Finance and Money Markets Quiz
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Questions and Answers

What amount will be saved annually if an investment of $2,000 is made for ten years at an interest rate of 7 percent?

  • $20,000
  • $30,000
  • $14,000
  • $22,210 (correct)

Which of the following is a characteristic of money market instruments?

  • They are generally sold in large denominations. (correct)
  • They must have an original maturity of more than one year.
  • They are generally sold in small denominations.
  • They have a high default risk.

What type of financial securities do money markets trade?

  • Debt securities with less than one year maturity (correct)
  • Real estate assets
  • Long-term bonds
  • Equity instruments

Which of the following participants is typically involved in money markets?

<p>Institutional investors and corporations (B)</p> Signup and view all the answers

What is the primary purpose of Treasury securities in the money market?

<p>To fund government operations (C)</p> Signup and view all the answers

How long must the maturity of a money market instrument be?

<p>Less than one year (C)</p> Signup and view all the answers

Which type of markets would you categorize instruments with a maturity of more than one year?

<p>Capital markets (D)</p> Signup and view all the answers

How do changes in interest rates primarily affect individuals, businesses, and governments?

<p>They influence investment decisions and savings. (B)</p> Signup and view all the answers

What does the term 'supply of loanable funds' refer to in financial markets?

<p>Funds provided by net suppliers to the financial markets. (B)</p> Signup and view all the answers

According to the loanable funds theory, how does the quantity of loanable funds supplied change as interest rates rise?

<p>It increases as the reward for supplying funds becomes higher. (B)</p> Signup and view all the answers

Who contributes to the supply of loanable funds in the financial markets?

<p>Households, businesses, governments, and foreign investors. (A)</p> Signup and view all the answers

What is the effect of interest rates on the present value of future cash flows?

<p>Higher interest rates decrease the present value of future cash flows. (D)</p> Signup and view all the answers

Which aspect does not influence the determination of interest rates in the financial market?

<p>Government regulations on savings accounts. (C)</p> Signup and view all the answers

What key factor is primarily driven by the loanable funds theory?

<p>Equilibrium interest rates based on supply and demand. (C)</p> Signup and view all the answers

Why do individual investments exhibit different interest rates?

<p>Different investments have varying levels of risk and return expectations. (A)</p> Signup and view all the answers

What is the main difference between Treasury Notes and TIPS?

<p>TIPS adjust principal based on inflation metrics. (C)</p> Signup and view all the answers

How frequently do TIPS pay interest to investors?

<p>Twice a year (B)</p> Signup and view all the answers

What happens to the principal value of a TIPS bond during periods of inflation?

<p>It increases based on the CPI. (D)</p> Signup and view all the answers

What is a characteristic of STRIPS?

<p>They separate coupon payments from the final principal payment. (B)</p> Signup and view all the answers

What is accrued interest when purchasing T-notes or T-bonds between coupon payments?

<p>The interest accrued from the last coupon payment to the settlement day. (B)</p> Signup and view all the answers

Who typically sells STRIPS to investors?

<p>Secondary market dealers. (B)</p> Signup and view all the answers

What is the primary purpose of investing in TIPS?

<p>To maintain purchasing power against inflation. (B)</p> Signup and view all the answers

Which of the following is true about the interest payments of TIPS?

<p>They are based on the inflation-adjusted principal value. (C)</p> Signup and view all the answers

What is the minimum denomination for publicly traded corporate bonds?

<p>$1,000 (A)</p> Signup and view all the answers

How often do coupon-paying corporate bonds generally pay interest?

<p>Semiannually (A)</p> Signup and view all the answers

What is a bond indenture?

<p>A legal contract outlining rights and obligations of bond parties (B)</p> Signup and view all the answers

Which type of bonds have their coupons detached for payment?

<p>Bearer bonds (A)</p> Signup and view all the answers

What distinguishes debentures from mortgage bonds?

<p>Debentures are unsecured and backed only by general creditworthiness (D)</p> Signup and view all the answers

Which statement about subordinated debentures is correct?

<p>They have junior rights compared to mortgage bonds (A)</p> Signup and view all the answers

What do bond covenants typically include?

<p>Rules and restrictions on issuers and bondholders (A)</p> Signup and view all the answers

What characterizes term bonds?

<p>They mature in a single date (B)</p> Signup and view all the answers

What does future value refer to in an investment context?

