Midterm Review Topics

1. Define Finance as a part of economics, explain three areas of Finance, why we should
study finance and briefly explain main principles of finance.

As we know, economics is a science that studies how people manage their limited resources
and learning economics helps us to get maximum profit with optimal costs, so its aim is to
create additional value, but to make this work system needs investment. At this time, finance
is a study of how individuals, institutions, governments, and businesses acquire, spend, and
manage money and other financial assets and decision of this people is related to prices of
goods and services and the price of them is determined by supply and demand, which are
studied in economics.

Three areas of finance are: 1) institutions and markets, 2)investments and 3)financial
management. Financial institutions help the financial system operate efficiently because they
transfer funds from savers to investors, financial markets are physical locations or electronic
forums where flow of funds happen. Investments area involves sale or marketing of securities,
analysis of securities, and management of investment risk. So it helps participants of financial
system to obtain financial resources and give their money to those needing them. Financial
management involves financial planning, asset management, and fund raising decisions to
enhance firm value. So it’s about managing your assets properly, in a way that they will be
most profitable.
There are several reasons why should we study finance. For example, it helps us to make
more informed economic decisions. Whatever you financial or economic goals may be, you
need to have knowledge in finance, many of us can’t make big decisions but we need to predict
the effect of others decisions on the system that we live in. The other reason is to make
informed personal and business decisions, this will enable us to better manage our financial
resources and accumulate wealth over time.
There are 6 principles of finance:
1. Money has a time value. it means that money in hand today is worth more
than the promise of receiving the same amount of money in the future. it exists because a sum
of money today could be invested and “grow” over time
2. Risk-return tradeoff. Risk is the uncertainty about the outcome or payoff of an
investment in the future. The more risk we take, higher aour profit may be. But we need to
be sure, that our return is high enough to justify the risk.
3. Diversification if investment. Some risk can be removed or diversified by investing
in several different assets or securities (example)

4. Efficient financial markets. A financial market is “information efficient” if at any point in

time the prices of securities reflect all information available to the public so when new
information becomes available, prices quickly change this provides liquidity and fair prices
 5. Management vs owner’s objectives. Management objectives may differ from owner
objectives. Owners or equity investors want to maximize the returns on their investments,
however, managers may want to increase the size of firm sales, assets, or other perks. There
is some solution: we can tie manager compensation to owners benefit
6. Reputation matters- we should follow ethical norms. Ethic is how an individual or
organization treats others legally, fairly, and honestly. So good reputation means that you
can easily and quickly obtain financial resources that you need.

2. Explain the differences between primary and secondary, money and capital markets;
list and define main types of financial markets.

Money Markets are those where debt securities with maturities of one year or less are
issued/traded. (Bond that has 6 or 12 months maturity.)

Capital Markets are those where debt securities with maturities longer than one year are
issued/traded.

Primary Markets are those where the initial offering/origination of debt and equity
securities takes place. (When TBC issued sec. for the first time, it was sold on primary market)
Secondary Markets: where the transfer of already existing securities between investors takes
place. (If the owner of TBC sec. wants to trade with the sec, it will be sold on secondary market.
Debt Securities Markets: where money market securities, bonds, & mortgages are sold and
traded
Equity Securities Markets: where ownership rights in the form of stocks are initially sold and
traded
Derivative Securities Markets: where financial contracts that derive their values from
underlying securities are originated and traded
Foreign Exchange Markets: electronic markets in which banks & traders buy and sell currencies
on behalf of businesses and clients
Mortgage Markets: where mortgage loans to purchase buildings and houses are originated and
traded

3. Define the monetary system, explain the process of financial intermediation, how
financial intermediaries facilitate movements of capital.
Monetary policy refers to the measures which the central bank of the country takes in
controlling the money supply in the country to achieve certain specific economic objectives
(maximum employment, stable prices and moderate long-term interest rates. It may
be expansionary or contractionary. Expansionary policy increases the total supply of money
in the economy, contractionary policy expands the money supply more slowly than usual or
even decreases it.
Financial Intermediation is a process by which savings are accumulated and then lent or
invested. So, if anyone has more money than it spends it can make some deposit and gain some
interest. (just saving our money at home is not rational, because money has a time value). Then
those who need this money can take it and invest it some business so that they can create some
additional value and increase economy. So there exsists some institutions that take deposits and
then lend these accumulated savings to others.

