Finance: Direct vs Indirect Concepts

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Questions and Answers

What is the primary form of equity securities?

Mortgages

Common stock (correct)

Derivatives

Bonds

What defines debt markets?

Contractual agreements requiring fixed payments to security holders (correct)

A market for trading ownership of assets

Claims to shares in a company’s net income

An obligation to pay a proportion of dividends

Who receives payments first when a company distributes earnings?

Residual claimants

Equity holders

Debt holders (correct)

Dividends receivers

What characterizes equity payments compared to debt payments?

Equity payments may increase with profitability Signup and view all the answers

How did equity holdings change during the 2001 recession?

Declined significantly Signup and view all the answers

Which of the following best describes residual claimants?

Equity holders who receive payments after debt obligations Signup and view all the answers

What was the trend in equity and debt holdings for US households during the stock boom from 2003-2007?

Equity holdings increased substantially Signup and view all the answers

Which event led to a shift from equity to debt holdings in 2008?

A significant decline in stock value Signup and view all the answers

What is direct finance primarily characterized by?

Borrowers obtaining loans directly from lenders through securities Signup and view all the answers

Which of the following is an example of indirect finance?

Mortgage loans from banks Signup and view all the answers

Why are financial institutions deemed essential for economic efficiency?

They create profitable investment opportunities enabling better fund usage Signup and view all the answers

What challenge do lenders/savers face without financial markets?

Difficulty in finding profitable investment opportunities Signup and view all the answers

How do security sales affect wealth creation in financial markets?

By enabling sellers to access funds for profitable investments Signup and view all the answers

Which of these best describes the role of financial intermediaries?

They bridge the gap between borrowers and lenders, minimizing transaction costs. Signup and view all the answers

What is a common characteristic of debt in finance?

It must be repaid with interest following a set timeline. Signup and view all the answers

How does the lack of financial markets influence funds held by individuals?

Excess funds often remain idle until investment opportunities arise. Signup and view all the answers

What is the primary purpose of primary markets?

To sell new issues of a security to initial buyers Signup and view all the answers

Which of the following best describes secondary markets?

Markets for reselling previously issued securities Signup and view all the answers

How do secondary markets influence primary markets?

By helping to determine the pricing of securities Signup and view all the answers

Which type of transaction occurs in a primary market?

Selling a new corporate bond for the first time Signup and view all the answers

What role does the Federal Reserve play in secondary markets?

Buying and selling previously issued bonds Signup and view all the answers

Which of the following could NOT be considered a primary market transaction?

A secondary sale of stocks on the NYSE Signup and view all the answers

What is one of the main benefits of secondary markets for investors?

They increase the liquidity of securities Signup and view all the answers

Which of these is NOT a common type of secondary market?

Treasury bond auctions Signup and view all the answers

What is the primary role of an investment bank during an IPO?

To purchase the IPO at a guaranteed minimum price Signup and view all the answers

Which of the following major investment banks did NOT disappear in 2008?

Goldman Sachs Signup and view all the answers

How do dealers operate compared to brokers in the securities market?

Dealers buy and sell securities from their own portfolios Signup and view all the answers

What distinguishes exchanges from over-the-counter markets?

Exchanges are centralized locations for trading Signup and view all the answers

What is a key characteristic of over-the-counter markets?

They allow dealers to buy and sell from multiple locations Signup and view all the answers

What major change has been proposed regarding traditional exchanges?

To merge NYSE with Archipelago, an online trading firm Signup and view all the answers

What happens when an investment bank guarantees a minimum price for an IPO?

The bank takes on the risk of purchasing unsold shares Signup and view all the answers

What is the typical compensation structure for brokers in the securities market?

They earn commissions from the securities sold Signup and view all the answers

What is one of the main functions of the Federal Reserve?

Conducting monetary policy Signup and view all the answers

Which act emphasizes the dual mandate of the Federal Reserve?

The Full Employment and Stabilization Act of 1946 Signup and view all the answers

How does the structure of the Federal Reserve reflect federalism?

