Part A: Answer each of the following questions. Each answer is worth 5.5 points.
ID: 2807789 • Letter: P
Question
Part A: Answer each of the following questions. Each answer is worth 5.5 points. 1. What are three reasons to be cautious in using ratios to evaluate firm performance? 2. Identify and discuss the causes of the financial crisis that peaked in autumn of 2008. Why did it get worse? 3. What are three factors that influence interest rates for individual securities? 4. Identify and describe the two components of risk that make up a stock's total risk. 5. What's the risk premium? What's the risk-free rate typically considered to be? 6. What duties does a company treasurer typically perform? 7. Name and describe the two main methods by which informal resolutions of financial distress take place.Explanation / Answer
Answer to Question 1The three reasons to be cautious while using financial ratios are:
a. Ratios are based on book value: Ratios are calculated on the book value of the financial statements, they do not reflect the current market reality in business. Ratios are based on historical numbers and may not be telling the whole story about the health of the company.
b. No Measurement of Management Quality: Ratios do tell about the financial statements related valuations andd quality, but an organisation is run by the manangement, and ratios analysis tells nothing about the quality of the management. It only gives the picture of the financial statements.
c. No indication of Causes of changes: Ratios tell a business owner about the changes, what happend in what, but it never tells what caused it to happen, Ratios neve reflect the causes to the changes.
Answer to Question 2.
There are several causes to the financial crisis of 2008. Some of whicha re below:
a. Banks created too much money: Each time banks gives loan, they create more money. Banks gave too much of loan. in just seven years they doubled the loan and increased debt in the econmy.
b. Much of the loans or debt created circulated within the real estate and financial market. Almosts 31% went to the financial markets, 32% went to the residential property, 20% went to the commercial real estate...........Out of all these only 8% went to the business. Thus very less of the money created went to the business.
c. The debts created became unpayable because of the push in real estate market prices, and push in interest rate rise. thus making the emi burden higher, which eventually made the loans or debts unpayable.
d. This caused financial crisis. Started as a chain reaction, and soon it spread to whole financial system.
Why did it get worse?
It went worse, because banks started to refuse to lend. They only lend money to those when they were confident that they would be repaid. This slowdown in lending caused prices in these markets to drop, and this means those that have borrowed too much to speculate on rising prices had to sell their assets in order to repay their loans. Houses prices dropped and the bubble burst. Banks went into panic mode, and further cut down lending. Thus the downward spiral began and the entire economy went into recession.
Answer to 3.
Factors that influence interest rates in securities are:
a. Change in existing rates: Since bonds compete in the market for investor dollars. As the interest rate rises, the price of the bond falls, since investors can obtain bonds with a superior interest rate, which decreases the value of the bond that, has already been issued. On the other side, current bond holders are benefitted by a drop in the interst rates, which makes bonds more valueable, other investors seeks higher yields of previously issued bonds. Bonds with longer maturities are subject to higher price movement upon interest rate changes.
b. Credit Risk: Investors rely on the credit risk ratings by the third party agencies like STandard and Poors. Bonds with higher credit ratings offer lesser interest rates, because they are more secure than the bonds with lesser or lower credit ratings. Normally the bonds with lower credit ratings offer higher interst rates, because investor would be looking for greater returns for higher risk. Thus the interest rates keep on changing as and when there is a change in credit ratings by these outside risk rating agencies.
c. Liquidity Risk: Unline stock markets, the bonds are traded in secondary market, giving the bondholder a window to exit the position as and when he needs to. The bonds are generally with lower liquidity in secondary markets, and thus the markets are with higher maturity have higher interest rates.
Answer to 4:
The two components of total risk of a stock are :
Systematic risk and Unsystematic Risk
a, Systematic risk: Systematic risk is the risk which is common to all asset classes available in the market, and cannot be diversified away
b. Unsystematic risk: This type of risk is the risk which is unique to the asset or asset class, it can be managed with diversification.