Finance Quiz: Financial Instruments and Securities
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Questions and Answers

What is a primary feature of Certificate of Deposits (CDs)?

  • They are unsecured short-term loans.
  • They are primarily for large institutions with high credit ratings.
  • They usually have maturities from one day to five years. (correct)
  • They can only be issued by corporations, not banks.
  • Which characteristic distinguishes Negotiable Bank Certificates of Deposits (NCDs) from traditional CDs?

  • NCDs are issued only by commercial banks.
  • NCDs have longer maturities than standard CDs.
  • NCDs have a lower face value than traditional CDs.
  • NCDs can be traded in secondary markets. (correct)
  • What is the typical maturity period of Commercial Paper?

  • Six months
  • 30 days (correct)
  • Up to 90 days
  • One year
  • What is a defining feature of a banker’s acceptance?

    <p>It is guaranteed for payment by a commercial bank. (C)</p> Signup and view all the answers

    What is a characteristic of Eurodollars?

    <p>They are dollar-denominated deposits in non-U.S. banks. (D)</p> Signup and view all the answers

    What distinguishes a financial asset from a non-financial asset?

    <p>A financial asset is a financial claim that can be traded. (D)</p> Signup and view all the answers

    Which of the following is a characteristic of securities?

    <p>Securities can be bought and sold in a financial market. (A)</p> Signup and view all the answers

    Why are financial intermediaries important in the financial system?

    <p>They facilitate the flow of funds between savers and borrowers. (C)</p> Signup and view all the answers

    What is meant by the term 'financial crisis'?

    <p>A market event where there is a sudden decrease in asset prices and liquidity. (A)</p> Signup and view all the answers

    Which of the following best describes a financial instrument?

    <p>It represents a claim or ownership in a financial asset. (B)</p> Signup and view all the answers

    Which of the following is considered a short-term debt instrument?

    <p>Commercial paper (D)</p> Signup and view all the answers

    What feature of debt securities indicates the total amount borrowed?

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

    Which type of equity security typically does not have voting rights?

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

    What is the characteristic of equity instruments compared to debt instruments?

    <p>Equities have a claim on assets (A)</p> Signup and view all the answers

    What is the classification of a debt instrument with a maturity between 1 and 10 years?

    <p>Intermediate-term (A)</p> Signup and view all the answers

    Which of the following types of stock allows holders to participate in the firm's residual earnings?

    <p>Common stock (D)</p> Signup and view all the answers

    Derivatives are financial contracts whose values are derived from what?

    <p>Underlying assets (D)</p> Signup and view all the answers

    Which of the following statements is true about bonds?

    <p>Bonds are debt instruments used to raise capital. (C)</p> Signup and view all the answers

    What is a characteristic of consol bonds?

    <p>They pay a steady stream of interest indefinitely. (B)</p> Signup and view all the answers

    Which of the following is NOT a source of income for investors in stocks?

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

    What type of claim do stockholders have on a corporation?

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

    Which of the following statements is true regarding stocks?

    <p>Stocks can yield income through dividends and capital gains. (C)</p> Signup and view all the answers

    Which term refers to the nominal value of a bond?

    <p>Face value (D)</p> Signup and view all the answers

    What distinguishes preferred stocks from common stocks?

    <p>Common stocks have voting rights while preferred stocks do not. (C)</p> Signup and view all the answers

    What is meant by yield to maturity in relation to bonds?

    <p>The total return anticipated if the bond is held until it matures. (C)</p> Signup and view all the answers

    What is a potential risk of investing in stocks?

    <p>Risk of losing the initial investment. (B)</p> Signup and view all the answers

    What is a call option?

    <p>An option to buy an underlying asset at a specified price. (A)</p> Signup and view all the answers

    How does a trader benefit from exercising a call option?

    <p>By purchasing shares below the current market price. (D)</p> Signup and view all the answers

    What distinguishes options from forward or futures contracts?

    <p>Options involve a premium for the right they offer. (C)</p> Signup and view all the answers

    In the example given, what was the total profit made by the trader after exercising the call option?

    <p>$2,050 (C)</p> Signup and view all the answers

    What characterizes a plain vanilla swap?

