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• Money is aggregated in small amounts and loaned in large amounts.

• he people with investment opportunities are rarely the ones who have the

money to lend.

• !inancial markets benefit consumers.

B. Moving Funds from Lenders to Borrowers

• "udget positions

"alanced budget# income and expenditures are e$ual

%urplus budget# income exceeds expenditures

Deficit budget# expenditures exceed income

• he primary concern of the financial system is funneling money from surplus

spending units &%%'s( to deficit spending units &D%'s(.

Direct funds flow, or

Indirect funds flow &intermediation(

2.2 (irect Financing

!inancial markets perform the important function of channeling funds from people who

have surplus funds &%%'s( to businesses &D%'s( that need money for capital pro)ects.

A . Direct Financial Markets ) wholesale markets in which the minimum transaction

si*e is +1 million or more.

• Investment "anks firms that speciali*e in helping companies sell new debt

or e$uity issues in the public or private security markets.

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• Money enter "anks large commercial banks located in ma)or '.%.

financial centers that transact in both the national and international money

markets.

'nderwriting a basic investment banking service is to assist firms in the

sale of debt or e$uity in the primary market. o underwrite a new security

issue, the investment banker buys the entire issue at a guaranteed price

from the issuing firm and resells the securities to institutional investors

and the public.

2.3 Types of Financial Markets

A. rimary Market any financial market in which new security issues are sold for

the first time.

B. Secondary Market ) any financial market in which the owners of outstanding

securities can resell them to other investors.

• Investors are willing to pay higher prices for securities in primary markets if

the securities have active secondary markets.

• he ease with which a security can be sold and converted into cash is called

mar*etabilit' .

• he ability to convert an asset into cash $uickly without loss of value is called

li+%idit'.

!. ,ro*ers vers%s (ealers

"rokers market specialists who bring buyers and sellers together in

secondary markets.

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hey execute transactions for their clients and are compensated for

their services with a commission fee.

hey bear no risk of ownership of the securities in the transactions0

their only service is that of a matchmaker.2

Dealers make markets2 for securities and do bear risk.

hey make a market for a security by buying and selling from an

inventory of securities they own. he risk is that they will not be

able to sell a security for more than they paid for it.

%ecurities Exchanges

3rgani*ed Exchanges provide a physical meeting place and

communication facilities for members to conduct business under a

specific set of rules and regulations. 3nly members can use the

exchange, and each exchange has a limited number of seats.

4ew 5ork %tock Exchange &45%E(

6merican %tock Exchange

7acific %tock Exchange

hicago %tock Exchange

7hiladelphia %tock Exchange

3ver8the8 ounter &3 ( Markets have no central trading location,

as the 45%E has. Instead, investors can execute 3 transactions by

visiting or telephoning an 3 dealer or by using a computer8based

electronic trading system linked to the 3 dealer.

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A. Money Markets ) a collection of markets with no formal organi*ation or location,

each trading distinctly different financial instruments. !inancial instruments sold

in money markets have very short maturities, usually overnight to 1:; days, are

highly marketable in that they can be easily converted into cash, and are issued by

economic units of the highest credit standing.

• Instruments include '.%. reasury bills, negotiable Ds, and commercial

paper.

B. !a"ital Markets that segment of the marketplace where capital goods, such as

plant and e$uipment, are financed with e$uities or long8term debt.

!. u#lic and rivate Markets

• 7ublic markets are organi*ed financial markets where the general public

buys and sells securities through their stockbroker.

• 7rivate markets involve direct transactions between two parties.

ransactions in private markets are called private placements.

D. Futures and $"tions Markets ) are often called derivative securities because

they derive their value from some underlying asset.

!utures ontracts contracts for future delivery of securities, foreign

currencies, interest rates, or commodities.

3ptions ontracts call for one party &the option writer( to perform a

specific act if called upon to do so by the option buyer or owner.

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2.! The &toc* -ar*et

A. The e/ 0or* &toc* E changea. !ounded in 1=>-, the 45%E is the oldest, largest, and best known traditional

securities exchange in the 'nited %tates.

B. &( 3a. 46%D6? is the world@s largest electronic stock market, listing nearly four

thousand companies. It was created in 1>=1 by the 4ational 6ssoc. of %ecurities

Dealers

!. &toc* -ar*et Inde esa. hese are used to measure the performance of the stock market A whether stock

prices on average are moving up or down. 6 wide variety of general and

speciali*ed indexes is available.

