book 3 chapter 1 answers eng

NSS BAFS: Basics of Personal Financial Management © Pearson Education Asia Limited 2009

Answers to textbook exercises 1

Chapter 1 Structure and Role of the Financial Market

Answers to Think It Over (p.2)

1 As your group does not have enough funds to finance the business, you will need to borrow

money from other people. Banks would be unwilling to lend you money since the business is

risky and your group has no prior experience in running a successful business. The most

available source of financing would be loans from your family members, relatives, friends and

teachers.

2 There are two major types of financing: equity financing and debt financing. (You have

already learnt about these in NSS BAFS: Business Environment and Introduction to

Management, Chapter 7.) Equity financing refers to funds supplied by the owners of a

business. Debt financing refers to funds obtained from outsiders, such as banks.

For debt financing, interest must be paid to the lender. Therefore, you have to consider

whether the business would be able to make enough money to pay the interest and repay the

loans. In addition, as the risk of failure is high, you should not borrow large sums of money to

finance the business. Most of the funds should be obtained in the form of equity financing.

You can raise funds by inviting your family members, relatives, friends and teachers to

become co-owners of the stall. This minimises borrowing and saves on interest expense. In

addition, you need not repay large loans if the business fails.

3 You can get your friends, relatives and teachers to invest in the business by offering them an

attractive return. This would sound more attractive if a limit is put on their losses in case the

business fails. In order to make them feel more confident, you should also allow them to have

more information about the business, e.g., nature of the business, budget, sales forecast,

marketing plan and operational plan.

Check Your Progress

Q1 The banking sector plays an important role in providing financial services in Hong Kong. It

acts as a financial intermediary, channelling savings into investment by receiving deposits

from the public and then lending the money to borrowers.

Q2 The major function of retail banking is to provide various financial services for private

individuals. Examples of such services include savings deposits, current accounts and loans.



Corporate banking helps companies perform needed financial transactions for their daily

operations. Commercial lending is the main service offered by corporate banking. Other

services include loans, deposit accounts, credit cards, insurance and MPF, corporate Internet

banking, and payroll services.

Q3 (a) Corporate banking

(b) Corporate banking

(c) Retail banking

Q4 (1) life insurance, (2) general insurance, (3) motor insurance and (4) casualty insurance (any

three)

Q5 Pool and transfer risks: The major function of insurance is to pool and transfer risks. The

insurance products provided by insurance companies help individuals and business manage

risks. This encourages firms to undertake risky but profitable projects. This also enables

individuals to receive financial protection for their life and assets at an affordable cost.

Provide a source of capital: Insurance companies are one of the biggest investors in the

securities markets. After receiving premiums from individuals and firms, insurance companies

invest them in the securities market. These premiums thus serve as a source of capital for

other companies.

Q6 (a) For individuals, securities are important investment vehicles for retirement and savings

purposes. They can earn dividends on shares and interests on bonds. They may also earn

capital gains by selling the shares and bonds when their prices go up.

(b) For firms, the securities sector provides a market for raising funds. To raise capital, they

can issue different kinds of securities.

Q7 (a) Bonds

(b) Common stocks

(c) Mutual funds

(d) Preferred stocks

Q8 (1) government authorities, (2) stock exchanges, (3) the public and (4) financial institutions

(any three)

Q9 The success of the primary market depends heavily on the health (i.e., the size and liquidity)

of the secondary market. Without a liquid secondary market, it would be difficult to attract

investors to buy new issues in the primary market. This is because investors need a platform



to trade newly issued securities immediately after the securities are issued in the primary

market.

Q10 Brokers act as middlemen to help investors buy and sell securities. On the other hand, dealers

trade from their own inventory of securities.

Q11 A primary market is a market where new securities are issued. It also refers to the system for

creating and listing newly issued securities such as stocks or bonds.

A secondary market is a market for trading securities that have already been issued. It

provides a continuous trading channel for securities owners and new buyers.

Q12 The major difference between the money market and the capital market is that the money

market is for short-term (normally within one year) borrowing and lending while the capital

market is for long-term financing activities. In the money market, most instruments are debt

instruments. In the capital market, most securities are equity instruments.

Money market instruments: (1) US treasury bills, (2) certificates of deposit, (3) commercial

paper, and (4) Exchange Fund Bills.

Capital market instruments: (1) bonds, (2) notes, (3) Exchange Fund Notes, (4) stocks, and (5)

residential mortgages.