    <p>One party pays a fixed interest rate while the other pays a floating interest rate. (B)</p> Signup and view all the answers

    Why did Company XYZ enter into a swap agreement?

    <p>To hedge against the anticipated increase in LIBOR rates. (C)</p> Signup and view all the answers

    Which of the following correctly describes a put option?

    <p>It allows the owner to sell an underlying asset at a predetermined price. (B)</p> Signup and view all the answers

    What are securities primarily characterized as?

    <p>Financial assets that represent a right to receive funds in the future. (B)</p> Signup and view all the answers

    What is a defining characteristic of a swap?

    <p>It is an arrangement to exchange cash flows based on predetermined formulas. (C)</p> Signup and view all the answers

    What happens if a buyer does not exercise an option by the expiration date?

    <p>The option becomes worthless, and the buyer loses the premium. (C)</p> Signup and view all the answers

    Which of the following is NOT a characteristic of marketable securities?

    <p>They are often illiquid and difficult to sell. (C)</p> Signup and view all the answers

    What differentiates options from a forward or futures contract in terms of obligations?

    <p>Only the seller is obligated to fulfill the transaction. (A)</p> Signup and view all the answers

    In the example given, what fixed interest rate does Company XYZ agree to pay to Investor ABC?

    <p>4.58% (D)</p> Signup and view all the answers

    What is the primary difference between money market securities and longer-term securities?

    <p>Money market securities are typically more liquid than longer-term securities. (C)</p> Signup and view all the answers

    What would be the potential impact of an increase in LIBOR for Company XYZ?

    <p>It would increase the company's borrowing costs. (D)</p> Signup and view all the answers

    What defines securities as being either debt or equity?

    <p>Debt offers fixed returns, while equity provides variable returns based on performance. (A)</p> Signup and view all the answers

    Flashcards

    Financial Asset

    A financial claim that represents the right to receive future payments. It is a claim on someone else to pay you money. It is a type of asset owned by a person or firm.

    Security

    A tradable financial asset that can be bought and sold in a financial market.

    What is the difference between a Financial Asset and a Security?

    A Financial Asset is a broader term encompassing any claim on future payments. A Security is a specific type of financial asset that is tradable on a financial market.

    What are Financial Instruments?

    Financial instruments represent the flow of funds within the financial system. They facilitate the transfer of funds from savers to borrowers.

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    What is the Function of the Financial System?

    The financial system facilitates the flow of funds from savers to borrowers. It helps to allocate capital efficiently and promotes economic growth.

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    Certificate of Deposit (CD)

    A debt instrument sold by a bank to depositors that pays annual interest and at maturity the bank repays the original purchase price.

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    Negotiable Certificate of Deposit (NCD)

    A type of Certificate of Deposit (CD) that can be traded in secondary markets, usually with large denominations, higher face value, and shorter maturities.

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    Commercial Paper

    A short-term debt instrument issued by large, creditworthy corporations with a maturity of typically 30 days, similar to an IOU.

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    Banker's Acceptance

    A short-term debt instrument guaranteed for payment by a commercial bank. The bank accepts responsibility for payment, reducing payment risk.

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    Eurodollars

    Dollar-denominated deposits held in banks outside the US.

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    Debt Instruments

    Financial contracts that represent a loan from an investor (creditor) to a borrower, with a promise of repayment of principal and interest.

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    What are Short-Term Debt Instruments?

    Debt instruments with a maturity of less than one year. Examples include commercial paper, bankers' acceptances, and Treasury bills.

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    What are Long-Term Debt Instruments?

    Debt instruments with a maturity of 10 years or more (in the US). Examples include bonds and debentures.

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    What is Par Value of a Debt Security?

    The principal amount of a debt security that will be repaid at maturity.

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    Interest Rate

    The annual percentage return paid on a debt security.

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    What is a Coupon?

    The periodic interest payments paid on a debt security.

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    Equity Instruments

    Claims of ownership in a firm, giving the holder a share of the firm's profits and assets.

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    Common Stock

    A type of equity instrument that represents a basic ownership claim in a company. Holders have voting rights and receive dividends.

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    Consol Bonds

    Bonds with no maturity date, meaning they pay interest forever and are never redeemed by the issuer.

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    Interest Rate vs. Coupon Rate

    Interest rate is the current market rate of return on similar bonds, whereas coupon rate is the fixed interest rate stated on a bond.

