ch02sm

ch02sm - Chapter 2 The Financial Environment and the Level...

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1 Chapter 2 The Financial Environment and the Level of Interest Rates Critical Thinking Questions 2.1 Explain why total financial assets in the economy must equal total financial liabilities. Every financial asset must be financed with some type of a claim or liability. Since all of an economy’s financial assets are just a collection of the individual financial assets, then they should also sum to the collective claims on those assets in the economy. 2.3 Why don’t small businesses make greater use of the direct credit markets since these markets enable firms to finance themselves at very low cost? Direct credit markets are geared toward big, established companies since they are wholesale in nature and the minimum transaction size is far beyond the needs of a small business. Small businesses are better off borrowing money from financial intermediaries, such as commercial banks. 2.3 Explain the economic role of brokers and dealers. How does each make a profit? Brokers and dealers play a similar economic role in that they both bring buyers and sellers of a commodity together in a market. However, brokers only facilitate a
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2 transaction by helping the two parties make a transaction and brokers are therefore only compensated for taking on that role. Dealers on the other hand, take risk in that they will purchase (sell) a commodity from a seller (buyer) without another buyer (seller) necessarily being available. In other words, a dealer will take the risk of purchasing (selling) a commodity and will therefore be compensated for taking that risk. 2.4 Why were commercial banks prohibited from engaging in investment banking activities beginning in the 1930s? Banks had been barred from investment banking following the Great Depression because it was believed that these activities were too risky for banks. At the time, it was believed that excessive risk taking by banks had resulted in a large number of bank failures, which precipitated the Great Depression. Recent research has exonerated the banking system of this charge. 2.5 What are the two basic services that investment banks provide in the economy? Investment banks specialize in helping companies sell new debt or equity as well as provide other services such as broker and dealer services. 2.6 Many large corporations sell commercial paper as a source of funds. From time to time, some of these firms find that they are temporarily unable to issue commercial paper. Why is this true?
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3 Generally, only 500 to 700 firms have access to the market at any given time. During economic expansion, the number of firms that can issue commercial paper increases. When the economy is slow, however, firms with lower credit rating tend to be excluded from the market, as investors are looking primarily for low-risk investments that are provided by companies with high credit rating. 2.7
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This note was uploaded on 05/06/2011 for the course FIN 300 taught by Professor Olander during the Spring '08 term at ASU.

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ch02sm - Chapter 2 The Financial Environment and the Level...

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