<p>The total amount received at the end of an investment period from an initial investment. (B)</p> Signup and view all the answers

How does an increase in interest rates affect future value?

<p>It increases the future value of an investment. (B)</p> Signup and view all the answers

When calculating present value, which of the following factors is essential?

<p>The time period until the cash flow is received. (C)</p> Signup and view all the answers

If you have an investment that will pay $10,000 in six years, what is being calculated to find out its worth today?

<p>Present value. (A)</p> Signup and view all the answers

How would you calculate the present value of $5,000 received in five years at a 10% interest rate compounded annually?

<p>Divide $5,000 by $(1 + 0.10)^5$. (B)</p> Signup and view all the answers

What is the result of compounding interest semiannually instead of annually?

<p>The investment grows at a faster rate. (B)</p> Signup and view all the answers

Which option correctly identifies a variable necessary for calculating future value?

<p>Initial investment amount. (C)</p> Signup and view all the answers

What is the purpose of calculating the present value of future cash flows?

<p>To determine how much future cash flows are worth today. (B)</p> Signup and view all the answers

What rating is considered the highest credit quality according to rating agencies?

<p>Aaa (B)</p> Signup and view all the answers

Bonds rated below Baa by Moody’s and BBB by S&P are classified as what type of bonds?

<p>Speculative grade bonds (C)</p> Signup and view all the answers

Which of the following ratings indicates a medium grade with moderate default risk?

<p>Baa1 (B)</p> Signup and view all the answers

Which rating represents a company with very speculative bonds?

<p>Ba1 (C)</p> Signup and view all the answers

What does the rating 'B2' indicate about a bond's investment characteristics?

<p>It lacks outstanding investment characteristics. (C)</p> Signup and view all the answers

What is another term for bonds rated below Baa by Moody's and BBB by S&P?

<p>Speculative grade bonds (C)</p> Signup and view all the answers

Which rating indicates an upper medium grade but may have a possible impairment in the future?

<p>A2 (B)</p> Signup and view all the answers

What rating range includes the lowest credit quality and highest default risk?

<p>B1 to B3 (A)</p> Signup and view all the answers

Flashcards

Loanable Funds Theory

The loanable funds theory explains interest rates, suggesting they are determined by the balance of available funds (supply) and demand for them.

Determinants of Interest Rates

Factors that influence the amount of money people and businesses are willing to lend.

Supply of Loanable Funds

The amount of money supplied to financial markets by lenders, like households, businesses, and governments.

Supply of Loanable Funds and Interest Rates

The quantity of loanable funds available for lending tends to increase as the interest rates rise.

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Demand for Loanable Funds

The amount of money that borrowers want to obtain from lenders.

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Determinants of Demand for Loanable Funds

Factors that influence the amount of money that businesses and individuals want to borrow.

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Equilibrium Interest Rate

The interest rate at which the supply of loanable funds equals the demand for loanable funds.

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Impact of Interest Rates

Changes in interest rates have a significant impact on the decisions and performance of individuals, businesses, and governments.

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Present Value

The value of a future cashflow in today's dollars. It considers the time value of money and the interest rate.

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Future Value

The value of a present cashflow at a future point in time, including interest and compounding.

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Discounting

A process of calculating the present value of a future cash flow using a specific discount rate. Higher interest rates mean lower present values.

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Interest Rate

A rate used in financial calculations to represent the time value of money. It reflects the opportunity cost of investing and the potential for returns.

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Compounding Frequency

The frequency at which interest is calculated and added to the principal. More compounding periods lead to faster growth.

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Compound Interest

A method of calculating interest on both the principal and accumulated interest. It leads to exponential growth over time.

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Bond

A security that promises fixed payments to the holder over a period of time and pays a lump sum at maturity. Often used in calculating present value.

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Present Value Calculation

The process of determining how much needs to be invested today, considering future value and the discount rate, to achieve a desired future amount.

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Money Market

A market that trades debt securities with maturities of less than one year.

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Treasury Securities Issuance

The process of issuing new Treasury securities, including auctions and the issuance of securities directly to dealers.

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Money Market Securities

Securities traded in money markets with maturities of one year or less, issued by governments, corporations, and financial institutions.

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Money Market Participants

Financial institutions, corporations, and governments that borrow and lend money in the money market.

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Bond Market Securities

Debt instruments with maturities of more than one year, including corporate bonds, government bonds, and municipal bonds.

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Capital Market

The market where long-term debt and equity securities are traded.

