profits from this sale?
A. IBM.
B. The first investor.
C. The second investor.
D. Profit is split between IBM and the investor.
54. Which of the following financial assets might be least likely to have an active secondary
market?
A. Common stock of a large firm
B. Bank loans made to smaller firms
C. Bonds of a major, multinational corporation
D. Debt issued by the U.S. Treasury
2-9
55. When Patricia sells her General Motors common stock at the same time that Brian
purchases the same amount of GM stock, GM receives:
A. the dollar value of the transaction.
B. the dollar amount of the transaction, less brokerage fees.
C. only the par value of the common stock.
D. nothing.
56. Which of the following financial markets is in one centralized location?

A. NYSE
B. NASDAQ
C. The over-the-counter market
D. The European Monetary Union
57. Which of the following financial markets is not located in one centralized location?
A. NYSE
B. LSE
C. NASDAQ
D. CBOT
58. Corporate debt instruments are most commonly traded:

A. on the NYSE.
B. on NASDAQ.
C. in the money market.
D. in the over-the-counter market.
59. A bond differs from a share of stock in that:

A. a bond represents a claim on the firm.
B. a bond has more risk.
C. a bond has guaranteed returns.
D. a bond has a maturity date.
2-10
60. Short-term financing decisions commonly occur in the:

A. primary markets.
B. secondary markets.
C. capital markets.
D. money markets.
61. Long-term financing decisions commonly occur in the:

A. option markets.
C. capital markets.
D. money markets.
62. You can buy silver in the:

A. capital markets.
B. foreign exchange markets.
C. commodities markets.
D. option markets.
63. Commodity and derivative markets:

A. are sources of financing.
B. enable the financial manager to adjust the firm's exposure to various business risks.
C. are always over-the-counter markets.
D. all of these.
64. A financial institution:

A. is a kind of financial intermediary.
B. simply pools and invests savings.
C. raises financing by selling shares or policies.
D. invests primarily in commodities.
2-11
65. U.S. corporate equities are mostly held by:

A. insurance companies.
B. households.
66. In 2010, U.S. corporate and foreign bonds totaled:

A. less than $500 billion.
B. about $3 trillion.
C. about $7 trillion.
D. more than $11 trillion.
67. In 2010, U.S. corporate equities totaled:

A. less than $6 trillion.
68. An example of how financial intermediaries can assist in shifting an individual's

consumption to the future is:
A. lending money to the individual.
B. providing a checking account.
C. opening a savings account.
D. requiring purchases to be in cash.

consumption forward in time is:
A. providing a line of credit.
B. opening a passbook account.
C. starting a life insurance policy.
D. starting an auto insurance policy.
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70. One reason suggesting that banks may be better than individuals at matching lenders to
borrowers is that banks:
A. can shift loan risk to their deposit customers.
B. are motivated by the potential for profit.
C. do not have any income tax liability.
D. have information to evaluate creditworthiness.
71. Which of the following is least liquid?

A. Foreign currency
B. U.S. Treasury bonds
C. Rare coins
D. Savings deposit
72. Financial markets and intermediaries:

A. channel savings to real investment.
B. enable investors and businesses to reduce risk.
C. provide liquidity.
D. all of these.
73. Which of the following functions does not require financial markets?
A. Transporting of cash across time
B. Provision of liquidity
C. Risk reduction by investment in diversified portfolios
D. Provision of trade information
74. For the consumer, a credit card:

A. transports money forward in time.
B. provides liquidity.
C. is a convenient way to pay.
D. all of these.
2-13
75. Which of the following actions does not help reduce risk?
A. Extending the service warranty for your notebook
B. Converting your money market account to a mutual fund account
C. Contracting to sell your farm produce to the neighborhood grocery
D. Buying Japanese yen now when you plan to study in Japan next year
76. Which of the following information is not provided by the financial markets?
A. The price of six ounces of gold
B. The cost of borrowing $500,000 for 5 years
C. Microsoft's earnings in 2002
D. The cost of wiring one million yen to Japan
77. The opportunity cost of capital:

A. is the interest rate that the firm pays on a loan from a financial institution.
B. is the maximum acceptable rate of return on a project.
C. is the minimum acceptable rate of return on a project.
D. is always less than 10%.
78. Who was responsible for the financial crisis of 2007-2009?

