Finance Chapter 2: Money and Capital Markets

Questions and Answers

What is a key characteristic of money market securities?

They have high default risk.

They mature in one year or less. (correct)

They are traded in specific locations.

They are usually sold in small denominations.

Why do money markets play a crucial role in finance?

They provide long-term loans.

They fill short-term financial needs efficiently. (correct)

They restrict trading to individual investors.

They eliminate the need for banks.

What market characteristic makes money market instruments flexible?

They are sold at high transaction costs.

There is an active secondary market. (correct)

They have a low default risk.

They are traded exclusively by individual investors.

Who primarily participates in the money markets?

Dealers and brokers from banks and brokerage houses. Signup and view all the answers

What is the typical transaction size in money markets?

$1 million or more. Signup and view all the answers

Which of the following is NOT a reason why money markets are needed?

Individual investors can trade freely. Signup and view all the answers

Which of the following best describes the trading mechanism of money markets?

Purchases and sales are arranged electronically and via phone. Signup and view all the answers

What is one reason banks have an advantage in providing short-term loans?

They maintain ongoing relationships with customers. Signup and view all the answers

What is a major advantage of investing in Treasuries?

They are exempt from state and local taxes. Signup and view all the answers

What type of bonds are typically issued by state and local governments for public projects?

Municipal bonds Signup and view all the answers

Which type of municipal bond is secured by the issuer’s taxing power?

General obligation bonds Signup and view all the answers

What is a common risk associated with municipal bonds?

Local governments can go bankrupt. Signup and view all the answers

What are high-yield bonds also referred to as?

Junk bonds Signup and view all the answers

What must be considered when selling a tax-exempt bond fund at a profit?

Capital gains taxes Signup and view all the answers

Which type of bonds generally carries a higher risk than government bonds?

Corporate bonds Signup and view all the answers

Which type of corporate bond can be converted into stock under certain conditions?

Convertible bonds Signup and view all the answers

What is the primary market?

A market where the issuer of a security receives the proceeds from the sale. Signup and view all the answers

What defines an initial public offering (IPO)?

The first sale of a company's securities to the public. Signup and view all the answers

What is a characteristic of treasury securities?

They have maturity dates ranging from 30 days to 30 years. Signup and view all the answers

Why are secondary markets important for investors?

They boost the liquidity of previously issued securities. Signup and view all the answers

What primarily distinguishes organized exchanges from over-the-counter exchanges?

Organized exchanges have a physical location for trading. Signup and view all the answers

How do households typically interact with capital markets?

They deposit funds in financial institutions that purchase capital market instruments. Signup and view all the answers

What is the main role of exchange rules in organized exchanges?

To ensure efficient and legal operation. Signup and view all the answers

Which of these is NOT a type of capital market transaction?

Private equity investment. Signup and view all the answers

What is the maximum maturity period for commercial paper?

270 days Signup and view all the answers

Which type of T-bills are auctioned monthly?

364-day T-bills Signup and view all the answers

What is a primary characteristic of certificates of deposit (CDs)?

They earn specified returns over a definite period. Signup and view all the answers

What risk is associated with competitive bids when purchasing T-bills at auction?

The bills may not be made available at the bid price. Signup and view all the answers

What typically happens if funds are withdrawn from a certificate of deposit before maturity?

A penalty is incurred for early withdrawal. Signup and view all the answers

What typically characterizes the interest rates on commercial paper compared to bonds?

Lower than bonds due to shorter maturities. Signup and view all the answers

Why are only firms with excellent credit ratings able to sell their commercial paper at a reasonable price?

Due to a lack of collateral backing. Signup and view all the answers

How can T-bills be purchased aside from auctions?

Indirectly through the secondary market. Signup and view all the answers

What is a primary role of the banking industry in relation to saver-lenders and borrower-spenders?

To mediate the asymmetric information problem Signup and view all the answers

Which of the following is a characteristic of short-term securities offered in the money markets?

They have a distinct cost advantage over banks when asymmetric information is not severe Signup and view all the answers

What is a reason most investors choose to utilize money markets instead of keeping cash in banks?

To minimize the opportunity cost of holding idle cash Signup and view all the answers

What do investment advisers often keep in the money market?

Funds to act quickly on investment opportunities Signup and view all the answers

What makes Treasury bills (T-bills) distinct in the money market?

They are short-term notes issued by the Philippine government Signup and view all the answers

What is one disadvantage of holding excess cash for an investor?

It represents an opportunity cost in missed interest income Signup and view all the answers

What is a benefit of the well-developed secondary market for money market instruments?

It allows firms to warehouse surplus funds until needed Signup and view all the answers

Why are money markets considered a low-cost source of funds?

They are less regulated than the banking industry Signup and view all the answers

Study Notes

Money Markets

Money markets involve short-term, highly liquid securities, not actual currency transactions.
Characteristics: large denominations, low default risk, and maturities of one year or less; most instruments mature in under 120 days.
Transactions are conducted electronically and over the phone, leading to an active secondary market for securities.
Primarily wholesale markets, with transactions exceeding $1 million, limiting participation to institutional investors and banks.
Provide a means for investment firms and institutions to temporarily hold surplus funds, offering a better return than cash in banks.

Importance of Money Markets

Serve as a low-cost funding source for firms, government, and intermediaries needing short-term capital.
Help mitigate opportunity costs associated with holding idle cash by providing alternative investment returns.
Used by investment advisers for flexibility in capitalizing on market opportunities quickly.

Participants in Money Markets

Treasury Bills (T-bills):
- Issued by the government with maturities of 91, 182, and 364 days.
- Available directly through auctions or the secondary market.
Certificates of Deposit (CDs):
- Issued by banks against deposits, offering specified returns for fixed periods (30 days to several months).
- Early withdrawal incurs penalties; can be sold to other investors.
Commercial Paper:
- An unsecured promissory note from large corporations with maturities up to 270 days.
- Used for short-term obligations and primarily issued by firms with excellent credit ratings.

Capital Markets

Focus on long-term securities: stocks and bonds.
Trading occurs in primary markets (new issues) and secondary markets (resale of existing securities).
The primary market involves initial public offerings (IPOs) and direct sales where issuers receive proceeds.

Importance of Capital Markets

Enable companies to raise funds for capital investment and expansion.
Households are significant purchasers of capital market securities, primarily through deposits that finance bonds and stocks.

Types of Bonds in Capital Markets

Treasury Securities:
- Highest quality bonds issued by the government, with maturities from 30 days to 30 years; interest is exempt from state/local taxes.
Municipal Bonds (Munis):
- Issued by state and local governments for public projects; often tax-exempt but come with specific risks associated with local government finances.
- Two types: general obligation bonds (secured by taxing power) and revenue bonds (repaid from project revenues).
Corporate Bonds:
- Issued for funding large capital investments, tend to carry higher risk than government bonds, associated with higher yield.
- High-yield or "junk bonds" carry more risk due to the low credit quality of the issuer.

Trading Mechanisms

Capital markets have organized exchanges for trading, governed by rules for efficient operation, contrasting with the phone-based transactions of money markets.
Secondary markets for capital securities allow previous owners to sell before maturity, enhancing liquidity.

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Description

This quiz covers the key concepts and importance of the Money Market and Capital Market. Students will explore participants involved in these markets and learn through examples. Test your understanding of the definitions and functions of these crucial financial sectors.