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Annuity

A series of equal payments made at regular intervals over a period of time.

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Treasury Inflation-Protected Securities (TIPS)

Treasury securities where the principal value adjusts based on inflation rates, ensuring the investor keeps up with the rising cost of living.

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Fixed-Principal Bonds

A type of Treasury security where the principal value remains fixed throughout the bond's life.

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Consumer Price Index (CPI)

A measure of the average change in prices paid by urban consumers for a basket of consumer goods and services, used to calculate inflation.

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Accrued Interest

Interest payments made on Treasury notes or bonds when purchased between coupon payment dates.

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STRIPS

A Treasury security where the periodic coupon payments are separated from the principal payment, creating individual securities.

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Semi-annual Interest Payments

Interest payments made on Treasury notes or bonds twice a year.

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Principal Payment

The final payment made to the bondholder, representing the original principal amount plus any accrued interest.

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Rate of Return

The rate of return investors expect to earn on their investment over time.

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Bond Rating System

A bond rating system used by credit rating agencies like Moody's, S&P, and Fitch to assess the creditworthiness of bond issuers based on their likelihood of defaulting on their debt obligations.

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Triple-A (Aaa/AAA) Rating

The highest credit rating assigned by credit rating agencies; signifies the lowest risk of default and highest quality.

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Speculative Grade Bonds (Junk Bonds)

Bonds with ratings below Baa (Moody's) or BBB (S&P and Fitch); considered speculative due to higher risk of default and potential lower returns.

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Credit Rating Agencies

Credit rating agencies that evaluate the creditworthiness of bond issuers and assign ratings to reflect their perceived risk of default.

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Issuer Default Risk

The perceived probability of a bond issuer defaulting on its debt obligations.

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Bond Rating

The assignment of a specific letter grade to a bond based on its perceived riskiness and the likelihood of timely repayment.

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High-Yield Bonds

Bonds that offer relatively high potential returns but carry higher risk compared to investment-grade bonds, often due to a lower credit rating.

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Bond Rating Process

The process of evaluating and assigning credit ratings to bond issuers based on their financial health, industry outlook, and other factors.

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Minimum denomination for corporate bonds

The minimum amount of money required to purchase a corporate bond in the public market.

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Frequency of corporate bond interest payments

Interest payments on corporate bonds are typically made twice a year.

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Challenges in evaluating municipal bond issuers

Assessing the financial health of municipal bond issuers, especially smaller entities, can be expensive and time-consuming.

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How bond rating agencies help municipal bonds

Bond rating agencies play a crucial role in reducing the cost of evaluating municipal bond issuers by providing independent assessments of their creditworthiness.

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What is a bond indenture?

A legal agreement outlining the rights and responsibilities of both the bond issuer and the bondholders.

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Bond covenants

Specific rules and restrictions outlined in a bond indenture that apply to both the bond issuer and the bondholders.

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Debenture bonds

Bonds that are backed solely by the issuing company's overall financial strength, without any specific assets as collateral.

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Subordinated debentures

Bonds that are unsecured and have lower claim priority compared to mortgage bonds and regular debentures.

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Study Notes

Financial Markets and Institutions

  • Learning Goals: Differentiate between primary and secondary markets, money and capital markets, foreign exchange markets, and derivative security markets. Understand types of financial institutions, their services, associated risks, and regulatory frameworks.

Why Study Financial Markets?

  • Markets and institutions play a crucial role in capital allocation.
  • Managers and investors need to understand money flow, domestic and international financial market operations, and structures for sound decisions.

Primary vs. Secondary Markets

  • Primary Markets: Corporations raise funds through new financial instruments like stocks and bonds (Initial Public Offerings - IPOs).
  • Secondary Markets: Existing financial instruments are traded after initial issuance, providing liquidity, pricing information, and low transaction costs.

Primary and Secondary Market Transfer of Funds Timeline

  • Funds flow from investors to corporations via underwriting by investment banks.
  • Securities are then traded in the secondary markets.

How were primary markets affected by the financial crisis?

  • Primary market sales dropped significantly in 2008.
  • Recovery in primary markets has not yet occurred by 2018.

Money vs. Capital Markets

  • Money Markets: Short-term debt securities and instruments with maturities of one year or less are traded. Lower risk and price fluctuations.
  • Capital Markets: Debt (bonds) and equity (stocks) with maturities over one year are traded. Larger price fluctuations.