A. The U.S. Federal Reserve, for its policy of easy money
B. The U.S. government, for pushing banks to expand credit for low-income housing
C. Bankers, who aggressively promoted and resold subprime mortgages
D. All of these
79. A capital investment that generates a 10% rate of return is worthwhile if:
A. corporate bonds of similar risk offer 8% rates of return.
B. corporate bonds of similar risk offer 10% rates of return.
C. top-quality corporate bonds offer 10% rates of return.
D. the expected rate of return on the stock market is 12%.
2-14
80. The cost of capital:

A. is the expected rate of return on capital investment.
B. is an opportunity cost determined by the risk-free rate of return.
C. is the interest rate that the firm pays on a loan from a bank or insurance company.
D. for risky investments is normally higher than the firm's borrowing rate.
81. In the context of housing, what is an ARM?

A. A mortgage with high initial payments, offset by significantly lower payments later
B. A mortgage with low initial payments, offset by significantly higher payments later
C. A mortgage with no initial payments, offset by significantly high payments later
D. A mortgage with equal payments per period
82. During the Financial Crisis of 2007-2009, the U.S. government bailed out the following
firms except:
A. AIG.
B. Fannie Mae.
C. Lehman Brothers.
D. all of these.
Essay Questions
83. How can an individual save and invest in a corporation?
2-15
84. What are the advantages of investing indirectly in stocks and bonds via mutual funds and
pension funds?
85. What are the key differences between a financial intermediary and a financial institution?
86. What are the largest institutional investors in bonds? In stocks?
87. Why are secondary market transactions of importance to corporations?
2-16
88. What is meant by over-the-counter trading?
89. Describe the distinguishing characteristics of the major financial markets.
90. What are the functions of financial markets?
91. Why do nonfinancial corporations need modern financial markets and institutions?
2-17
92. Rhonda and Reggie Hotspur are working hard to save for their children's college
education. They don't need more cash for current consumption but will face big tuition bills in
2020. Should they therefore avoid investing in stocks that pay generous current cash
dividends? Explain briefly.
93. What is an exchange traded fund? What are some popular choices of exchange traded
funds?
94. How can the financial manager identify the cost of the capital raised by a corporation?
95. How was the role of many bankers in the Financial Crisis of 2007-2009 an example of an
agency problem?
2-18
96. Investing $100,000 in additional raw materials todaymostly in palladiumshould allow

Cryogenic Concepts to increase production and earn an additional $112,000 next year. This
payoff would cover the investment today, plus a 12% return. Palladium is traded in
commodity markets. The CFO has studied the history of returns on investments in palladium
and believes that investors in that precious metal can reasonably expect a 15% return. Is
Cryogenic's investment in palladium a good idea? Why or why not?
97. Healthy Fish, Inc. is considering the purchase of a batch of experimental fish fry for
$10,000. The fry will mature and be ready for the market in a year. A government agency
guarantees the hardiness of the new breedit will make a one-for-one same-size replacement
if any fish should die of infections during the first year when reared according to clearly
specified instructions. Healthy Fish expects to spend another $42,000 to raise the fish.
Suppose that Healthy Fish can enter into a futures contract to sell the entire batch of fish for
$60,000, the contract will cost $3,000. What is the opportunity cost of capital for this
investment? Should Healthy Fish make the investment? If Healthy Fish cannot set up a
futures contract, what is its opportunity cost of capital? Should it invest in this case? Assume
that the current interest rate on AAA corporate bonds is 6.25%, and that the historical rate of
return on the stock exchange is 10%.
98. What are subprime mortgages and how were they a part of the Financial Crisis of 2007-
2009?
2-19
Chapter 02 Financial Markets and Institutions Answer Key
True / False Questions
1. The reinvestment of cash back into the firm's operations is an example of a flow of savings
to investment.
TRUE
AACSB: Reflective Thinking Skills

Blooms: Understanding
Difficulty: 1 Easy
Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment.
Topic: The Importance of Financial Markets and Institutions
2. Smaller businesses are especially dependent upon internally generated funds.

TRUE

Difficulty: 3 Hard
3. An individual can save and invest in a corporation only by lending money to it or by

purchasing additional shares.
FALSE

Difficulty: 2 Medium
Topic: The Flow of Savings to Corporations
2-20
4. Apple Computer is well known for its product innovations. Access to financing was not
vital to Apple's growth and profitability.
FALSE

Blooms: Application
5. Hedge fund managers, unlike mutual fund managers, do not receive fund-performance-
related fees.
FALSE

Blooms: Knowledge
Learning Objective: 02-02 Understand the basic structure of mutual funds; pension funds; banks; and insurance companies.
6. In the United States, banks are the most important source of long-term financing for
businesses.
FALSE

7. A financial intermediary invests in financial assets rather than real assets.

TRUE

Difficulty: 1 Easy
2-21
8. Only small companies can go through financial markets to obtain financing.