4. List and explain the functions of money. What are the measures of the money supply
in the economy?

Any item that people are generally willing to accept in exchange for goods, services, generally
for financial assets is money.

Money performs three main functions. It is a medium of exchange, a store of value, a standard
of exchange.

MEDIUM OF EXCHANGE The fundamental function of money is to serve as a medium of

exchange. This means that people who trade goods, services, or financial assets are willing to
accept money in exchange for these items. By using money, people avoid engaging in barter,
or the direct exchange of goods, services, and financial assets. Barter is a very costly activity,
because it requires finding others willing to exchange items directly. A key reason that people
use money is to avoid this cost.

STORE OFVALUE Nevertheless, money has other important functions. One is its use as a store
of value. An individual can set money aside today with an intent to purchase items at a later
time. Meanwhile, money retains value that the individual can apply to those future purchases.

Standard of value- it means that we can easily measure the value of goods and services. It would
be really hard to measure how much banana is worth in terms of gold, so by this function we
standardize values of financial assets. Of course its important to use stable monetary unit
because if 1 banana cost 1 $ today and 2 tomorrow, such money wouldn’t be effective.

Measures of the money supply in economy are M1, M2 and M3.

M1=monetary base (paper money and coins) + current accounts (checks and debit cards) +
demand deposits (you can withdraw these at any time you want) (M1 is the money that doesn’t
give you any interest and its purposes are speculation and liquidity)

M2= M1 + SDTM (small denominated time deposits- deposits less than 100000 and small
maturity) + saving accounts (they have low interest rates and you’re allowed to withdraw
money when you want, but % rate will be lower) + MMMF (retail money market mutual funds,
you are allowed to write checks according to your share of stocks)
M2 has investing purpose. They have intermediate liquidity

M3=M2+LDTM(more than 100000 its maturity is more than 2 years) + IMMF( institutional
money market mutual funds) + REPO(repurchase agreement, it cant be sold to a third part) +
EURODOLLARS (money outside the country)

5. List and explain the money market securities, their meanings and functions.

Money market instruments have maturities shorter than one year, because they are so widely
traded, money market instruments typically are more liquid than capital market instruments.
Also are less risky because of their shorter terms to maturity.

TREASURY BILLS The U.S. government issues financial instruments called Treasury
securities. They are exchanged in both the money markets and the capital markets. They have
maturities of less than a year, so they are money market instruments. And they are very safe
assets. They exists because of liquidity purposes

Negotiable Certificate of Deposit - short-term debt instrument issued by depository institutions

that can be traded in the secondary money markets

COMMERCIAL PAPER Banks, corporations, and finance companies often need to obtain
short-term funding. One way to obtain such funds is to issue commercial paper, which is a
short-term debt instrument. Typically, only the most creditworthy banks and corporations are
able to sell commercial paper to finance short-term debts because they are unsecured.

CERTIFICATES OF DEPOSIT Banks also raise short-term funds by issuing certificates of

deposit (CDs). Most CDs are short-term time deposits They now are traded actively in a
secondary money market.

REPURCHASE AGREEMENTS a repurchase agreement is a contract to sell a financial asset

with the understanding that the seller will buy back the asset at a later date and, typically, at
a higher price. This means that effectively the seller of the asset borrows from the buyer. They
are very short term loans.

FEDERAL FUNDS When banks borrow from or lend to one another, the funds that they trade
are federal funds. These funds are held on deposit at Federal Reserve banks.

BANKER’S ACCEPTANCES is issued by a company and guaranteed by the bank. They are
typically used to finance storage or shipment of goods. These instruments commonly arise from
international trade arrangements. They are traded in secondary money markets.

6. Explain how money supply is related with economic activity and creation of countries
GDP.

GDP measures out of products and services that country produces in specific period of time.

Money supply has one of key roles in creation of GDP. GDP = MS x VM. MS is money supply
and VM is velocity of money (how quickly money creates goods and services). There is also
another equation for it, GDP = RO X PL.. So there are two ways to increase GDP increase MS
OR RO. Increasing money supply is related with high inflation because when the money
supply goes up and number of products is the same, people who will pay more money will get
those products, so price level increases and purchasing power decreases. This is the reason of
high inflation rate . so we should always try to maintain PL on reasonable level. Comes out,
that the proper way to increase GDP is increasing real output and not prices.

