Finance 333 homework 1

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University of South Carolina *

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333

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Finance

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Feb 20, 2024

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Select the term that corresponds to each of the given descriptions. ( Note : There is only one possible answer for each description.) Descriptions Terms This institution consists of an organized pool of assets designed to support a group of workers in retirement. Pension fund This institution offers two major types of contracts: a relatively short-term contract that provides protection for a temporary period of time, and a long-term contract that provides lifetime protection. Insurance company By virtue of investing the saved funds of its investors into a large number of different securities, it is able to realize both economies of scale and risk diversification for its investors. Mutual fund

This institution was originally created to develop pools of savings that could be used to provide temporary credit to neighboring farmers who suffered due to crop failures or similar catastrophes. Credit union This institution was originally created to provide loans and deposit services to business customers, and it continues to be the primary source of business loans. Commercial bank Points: 1 / 1 Commercial Bank Credit Union Insurance Company Mutual Fund Pension Fund Thrift Institution This institution was originally created to provide loans and deposit services to business customers, and it continues to be the primary source of business loans. Commercial banks have no membership restrictions and offer a wide range of consumer services to their clients, including checking accounts. This institution has always been considered to be the “department store of finance” due to the wide range of products and services offered. This institution has historically served as the principal vehicle through which the money supply of the United States is expanded or contracted. This practice continues today. Back to Assignment Attempts Attempt 1 score is

3 Attempt2 score is 4 Attempt 3 was not attempted. - Keep the Highest 4 out of 4 4 / 4 2. Three methods of funds and security transfer between financial market participants There are three mechanisms used to move funds and securities between savers and borrowers. The simplest of these involves a direct transfer to transfer funds and securities between the market participants. Points: 1 / 1 The following diagram describes the exchange of funds and securities between borrowers (businesses) and savers (investors). Examine the diagram and use it to answer the following questions.

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Flow #1 represents: The flow of securities from the borrower to the saver . Points: 1 / 1 Flow #2 represents: The flow of money from the saver to the borrower . Points: 1 / 1 This form of exchange involves: Two market participants, one transfer of money, and the exchange of one security . Points:

1 / 1 The simplest mechanism or market arrangement in which money is transferred from a saver with a surplus of funds to a borrower with a shortage of funds is called a direct transfer. In this situation, funds flow from the saver to the borrower, while the security, which provides evidence of the transfer and the terms of repayment or ownership, flows from the borrower to the saver (investor). In a direct transfer, there are two market participants (the borrower and the saver), one transfer of money (from the saver/investor to the borrower), and one security. At the conclusion of the loan period, the borrower will repay the funds owed to the saver in accordance with the terms specified in the security. Back to Assignment Attempts Attempt 1 score is 0.7 Attempt 2 score is 0.2 Attempt3 score is 0.6 Keep the Highest 0.7 out of 1 0.7 / 1 3. Types of financial markets

There are a variety of criteria by which financial markets and their securities can be differentiated. For example, they can be segmented according to the types and maturities of the securities traded, who receives the proceeds of the sale, and the mechanisms used to operate the markets. Consider the following transactions, and indicate which of each category of markets best describes the transaction. Thus, select equity or debt, primary or secondary, and capital or money for each transaction. Transaction Debt or Equity Market Primary or Secondary Market Capital or Money Market Newcastle Coal Company, a publicly-traded company, sells a new issue of 4.50% twenty-year bonds. Equity Primary Money Neha called her broker to purchase ten of the 5.25% 10-year bonds recently issued by the United States Treasury. Debt Secondary Capital Lorenzo uses an online brokerage account to purchase 2,000 shares of National Petroleum Refiners, Inc. at the current market price. Debt Primary Capital Points: 0.56 / 1 Newcastle Coal Company’s sale of a new issue of 4.50% twenty-year bonds constitutes a debt market transaction, since the bond issue represents a loan made by the purchasers of the bonds to Newcastle