FALSE

Difficulty: 1 Easy
Learning Objective: 02-03 Explain the functions of financial markets and institutions.
9. Previously issued securities are traded among investors in the secondary markets.
TRUE
AACSB: Communication Abilities

Blooms: Knowledge
Difficulty: 1 Easy
10. Only the IPOs for large corporations are sold in primary markets.
FALSE

Blooms: Knowledge
11. The markets for long-term debt and equity are called capital markets.
TRUE

Blooms: Knowledge
Difficulty: 1 Easy
2-22
12. The stocks of major corporations trade in many markets throughout the world on a
continuous or near-continuous basis.
TRUE

Blooms: Knowledge
13. The derivative market is also a source of financing.

FALSE

14. Households hold more than half of U.S. corporate equities.

FALSE

Blooms: Knowledge
Difficulty: 1 Easy
15. The key to the banks' ability to make illiquid loans is their ability to pool liquid deposits
from thousands of depositors.
TRUE

2-23
16. For corporate bonds, the higher the credit quality of an issuer, the higher the interest rate.
FALSE

17. The cost of capital is the interest rate paid on a loan from a bank or some other financial
institution.
FALSE

Topic: Functions of Financial Markets and Intermediaries
18. Like public companies, private companies can also use their stock price as a measure of
performance.
FALSE

19. The opportunity cost of capital is the expected rate of return that shareholders can obtain
in the financial markets on investments with the same risk as the firm's capital investments.
TRUE

Blooms: Knowledge
Difficulty: 3 Hard
2-24
20. Whenever there is uncertainty, investors might be interested in trading, either to speculate
or to lay off their risks, and a market may rise to meet the trading demand.
TRUE

21. Financial markets and intermediaries allow investors and businesses to reduce and
reallocate risk.
TRUE

22. The cost of capital is the minimum acceptable rate of return for capital investment.
TRUE

23. The rates of return on investments outside the corporation set the minimum return for
investment projects inside the corporation.
TRUE

2-25
24. Financing for public corporations must flow through financial markets.
FALSE

25. Financing for private corporations must flow through financial intermediaries.
FALSE

26. Almost all foreign exchange trading occurs on the floors of the FOREX exchanges in New
York and London.
FALSE

Blooms: Knowledge
27. During the Financial Crisis of 2007-2009, the U.S. government bailed out all firms in
danger of failing.
FALSE

Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009.
Topic: The Crisis of 2007-2009
2-26
28. From June 2001 to June 2006, housing prices in the United States doubled.
TRUE

29. The effects of the financial crisis of 2007-2009 were confined to the U.S. and domestic
companies.
FALSE

30. One root of the financial crisis of 2007-2009 was the strict money policies promoted by
the U.S. Federal Reserve and other central banks after the technology bubble burst (i.e.,
money was relatively expensive during this time).
FALSE

2-27
Multiple Choice Questions
31. Corporate financing comes ultimately from:

A. savings by households and foreign investors.
B. cash generated from the firm's operations.
C. the financial markets and intermediaries.
D. the issue of shares in the firm.

Difficulty: 1 Easy
32. A company can pay for its expansion in all the following ways except:
A. by using the earnings generated from its sale of obsolete equipment.
B. by persuading the director's mother to make a personal loan to the company.
C. by purchasing bonds in the secondary market.
D. by selling stock certificates for a new subsidiary.

Blooms: Application
33. "Reinvestment" means:

A. new investment in new operations.
B. additional investment in existing operations.
C. new investment by new shareholders.
D. additional investment by existing shareholders.

Blooms: Knowledge
2-28
34. Excess cash held by a firm should be:

A. reinvested by the firm in projects offering the highest rate of return.
B. reinvested by the firm in projects offering rates of return higher than the cost of capital.
C. reinvested by the firm in the financial markets.
D. distributed to bondholders in the form of extra coupon payments.

35. A financial intermediary provides financing for:

A. individuals.
B. companies.
C. other organizations.
D. all of these.

Blooms: Knowledge
36. Which of the following statements is not characteristic of mutual funds?

A. They are financial institutions.
B. They raise money by selling shares to investors.
C. They pool the savings of many investors.
D. They offer professional management.