7. Distinguish depository and non-depository financial institutions. Define depository

institutions and describe their main representatives, commercial banks and its
functions.

Depository institutions are financial intermediaries, They accept deposits from individuals,
who have savings and then they lend this pooled deposits to individuals or businesses, those
who need funds to make investments.

Non-depository financial intermediaries are organizations which connects savors and lenders
to each other, but they don’t accept deposits. Such types of organizations are: Contractual
Savings Organizations, Securities Firms and Finance Firms.
Main representatives of depository institutions are: commercial banks, savings and loans
asossiations, savings banks and credit unions.

Main functions of commercial banks are:

1) Accepting deposits- so they pool deposits together in order to grant big amount of loans

2) Issuing loans- they provide loans for ones who need it to invest in different fields

3) Managing current accounts

4) Clearing checks (there are 3 ways to do this: to present check exactly where they were
issued, to present check at the clearing house=not in Georgia, mainly in US and to clear check
through the central bank)

5) Creating money (…)

Savings and loans associations and first appeared in 19 century, when rich people realized that
building stronger society would benefit them in future. At first they provided mortgage loans
with no interest rate and no back-up. Today, they accept individual savings and lend pooled
savings to individuals and businesses.
Savings banks – has the same history, they accept the savings of individuals & lend pooled
savings to individuals mainly in the form of mortgage loans
Credit unions are cooperative nonprofit organizations that exist primarily to provide member
depositors with consumer credit (to purchase a house or car)

8. Distinguish depository and non-depository financial institutions. List and describe non-
depository institutions.

Depository institutions are financial intermediaries, They accept deposits from individuals,
who have savings and then they lend this pooled deposits to individuals or businesses, those
who need funds to make investments.

Non-depository financial intermediaries are organizations which connects savors and lenders
to each other, but they don’t accept deposits. Such types of organizations are: Contractual
Savings Organizations, Securities Firms and Finance Firms.
Contractual Savings Organizations collect premiums and contributions from participants and
provide insurance against major financial losses and retirement, there are two types of this
organizations: Insurance Companies (provide financial protection to individuals and businesses
for life, property, liability…) and Pension Funds (receive contributions from employees and/or
their employers and invest the proceeds on behalf of the employees for use during their
retirement years
Securities Firms accept and invest individual savings and also facilitate the sale and transfer of
securities between investors. These are: Investment Companies (mutual funds- sell shares in
their firms to individuals and others and invest the pooled proceeds in corporate and
government securities.) Investment Banking Firms (sell or market new securities issued by
businesses to individual and institutional investor) Brokerage Firms assist individuals to
purchase new or existing securities issues or to sell previously purchased securities
Finance firms Provide loans directly to consumers and businesses and help borrowers obtain
mortgage loans on real property. Two Types:Finance Companies provide loans directly to
consumers and businesses or aid individuals in obtaining financing of durable goods Mortgage
Banking Firms: originate mortgage loans on homes and other real property by bringing
together borrowers and investors

9. Distinguish commercial and investment banking and their functions, explain concept
of universal banking.

Commercial banks accept deposits from individuals, who have savings and then they lend this
pooled deposits to individuals or businesses, those who need funds to make investments.
Main functions of commercial banks are:

1) Accepting deposits- so they pool deposits together in order to grant big amount of loans

2) Issuing loans- they provide loans for ones who need it to invest in different fields

3) Managing current accounts

4) Clearing checks (there are 3 ways to do this: to present check exactly where they were
issued, to present check at the clearing house=not in Georgia, mainly in US and to clear check
through the central bank)
5) Creating money (…)

Investment Banking means selling or marketing new securities issued by businesses to

individual and institutional investor and if the commercial bank with its 5 functions does thins
function as well, it becomes universal bank.
 10. Explain the structure and management system of commercial banks. What are the
challenges related to bank liquidity and solvency and what are the main risks associated
with banking activities.

