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Name: ___________________________________________________ Period:__________________
Chapter 2
Part One – Financial Environment
Goals
 Explain the role of scarcity and choice in economic decision making
 Construct supply and demand curves
 Know how changes supply and demand affect interest rates
 Explain how monetary policy can be used to affect interest rates
 Identify the components of the nominal interest rate
 Calculate interest rates, interest premiums, returns, and expected interest rates
Vocabulary
economics
scarcity
choice
resources
natural resources
renewable resources
non-renewable resources
capital resources
human resources/labor
microeconomics
macroeconomics
traditional economy
command economy
market economy
mixed economy
free enterprise economy
nominal rate
coupon rate
real rate
risk-free rate
risk premium
inflation premium
demand
supply
market price
equilibrium price
discount rate
open market activity
term structure of interest rates
yield curve
Geekonomics
Why abundance sucks, and other unexpected lessons of the game economy.
By Edward Castronova
What if everything in life were free? You'd think we'd be happier. But game designers know better: We'd
be bored.
Economics is loosely defined as choice under scarcity. After all, in the real world, there's only so much to
go around. You can't always get what you want, and unfulfilled desires give rise to markets. But in a game
world, there's no inherent reason for scarcity. Game designers have given us plenty of utopias where we can
have all the mithril we want, to buy whatever we want whenever we want it. Problem is, those worlds turn
out to be dull. For example, the developers of Active Worlds made everything in the game free. Players built
enormous houses - in which there was nothing to do. The game never quite caught on. That's why today's
newer massive synthetic worlds make life hard. It's why we have to scheme, fight, and occasionally beg for
food, shelter, transportation, and great big flaming swords. Games show us that scarcity can be fun.
The lessons of Game Economics 101 pop up in unexpected places. To spice up life in Habitat, developers
added money and pawn machines. For a while, you could buy crystal balls at one machine and sell them for
nearly twice as much at another. Of course, someone coded his computer to run a character between sellers,
quintupling the money supply overnight. Can you say inflation? In the early days of Ultima Online, storage
space was unlimited. Eventually, a guy decided to hoard 10,000 shirts, utterly borking the market for cloth.
In Shadowbane, players became convinced that higher-ups moved the entire population to a new server sans
money because the economy got so out of hand. When gold farmers began to leach the precious metal out of
EverQuest to sell elsewhere, Sony ordered eBay to close all currency auctions related to the game. Within
days, online auctions sprang up in even greater numbers elsewhere.
What we're learning is that scarcity itself is an essential variable. We just haven't needed to worry about it
before. Thanks to God, the Man, or whoever's running this show, we're used to taking scarcity for granted.
The emergence of virtual communities means that we have to make it explicit.
In the end, the best game economies are not radically different, just a little weird. Yet one built-in,
unavoidable limit remains: time. Designers can control the abundance of all other resources, but the number
of hours in the day is a constant. Games make money by occupying time - grabbing eyeballs and holding on
to them. The point of economic policy in a game isn't to simulate reality; it's to make the synthetic scarcity
so entertaining that the truly scarce good - players' time - goes toward solving problems in the game, not in
the outer world.
Edward Castronova ([email protected]) is associate professor of telecommunications at Indiana
University, where he specializes in the economic and social impact of multiplayer online videogames
Section 2.1 Basic Economic Systems and Principles
Economics is the _______________ of decision making about the _______________________ of
___________________ resources. All individuals must make _____________________ about which wants
and needs they will meet and which will be let go. People use _______________________ as a means to
develop solutions to satisfy needs and wants.
Types of Resources
The study of economics is divided into two categories. ____________________________ is concerned with
decision made by businesses and individuals and is controlled by _____________ and _____________.
___________________________ deals with decision made at the national level about the production of
products and services as a whole. The way a nation makes decisions about its products and services determines
the type of economy the nation has. In a _______________________ economy, economic decisions are made
at the local level and center around maintaining basic needs. By contrast, the government makes most economic
decisions in _______________ economies. With a _____________ economy, economic decisions are
determined by what businesses are willing to sell and individuals to buy. Economies that combine the features
of the three basic economic structures are known as _______________ economies. In the United States, the
combination of the market economy to set prices and government regulation for fairness is known as a
_________________________________________ economy which follows the following basic principles:
1.