Q13 Fixed-income securities (three-year note) and a three-year bank loan.

The main reasons for using the note and term loan are:

1 Unless the factory is really large, the amount required is too small to issue common stock

or preferred stock.

2 The duration of the project is two years. As it takes one year to make a profit, the

company can pay the money back to investors by the third year. Thus, the time frame for

the note or loan should be three years.

Q14 Common stock. The reasons are:

1 it is a public company. That means its shares are listed on the stock exchange and the

company can issue more shares to raise capital.

2 the amount is large and the project is long-term. The payback period of the project is



uncertain. Thus, a bank loan is not possible.

Q15 The major difference is that trading on a stock exchange involves brokers who charge a

commission. On the OTC market, no brokers are involved and no commission is charged.

Instead, dealers buy securities from clients and sell them to other clients as holders of

securities. They pay a lower price when they buy and charge a higher price when they sell.

The difference between the two prices reflects the service charge or profit of the dealer.

Q16 Open-end funds are traded on the OTC market. There is no restriction on the number of shares

it can issue. Investors buy units of the fund from a mutual fund company and sell (redeem)

them to the company through investment companies whenever they choose.

Closed-end funds are traded on stock exchanges. The number of shares issued is fixed at its

IPO. The mutual fund company is not required to buy back shares of the fund from investors.

Q17 Stamp duty, transaction levy, brokerage commission and HKEx trading fee

Q18 (1) Stocks, (2) bonds, (3) mutual funds and (4) foreign currencies (any two)

Q19 Compared with a single stock, ETFs can provide better risk diversification. ETFs are

index-tracking funds and are traded like stocks on a stock exchange. They invest in a basket of

securities tracking an index. That means the ETF would buy stocks following a well-known

index such as the NASDAQ 100 Index or the Hang Seng Index. As a result, the price

movements of an ETF would be similar to that of the index.

Q20 As of 8 October 2008, there were 42 constituent stocks in the Hang Seng Index and 30

constituent stocks in the Dow Jones Industrial Average. Each represents large companies in

their own stock market. Thus, these indices reflect the general price movements of an entire

market.

Q21 Insurance premiums are the major source of revenue for insurance companies. After receiving

premiums from clients, insurance companies then invest them in the financial market to

generate additional investment returns.

Q22 Securities firms serve as middlemen for investors in securities trading. Because of the large

amounts of investments and the frequency of trading that securities firms handle, they are a

major player in the financial market.



Q23 (1) The Securities and Futures Commission, (2) the Hong Kong Monetary Authority, (3) the

Office of the Commissioner of Insurance and (4) the Mandatory Provident Fund Schemes

Authority (any three)

Q24 Investors buy and sell financial products in the financial market. They always need reliable

information and a fair market to make sound investment decisions. Other market participants,

such as securities firms and banks, can help investors make wise investment decisions by

assessing the risks and returns of different financial products.

Try This Activity

A1 (a) (1) savings deposits, (2) credit card, etc.

(b) (1) Without savings deposits, people would find it difficult to hold their money safely

and conveniently. They would earn no interest on it.

(2) Without credit cards, people could buy things only when they had enough cash.

They would have to carry a large amount of money around to shop.

Assessment MCQ

1 B

2 C

3 C

4 B

5 C

6 B

7 A

8 B

9 B

10 B

11 D

12 B

13 D

14 A



Short Questions

15 Money market

Certificates of deposit: Certificates of deposit (CDs) which are generally issued by

commercial banks are a kind of time deposit. Holders usually enjoy higher interest rates than

time deposit holders. They can withdraw the deposits together with the interest on maturity

dates.

Commercial paper: Commercial paper is a debt obligation issued by large banks and

well-known corporations. It is not backed by collateral and is a short-term instrument.

Commercial paper is normally regarded as a safe investment product.

Exchange Fund Bills: They are short-term debts issued by the HKMA. Exchange Fund Bills

are fully backed by foreign currency reserves.

(Any two of the above)

Capital market

Fixed-income securities: Fixed-income securities are debt instruments. They are

interest-bearing securities which pay a fixed percentage of return. Provided that the issuer of

the fixed-income securities does not go bankrupt and investors hold the securities to maturity,

the return on these securities is guaranteed. Examples of fixed-income securities are bonds,

notes and Exchange Fund Notes.