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    Face Value (Par Value)

    The original price of a bond at issuance, which is typically $1,000 and is the amount the issuer promises to pay back at maturity.

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    Market Value

    The current price of a bond in the market, which can fluctuate based on factors like interest rates and credit risk.

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    Yield to Maturity (YTM)

    The total return an investor can expect to receive if they hold a bond until maturity, taking into account interest payments and the difference between purchase price and face value.

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    Stocks: Equity Securities

    Represent partial ownership in a corporation, giving holders a claim on the company's net income and assets.

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    Stockholders' Income Sources

    They receive income from dividends, which are a portion of the company's earnings, and capital gains from selling the stock at a higher price than purchased.

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    Types of Stocks

    Common stocks and preferred stocks.

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    What is an option?

    A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (strike price) on or before a specific date. The seller is obligated to fulfill the transaction if the buyer exercises the option.

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    Call Option

    An option that gives the buyer the right to purchase an underlying asset at a specific price (strike price) on or before a specific date.

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    Put Option

    An option that gives the buyer the right to sell an underlying asset at a specific price (strike price) on or before a specific date.

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    Option Premium

    The price the buyer pays to the seller for the right to exercise the option.

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    Forward/Future vs. Option

    Forwards/Futures are binding obligations on both buyers and sellers, while options only bind the seller. The buyer has the right but not the obligation to exercise the option.

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    What is a Swap?

    An agreement between two parties to exchange one stream of cash flows for another based on a predetermined formula.

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    Swap Example

    One party may pay a fixed interest rate to the other party in exchange for a market-determined floating interest rate.

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    Swap Key Feature

    Swaps involve exchanging future cash flows based on a specific formula, typically involving one fixed and one floating rate.

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    What is a plain vanilla swap?

    A basic type of interest rate swap where one party pays a fixed interest rate and the other pays a floating interest rate based on a benchmark like LIBOR. Both parties exchange payments based on a notional principal amount.

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    What is LIBOR?

    The London Interbank Offered Rate. A benchmark interest rate that represents the average interest rate at which banks lend to each other in the London interbank market.

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    What is a security?

    A tradable financial asset that represents the right to receive future payments. It can be bought and sold on a financial market.

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    What are the types of securities?

    Securities can be categorized in various ways:

    • Marketable or non-marketable
    • Short-term or long-term
    • Debt or equity
    • Others

    These classifications depend on their characteristics and how they are traded.

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    Why are money market securities more liquid?

    Money market securities are short-term debt instruments that are generally more actively traded than longer-term securities. This means there are more buyers and sellers in the market, making it easier to buy or sell them quickly at a fair price.

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    What is the assignment for Chapter 2?

    The assignment includes a self-test, review questions, and problems. You should attempt these assignments independently before asking questions in class.

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    How to prepare for Chapter 3?

    Start by reading the assigned documents for Chapter 3. This will give you a foundation of knowledge for the topic.

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    Study Notes

    Introduction to Finance

    • The course is titled "Introduction to Finance"
    • The lecturer is Tran Thi Minh Tram
    • The lecturer's email is [email protected]

    Chapter 2: Financial System

    • Sources include: Bodie, Z, & Merton, R. (2000), Finance, Prentice Hall Inc.; Timothy J.G (2013), Financial Management: Principle and practices, 6th ed, Freeload Press Publishers; Mishkin, F.S. (2010), The Economics of Money, Banking and Financial markets, 9th ed, The Addison - Wesley Series în Economics; Mandura, J.(2011), Financial Markets and Institutions, 10th ed, South Western

    Topics in Financial System

    • Overview of Financial System
    • Flow of Funds
    • Financial Instruments/Securities
    • Financial Markets
    • Financial Intermediaries
    • Financial Crisis and Financial Regulation

    Financial Instruments

    • An asset is anything of value owned by a person or firm.
    • A financial asset is a financial claim giving a claim on someone else to pay you money.
    • Economists divide financial assets into securities and those that aren't.
    • Securities are tradable, meaning they can be bought and sold in a financial market.

    Non-Marketable Financial Assets

    • Cannot be traded between investors.
    • May be redeemable (a reverse transaction between borrower and lender).
    • Examples include savings accounts, term deposits, and certificates of deposits.