%tock Market Indexes used to measure the performance of the stock market

whether stock prices on average are moving up or down.

Dow Bones Industrial 6verage consists of /; companies that represent about

-; percent of the market value of all '.%. stocks.

%tandard and 7oor@s <;; Index is regarded as the best index for measuring

the performance of the largest companies in the '.%. economy. It represents

about :; percent of the total market capitali*ation of all stocks on the 45%E.

46%D6? omposite Index consists of all of the common stocks listed on

the 4ational 6ssociation of %ecurities Dealers 6utomatic ?uotation %ystem

&hence 46%D6?( of over <,;;; firms.

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2." Financial Instit%tions and Indirect Financing

6. %ndirect Financing —when a financial intermediary such as a commercial bank or

insurance company stands between the %%' and the D%'.

B. Financial Instit%tions and Their &ervices

a. !ommercial Banks ) are the most prominent and largest financial intermediaries

in the economy and offer the widest range of financial services to businesses.

he ma)or sources of funds for commercial banks are consumers#

checking accounts, savings accounts, and a variety of time deposits. he

banks accumulate these funds and make a variety of loans to consumers,

businesses, and governments.

hey also do a significant amount of e$uipment lease financing.

b. Life %nsurance !om"anies obtain funds by selling life insurance policies that

protect individuals against the loss of income from a family member@s premature

death.

7rovide funding to public corporations through the purchase of stocks and

bonds in the direct credit markets and to closely held corporations through

direct placement financing.

c. !asualty %nsurance !om"anies sell protection against loss of property from

fire, theft, accidents, negligence, and other predictable causes.

d. ension Funds provide retirement programs for businesses as part of their

employee benefit programs. hey obtain money from employee and employer

contributions during the employee@s working years, and they provide monthly

payments upon retirement.

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e. %nvestment Funds ) sell shares to investors and use the funds to purchase a wide

range of direct and indirect financial instruments.

f. Business Finance !om"anies sell short8terms I3's, called commercial paper,

to investors in the direct credit markets, where these funds are used to make a

variety of short8 and intermediate8term loans and leases to small and large

businesses.

2.$.# The (eterminants of Interest Rate Levels

A. The &eal &ate of %nterest a long8term interest rate determined in the absence of

inflation.• he determinants of the real rate are a firm@s return on investment as well as

the time preference for consumption.

B. Money' %nflation' and urchasing ower

• he value of money is its purchasing power.

• here is an inverse relationship between changes in price level and the value

of money.

!. %nflation and Loan !ontracts the real rate of interest ignores inflation.

• enders must incorporate anticipated inflation into lending contracts0

otherwise they may lose purchasing power when the loan is repaid.

D. %nflation remiums lenders can incorporate protection against changes in buying

power due to inflation in a loan contract.

• 4ominal ate F eal ate of interest G Expected hanges in ommodity

7rices

• eali*ed rate of return F 4ominal ate A 6ctual ate of Inflation

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(. The Fisher E+%ation and Inflation

How do we write a loan contract that provides protection against loss of

purchasing power due to inflation

o incorporate inflation expectations2 into a loan contract we need to ad)ust

the real rate of interest by amount of inflation expected during the contract

period

o he mathematical formula for this is called the !isher E$uation

F. !yclical and Long)Term Trends in %nterest &ates

• Interest rates tend to follow the business cycle during periods of

economic expansion, interest rates tend to rise0 during a recession, the

opposite tends to occur.

• Inflationary expectations have a ma)or impact on interest rates.

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II. &%ggested and lternative pproaches to the -aterial

his chapter provides useful background for the material presented later in the course. 6t some

universities, this material has already been covered in a previous course, and therefore the

chapter will serve as an optional review to ensure that the students are comfortable with the

nomenclature and general workings of the financial markets. In that event, this chapter can be

covered in a single lecture or a portion of a single lecture.

If the students have not had a previous course in Money and "anking, then the text offers

a proper introduction of the material. his might provide non8!inance ma)ors with the only

source of this important material, such as the relationship between real and nominal interest

rates. In addition, the chapter introduces many definitions and concepts that will be used later in

the text.

