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Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHall.1-5ANSWERSTOQUESTIONSFORCHAPTER1(Questionsareinboldprintfollowedbyanswers.)1.Whatisthedifferencebetweenafinancialassetandatangibleasset?Atangibleassetisonewhosevaluedependsuponcertainphysicalproperties,e.g.land,capitalequipmentandmachines.Afinancialasset,whichisanintangibleasset,representsalegalclaimtosomefuturebenefitsorcashflows.Thevalueofafinancialassetisnotrelatedtothephysicalforminwhichtheclaimisrecorded.2.WhatisthedifferencebetweentheclaimofadebtholderofGeneralMotorsandanequityholderofGeneralMotors?Theclaimofthedebtholderisestablishedbycontract,whichspecifiestheamountandtimingofperiodicpaymentsintheformofinterestaswellastermtomaturityoftheprincipal.Thedebtholderstandsasacreditorandincaseofdefault,hehasapriorclaimonfirmassetsovertheequity-holder.Theequityholderhasaresidualclaimtoassetsandincome.Hecanreceivefundsonlyafterotherclaimantsaresatisfied.Incomeisintermsofdividends,theamountandtimingofwhicharenotcertain.3.Whatisthebasicprincipleindeterminingthepriceofafinancialasset?Thepriceofanyfinancialassetisthepresentvalueoftheexpectedcashflowsorastreamofpaymentsovertime.Thus,thebasicvariablesindeterminingthepriceare:expectedcashflows,discountrateandthetimingofthesecashflows.4.Whyisitdifficulttodeterminethecashflowofafinancialasset?Theestimationanddeterminationofcashflowsisdifficultbecauseofseveralreasons.Theseincludeaccountingmeasures,possibilityofdefaultoftheissuer,andembeddedoptionsinthesecurity.Interestpaymentscanalsochangeovertime.Thereisuncertaintyastotheamountandthetimingofthesepayments.5.Whyarethecharacteristicsofanissuerimportantindeterminingthepriceofafinancialasset?Thecharacteristicsoftheissuerareimportantbecausethesedeterminetheriskinessoruncertaintyoftheexpectedcashflows.Thesecharacteristics,whichdeterminetheissuer’screditworthinessordefaultrisk,haveanimpactontherequiredrateofreturnforthatparticularfinancialasset.001Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHall.1-66.Whatarethetwoprincipalrolesoffinancialassets?Thefirstroleoffinancialassetsistotransferfundsfromsurplusspendingunits(i.e.personsorinstitutionswithfundstoinvest)todeficitspendingunits(i.e.personsorfirmsneedingfundstoinvestintangibleassets).Thesecondroleistoredistributeriskamongpersonsorinstitutionsseekingandprovidingfunds.Fundsproviderssharetherisksofexpectedcashflowsgeneratedbytangibleassets.7.InSeptember1990,astudybytheU.S.Congress,OfficeofTechnologyAssessment,entitled“ElectronicBulls&Bears:U.S.SecuritiesMarketsandInformationTechnology,”includedthisstatement:Securitiesmarketshavefivebasicfunctionsinacapitalisticeconomy:a.Theymakeitpossibleforcorporationsandgovernmentalunitstoraisecapital.b.Theyhelptoallocatecapitaltowardproductiveuses.c.Theyprovideanopportunityforpeopletoincreasetheirsavingsbyinvestinginthem.d.Theyrevealinvestors’judgmentsaboutthepotentialearningcapacityofcorporations,thusgivingguidancetocorporatemanagers.e.Theygenerateemploymentandincome.Foreachofthefunctionscitedabove,explainhowfinancialmarkets(orsecuritiesmarkets,intheparlanceofthisCongressionalstudy)performeachfunction.Thefiveeconomicfunctionsofafinancialmarketare:(1)transferringfundsfromthosewhohavesurplusfundstoinvesttothosewhoneedfundstoinvestintangibleassets,(2)transferringfundsinsuchawaythatredistributestheunavoidableriskassociatedwiththecashflowgeneratedbytangibleassets,(3)determiningthepriceoffinancialassets(pricediscovery),(4)providingamechanismforaninvestortosellafinancialasset(toprovideliquidity),and(5)reducingthecostoftransactions.ThefiveeconomicfunctionsstatedintheCongressionalStudycanbeclassifiedaccordingtotheabovefivefunctions:1.“theymakeitpossibleforcorporationsandgovernmentalunitstoraisecapital”--functions1and2;2.“theyhelptoallocatecapitaltowardproductiveuses”--function3;3.“theyprovideanopportunityforpeopletoincreasetheirsavingsbyinvestinginthem”--functions1and5;4.“theyrevealinvestors’judgmentsaboutthepotentialearningcapacityofcorporations,thusgivingguidancetocorporatemanagers”--function3;5.“theygenerateemploymentandincome”--followsfromfunctions1and2allowingthosewhoneedfundstousethesefundstocreateemploymentandincomeopportunities.002Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHall.1-78.Explainthedifferencebetweeneachofthefollowing:a.moneymarketandcapitalmarketb.primarymarketandsecondarymarketc.domesticmarketandforeignmarketd.nationalmarketandEuromarketa.Themoneymarketisafinancialmarketofshort-terminstrumentshavingamaturityofoneyearorless.Thecapitalmarketscontaindebtandequityinstrumentswithmorethanoneyeartomaturity;b.Theprimarymarketdealswithnewlyissuedfinancialclaims,whereasthesecondarymarketdealswiththetradingofseasonissues(onespreviouslyissuedintheprimarymarket);c.Thedomesticmarketisthenationalmarketwhereindomesticfirmsissuesecuritiesandwheresuchissuedsecuritiesaretraded.Foreignmarketsarewheresecuritiesoffirmsnotdomiciledinthecountryareissuedandtraded;d.Inanationalmarketsecuritiesaretradedinonlyonecountryandaresubjecttotherulesofthatcountry.IntheEuromarket,secur