Key Concepts

Discussion and Review Questions

Learning Objective 27.1 Assess the role that banks play in funneling money from savers to investors.

  1. You deposit money into a bank account. Explain what happens to that money and how the bank makes a profit.

  2. Do you have a checking or savings account? Why or why not? Would you still have an account if you earned no interest on your deposits? What if you had to pay fees?

  3. How does maturity transformation impact long-term investment spending? What are some risks a bank can face trying to balance the tension that maturity transformation creates?

  4. Bank runs are often called manias, or panics, but are individual people acting irrationally when they participate in a bank run? Explain your reasoning.

Learning Objective 27.2 Understand how companies and governments raise money by issuing bonds.

  1. Explain the differences between a company issuing a bond versus taking a loan from a bank. How are they similar and how are they different?

Learning Objective 27.3 Learn how companies raise money by issuing stock.

  1. You get a large bonus at the end of the year that you don’t plan on spending anytime soon. Should you put your money in stocks, in bonds, or in the bank as savings? What factors inform your decision? Explain.

  2. You are discussing buying stocks with a friend and mention that you want to buy a few shares of Amazon stock. Your friend says that’s a terrible idea because Amazon has never paid dividends to its shareholders so you would never receive any of Amazon’s profits or make any money off the stock. Is your friend right or wrong? Explain your answer.

Learning Objective 27.4 Discover what drives financial prices.

  1. Search online to find a company that issues stock on the New York Stock Exchange. Describe how you can assess the company’s fundamental value and how you could use that information to decide to purchase the stock or not.

  2. Do changes in stock prices precede economic downturns and expansions, or do they follow changes in economic activity? Are stock market prices a cause or an effect of changes in the macroeconomy?

  3. The following graph shows the price of Bitcoin—an online cryptocurrency—over time.

    A graph shows the price of bitcoin from 2016 to 2019.

    Do you think Bitcoin experienced a speculative bubble? Explain why someone acting rationally would purchase bitcoin even at a price so much higher than its historical level.

Learning Objective 27.5 Make better decisions in financial markets.

  1. You are just beginning to invest in the stock market. A friend that you trust advises you to invest all your money in the stock of one certain company. “It’s done really well in the past,” she states. “The stock price is only going to go up. If you go all in now, you’ll make a ton of money later.” Which lessons did you learn from the chapter that will help you analyze your friend’s advice?

  2. Why do people value liquidity? What are the different ways that banks, the bond market, and the stock market create liquidity?

Study Problems

Learning Objective 27.1 Assess the role that banks play in funneling money from savers to investors.

  1. For each situation, explain why seeking out an individual saver to borrow money from is not ideal. Then, identify which function of banks eliminates the problem.

    Hint: Banks serve five functions. Read all the scenarios, then determine which function best addresses each situation. A function will only be used once.

    1. As a first-year student, you need to borrow $20,000 for school. You intend to repay this loan over time after you graduate.

    2. You are starting a business in a new industry and need $300 million for your initial investment.

    3. You need to take out a $15,000 loan to purchase a new car. No one who knows you personally has the money to lend.

    4. You want to be able to pay your bills online instead of paying for everything using cash.

  2. When the Federal Deposit Insurance Corporation (FDIC) created deposit insurance after the Great Depression, what effect did this have on the occurrence of bank runs? Did the introduction of deposit insurance have the same effect on other financial markets, such as the stock or bond market? Explain.

Learning Objective 27.2 Understand how companies and governments raise money by issuing bonds.

  1. Your parents are thinking about purchasing bonds with a 25-year term, but they are a little worried that they might need the money before the 25-year term is up. How would they go about accessing the money if they needed it before the end of the term?

  2. Around $500 billion in U.S. Treasuries are traded each day and many countries hold U.S. Treasuries, as they are considered a very safe investment. For example, as of October 2018, Japan held $1,018.5 billion in U.S. Treasuries, and Ireland held $287.3 billion. Use the three types of bond risks to explain why U.S. government bonds are considered such a safe investment. What is the trade-off that accompanies this low risk?

Learning Objective 27.3 Learn how companies raise money by issuing stock.

  1. For each part, determine whether you should invest in stocks or bonds. Explain your reasoning.

    1. You want a high return and are not concerned about risk.

    2. You would like to participate in how the companies you invest in are managed.

    3. You are worried about losing money if a company declares bankruptcy.

    4. You want a guaranteed, regular payment from your investment.

  2. Stitch Fix Inc is a newly-publicly-traded company. Stitch Fix offers a subscription that provides users with a personal stylist and shopper, who ships clothes to the subscriber’s door. Use the stock market snapshot from Google Finance to interpret the questions about Stitch Fix.

    A snapshot of Stitch Fix stock market shows its stock market numbers summary.

    1. How much was a share of Stitch Fix worth at the time of the snapshot?

    2. What is the market capitalization? What does that mean?

    3. Assess the level of risk associated with investing in Stitch Fix Inc.

Learning Objective 27.4 Discover what drives financial prices.

  1. Use the following data for Nordstrom to estimate the values for a comparable department store, Macy’s.

    Nordstrom:

    Stock price per share (July 2018) $50.71
    Earnings per share (quarter ending July 2018) $0.97
    Book value per share (quarter ending July 2018) $6.81

    1. Macy’s book value per share was $19.27. If Macy’s produces the same price-to-book ratio as Nordstrom, what is the value of Macy’s stock?

    2. Macy’s earnings per share was $0.54. If Macy’s has the same price-to-earnings ratio as Nordstrom, what is the value of Macy’s stock?

    3. The actual price of Macy’s stock as of July 2018 was $36.54. What does this tell us about our valuation technique? What issues (if any) may be leading to any differences?

  2. Your friend just received a promotion and wants to invest the extra annual income from their raise. They tell you that they’re thinking of hiring a fund manager, saying: “The fee is only 1.1%, and this stock picker has a great track record!” What advice would you give your friend?

  3. On September 29, 2008, the stock market fell almost 7%. How can we reconcile these kinds of huge losses in the stock market with the efficient market hypothesis?

Learning Objective 27.5 Make better decisions in financial markets.

  1. The 1990s was a period of rapid economic growth and a robust stock market that yielded an average annual return of 18.6%!

    1. If you invested $1,000 at the beginning of the decade, and you reinvested the returns you earned every year, calculate the value of your investment at the end of the decade.

    2. Did this high rate of return continue into the 2000s and beyond? Look online at stock charts for the S&P 500 to figure out what happened. Use what you learned in the chapter to explain why.