Download CHAPTER 21 - MONEY AND BANKING

CHAPTER 13 – MONEY, FINANCIAL INSTITUTIONS,
AND SECURITIES MARKETS
ANSWERS
LEARNING THE LANGUAGE
1. Securities
2. Federal Open Market
Committee (FOMC)
3. Reserve requirement
4. Securities and Exchange
Commission (SEC)
5. Dividends
6. Money
7. NASDAQ
8. Insider trading
9. Stock
10. Federal Reserve
11. Initial Public Offering (IPO)
12. Stock exchange
13. Barter
23. Reserve
24. Maturity date
14. M-3
15. Money supply
25. Common stock
26. Over –the-counter market
(OTC)
27. Mutual fund
28. Bond
16. Monetary policy
17. New York Stock Exchange
(NYSE)
18. Preferred stock
19. Open market operations
20. Discount rate
21. M-2
22. Securities market
29. M-1
30. Par value
31. Index fund
32. Prospectus
ASSESSMENT CHECK
Learning Goal 1
Why Money Is Important
1.
Five characteristics of a “useful” form of money are:
a. Portability – money needs to be easy to carry around.
b. Divisibility – different sized coins are made to represent different values.
c. Stability – the value of money is more stable (unlike the value, or prices, of bartered goods).
d. Durability – Coins last for a long time.
e. Uniqueness – money must be hard to copy, so it must be elaborately designed.
2.
Electronic, or e-cash is the latest form of money. You can e-mail e-cash to anyone using websites,
and make online bill payments.
Learning Goal 2
Money Supply
3.
These terms stand for different definitions of the money supply.
M-1 includes coins and paper bills, money that is available by writing checks and money that is
held in traveler's checks or money that is easily available to pay for goods and services.
M-2 includes all of that, but adds in money in savings accounts, money market accounts, mutual
funds, certificates of deposit and the like.
M-3 is M-2 plus big deposits like institutional money market funds and bank agreements.
M-1 is the most commonly used definition of money.
4.
If the Fed significantly more money available, prices would go up, assuming that the same
amount of goods and services were available. People would bid up prices to get what they want,
causing inflation. This could be called “too much money chasing too few goods.”
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5.
If money were taken out of the economy prices would go down because there would be an
oversupply of goods and services compared to the money available to buy them. This is called
deflation. If too much money is taken out of the economy, a recession could occur. People would
lose jobs and the economy would stop growing.
6.
The Federal Reserve System consists of:
a. The board of governors.
b. The Federal Open Market Operations.
c. 12 Federal Reserve Banks.
d. Three advisory councils.
e. The member banks of the system.
7.
The board of governors administers and supervises the 12 Federal Reserve System banks. The
primary function of the board of governors is to set monetary policy.
8.
The Federal Open Market Committee has 12 voting members and is the policy-making body. The
committee is made up of the seven members of the Board of Governors plus the president of the
New York Reserve Bank. Four others rotate in from the other Reserve Banks. The advisory
councils offer suggestions to the board and the FOMC. The councils represent the various
banking districts, consumers, and member institutions, including banks, savings and loans, and
credit unions.
9.
Other than setting monetary policy, the Federal Reserve:
a. buys and sells foreign currencies.
b. regulates various types of credit.
c. supervises banks.
d. collects data on the money supply and other economic activity.
e. determines the level of reserves that must be held by financial institutions.
f. lends money to member banks.
g. sets the rate charged for such loans, the discount rate.
h. buys and sells government securities.
10.
When the Fed increases the reserve requirement banks have less money to loan, and money
becomes scarce. In the long run, this tends to reduce inflation.
A decrease in the reserve requirement increases the funds available to banks for loans, so banks
make more loans, and money becomes more readily available. An increase in the money supply
stimulates the economy.
11.
a.
To decrease the money supply, the federal government sells U.S. government securities to the
public. The money it gets as payment is taken out of circulation, decreasing the money
supply.
b.
