Chapter 2 Integrated Case 2-11
A) In a well-functioning economy, capital flows efficiently from those with surplus capital to those who need it in one of three ways: • Direct transfers: occur when a business sells its stocks or bonds directly to savers without going through any type of financial institution. This is used primarily by small firms and doesn’t raise much capital. • Transfers also can go through an investment bank that underwrites the issue, or serves as middleman/facilitator. The company sells its stocks or bonds to the investment bank, which then sells these same securities to savers. Because new securities are involved and the corporation receives the sale proceeds, this transaction is called a primary market transaction. • Transfers can also be made through a financial intermediary, such as a bank, insurance company, or mutual fund. Intermediaries increase efficiency of money and capital markets.
B) People and organizations wanting to borrow money are brought together with those who have surplus funds in the financial markets.
Types of Financial Markets include…
• Physical Asset vs. Financial Asset: physical asset markets are for tangible products, while financial asset markets are for stocks, bonds, notes, and mortgages. They also deal with derivative securities whose values are derived from changes in the prices of other assets. o A share of Ford stock is a pure financial asset, while an option to buy Ford shares is a derivative security whose value depends on the price of Ford stock. • Spot Markets vs. Futures Markets: spot markets are markets in which assets are bought or sold for on the spot delivery (within a few days). Future markets are markets in which participants agree today to buy or sell an asset at some future date. Future market transactions can reduce, or hedge, the risks faced by buyers and sellers if the market changes. • Money Markets vs. Capital Markets: money markets are the markets for short-term, highly liquid debt securities. Capital markets are the markets for intermediate or long-term debt and corporate stocks, like the NYSX. o Short-term markets = less than one year
o Intermediate term markets = 1 to 10 years
o Long-term markets = more than 10 years
• Primary markets are the markets in which corporations raise new capital, so the corporation itself receives proceeds. • Secondary markets are markets in which existing, already outstanding securities are traded among investors. The corporation does not receive funds from a secondary market sale. • Private markets are markets in which transactions are negotiated directly between two parties. • Public markets are markets where standardized contracts are traded on organized exchanges.
C) Financial markets are essential for a healthy economy and economic growth because they provide a variety of opportunities for buyers and sellers to meet, exchange goods and services, better address financial needs, and accumulate wealth to stimulate the economy.
D) A derivative is any security whose value is derived from the price of some other underlying asset. The use of derivatives has increased in recent years. If a bank or any other company invests in derivatives, it is difficult to tell whether it is an investment as a hedge against something like an increase in the price of good X, or a speculative bet that prices will rise. This makes the firm’s risk profile more difficult to determine. Derivatives can...