Finance Chapter 1: Introduction

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Questions and Answers

What is the primary purpose of secondary markets?

To facilitate long-term investments

To provide liquidity for assets (correct)

To increase transaction costs

To guarantee asset appreciation

Which of the following best describes money markets?

Deal primarily with equity instruments

Involve transaction costs significantly higher than capital markets

Trade securities with maturities over one year

Trade debt securities with maturities of one year or less (correct)

What characteristic does the capital market have compared to the money market?

Narrower price fluctuations

Shorter investment horizons

Requires immediate cash transactions

Trading of equity and debt securities (correct)

What does foreign exchange risk refer to?

Sensitivity of foreign investment returns to currency value changes Signup and view all the answers

What are derivative securities linked to?

Previously issued financial securities Signup and view all the answers

Which statement about derivative markets is true?

They are considered potentially the riskiest security markets Signup and view all the answers

During what period did derivative activity experience significant growth?

1992-2013 Signup and view all the answers

Which of the following is NOT a type of derivative security?

Preferential stock Signup and view all the answers

What type of loans do commercial banks typically provide?

Consumer, commercial, and real estate loans Signup and view all the answers

What distinguishes the liabilities of commercial banks from those of other depository institutions?

They have more non-deposit sources of funds. Signup and view all the answers

How do thrifts primarily differ from commercial banks in their loan offerings?

They concentrate their loans in specific segments. Signup and view all the answers

What type of insurance do life insurance companies primarily provide protection against?

Adverse events like death or illness. Signup and view all the answers

How do finance companies primarily differ from depository institutions?

They rely on debt for funding rather than deposits. Signup and view all the answers

What is a primary function of securities firms and investment banks?

Helping firms issue securities and engaging in brokerage. Signup and view all the answers

What is a significant tax advantage of pension funds?

They provide tax deductions on contributions. Signup and view all the answers

Which statement describes FinTech institutions?

They utilize technology to deliver financial solutions. Signup and view all the answers

What was the purpose of the Troubled Asset Relief Program (TARP)?

To buy toxic mortgages and securities from financial institutions Signup and view all the answers

What amount did the Federal Reserve and central banks invest to unfreeze credit markets in September 2008?

$180 billion Signup and view all the answers

Which event contributed positively to the financial situation between September and December 2008?

Oil prices dropping below $40 Signup and view all the answers

Who was the Treasury Secretary that met with congressional leaders to devise the rescue plan?

Henry Paulson Signup and view all the answers

What approach did many banks take regarding delinquent mortgage loans during the period mentioned?

They restructured the loans rather than foreclose Signup and view all the answers

What is the main function of primary markets?

To raise funds through new issues of financial instruments. Signup and view all the answers

Which type of market involves trading financial instruments after they have been issued?

Secondary markets Signup and view all the answers

What are capital markets primarily used for?

Raising long-term funds. Signup and view all the answers

What distinguishes money markets from capital markets?

Type of financial instruments traded. Signup and view all the answers

Which statement accurately reflects the role of financial institutions?

They perform functions like capital allocation and risk management. Signup and view all the answers

Why are financial markets becoming increasingly global?

Investment and financing decisions are increasingly interconnected globally. Signup and view all the answers

What is the primary risk that financial institutions face?

Credit risk and market risk. Signup and view all the answers

Which of the following best describes derivative securities markets?

Markets that deal with financial instruments derived from other assets. Signup and view all the answers

What is one benefit of aggregating funds for small investors?

Reduces the cost of monitoring fund user actions Signup and view all the answers

Which risk is associated with fluctuations in currency value?

Foreign exchange risk Signup and view all the answers

Which of the following is not a function provided by financial intermediaries (FIs)?

Asset valuation Signup and view all the answers

What was one objective of the 2008 increase in the deposit cap to $250,000?

To instill confidence in the banking system Signup and view all the answers

Which of the following risks refers to the possibility of bank insolvency?

Insolvency risk Signup and view all the answers

How did the share of depository institutions in the U.S. change from 1948 to 2020?

Declined from 62.7% to 29.7% Signup and view all the answers

What type of risk do financial institutions face related to the value of their assets?