2-29
37. Compared to buying stocks and bonds directly, what are the advantages of investing in a
mutual fund?
A. Mutual funds are efficiently diversified and professionally managed.
B. Investment returns are never taxed until withdrawn from the fund.
C. You can buy additional shares in the fund or cash out at any time.
D. All of these.

38. "Balanced" mutual funds:

A. offer mixtures of stocks and bonds.
B. spread their investments equally over a specified geographic area.
C. spread their investments equally over various industries.
D. charge a management fee that is proportionate to the investment return.

Blooms: Knowledge
39. Which of the following mutual funds have a tax advantage?

A. Balanced funds
B. Pension funds
C. Bond funds
D. Funds that invest in foreign countries

Blooms: Knowledge
2-30
40. Banks cover the costs of the service they provide primarily via:
A. a management fee.
B. a service charge.
C. an interest rate differential.
D. an operating fee.

41. Which of the following financial intermediaries has shown a preference for investing in
long-term financial assets?
A. Commercial banks
B. Insurance companies
C. Finance companies
D. Savings banks

42. Which of the following financial intermediaries can loan money directly to businesses?
A. Mutual funds
B. Pension funds
D. All of these

Blooms: Knowledge
Difficulty: 1 Easy
2-31
43. Insurance companies can usually cover the claims of policyholders because:
A. the incidence of claims normally averages out.
B. they issue thousands of insurance policies.
C. the cost of paying for claims has already been factored into the price of the policies.
D. all of these.

44. Which of the following is not typically considered a function of financial intermediaries?
A. Providing a payment mechanism
B. Investing in real assets
C. Accumulating funds from smaller investors
D. Spreading, or pooling risk among individuals

Blooms: Knowledge
45. U.S. bonds and other debt securities are mostly held by:
A. institutional investors.
B. households.

Blooms: Knowledge
2-32
46. Liquidity is important to a mutual fund because:

A. a fund that is less liquid will attract more investors.
B. the fund's shareholders may want to redeem their shares at any time.
C. the fund's managers need liquidity to trade actively.
D. the fund needs to distribute payouts to its shareholders and managers periodically.

Difficulty: 3 Hard
47. Property insurance companies protect themselves against the extensive damage caused by
hurricanes and earthquakes by:
A. selling thousands of policies to different homeowners.
B. factoring the cost into the price of the policies.
C. buying reinsurance against such catastrophes.
D. declaring bankruptcy when the need arises.

Difficulty: 3 Hard
48. Financing for public corporations flows through:

A. the financial markets only.
B. financial intermediaries only.
C. derivatives markets.
D. the financial markets, financial intermediaries, or both.

Difficulty: 1 Easy
2-33
49. When corporations need to raise funds through stock issues, they rely on the:
A. primary market.
B. secondary market.
C. tertiary market.
D. centralized NASDAQ exchange.

Blooms: Knowledge
50. A primary market would be utilized when:

A. investors buy or sell existing securities.
B. shares of common stock are exchanged.
C. securities are initially issued.
D. a commission must be paid on the transaction.

Blooms: Knowledge
Difficulty: 1 Easy
51. The primary distinction between securities sold in the primary and secondary markets is
the:
A. riskiness of the securities.
B. price of the securities.
C. previous issuance of the securities.
D. profitability of the issuing corporation.

2-34
52. Which of the following are both a financial intermediary and a financial institution?
A. Mutual funds
B. Pension funds
D. Hedge funds

53. A share of IBM stock is purchased by an individual investor for $75 and later sold to
another investor for $125. Who profits from this sale?
A. IBM.
B. The first investor.
C. The second investor.
D. Profit is split between IBM and the investor.

54. Which of the following financial assets might be least likely to have an active secondary
market?
A. Common stock of a large firm
B. Bank loans made to smaller firms
C. Bonds of a major, multinational corporation
D. Debt issued by the U.S. Treasury

Difficulty: 3 Hard
2-35
55. When Patricia sells her General Motors common stock at the same time that Brian
purchases the same amount of GM stock, GM receives:
A. the dollar value of the transaction.
B. the dollar amount of the transaction, less brokerage fees.
C. only the par value of the common stock.
D. nothing.

Difficulty: 3 Hard
56. Which of the following financial markets is in one centralized location?

