Financial Markets & Institutions Exam
1 Study Guide
Financial Markets - ANSWER markets where financial securities, such as stocks and
bonds, are bought and sold (surplus units & deficit units)
Money Market - ANSWER -short term debt (ex: Treasury bills & commercial papers)
-lower risk, higher liquidity (must meet time and value dimensions)
Derivative Securities - ANSWER -financial contracts whose values are derived from the
values of underlying assets (ex: futures & options)
-enable investors to:
*speculate: more risk to get higher return
*hedge: reduce risk to sacrifice higher return
Primary Market vs. Secondary Market - ANSWER -Primary: issuers trade new securities,
issuers get funds
-Secondary: trades previously issued securities (shareholders), issuers do not get funds
The Security Pricing Principle - ANSWER definition: the price of a security should be the
same as the present value of all future cash flows that an investor can receive by
holding the security (APPLIES TO ALL SECURITIES)
Depends on:
-expected future cash flows (lower return)
-uncertainty on the cash flows (higher return affects little "r")
Perfect Market - ANSWER all relevant information are freely available to investors
Efficient Market - ANSWER all available information are already reflected onto security
prices
Financial Institutions - ANSWER they exist because financial markets are imperfect (not
all information is free)
Depository Institutions - ANSWER accept deposits from surplus units and provide credit
to deficit units through loans and purchases of securities
-commercial banks
, -savings institutions
-credit unions
nondepository institutions - ANSWER -finance companies
-mutual funds
-securities firms
-insurance companies
-pension funds
Loanable Funds Theory - ANSWER market interest rate is determined by the factors that
control the supply of and demand for loanable funds.
Demand for Loanable Funds - ANSWER government= interest-inelastic
Demand vs Supply on Loanable Funds - ANSWER -demand is flatter than supply (more
sensitive), based on borrowing
-supply is more inelastic, based on savings
Equilibrium Interest Rate
1)How if the current interest rate is higher than the equilibrium interest rate?
2)How if the current interest rate is lower than the equilibrium interest rate? - ANSWER
1) Q supplied > demanded, IR will go down
2) IR will go up
Factors Affecting Interest Rates - ANSWER -economic growth: higher EG--->demand
shifts to the right causing higher IR to go up.
-inflation-same as EG
-monetary policy: supply shifts right, IR go down
-budget deficits: demand shifts right, IR pressure up
-foreign flows of funds: I get money, IR goes down
Fisher Effect - ANSWER (1 + nominal interest rate)= (1 + real interest rate) x (1 +
expected inflation rate)
When the Fed increases the money supply, it increases the supply of loanable funds -
ANSWER supply shifts to the right; downward pressure on interest rates
If the increased money supply also raises inflation expectation.... - ANSWER demand
shifts to the right; upward pressure on interest rates
1 Study Guide
Financial Markets - ANSWER markets where financial securities, such as stocks and
bonds, are bought and sold (surplus units & deficit units)
Money Market - ANSWER -short term debt (ex: Treasury bills & commercial papers)
-lower risk, higher liquidity (must meet time and value dimensions)
Derivative Securities - ANSWER -financial contracts whose values are derived from the
values of underlying assets (ex: futures & options)
-enable investors to:
*speculate: more risk to get higher return
*hedge: reduce risk to sacrifice higher return
Primary Market vs. Secondary Market - ANSWER -Primary: issuers trade new securities,
issuers get funds
-Secondary: trades previously issued securities (shareholders), issuers do not get funds
The Security Pricing Principle - ANSWER definition: the price of a security should be the
same as the present value of all future cash flows that an investor can receive by
holding the security (APPLIES TO ALL SECURITIES)
Depends on:
-expected future cash flows (lower return)
-uncertainty on the cash flows (higher return affects little "r")
Perfect Market - ANSWER all relevant information are freely available to investors
Efficient Market - ANSWER all available information are already reflected onto security
prices
Financial Institutions - ANSWER they exist because financial markets are imperfect (not
all information is free)
Depository Institutions - ANSWER accept deposits from surplus units and provide credit
to deficit units through loans and purchases of securities
-commercial banks
, -savings institutions
-credit unions
nondepository institutions - ANSWER -finance companies
-mutual funds
-securities firms
-insurance companies
-pension funds
Loanable Funds Theory - ANSWER market interest rate is determined by the factors that
control the supply of and demand for loanable funds.
Demand for Loanable Funds - ANSWER government= interest-inelastic
Demand vs Supply on Loanable Funds - ANSWER -demand is flatter than supply (more
sensitive), based on borrowing
-supply is more inelastic, based on savings
Equilibrium Interest Rate
1)How if the current interest rate is higher than the equilibrium interest rate?
2)How if the current interest rate is lower than the equilibrium interest rate? - ANSWER
1) Q supplied > demanded, IR will go down
2) IR will go up
Factors Affecting Interest Rates - ANSWER -economic growth: higher EG--->demand
shifts to the right causing higher IR to go up.
-inflation-same as EG
-monetary policy: supply shifts right, IR go down
-budget deficits: demand shifts right, IR pressure up
-foreign flows of funds: I get money, IR goes down
Fisher Effect - ANSWER (1 + nominal interest rate)= (1 + real interest rate) x (1 +
expected inflation rate)
When the Fed increases the money supply, it increases the supply of loanable funds -
ANSWER supply shifts to the right; downward pressure on interest rates
If the increased money supply also raises inflation expectation.... - ANSWER demand
shifts to the right; upward pressure on interest rates