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III. &%mmar' of Learning Objectives

1. (isc%ss the primar' role of the financial s'stem in the econom'4 and describe the

t/o basic /a's f%nd transfers ta*e place.

he primary role of the financial system is to transfer money from those that have more

money than they need to spend &surplus spending units, or %%'s( to businesses and

consumers who need to borrow money &deficit spending units, or D%'s(. he more

efficient the financial system, the more likely it is that consumers will get the highest

possible interest rate on their savings, businesses will be able to borrow at the lowest

possible cost, and the most desirable investment opportunities with the highest rates of

return will be funded.

Money is transferred from %%'s to D%'s in two basic ways# &1( directly, through

financial markets or &-( indirectly, through intermediation markets. he direct markets are

wholesale markets where large public corporations transact. %maller business firms, as

well as consumers, secure most of their financial services from commercial banks andother financial intermediaries because their transactions are too small for the wholesale

markets.

2. (isc%ss direct financing and the important role that investment ban*s pla' in this

process.

Direct markets are wholesale markets where large public corporations transact. hese

corporations sell securities, such as stocks and bonds, directly to investors in exchange

for money, which they use to invest in their businesses. Investment banks are important in

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the direct markets because they help firms sell their new security issues. he services

provided by investment bankers include origination, underwriting, and distribution.

. (escribe the primar' and secondar' mar*ets4 and e plain /h' secondar' mar*ets

are so important to b%sinesses.

7rimary markets are markets in which new securities are sold for the first time.

%econdary markets provide the aftermarket for securities previously issued. 4ot all

securities have secondary markets. %econdary markets are important because they enable

investors to convert securities easily to cash. "usiness firms whose securities are tradedin secondary markets are able to issue securities at a lower cost than they otherwise could

because investors are willing to pay a premium price for securities that have secondary

markets.

!. E plain /h' mone' mar*ets are important financial mar*ets for large corporations.

arge corporations use money markets to ad)ust their li$uidity because cash inflows and

outflows are rarely perfectly synchroni*ed. hus, on the one hand, if cash expenditures

exceed cash receipts, the firm can borrow short term by issuing commercial paper, or, if

the firm holds a portfolio of money market instruments, some of the securities can be sold

for cash. 3n the other hand, if cash receipts exceed expenditures, the firm can

temporarily invest the funds in short8term money market instruments such as reasury

bills, negotiable Ds, or commercial paper issued by other corporations. "usinesses are

willing to invest large amounts of idle cash in money market instruments because of their

high degree of marketability and their low default risk.

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". (isc%ss the most important stoc* mar*et e changes and inde es.

apital markets are the wholesale markets where capital assets, such as plant and

e$uipment, are financed. he two most important capital market instruments are

corporate bonds and common stock. ompared with money market instruments, capital

market instruments are less marketable and carry more default risk.

#. E plain ho/ financial instit%tions serve cons%mers and small b%sinesses that are

%nable to participate in the direct financial mar*ets and describe ho/ corporations

%se the financial s'stem.

he problem with direct financing is that it takes place in a wholesale market. Most small

businesses and consumers do not have the professional skills or the money to transact in

this market. In contrast, a large portion of the intermediation market focuses on providing

financial services to consumers and small businesses. !or example, commercial banks

collect money from consumers in small dollar amounts by selling them checking

accounts, savings accounts, and consumer Ds. hey then aggregate the funds and make

loans in larger amounts to consumers and businesses. he financial services bought or

sold by intermediaries are tailor made to fit the needs of the market they serve. Exhibit

-./ illustrates how corporations use the financial system.

$. E plain ho/ the real rate of interest is determined in the econom'4 differentiate

bet/een the real rate and the nominal rate of interest4 and be able to comp%te the

nominal real rate of interest.

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he real rate of interest is the long8term interest rate in the economy in the absence of

inflation. It is determined by the interaction of &1( the rate of return that business can

expect to earn on capital goods and &-( individuals@ time preference for consumption. he

interest rate we observe in the marketplace is called the nominal rate of interest. he

nominal rate of interest is composed of two parts# &1( the real rate of interest and &-( the

expected rate of inflation. he inflation premium provides protection to the lender and

borrower against changes in purchasing power due to inflation.

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I5. &%mmar' of 6e' E+%ations

1<

E+%ation (escription Form%la

2.1 !isher e$uation i F r G J P eG &r∆P e(

2.2!isher e$uation

simplifiedi F r G J P e

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5. ,efore 0o% 7o On 3%estions and ns/ers

&ection 2.1

1. Khat essential economic role does the financial system play in the economy

he financial system is in place to gather money from people and businesses and then

channel these funds to those who need it. 6n efficient financial system is essential for a

healthy economy. he ma)or players in the '.%. financial system are big institutions such

as the 4ew 5ork %tock Exchange, itigroup, or %tate !arm Insurance.