A. NYSE
B. NASDAQ
C. The over-the-counter market
D. The European Monetary Union

Blooms: Knowledge
57. Which of the following financial markets is not located in one centralized location?
A. NYSE
B. LSE
C. NASDAQ
D. CBOT

Blooms: Knowledge
2-36
58. Corporate debt instruments are most commonly traded:

A. on the NYSE.
B. on NASDAQ.
C. in the money market.
D. in the over-the-counter market.

Blooms: Knowledge
59. A bond differs from a share of stock in that:

A. a bond represents a claim on the firm.
B. a bond has more risk.
C. a bond has guaranteed returns.
D. a bond has a maturity date.

60. Short-term financing decisions commonly occur in the:

A. primary markets.
C. capital markets.
D. money markets.

Difficulty: 1 Easy
2-37
61. Long-term financing decisions commonly occur in the:

A. option markets.
C. capital markets.
D. money markets.

Difficulty: 1 Easy
62. You can buy silver in the:

A. capital markets.
B. foreign exchange markets.
C. commodities markets.
D. option markets.

Blooms: Knowledge
Difficulty: 1 Easy
63. Commodity and derivative markets:

A. are sources of financing.
B. enable the financial manager to adjust the firm's exposure to various business risks.
C. are always over-the-counter markets.
D. all of these.

Difficulty: 3 Hard
2-38
64. A financial institution:

A. is a kind of financial intermediary.
B. simply pools and invests savings.
C. raises financing by selling shares or policies.
D. invests primarily in commodities.

Difficulty: 3 Hard
65. U.S. corporate equities are mostly held by:

A. insurance companies.
B. households.

Blooms: Knowledge
66. In 2010, U.S. corporate and foreign bonds totaled:

A. less than $500 billion.

Blooms: Knowledge
2-39
67. In 2010, U.S. corporate equities totaled:

A. less than $6 trillion.

Blooms: Knowledge

consumption to the future is:
A. lending money to the individual.
B. providing a checking account.
C. opening a savings account.
D. requiring purchases to be in cash.

Difficulty: 3 Hard

consumption forward in time is:
A. providing a line of credit.
B. opening a passbook account.
C. starting a life insurance policy.
D. starting an auto insurance policy.

2-40
70. One reason suggesting that banks may be better than individuals at matching lenders to
borrowers is that banks:
A. can shift loan risk to their deposit customers.
B. are motivated by the potential for profit.
C. do not have any income tax liability.
D. have information to evaluate creditworthiness.

71. Which of the following is least liquid?

A. Foreign currency
B. U.S. Treasury bonds
C. Rare coins
D. Savings deposit

72. Financial markets and intermediaries:

A. channel savings to real investment.
B. enable investors and businesses to reduce risk.
C. provide liquidity.
D. all of these.

Difficulty: 1 Easy
2-41
73. Which of the following functions does not require financial markets?
A. Transporting of cash across time
B. Provision of liquidity
C. Risk reduction by investment in diversified portfolios
D. Provision of trade information

74. For the consumer, a credit card:

A. transports money forward in time.
B. provides liquidity.
C. is a convenient way to pay.
D. all of these.

75. Which of the following actions does not help reduce risk?
A. Extending the service warranty for your notebook
B. Converting your money market account to a mutual fund account
C. Contracting to sell your farm produce to the neighborhood grocery
D. Buying Japanese yen now when you plan to study in Japan next year

Blooms: Application
2-42
76. Which of the following information is not provided by the financial markets?
A. The price of six ounces of gold
B. The cost of borrowing $500,000 for 5 years
C. Microsoft's earnings in 2002
D. The cost of wiring one million yen to Japan

77. The opportunity cost of capital:

A. is the interest rate that the firm pays on a loan from a financial institution.
B. is the maximum acceptable rate of return on a project.
C. is the minimum acceptable rate of return on a project.
D. is always less than 10%.

78. Who was responsible for the financial crisis of 2007-2009?

A. The U.S. Federal Reserve, for its policy of easy money
B. The U.S. government, for pushing banks to expand credit for low-income housing
C. Bankers, who aggressively promoted and resold subprime mortgages
D. All of these

2-43
79. A capital investment that generates a 10% rate of return is worthwhile if:
A. corporate bonds of similar risk offer 8% rates of return.
B. corporate bonds of similar risk offer 10% rates of return.
C. top-quality corporate bonds offer 10% rates of return.
D. the expected rate of return on the stock market is 12%.

Blooms: Application
Difficulty: 1 Easy
80. The cost of capital:

A. is the expected rate of return on capital investment.
B. is an opportunity cost determined by the risk-free rate of return.
C. is the interest rate that the firm pays on a loan from a bank or insurance company.
D. for risky investments is normally higher than the firm's borrowing rate.