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Coal Company. The loan will be repaid in twenty years in accordance with the terms of the borrowing (indenture) agreement that accompanies the bonds. The twenty-year maturity makes this a capital market transaction. Since this is a new bond issue, not a transaction involving previously issued securities, it is a primary market transaction. Transactions occurring in the equity market involve purchases and sales of stock and ownership interests in the issuing companies. Secondary market transactions involve securities that have been previously issued. In contrast, with capital market transactions, those occurring in the money market involve securities with an original maturity of one year or less. Securities issued in the primary market may later be traded in the secondary market. Neha’s purchase of government bonds issued by the United States Treasury is a debt market transaction, as well as a secondary market, and capital market transaction. Lorenzo’s instructions to purchase the shares of National Petroleum Refiners, Inc. will be carried out in an equity market (the New York Stock Exchange). The transaction will be conducted in a secondary market and in a capital market. Back to Assignment Attempts Attempt1 score is 3

Attempt 2 was not attempted. - Attempt 3 was not attempted. - Keep the Highest 3 out of 3 3 / 3 4. The forms and methods of stock market operation In the United States, stock markets support several types of trading activity. Which of the following transactions falls into these supported types of activities? They facilitate the purchase and sale of short-term debt securities (e.g., notes and bonds).

They facilitate the sale of shares so that a company can go public. Points: 1 / 1 United States stock markets support three types of trading activity: Trading in the outstanding, previously issued shares of established, publicly owned companies—that is, they facilitate trading for secondary market (purchase and sale) transactions Trading in the additional shares sold by established, publicly owned companies—that is, they facilitate trading in primary market (sale) transactions Trading in the shares of privately held firms engaging in an initial public offering (IPO)—that is, they facilitate the sale of shares for firms going public

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In the United States, the stock markets do not support trades in options, debt securities (e.g., notes or bonds), or commodities (e.g., oil, gold, silver, etc.). On the New York Stock Exchange (NYSE), if investor demand for a stock outweighed its supply, the designated market marker (DMM) would sell shares from his/her inventory of shares. Before he or she begins selling shares, what would likely happen to the DMM’s ask price for the stock? It would not be affected It would increase It would decrease Points: 1 / 1 Here, demand is greater than supply. When demand is greater than supply, the price should increase, since that will decrease the number of shares demanded by investors. Therefore, the DMM’s asked price

should increase. The ask price is the price at which the DMM will sell shares, and the bid price is the price at which he or she will buy shares. True or False: One of the major differences between the New York Stock Exchange (NYSE) and the over-the-counter (OTC) markets is that in the NYSE, designated market markers make markets and floor brokers act as agents for their customers, while in the OTC, dealers make markets and brokers act as agents for their customers. True False Points: 1 / 1 In the New York Stock Exchange (NYSE), three types of trading licenses (permits) are sold: designated market makers (DMMs), floor brokers, and supplemental liquidity providers. DMMs are given the responsibility of ensuring that the market for a company’s shares are active, orderly, and fair. To accomplish this, specialists maintain an inventory of the firm’s shares and quote buy and sell prices (and complete buy and sell transactions) to keep the supply and demand for the shares in balance. In contrast, NYSE floor brokers act as agents for the investors that want to buy and sell the firm’s shares.

In the OTC market, on the other hand, dealers maintain the inventory of the listed firm’s shares and make the markets from which brokers execute the buy and sell orders of their customers. 5. The investment banking process When a firm needs to raise funds in the financial markets, it usually uses the services of an investment banker. First, it must make some initial decisions regarding how much capital it needs, what kind of securities to issue, and whether to accept competitive bids or negotiate a price privately. Then it is time for the firm to select an underwriter and begin the issuing process. However, the competitive bid agreements between underwriters and issuing firms can take a couple of different forms. In some cases, an investment bank agrees to arrange the sale of the issuing firm’s securities and does its best to sell all shares but makes no guarantees to that effect. This is an example of:

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A best-efforts arrangement An underwritten arrangement Points: 1 / 1 In the event that an issuer elects to use a best-efforts arrangement, who bears all the risk that the stock issue might be undersubscribed? In other words, who is at risk if the investment bank cannot sell all shares to investors at the time of issue? The issuing firm Points: 1 / 1 In a best-efforts arrangement, the investment bank tries its best to sell all shares, but it does not guarantee that they will all be sold. In an underwritten arrangement, the investment bank guarantees that all shares will be sold by first buying the securities from the issuer and then agreeing to bear any risks involved in the transaction. In the event that the issuing firm and its investment bank agree to use a best-efforts arrangement, the issuing firm incurs the risk of loss in the event that the issue is undersubscribed (that is, the entire issue is

