ECS3701 EXAM PACK.

LEARNING UNIT 1: Why study money, banking and financial markets? 1. Differentiate between a security and a bond. A security is a claim on the issuer’s future income or asset. A bond is a debt security that promises to make payments periodically for a specified period of time. A security earns dividends, whilst is not a liability to the institution as it may defer payments, however, bonds earn interest which is a liability and, if deferred, may attract penalties and liability will accumulate. 2. What is the difference between a stock and a bond? A stock (also called a share) is a claim on the issuer’s future income or assets whilst a bond is a debt that promises to make payments periodically for a specific period of time. a stock earns dividends, whilst it is not a liability to the institution as it may defer payments, however, bonds earn interest which is a liability and, if deferred, may attract penalties and liability will accumulate 3. Explain briefly and in general terms what is the meaning of a security and how it facilitates direct lending and borrowing. A security, is also called a financial instrument, and is a claim on the issuers future income or asset. A bond or stock are examples of a security. They are sold to initial buyers by the corporation borrowing the funds. 4. Explain briefly what a common stock is, what purpose it serves and how it affects business investment decisions. A common stock, usually just referred to as a ‘stock’, represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issueing stock and selling it to the public is how corporations raise funds to finance their activities. The stock market is an important factor in business investment decisions, because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price for a businesses shares means that it can raise a larger amount of funds, which it can use to buy production facilities and equipment. 5. What is a financial crisis? A financial crisis is major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of mnay financial and nonfinancial firms. Financial crises have been a feature of capitalist economies for hundreds of years and are typically followed by the most severe business cycle downturns. Financial crises can interfere with the ability of financial markets to channel funds to people with productive investment opportunities leading to economic contraction. 6. List two ways in which the quantity of money may affect the economy. 7. Explain the difference between nominal and real GDP and the purpose for which each should be used. Nominal GDP refers to the GDP measure when the total value of final goods and services is calculated using current prices. If all prices are doubled but actual production of goods and services remained the same, nominal GDP would double even though people would not enjoy the benefits of twice as many goods and services. As a result, nominal variables can be misleading measures of economic well-being. Real GDP is GDP measured with constant prices i.e fixed prices. Real variables thus measure the quantities of goods and services and do not change because prices have changed, but rather only if actual quantities have changed. Real variables are typically of more interest than nominal variables. 8. List and define three commonly used measures of the aggregate price level. The aggragate price level can be defined as the price of a basket of goods and services. The three measures of aggregate price levels are the GDP deflator, which is defined as nominal GDP divided by real GDP. Another measure is the PCE deflator, which is similar to the GDP deflator and is defined as nominal personal consumption expenditures (PCE) divided by the real PCE. The most frequently used is the consumer price index (CPI), which is measured by pricing a basket of goods and services bought by a typical urban household. 9. What is the function of financial markets. (2) A financial market is markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. The financial market channels funds from households, firms and government that have surplus funds by spending less than their incomes (lender-savers) to those that have shortages of funds because they wish to spend more than their income (borrower-spenders). Financial markets are important for producing an efficient allocation of capital which contributes to higher production and efficiency for the overall economy. LEARNING UNIT 2: An overview of the financial system 10. Briefly explain the meaning of direct and indirect financing and the meaning of a financial intermediary (5) Direct financing is when borrowers borrow funds directly from lenders in the financial markets by selling them securities. Indirect financing is where financial intermediary stands between lendersavers and borrower-spenders and helps transfer funds from one to the other. 11. Explain the differences between debt and equity markets, primary and secondary markets, exchanges and OTC markets, and money and capital markets (10) Debt and equity markets: A firm or an individual can obtain funds in a financial market in two ways. Issuing a debt instrument, such as a bond or mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals until a specified date when a final payment is made. The other method is by issuing equities, such as common stock, which are claims to share in the net income and the assets of a business. Primary and secondary markets: A Primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the cooperation or government agency borrowing the funds. The primary market for securities are not well known to the public because the selling of securities to initial buyers often take place behind closed doors. A secondary market is a financial market in which securities that have been previously issued can be resold. Examples of secondary markets are foreign exchange markets, futures markets, and options markets. secondary markets can be organized in exchanges or over-the-counter (OTC) market. Exchanges and OTC markets: To organize exchanges is where buyers and sellers of securities meet in one central location to conduct trades. Examples are The New York Stock Exchange for stocks, and the Chicago Board of Trade for commodities. OTC markets are those in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities ‘over-the-counter’ to anyone who comes to them and is willing to accept their prices. These dealers are in contact via computers and know the prices set by one another, thus the OTCmarket is very competitiveand not very different from a market with an organized exchange. Money and capital markets: The money market is a financial market in which only short-term debt instruments are traded. They are more widely traded and so tend to be more liquid. Short-term instruments also have smaller fluctuations making them safer instruments. Corporations and banks actively used the money market to earn interest on surplus funds that they expect to have only temporarily. The capital market is the market in which longer-term debt and equity instruments are traded. Capital market securities are often held by financial intermediaries such as insurance companies and pension funds. 12. List and explain the operation of any three money market instruments (15) Money market instruments include repurchase agreements (repos) which are effectively short-term loans, often with a maturity of less than 2 weeks, for which treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the loan. Repurchase agreements are now an important source of bank funds. 13. List and explain the operation of any three capital market instruments (1