Difficulty: 3 Hard
81. In the context of housing, what is an ARM?

A. A mortgage with high initial payments, offset by significantly lower payments later
B. A mortgage with low initial payments, offset by significantly higher payments later
C. A mortgage with no initial payments, offset by significantly high payments later
D. A mortgage with equal payments per period

2-44
82. During the Financial Crisis of 2007-2009, the U.S. government bailed out the following
firms except:
A. AIG.
B. Fannie Mae.
C. Lehman Brothers.
D. all of these.

Essay Questions
83. How can an individual save and invest in a corporation?
Households and foreign investors provide most of the savings for corporate financing;
financial markets and institutions provide the process and contracts to channel funds from
savers to corporations (financial investment) for real investment. Figures 2-1 and 2-2 are
excellent graphics for this discussion. Individuals can save and invest in a corporation by
lending to, or buying shares in, the financial markets or a financial intermediary such as a
bank or mutual fund that subsequently invests in the corporation. When the corporation
retains cash and reinvests in the firm's operations, that cash is saved and invested on behalf of
the firm's shareholders. The reinvested cash could have been paid out to the shareholders. By
not taking the cash, these investors have also reinvested their savings in the corporation.

Difficulty: 1 Easy
2-45
84. What are the advantages of investing indirectly in stocks and bonds via mutual funds and
pension funds?
Mutual funds pool savings from many individual investors and then invest in a diversified
portfolio of securities. Each individual investor then owns a proportionate share of the mutual
fund's portfolio. The advantages of mutual funds for individuals are diversification,
professional investment management, and record keeping. In particular, an individual can
achieve a widely diversified portfolio at a reasonable cost even when the investment amount
is very small. Pension funds are also pooled investments, but are set up by an employer to
provide for employees' retirement. Pension funds offer efficient diversification and
professional management, too. Additionally, they offer a tax advantage because investment
returns are not taxed until withdrawn from the fund.
AACSB: Analytical Skills

Blooms: Analysis
85. What are the key differences between a financial intermediary and a financial institution?
Financial intermediaries such as mutual funds and pension funds pool and invest savings in
financial assets. Financial institutions such as banks or insurance companies raise money in
various waysfor example, by accepting deposits or selling insurance policies. They not only
invest in securities but also lend directly to businesses. They also provide various other
financial services such as payment and risk management services.

Blooms: Analysis
2-46
86. What are the largest institutional investors in bonds? In stocks?
The largest institutional investors in bonds are insurance companies. Other major institutional
investors in bonds are pension funds, mutual funds, and banks and other savings institutions.
The largest institutional investors in shares are pension funds, mutual funds, and insurance
companies.

Blooms: Knowledge
Difficulty: 1 Easy
87. Why are secondary market transactions of importance to corporations?
Although corporations do not generate cash flows from secondary market transactions (other
than those they initiate), it is the existence of secondary markets that made many investors
comfortable enough to invest in their primary market offerings. In other words, if investors
felt there would not be an organized, convenient market in which to alter their portfolio of
securities, their original investment decisions might be quite different. Also, the secondary
market acts as a form of "scorecard" for the decisions of management and the general
prospects of the firm. Market values are, in most instances, much more important than book
values, thus values in the secondary market give investors and analysts alike the ability to
evaluate a firm. These evaluations will also affect future primary market offerings.

Blooms: Analysis
2-47
88. What is meant by over-the-counter trading?
"Over the counter" refers to trading that does not take place on a centralized exchange such as
the New York Stock Exchange. For example, trading of securities on NASDAQ is over the
counter because NASDAQ is a network of security dealers linked by computers. Although
some corporate bonds are traded on the NYSE, most corporate bonds are traded over the
counter, as are all U.S. Treasury securities. Foreign exchange trading is also over the counter.

Blooms: Knowledge
Difficulty: 1 Easy
89. Describe the distinguishing characteristics of the major financial markets.
The stock market, or equity market, is the market where the stocks of corporations are issued
and traded. Most trading in the shares of large corporations takes place on centralized stock
exchanges such as the NYSE. A corporation may also list its shares on several stock
exchanges simultaneously. There is also a thriving over-the-counter market in shares. The
fixed-income market is the market for bonds and other debt securities. A few corporate debt
securities are traded on stock exchanges, but most corporate debt securities and government
debt are traded over the counter. The foreign exchange market is the market where different
currencies are traded. Most trading takes place in over-the-counter transactions between the
major international banks. Another major market is the commodities market, where
agricultural commodities, fuels (including crude oil and natural gas), and metals (such as
gold, silver, and platinum) are traded on organized exchanges. In addition to these, there are
also markets for options and other derivatives, which derive their value from the price of other
underlying securities such as stocks or commodities.