not sold to the public). In this case, the issuing firm will not garner as much money as they would have received had the issue been fully subscribed (sold out). Because of the magnitude of the potential losses that may be incurred by an investment bank participating in the sale of a large underwritten security issue, it is customary for a group of banks to create an underwriting syndicate to reduce the risk exposure of each participating bank. The investment bank that organizes and leads the syndicate is called the managing underwriter . Points: 1 / 1 The investment bank that sets up the deal and organizes and manages an issue’s underwriting syndicate is called the lead or managing underwriter . When issues are really large, the underwriting syndicate may allow additional investment banks to participate in the sale by making them members of a selling group . The selling group, which includes all members of the underwriting syndicate plus additional dealers who accept relatively small participations (shares of the total issue) from the syndicate members, sells the securities to individual investors. Members of the selling group act as selling agents and receive commissions for their efforts.

Terms The income statement reports this value, which is calculated by dividing the firm’s earnings available to common shareholders by the number of common shares outstanding. Many people consider this to be one of the most important numbers in this statement. Earnings per share This document, issued once a year, provides a thorough reporting of the firm’s activities during the previous year and its prospects for the future, including both quantitative and descriptive information. Annual report This statement can be created using either of two methods: the direct or the indirect methods. The indirect method requires the use of some information from the period’s income statement and the comparison of the balances between two balance sheets. Statement of cash flows This type of cash inflow or outflow results from the production, sale, and delivery of the firm’s goods and services as well as collecting customer payments, and is reported in the statement of cash flows. Operating cash flows This statement is said to report an “accumulation of the firm’s earnings” from the beginning of the firm’s life (since it represents the year-to-year accumulation of the firm’s profits (and losses). Statement of retained earnings market a central meeting place for buyers and sellers to gather (examples: Ebay, Craigslist, car dealerships)

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securities "paper" claims on physical assets that are traded in financial markets derivative securities securities where the underlying asset is another security- the underlying may be a stock or bond (the underlying of an option is common stock, the underlying of a credit default swap is a bond or mortgage) financial assets -stocks and bonds - currencies real assets include such tangible properties as real estate, airplanes, machinery, or lumber stands- these assets normally are helped by operating companies, such as real estate developers, airplane leasing companies, manufacturers, or loggers risk sharing contracts - contracts and derivatives

primary market where investors buy securities directly from the source (example: buying stock directly from the company during an IPO or SEO, or bonds directly from the borrower (company or government)) secondary markets the place where already issued securities are traded (example: stock exchanges) money markets trading short-term debt (less than 1 year); low risk, low return; traded by corporations and banks; no "central exchange" money market accounts When you have money in a savings account, CDs, or in a brokerage accounts, they are often referred to as ____ _____ _____ because the bank/broker invests your money in short money market funds to give you a small interest rate on your money. capital market securities provide capital to a demander of funds (used to purchase capital assets such as buildings, equipment, or machinery); bonds, stocks/equities, mortgages and mortgage backed securities

bond markets long-term debt securities issued by a treasury, government, or corporation to finance their operations; same thing as debt or loans; initially placed using an investment bank primary The ______ market for bonds is usually the investment bank that does the underwriting for the corporation, government, or municipality- institutions will purchase bonds directly from the investment bank. secondary The ______ market for bonds is usually a "dealer" market- there is no central meeting place- if you want to buy a bond, you contact your broker, who finds another agent who is willing to sell a bond. stocks and equities partial ownership in a corporation primary The _____ market for stocks and equities is IPOs and SEOs.

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secondary The ______ market for stocks and equities is NYSE, NASDAQ, BATS, etc. derivative markets the main investors who trade derivatives are either managing their risk or speculating (example: credit default swaps can provide insurance on a bond or it can be used to speculate if a bond is going to crash) contract an agreement among traders to do something in the future forward contract an agreement to trade the underlying asset in the future at a price agreed upon today; often used to reduce risk futures contract standardized forward contract in which a clearinghouse guarantees the performance of all traders buyer seller