Banks as every business are managed to make profits and increase the wealth of their owners. However,
bank management must also consider the interest of depositors and bank regulators. Profitability often
can be increased when bank managers take on more risk at the expense of bank safety. The lower the
level of bank safety, the greater is the opportunity that bank will fail. Banks can fail because of different
risks. In order to avoid this risk we should know structure of bank really well.
Assets of a bank are: cash, securities, loans, fixed assets and so on… The biggest liability of a bank is its
deposits that it has to pay interest for. So in order to make max profit they can grant huge amount of
loans, so they will take all the deposits, but if there isn’t anything left in case depositors want to
withdraw their money, they wont be able to pay it back so the bank has liquidity risk. Bank liquidity
reflects the ability to meet depositor withdrawals and to pay off other liabilities when due.
In another case, bank may grant huge amount of loans but they are risky and there is a big chance that
they wont be paid back so there is also solvency risk for the banks. Bank solvency reflects the ability to
keep the value of a bank’s assets greater than its liabilities. In order to avoid this risk banks should keep
some reserves according to their risk weighted assets. NBG sets this regulatory amount and its 12% in
Georgia.

11. The meaning of central banking and base of central banking emergence. List and
explain basic objectives and functions of the National Bank of Georgia.

The Central bank of the country is the bank of all banks, and the banker and fiscal agent of the
Government. Bank of all banks means that it is a supervisor of them. The aim of all banks are
to make maximum profit, but sometimes its against society’s interests so in such cases central
banks regulates behavior of the banks by different tools. Also, central bank is not only
supervisor, it is protector as well, banks hold peoples money so if bank bankrupts economy
will fail, it is a lender of last resort, so this is one more emergency of central bank.

The objective of the National Bank shall be to achieve and maintain the purchasing power of
the national currency, and price stability, and to ensure the liquidity, solvency and stable
functioning of the financial systems of Georgia. Other main functions are:

a) to develop and implement monetary and foreign exchange policies;

b) to supervise the activities of commercial banks, non-bank depositary institutions and

currency exchange offices
c) to hold, keep and dispose the official foreign exchange reserves;

d) to ensure the efficient operation of the payments system;

12. Explain the goals of monetary policy. What are the tools of central bank for
implementing monetary policy?

Monetary policy refers to the measures which the central bank of the country takes in
controlling the money and credit supply in the country with a view to achieving certain
specific economic objectives.

It is referred to as either being expansionary or contractionary, where an expansionary policy

increases the total supply of money in the economy, contractionary policy expands the money
supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to
try to decrease unemployment in a recession by lowering interest rates in the hope that easy
credit will entice businesses into expanding. Contractionary policy is intended to slow
inflation.

So the goals of monetary policy are to promote maximum employment, stable prices and
moderate long-term interest rates.

The Central Bank has three instruments of monetary policy: open market operations, the
discount rate and reserve requirements.

1. Open Market Operations

Open market operations involve the buying and selling of government securities. The Central
Bank is authorised to operate in the open market by purchasing and selling debt securities
issued by the Ministry of Finance and securities issued by the Central bank. Buying
government bonds means expanding the money supply and selling them - decreasing the
money supply. Most of the government bonds bought and sold through open market
operations are short-term bonds.

2. Minimum Reserve Requirement

The Central Bank determines the minimum required reserves for all commercial banks and
non-bank depositary institutions. Monetary policy can be implemented by changing the
proportion of total assets that banks must hold in reserve with the central bank. By changing
the proportion of total assets to be held as liquid cash, the Federal Reserve changes the
availability of granting loans. This acts as a change in the money supply. Central banks
typically do not change the reserve requirements often as it can create volatile changes in the
money supply and may disrupt the banking system.

3. Discount Operations

The discount rate is the interest rate charged by Central Bank to depository institutions on
short-term loans. Central banks normally offer a discount window, where commercial banks
and other depository institutions are able to borrow reserves from the Central Bank to meet
temporary shortages of liquidity caused by internal or external disruptions. The interest rate
charged (called the 'discount rate') is usually set below market rates. Accessing the discount
window allows institutions to vary the amount of money they have to loan out. So this effects
the money supply.

13. Explain the History of International Monetary System. Advantages & Disadvantages of
Bretton-Woods system. What was the need for introduction of Euro. Describe the types
of exchange rate system in modern world.

Before World War I -Prior to 1914 the international monetary system operated mostly under
a “gold standard” whereby the currencies of major countries were convertible into gold at fixed
exchange rates. For example, 1 ounce of gold might be worth 20 U.S. dollars, or $1 would be
worth 0.05 of an ounce of gold.

