Solutions Manual

CHAPTER 8
UNDERSTANDING THE ROLE OF THE FINANCIAL
MARKETS AND INSTITUTIONS
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS
I. Questions
1.

Spot markets the markets in which assets are bought or sold for
on-the-spot delivery; Future markets the markets in which
participants agree today to buy or sell an asset at some future
date.

Money markets the financial markets in which funds are

borrowed or loaned for short periods (less than one year);
Capital markets the financial markets for stocks and for
intermediate or long-term debt (one year or longer).

Primary markets markets in which corporations raise capital

by issuing new securities; Secondary markets markets in which
securities and other financial assets are traded among investors
after they have been issued by corporations.

Private markets markets in which transactions are worked out

directly between two parties; Public markets markets in which
standardized contracts are traded on organized exchanges.

Derivatives any financial asset whose value is derived from the

value of some other underlying asset.

Investment banks an organization that underwrites and

distributes new investment securities and helps businesses obtain
financing; Commercial banks the traditional department store
of finance serving a variety of savers and borrowers; Financial
services corporations a firm that offers a wide range of

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financial services, including investment banking, brokerage

operations, insurance and commercial banking.

Mutual funds organizations that pool investor funds to

purchase financial instruments and thus reduce risks through
diversification; Money market funds mutual funds that invest in
short-term, low-risk securities and allow investors to write
checks against their accounts.

Physical location exchanges formal organizations having

tangible physical locations that conduct auction markets in
designated (listed) securities; Over-the-Counter (OTC) market
a large collection of brokers and dealers connected electronically
by telephones and computers that provides for trading in unlisted
securities; Dealer market includes all facilities that are needed
to conduct security transactions not conducted on the physical
location exchanges.

Closely held corporation a corporation that is owned by a few

individuals who are typically associated with the firms
management; Publicly owned corporation a corporation that is
owned by a relatively large number of individuals who are not
actively involved in the firms management.

Going public the act of selling stock to the public at large by a

closely held corporation or its principal stockholders; Initial
public offering (IPO) market the market for stocks of
companies that are in the process of going public.

2. In a well-functioning economy, capital will flow efficiently from those

who supply capital to those who demand it. This transfer of capital can
take place in three different ways:
a. Direct transfers of money and securities occur when a business
sells its stocks or bonds directly to savers, without going through
any type of financial institution. The business delivers its
securities to savers, who in turn give the firm the money it needs.
b. Transfers may also go through an investment banking house
which underwrites the issue. An underwriter serves as a
middleman and facilitates the issuance of securities. The
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company sells its stocks or bonds to the investment bank, which

in turn sells these same securities to savers. The businesses
securities and the savers money merely pass through the
investment banking house.
c. Transfers can also be made through a financial intermediary.
Here, the intermediary obtains funds from savers in exchange for
its own securities. The intermediary uses this money to buy and
hold businesses securities. Intermediaries literally create new
forms of capital. The existence of intermediaries greatly
increases the efficiency of money and capital markets.
3. A money market transaction occurs in the financial market in which
funds are borrowed or loaned for short periods (less than one year). A
capital market transaction occurs in the financial market in which stocks
and intermediate or long-term debt (one year or longer) are issued.
a. A BSP Treasury bill is an example of money market securities.
b. Long-term corporate bonds are examples of capital market
securities.
c. Common or ordinary stocks are examples of capital market
securities.
d. Preferred stocks are examples of capital market securities.
e. Dealer commercial paper is an example of money market
securities.
4. If people lost faith in the safety of financial institutions, it would be
difficult for firms to raise capital. Thus, capital investment would slow
down, unemployment would raise, the output of goods and services
would fall, and in general, our standard of living would decline.
5. Financial markets have experienced many changes during the last two
decades. Technological advances in computers and telecommunications,
along with the globalization of banking and commerce, have led to
deregulation and this has increased competition throughout the world.
The result is a much more efficient, internationally linked market, but
one that is far more complex than existed a few years ago. While these
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developments have been largely positive, they have also created

problems for policy makers. Large amounts of capital move quickly
around the world in response to changes in interest and exchange rates,
and these movements can disrupt local institutions and economies. The
subprime mortgage crisis illustrates how problems in one country
quickly affect the economies of other nations.
Globalization has exposed the need for greater cooperation among
regulators at the international level. Factors that complicate coordination
include (1) the differing structures among nations banking and securities
industries, (2) the trend in Europe toward financial services
conglomerates, and (3) reluctance on the part of individual countries to
give up control over their national monetary policies. Regulators are
unanimous about the need to close the gaps in the supervision of
worldwide markets.
Another important trend in recent years has been the increased use of
derivatives. The market for derivatives has grown faster than any other
market in recent years, providing corporations with new opportunities
but also exposing them to new risks. Derivatives can be used either to
reduce risks or to speculate. Its not clear whether recent innovations
have increased or decreased the inherent stability of the financial
system.
6. Money markets refer to those markets dealing with short-term securities
that have a life of one year or less. Capital markets refer to securities
with a life of more than one year.
7. A primary market refers to the use of the financial markets to raise new
funds. After the securities are sold to the public (i.e., institutions and
individuals), they trade in the secondary market between investors. It is
in the secondary market that prices are continually changing as investors
buy and sell securities based on the expectations of corporate prospects.
8. Given companies with equal risk, those companies with expectations of
high return will have higher common stock prices relative to those
companies with poor expectations.
9. Restructuring can result in changes in the capital structure (liabilities and
owners equity on the balance sheet). It can also result in the selling of
low-profit-margin divisions with the proceeds reinvested in better
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investment opportunities, and sometimes restructuring results in the

removal of the current management team or large reductions in the work
force. Restructuring has also included mergers and acquisitions.
II. Multiple Choice Questions
1.
2.
3.
4.

A
B
D
B

5.
6.
7.
8.

D
D
A
D

III. Matching Quiz

1.
2.
3.
4.
5.
6.
7.
8.
9.

i.
e.
f.
c.
a.
h.
b.
g.
d.

financial capital
inflation
primary market
money market
restructuring
disinflation
capital market
secondary market
real capital

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