Question and answers for homework-1
1. What is the difference between a financial asset and a tangible asset?
A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines. A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows. The value of a financial asset is not related to the physical form in which the claim is recorded.
2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?
The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal. The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.
The equity holder has a residual claim to assets and income. He can receive funds only after other claimants are satisfied. Income is in terms of dividends, the amount and timing of which are not certain.
3. What is the basic principle in determining the price of a financial asset?
The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.
4. Why is it difficult to determine the cash flow of a financial asset?
The estimation and determination of cash flows is difficult because of several reasons. These include accounting measures, possibility of default of the issuer, and embedded options in the security. Interest payments can also change over time. There is uncertainty as to the amount and the timing of these payments.
5. Why are the characteristics of an issuer important in determining the price of a financial asset?
The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows. These characteristics, which determine the issuer’s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.
8. Explain the difference between each of the following:
a. money market and capital market
b. primary market and secondary market
c. domestic market and foreign market
d. national market and Euromarket
a. The money market is a financial market of short-term instruments having a maturity of one year or less. The capital markets contain debt and equity instruments with more than one year to maturity;
b. The primary market deals with newly issued financial claims, whereas the secondary market deals with the trading of season issues (ones previously issued in the primary market);
c. The domestic market is the national market wherein domestic firms issue securities and where such issued securities are traded. Foreign markets are where securities of firms not domiciled in the country are issued and traded;
d. In a national market securities are traded in only one country and are subject to the rules of that country. In the Euromarket, securities are issued outside of the jurisdiction of any single country. For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.
1. Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity?
An individual’s account at a financial intermediary is a direct claim on that intermediary. In turn, the intermediary pools individual accounts and lends to a firm. As a result, the intermediary has a direct contractual claim on that firm for the expected cash flows. Since the individual’s funds have in essence been passed through the intermediary to the firm, the individual has an indirect claim on the firm. Two separate contracts exist. Should the individual lend to...
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