2. Khat are the two basic ways in which funds flow through the financial system from

lenderAsavers to borrowerAspenders

here are two basic mechanisms by which funds flow through the financial system# 1(!unds can flow directly through financial markets, and &-( funds can flow indirectly

through financial institutions.

&ection 2.2

1. Khy is it difficult for individuals to participate in the direct financial markets

he financial markets where direct transactions take place are wholesale markets with a

typical minimum transaction si*e of +1 million. Ma)or buyers and sellers of securities in

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direct financial markets include commercial banks, large corporations, the federal

government, hedge funds, and some wealthy individuals.

-. Khy might a firm prefer to have a security issue underwritten by an investment banking

firm

In the most common type of underwriting arrangement, called firm-commitment

underwriting, the investment banker assumes the risk of buying the new securities from

the issuing company and reselling them to investors. he investment banker guarantees to buy the entire security issue from the company at a fixed price.

&ection 2.

1. Khat is the difference between primary and secondary markets

7rimary markets are markets where new securities are sold for the first time. %econdary

markets are where the owners of outstanding securities can sell them to other investors.

hey provide the means for investors to sell their securities and get cash.

-. How and why do large business firms use money markets

arge businesses use money markets to ad)ust their li$uidity positions. If a firm has idle

cash sitting around, it can invest it in negotiable Ds, reasury bills, or other money

market instruments. 3n the other hand, if a company has a temporary cash shortage, it

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can borrow in the money markets by selling commercial paper at lower interest rates than

they could borrow through a commercial bank.

/. Khat are capital markets, and why are they important to corporations

apital markets refer to the segment of the marketplace where capital goods are financed

with long8term debt or e$uities. he most important capital market instruments are

common stocks and corporate bonds. apital markets are important to corporations

because they allow them to obtain necessary financing.

&ection 2.!

. Khat is 46%D6?

46%D6? is the world@s largest electronic stock market, listing nearly four thousand

companies. It was created in 1>=1 by the 4ational 6ssociation of %ecurities Dealers, and its odd

name is an acronym for 4ational 6ssociation of %ecurities Dealers 6utomated ?uotation

&46%D6?( system.

. ist the ma)or stock market indexes, and explain what they tell us.

he ma)or '.%. stock market indexes are the Down Bones 6verage, 4ew 5ork %tock

Exchange, %tandard and 7oor@s <;; Index, and 46%D6? omposite Index. he stock

market index is essentially a listing of stocks that bear some commonality, such as being

traded on the same market exchange. hey are used to measure the stock market

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performance, and many are used to benchmark the performance of portfolios, such as

mutual funds.

&ection 2."

1. Khat is financial intermediation, and why is it important

!inancial intermediation is the process of converting financial securities with one set of

characteristics into securities with another set of characteristics. !or example, commercial

banks use consumer D deposits to make loans to small businesses.

-. Khat are some services that commercial banks provide to businesses

ommercial banks are the largest financial intermediaries in the economy and offer the

widest range of financial services to businesses. 4early every business has a significant

relationship with a commercial bank A usually a checking or transaction account and

some type of credit or loan arrangement. In addition, banks do a significant amount of

e$uipment lease financing.

/. Khat is an I73, and what role does an investment banker play in the process

Investment bankers speciali*e in helping firms to sell their new debt or e$uity issues in

financial markets. In an initial public offering &I73(, the investment banker prepares the

new issue for sale and then underwrites the deal. 3ther functions of the investment

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banker in an I73 process include preparing the prospectus, registering the documentation

with the %E , and providing general financial advice to the issuer.

&ection 2.#

1. Explain how the real rate of interest is determined .

he real rate of interest depends on interaction between the rate of return that businesses

can expect to earn on investments in capital goods and savers@ time preference for

consumption today versus willingness to save. herefore, the real rate of interest is

determined when the desired saving level e$uals the desired level of investment.

-. How are inflationary expectations accounted for in the nominal rate of interest

he nominal interest rate is the rate that is actually observed in the financial markets, and

it is e$ual to the real interest rate plus the expected annuali*ed changes in commodity

prices, or inflation premium. his is commonly referred to as the !isher effect.

/. Explain why interest rates follow the business cycle.