2-48
90. What are the functions of financial markets?
Financial markets allow for many necessary and important functions including providing the
abilities to transport cash across time, transfer risk, provide liquidity, and allow for greater
diversification in investing. Financial markets help channel savings to corporate investment,
matching borrowers and lenders. Trading in financial markets provides a wealth of useful
information for the financial manager.

91. Why do nonfinancial corporations need modern financial markets and institutions?
The reason is straightforward: Corporations need access to financing in order to innovate and
grow. A modern financial system offers different types of financing, depending on a
corporation's age and the nature of its business. A high-tech startup will seek venture capital
financing, for example. A mature firm will rely more on bond markets.

Blooms: Analysis
Difficulty: 1 Easy
92. Rhonda and Reggie Hotspur are working hard to save for their children's college
education. They don't need more cash for current consumption but will face big tuition bills in
2020. Should they therefore avoid investing in stocks that pay generous current cash
dividends? Explain briefly.
Rhonda and Reggie need not avoid high-dividend stocks. They can reinvest the dividends and
keep reinvesting until it's time to pay the tuition bills. They will have to pay taxes on the
dividends, however, which could affect their investment strategy.

Blooms: Analysis
2-49
93. What is an exchange traded fund? What are some popular choices of exchange traded
funds?
Exchange traded funds (ETFs) are portfolios of stocks that can be bought or sold in a single
trade. These include Standard & Poor's Depository Receipts (SPDRs, or "spiders"), which are
portfolios matching Standard & Poor's stock market indexes. The total amount invested in the
spider tracking the benchmark S&P 500 index was about $94 billion by early 2011. You can
also buy DIAMONDS, which track the Dow Jones Industrial Average; QUBES or QQQQs,
which track the NASDAQ 100 index; and Vanguard ETFs, which track the Vanguard Total
Stock Market index, a basket of almost all the stocks traded in the United States. You can also
buy ETFs that track foreign stock markets, bonds, or commodities.

Blooms: Knowledge
94. How can the financial manager identify the cost of the capital raised by a corporation?
The cost of capital is the minimum acceptable rate of return on capital investment. It is an
opportunity cost, that is, a rate of return that investors could earn in financial markets. For a
safe capital investment, the opportunity cost is the interest rate on safe debt securities, such as
high-grade corporate bonds. For riskier capital investments, the opportunity cost is the
expected rate of return on risky securities, such as investments in the stock market.

2-50
95. How was the role of many bankers in the Financial Crisis of 2007-2009 an example of an
agency problem?
An agency problem is a failure for an agent (the banker) to work in the best interest of his or
her principals (the bank's shareholders). Typically a result of a poor incentive structure,
agency problems played a role in the Financial Crisis of 2007-2009. Bonuses and promotions
provided the incentive to promote the sale and resale of subprime mortgages and mortgage-
backed securities. As suggested in the last chapter, managers were probably aware that a
strategy of originating massive amounts of subprime debt was likely to end badly.

Blooms: Analysis
Difficulty: 3 Hard
96. Investing $100,000 in additional raw materials todaymostly in palladiumshould allow

Cryogenic Concepts to increase production and earn an additional $112,000 next year. This
payoff would cover the investment today, plus a 12% return. Palladium is traded in
commodity markets. The CFO has studied the history of returns on investments in palladium
and believes that investors in that precious metal can reasonably expect a 15% return. Is
Cryogenic's investment in palladium a good idea? Why or why not?
This would not be a good investment, as the opportunity cost of capital in this situation (15%)
is greater than the expected return (12%). The investment should be made only if the expected
return on the project is greater than the opportunity cost of capital.