It has twelve regional banks spread throughout the country. Signup and view all the answers

What is one of the goals that the Federal Reserve strives to achieve?

Maintaining a stable rate of GDP growth Signup and view all the answers

Who selects the Board of Governors of the Federal Reserve?

The President of the United States Signup and view all the answers

What is the purpose of having staggered fourteen-year terms for the Fed's Governors?

To ensure continuous leadership and avoid abrupt shifts Signup and view all the answers

What primary tool does the Federal Reserve use to assure financial stability?

Conducting rigorous bank supervision Signup and view all the answers

Which statement best reflects the relationship between the Federal Reserve and Congress?

The Fed relies on Congress to delegate powers while maintaining some independence. Signup and view all the answers

Study Notes

Direct Finance

Direct finance involves borrowing directly from lenders by selling securities like stocks, bonds, or commercial paper.
Lenders may not always have productive uses for their funds but can find investment opportunities through financial markets.

Indirect Finance

Indirect finance uses financial intermediaries like banks or finance companies to connect borrowers and lenders.
Examples include commercial bank loans, mortgages, and insurance policies.

Debt vs Equity Markets

Debt markets include instruments like bonds and mortgages.
Debt involves a contractual agreement to pay holders of securities fixed payments until a specified date.
Debt markets can be short-term (less than a year), intermediate-term (1 to 10 years), or long-term (over 10 years).
Equity markets consist of claims to shares in the net income or assets of businesses.
Dividends: Periodic equity payments.
Common stock is the most common form of equity security.
Other equity instruments include preferred stock, options, futures, asset-backed securities, collateralized debt obligations, and credit default swaps.
Equity holders are considered residual claimants, as companies are legally obligated to pay debt holders first.
Debt payments are fixed, while equity payments may increase if the firm becomes more profitable.

Primary vs. Secondary Markets

Primary markets involve the sale of new securities to initial buyers.
Secondary markets involve the resale of previously issued securities.
Primary market examples include Treasury sales, corporate bond sales, commercial paper, and IPOs.
Secondary market examples include the New York Stock Exchange (NYSE), National Association of Securities Dealers (NASDAQ), bond markets, Fed open market operations, negotiable CDs, mortgages, commodities markets (e.g., Chicago Mercantile Exchange), futures markets, and options markets.
Secondary markets increase liquidity by making it easier to sell securities before maturity.

Dealers vs. Brokers

Dealers link buyers and sellers by purchasing and selling securities from their own portfolios at stated prices.
Brokers are agents of investors who match buyers and sellers of securities.
Dealers buy at the "bid price" and sell at the "asked price".
Brokers link buyers and sellers through exchanges or over-the-counter markets for a fee.
Investment banks historically performed most dealer and broker services, but commercial bank divisions are increasingly offering these services.

Exchanges vs. Over-the-Counter Markets

Exchanges are markets where buyers and sellers meet in one location.
Over-the-Counter Markets (OTC) involve dealers in different locations buying and selling to anyone willing to accept their prices.
Examples of exchanges include the New York Stock Exchange, the London Stock Exchange, and the Chicago Mercantile Exchange.
Examples of OTC markets include NASDAQ, Treasury bonds, negotiable CDs, federal funds, and foreign exchange.

Federal Reserve (Fed)

The Fed is the central bank of the United States, established in 1913.
Key functions include conducting monetary policy, supervision and regulation, assuring financial stability, and operating the nation’s payments system.
Goals: maintaining a stable rate of GDP growth, high employment, stable prices, and moderate long-term interest rates.
Structure: Twelve regional banks across the country, reflecting the concept of federalism.
The President appoints the Board of Governors, who have staggered, fourteen-year terms.
Member commercial banks purchase equity capital in regional Federal Reserve Banks, provide reserve funds, and help select the Board of Directors of their regional Federal Reserve Banks.

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Description

This quiz explores the differences between direct and indirect finance, as well as the characteristics of debt and equity markets. Participants will learn about borrowing methods, financial intermediaries, and the types of securities involved in these financial processes. Test your knowledge and understanding of these fundamental finance concepts.