Interest rates tend to follow the business cycle and to rise during economic expansion and

decline during recession. 3n the one hand, during an expansion, there is upward pressure

on interest rates as businesses begin to grow and borrow more money. 3n the other hand,

during a recession, the demand for goods and services is lower, businesses borrow less,

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and as a result the economy slows down and the interest rates decline. ypically, the !ed

also loosens credit to stimulate the economy, which puts further downward pressure on

the interest rates.

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5I. &elf &t%d' 8roblems

2.1 Economic units that are in a need to borrow money are#

a. enderAsavers

b. "orrowerAspenders &correct answer(

c. enderAspenders

d. "orrowerAsavers

&ol%tion9 %uch units are said to be &b( borrower8spenders.

2.2 Explain what marketability of a security means and how it is determined.

&ol%tion9 Marketability refers to the ease or difficulty with which securities can be sold in

the market. he level of marketability depends on many factors, such as the

security@s coupon and maturity, as well as all the transaction costs# cost of trading,

physical transfer cost, and search and information cost. he lower these costs are,

the greater the security@s marketability.

2. Khat are over8the8counter markets &3 (, and how do they differ from organi*ed

exchanges

&ol%tion9 3 is a market for securities that are not listed on one of the organi*ed

exchanges. It differs from organi*ed exchanges in that there is no central trading

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location, but rather the securities transactions are made via phone or computer as

opposed to the floor of an exchange. 'sually, small companies that could not

$ualify for one of the exchanges trade their stock 3 .

2.! Khat effect does an increase in the demand for business goods and services have on the

real interest rate Khat other factors can affect the real interest rate

&ol%tion9 6n increase in the demand for business goods and services will cause the desired

borrowing schedule to shift to the right, thus increasing the real rate of interest.3ther factors that contribute to increases in the real interest rate are, for example,

increases in technological inventions and a reduction of corporate tax rates.

Demographic factors, such as growth and age of the population, as well as

cultural differences, also affect the real rate of interest.

2." How does the business cycle affect the interest and inflation rates

&ol%tion9 "oth the interest and inflation rates follow the business cycle0 that is, they rise

with economic expansion and fall in time of recession.

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5II. Critical Thin*ing 3%estions

*.+ Explain why total financial assets in the economy must e$ual total financial liabilities.

Every financial asset must be financed with some type of a claim or liability. %ince all of

an economy@s financial assets are )ust a collection of the individual financial assets, then

they should also sum to the collective claims on those assets in the economy.

. Khy don@t small businesses make greater use of the direct credit markets since these

markets enable firms to finance themselves at very low cost

Direct credit markets are geared toward big, established companies since they are

wholesale in nature and the minimum transaction si*e is far beyond the needs of a small

business. %mall businesses are better off borrowing money from financial intermediaries,

such as commercial banks.

. Explain the economic role of brokers and dealers. How does each make a profit

"rokers and dealers play a similar economic role in that they both bring buyers and

sellers of a commodity together in a market. However, brokers only facilitate a

transaction by helping the two parties make a transaction and brokers are therefore only

compensated for taking on that role. Dealers on the other hand, take risk in that they will

purchase &sell( a commodity from a seller &buyer( without another buyer &seller(

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necessarily being available. In other words, a dealer will take the risk of purchasing

&selling( a commodity and will therefore be compensated for taking that risk.

2.! Khy were commercial banks prohibited from engaging in investment banking activities

beginning in the 1>/;s

"anks had been barred from investment banking following the Lreat Depression because

it was believed that these activities were too risky for banks. 6t the time, it was believed

that excessive risk taking by banks had resulted in a large number of bank failures, which precipitated the Lreat Depression. ecent research has exonerated the banking system of

this charge.

2." Khat are the two basic services that investment banks provide in the economy

Investment banks speciali*e in helping companies sell new debt or e$uity as well as

provide other services such as broker and dealer services.

2.# Many large corporations sell commercial paper as a source of funds. !rom time to time,

some of these firms find that they are temporarily unable to issue commercial paper. Khy

is this true

Lenerally, only <;; to =;; firms have access to the market at any given time. During

economic expansion, the number of firms that can issue commercial paper increases.

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Khen the economy is slow, however, firms with lower credit rating tend to be excluded

from the market, as investors are looking primarily for low8risk investments that are

provided by companies with high credit rating.