    Marketable Financial Assets

    • Can be traded between investors after initial issue in public markets..
    • Examples include bonds and stocks.

    Market Capitalization

    • An important term in finance.
    • The total market value of a company
    • Calculated by multiplying the number of outstanding shares by the market price per share.

    Securities

    • Short-term or long-term
    • Debt or equity
    • Others (e.g., hybrid and derivatives)

    Short-Term Securities

    • Maturity of one year or less.
    • Least price fluctuations, least risky investments.
    • Examples include Treasury bills, negotiable bank certificates of deposit, commercial paper, bankers' acceptances, eurodollars, repurchase agreements, and federal (Fed) funds/overnight funds.

    Treasury Bills (T-bills)

    • Short-term securities issued by the treasury to finance government.
    • Investors buy at a discount; receive full face value at maturity.
    • Active secondary market, most liquid and safest money market instruments.
    • Primarily held by banks but also some households, corporations, and other financial intermediaries.

    Certificate of Deposits (CDs)

    • Debt instrument sold by banks to depositors.
    • Pay annual interest; at maturity, bank receives original purchase price.
    • Small denominations are safer and often have lower interest.
    • Negotiable Bank Certificates of Deposits (NCDs) are tradable in secondary markets, often longer term with higher face values.

    Commercial Paper

    • Short-term debt instrument issued by large banks and corporations.
    • Maturity typically 30 days.
    • Similar to an IOU, unsecured.
    • Issued by corporations with good credit ratings to raise cash for current transactions; often cheaper than bank loans; mostly held by large institutions.

    Banker's Acceptance

    • Short-term debt instrument guaranteed by a commercial bank for payment.
    • Avoids problems collecting payments from reluctant debtors.
    • Facilitates international transactions.

    Eurodollars

    • Dollar-denominated deposits held in non-US banks.
    • Originally held almost exclusively in Europe due to U.S. banking regulations, are still mostly held in Europe but held in many other countries.
    • Held primarily by large institutions.

    Repurchase Agreements (repos)

    • Agreement where the borrower sells government securities to the lender & commits to repurchasing them at a specified price.
    • Effectively short-term loans (often less than 2 weeks).
    • Government securities serve as collateral if the borrower cannot repay.

    Overnight Funds

    • Typically overnight loans between banks.
    • Banks may borrow if they do not have enough settlement deposits at the central bank.
    • Central bank settlement balances are borrowed from other banks that have excess of the same.
    • Overnight interest rate is important for assessing economic conditions.

    Long-Term Securities

    • Securities with a maturity of one year or longer.
    • Common examples include bonds, stocks, mortgages.

    Bonds

    • Long-term debt securities issued by borrowers to raise funds.
    • Issued by Treasury, government agencies, and corporations.
    • Issuer promises to repay a face value and pay interest.
    • Tradable in secondary markets with prices that change.
    • Special Features Include face value (par value), maturity date, and coupon interest.

    Types of Bonds

    • Treasury bonds (issued by the government)
    • Municipal bonds (issued by state and local governments typically tax free)
    • Corporate bonds (issued by corporations).
    • Special Types Include Zero-coupon, convertible, and consol bonds.

    Government Bonds

    • Long-term securities issued by the Treasury to finance government deficits.
    • Examples include T-notes and T-bonds in the U.S.
    • Widely traded and are considered very liquid.
    • Principally held by banks, households, and foreigners.

    Municipal Bonds

    • Issued by state and local governments (often referred to as "munis").
    • Many investors like these bonds because coupon interests are free from federal tax.
    • Two types: general obligation bonds (GOs) paid off from various tax revenue sources., and revenue bonds paid off with funds generated from project the bonds were issued for.

    Corporate Bonds

    • Issued by corporations for raising funds.
    • Lower liquidity relative to other securities like government bonds.

    Stocks

    • Equity securities representing claims on the net income and assets of a corporation.
    • Investors receive income from dividends and capital gains.
    • Stockholders have a residual claim on the company.
    • Types include common and preferred stocks.

    Common Stocks

    • Stockholders own a portion of the company and vote on major decisions.
    • Receive a return as dividends and capital gains.

