The financial markets where direct transactions take place are wholesale markets with a typical minimum transaction size of $1 million. Major buyers and sellers of securities in direct financial markets include commercial banks, large corporations, the federal government, hedge funds, and some wealthy individuals. Why might a firm prefer to have a security issue underwritten by an investment banking firm? In the most common type of underwriting arrangement, called firm-commitment underwriting, the investment banker assumes the risk of buying the new securities from the issuing company and reselling them to investors. The investment banker guarantees to buy the entire security issue from the company at a fixed price. Section 2.3 What is the difference between primary and secondary markets? Primary markets are markets where new securities are sold for the first time. Secondary markets are where the owners of outstanding securities can sell them to other investors. They provide the means for investors to sell their securities and get cash. How and why do large business firms use money markets? Large businesses use money markets to adjust their liquidity positions. If a firm has idle cash sitting around, it can invest it in negotiable CDs, Treasury bills, or other money market instruments. On the other hand, if a company has a temporary cash shortage, it can borrow in the money markets by selling commercial paper at lower interest rates than it could borrow through a commercial bank. 3. What are capital markets, and why are they important to corporations?
purchase price and the total resale price is called the underwriting spread, and it is the banker’s compensation. In addition to underwriting new securities, investment banks also provide other services, such as preparing the prospectus, preparing legal documents to be filed with the SEC, and providing general financial advice to the issuer. Investment Banking: Cranjet, Inc. is issuing 10,000 bonds, and its investment banker has guaranteed a price of $985 per bond. The investment banker sells the entire issue to investors for $10,150,000. What is the underwriting spread for this issue? What is the percentage underwriting cost? How much did Cranjet raise? LO 2 Solution: a. $300,000 ($10,150,000 – $985 x 10,000) b. 3.05 percent ($30/$985) c. $9,850,000 ($985 x 10,000) Financial Institutions: What are some of the ways in which a financial institution or intermediary can raise money? LO 6 Solution: A financial intermediary can raise money through the sale of financial products that individuals or businesses will purchase, such as checking and savings accounts, life insurance policies, or pension or retirement funds. Financial Institutions: How do financial institutions act as intermediaries to provide services to small businesses? LO 6
Solution: The real rate of interest measures the return earned on savings, and it represents the cost of borrowing to finance capital goods. The real rate of interest is determined by the interaction between firms that invest in capital projects and the rate of return businesses can expect to earn on investments in capital goods, and individuals’ time preference for consumption. Graphically, it is that point when the desired saving level equals the desired level of investment in the economy. Interest Rates: How does the nominal rate of interest vary over time? LO 7 Solution: The nominal rate is the rate that we observe in the marketplace. it is determined by both the real rate as well expected inflation. Therefore, the nominal rate will fluctuate according the changes in the real rate as well as changes in expected inflation. Interest Rates: What is the Fisher equation, and how is it used? LO 7 Solution: The Fisher equation is the expected, not the reported or actual, annualized change in commodity prices (∆Pe). It is used to protect the buying power from changes in inflation, and it is incorporated into a loan contract by adding it to the real interest rate that would exist in the absence of inflation. Interest Rates: Imagine you borrow $500 from your roommate, agreeing to pay her back the $500 plus 7 percent interest in one year. Assume inflation over the life of the contract is expected to be 4.25 percent. What is the total amount you will have to pay her back in a year? What percentage of the interest payment is the result of the real rate of interest? LO 7