Equity securities: Equity securities refer to securities that entitle holders to part of the

ownership of listed companies (i.e., stocks). Investors may earn dividends and capital gains

when stock prices increase. However, they may suffer a loss if the price drops. Examples of

equity securities are common stocks and preferred stocks.

16 Similarities:

1 Both open-end and closed-end funds provide risk diversification for small investors who

cannot afford to buy a large number of individual stocks.

2 Both open-end and closed-end funds provide professional wealth management for small

investors who cannot afford to engage these services directly.

Difference:

Open-end funds are traded on the OTC market. There is no restriction on the number of shares

it can issue. Investors buy units of the fund from a mutual fund company and sell (redeem)

them to the company through investment companies whenever they choose. Closed-end funds

are traded on stock exchanges. The number of shares issued is fixed at its IPO. The mutual



fund company is not required to buy back shares of the fund from investors.

17 Mutual funds operate by pooling funds from investors and investing the money in different

securities. They are managed by professional fund managers based on certain pre-determined

investment objectives.

Mutual funds act as an important investment vehicle for small investors who cannot afford to

buy a large number of individual stocks. They help small investors achieve long-term

investment goals such as preparing for retirement. Through mutual funds, small investors can

invest in various securities and achieve risk diversification with a relatively low investment

amount.

18 After receiving premiums from individuals and firms, insurance companies invest them in the

securities market to generate additional investment returns. These premiums serve as a source

of capital for other companies. Insurance companies are big investors in the securities market

because premiums from individuals collectively add up to a huge amount. In addition,

insurance premiums are a very stable source of cash inflows. They serve as a major source of

capital for long-term investment in the securities market.

19 1 Common stocks: Also known as ordinary shares. These are shares which have voting

rights at annual general meetings and potential dividend payments.

2 Preferred stocks: Also known as preference shares. These are shares without voting rights.

They have a priority over common stocks in dividend payment.

3 Bonds: Also known as debentures. These are long-term debts (normally 10 years or longer)

issued by governments and companies. The bond-issuing institution has to pay back the

principal to the bondholder on the maturity date.

4 Notes: Medium-term debts (normally one to nine years) issued by governments and

companies.

5 Mutual funds: Also known as unit trusts. These are pools of money managed by

professional fund managers which have certain investment objectives.

6 Futures: These are standardised forward contracts that demand delivery of an asset at a

specific date and price.

7 Options: These are a right to buy or sell a certain asset at a specific date and price.



8 Equity warrants: These offer holders the right to buy certain common stocks at a

pre-determined price (i.e., exercise price) on or before a given date.

(Any five of the above)

20 The success of the primary market depends heavily on the health (i.e., the size and liquidity)

of the secondary market. Without a liquid secondary market, it would be difficult to attract

investors to buy new issues in the primary market. This is because investors need a platform to

trade newly issued securities immediately after the securities are issued in the primary market.

Newly issued securities in the primary market form the basis of the secondary market. Without

securities issued in the primary market, there would be no securities to trade in the secondary

market.

21 The over-the-counter (OTC) market is a network of buyers and sellers organised for the

purpose of securities trading. Transactions in the OTC market are made directly between two

parties through electronic systems.

Essay Questions

22 Companies can raise capital on the stock exchange. They may apply for a listing on the stock

exchange. If their applications are approved, they may issue shares to raise capital.

Individuals can trade stocks on the stock exchange. They can earn dividends and capital gains

when stock prices increase. This allows them to accumulate wealth for long-term goals (e.g.,

buying a flat, retirement).

23 Listed companies

Through IPOs and debt issues, listed companies can raise capital for their operations in the

financial market. These capital market securities are ideal for investors looking for long-term

investments for retirement purposes. While some listed firms buy securities as well, most

supply securities in the financial market.

Insurance companies

Insurance companies play important roles in the financial services industry, particularly in

financial planning. They help individuals and firms manage risks and in return receive

premiums. After receiving premiums from clients, the insurance companies then invest them

in the financial market to generate additional investment returns.



Pension fund companies

The assets of pension plans that are pooled in pension funds will then be invested in the

financial market to generate additional funds. Financial institutions that manage pension funds

are, therefore, major players in the financial market. Pension funds are an important source of

capital for the financial market.

Banks

Commercial banks provide banking services for the general public. Private banks help wealthy

people and organisations invest their money. Investment banks focus on corporate business

such as raising capital for firms. All types of banks serve as middlemen between borrowers

and lenders of capital in the financial market.