2.$ How do large corporations ad)ust their li$uidity in the money markets

arge corporations can take advantage of money markets to ad)ust for their li$uidity by

selling or buying short8term financial instruments such as commercial paper, Ds, or

reasury bills. arge corporations with cash surplus can invest in short8term securities,while corporations with cash shortfall can sell securities or borrow funds on a short8term

basis. Money market instruments have a maturity anywhere between one day and one

year and therefore are very li$uid and less risky than long8term debt.

2.: %houldn@t the nominal rate of interest &E$uation -.1( be determined by the actual rate of

inflation (∆P a ), which can be easily measured, rather than by the expected rate of

inflation (∆P e )?

he nominal rate of interest is a forward8looking measure, and therefore it makes sense

that it is using the expected rate of inflation as opposed to the actual rate of inflation. he

expected rate of inflation is the market@s best estimate of what the inflation rate will be in

the future.

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2.; How does Exhibit -.< help explain why interest rates were so high during the early 1>:;s

as compared to the relatively low interest rates in the early 1>C;s

he nominal rate of interest is determined by the real rate of interest plus the expected

rate of inflation, and during the 1>:;s, the '.%. economy experienced a very high rate of

inflation and, thus, high interest rates. ooking at Exhibit -.:, we can see that the

inflation increased from less than - percent in the 1>C;s to almost 1/ percent in the

1>:;s. his was a result of the monetary policy instituted by the '.%. government during

this period of time.

2.1< Khen determining the real interest rate, what happens to businesses that find themselves

with unfunded capital pro)ects whose rate of return exceeds the firms@ cost of capital

he real rate of interest reflects a complex set of forces that control the desired level of

lending and borrowing in the economy. In this example, businesses are not investing in

pro)ects where the rate of return exceed the cost of capital. his means that there is

lessened a demand for investment funds at the current real interest rate. his will remain

so until either the real interest rate changes or until something changes for the firm such

as introducing a new technology that will increase the rate of return on pro)ects for the

firm.

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5III. 3%estions and 8roblems

2.1 Financial &'stem9 Khat is the role of the financial system, and what are the components

of the system

he role of the financial system is to gather money from businesses and individuals and

to channel funds to those who need them. he financial system consists of financial

markets and financial institutions.

2.2 Financial &'stem9 Khat does a competitive financial system imply about interest rates

If the financial system is competitive, one will receive the highest possible rate for money

invested with a bank and the lowest possible interest rate when borrowing money. 6lso,

only firms with good credit ratings and pro)ects with high rates of return will be financed.

2. Financial &'stem9 Khat is the difference between saverAlenders and borrowerAspenders,

and who are the ma)or representatives of each

%averAlenders are those who have more money than they need right now. he principal

saverAlenders in the economy are households. "orrowerAspenders are those who need the

money saverAlenders are offering. he main borrowerAspenders in the economy are

businesses, although households are important mortgage borrowers.

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2.! Financial -ar*ets9 ist the two ways in which a transfer of funds takes place in an

economy. Khat is the main difference between these two

!unds can flow directly through financial markets or indirectly through intermediation

markets where funds flow through financial institutions first.

2." Financial -ar*ets9 %uppose you own a security that you know can be easily sold in the

secondary market, but the security will sell at a lower price than you paid for it. Khat

would this mean for the security@s marketability and li$uidity

6s the price of the security is lower than that you paid for it, it has a lower degree of

li$uidity to you, the owner. hat is because the security cannot now be sold without a

loss in value to the owner. Marketability refers to the ease to which a security can be sold

or converted to cash. he information in the problem does mention a drastically lower

price and so we must conclude that the security@s marketability in not affected.

2.# Financial -ar*ets9 Khy are the direct financial markets also called wholesale markets

he financial markets are also called wholesale markets because the minimum

transaction or security denomination is +1 million or more.

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2.$ Financial -ar*ets9 rader, Inc., a +/;; million company, and Horst orp., with an asset

si*e of +/< million, are two privately held corporations. Explain which firm is more

likely to go public and register with the %E , and why.

rader, Inc., is more likely to go public. Loing through an I73 is a very expensive

process, and given rader@s higher worth, they are more likely to be positioned to go

through with it.

2.: 8rimar' -ar*ets9 Khat is a primary market Khat does I73 stand for

6 primary market is where new securities are sold for the first time. I73 stands for initial

public offering.

