ECO 3223 01 FALL 2011 EVANS STUDY GUIDE FOR EXAM 1 Note This is intended to direct you to the relevant topics that will be covered on the exam Questions will be worded differently so don t MEMORIZE this content use it to help you understand the concepts Understand the definitions of all terms at the end of each chapter CHAPTER 1 1 What role do financial markets play in the economy They transfer funds from people with an excess to those who have a shortage 2 Know the structure of the Financial System a Two types of financing available to borrowers Stocks and bonds not sure on this one b previously c are they d generally Market in which new issues of financial instruments are sold market in which issued financial instruments are sold Primary market new issues of financial instruments Secondary market selling of previously issued financial instruments Markets for financial instruments are segmented into two maturity classes What Money markets short term Capital markets long term What is the difference between the direct market and the indirect market Who borrows in the Direct Market Direct market borrowers borrow funds directly from lenders in financial markets by selling them securities Indirect market 2 What is a Bond What is a Stock Bond a debt security that promises to make payments periodically for a specified period of time Stock Common stock represents a share of ownership in a corporation A share of stock is a claim on the earnings and assets of the corporation 4 What is meant by the term financial intermediary 1 people money 5 6 7 Institutions that borrow funds from people who have saved and make loans to other For example banks insurance and finance companies pension funds etc What is meant by fiscal policy monetary policy Fiscal controlling economic wellbeing through taxation and government spending Monetary controlling economic wellbeing through increasing or decreasing the supply of Why does the federal government need to borrow money How would you calculate the real rate of economic growth from one period to the next Use the GDP deflator to see the true price levels from one period to the next 8 What is meant by the Dow Jones Industrial Average and how is it calculated It is a stock index that shows how 30 large publicly owned companies based in the United States have traded during a standard trading session in the stock market To calculate the DJIA the sum of the prices of all 30 stocks is divided by a divisor the Dow Divisor The divisor is adjusted in case of stock splits spinoffs or similar structural changes to ensure that such events do not in themselves alter the numerical value of the DJIA Early on the initial divisor was composed of the original number of component companies which made the DJIA at first a simple arithmetic average The present divisor after many adjustments is less than one meaning the index is larger than the sum of the prices of the components That is where p are the prices of the component stocks and d is the Dow Divisor Events like stock splits or changes in the list of the companies composing the index alter the sum of the component prices In these cases in order to avoid discontinuity in the index the Dow Divisor is updated so that the quotations right before and after the event coincide The Dow Divisor is currently 0 132129493 23 Presently every 1 change in price in a particular stock within the average equates to a 7 57 1 0 132129493 point movement 2 CHAPTER 2 1 How do financial markets benefit consumers How do they promote economic growth 2 Financial markets benefit consumers by allowing them to time their purchases more efficiently They promote economic growth by producing efficient allocation of funds which increases production What is the key difference between Debt and Equity The equity market allows companies to raise capital without incurring debt In the equity market lenders are able to share ownership in the company whose stock they purchase In the debt market though they are essentially just creditors to the company whose bonds they purchase rather than partial owners 3 What s the main disadvantage of owning stocks versus bonds Stocks are not guaranteed to pay anything back as there is a much higher risk versus purchasing a bond which guarantee repayment through coupons and by paying back the initial principal of the bond The Primary Market serves a different purpose from the Secondary Market What is it Transferring money from investors directly to companies In the secondary market money is transferred between two people usually through some sort of intermediation i e a broker giving no additional funds to the company whose bond or stock is being traded Brokers and Dealers work in Secondary Markets What s the difference between them Brokers a person who executes a trade on the behalf of others Does not personally owns the stocks or bonds he she is trading A broker will buy and sell securities for their clients Broker will only make purchases per the clients request where a dealer will make their own purchases and find people willing to trade Dealers a person who executes a trade on their own behalf Personally owns the stocks bonds that he she is trading with others A dealer will buy and sell securities on their own account What s the difference between an Exchange and an Over the Counter market Exchange markets are centralized and usually involve a physical building where trading occurs think wall st and new York stock exchange An over the counter market is decentralized and involve mediators who link buyers and sellers There is no regulator in otc markets and are more prone to fraudulent and dishonest traders 3 4 5 6 Treasury Bills Commercial Paper and Federal Funds are sold in the Money Market What is meant by Money Market and what is the purpose of each of these three types of financial instruments Money market involve short term borrowing and lending with original maturity of one year or less Treasury bills mature in one year or less Used as a form of borrowing by U S government to investors in the primary market Considered by some as the least risky form of investment Commercial Paper an unsecured promissory note with maturity ranging from 1 to 270 days Money market securities issued by large banks and corporations to get money to pay off short term debts Federal Funds Overnight borrowings by banks to maintain their bank reserves Used to ensure that all financial transactions of bank and its customers will clear CHAPTER