ECON 2210- KPU Copyright: Rabia Aziz Spring Homework Assignment Ch 2 1 Using your own words describe each of the following financial instruments, including the kind of claim (debt or equity), maturity (money market or capital market), risk, and liquidity characteristics, and any other distinguishing characteristics. Identify a type of financial institution or other participant in the financial market (individuals, government, business) that are most likely to borrow using these instruments, and a type of institution or other participant that are most likely to lend using these instruments. (a) Commercial Paper (b) 20 year Government of Canada Bond (c) Canada Mortgage Bond (Mortgage backed security) 2 Categorize each transaction below according to whether it: (1) relies on financial markets (direct finance) or financial intermediaries (indirect finance), AND, (2) occurs in the primary or secondary market, AND, (3) is carried out in the money or capital market. (a) Zebra Corporation opens for business by selling shares of common stock to 15 private investors. (b) One of the investors sells her shares of Zebra stock to someone else on TSX. (c) A manager at Mackenzie Investments purchases $10,000 of three -month Government of Canada Bonds from a commercial bank. 3 Zimbabwe introduced a 100 trillion Zimbabwean dollar note at the height of its hyperinflation in 2008. The currency was eventually abandoned in 2009 and the US dollar was used for all major transactions. Explain why hyperinflation causes the domestic currency to be abandoned? 4 If I can buy a car today for $5,000 and it is worth $10,000 in extra income to me next year because it enables me to get a job as a traveling salesman, should I take out a loan from Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I be better or worse off as a result of taking out this loan? Can you make a case for legalizing loan sharking?
Money And Banking
Question One
- Commercial Paper
A commercial paper is a short-range, unsecured debt financial instrument often issued to cover an institution’s short-term liabilities. The maturities on a commercial paper last less than 270 days, thus qualifying it as a money market instrument. Compared to other financial instruments, a commercial paper has a low-risk and high liquidity. Typically, financial institutions and large corporations with high credit ratings are likely to borrow using commercial papers. Wealthy persons, money market funds, corporations, and other financial institutions may also lend using these instruments.
- 20-year Government of Canada Bond
A 20-year government of Canada bond is a long-term debt instrument issued to finance government spending. The stated bond’s maturities are more than one year, implying that it is a long-term asset traded in the capital market. Government bonds are typically highly liquid and low-risk because the federal authority backs them. The Government of Canada is likely to borrow using this instrument while bank and non-bank institutions may lend using the long-term bond.
- Canada mortgage bond (Mortgage-backed security)
A mortgage-backed security is a long-term asset-backed debt instrument used to finance a bank’s balance sheet. This instrument qualifies in the capital market because its maturities last more than a year to approximately thirty years. A mortgage-backed security is highly liquid because it is used to create loans for other borrowers and highly-risky due to the increased chances of defaulting by bank loaners. Banks are likely to use these instruments to borrow, while individual investors and large corporations may lend using the security.
Question Two
This transaction relies on financial markets because Zebra Corporation’s shares of common stock are traded directly to the fifteen private investors. The transaction also occurs in the primary market because Zebra Corporation is issuing its share of common stock to the private investor for the first time. Thirdly, the transaction is conducted in the capital market because long-term assets such as common stocks are only traded in this market.
The second transaction relies on a financial market because the investor’s shares of Zebra stock are sold directly to an individual on TSX in the absence of a middle person. The transaction occurs in the secondary market because the first investor sells Zebra stock shares that they initially owned. Finally, the transaction occurs in the capital market because it involves a trade of long-term assets.
This transaction relies on financial intermediaries because the manager purchases the government bonds through a middle person- the commercial bank. The transaction also occurs in the secondary market, which consists of debt and equity markets. Notably, the manager purchases a short-term government bond, a short-term debt traded in the secondary market. The manager also carries out the transaction in the money market, which focuses primarily on the trade of short-term debt instruments.
Question Three
Hyperinflation is the rapid increase in the prices of goods and services in a country. In countries such as Zimbabwe, hyperinflation causes the federal government to abandon the domestic currency due to the latter’s loss of value and the need to shift to a more stable currency such as the US dollar.
Question Four
If the individual can only buy the car by taking a loan from Larry the Loan shark at a 90% interest rate, he will owe Larry an interest of $4,500 ($5,000*0.90) by next year. In total, the loan will put the borrower in a debt of $9,500 ($5,000+$4,500). However, if the borrower gets the job as a traveling salesman, he will earn $10,000 in extra income. Therefore, after settling the $9,500 loan, the individual will profit from $500. Based on this computation, it is evident that the individual should take out the loan because it will ultimately earn him a profit. One case for legalizing loan sharking is based on its social benefits, as evidenced in this case.
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