TEST BANK FOR DERIVATIVES MARKETS THIRD EDITION BY ROBERT L. McDonald

What is the difference between a financial asset and a tangible asset? - ANS-A tangible asset: value depends on particular physical properties. A financial asset: value is a claim to future cash. What is the difference between the claim of a debt holder of Chevron Corporation and a common stockholder of Chevron Corporation? - ANS-A debt holder will be paid first. common stockholders will receive the remaining amount What is the basic principle followed in determining the value of a financial asset? - ANS-the price of a financial asset is equal to the present value of its expected cash flow, even if the cash flow is not known with certainty. Why is it difficult to determine the cash flow of a financial asset? - ANS-Cash flow is influenced by a large number of factors which could change in the future. Some factors are controlled by issuer while others are out of their control. What factors affect the interest rate used to discount the cash flow expected from a financial asset? - ANS-Purchasing Power Risk: inflation risk Credit Risk: risk that the issuer or borrower ill default Currency Risk: risk that exchange rate will change adversely Why are the characteristics of an issuer important in determining the price of a financial asset? - ANS-characteristics of an issuers can collectively determine a risk level of a financial asset. The level of risk can have a large impact on the expected cash flow What are the two principal roles of financial assets? - ANS-1. Transfer funds from those who have surplus funds to invest to those who need funds to invest in tangible assets. 2. transfer funds in such a way as to redistribute the unavoidable risk In September 1990, a study by the U.S. Congress, Office of Technology Assessment, titled "Electronic Bulls & Bears: U.S. Securities Markets and Information Technology," included the following statement: "Securities markets have five basic functions in a capitalistic economy: 1. they make it possible for corporations and governmental units to raise capital. 2. they help to allocate capital toward productive uses. 3. they provide an opportunity for people to increase their savings by investing in them. 4. they reveal investors' judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers. 5. they generate employment and income." For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function. - ANS-1. corps and gov sell financial assets in exchange for capital 2. investors receive return while the companies are able to expand, employ more people, fund innovation, serve consumers better. 3. investment options for different levels of potential return. low return is connected with low risk government bonds. high risk is connected to potentially high return equities or derivative contracts. 4. the price of a financial asset is determined through the price discovery process of a financial market. This provides signals responsive to actions that managers make. 5. capital is put into companies, allowing more employees to be hired and higher incomes. A U.S. investor who purchases the bonds issued by the Japanese government makes the following comment: "Assuming that the Japanese government does not default, I know what the cash flow of the bond will be." Explain why you agree or disagree with this statement. - ANS-If the government does not default, the investor will receive money but the purchasing power of the cash flow is not known with certainty and the currency risk could change the amount of cash flow received. Explain the difference between each of the following: a. money market and capital market b. primary market and secondary market c. domestic market and foreign market d. national market and Euromarket - ANS-a. money market is used to exchange short-term debt instruments while capital market is used to exchange longer-maturity financial assets b. primary market is used to exchange newly issued financial claims (IPO) while the secondary market is used to exchange previously issued financial claims c. (both under national market) domestic market is where issuers domiciled in a country issue securities and where those securities are subsequently traded. foreign market is where the securities of issuers not domiciled in the country are sold and traded. d. national market is internal euro market is external dealing with a number of different countries Indicate whether each of the following instruments trades in the money market or the capital market: a. General Motors Acceptance Corporation issues a financial instrument with four months to maturity. b. The U.S. Treasury issues security with 10 years to maturity. c. Microsoft Corporation issues common stock. d. The State of Mississippi issues a financial instrument with eight months to maturity. - ANS-a. money market b. capital market c. capital market d. money market A U.S. investor who purchases the bonds issued by the U.S. government makes the following statement: "By buying this debt instrument, I am not exposed to default risk or purchasing power risk." Explain why you agree or disagree with this statement. - ANS-No investment is without risk. But the US government is recognized as low default risk, as they are the safest bond investment in terms of default risk. Purchasing power risk (inflation risk) still remains as the stability of the US government provides no guarantee of future purchasing power. Explain why liquidity may depend not only on the type of financial asset but also on the quantity one wishes to sell or buy. - ANS-available liquidity is depended on the number of market participants and relative demand for a financial asset. In 2016, McDonald's issued in the Swiss bond market an eight-year bond denominated in Swiss francs (CHF). The par value was CHF 400 million. From the perspective of the Swiss financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market. - ANS-the bond would be issued on Switzerland's foreign market Give three reasons for the trend toward greater integration of financial markets throughout the world. - ANS-1. deregulation or liberalization of markets and the activities of market participants in key financial centers of the world 2. technological advances for monitoring world markets, executing orders, and analyzing financial opportunities 3. increased institutionalization of financial markets (as opposed to individual investors) What is meant by