Financial Instruments Overview

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Questions and Answers

What is the primary function of financial instruments in the markets?

To raise funds for companies and governments.

Define the difference between the primary market and the secondary market.

The primary market is where new securities are issued, while the secondary market is for buying and selling existing securities.

What are the two main types of issues that occur in the primary market?

Initial Public Offerings (IPOs) and Rights Issues.

How do financial intermediaries facilitate the flow of funds in financial markets?

They act as middlemen between investors and borrowers. Signup and view all the answers

What is an IPO and why do companies typically pursue one?

An IPO is the first public sale of a company's stock, pursued to raise capital and expand operations. Signup and view all the answers

What role does the Board of Directors play in corporate governance?

The Board oversees the company's operations and ensures accountability. Signup and view all the answers

Explain the concept of price discovery in the context of financial markets.

Price discovery is the process of determining the value of securities through supply and demand. Signup and view all the answers

How does the prospectus benefit potential investors during an IPO?

It provides detailed information about the company’s financials and associated risks. Signup and view all the answers

What are Treasury Bills (T-Bills) and how are they characterized in terms of investment risk?

Treasury Bills (T-Bills) are short-term government debt securities issued at a discount, characterized by low risk. Signup and view all the answers

Explain the main difference between stocks and bonds in terms of ownership and returns.

Stocks represent ownership in a company and offer dividends, while bonds are debt securities that provide periodic interest and principal repayment. Signup and view all the answers

What are commercial paper and its purpose in the financial market?

Commercial paper is an unsecured, short-term debt issued by companies to finance their operations. Signup and view all the answers

Describe the role of repurchase agreements (repos) in the money market.

Repurchase agreements (repos) are short-term loans where securities are sold with an agreement to repurchase them later. Signup and view all the answers

How does liquidity affect the attractiveness of money market instruments?

Liquidity indicates how quickly an asset can be converted to cash, making money market instruments highly attractive due to their ease of liquidation. Signup and view all the answers

What distinguishes convertible bonds from regular bonds?

Convertible bonds can be converted into a predetermined number of shares of the issuing company, unlike regular bonds which cannot be converted. Signup and view all the answers

What are the key features of capital market instruments?

Key features of capital market instruments include risk, liquidity, return, and valuation based on cash flows and market conditions. Signup and view all the answers

Contrast Over-the-Counter (OTC) markets with exchange markets.

OTC markets are decentralized and involve direct trading between parties, while exchange markets are centralized and regulated for trading securities. Signup and view all the answers

Study Notes

Primary Function of Financial Instruments

Financial instruments facilitate the flow of funds between those with surplus funds (lenders) and those who need funds (borrowers). They provide a way to transfer funds efficiently and manage risk.

Primary vs. Secondary Market

Primary market: Where new financial instruments are initially issued (e.g., IPOs, bond issues). Funds flow directly from investors to the issuer.
Secondary market: Where existing financial instruments are bought and sold (e.g., stock exchanges). Investors trade with each other, with the issuer not directly involved.

Primary Market Issues

Initial Public Offerings (IPOs): First-time issuance of shares by a private company to the public.
Bond issues: Corporations and governments issue bonds to borrow funds from investors.

Financial Intermediaries

Banks: Collect deposits from savers and lend to borrowers. They transform short-term deposits into long-term loans, increasing the liquidity of financial markets.
Investment companies: Pool funds from many investors to purchase securities and diversify portfolios.
Insurance companies: Provide financial protection against different risks. They receive premiums and use the funds to invest in capital markets.

IPO and Corporate Purpose

Initial Public Offering (IPO): A company's first offering of shares to the public.
Reasons for pursuing an IPO: Raise capital for expansion, create a public market for company shares to facilitate future fund-raising, increase company visibility, and enhance employee compensation.

Board of Directors Role in Corporate Governance

The Board of Directors oversees the company's management, ensures alignment with shareholder interests, and monitors the performance of the company's executives. They play a critical role in ensuring responsible corporate governance and financial transparency.

Price Discovery in Financial Markets

Price discovery is the process by which the market determines the price of a financial instrument through the interaction of supply and demand. This process creates a fair and efficient allocation of resources by reflecting the collective knowledge and expectations of investors.

Prospectus Benefit in IPO

The prospectus provides potential investors with detailed information about the company's business model, financial performance, and management team. This document helps investors make informed decisions about whether to invest.

Treasury Bills (T-Bills)

T-Bills are short-term debt securities issued by the government. They are considered practically risk-free investments due to the very low probability of default by the government.
Typical maturities are 4, 13, 26, and 52 weeks.

Stocks vs. Bonds: Ownership and Returns

Stocks: Represent ownership in a company. Returns come from dividends and potential capital appreciation.
Bonds: Represent a loan to a company or government. Returns come from fixed interest payments and potential capital appreciation.

Commercial Paper

Short-term unsecured debt issued by corporations, typically with maturities of less than 270 days.
Purpose: It provides a source of funding for working capital and short-term needs.

Repurchase Agreements (Repos)

A short-term, secured loan using a security as collateral. The borrower (seller) sells the security to the lender with an agreement to repurchase it at a later date at a higher price (fixed interest rate).
Repurchase agreements are important in the money market as a source of short-term financing for banks and other financial institutions.

Liquidity and Attractiveness of Money Market Instruments

Liquidity indicates how readily a security can be bought or sold without affecting its market price.
Money market instruments with higher liquidity are more attractive to investors because they can easily be traded in case of need.

Convertible Bonds

Convertible bonds can be exchanged for a predetermined number of common stock shares.
Investors benefit from potential capital appreciation of the underlying stock, while the issuer benefits from lower interest rate costs.

Capital Market Instruments

Key Features:
- Long-term maturities (over a year)
- Higher risk than money market instruments
- Include stocks, bonds, and mortgages

OTC Markets vs. Exchange Markets

Over-the-Counter (OTC) Markets: Unregulated markets where financial instruments are traded directly between two parties without a central exchange.
Exchange Markets: Organized, regulated markets with centralized trading, where financial instruments are traded according to specified rules and procedures.

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Description

This quiz covers various financial instruments including money market and capital market instruments, as well as OTC and exchange markets. Explore the features, valuation, and examples of these financial tools to enhance your understanding of their roles in finance.