If the Fed wants to increase the money supply, it buys government securities from
individuals, corporations, or organizations that are willing to sell. The money paid by the Fed
in return for these securities enters circulation, resulting in an increase in the money supply.
12.
One reason the Fed is called the banker’s bank is that member banks can borrow money from the
Fed and then pass it on to their customers as loans. The discount rate is the interest rate that the
Fed charges for loans to member banks.
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13.
An increase in the discount rate by the Fed discourages banks from borrowing and consequently
reduces the number of available loans, resulting in a decrease in the money supply.
A decrease in the discount rate encourages member bank borrowing and increases the funds
available for loans, which increases the money supply.
14.
The federal funds rate is the rate that banks charge each other.
15.
A falling dollar means that the amount of goods and services you can buy with a dollar decreases
compared to other currencies. It also means that U.S. products are less expensive for those using
other currencies. This could increase U.S. exports.
A rising dollar means that the amount of goods and services you can buy with a dollar goes up.
16.
What makes a dollar weak or strong (falling or rising dollar) is the position of the U.S. economy
relative to other economies.
17.
When the economy is strong, the demand for dollars is high, and the value of the dollar rises.
When the economy is weak, the demand for dollars declines and the value of the dollar falls.
So, the value of a dollar depends upon the strength of the U.S. economy.
Learning Goal 4
The Functions of Securities Markets
18.
Two major functions of securities markets are:
a. to assist businesses in finding long-term funding they need to finance capital needs, expand
their businesses, or buy goods and services.
b. to give investors a place to buy and sell investments such as stocks and bonds to help build
their financial future.
19.
The primary market handles the sale of new securities. This is the only time corporations make
money on the sale of securities.
After the corporation has made its money, the secondary market handles the trading of securities
between investors. The proceeds of sales in the secondary market go to the investor selling the
stock, not to the corporation whose stock is sold.
20.
Businesses prefer to meet long-term financial needs by using retained earnings or by borrowing.
21.
Debt financing is obtained through issuing bonds.
Equity financing is obtained through selling stock.
22.
Investment bankers are specialists who assist in the issue and sale of new securities.
Learning Goal 5
Bonds
23.
A company that issues bonds has a legal obligation to pay regular interest payments to investors
and repay the entire bond principal amount at a prescribed time, called the maturity date.
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24.
The interest rate paid on a bond varies according to factors such as the state of the economy, the
reputation of the company issuing the bond, and the going interest rate being paid by U.S.
government bonds or bonds of similar companies. Once an interest rate is set it can’t be changed.
25.
a.
b.
c.
Bondholders are not owners of a firm so they have no vote on corporate matters.
The interest paid on bonds is tax deductible for the firm.
Bonds are a temporary source of funding. They are eventually repaid, and the debt is
eliminated.
d. Bonds can be repaid before the maturity date if they contain a call provision, and can also be
convertible to common stock.
a.
b.
c.
Bonds are an increase in debt and could adversely affect the firm.
Interest on bonds is a legal obligation. If interest isn’t paid, bondholders can take legal action.
The face value of bonds must be repaid at maturity, which could cause cash flow problems.
Stock
26.
A stock certificate shows evidence of stock ownership and specifies the name of the company, the
number of shares it represents and the type of stock being issued.
27.
Dividends are a part of a firm’s profits that may be distributed to shareholders. Dividends are
declared by a corporation’s board of directors and are generally paid quarterly. Unlike bond
interest, which is a legal obligation, companies are not required to pay dividends.
28.
The advantages of raising funds through the sale of stock are:
a. Because stockholders are owners, they never have to be repaid.
b. There is no legal obligation to pay dividends.
c. Selling stock can improve the condition of the balance sheet because it creates no debt.
The disadvantages of issuing stock are:
a. As owners, stockholders can alter the direction of the firm, through voting for the board of
directors.
b. Dividends are paid out of after tax profits.
c. Management decision-making can be hampered by the need to keep the stockholders happy.