The ____ of a futures contract is the side that takes the physical delivery (or its cash equivalent). The ____ of a futures contract is the side that is liable for delivery (or its cash equivalent). clearing house an organization that ensures that no trader is harmed if another trader fails to honor the contract swap contract an agreement to exchange payments for period cash flows- includes two agents swapping their interest rates- may occur with commodities, currencies, and equities option contract allows the holder (purchaser) of the option to buy or sell (depending on the type of option) at or before a specified date in the future call put Holders of a ___ option can buy the underlying instrument at the exercise price. Holders of a ___ option can sell the underlying instrument at the exercise price. insurance contract

pay beneficiaries a cash benefit if some event occurs- life, liability, and automobile are examples sold to retail clients- usually used to compensate for losses if bad things happen unexpectedly credit default swaps insurance contracts that promise payment of principle in the event that a company defaults on its bonds- used to convert risk bonds into more secure investments commodities include precious metals, energy products, agriculture products, and oil immediate future Commodity markets trade commodities for ______ delivery whereas the forward and future markets trade commodities for ____ delivery. directly indirectly Many investors have been adding real assets to their portfolios: - _____ (they own the assets)

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- ______ (they have shares in a trusts that owns the asset) credit risk If an investment is risky, then investors will require higher interest rates as compensation for holding the risky security- investors prefer riskless securities, however if the interest rate is high enough, they will purchase securities that have higher rates liquid Investors prefer _____ investments- they like to be able to assume a position easily (easy to buy, easy to sell). compensation Illiquid bonds must give the investors some sort of _______ to convince them to purchase the bond. after-tax interest rate Investors aren't necessarily interested in the yield that is quoted, but instead they are interested in the _______ ____ ___. yield after tax = yield before tax * (1 - tax rate)

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taxable equivalent = yield after tax / (1 - tax rate) pure expectations theory according to this theory, the term structure of interest rates is determined solely by expectations of interest rates increases If the market expects interest rates to rise, the yield curve ______. decrease If the market expects the interest rates to fall, the yield curve will ______. liquidity premium theory some investors may prefer to own short-term rather than long-term securities because shorter maturity represents greater liquidity- in this case, they may be willing to hold long-term securities only is they are compensated for the lower liquidity segmented markets theory

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according to this theory, investors and borrowers choose securities with maturities that satisfy their forecasted cash needs long Pension funds and life insurance companies may generally prefer ____-term investments that coincide with their long-term liabilities. short Commercial banks may prefer more ____- term investments to coincide with their short-term liabilities. segmented Short-term and long-term markets are ______ and the yields will operate independently. wander Although there may be preferred habitats for investors and borrowers, certain market conditions may allow for a market participant to "______" from their preferred security to a new one (example: a commercial bank may normally issue short-term interest rates, but if they expect rates to fall in the near term, they may issue longer term maturities). central bank

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Crashes during the late 1800s and early 1900s in the United States motivated congress to establish a _____ _____. Federal Reserve Act In 1913, the _____ _____ ___ was implemented, which established reserve requirements for the commercial banks that chose to become members. 12 centralized The Federal Reserve system is separated into __ districts- in each district there is a district bank located in a city within the district- historically, district banks could control monetary policy within the district, but today monetary policy is _____ among banks. district banks _____ ____ facilitate check clearing, replace old currency, and provide loans to depository institutions in need of funds- they also collect economic data and conduct research projects on banking and economic trends. member banks Commercial banks can elect to become ____ ____ if they meet specific requirements- all national banks are required to be members of the Fed, but other banks chartered by states are not required. 35

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Currently, about ___% of all banks are members, which account for about 70% of all bank deposits. Board of Governors made up of seven individual members with offices in Washington DC- each member is appointed by the President of the United States and serves a nonrenewable 14-year term which should help the board avoid political influence and develop policies for the US economy over the long run (1 term expires every even-numbered year)- 1 of the 7 members if selected by the president to be the Federal Reserve Chairman for a 4 year term (which may be renewed); helps set credit controls (such as initial margin for purchasing securities) and reserve requirements (amount banks must keep of deposits) Paul Vockler Alan Greenspan Ben Bernake Janet Yellen Federal Reserve Chairmen: - ____ ______: 1979-1987 - ____ ______: 1987-2006 - _____ _____: 2006-2014 - _____ _____: 2014-present Federal Open Market Committee