2.
3.
4.
5.
Supply and Demand
1.
The interest rate represents the ____________ of money to the borrower and the _______________
on the invested money to an investor.
2. The stated/actual/coupon/nominal rate is comprised of three components. They are:
compensates investors for the risk associated with the particular investment (e.g.- default)
compensates investors for the loss of purchasing power due to inflation
pure cost to borrow money not considering any other factors
3. Supply, Demand, and Equilibrium Rates
a.
The interest rate on borrowed funds is determined by the _______________ ____________ of
funds by investors and the ________________ ____________ for funds by borrowers.
Rate
Rate
S-
S
S+
D+
D
DQuantity of Funds Available
Rate
S
6%
D
$9 B
Quantity
Quantity of Funds Available
b. Factors that affect shifts in supply
i.
ii.
iii.
c.
Factors that affect shifts in demand
i.
ii.
iii.
d.
Factors that affect both shifts in supply and demand
i.
ii.
4. Term Structure of Interest Rates looks at the relationship between the interest rate and the time to
__________________________. This relationship is usually shown using _______________________
_____________________.
a.
Upward sloping curve – longer times to maturity earn a ______________ rate of return.
b. Downward sloping curve – longer times to maturity earn a ________________ rate of return.
c.
Flat Curve - no difference in the yield based on maturity.
Homework
1. On page 40 in the text, answer questions 1, 2, 3, and 6.
2. Complete the attached Interest Rate Changes worksheet.
3. Complete the attached Chapter 2.1 Exercises worksheet.
4. Complete the attached Monetary Policy worksheet.
Note: Section 2.2 on Legal Forms of Business and Section 2.4 on Global Financial Activities was studied as part
of the job fair.
MONETARY POLICY
Discount Rate
The Federal Reserve Lowers the Discount Rate
THE FED
The Federal Reserve lowers
the discount rate.
The Fed issues more loans
to bankers and the money
supply increases; interest
rates decrease.
Member banks take
advantage of the lower rate
and borrow more money.
The Federal Reserve Raises the Discount Rate
THE FED
The Federal Reserve raises
the discount rate.
The Fed issues fewer loans
to bankers and the money
supply decreases; interest
rates increase.
Bankers shy away from the
higher interest rates and take
out fewer loans.
MONETARY POLICY
Open Market Operations
The Federal Reserve Buys a Security
Jane
THE FED
The Federal Reserve buys a
government security from
Jane. The Fed receives the
security and pays Jane.
Jane sells her government
security and is paid by the
Fed. Jane puts the money in
her bank.
With Jane’s deposit, the
bank now has additional
money to make more loans.
The Federal Reserve Sells a Security
Bob
THE FED
The Federal Reserve sells a
government security to Bob.
The Fed receives a check
from Bob. The Fed sends the
check to Bob’s bank for
payment.
Bob buys a government
security from the Fed. He
writes a check for it, so
money comes out of his
bank and flows to the Fed.
Bob’s bank pays the Fed on
Bob’s check and reduces
Bob’s account balance. The
bank now has less money on
deposit, and can make fewer
loans.
Honors Finance
Monetary Policy Worksheet
Name
The Federal Reserve System is able to increase or decrease the amount of money in circulation by buying or
selling government securities or by changing the discount rate. Listed below are a series of consequences that
may occur when the Fed adjust the discount rate or engages in open market operations. Carefully consider each
consequence, and then indicate which action by the Fed may have caused the consequence by writing it in the
appropriate part of the chart below. Note: Items may be the consequence of more than one policy.
Increase in money supply
Slowdown in production
Higher interest rates
Decrease in money supply
Increase in jobs
Lower interest rates
Less income
Greater production
Lower number of jobs
More income
Monetary Policy
The Fed Lowers the Discount Rate
The Fed Buys a Security
The Fed Raises the Discount Rate
The Fed Sells a Security
Honors Finance
Interest Rate Changes
Name:
Directions: Indicate whether each event will (1) affect the supply or demand of funds, and (2) cause an increase or
decrease in interest rate.
