Asset Classes and Financial Instruments

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CHAPTER 2: ASSET CLASSES AND FINANCIAL
INSTRUMENTS

PROBLEM SETS

1. Preferred stock is like long-term debt in that it typically promises a fixed payment each year. In this way, it is a perpetuity. Preferred stock is also like long-term debt in that it does not give the holder voting rights in the firm.
Preferred stock is like equity in that the firm is under no contractual obligation to make the preferred stock dividend payments. Failure to make payments does not set off corporate bankruptcy. With respect to the priority of claims to the assets of the firm in the event of corporate bankruptcy, preferred stock has a higher priority than common equity but a lower priority than bonds.

2. Money market securities are called “cash equivalents” because of their great liquidity. The prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on very short notice and with very low transaction costs.

3. (a) A repurchase agreement is an agreement whereby the seller of a security agrees to “repurchase” it from the buyer on an agreed upon date at an agreed upon price. Repos are typically used by securities dealers as a means for obtaining funds to purchase securities.

4. The spread will widen. Deterioration of the economy increases credit risk, that is, the likelihood of default. Investors will demand a greater premium on debt securities subject to default risk.

5.

Corp. Bonds Preferred Stock Common Stock
Voting Rights (Typically) Yes
Contractual Obligation Yes
Perpetual Payments Yes Yes
Accumulated Dividends Yes
Fixed Payments (Typically) Yes Yes
Payment Preference First Second Third

6. Municipal Bond interest is tax-exempt. When facing higher marginal tax rates, a high-income investor would be more inclined to pick tax-exempt securities.

7. a. You would have to pay…...

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