the "institutionalization" of capital markets? - ANS-markets have grown in size, institutional investors have begun to trade more than individual investors. More trading is being conducted by highly experienced and large institutional investors a. How is an asset class defined? b. What are the traditional asset classes? - ANS-a. an asset class is defined in terms of the investment attributes that the members of the asset class have in common b. common stocks, bonds, cash equivalents On August 25, 2017, the market capitalization of ExxonMobil was $324.73 billion. In terms of market cap, how would this company's stock be classified? - ANS-Mega-cap stock: companies with market values well above the rest of the market, with valuations over $200 billion. On August 25, 2017, Facebook's common stock closed at a price of $166.32 and the market cap of the company was $489.97 billion. What was the approximate number of shares outstanding? - ANS-489.97 / 166.32 = 29,459,476 shares. What is the difference between an emerging stock market and a frontier stock market? - ANS-emerging markets are currently developing while frontier markets have not begun developing yet What are the two basic types of derivative instruments? - ANS-future/forwards contracts: agreement whereby two parties agree to transact with respect to some financial asset at a predetermined price at a specified future date options contracts: gives the owner of the contract the right, but not the obligation, to buy (or sell) a financial asset at a specified price from (or to) another party "Derivatives markets are nothing more than legalized gambling casinos and serve no economic function." Comment on this statement. - ANS-Derivative contracts provide issuers and investors an inexpensive way of controlling some major risks. Controlling risk can take the form of greatly reducing price volatility (price fluctuations) for corporations and costumers. The increasing complexity of derivatives shows just how useful they can be in managing specific types of risk. What is the economic rationale for the widespread use of disclosure regulation? - ANS-To prevent asymmetric information. The managers of the issuing firm have more information about the financial health and future of the firm than investors who own or are considering the purchase of the firm's securities, therefore disclosure regulation is necessary to prevent asymmetric information. Why do some economists believe that disclosure regulation is unnecessary? - ANS-They argue that the securities market would, without governmental assistance, get all the information necessary for a fair pricing of new as well as existing securities. What is meant by "regulation of financial activities?" - ANS-Regulation of financial activities consists of rules about traders of securities and trading on financial markets, for instance, laws that prevent insider trading. What is meant by "systemic financial risk?" - ANS-Systemic financial risk: risk to the entire financial system, market risk, the probability that an entire system will collapse or fail. unavoidable risk. An example typically given to illustrate systemic financial risk is a run on the bank (i.e., many bank depositors simultaneously withdrawing their funds from a bank). Explain why. - ANS-A bank run could theoretically occur at any bank and spread across the financial system as more people demand their money from their banks. the interconnectedness of banks could possibly cause a failure of the entire financial system. banks must have risk-based capital requirements. Compare macroprudential and microprudential perspectives - ANS-Macroprudential policy: seeks to reduce systemic risk. focuses on the welfare of the entire financial system by ultimately acting to limit costs to real GDP. Because this policy involves interconnected institutions, correlations and common exposure are important aspects to pay attention to. Top-down approach that focuses on the large scale. Microprudential policy: seeks to control the risks associated with financial intermediaries. focuses on the welfare of the individual financial institutions by ultimately acting to limit consequences for consumers in a particular institution. involves independent institutions. Bottom up approach that focuses on the small scale. a. What is meant by "financial stability"? b. Why is a macroprudential perspective important when dealing with financial stability? - ANS-Financial stability: financial system where systemic risk is low regulation of the broader financial system and not only select financial institutions may be necessary to create financial stability. a. In what ways does a government act like a financial intermediary? b. What are the concerns when a government plays the role of a financial intermediary? - ANS-By providing loans and guarantees by providing low interest loans, a gov may fuel bubbles and cause market failure by encouraging activity that would otherwise not take place. Additionally, a gov may underestimate risk when pricing loans due to the lack of a profit motive. a. In setting forth monetary policy, certain objectives, such as price stability, can be quantified. Explain why. b. In contrast to such objectives as price stability, monetary policy objectives dealing with financial stability cannot be quantified. Explain why. - ANS-a. price stability objectives target a specific rate like inflation, which is easily quantified b. other factors dealing with financial stability are often complex non-monetary factors which change over time and cannot be necessarily counted or quantified a. What are the arguments in favor of government bailouts? b. What are the arguments against government bailouts? - ANS-a. financial institutions may be "too big to fail" because of interconnectedness with other financial institutions. By allowing them to fail would cause market turmoil that would adversely affect the real economy b. bailing out the largest institutions incentivized bad or irresponsible behavior at those institutions because they know that, should they fail, the government will bail them out. (moral hazard) What are the different forms of support that government bailouts can take? - ANS-can take the form of federal loans: better terms of interest lines of credit: flexible loan that consists of a defined amount , gain access to short-term funding. stock warrants: represents a stock at a certain company's stock at a certain