Financial Management Integrated Case 2 Answers
|Ally Zmijeski | |Financial Management Section C | |Homework 2: Integrated Case Questions | Chapter 2 Integrated Case 2-11
A) In a well-functioning economy, capital flows efficiently from those with surplus capital to those who need it in one of three ways: • Direct transfers: occur when a business sells its stocks or bonds directly to savers without going through any type of financial institution. This is used primarily by small firms and doesn’t raise much capital. • Transfers also can go through an investment bank that underwrites the issue, or serves as middleman/facilitator.
The company sells its stocks or bonds to the investment bank, which then sells these same securities to savers. Because new securities are involved and the corporation receives the sale proceeds, this transaction is called a primary market transaction. • Transfers can also be made through a financial intermediary, such as a bank, insurance company, or mutual fund. Intermediaries increase efficiency of money and capital markets. B) People and organizations wanting to borrow money are brought together with those who have surplus funds in the financial markets.
Types of Financial Markets include… • Physical Asset vs. Financial Asset: physical asset markets are for tangible products, while financial asset markets are for stocks, bonds, notes, and mortgages. They also deal with derivative securities whose values are derived from changes in the prices of other assets. o A share of Ford stock is a pure financial asset, while an option to buy Ford shares is a derivative security whose value depends on the price of Ford stock. • Spot Markets vs.
Futures Markets: spot markets are markets in which assets are bought or sold for on the spot delivery (within a few days). Future markets are markets in which participants agree today to buy or sell an asset at some future date. Future market transactions can reduce, or hedge, the risks faced by buyers and sellers if the market changes. • Money Markets vs. Capital Markets: money markets are the markets for short-term, highly liquid debt securities. Capital markets are the markets for intermediate or long-term debt and corporate stocks, like the NYSX. Short-term markets = less than one year o Intermediate term markets = 1 to 10 years o Long-term markets = more than 10 years • Primary markets are the markets in which corporations raise new capital, so the corporation itself receives proceeds. • Secondary markets are markets in which existing, already outstanding securities are traded among investors. The corporation does not receive funds from a secondary market sale. • Private markets are markets in which transactions are negotiated directly between two parties. Public markets are markets where standardized contracts are traded on organized exchanges. C) Financial markets are essential for a healthy economy and economic growth because they provide a variety of opportunities for buyers and sellers to meet, exchange goods and services, better address financial needs, and accumulate wealth to stimulate the economy. D) A derivative is any security whose value is derived from the price of some other underlying asset.
The use of derivatives has increased in recent years. If a bank or any other company invests in derivatives, it is difficult to tell whether it is an investment as a hedge against something like an increase in the price of good X, or a speculative bet that prices will rise. This makes the firm’s risk profile more difficult to determine. Derivatives can hedge risk if the price of a good is assumed to change in the future, or if the company is dealing with foreign markets.
However, if a company is buying derivatives to speculate on a price change that could ultimately benefit them, this is raising the company’s risk because they are unsure of the future worth of assets associated with the derivative. E) Investment banks help companies raise capital by helping them design attractive securities, buying securities from corporations, and reselling them to savers. Commercial banks are large national banks that offer a variety of services to a wide range of customers.
Financial services corporations are large conglomerates that combine many different financial institutions within a single corporation. Most started in one area but later diversified to cover more of the financial spectrum, like including insurance or leasing companies. Pension funds are retirement plans funded by corporations or government agencies for their workers. Mutual funds are corporations that accept money from savers and then use those funds to buy stocks, long-term bonds, or short term debt instruments issued by businesses/government.
They pool funds and reduce risk through diversification. Exchange traded funds are similar to regular mutual funds and are often operated by mutual fund companies. ETFs buy a portfolio of stocks of a certain type and then sell their own shares to the public. Hedge funds are similar to mutual funds because they accept money from savers and use the funds to buy various securities, but they are largely unregulated, have large minimum investments, and are marketed to high net worth people.
Private equity companies are organizations that operate much like hedge funds, but they buy and then manage entire firms. They are relatively unregulated. F) The two leading stock markets are the New York Stock Exchange and the Nasdaq. Physical location exchanges are tangible entities that have their own building and an elected governing body called a board of governors. The exchange members will sell orders offer the shares for sale, and they are bid for by the members with buy orders.
OTC markets are often referred to today as dealer markets, and include all the facilities that are needed to conduct security transactions, but not all are made on the physical location exchanges. The dealer market system consists of the relatively few dealers who hold inventories of securities and make a market for the securities, the thousands of brokers who act as agents in bringing the dealers together with investors, and the computers, terminals, and electronic networks that provide a communication link between dealers and brokers.
G) Since Varga is not purchasing the stock directly from Apple, but instead from Smyth Barry, who probably purchased it from Apple, she is dealing in a secondary market; the money she spends to buy the stock is not going directly to Apple, but to a second party. This would not be different if Varga purchased previously outstanding Apple stock in the dealer market, because in both situations she is not giving money directly to Apple, but buying stock that someone else has bought previously from Apple. H) An initial public offering, or IPO, is the first sale of stock by a private company to the public.
IPOs are often issued by smaller, newer companies seeking the funds to expand, but can also be done by large privately owned companies looking to become publicly traded. I) Efficient Market: a market in which prices are close to intrinsic values and stocks seem to be in equilibrium. Today, we have an efficiency continuum, where the market for some companies’ stocks is highly efficient and the market for other stocks is highly inefficient. This is defined by the size of the company – the bigger the company is, the more analysts tend to follow it, so new information is more likely to be reflected in the stock price.
J) Part One: If the stock market is highly efficient, this would imply that the company that received the FDA grant is a large and well-researched firm, so the rise in the company’s stock price is reflective of its true value and would be a good purchase. Still, I would recommend warning Michelle that some companies let information like this leak into the public for hidden reasons, so she should do her own research to ensure the new stock price is close to its true value.
Part Two: Oftentimes, stock prices at IPO’s and shortly thereafter are the highest they will ever be for the company. This is a result of the hype created by the company, media, and investing world around its first public offering. I would tell Michelle again to do her own research, but I also think if she is the type of investor who enjoys the risk of a new company and the excitement of that type of investment, that if she understands the potential to lose, she might as well buy a reasonable number of shares.
