Chapter 2

Question 1

Capital Allocation Process

Answer 1

How money flows from savers to borrowers (companies)

Question 2

Internal Funds

Answer 2

The money a company generates from its own operations

• Cash Flow
• Retained Earnings

Question 3

Retained Earnings

Answer 3

Profits the company keeps and reinvests

Question 4

Cash Flow

Answer 4

Cash generated from business operations

Question 5

External Funds

Answer 5

Money a business raises from outside sources, rather than from its own profits

Ex/ Banks, investors, financial markets

Question 6

Direct Finance

Answer 6

Borrowers get money straight from savers without using a financial middleman.

Example: company issues stocks or bonds to public

Question 7

Indirect Finance

Answer 7

Borrowers get funds through a financial intermediary—like a bank—instead of directly from investors

Question 8

Commercial banks

Answer 8

Financial institution that takes deposits from the public and uses that money to make loans to individuals and business

Ex/ Bank of America, Citi Bank, Wells Fargo

Question 9

Investment Banks

Answer 9

Financial institution that helps companies raise money by issuing and selling stocks or bonds, and also advises on major financial deals like mergers and acquisitions

• IBs are underwriters

Ex/ JP Morgan, Goldman Sachs, Morgan Stanley

Question 10

Credit Unions

Answer 10

Member-owned, non-profit financial institution that provides banking services to its members

• Lower fees and better interest rates than traditional banks

Question 11

Mutual funds

Answer 11

Organizations that pool investor funds to purchase financial instruments

Question 12

Pension Funds

Answer 12

Large pool of money collected from workers and employers to provide income to people after they retire

• Retirement fund

Question 13

Insurance Companies

Answer 13

Take savings in the form of annual premiums; invest these funds into stocks, bonds, real estate, and mortgages; and make payments to the insured parties

Question 14

Physical Assets

Answer 14

A tangible, real object that has economic value

Ex/ Buildings, land, machinery, etc

Question 15

Financial Assets

Answer 15

Claim to future money, not a physical object

Ex/ Stocks, bonds, etc

Question 16

Spot Market

Answer 16

Markets in which assets are bought and sold for “on the spot” delivery

• Transactions process within a few days

Ex/ Grocery Store, energy products, industrial commodities

Question 17

Forwards/Futures Market

Answer 17

Participants agree today to buy or sell an asset at some future date

Question 18

Money Market

Answer 18

Markets for short-term, highly liquid debt securities

Ex/ Treasury bills, CD’s, commercial paper, etc

Question 19

Capital Market

Answer 19

Markets for intermediate or long-term debt and corporate stocks

Ex/ Corporate debt, mortgages

Question 20

Primary Market

Answer 20

Markets in which corporations raise new capital

• New securities are sold for the first time
• Money transferred to company’s account

Question 21

Secondary Market

Answer 21

Markets where investors buy and sell existing securities from each other

• Money not transferred to company’s account

Question 21

Public Market

Answer 21

Place where stocks, bonds, and other financial assets are bought and sold openly to anyone

Ex/ NYSE, NASDAQ

Question 21

Private Market

Answer 21

Investments are made through private deals, not on public stock exchanges

Ex/ Bank loans, venture capital, private equity

Question 22

Derivative Security

Answer 22

Any financial asset whose value is derived from the value of some other underlying asset

Question 23

Electronic Market

Answer 23

Marketplace where buyers and sellers trade financial assets through computers and online systems instead of face‑to‑face or over the phone Ex/ NASDAQ

Question 24

Initial Public Offering (IPO)

Answer 24

When a private company sells its stock to the public for the first time to raise money and become a publicly traded company

Question 25

Large companies' stock prices are ______ efficient

Answer 25

More

Question 26

Small companies' stock prices are ________ efficient

Answer 26

Less

Question 27

Efficiency Continuum

Answer 27

The idea that stock markets vary in how quickly and accurately they incorporate new information into stock prices - from less efficient to more efficient.

Question 28

Efficient-Market Hypothesis (EMH)

Answer 28

Says that asset prices already reflect all available information, so you can’t consistently beat the market through stock‑picking or timing - Believes investors are rational - Smart investors remove mispricing (arbitrage)

Question 29

Challenges to EMH:

Answer 29

- Stocks are too volatile - Investors are not fully rational - Herd behavior (everyone follows each other) - Arbitrage is hard (mispricing can last a long time)

Question 30

Three Forms of EMH:

Answer 30

- Strong Form - Semi-Strong Form - Weak Form

Question 31

Strong Form EMH

Answer 31

No public or private information can help you predict future prices

Question 32

Semi-Strong Form EMH

Answer 32

No publicaly available information can help you predict future prices

Question 33

Weak Form EMH

Answer 33

Past prices cannot help you predict future prices

Question 34

Behavioral Finance

Answer 34

Studies how human behavior affects markets

Question 35

Two Types of Irrational Behavior

Answer 35

- Cognitive Biases - Emotional Biases

Question 36

Cognitive Biases

Answer 36

Deviations which occur from the manner in which we predict and process information

Question 37

Emotional Biases

Answer 37

Deviations in decision making due to emotional factors Ex/ Loss/regret aversion, overconfidence, self-control, etc

Question 38

Publicly Owned Corporations

Answer 38

A corporation that is owned by a relatively large number of individuals who are not actively involved in the firm's management

Question 39

Hedge Funds

Answer 39

Private Investment pool that uses aggressive or complex strategies to try to earn high returns for wealthy investors

Question 40

Private Equity Firms

Answer 40

Investment firms that buy ownership stakes in businesses, improves their operations and financial performance, and then sells those businesses to earn a return for its investors