Scribd
Upload
63 views1 page

1.5 Financial Securities and The Cost of Money: Self-Test

1) Capital is transferred between savers and borrowers through financial markets where providers of funds supply capital that is allocated to users of funds through the price system. 2) The cost of capital, whether debt or equity, is determined by the interaction of supply and demand in financial markets and is represented by interest rates or expected dividends and capital gains. 3) Financial securities can be classified based on their time to maturity and whether they represent debt, equity, or derivatives claims. The most common securities include money market instruments that mature in less than a year and capital market securities that mature in over a year.

Uploaded by

adrien_ducaillou
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
63 views1 page

1.5 Financial Securities and The Cost of Money: Self-Test

1) Capital is transferred between savers and borrowers through financial markets where providers of funds supply capital that is allocated to users of funds through the price system. 2) The cost of capital, whether debt or equity, is determined by the interaction of supply and demand in financial markets and is represented by interest rates or expected dividends and capital gains. 3) Financial securities can be classified based on their time to maturity and whether they represent debt, equity, or derivatives claims. The most common securities include money market instruments that mature in less than a year and capital market securities that mature in over a year.

Uploaded by

adrien_ducaillou
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 1

14 Chapter 1 An Overview of Financial Management and the Financial Environment

involved. Third, allocation between providers and users of funds occurs in financial markets. The following sections discuss each of these characteristics.

1.5 Financial Securities and the Cost of Money


The variety of financial securities is limited only by human creativity and ingenuity, which isnt much of a limit. At the risk of oversimplification, we can classify most financial securities along two dimensions: (1) time until maturity and (2) debt, equity, or derivatives. In general, short-term securities are those that mature in less than a year; these are called money market securities. Those that mature in more than a year are called capital market securities. Financial securities are simply pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values. Debt instruments typically have specified payments and a specified maturity. For example, an IBM bond might promise to pay 10% interest for 30 years, at which time it makes a $1,000 principal payment. Equity instruments are a claim upon a residual value. For example, IBMs stockholders are entitled to IBMs cash flows after its bondholders, creditors, and other claimants have been satisfied. Notice that debt and equity represent claims upon the cash flows generated by real assets, such as the cash flows generated by IBM. In contrast, derivatives are securities whose values depend on, or are derived from, the values of some other traded assets. For example, futures and options are two important types of derivatives, and their values depend on the prices of other assets, such as IBM stock, Japanese yen, or pork bellies. Most conventional securities are forms of debt or equity, and most derivatives are forms of options, futures, forward contracts, or swaps. However, there are hybrid securities for which these distinctions blur. For example, preferred stock has some features like debt and some like equity, while convertible debt has debtlike features and option-like features. We discuss many financial securities in detail later in the book, but Table 1-1 (on pages 16 and 17) provides a summary of the most important conventional financial securities. See Web Extension 1B for an overview of derivatives and see Chapter 23 for a more detailed discussion within the context of risk management. In a free economy, capital from providers with available funds is allocated through the price system to users that have a demand for funds. The interaction of the providers supply and the users demand determines the cost (or price) of money, which is the rate users pay to providers. For debt, we call this price the interest rate. For equity, we call this price the cost of equity, and it consists of the dividends and capital gains stockholders expect. Keep in mind that the cost of money from a users perspective is a return from the providers point of view, so we often use those terms interchangeably. Notice in Table 1-1 that a financial securitys rate of return generally increases as its maturity and risk increase. We will have much more to say about the relationships
You can access current and historical interest rates and economic data as well as regional economic data for the states of Arkansas, Illinois, Indiana, Kentucky, Mississippi, Missouri, and Tennessee from the Federal Reserve Economic Data (FRED) site at http://www.stls .frb.org/fred/. For an overview of derivatives, see Web Extension 1B at the textbooks Web site.

Identify three ways capital is transferred between savers and borrowers. Distinguish between the roles played by investment banking houses and financial intermediaries.

SELF-TEST

You might also like