Foreign Exchange Markets

  • The global market for exchanging currencies.
  • Foreign exchange risk is the sensitivity of cash flows on foreign investments to currency fluctuations.

Derivative Security Markets

  • Derivative securities link their payoff to other previously established securities (futures, options, swaps).
  • Traded in derivative security markets.
  • Can be the riskiest type of securities.

Financial Market Regulation

  • Agencies like the Capital Market Authority (CMA) ensure fair and full disclosure of information to investors.
  • CMA monitors trading on major exchanges to prevent insider trading.

Overview of Financial Institutions

  • Types: Commercial banks, thrifts, insurance companies, securities firms, investment banks, finance companies, investment funds, pension funds, and FinTechs.
  • Services: Functions include transferring funds from surplus to deficit entities, monitoring costs, managing liquidity and price risk, facilitating transactions, maturity intermediation.
  • Risks: Default, foreign exchange and country risk, interest rate risk, market/asset price risk, off-balance sheet risk, liquidity risk, technology and operational risk, and insolvency risk.

Benefits and Functions of Financial Institutions

  • To Suppliers of Funds: Lower monitoring costs, higher liquidity and lower price risk, cost-efficient transactions, and maturity intermediation.
  • To the Economy: Money supply transmission, credit allocation, facilitate inter-generational wealth transfers, and payment services.

Regulation of Financial Institutions

  • Failures lead to widespread panic and withdrawal runs in institutions like the 2008 crisis.
  • Regulation prevents market failures and controls associated economic and societal costs.

Fintechs

  • Utilize technology to provide financial services, including cryptocurrencies and blockchain.
  • Fintech risk stems from disrupting established financial service businesses.
  • Supports peer-to-peer mass collaboration models.

Appendix 1A - The Financial Crisis: The Failure of Fls

  • Dropping home prices in 2006-2007 led to subprime mortgage defaults.
  • Significant losses occurred in financial institutions (FIs).
  • Losses exceeded $400 billion globally.

Chapter Two: Determinants of Interest Rates

  • Learning Goals: Understand suppliers and demanders of loanable funds, interest rate determination, shifts in the supply and demand curves, different rates on securities, and time value of money applications.
  • Nominal Interest Rates: Directly impact the value of money and capital market securities.

Loanable Funds Theory

  • Explains interest rates as the result of the supply and demand for loanable funds.
  • Participants are categorized as suppliers or demanders (consumers, businesses, governments, and foreign entities).

Supply and Demand for Loanable Funds

  • Supply: Increases as interest rates rise.
  • Demand: Increases as interest rates fall.
  • Shifts affected by factors like wealth, risk, spending needs, and economic conditions.

Determinants of Interest Rates for Individual Securities:

  • Inflation: Higher inflation leads to higher interest rates.
  • Liquidity Risk: Higher liquidity risk leads to higher interest rates.
  • Default Risk: Higher default risk leads to higher interest rates.
  • Special Provisions/Covenants: May lead to higher or lower interest rates, depending on the terms.
  • Term to Maturity: Longer-term securities usually have higher rates.

Time Value of Money

  • A dollar today is worth more than a dollar in the future.
  • Present value calculations discount future values to reflect this time value.
  • Future value calculations compound present values to account for future returns.

Bond Markets

  • Identify major bond markets.
  • Identify characteristics of bond market securities (Treasury notes, bonds, municipal bonds, corporate bonds, TIPS).
  • Identify major participants in bond markets.
  • Discuss international bond markets.

Secondary Market Trading in T-Notes and T-Bonds

  • U.S. Treasury sells T-notes and T-bonds through competitive and non-competitive Treasury auctions.
  • Secondary trading occurs directly through brokers and dealers.

Bond Ratings and Interest Rate Spreads

  • Major agencies (Moody's, Standard & Poor's, Fitch) rate bonds based on default risk.
  • Higher ratings reflect lower perceived default risk.

International Aspects of Bond Markets

  • Eurobonds: Issued outside the issuing country's currency.
  • Foreign bonds: Issued by foreign entities, typically in the currency of the host country.
  • Sovereign bonds: Government-issued, denominated in a strong foreign currency.

Bond Market in KSA

  • Sukuk and bonds can be traded through brokers, or over-the-counter.

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Description

This quiz tests your understanding of key concepts related to finance and money markets. You'll answer questions about investment amounts, money market instruments, interest rates, and the loanable funds theory. Deepen your knowledge of financial markets and their characteristics.

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