29.
Owners of preferred stock:
a. have a preference in the payment of dividends.
b. have a prior claim on company assets if the firm goes out of business.
30.
Preferred stock is referred to as a hybrid investment because it has characteristics of both bonds
and stocks.
31.
Preferred stock dividends differ from common stock dividends in several ways.
a. Preferred stock is generally issued with a par value that becomes the base for the dividend
the firm is willing to pay.
b. The owner is assured that the dividends on preferred stock must be paid in full before any
common stock dividends can be distributed.
32.
Both preferred stock and bonds have a face (or par) value, and both have a fixed rate of return.
Preferred stocks are rated by Standard and Poors and Moody’s Investment Service just like
bonds.
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33.
As debt, companies are legally bound to pay bond interest and must repay the face value of the
bond on its maturity date. Even though preferred stock dividends are generally fixed, they do
not legally have to be paid, and stock never has to be repurchased. Though both bonds and stock
can increase in market value, the price of stock generally increases at a higher percentage than a
bond.
34.
The special features of preferred stock are that it can be:
a. Callable, like bonds. This means a company could require preferred stockholders to sell back
their shares.
b. Convertible to common stock.
c. Cumulative. If one or more dividends are not paid when due, the missed dividends of
cumulative preferred stock will accumulate and be paid later and must be paid before any
common dividends can be paid.
35.
Three rights of common stockholders are:
a. the right to vote for the board of directors and important issues affecting the company.
b. to share in the firm’s profits though dividends declared by the board of directors.
c. preemptive right, which is the first right to purchase any new shares of common stock the
firm decides to issue. This right allows common stockholders to maintain a proportional
share of ownership in the company.
36.
The benefit of a mutual fund to an investor is they can buy shares of the mutual fund and share in
the ownership of many different companies they could not afford to invest in individually. Thus
mutual funds help investors diversify.
37.
Mutual funds range in purpose from very conservative funds that invest only in government
securities or secure corporate bonds to others that specialize in emerging high-tech firms, Internet
companies, foreign companies, precious metals, and other investments with greater risk. Some
mutual funds even invest only in socially responsible companies.
38.
The main difference between a mutual fund and an index fund is the fact that the index fund
follows an index, rather than having someone actively selecting stocks, as is done with mutual
funds. As a result the fees for an index fund are usually lower than for mutual funds.
39.
In terms of investing, to diversify means to invest in a number of different types of investments to
safeguard against a loss from one part of the portfolio not performing well.
Stock Exchanges
40.
Brokerage firms purchase memberships, or seats to obtain the right to trade on an exchange.
41.
The largest stock exchange is the New York Stock Exchange, NYSE, and is often referred to as the
Big Board.
The second largest exchange is the American Stock Exchange, the AMEX
42.
The NYSE and the AMEX exchanges are national exchanges because they handle stocks of
companies from all over the United States. Regional exchanges deal mostly with firms in their own
areas but also handle the stock of many large corporations listed on the New York exchange. They
are often used by institutional investors since transaction costs are less than those of large
exchanges.
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43.
Trades in the OTC market are made electronically through a network of several thousand brokers
who maintain contact with each other through a nationwide electronic system.
44.
The NYSE is a floor based exchange, whereas the NASDAQ is a telecommunications network
which links dealers across the country so they can guy and sell securities electronically rather
than in person.
Securities Exchange Regulation
45.
The Securities Act of 1933 protects investors by requiring full disclosure of financial information
by firms selling new stocks or bonds. Congress passed this act to deal with the “free-for-all”
atmosphere that existed during the Roaring Twenties.
46.
The Securities and Exchange Act of 1934:
a. created the Securities and Exchange Commission, which has the responsibility at the federal
level for regulating activities in the various exchanges.
b. companies trading on the national exchange must register with the SEC and provide annual
updates.
c. established guidelines companies must follow when issuing stocks or bonds.
d. established guidelines to prevent insiders from taking advantage of privileged information.
