LECTURE 3 Practice Questions Chapter 1 Chapter 2

CHAPTER 2 The Financial Environment: Markets, Institutions, and Interest Rates and Taxes Financial markets Types of financial institutions Determinants of interest rates Yield curves

1-3 What is a market? A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

1-4 Types of financial markets Physical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Mortgage vs. Consumer credit

1-5 Physical assets vs. Financial assets Physical assets: wheat, autos, real estate, machinery Financial assets: Stocks, bonds

1-6 Money vs. Capital Money mkt: for debt securities with maturity of less than 1 year Capital mkt: for long-term debt AND common stock

1-7 Primary vs. Secondary Primary mkts: in which corporations & governments raise new capital Secondary mkts: in which existing, previously issued (already OUTSTANDING) securities are traded

1-8 Spot vs. Futures Spot markets: where assets are bought or sold for “on the spot” delivery (immediately or within a few days) Futures markets: where assets are bought or sold for delivery at a later date (e.g. six months or a year into the future)

1-9 Mortgage vs. Consumer credit Mortgage mkts: loans on commercial, residential, industrial real estate & farmland Consumer credit markets: loans for autos, appliances, education etc.

1-10 How is capital transferred between savers and borrowers? 1. Direct transfers 2. Investment banking house 3. Financial intermediaries

1-11 Capital transfer… Business sells stocks or bonds to savers w/o going through any financial institution

1-12 Capital transfer… Intermediary obtains funds from investors, issuing its own securities The intermediary might lend to business Intermediaries create new forms of capital (e.g. certificates of deposit) Efficiency of financial mkts increases

1-13 Capital transfer… Investment bank deals with the issuance of securities not loans and deposits Investment bank buys & holds securities for a period of time—so it is taking a chance

1-14 Types of financial intermediaries Commercial banks Pension funds Life insurance companies Mutual funds

1-15 Physical location stock exchanges vs. Electronic dealer-based markets New York Stock Exchange (NYSE) National Association of Securities Dealers Automated Quotations (NASDAQ)

1-16 NYSE (New York Stock Exchange) All trades occur in a physical place, on the trading floor of the NYSE An auction market, wherein individuals are typically buying and selling between one another and there is an auction occurring Highest buying (bidding) price will be matched with the lowest selling (asking) price Stocks of well established (Blue chip) companies

1-17 NASDAQ (National Association of Securities Dealers’ Automated Quotations) Located on a telecommunications network. Dealer's market, wherein market participants are not buying from and selling to one another but to and from a dealer The dealer is the market maker Stocks of firms dealing with the Internet or electronics. Stocks are more volatile

1-18 Differences have narrowed NASDAQ exchange was listed as a publicly- traded corporation, while the NYSE was private corporation. In March 2006 the NYSE went public after being a not-for-profit exchange for nearly 214 years. The shares of these exchanges, like those of any public company, can be bought and sold by investors on an exchange.

1-19 Organized exchange vs. OTC market Organized exchange: Physical place Over-the-Counter market: Brokers and Dealers connected over an electronic network Although, it started out as an OTC market, today NASDAQ is considered a sophisticated market separate from the OTC market

1-20 Video Clip: Key Takeaways Most people think of the stock market when we talk of financial markets but there are many different markets Primary and Secondary markets Public financial markets Where govts borrow money Corporate financial markets Where corporations borrow money Organized security exchanges vs. virtual networks

1-21 Cost of money The price, or cost, of debt capital is the interest rate. The price, or cost, of equity capital is the required return. The required return investors expect is composed of compensation in the form of dividends and capital gains.

Role Play

1-23 What four factors affect the cost of money? 1. Production opportunities The returns available within an economy from investment in productive (cash- generating) assets The higher the production opportunities, the more the borrower (producer) can offer

1-24 Factors affecting cost of money… 2. Time preferences for consumption Preferences of consumers for current consumption as opposed to saving for future consumption The higher the time preference the more the lender will demand

1-25 Factors affecting cost of money… 3. Risk The chance that the financial asset will not earn the return promised The higher the risk, the more the lender demands 4. Expected inflation The tendency of prices to increase over time The higher the expected inflation, the more the lender will demand