Question

Assume that you recently graduated with a degree in finance and have just reported to work as an investment adviser at the brokerage firm of Smyth Barry and Co. Your first assignment is to explain the nature of the U.S financial markets to Michelle Varga, a professional tennis player who recently came to the United States from Mexico. Varga is a highly ranked tennis player who expects to invest substantial amounts of money through Smyth Barry. She is very bright; therefore, she would like to understand in general terms what will happen to her money. Your boss has developed the following questions that you must use to explain the U.S financial system to Varga.

a. what are the three primary ways in which capital is transferred between savers and borrowers?

b. What is market? Differentiate between the following types of markets; physical asset markets versus financial asset markets, spot markets versus futures markets, money markets versus capital markets, primary markets versus secondary markets, and public markets versus private markets.

c. Why are financial markets essential for healthy economy and economic growth?

d. What are derivatives? How can derivatives be used to reduce risk? Can Derivatives be used to increase risk? Explain.

e. Briefly describe each of the following financial institutions: investment banks, commercial banks, financial services corporations, pension funds, mutual funds, exchange traded funds, hedge funds, and private equity companies.

f. What are the two leading stock markets? Describe the two basic types of stock markets.

Answer 1

1. Transfers of capital can be made (1) by direct transfer of money and securities, (2) through an investment banking house, and (3) through a financial intermediary.
2. Market- A market is a place where buyer and seller meets to trade.
   Financial asset is an asset that has a value from a contractual claim. Eg: Cash, stocks, bonds, bank deposits. Physical assets are assets which have a physical worth like land, property, commodities.
   In a forward market foreign exchange is bought and sold for future delivery at forward rates, actual transaction takes place in future. In a Spot market the exchange happens today at today’s price.
   Money market includes assets that deal with short-term borrowing, lending, buying and selling. However, capital market is a component of a financial market that allows long-term trading of debt and equity-backed securities.
   In the primary capital market, investors buy directly from the issuing company. In the secondary market after a company goes public, investors trade securities through an exchange among themselves (buy-sell).
   In private markets money is raised privately Eg: PE firms, debt. However, to raise funds on a publicly traded exchange, a company will often hire an investment bank to help construct an investment package, strategize on an initial public offering (IPO).
3. For an economy it is a very crucial thing as it provides liquidity to securities. Through the medium of financial market, the investors can invest their money, whenever and however they desire. A healthy economy is dependent on efficient funds transfers from people/companies who have money to lend to individuals who need capital.
4. A derivative is a contract between two parties which derives its price from an underlying asset. Hedging is a technique or strategy that comes as a form of investment designed to avoid market volatility or to protect another investment or portfolio against potential investment risk or loss.
5. Investment banking is a specific division of banking related to the creation of capital for other companies and other entities.
   A commercial bank is an institution that provides services such as accepting deposits, providing business loans, and offering basic investment products.
   A mutual fund is an investment made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets.
   Pension fund is a fund created from which pensions are paid, accumulated from contributions from employers/employees.
   Exchange Traded Funds are essentially Index Funds that are listed and traded on exchanges like stocks.
   A hedge fund is a less restricted fund which can invest in anything from real estate, stocks, derivatives, and currencies.
   Private equity companies are who directly invest in private companies via private placement
6. New York Stock Exchange (NYSE), founded in 1792 and Nasdaq, founded in 1971.