Market risk Signup and view all the answers

Which of the following correctly describes a role of financial intermediaries in liquidity?

They transform financial claims into more attractive options for investors Signup and view all the answers

Study Notes

Learning Goals

Differentiate primary markets (new securities issuance) from secondary markets (trading of existing securities).
Distinguish between money markets (debt instruments maturing in one year or less) and capital markets (debt and equity instruments maturing in more than one year).
Understand foreign exchange markets and the risks associated with currency fluctuations.
Recognize the variety of derivative security markets and their potential risk levels.
Identify different financial institutions and the services they provide, as well as the risks they encounter.
Comprehend the reasons for the regulation of financial institutions.
Acknowledge the global nature of financial markets.

Importance of Financial Markets and Institutions

Financial markets allocate capital, facilitating investments and funding decisions.
Understanding fund flows is essential for managers and investors in the economy.
Knowledge of both domestic and international market operations is crucial.

Primary Markets vs. Secondary Markets

Primary Markets: Corporations raise funds through new stock/bond issues, including Initial Public Offerings (IPOs).
Secondary Markets: Enable trading of previously issued financial instruments.
Secondary markets provide liquidity, price information, and low transaction costs.

Money Markets vs. Capital Markets

Money Markets: Focus on short-term debt securities (maturities ≤ 1 year), primarily over-the-counter (OTC).
Capital Markets: Involve long-term debt (bonds) and equity (stocks) with higher price volatility.

Foreign Exchange Markets

Foreign exchange risk influences the value of cash flows from foreign investments based on exchange rates.
The conversion of non-dollar cash flows into U.S. dollars is subject to currency rate changes.

Derivative Security Markets

Derivatives are financial securities with payoffs linked to other securities (e.g., futures, options).
Trading occurs in derivative markets, representing agreements between parties to exchange assets at predetermined future dates.
Significant growth in this market segment occurred from 1992 to 2013.

Types of Financial Institutions

Commercial Banks: Provide a wide range of loans (consumer, commercial, real estate); rely on non-deposit funding sources.
Thrifts: Focus on specific loan segments like real estate or consumer loans; include savings associations and credit unions.
Insurance Companies: Offer protection against financial losses; types include life and property casualty insurance.
Securities Firms and Investment Banks: Facilitate security issuance and trading.
Finance Companies: Provide loans without accepting deposits; fund through debt.
Investment Funds: Pool resources to invest in diversified portfolios.
Pension Funds: Accumulate savings for retirement, tax-exempt until withdrawal.
FinTechs: Utilize technology for financial services, competing with traditional methods.

Benefits and Functions of Financial Institutions

Reduce transaction costs for fund suppliers.
Facilitate maturity intermediation, allowing for different investment and loan timelines.
Support economic functions: monetary policy transmission, credit allocation, intergenerational wealth transfers, and payment services.

Risks Faced by Financial Institutions

Types of risks include default (credit), foreign exchange, interest rate, market (asset price), off-balance sheet, liquidity, technology/operational, and insolvency risks.

Regulation of Financial Institutions

Regulation is key to prevent market failures and associated economic costs.
Increased deposit insurance (2008) aimed to restore confidence in banking systems following financial crises.

Trends in U.S. Financial Institutions

A significant reduction in the share of depository institutions from 62.7% in 1948 to 29.7% by 2020.

Financial Crisis and Government Response

In September 2008, global financial markets were stabilized through a $180 billion investment to unfreeze credit.
The U.S. Treasury enacted TARP (Troubled Asset Relief Program) to manage "toxic" assets, allocating $700 billion for purchases from financial institutions.

Recent Positive Developments (2008)

Oil prices dropped below $40, benefiting consumers through lower gas prices.
Banks began restructuring delinquent loans to avoid foreclosure.
The Federal Reserve reduced target rates to stimulate the economy.

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Description

This quiz covers the foundational concepts of finance as introduced in Chapter 1. You will learn to differentiate between primary and secondary markets, understand the roles of money and capital markets, and explore foreign exchange and derivative security markets. Additionally, you'll distinguish various types of financial institutions and their services.