1. A recession has caused investors to withdraw funds from their savings accounts.
Affects:
Supply
Demand
Rate:
Increase
Decrease
Increase
Decrease
2. The U.S. government needs to borrow more money to meet the budget.
Affects:
Supply
Demand
Rate:
3. The Fed reduces the discount rate (the interest rate the Fed charges for loans to depository institutions).
Affects:
Supply
Demand
Rate:
Increase
Decrease
Rate:
Increase
Decrease
Rate:
Increase
Decrease
Rate:
Increase
Decrease
Rate:
Increase
Decrease
4. The unemployment rate increases.
Affects:
Supply
Demand
5. Economic forecasts for the technology industry are positive.
Affects:
Supply
Demand
6. The Fed sells some of its Treasury securities.
Affects:
Supply
Demand
7. Foreign investors deposit money in U.S. banks.
Affects:
Supply
Demand
Honors Finance
Interest Rate Fundamentals Exercises
Name:
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Debbie Sompels has $1,000 with which to buy furniture today or invest in a certificate of deposit for 1 year
and then purchase the furniture after that. Suppose the nominal rate of interest remains at 7% but the
expected rate of inflation is 7%. Will Debbie expect to benefit from her investment in the CD that pays 7%?
Why is it important for borrowers and lenders to understand how the risk-free interest rate changes?
What are the components of the nominal rate of interest?
Which securities set the risk-free rates of interest? Why are these securities used for this purpose?
How is the equilibrium interest rate determined?
Of governments, businesses and individuals, which are net suppliers of funds? net demanders of funds?
What are the factors that will cause a shift in the supply of funds?
What are the factors that affect aggregate demand for funds?
Explain how the Fed can change the money supply.
What is the term structure of interest rates, and how is it related to the yield curve?
What does an upward-sloping yield curve tell you about interest rates?
Explain a situation that would cause the yield curve to be (a) downward sloping and (b) flat.
What is a risk premium?
What factors would affect the risk premium on a bond? on a stock?
Why are stocks considered more risky than bonds in general?
Rank the following stocks in order from most risky to least risky: (a) General Electric Company (GE), an
established conglomerate in many lines of business; (b) E-Bay, a newly established company engaged in auction
over the Internet; (c) Merck, a pharmaceuticals company developing new drugs
The risk-free rate on long-term capital is 5.80%. Rates of return on A grade corporate bonds average 7.80%
and the average return on the S&P 500 (a basket of stocks consisting of 500 of the largest companies in
different industries) is 12.60%. If inflation is expected to increase by another 1.10%, what will be the
expected return on the A grade corporate bond? On the S&P 500? What can you say about the new expected
returns on both groups of securities?
Consumers are saving less as the result of a tax increase. How will this event affect the risk-free rate? How
will this event affect risk premiums on specific stocks and bond?
Your firm operates a subsidiary in a foreign country that is in turmoil. How will this event affect the risk-free
rate? How will this event affect risk premiums on your firm’s stocks and bond?
The chart on the right shows the average annualized yields on Treasury and corporate securities. Use the data
in the chart to answer the questions.
a.
Determine the premium paid on 10-year Treasury bonds
as a result of the longer term to maturity.
b. What is the real rate of return on Treasury bills?
c. What is the risk premium on the highest-grade corporate
bonds? On the lowest-grade corporate bonds?
d. If you are working for a financial institution bound by
regulation to invest only in investment grade bonds
(bonds graded Baa and higher), what is the highest
return you can receive on your investment?