time and date; the company gets the funds directly. allows taxpayers to benefit from a recovery. What was the purpose of the Targeted Asset Relief Program (TARP)? - ANS-The purpose of TARP was to deal with the adverse economic consequences resulting from the subprime mortgage crisis that began in the summer of 2007. How did the U.S. congress deal with the financial problems faced by Fannie Mae and Freddie Mac in 2008? - ANS-Bailing them out and placing them under the conservatorship of the US government. What is meant by a systemically important financial institution (SIFI)? - ANS-in the view of regulators is a large firm whose failure would cause a financial crisis. What two solutions to the "too big to fail" issue have been suggested? - ANS-1. no longer permit a bailout 2. implement the Dodd-Frank Act which requires higher capital requirements on such firms. In 2004, then chair of the President's Council of Economic Advisers, Gregory Mankiw, stated: "Expecting a government bailout if things go wrong creates an incentive for a company to take on risk and enjoy the associated increase in return." Explain whether you agree or disagree with this statement. - ANS-This statement makes sense because unregulated action in systemically important financial institutions combined with the near guarantee of a government bailout creates moral hazard. What is the purpose of the bank for international settlements (BIS)? - ANS-provides research, education, and guidance for central bankers to help improve various aspects of banking supervision, infrastructure market issues, and financial stability policies. Main objective is to oversee the adoption of best practices by central banks as they address the various issues they face. What is the purpose of the Basel Committee on Banking Supervision of the BIS? - ANS-educate policymakers on the key issues associated with the supervision of banks to improve the quality of bank supervision throughout the world. What is the purpose of the Markets Committee of the BIS? - ANS-provide policy guidelines for enhancing market transparency, discussion of developments in finance markets, and an exchange of views on future developments that will have an impact of financial markets What does the Financial Stability Oversight Council (FSOC) have the authority to do? - ANS-has the authority to constrain nonbank financial entities from what the FSOC views as excessive risk taking that threatens the stability of the financial system. What are the views held by economists on the degree of regulation needed for financial markets? - ANS-1. there should be large-scale government interventions to solve problems that involve massive market failures 2. government intervention is the problem, not the solution. it may lead to market failures by implementing policies that are not beneficial to financial markets Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity? - ANS-When an investor holds a claim on a financial intermediary, he or she also effectively has made an indirect investment in the borrowing entity because the financial intermediary's direct investment is in that borrowing entity. The Insightful Management Company sells financial advice to investors. This is the only service provided by the company. Is this company a financial intermediary? Explain your answer. - ANS-Financial intermediary: obtains funds by issuing financial claims against themselves to market participants, and then invests those funds. A company that only sells financial advice does not fit this description and is therefore not a financial intermediary. Explain how a financial intermediary reduces the cost of contracting and information processing. - ANS-Financial intermediaries have highly trained employees focused on contracting and information processing. This lowers the cost of contracting and information processing through efficiency via economies of scale. economies of scale: a proportionate saving in costs gained by an increased level of production. "All financial intermediaries provide the same economic functions. Therefore, the same investment strategy should be used in the management of all financial intermediaries." Indicate whether you agree or disagree with this statement. Explain your answer. - ANS-Financial intermediaries vary greatly in their organizational structure and purpose, therefore should have different investment strategies that suit the needs of their clients and themselves. Types of financial intermediaries: commercial banks: banks that accept deposits and use the proceeds to lend funds to consumers and businesses S&L associations: savings and loan associations; similar to a bank that specializes in helping people get residential mortgages. investment companies: pools the funds of market participants and uses those funds to buy a portfolio of securities, such as stocks and bonds insurance companies: life, property, and casualty companies. pools clients' risks to make payments more affordable for insured; used to hedge against the risk of financial losses. pension funds: investment pools that pay for workers' retirements A bank issues an obligation to depositors in which it agrees to pay 3% guaranteed for one year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is the risk if the bank uses the funds to invest in common stock? - ANS-it faces market risk and will be subject to the level and volatility of market prices Look at table 3.1 again. Match the types of liabilities to these four assets that an individual might have: a. car insurance policy b. variable-rate certificate of deposit c. fixed-rate certificate of deposit d. a life insurance policy that allows the holder's beneficiary to receive $100,000 when the holder dies; however, if the death is accidental, the beneficiary will receive $150,000 - ANS-Type 1: amount of cash outlay: known; timing: known Type 2: amount of cash outlay: known, timing: unknown Type 3: amount of cash outlay: unknown, timing: known Type 4: amount of cash outlay: unknown, timing: unknown a. Type 4 b. Type 3 c. Type 1 d. Type 2 Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly? - ANS-1. maturity intermediation: convert a longer term asset into a shorter term asset by pooling many people's funds at once. 2. reducing risk via diversification: create a portfolio 3: reducing the costs of contracting and information processing 4. providing a payment mechanisms: payment options different from cash