The gold standard broke down during World War I, but was briefly remained from 1925 to
1931. Between 1946and 1971, countries operated under the Bretton Woods system- the U.S.
dollar was valued in gold & other exchange rates were pegged to the dollar. most countries
settled their international balances in U.S. dollars. So international trade was performed with
US dollar. 1ounce of gold was equal to 35 $ but when in 1971 oil shock happened countries
increased demand on $ and USA declared that it wouldn’t buy any more gold, because it
neither needed or was capable of keeping so much gold. Pros of this system were that weak
countries after 2 world war wouldn’t have problems with exchange rates and it was easy to
manage international trade with every one with an unique currency, also inflation was low.
Cons of this system was that it was really hard to maintain it and countries needed huge
amount of currency reserves to keep exchange Fixed.
Flexible Exchange Rate System: 1973—Present time - Gold was abandoned as a reserve asset
& major currencies were allowed to “float” against one another with currency exchange rates
being determined by supply and demand.

Maastricht Treaty - In late 1991, EC members signed this treaty which provided for economic
convergence, the fixing of exchange rates, and the introduction of the euro as a common
currency at the beginning of the 1994.

There are 4 types of exchange rates in the world:

1) free floating (well developed countries, us, Canada..)

2) managed floating ( when central bank interferes and influencec exchange rates, most
countries)

3) Fixed exchange rate – (when currency is pegged to another one. Breton-wood system,
Arabian countries have their currency pegged to US)

4)dollarized ( some countries were allowed to take $as their currency, equador, Salvador,
zimbabwe tu rogorc iwereba :D )

14. Define currency exchange markets and types of exchange rate, describe determinants
and factors that affect exchange rates, and explain how exchange rates between
currencies are determined using example.

Currency exchange markets, also called foreign exchange markets, are electronic markets
where banks and institutional traders buy and sell currencies on behalf of business, other
clients and themselves. The major financial centers of the world are connected electronically

A currency exchange rate includes the value of one currency relative to another currency.
Currency exchange rates are stated in two basic ways:

The direct quotation method – indicates the amount of a home country’s currency needed to
purchase one unit of a foreign currency.

The indirect quotation method – indicates the number of units of a foreign currency needed
to purchase one unit of the home country’s currency.
The indirect quotation (foreign currency units) = 1 / The direct quotation (home currency
value)

Spot exchange rate – rate being quoted for current delivery of the currency

Forward exchange rate – rate for the purchase or sale of a currency where delivery will take
place at a future date.

Factors that affect exchange rates:

Supply and demand relationships – involving two currencies is said to be in balance at the
current or spot exchange rate. Demand for a foreign currency derives from the demand fot the
goods, services and financial assets of a country.

Inflation, interest rate and other factors:

Purchasing power parity (PPP) states that a currency of a country with relatively higher
inflation rate will depreciate relative to the currency of a country with a relatively lower
inflation rate.

Interest rate parity (IRP) – states that a currency of a country with a relatively higher interest
rate will depreciate relative to the currency of a country with a relatively lower interest rate.

Political risk – is the risk associated with the possibility that a national government might
confiscate or expropriate assets held by foreigners.

Economic risk – associated with possible slow or negative economic growth, as well as with
the likelihood of variability.

15. What is highlighted in countries Balance of Payments, list and explain its main
components. List and describe capital market securities.

Balance of payments – a summary of all economic transactions between one country and the
rest of the world. The most important component of the balance of payments is the balance of
trade which is the net value of a country’s exports of goods and services compared to its
imports. The second part is: Capital Account Balance: Foreign government and private
investments in the home-country netted against similar home countries investment in foreign
countries

Capital market securities:

EQUITIES such as common stock and preferred stock typically offer dividends, which are
periodic payments to holders that are related to the corporation’s profits. .

CORPORATE BONDS Corporations may wish to fund capital expansions by borrowing instead
of by issuing stock. One way to borrow is by issuing corporate bonds, which are long-term debt
instruments of corporations. A typical corporate bond pays a fixed amount of interest twice each
year until maturity.