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made up of 7 members of the Board of Governors, 5 presidents of Fed district banks (New York + 4 others of the 11) which are determined on a rotating basis; influences markets through controlling interest rates (through the federal funds rate) which will turn economic conditions federal funds rate the rate in which member banks can loan to each other overnight, with no collateral loaning Some banks will have sudden influxes and withdrawals of funds, creating surpluses or shortages of money- _____ to other banks helps keep the system stable FOMC The ____ meets eight times a year- at each meeting, they set targets for growth and interest rates- prior to meeting members are sent a Beige Book which is a consolidated report of regional economic conditions of each of the 12 districts- one week before meeting participants receive analyses of the economy and economic forecasts FOMC meeting The _____ _____ is conducted in the boardroom of the Federal Reserve Building in Washington DC- the 7 members of the Governors, the 12 presidents of the Fed district banks, and staff members are in attendance; includes presentations about wages, prices, unemployment, GDP, forex rates, interest rates, etc.

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reduce Once the presentations are complete, each FOMC member has a chance to offer recommendations as to whether the federal funds rate target should be changed- generally, evidence that the economy is weakening may result in recommendations that the Fed _____ the federal funds rate to stimulate the economy. 0 0.25 In December 2008, the Fed set the targeted federal funds rate in the form of a range between __ and ___ percent. statement Following the FOMC meeting, the committee provides a _______ that summarizes its conclusion- important so the committee also votes before it is distributed Trading Desk When the FOMC determines that a change in monetary police is appropriate, the decision is forwarded to the _____ ____ at the New York Federal Reserve District Bank who will buy and sell securities through primary dealers to influence interest rates (often temporary actions)- the fed will buy securities temporarily and then sell them back later (a repurchase agreement), alternatively, the fed may sell securities, and then by them back (reverse repo) secondary

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When the Trading Desk is instructed to lower the fed funds rate the Fed purchases Treasury Securities in the _____ market- the desk calls major securities dealers to obtain a list of securities for sale including the ask quote, buys securities that are the most attractive- buying securities injects cash into the system and the Trading Desk continues to buy until there is enough cash to decrease the Fed funds rate to the desired level. raise If the Trading Desk wants to ____ interest rates the fed will sell securities to the major brokers- the fed contacts major dealers and asks for the highest bids that the institutions are willing to pay for government securities and then the fed will sell securities to those institutions; if brokers buy securities, this will decrease the total amount of cash, if there is less cash in the economy, banks will charge higher rates on their loans, the reduced supply puts upward pressure on the federal funds rate; "tightening the money supply" reserve requirement ratio Depository institutions are subject to a ____ _____ ___- the proportion of deposit accounts that must be held as reserves. 8 12 10 The reserve requirement ratio is generally between __ and __ percent- currently it is __ percent. reserve requirement The _____ _____ is considered a monetary policy tool, since it can impact the amount of money supply in the economy.

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discount window The fed has traditionally provided short-term loans to depository institutions through its ____ ____. loan rate Before 2003, the Fed set its ___ ___ (called the "discount rate" at low levels when it wanted to encourage banks to borrow, since this increased the amount of funds injected into the financial system. primary credit lending rate Since 2003, the Fed's rate on short-term loans to depository institutions has been called the _____ ____ ____ ___, which is set slightly above the federal funds rate- depository institutions therefore rely on the Fed only as a backup for loans, since they should be able to obtain short-term loans from other institutions. liquidity The Fed's lending facility can be an important source for _____, but no longer used to control the money supply. mortgage backed securities During the crisis, ____ ____ ____ were considered "toxic" assets- due to high levels of default, nobody knew the true value of the assets and the prices began to plummet- many institutions held these assets (ranked AAA).

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reduction During the crisis, the Fed purchased a large amount of outstanding mortgage backed securities- the strategy was to offset the _______ in the market demand for these securities due to investor fears (partly triggered by the failure of Lehman Brothers which suffered serious losses in its investments in mortgages and mortgage-backed securities). commercial paper During the financial crisis the Fed purchased a large amount of _____ ____ which it normally did not purchase, but this strategy was implemented to offset the reduction in the market demand due to investor fears of defaults (partly triggered by the failure of Lehman Brothers, which caused Lehman to default on the commercial paper it previously issued. treasury notes bonds In 2010, the Fed purchased a large amount of long-term ____ ____ and ____ which was different from normal open market operations that focused on purchasing short-term borrowing rates- the Fed was attempting to reduce long-term interest rates to encourage more long-term borrowing by corporations for capital expenditures and more long-term borrowing for individuals to purchase homes .

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