Categorize each of the following transactions as taking place in either the primary or secondary market:
Supercorp issues $180 million of new common Stock- Primary market
HiTech, Inc. issues $30 million of common stock in an IPO- Primary market
Megaorg sells $10 million of HiTech preferred stock from its marketable securities portfolio- Secondary market
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The XYA Fund buys $220 million of previously issued Supercorp bonds. - Secondary market
B. Corporation sells $15 million of XYZ common stock. - secondary market
Identify whether the following financial instruments are capital market securities or money market securities
U.S. Treasury bills. - money market
U.S. Treasury notes. - money market
U.S. Treasury bonds. - capital market
Mortgages. - capital market
Federal funds- money market
Negotiable certificates of deposit- money market
Common stock- capital market
State and government bonds- capital market
Corporate bonds. - capital market
3. Identify the different types of financial institutions. What are the main services each of these financial institutions offers?
Commercial Banks - These are financial institutions which accept deposits and offers different forms of loans such as personal, commercial and real estate. Banks also act as agents to be used during payment processes and are also custodians of valuable property.
Insurance companies - This institution offers protection to individuals and other bodies, by pooling risks through receiving premiums from a large number of people and offers compensation in case of losses. It insures against risks such as fire, death and accidents.
Investment Companies - This is a corporation where investors are given the opportunity to invest in a diversified security portfolio by pooling their funds. An example is the Unit Investment Trusts.
Brokerage firms - These companies act as intermediaries between the buyers and sellers of financial securities. They offer full or discount services to the investors for instance giving advice.
Nonbank Financial Institutions -These are companies which resemble banks but do not offer similar services and have different term. For instance, the Credit Unions which offer loans but do not accept deposits (Weaver & Weston 2001).
4. Define the six factors that determine the nominal interest rate on a security .
Inflation- This is the continuous increase on the price level of commodities in an economy. Nominal interest rate is found by combining the real interest rate and the rate of inflation. Thus, the more the inflation the higher the nominal interest (Weaver & Weston 2001).
Real interest Rate- This is the risk free rate that has not been adjusted for inflation. It is used to determine the nominal rate and hence the higher the real rate the higher the nominal interest rate.
Default risk- This is the risk that the issuer of a given security will default or not make the partial interest payment as stipulated in the agreement. The higher the default risk the higher the nominal interest rest so as to compensate the risk.
Liquidity risk- This is the risk that the security at hand will not be easily converted or sold at a price close to its original price on short notice. The higher the liquidity risk the higher the nominal interest rate.
Term to Maturity -This is the period in which the security will be fully repaid. The longer the term to maturity the lesser the nominal interest rate charged on the security.
Provision regarding use of funds- The provisions which accompany the security such as tax and convertibility are also considered when setting the nominal interest rate.
Define the concept of term structure of interest rates. What are three theories that explain the future yield curve of interest rates?
Also known as the yield curve, the term structure of interest rate reflects its relationship with the term to maturity. The three theories explaining the future yield curve are:
Pure Expectation Theory : This theory is based on short term rates and suggests that two-year yield is the same as a one-year bond presently plus the return expected on another one-year bond the is purchased today.
Liquidity Preference Theory: This theory states that a security that has a longer maturity is riskier and investors want more compensation. The structure is determined by the future expectations of rates.
Market Segmentation Theory: This theory suggests that interest rate is determined by demand and supply of the security. It is also called the preferred habitat theory of investors ( Cox et al., 1985).
References
Cox, J. C., Ingersoll Jr, J. E., & Ross, S. A. (1985). A theory of the term structure of interest rates. econometrical: Journal of the Econometric Society , 385-407.
Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: American Management Association.
Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York, NY: McGraw-Hill.