Security
Expected inflation rate
30-day Treasury bill
10-year Treasury bond
10-year Aaa corporate bond
5-year Ba corporate bond
10-year Ba corporate bond
15-year Ba corporate bond
10-year B corporate bond
30-year Baa corporate bond
Corporate Stocks
Yield
3.10%
6.60%
7.10%
8.00%
8.60%
8.85%
9.10%
10.04%
8.55%
13.50%
Review – Chapter 2.1
Honors Finance
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1b
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Across
2. person or group that affects the demand for funds
3. deciding which wants and needs will be satisfied
5. compensates investors for the uncertainty
surrounding a particular investment (2 words)
7. another name for the nominal rate
9. the ease with which an investment can turn into cash
11. a factor affecting supply of funds
12. The Federal Reserve's way of controlling the
economy (2 words)
14. rate paid by the borrower to the lender
15. type of operation the government uses when it buys
and sells Treasury securities (2 words)
16. storehouses for the money supply
17. effect a decline in the discount rate would have on
supply
19. your ability to buy goods (2 words)
20. interest rate based on the cost to use other people's
money
23. a graph plotting return against time to maturity (2
words)
25. resources like water
26. the date a debt instrument is due
27. reason why people must make choices
Down
1. expectation that in exchange for low risk investors accept
a low expected return
1b. man-made resources
4. point at which supply and demand curves intersect
6. possible reason why short-term investments are earning
more than long-term investments
8. rate at which the Fed loans money to member banks
10. effect an increase in the tax rate would have on demand
12. total amount of deposits held at banks plus currency held
by the public (2 words)
13. science of decision making about allocation of resources
17. a general rise in the price of goods
18. securities that set the risk-free rates
21. the possibility that a company will not make its loan
payments
22. slope of a normal yield curve
24. the cost of money
Name: ______________________________________________________ Period:__________________
Chapter 2.3
Part Two – Financial Markets
Goals – Financial Markets
 Discuss the purpose and general structure of financial markets
 Describe the major types of financial markets
 Define authorized, issued, outstanding and treasury shares
 Understand the role of investment banking in financial markets
 Explain the types of financial exchanges
 Calculate spreads, net proceeds of issues, bond payments, amount of shares that can be issued
Vocabulary
financial market
term
commodity markets
spot markets
futures markets
face value/par value/principal
discount
coupon bonds
bearer bonds
registered bonds
semi-annual
stock markets
stock exchanges
organized exchange (e.g. NYSE)
buy price
sell price
listed
Over the counter (OTC) exchange (e.g. NASDAQ)
bid price
ask price
dealer
broker
public placement
private offering
authorized shares
issued shares
outstanding shares
treasury shares
investment banking
spread
underwriting
best-efforts basis
prospectus
red herring
initial public offering (IPO)
primary market/offering
secondary market/offering
private/closely held corporation
public corporation
board of directors
charter
Section 2.3 Types of Financial Markets
1.
A financial market provides an organized process for the exchange of money. Businesses and governments
use the money to obtain ____________________ to operate the business or provide services. Consumers
use the money to meet ______________________. When deciding which market to invest in, investors
consider __________, __________________ and the ___________, or time, of the investment. Each
market helps to set the supply and demand for a specific investment, thereby setting the ____________.
2. Shares of stock that a company can sell are known as __________________________ shares. The
number of shares of stock a company can sell is listed in the company _____________________. Stocks
that have been sold in the marketplace are known as ___________________ shares.
3. When a company decides to offer securities they can choose between a private placement and a public
offering. With a ________________________________, the company knows exactly who will purchase
the security when it goes to market. This type of offering is most common with small companies that are
owned by a small number of people. These types are companies are known as _______________________
or ___________________ corporations. Large companies may also use a private placement when the
security is purchased by an ________________________ investor such as a mutual fund. The sale of
securities to the general public is known as a _________________ offering. When a company issues
stock for the very first time ever it’s called the company’s ____________________________________
or _________. If the company decides to issue more of its authorized shares at a later date, those
shares are known as the company’s _______________________ offering. Public offerings often bring in
_______________ amounts of cash to the company, but they are __________ expensive than private
offerings.
4. When a security is issued for the first time, it is sold in the _____________________ market. The
primary market is the place where both __________________ and _____________________ offerings
are sold. Once a share has been issued, it can then be traded by the public in the ___________________
market. Stocks that are traded by the public are called _______________________________ shares.
Sometimes the company issuing the stock buys some of its own shares back. These shares then become
__________________________ stock and are no longer considered to be outstanding.
5. The __________________________ market is used to trade raw materials and other basic production
resources. Spot markets buy and sell commodities for ________________________ delivery. Futures
markets negotiate ___________________ to buy and sell commodities at a ________________ date.
Futures markets help buyers and sellers protect against the __________ of uncertain markets.
6. Bond markets trade _________ securities issued by ____________________ and
___________________. Bonds in the United States are issued with face amounts, or ________ values,
of __________________. Some bonds earn interest which is payable to the _____________________
every ____ months. These types of bonds are called _______________ bonds. Bonds that do not earn
interest are called _________________________ bonds. These bonds are issued at a
_______________________ which means they are sold for less than the par value, or _________
amount. In the past, bond payments were made to whoever had physical possession on the bond. These
types of bonds are called ______________ bonds. Because these bonds could be easily stolen, the SEC
now requires bonds to be _______________________ in a computer which keeps track of the owner of
the bond. Payments are then made to the registered owner.
