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?

It is guaranteed for payment by a commercial bank. Signup and view all the answers

What is a characteristic of Eurodollars?

They are dollar-denominated deposits in non-U.S. banks. Signup and view all the answers

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

A financial asset is a financial claim that can be traded. Signup and view all the answers

Which of the following is a characteristic of securities?

Securities can be bought and sold in a financial market. Signup and view all the answers

Why are financial intermediaries important in the financial system?

They facilitate the flow of funds between savers and borrowers. Signup and view all the answers

What is meant by the term 'financial crisis'?

A market event where there is a sudden decrease in asset prices and liquidity. Signup and view all the answers

Which of the following best describes a financial instrument?

It represents a claim or ownership in a financial asset. Signup and view all the answers

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

Commercial paper Signup and view all the answers

What feature of debt securities indicates the total amount borrowed?

Par value Signup and view all the answers

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

Preferred stock Signup and view all the answers

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

Equities have a claim on assets Signup and view all the answers

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

Intermediate-term Signup and view all the answers

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

Common stock Signup and view all the answers

Derivatives are financial contracts whose values are derived from what?

Underlying assets Signup and view all the answers

Which of the following statements is true about bonds?

Bonds are debt instruments used to raise capital. Signup and view all the answers

What is a characteristic of consol bonds?

They pay a steady stream of interest indefinitely. Signup and view all the answers

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

Interest payments Signup and view all the answers

What type of claim do stockholders have on a corporation?

Residual claim Signup and view all the answers

Which of the following statements is true regarding stocks?

Stocks can yield income through dividends and capital gains. Signup and view all the answers

Which term refers to the nominal value of a bond?

Face value Signup and view all the answers

What distinguishes preferred stocks from common stocks?

Common stocks have voting rights while preferred stocks do not. Signup and view all the answers

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

The total return anticipated if the bond is held until it matures. Signup and view all the answers

What is a potential risk of investing in stocks?

Risk of losing the initial investment. Signup and view all the answers

What is a call option?

An option to buy an underlying asset at a specified price. Signup and view all the answers

How does a trader benefit from exercising a call option?

By purchasing shares below the current market price. Signup and view all the answers

What distinguishes options from forward or futures contracts?

Options involve a premium for the right they offer. Signup and view all the answers

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

$2,050 Signup and view all the answers

What characterizes a plain vanilla swap?

One party pays a fixed interest rate while the other pays a floating interest rate. Signup and view all the answers

Why did Company XYZ enter into a swap agreement?

To hedge against the anticipated increase in LIBOR rates. Signup and view all the answers

Which of the following correctly describes a put option?

It allows the owner to sell an underlying asset at a predetermined price. Signup and view all the answers

What are securities primarily characterized as?

Financial assets that represent a right to receive funds in the future. Signup and view all the answers

What is a defining characteristic of a swap?

It is an arrangement to exchange cash flows based on predetermined formulas. Signup and view all the answers

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

The option becomes worthless, and the buyer loses the premium. Signup and view all the answers

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

They are often illiquid and difficult to sell. Signup and view all the answers

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

Only the seller is obligated to fulfill the transaction. Signup and view all the answers

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

4.58% Signup and view all the answers

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

Money market securities are typically more liquid than longer-term securities. Signup and view all the answers

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

It would increase the company's borrowing costs. Signup and view all the answers

What defines securities as being either debt or equity?

Debt offers fixed returns, while equity provides variable returns based on performance. Signup and view all the answers

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.