47.
Insider trading involves the use of knowledge or information that individuals gain through their
position that allows them to benefit unfairly from fluctuations in security prices.
The term “insider” includes just about anyone with securities information that is not available to
the general public.
Investing in Securities
48.
A stockbroker is a registered representative who works as a market intermediary to buy and sell
stocks for a client. Stockbrokers place an order with a stock exchange member who goes to the
place at the exchange where the bond or stock is traded and negotiates a price. When the
transaction is completed, the trade is reported to your broker who notifies you to confirm your
purchase. The same procedures are followed if you sell stocks or bonds.
49.
The five criteria to use when selecting an investment option are:
a. Investment risk – the chance that your investment could go down in value in the future.
b. Yield - the rate of return.
c. Duration – the length of time for which you are committing your assets.
d. Liquidity – how quickly you can get back your money if you need to.
e. Tax consequences – how the investment affects your tax situation.
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Reading Stock, Bond, and Mutual Fund Quotes
50.
A stock quote will contain the following information:
a. The percent of change in the stock’s price for the year to date.
b. The highest and lowest price over the past 52 weeks.
c. The company name and stock symbol.
d. Last dividend per share.
e. The dividend yield.
f. The price/earnings (P/E) ratio.
g. The number of shares traded that day.
h. The closing price for the day.
i. The net change of the stock price from the previous day.
51.
The information contained in a mutual fund quote includes:
a. Name of the fund family.
b. Price per share, called the Net Asset Value (NAV).
c. Change from the previous day’s NAV.
d. Rate of return of the fund year to date (YTD).
The Wall Street Journal also lists a fund’s 13 week return, one-year return, and five-year return
on different days of the week.
52.
The Net Asset Value, NAV, is the market value of the mutual fund’s portfolio divided by the
number of shares it has outstanding. The NAV is the price per share of the mutual fund.
53.
A zero-coupon bond is a bond that does not pay interest to the buyer until the maturity date.
54.
A bond quote in the paper contains:
a. the name of the company issuing the bond.
b. the interest rate.
c. the year the bond matures.
d current yield.
e. volume, which is the number of bonds traded that day.
f. price.
g. change from the previous day.
CRITICAL THINKING EXERCISES
Learning Goals 1, 2
1.
The stability of the value of money in the global marketplace is important because if the value of
money is not stable, other countries will not accept that money in trade. In other words, if the
marketplace believes your money will not be valuable to use, the market will not accept your
money as payment for what you want to buy.
The money supply needs to be controlled in order to control prices, and in part, the American
economy. If there is too much money in the economy, prices of goods and services will increase,
because demand will be greater than supply. If there is less money, people will not be spending at
the same rate, demand correspondingly goes down, and prices will go down. That could result in
an oversupply of goods and services, and possibly a recession. What makes a dollar weak or
strong is the position of the U.S. economy relative to other economies. When the economy is
strong, people want to buy dollars and the value of the dollar rises. The value of the dollar
depends on a strong economy.
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Learning Goals 2,3
2.
a. Tool
Action
Reserve
Requirement
Increase
Decrease
Effect on
Money supply
Decrease
Increase
Effect on
Economy
Slows down
Stimulated
Open market
operations
Buy securities
Sell securities
Increase
Decrease
Stimulated
Slows down
Discount rate
Increase
Decrease
Decrease
Increase
Slows down
Stimulated
b. 1. In a situation of high unemployment, the Federal Reserve may increase the money
supply, which would have the effect of reducing interest rates. This would be a tool to
stimulate the economy and encourage businesses to borrow, which could create jobs.
2. With high rates of inflation, the Fed may choose to decrease the money supply. This
would have the effect of raising interest rates, which may cool the economy and fight
inflation.
3.