    Preferred Stocks

    • Do not usually have voting rights but have priority in receiving dividends.
    • Dividends are paid at a pre-set rate (stated as percentage of face or par value).

    Mortgages

    • Long-term debt obligations created to finance real estate purchases.
    • Households and firms can borrow using mortgages for houses, land or other real structures where land/structure serves as collateral.
    • Two types based on creditworthiness of the borrower: prime and subprime mortgages.
    • Subprime mortgages have a higher default risk.

    Mortgage-backed Securities

    • Debt obligations representing claims on a package of mortgages.

    Other Loans

    • Consumer and bank commercial loans are made principally by banks, but consumer loans are also made by finance companies.

    Securitized Loans

    • Securitization is changing non tradable loans into securities.

    Debt Securities

    • Debt security is a contractual agreement where a borrower pays the holder of the security for a predefined interest and principal payments until the document's specified maturity date which is the date of final payment.
    • Features include: par value, interest rate, the price, coupon, and the maturity date.
    • Different types of debt securities include commercial paper, bankers' acceptances, treasury bills, mortgage loans and bonds and debentures.
    • Debt securities can be short term, long term or intermediate term depending on their maturity date.

    Equity Securities

    • An Equity Security (also known as a stock) is the owners' claim to a firm's income and assets.
    • Equity securities generally are common stocks or preferred stocks.
    • If an individual owns a single share in a company with a million shares, then they have a claim to a millionth of that company's assets and net income and do not expire. Often they pay dividends periodically.

    Hybrid Securities

    • Hybrid securities share characteristics of both debt and equity securities.

    Derivatives

    • Financial contracts whose values depend on or are derived from the values of other underlying assets or instruments including commodities, interest rates, debt or equity securities or foreign currencies.
    • Examples include forwards, futures, options and swaps.

    Purposes of Derivatives

    • Speculation: Derivative securities allow investors to bet on the price movements of underlying assets without having to own them.
    • Risk Management: Derivatives (hedging) are used to reduce the exposure associated with an existing investment in securities.

    Forwards

    • Customized contract to Buy/Sell a specified asset at a predetermined price at a specific future date or agreed-upon time (delivery date)
    • Forward contracts are not standardized, are traded privately, and are considered to have low liquidity.
    • A forward contract is different from a spot contract where the price and delivery occur immediately.

    Futures

    • Standardized contract to Buy/sell a specific standardized asset at a predetermined price with standardized quantity and quality at a specified future date or agreed-upon time (delivery date).
    • Futures contracts are more standardized and liquid than forward contracts traded on exchanges and guaranteed by clearing houses to improve liquidity.

    Options

    • A contract that gives the buyer the right, not the obligation, to buy or sell an underlying asset or instrument at a specified price (strike price) on or before a specified date (expiry date).
    • The seller has the obligation to fulfill the transaction if the buyer (option owner) chooses to exercise the option.
    • The buyer of an option pays a premium to the seller for this right.
    • Two types of options: Call options (to buy) and put options (to sell).

    Swaps

    • An agreement where two counterparties exchange one stream of future payments based on some pre-determined formula
    • Typically, one party exchanges a fixed payment in return for a floating rate of an underlying asset.
    • Financial institutions and their corporate clients mainly use swaps outside of organized exchanges.

    Summary of Securities

    • Securities are documents representing the right to receive something in the future.
    • Securities may be marketable or non-marketable.
    • Securities may be debt or equity.

    Review Question 1

    • Security is a document representing the right to receive something in the future. Different kinds of securities include short-term and long-term (bonds, stocks, mortgage-backed securities), debt (like mortgages, bonds and commercial paper) and equity (like common stock and preferred stocks)

    Review Question 2

    • Money market securities (short term) are generally more widely traded than longer-term securities and are often thought of as being more liquid since they are more actively bought and sold.

    Assignment of Chapter 2

    • Students are assigned self-testing, review questions and problems from Chapter 2; the instructor encourages them to complete these steps independently and then seek assistance in class should they be unable to do so completely successfully.

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    Description

    Test your knowledge on key features of financial instruments, including Certificates of Deposit, Commercial Paper, and the role of financial intermediaries. This quiz covers their characteristics, classifications, and the importance of understanding financial assets in today's economy.

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