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 & 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.

1. What are the three primary ways in which capital is transferred between savers and borrowers? Describe each one.

2. What is a 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.

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

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

5. 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.

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

7. If Apple Computer decided to issue additional common stock, and Varga purchased 100 shares of this stock from Smyth Barry, the underwriter, would this transaction be a primary or a secondary market transaction? Would it make a difference if Varga purchased previously outstanding Apple stock in the dealer market? Explain.

8. What is an initial public offering (IPO)?

9. What does it mean for a market to be efficient? Explain why some stock prices may be more efficient than others.

10. After your consultation with Michelle, she wants to discuss these two possible stock purchases:

    1. While in the waiting room of your office, she overheard an analyst on a financial TV network say that a particular medical research company just received FDA approval for one of its products. On the basis of this “hot” information, Michelle wants to buy many shares of that company’s stock. Assuming the stock market is highly efficient, what advice would you give her?

    2. She has read a number of newspaper articles about a huge IPO being carried out by a leading technology company. She wants to purchase as many shares in the IPO as possible and would even be willing to buy the shares in the open market immediately after the issue. What advice do you have for her?

11. How does behavioral finance explain the real-world inconsistencies of the efficient markets hypothesis (EMH)?

Answer 1

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.