Some of the "money" issues Sun-2-Shade will need to research relate to how strong the American
dollar is compared to the currency of the countries in which Sun-2-Shade is interested. If our
dollar is weak, or falling, in comparison to the euro, the British pound, the Japanese yen, or
others, Sun-2-Shade could be very affordable for their target market. If the American dollar is
strong, or rising, the price of Sun-2-Shade’s product could be too high for some.
Further, we would want to know what the forecast might be for the future of the U.S. economy. Is
our economy expected to be strong? What are the forecasts for recession, inflation, income
growth, both here, and in our target countries?
Learning Goal 4
4.
The finance manager of Sun-2-Shade has the opportunity to avoid the difficulties of a new issue by
making use of specialists in the securities markets such as investment bankers. These companies
will underwrite the new issue, by purchasing the entire issue for a discount. The investment banker
will then sell the issue on the open market to either private or institutional investors, such as
pension funds, mutual funds, insurance companies, or banks.
Learning Goal 4
4.
As we learned in previous chapters, one of the jobs of a finance manager is to determine the best
way for a firm to raise long-term capital. When deciding which form of long-term funding is best
a finance manager will weigh the options of both equity and debt funding.
You will probably tell Eric that bonds offer several long term financing advantages. Perhaps one
of the most important to Eric will be that bondholders are not owners of the firm, so they won’t
have a vote on corporate matters. So, Eric and his management team will maintain control over
the firm. Other benefits include the fact that bond interest is tax deductible, and that eventually
the debt will be repaid. If interest rates are high when the bonds are issued, they can be called
and re-issued when rates have lowered.
Conversely, when the firm goes into debt by issuing bonds, there could be an adverse affect on
the market’s perception of the firm. If for some reason a cash flow problem develops, interest is a
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legal obligation, and the firm would still have to pay interest, even with a negative cash flow, and
provisions have to be made for when the face value has to be paid off. This could also negatively
affect cash flow.
Stocks offer the opportunity for a firm to stay out of debt, and there is no legal obligation to pay
dividends. Selling stock can also improve the look of the balance sheet.
The downside of stock issues is that the structure of ownership changes, and stockholders have
the right to vote on the board of directors, and sometimes decisions have to be made with the
primary goal of keeping stockholders happy. Eric may not want to give up his ownership control.
Another downside is that dividends, if paid, are not tax deductible.
Learning Goal 5
5.
a. Common stock
b. Stock certificate
c. Dividends
d. Preferred stock
e. Pre-emptive right
f. Stock
Learning Goal 5
6.
a. This couple would probably want a low to moderate risk investment, which will increase
their principal over time. Tax consequences will be minimal, at least at first, as the child will
have little income in the early years.
(If they opt for an interest or dividend bearing type of account, the child will be earning
income, and tax consequences may become a more important consideration). They will
choose an investment that will yield a high return over the long run, and liquidity isn't
important for now.
7.
b.
Since this investment may be for retirement, this couple will probably want a low risk
investment, with as high an after-tax yield as they can earn. It will be of short duration, since
they plan to retire in five years, and they may want to keep it fairly liquid in case they retire
in less than five years. A big factor will be the tax consequences, as they are a two-income
family, and are probably in a high tax bracket with few deductions.
c.
A young, single person will choose a higher risk investment than the others, because they
probably are not concerned with long-term considerations such as retirement. Since they
want to build capital, the yield will be important for the short term. This individual may want
to keep investments of short duration to make a large return in a few years, when they may
want the money as a down payment for a house, for example, and they may want them fairly
liquid. Tax consequences will be important, as there are few deductions, and they may be in a
relatively high bracket
Your answers for each section will vary according to which companies you choose to study, and
when you are studying this chapter.
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PRACTICE TEST
MULTIPLE CHOICE
1. d
2. a
3. b
4. d
5. d
6. b
7. c
8. c
9. b
10. b
11. b
12. c
13. c
14. b
TRUE-FALSE
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
T
T
F
T
F
T
F
T
T
F
T
T
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