TREASURY NOTES AND BONDS The U.S. Treasury issues two categories of financial
instruments with maturities of more than one year. These are Treasury notes and Treasury bonds.
Treasury notes have maturities ranging from one to ten years. Treasury bonds have maturities
of ten years or more. Both notes and bonds have minimum denominations of $1,000. The Treasury
sells most notes and bonds at auctions.

SECURITIES OF GOVERNMENT AGENCIES These are long-term debt instruments issued

by a variety of federal agencies. For instance, one agency called the General National Mortgage
Association (GNMA) issues securities backed by the value of household mortgages that it holds.

MUNICIPAL BONDS Long-term securities issued by state and local governments are called
municipal bonds. An attractive feature of these bonds for many holders is that the interest
payments the holders receive typically are tax-free. Consequently, the stated interest rates on
municipal bonds are lower than the rates on corporate bonds.

MORTGAGE LOANS AND MORTGAGE-BACKED SECURITIES Long-term loans to

individual homeowners or to businesses for purchases of land and buildings are mortgage loans.

COMMERCIAL AND CONSUMER LOANS Long-term loans made by banks to businesses

are commercial loans. Long-term loans that banks and other institutions, such as finance
companies, make to individuals are consumer loans. Until recently, there were not many
secondary markets for these loans, so they traditionally have been the most illiquid capital market
instruments.

16. What is the savings role in formation countries capital and perspectives for future
growth, identify major sources of saving and factors that affect creation of savings.

Every countries aim is economic growth and development. Economic growth is connected
with gdp , the higher gdp is more goodwill it brings to people. But increasing gdp isnot enough,
its really important how we increase it. Increasing money suply won’t give us anything (iyo
wina kitxvebshi amaze) so countries should increase real output and to increase productivity
we need some material, starting investments. And where does this invesments come fro? Of
course from those who have saved some amount of money or other assets. So our saving
become investments all the time. Comes out that there are many sources for savings. First of
all, savings appear when our income is higher than our expenditures. Therefore, every time
we use our assets we are making investments. For example if I buy a car with a saving, it is an
expenditure, but at the same time it is investment for car manufacturer. So savings aren’t
profitable when they are held aside(hidden in the closet) they are effective when we use them
and transfer into investments. And these investment help countries to create and form their
capital. The major source os savings are the households. There are some factors that affect
savings, for example: Levels of income, its not strange that if your income is enough for only
paying bills or buying food, you wont be able to save up more. Also economic expectations
affect savings, for example if 10% inflation is expected, you may consider spending less and
saving more for future. And at last, savings are also affected by life stage of individual or
corporation.

17. What type of document is The Country’s Budget. Explain its main components, sources
for income and targets for expenditure.

18.How interest rate is formed on financial markets, what are main

components of market interest rate.

Like everything in the economy, interest rate is determined by the forces of

supply and demand. Interest rate itself is the price that equates the demand for
and supply of loanable funds. Interest rates are affected by any change in these
forces, for example:
(in the first picture we can see the equilibrium but if demand increases, its graph
will shift to the right and we will have new equilibrium.)

There are several factors which influence the supply of loanable funds, such as
volume of savings(which is mainly determined by the national income), lending
policy of central bank and other depository institutions and the last one is
liquidity attitude ( its about how lenders see the future).

Market interest rate or nominal interest rate is the interest rate that is observed
in the marketplace. It is formed by different rates and risk premiums and the
basic equation looks like:

r = RR + IP + DRP + MRP + LP
RR stands for Real Rate of Interest and it is an interest rate on a risk-free debt
instrument when no inflation is expected.
IP-inflation premium- this is a premium to compensate average inflation rate
expected over the life of security
DRP – default risk premium and it compensates the possibility of borrowers
failure to pay interest/principal when due.
MRP - Maturity Risk Premium is the compensation on securities with longer
maturities for increased interest rate risk. We define interest rate risk as : Possible
price fluctuations in fixed-rate debt instruments associated with changes in
market interest rates.
LP - Liquidity Premium is the compensation for securities that cannot easily be
converted to cash without major price discounts
If we take out DPR<,MRP and LP from this equation we will get Risk-free rate
of interest, which is rate on security with no default, maturity or liquidity risks
(treasury securities), so risk-free rate of interest (rf) = RR + IP.
 19.What are three main external sources for financing business, their
advantages and disadvantages?

