BFN3104

Chapter 2
Questions
1.

Define these terms:

Opportunity cost The difference between the value of one action and the value
of the best alternative action.
Principal-agent relationship A situation in which one participant, the agent
makes decisions that affect another participant, the principal.
Moral hazard A situation in which an agent can take unseen actions for personal
benefit even though such actions are costly to the principal.
Zero-sum game A situation in which one player can gain only at the expense of
another player.
Adverse selection When offering something to the market seems to indicate
something negative about what is being offered.

2.

Distinguish between each of the following pairs:

a.

Option contract and futures contract

An option contract is the right, without any obligation, to buy or sell something. A
futures contract is a standardized forward contract that is traded in futures market.

b.

Investment banker and financial intermediary

An investment banker specializes in marketing new securities in the primary
market. A financial intermediary is an institution that offers financing to
corporations.

c.

Primary market and secondary market

A primary market is a market in which firms sell newly created securities to raise
capital. A secondary market is a market in which previously created securities are
traded.

d.

KT/T12012

Forward contract and future contract

BFN3104
A forward contract is a contract to exchange an asset for cash at specific future
rate. A futures contract is a standardized forward contract that is traded in futures
market.
3.

Describe in your own words what is meant by the term efficient capital market.
What is arbitrage?
Prices of assets in an efficient capital market adjust quickly to new information about
the assets being traded. Arbitrage is the act of buying and selling an asset
simultaneously, when the sale price is greater than the purchase price, so that the
difference provides a risk-free profit.

4.

What is ethics? If you follow all applicable rules and regulations, are you an
ethical person?
Ethics consist of standard of conduct or moral judgments. Following all applicable
rules and regulations does not necessarily make one an ethical person. No set of rules
and regulations can account for everything that can and will happen. A code of ethics
can reduce unethical behavior by providing a set of guidelines that can be applied
generally to situations that arise.

5.

Explain how signaling Principle is derived directly from the Principle of SelfInterest Behavior?
According to the Principle of Self-Interest Behavior, each party to financial
transaction will choose the course of action that is most advantageous to that party,
given the information they possess. A particular piece of information may result in a
particular action when the decision-maker acts in his own self-interest. In the case, we
have the signaling principle observing the decision-makers action may allow us to
deduce the information that is known to the decision-maker.

6.

Suppose you are a manager in a manufacturing business. How are the capital
markets relevant to the effective performance of your job?
Capital markets are relevant to the performance of mangers in any industry because
mangers may need access to capital for expansion or raw materials. The cost of
raising funds for expansion or raw material will affect the profits of the firm. A
manager must take this account when making decisions. A manager will also want to
watch the capital markets for signals from competitors, supplies and customers.

Problem
7.

You own a small apartment complex near campus. You bought it several years ago
for RM1,000,000. You can sell it today for RM1,600,000, or you can add on to the
complex and sell it for RM2,000,000. The addition would cost RM500,000. Should

KT/T12012

BFN3104
you sell the complex as is, or should you invest in the addition and then sell? At
what selling price would you change your mind?
Profit that sell it today = RM 1600000 RM 1000000
= RM 600000
Profit that selling after addition invest = RM 2000000 RM 1000000 RM 500000
= RM 500000
No, because profit that selling after addition invest is lower than the profit that sell it
today.
If the selling price for today is lower than RM 1500000 then I will change the mind of
sell it by today. Or if the selling price at complex is higher than RM 2100000 then I
will change the mind to sell the apartment after addition invest.

KT/T12012