7. Securities _________________________________ provide the marketplace for the sale and purchase
of securities. ____________________________________ exchanges are formal organizations with
________________ locations. They act as secondary markets for securities by holding ____________.
The goal of trading is to fill ________ orders at the lowest price and _________ orders at the highest
price. These exchanges own the exclusive rights to trade the stocks of _____________ companies. The
largest organized exchange in the U.S. is the _____________________________________________.
8. An over-the-counter, or ________, exchange is used to trade securities that are not ____________ on
any of the organized exchanges. These markets do not have a ____________________ location. Trades
in this market are made by a collection of _______________ who hold _______________________ of
OTC securities. Thousands of ___________________ act as agents in bringing together the dealers and
potential investors. Telephones and computers are used to continuously communicate the dealer’s current
______________ price (price at which the dealer will purchase securities) and the dealer’s ___________
price (the price at which the dealer will sell securities). The largest OTC market in the U.S. is the National
Association of Securities Dealers Automated Quotation, or ___________________.
Honors Finance
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Financial Markets Review Questions
Why are financial markets important to firms and investors?
What are (a) initial public offerings and (b) secondary offerings?
Distinguish between public offerings and private placements.
What functions does an investment banker perform?
Explain the sequence of events in the issuing of a new security?
How are underwriting costs affected by the size and type of an issue?
What is the purpose of a prospectus?
Hildreth Recycling is interested in selling common stock to raise capital for a plant expansion. The firm has
hired First Atlanta Company, a large investment banking firm, to serve as underwriter. First Atlanta
believes that the stock can be sold for $80 per share, that its administrative costs will be 2% of the sale
price, and that its selling costs will be 1.5% of the sale price. If First Atlanta requires a profit equal to 1%
of the sale price, how much will the spread have to be, in dollars, to cover its costs and profits?
RM International wishes to sell $100 million of bonds whose net proceeds will be used in the acquisition of
Little Books. The company has estimated that the net proceeds, after paying underwriting costs, should
provide an amount sufficient to make the acquisition. The underwriter believes that the 100,000 bonds can
be sold to the public for par and estimates that its administrative costs will be $4.25 million. The
underwriting commission (in addition to recovery of its administrative costs) is 1% of the par value of the
offering.
a. Calculate the per bond spread required by the underwriter to cover its costs.
b. How much money will RM International net from the issue?
c. How much will the underwriter receive from the issue?
d. Assuming that this is a public offering, describe the nature of the underwriter’s risk.
Why are secondary markets important?
Charter Corp. has issued 2,500 bonds with a total value of $2,500,000. The bonds have a coupon rate of
7%.
a. What dollar amount of interest per bond can an investor expect to receive every six months from
Charter Corp.?
b. What is Charter’s total interest expense per year associated with these bonds?
Aspin Corporation’s charter authorizes issuance of 2,000,000 shares of common stock. Currently,
1,400,000 shares are outstanding and 100,000 shares are being held as treasury stock. The firm wishes to
raise $48,000,000 for a plant expansion. Discussions with its investment bankers indicate that the sale of
new common stock will net the firm $60 per share.
a. What is the maximum number of new shares of common stock the firm can sell without receiving
further authorization from shareholders?
b. Based on the data given and your finding in part a, will the firm be able to raise the needed funds
without receiving further authorization?
c. What must the firm do to obtain authorization to the number of shares needed?
Why might the financial manager of a company buy its own shares? Why might the manager sell the
treasury shares?
Compare and contrast organized exchanges with OTC exchanges.
What are bid prices and ask prices? Why are prices in the OTC quoted in this way?
Answer the following questions from your textbook:
a. Page 40 - Questions 4, 5
b. Page 45 – Checkpoint question
c. Page 47 – Questions 1, 2, 4, 5
d. Page 52 – Questions 1, 2, 3, 4, 5
e. Page 57 – Questions 1, 3, 4
f. Pages 59 to 62 – Questions 11, 12, 13, 17, 20, 21, 22, 23, Stock Market Activity 1, 2, 3