Blooms: Analysis
2-51
97. Healthy Fish, Inc. is considering the purchase of a batch of experimental fish fry for
$10,000. The fry will mature and be ready for the market in a year. A government agency
guarantees the hardiness of the new breedit will make a one-for-one same-size replacement
if any fish should die of infections during the first year when reared according to clearly
specified instructions. Healthy Fish expects to spend another $42,000 to raise the fish.
Suppose that Healthy Fish can enter into a futures contract to sell the entire batch of fish for
$60,000, the contract will cost $3,000. What is the opportunity cost of capital for this
investment? Should Healthy Fish make the investment? If Healthy Fish cannot set up a
futures contract, what is its opportunity cost of capital? Should it invest in this case? Assume
that the current interest rate on AAA corporate bonds is 6.25%, and that the historical rate of
return on the stock exchange is 10%.
When Healthy Fish can enter into a futures contract, the capital outlay required = $10,000 +
$42,000 + $3,000 = $55,000. So the rate of return = ($60,000 - $55,000)/$55,000 = 9.09%.
Since the government agency and futures contract guarantee the payoff for the investment, the
opportunity cost of capital is the rate of return on safe investments, such as top-quality (AAA)
corporate debt issues (i.e., 6.25%). Since the investment return of 9.09% is higher than the
opportunity cost of capital, Healthy Fish should invest in the experimental fish fry. When
Healthy Fish cannot set up a futures contract, the capital outlay required = $10,000 + $42,000
= $52,000. So the expected rate of return = ($60,000 - $52,000)/$52,000 = 15.38%. Since the
expected selling price is not guaranteed, the opportunity cost of capital is the rate of return on
risky securities, such as investments in the stock market (i.e., 10%). Since the expected
investment return of 15.38% is higher than the opportunity cost of capital, Healthy Fish
should still invest in the experimental fish fry. In fact, even when Healthy Fish can set up a
futures contract, it should consider whether the contract is worthwhile given the company's
risk-return preferences and risk characteristics (such as value-at-risk).

Blooms: Evaluation
Difficulty: 3 Hard
2-52
98. What are subprime mortgages and how were they a part of the Financial Crisis of 2007-
2009?
In the early twenty-first century, central banks promoted a policy of cheap money (low
interest rates). Banks took advantage of this cheap money to expand the supply of subprime
mortgages to low-income borrowers. Subprime mortgages are mortgages given to people with
a higher probability of default than a typical home buyer. Many banks tempted would-be
home buyers with low initial payments, offset by significantly higher payments later. Most
subprime mortgages were then bundled with other mortgages into mortgage-backed securities
that could be resold. But, instead of selling these securities to investors who could best bear
the risk, many banks kept large quantities of the loans on their own books or sold them to
other banks. When housing prices began to decline and mortgage default rates began to rise,
owners of the mortgage-backed securities began to report massive losses and many teetered
on the brink of bankruptcy.

Difficulty: 3 Hard
2-53

Chapter 02 - Financial Markets and Institutions

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Chapter 02 - Financial Markets and Institutions

True / False Questions

2. Smaller businesses are especially dependent upon internally generated funds.

3. An individual can save and invest in a corporation only by lending money to it or by

7. A financial intermediary invests in financial assets rather than real assets.

8. Only small companies can go through financial markets to obtain financing.

13. The derivative market is also a source of financing.

14. Households hold more than half of U.S. corporate equities.

Multiple Choice Questions

31. Corporate financing comes ultimately from:

33. "Reinvestment" means:

34. Excess cash held by a firm should be:

35. A financial intermediary provides financing for:

36. Which of the following statements is not characteristic of mutual funds?

38. "Balanced" mutual funds:

39. Which of the following mutual funds have a tax advantage?

46. Liquidity is important to a mutual fund because:

48. Financing for public corporations flows through:

50. A primary market would be utilized when:

56. Which of the following financial markets is in one centralized location?

58. Corporate debt instruments are most commonly traded:

59. A bond differs from a share of stock in that:

60. Short-term financing decisions commonly occur in the:

61. Long-term financing decisions commonly occur in the:

62. You can buy silver in the:

63. Commodity and derivative markets:

64. A financial institution:

65. U.S. corporate equities are mostly held by:

66. In 2010, U.S. corporate and foreign bonds totaled:

67. In 2010, U.S. corporate equities totaled:

68. An example of how financial intermediaries can assist in shifting an individual's

69. An example of how financial intermediaries can assist in shifting an individual's

71. Which of the following is least liquid?

72. Financial markets and intermediaries:

74. For the consumer, a credit card:

77. The opportunity cost of capital:

78. Who was responsible for the financial crisis of 2007-2009?

80. The cost of capital:

81. In the context of housing, what is an ARM?

83. How can an individual save and invest in a corporation?

86. What are the largest institutional investors in bonds? In stocks?

87. Why are secondary market transactions of importance to corporations?

88. What is meant by over-the-counter trading?

89. Describe the distinguishing characteristics of the major financial markets.

90. What are the functions of financial markets?

96. Investing $100,000 in additional raw materials todaymostly in palladiumshould allow