2.; 8rimar' -ar*ets9 Identify whether the following transactions are primary market or

secondary market transactions.

a. Bim Hendry bought /;; shares of I"M through his brokerage account.

b. 7eggy Bones bought +<,;;; of I"M bonds from the firm.

c. Hathaway Insurance ompany bought <;;,;;; shares of rigen orp. when the

company issued stock.

• secondary

• secondary

• primary

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2.1< Investment ,an*ing9 Khat does it mean to underwrite a new security issue Khat

compensation does an investment banker get from underwriting a security issue

o underwrite a new security issue means that the investment banker buys the entire issue

from the firm at a guaranteed price and then resells the security to individual investors or

other institutions at a higher price. he difference between the banker@s purchase price

and the total resale price is called the underwriting spread, and it is the banker@s

compensation. In addition to underwriting new securities, investment banks also provideother services, such as preparing the prospectus, preparing legal documents to be filed

with the %E , and providing general financial advice to the issuer.

2.11 Investment ,an*ing9 ran)et, Inc., is issuing 1;,;;; bonds, and its investment banker

has guaranteed a price of +>:< per bond. he investment banker sells the entire issue to

investors for +1;,1<;,;;;.

a. Khat is the underwriting spread for this issue

b. Khat is the percentage underwriting cost

c. How much did ran)et raise

a. +/;;,;;; &+1;,1<;,;;; A +>:< x 1;,;;;(

b. /.;< percent &+/; +>:<(

c. +>,:<;,;;; &+>:< x 1;,;;;(

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2.12 Financial Instit%tions9 Khat are some of the ways in which a financial institution or

intermediary can raise money

6 financial intermediary can raise money through the sale of financial products that

individuals or businesses will purchase, such as checking and savings accounts, life

insurance policies, or pension or retirement funds.

2.1 Financial Instit%tions9 How do financial institutions act as intermediaries2 to provide

services to small businesses

!inancial intermediation is the process whereby borrowing occurs indirectly from a

financial institution that has converted financial securities with one set of characteristics

into securities with another set of characteristics for the borrower@s specific need.

2.1! Financial Instit%tions9 Khich financial institution is usually the most important to

businesses

he primary financial intermediaries are commercial banks, life insurance companies,

casualty insurance companies, pension funds, investment funds, and business finance

companies. ommercial banks are the largest and most prominent financial

intermediaries in the economy and offer the widest range of financial services to

businesses.

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2.1" Financial -ar*ets9 Khat is the main difference between money markets and capital

markets

Money markets are markets in which short8term debt instruments with maturities of less

than one year are bought and sold. apital markets are markets in which e$uity securities

and debt instruments with maturities of more than one year are sold.

2.1# &toc* -ar*et Inde 9 Khat is a stock market index ist three stock market indexes.

6 stock market index is a tool used to measure the performance of the stock market

whether the prices are on average going up or down. %ome of the better known indexes

are the Dow Bones Industrial 6verage, the 45%E Index, and the %N7 <;; Index.

2.1$ &toc* -ar*et Inde 9 Khat is the Dow Bones Industrial 6verage

he Dow Bones Industrial 6verage consists of the /; largest public companies in the

'nited %tates, and it was established to gauge the performance of the '.%. economy,

specifically the industrial component of the stock market.

2.1: &toc* -ar*et Inde 9 Khat does 46%D6? represent

46%D6? is an acronym for 4ational 6ssociation for %ecurities Dealers 6utomated

?uotations, and it is the largest electronic stock exchange in the 'nited %tates.

//

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2.1; -one' -ar*ets9 Khat are '.%. reasury bills

reasury "ills are one of the most common money market instruments. Money market

instruments are lower in risk than other securities because of their high li$uidity and low

default risk.

2.2< -one' -ar*ets9 "esides '.%. reasury bills, what are other money market instruments

3ther common money market instruments include commercial paper, bank negotiable

Ds, and other marketable short8term securities.

2.21 -one' -ar*ets9 Khat is the primary role of money markets Explain how money

markets work.

Money markets provide an option for large corporations to ad)ust their li$uidity positions.

%ince only seldom are cash receipts and cash expenditures perfectly synchroni*ed, money

markets allow companies to temporarily invest idle cash in reasury bills or negotiable

Ds. If a company is short on cash, it can borrow the money from money markets by

selling commercial paper at lower interest rates than through commercial banks.

2.22 Capital -ar*ets9 How do capital market instruments differ from money market

instruments

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apital market instruments are less li$uid or marketable, they have longer maturities,

usually between 1 and /; years, and they carry more financial risk.

