Chapter 5 Financial Markets and Institutions

Answers to End-of-Chapter Questions

5-1 The prices of goods and services must cover their costs. Costs include labor, materials, and capital. Capital costs to a borrower include a return to the saver who supplied the capital, plus a mark-up (called a spread) for the financial intermediar that brings the saver and the borrower together. The more efficient the financial s stem, the lower the costs of intermediation, the lower the costs to the borrower, and, hence, the lower the prices of goods and services to consumers. !n a well-functioning econom , capital will flow efficientl from those who suppl capital to those who demand it. This transfer of capital can take place in three different wa s" #. $irect transfers of mone and securities occur when a business sells its stocks or bonds directl to savers, without going through an t pe of financial institution. The business delivers its securities to savers, who in turn give the firm the mone it needs. %. Transfers ma also go through an investment banking house which underwrites the issue. &n underwriter serves as a middleman and facilitates the issuance of securities. The compan sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses' securities and the savers' mone merel pass through the investment banking house. (. Transfers can also be made through a financial intermediar . )ere the intermediar obtains funds from savers in e*change for its own securities. The intermediar uses this mone to bu and hold businesses' securities. !ntermediaries literall create new forms of capital. The e*istence of intermediaries greatl increases the efficienc of mone and capital markets. 5-3 & primar market is the market in which corporations raise capital b issuing new securities. &n initial public offering is a stock issue in which privatel held firms go public. Therefore, an !+, would be an e*ample of a primar market transaction. & mone market transaction occurs in the financial market in which funds are borrowed or loaned for short periods (less than one ear). & capital market transaction occurs in the financial market in which stocks and intermediate-or long-term debt (one ear or longer)-are issued. a ! c d e 5-5 & ../. Treasur bill is an e*ample of a mone market transaction. 0ong-term corporate bonds are e*amples of capital market transactions. Common stocks are e*amples of capital market transactions. +referred stocks are e*amples of capital market transactions. $ealer commercial paper is an e*ample of a mone market transaction.

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!t would be difficult for firms to raise capital. Thus, capital investment would slow down, unemplo ment would rise, the output of goods and services would fall, and, in general, our standard of living would decline.

Chapter 5" Financial Markets and Institutions

Integrated Case

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1inancial markets have e*perienced man changes during the last two decades. Technological advances in computers and telecommunications, along with the globali2ation of banking and commerce, have led to deregulation, and this has increased competition throughout the world. The result is a much more efficient, internationall linked market, but one that is far more comple* than e*isted a few ears ago. 3hile these developments have been largel positive, the have also created problems for polic makers. 0arge amounts of capital move 4uickl around the world in response to changes in interest and e*change rates, and these movements can disrupt local institutions and economies. The sub-prime mortgage crisis illustrates how problems in one countr 4uickl affect the economies of other nations. 5lobali2ation has e*posed the need for greater cooperation among regulators at the international level. 1actors that complicate coordination include (#) the differing structures among nations' banking and securities industries, (%) the trend in 6urope toward financial services conglomerates, and (() reluctance on the part of individual countries to give up control over their national monetar policies. 7egulators are unanimous about the need to close the gaps in the supervision of worldwide markets. &nother important trend in recent ears has been the increased use of derivatives. The market for derivatives has grown faster than an other market in recent ears, providing corporations with new opportunities but also e*posing them to new risks. $erivatives can be used either to reduce risks or to speculate. !t's not clear whether recent innovations have increased or decreased the inherent stabilit of the financial s stem. The ph sical location e*changes are tangible ph sical entities. 6ach of the larger ones occupies its own building, has a limited number of members, and has an elected governing bod . & dealer market is defined to include all facilities that are needed to conduct securit transactions not made on the ph sical location e*changes. These facilities include (#) the relativel few dealers who hold inventories of these securities and who are said to make a market in these securities8 (%) the thousands of brokers who act as agents in bringing the dealers together with investors8 and (() the computers, terminals, and electronic networks that provide a communication link between dealers and brokers. The two leading stock markets toda are the 9ew :ork /tock 6*change (9:/6) and the 9asda4 stock market. The 9:/6 is a ph sical location e*change, while the 9asda4 is an electronic dealerbased market. The three forms, or levels, of market efficienc are" weak-form efficienc , semistrong-form efficienc , and strong-form efficienc . The weak form of the 6;) states that all information contained in past stock price movements is full reflected in current market prices. The semistrong form of the 6;) states that current market prices reflect all publicl available information. The strong form of the 6;) states that current market prices reflect all pertinent information, whether publicl available or privatel held. !f the market is semistrong-form efficient and the compan announces a #< increase when investors had e*pected it to announce a #=< earnings increase, ou would e*pect the stock's price to fall because the earnings increase was less than e*pected, which is /tatement b. !n fact, if the assumption were made that weak-form efficienc e*isted then ou would e*pect the stock's price to increase slightl because the compan had a slight increase in earnings, which is /tatement a. !f the assumption were made that strong-form efficienc e*isted then ou would e*pect the stock's price to remain the same because earnings announcements have no effect because all information, whether publicl available or privatel held, is alread reflected in the stock price.

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Integrated Case

Chapter 5" Financial Markets and Institutions

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There is an efficienc continuum, with the market for some companies' stocks being highl efficient and the market for other stocks being highl inefficient. The ke factor is the si2e of the compan -the larger the firm, the more anal sts tend to follow it and thus the faster new information is likel to be reflected in the stock's price. &lso, different companies communicate better with anal sts and investors8 and the better the communications, the more efficient the market for the stock.
)ighl !nefficient )ighl 6fficient

/mall companies not followed b man anal sts. 9ot much contact with investors.

0arge companies followed b man anal sts. 5ood communications with investors.

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1alse8 derivatives can be used either to reduce risks or to speculate. True8 hedge funds have large minimum investments and are marketed to institutions and individuals with high net worths. )edge funds take on risks that are considerabl higher than that of an average individual stock or mutual fund. 1alse8 hedge funds are largel unregulated because hedge funds target sophisticated investors. True8 the 9:/6 is a ph sical location e*change with a tangible ph sical location that conducts auction markets in designated securities. 1alse8 a larger bid-ask spread means the dealer will reali2e a higher profit. 1alse8 the 6;) does not assume that all investors are rational.

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Chapter 5" Financial Markets and Institutions

Integrated Case