Chapter 2

An Overview of the Financial System

2.1 Function of Financial Markets
1) Every financial market has the following characteristic:
A) It determines the level of interest rates.
B) It allows common stock to be traded.
C) It allows loans to be made.
D) It channels funds from lenders-savers to borrowers-spenders.

2) Financial markets have the basic function of

A) getting people with funds to lend together with people who want to borrow funds.
B) assuring that the swings in the business cycle are less pronounced.
C) assuring that governments need never resort to printing money.
D) providing a risk-free repository of spending power.

3) Financial markets improve economic welfare because

A) they channel funds from investors to savers.
B) they allow consumers to time their purchase better.
C) they weed out inefficient firms.
D) eliminate the need for indirect finance.

4) Well-functioning financial markets

A) cause inflation.
B) eliminate the need for indirect finance.
C) cause financial crises.
D) produce an efficient allocation of capital.
D

5) A breakdown of financial markets can result in

A) financial stability.
B) rapid economic growth.
C) political instability.
D) stable prices.

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6) The principal lender-savers are
A) governments.
B) businesses.
C) households.
D) foreigners.

7) Which of the following can be described as direct finance?

A) You take out a mortgage from your local bank.
B) You borrow $2500 from a friend.
C) You buy shares of common stock in the secondary market.
D) You buy shares in a mutual fund.

8) Assume that you borrow $2000 at 10% annual interest to finance a new business project. For this
loan to be profitable, the minimum amount this project must generate in annual earnings is
A) $400.
B) $201.
C) $200.
D) $199.
9) You can borrow $5000 to finance a new business venture. This new venture will generate annual earnings of
$251. The maximum interest rate that you would pay on the borrowed funds and
still increase your income is
A) 25%.
B) 12.5%.
C) 10%.
D) 5%.

10) Which of the following can be described as involving direct finance?

A) A corporation issues new shares of stock.
B) People buy shares in a mutual fund.
C) A pension fund manager buys a short-term corporate security in the secondary market.
D) An insurance company buys shares of common stock in the over-the-counter markets.

11) Which of the following can be described as involving direct finance?

A) A corporation takes out loans from a bank.
B) People buy shares in a mutual fund.
C) A corporation buys a short-term corporate security in a secondary market.
D) People buy shares of common stock in the primary markets.

12) Which of the following can be described as involving indirect finance?

A) You make a loan to your neighbor.
B) A corporation buys a share of common stock issued by another corporation in the primary
market.
C) You buy a U.S. Treasury bill from the U.S. Treasury.
D) You make a deposit at a bank.

13) Which of the following can be described as involving indirect finance?

A) You make a loan to your neighbor.
B) You buy shares in a mutual fund.
C) You buy a U.S. Treasury bill from the U.S. Treasury.
D) A corporation buys a short-term security issued by another corporation in the primary
market.

14) Securities are ________ for the person who buys them, but are ________ for the individual or firm that issues
them.
A) assets; liabilities
B) liabilities; assets
C) negotiable; nonnegotiable
D) nonnegotiable; negotiable

15) With ________ finance, borrowers obtain funds from lenders by selling them securities in the
financial markets.
A) active
B) determined
C) indirect
D) direct

16) With direct finance funds are channeled through the financial market from the ________ directly
to the ________.
A) savers, spenders
B) spenders, investors
C) borrowers, savers
D) investors, savers
17) Distinguish between direct finance and indirect finance. Which of these is the most important
source of funds for corporations in the United States?
With direct finance, funds flow directly from the lender/saver to the borrower. With
indirect finance, funds flow from the lender/saver to a financial intermediary who then
channels the funds to the borrower/investor. Financial intermediaries (indirect finance)
are the major source of funds for corporations in the U.S.

2.2 Structure of Financial Markets

1) Which of the following statements about the characteristics of debt and equity is false?
A) They can both be long-term financial instruments.
B) They can both be short-term financial instruments.
C) They both involve a claim on the issuerʹs income.
D) They both enable a corporation to raise funds.

2) Which of the following statements about the characteristics of debt and equities is true?
A) They can both be long-term financial instruments.
B) Bond holders are residual claimants.
C) The income from bonds is typically more variable than that from equities.
D) Bonds pay dividends.

3) Which of the following statements about financial markets and securities is true?
A) A bond is a long-term security that promises to make periodic payments called dividends
to the firmʹs residual claimants.
B) A debt instrument is intermediate term if its maturity is less than one year.
C) A debt instrument is intermediate term if its maturity is ten years or longer.
D) The maturity of a debt instrument is the number of years (term) to that instrumentʹs
expiration date.

4) Which of the following is an example of an intermediate-term debt?

A) A thirty-year mortgage.
B) A sixty-month car loan.
C) A six month loan from a finance company.
D) A Treasury bond.

5) If the maturity of a debt instrument is less than one year, the debt is called ________.
A) short-term
B) intermediate-term
C) long-term
D) prima-term

6) Long-term debt has a maturity that is ________.

A) between one and ten years.
B) less than a year.
C) between five and ten years.
D) ten years or longer.

7) When I purchase ________, I own a portion of a firm and have the right to vote on issues
important to the firm and to elect its directors.