2.2 Interest Rates # Khat are the ma)or differences between public and private markets

7ublic markets are organi*ed financial markets where the public buys and sells securities

through their stock brokers. he %E regulates public securities markets in the 'nited

%tates. In contrast, private markets involve direct transactions between two parties. hesetransactions lack %E regulation.

2.2! Financial Instr%ments9 Khat are the two risk8hedging instruments discussed in the

chapter

he two risk8hedging instruments discussed are futures and options markets.

2.2" Interest Rates # Khat is the real rate of interest, and how is it determined

he real rate of interest measures the return earned on savings, and it represents the cost

of borrowing to finance capital goods. he real rate of interest is determined by the

interaction between firms that invest in capital pro)ects and the rate of return businesses

can expect to earn on investments in capital goods, and individuals@ time preference for

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consumption. Lraphically, it is that point when the desired saving level e$uals the desired

level of investment in the economy.

2.2# Interest Rates # How does the nominal rate of interest vary over time

he nominal rate is the rate that we observe in the marketplace. it is determined by both

the real rate as well expected inflation. herefore, the nominal rate will fluctuate

according the changes in the real rate as well as changes in expected inflation.

2.2$ Interest Rates # Khat is the !isher e$uation, and how is it used

he !isher e$uation is the expected, not the reported or actual, annuali*ed change in

commodity prices &J P e(. It is used to protect the buying power from changes in inflation,

and it is incorporated into a loan contract by adding it to the real interest rate that would

exist in the absence of inflation.

2.2: Interest Rates # Imagine you borrow +<;; from your roommate, agreeing to pay her back

the +<;; plus = percent interest in one year. 6ssume inflation over the life of the contract

is expected to be 9.-< percent. Khat is the total amount you will have to pay her back in a

year How much of the interest payment is the result of the real rate of interest

5ou will pay her back +<<C.-< &+<;; x 1.11-<( in one year, of which +/< will be a result

of the real interest rate &+<;; x 1.;=(.

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2.2; Interest Rates # 5our parents have given you +1,;;; a year before your graduation so that

you can take a trip when you graduate. 5ou wisely decide to invest the money in a bank

D that pays C.=< percent interest. 5ou know that the trip costs +1,;-< right now and that

the inflation for the year is predicted to be 9 percent. Kill you have enough money in a

year to purchase the trip

5es. he D will be worth +1,;C=.<; at the end of the year &+1,;;; x C.=<O G +1,;;;(,

and the price of the trip will be +1,;CC &+1,;-< x 9O G +1,;-<(. he D will be able tocover the trip.

2. < Interest Rates # Khen are the nominal and real interest rates e$ual

he only time the nominal and real interest rates are e$ual is when the expected rate of

inflation over the contract period is *ero.

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&ample Test 8roblems

2.1 How are brokers different from dealers

&ol%tion9

"rokers execute transactions for their clients, but they bear no risk of ownership of the

securities in the transaction0 in contrast, dealers make markets2 for securities and do

bear risk.

2.2 Khat is the %N7 <;; Index

&ol%tion9

he %N7 <;; Index represents the largest <;; companies in the publicly traded '.%.

stock issues, and it incorporates about :; percent of the total market capitali*ation of all

stocks on the 4ew 5ork %tock Exchange.

2. Identify the type of transactions &direct or indirect( the following are#

a. 5ou buy -;; shares of !idelity Lrowth Mutual !und.

b. oger opens a bank D for +<,;;;.

c. "ank of 6merica makes a +-<,;;; loan to eila offee %hop.

d. 4ora buys +/,;;; of Perox bonds from a new issue.

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&ol%tion9

a. indirect, since !idelity is an investment fund

b. indirect, since the bank will then loan the funds to a deficit spending unit

c. direct, since "ank of 6merica is a money center bank, which is making a direct loan

d. direct, since 4ora is buying the new issue through an investment bank

2.! If the nominal rate of interest is =.< percent and the real rate is 9 percent, what is the expected

inflation premium

&ol%tion9

If we follow the !isher e$uation,

i F r G J P e and note that i F ;.;=< while r F;.;9, then it is easy to see that F J P eF ;.;/<

or /.<O.

2." Khat is the relationship between business cycles and the general level of interest rates

&ol%tion9

6s Exhibit -.< shows, we can see that interest rates tend to follow the business cycle.

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