1. When the stock market crashes, financial losses may well transmit
themselves into the real sector of the economy causing unemployment and
recession. Such a transmission from the financial sector to the real
sector can occur via the wealth effect and, or via the influence of financial
markets on the solvency of the financial institutions and the financial
system.
2. Ceteris paribus, within the stock market, common stocks are riskier
than shares of preferred stock. In the bond market, the ranking from
least to most risky is—collateral bonds, mortgage bonds, debenture bonds,
and subordinate debenture bonds.
3. Ceteris paribus, within the stock market, common stockholders may
receive a higher return than the fixed dividend (return) paid to owners
of preferred stock. In the bond market, ceteris paribus, subordinate
debenture bonds, followed by mortgage and collateral bonds.
4. Stock market performance can be gauged by a variety of stock market
indexes such as the S & P 500 or the Wilshire 5000. Although
the Dow Jones Industrial Average is the oldest and the best known, many
analysts consider the S & P 500 to be a more meaningful index of stock
market activity.
The Dow and the S & P 500 are correlated over the long run as they
both reflect general conditions and trends in the economy.
5. Treasury securities are generally considered free from any default
risk, as they are a credit obligation of the U. S. Government. Thus,
investors are confident that the government will always pay back principal
and interest on treasury securities. Further, the interest earned
on such securities is exempt from state income taxes. For these reasons,
such securities are used to benchmark the riskiness and liquidity of other
securities.
6. STRIPS are advantageous because investors can trade ownership of
the coupon and principal payments separately.
7. The risk associated with a fixed rate mortgage is that market
interest rates may rise, causing the value of the fixed-rate mortgage to
decline. Further, if financial institutions fund long-term 30-year
fixed rate mortgages with short-term deposits, the institution can be in
financial trouble if the cost of liabilities becomes greater than the earnings
on assets.
Financial institutions mitigate the risks arising out of issuing fixed
rate mortgages by utilizing variable rate mortgages.
8. Mutual (pooled) funds are perceived to be less risky than a basket
of individual stocks because they offer greater safety and more diversity
as compared to investing in one or a few individual stocks.
9. Institutional investors such as pension funds, insurance companies
and mutual funds trade in larger blocks of stocks as compared to individual
investors. The sheer weight of institutional capital markets enables
them to exert a greater influence on capital market activity.
This, is noteworthy, as in recent years institutional investors have begun
to dominate capital markets.
10. Inflation – indexed bonds allow for adjustment to be applied to
prinipal at the time when the coupon payments are made. These are
good for long term investments as the investor’s principal is protected
from inflation. Also, the rate of interest on inflation – indexed
bond does not change after they have been issued.
11. The over the counter market (OTC) is made up of a network of dealers
who trade stocks over 30,000 companies via telephone or computer.
Previously the OTC market traded stocks of smaller companies, yet nowadays
large company stocks (e.g., Apple & Microsoft) are also traded on this
market.
12. Stocks of a particular company may be traded on several competing
exchanges.
13. A “circuit breaker” temporarily halts market trading if prices
fall by a specific amount. Such breakers were initiated after the
October 1987 crash and were designed to give market -makers time to analyze
the situation and the opportunity to take positions in the market.
The rules have changed in recent years. Originally the breakers were
tipped and trading suspended for half and hour if the market declined 250
points from the previous day’s close. Market response to the turmoil
caused by the Asian crisis, created new rules based on a threshold percentage.
For instance if before2 p. m. the Dow Jones Industrial Average declines
by 10 percent from the average threshold the market will close for one
hour; between 2:00-2:30 the halt is for one hour and beyond 2:30 the 10
percent threshold is renewed and the market resumes trading.
14. The organized stock exchanges such as NYSE, The American Stock
exchange, and regional stock exchanges operate where specialists can trade
shows at a post. By contrast, the OTC market is an informal network
of dealers who can trade shares electronically via telephone. With
the rapid development of telecommunication technology, the OTC market has
become increasingly popular and efficient. As the use of information
technology such as e-commerce becomes more widespread, I is possible that
the OTC market may become more important than the organized stock exchanges.
15. Open-End Mutual Fund: sells new shares or buys outstanding shares
from the public at a price equal to the net asset value.
Closed-End Mutual Fund: sells a limited number if shares and does not
buy back outstanding shares.
Load: is the sales commission to be paid to a broker for the
purchase of some mutual funds.
No-Load: is purchased directly from the company thus avoiding
a commission.
Net Asset Value: is the difference between the market value of shares
owed by a fund and its liabilities, all divided by the number of outstanding
shares.
16. Mortgage-backed securities are created when mortgages are pooled
or bundled together and sold to investors as financial instruments.
The GNMA is a program that has enabled the creation of a secondary
market in mortgages by guaranteeing timely payment of it and principle
on budgets of at least $1 million of standard second mortgages. Freddie
Mae and Fannie Mae stand for government-sponsored Federal Home Loan Mortgage
Corporation and the Federal National Mortgage Association, respectively.
These programs are different from the GNMA as they actually purchase mortgages
and create pools.
17. The risk in this situation arises from the fact that Sandi and
Dave’s lender may have to re-invest the funds at a lower interest rate.
18. A bond indenture is a document that states the terms of a bond
issue. The indenture is made out to a trustee who specifically represents
the investor that is buying the bonds. The trustee thus has to ensure
that the bond issue fulfills the terms and conditions of the indenture.
19. Inflation in asset prices results in an increase in a consumer’s
nominal wealth, which in turn precipitates an increase in consumption spending
(wealth effect). Such consumption-induced increases in aggregate
demand can, ceteris paribus, contribute to inflation in the real sector
of the economy. The wealth effect emerging from the financial sector
of the economy can work in the opposite fashion as well. This can
happen when declining asset prices lead to cutbacks in consumption spending
and result in a decline in aggregate demand. Other things remaining
the same, a reduction in aggregate demand can precipitate deflationary
tendencies in the real sector of the economy.
20. The value of previously issued mortgages can fall if declining
real estate values cause some borrowers to default.
Falling interest rates will actually result in an increase in the value
of outstanding mortgages.
21. No. Revenue bonds are paid out of the revenues from the specific
project that the board selects. The repayment is tied to the success
of the project in general. General obligationbonds on the other hand
are re-paid out of general tax revenues.
22. The bond is selling at a price that is up 1/8 from the previous
day’s closing price. This development may have been caused by a decline
in market interest rates.
23. $72.50
24. The current yield on the bond is 7.6 percent. For the bond
to have a current yield of 8 percent, it would have to sell for $1,000.
25. 8.33 percent
26. Current yield on T-bill is 6.38 percent
Current yield on bond is 8.16 percent
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