Securities firms

Securities firms serve as middlemen for investors in securities trading. Sometimes, they also

use their own money to trade securities for profit. Because of the large amounts of investments

and high frequency of trading handled by securities firms, they are a major player in the

financial market.

Regulators

Regulators are responsible for regulating financial institutions and market participants and

protecting the interests of investors.

Investors

Investors trade financial products and create a demand for and supply of securities in the

financial market.

(Any three of the above)

24 Role of banking sector

The banking sector plays an important role in providing financial services in Hong Kong. It

acts as a financial intermediary, channelling savings into investment by receiving deposits

from the public and then lending the money to borrowers.

Role of insurance sector

1 The major function of insurance is to pool and transfer risks. Insurance products provided

by insurance companies help individuals and businesses manage risks. This encourages

firms to undertake risky but profitable business projects. This also enables individuals to

receive financial protection for their life and assets at an affordable cost.

2 Insurance companies are one of the biggest investors in the securities market. After



receiving premiums from individuals, insurance companies invest them in the securities

market. Premiums therefore serve as a long-term source of capital.

Role of securities sector

1 Securities are important investment vehicles for retirement and savings purposes. For

example, people can earn dividends on shares and interest on bonds. They may also earn

capital gains by selling shares and bonds when their prices go up.

2 The securities sector provides a market for raising funds. To raise capital, companies may

issue different kinds of securities while the government and public corporations issue

bonds.

In conclusion, our economy will suffer without these financial sectors. They help allocate

capital among different participants. They serve as middlemen in matching suppliers and

borrowers of funds. Without these sectors, individuals would not be able to hold their money

in a safe and convenient way. They could not earn interest on their savings. Firms would find

it difficult to raise funds for expansion. They would be unwilling to bear risks because of a

lack of protection. The operation of business sectors and the development of our economy

would be seriously hampered.

25 1 Fixed-income securities are debt instruments. They are interest-bearing securities with a

fixed percentage of return. Provided that the issuer of the fixed-income securities does not

go bankrupt and the investors hold the securities to maturity, the return on those securities

is guaranteed.

2 Equity securities refer to securities that entitle holders to part of the ownership of listed

companies (i.e., stocks). Investors may earn dividends and capital gains when stock prices

increase. However, they may suffer a loss if the price drops.

3 Mutual funds operate by pooling funds from investors and investing the money in

different securities. They are managed by professional fund managers based on certain

pre-determined investment objectives. Through mutual funds, investors can invest in

various securities and achieve risk diversification with a relatively low investment

amount.

26 The advantages of using debentures over shares are:

1 As interest on debentures is fixed, companies can predict the cost of raising capital..

2 By issuing debentures to raise capital, companies can retain decision-making power. This



is because bondholders are only creditors of the companies. Shareholders are owners of

the companies and companies must obtain approval from shareholders for important

decisions.

3 Management can avoid losing control of the company. If companies issue shares and most

of the shares fall into the hands of other companies (i.e., the majority shareholders), the

majority shareholders could take control of the companies (Students may refer to Chapter

3 of Business Environment and Introduction to Management).

Case Analysis

27 (b) Martin can vote for or against important decisions made by SJM Holdings. He also has

the right to receive dividends if declared.

(c) He should pay: 3 lots × 1,000 shares × $4 = $12,000

(d) The securities sector allows SJM Holdings to raise capital by issuing shares. SJM

Holdings can then use the capital raised for business development. On the other hand,

SJM Holdings’ investors can earn dividends and capital gains by selling the shares when

the stock price goes up. They can save for retirement and accumulate wealth through

trading securities.

28 (a) Tom should use equity financing by issuing common stocks. The reasons are:

(1) the company can issue shares to raise a huge amount of capital with riskier

projects.

(2) the amount is so big and the project is long-term without a clear timetable as to

when there would be a profit. Thus, a bank loan (i.e., debt financing) is not

possible.

(b) Step 1 Investment banks will identify suitable firms for listing

Step 2 Various professionals will then evaluate the listing candidate

Step 3 The listing candidate needs to obtain approval from government authorities

Step 4 The listing candidate also needs to obtain approval from the stock exchange

Step 5 The listing candidate becomes a listed company and needs to distribute new

shares

(c) Advantages of using bonds: Refer to question 26.

Disadvantages of using bonds:

The company needs to pay interest to bondholders whether or not it makes a profit.

book 3 chapter 1 answers eng

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