There are three main external sources for financing business:

 Taking a loan – its disadvantages are : it requires the highest interest rate
from you, you need to have good reputation and some wealth to back your
loan with and you may lose your assets, which you provided as a collateral
for the loan. In addition, you are paying principal and interest rate at the
same time, together, so you lose your opportunity to use-invest that
money. And the advantage of taking a loan is that it is a quick and easy
way to finance your business.
 Issuing bonds – in case of bonds, you are borrowing money from the public
and companies. It has the lowest interest rate, so you have the lowest
expenses. Another advantage of it is that you are paying principal at the
maturity, and during this time, you can use many opportunities and invest
your money wisely. However, to issue bonds you need the help of financial
intermediaries – investment banks or brokerage companies, you have to go
through underwriting process and this help is not free of course, you have
to pay them and it requires a lot of time. Besides that, you should have
good reputation to issue bonds otherwise, nobody will buy your bond.
(sometimes underwriters with high reputation help you to sell these
bonds) This means that this process is not easy. There are variety of bond,
they all have different advantages and disadvantages, and you can issue
different bond according to your situation and needs.
 Issuing stocks – you are selling part of your company, transferring/sharing
ownership rights to another party. The main reason to do so is to expand
and attract other sources, strong, reliable investors. It’s not an easy process-
you need underwriters and good reputation. The biggest advantage of
issuing stocks is that you’re not paying anything, just attracting money and
it is likely that price of shares will rise and this gives you an opportunity
 to make capital gain- resell stocks for higher price. However, the company
has to share its profit among the shareholders and they are provided with
dividends if supervisory board decides to do so.

20. Differentiate between stocks and bonds and define their types and
characteristics.

Issuing bonds means borrowing money from public or companies, but issuing
stocks means selling part of the company, transferring/sharing ownership rights
to another party.

There are different types of bonds :

Registered bond - is a bond whose owner is registered with the bond's issuer. The
owner's name and contact information is recorded and kept and
bond's coupon payment is paid to the appropriate person. If the bond is in physical
form, the owner's name is printed on the certificate.

Bearer bond - is owned by the holder (bearer), rather than a registered owner and it is
the bondholder's responsibility to submit the coupons to a bank for payment and
redeem the physical certificate when the bond reaches the maturity date.

Debentures – bonds that are not secured by any asset.

USA bond- bonds with maturity from 10 to 30 years and semi-annual coupon
payment

Eurobond - bonds with maturity from 7 to 10 years and annual coupon payment

Convertible bond – bonds that can be converted into common stock

Callable bond – allows issuer to redeem the bond at some point at maturity

Puttable bond – its holder has the right( not obligation) to demand early payment
of the principal
Extendable bond – its holder has the right (not obligation) to extend bonds
maturity date.

Sinking fund bond- a bond with an account where issuer of the bond deposits
money on a regular basis to repay the principal at maturity. It isn’t secured bond

Eurodollar bond – denominated in us dollars, but traded outside the country

Yankee bond – issued in USA, in us dollars, but by foreign entities

Global bond – bond issued/traded outside domestic country (currency

denomination)

Zero coupon bond – it does not pay you any coupons, it pays you principal at
maturity and it is traded with a deep discount.

And there are different types of stocks also:

Common stock – owners of common stock have a right to make decisions about
the company. Only they have ownership rights for the company. For example,
they choose board of directors. They have a right to take dividends, when
declared, but their par value is meaningless, because their price is determined by
the supply and demand on the market. Common stocks also have lowest priority
in bankruptcy , they will be satisfied at last time.

Preferred stocks – these types of stocks don’t provide their owners with
ownership rights, they cant make decisions, they don’t vote, they just get fixed
payment from dividends. They have senior claim on earnings, assets. And their
par value is important because if the market interest rate rises their price declines
and vice versa. There are different preferred stocks like: cumulative - requires the
company to pay preferred shareholders all dividends, including those that were
omitted in the past, before the common shareholders are able to receive their
dividend payments. Non-cumulative preferred stock does not issue any omitted
or unpaid dividends. Callable preferred stock - the issuer has the right to call in
or redeem the stock at a preset price after a defined date. Convertible- these
stocks allow owners to transfer them into fixed amount of common stock after
pre-determined date.