2 - Role of FM

Question 1

What are financial markets in short terms?

Answer 1

Market where people trade financial securities (e.g., stocks and bonds), commodities (e.g., metal or agricultural products), and other fungible assets

Question 2

What are some of the different types of financal markets?

Answer 2

1) Loan Markets
2) Capital Markets
3) Money markets
4) Commodity markets
5) Options, futures and other derivatives
6) Insurance markets
7) Foreign exchange markets

Question 3

What can capital markets be divided into?

Answer 3

Primarily markets
* Newly formed (issued) securities are bought and sold in here, such as IPOs

Secondary markets
* Allows investors to buy and sell existing securities

Question 4

Provide an example of imperfect information between seller and buyer in regular market

Answer 4

Sellers often have better info about the good than the buyer (selling a car)

Question 5

Example of imperfect info between workers and employers

Answer 5

Workers are knownledgeable about their skill, insustriousness and productivity.

Employers have limited info about the quality of prospective workers

Question 6

Example imperfect info insurers and insures

Answer 6

Adverse: Insurers have often less info about the risk that their clients are taking

Moral: insured person might take higher risks

Question 7

Example imperfect info insurers and insures

Answer 7

Insurers have often less info about the risk that their clients are taking.

nsurance might alter a persons behavior

Question 8

Example of imperfect info between Professor and student

Answer 8

Ability, IQ, EQ, Exams, Student grades

Question 9

Adverse selection and moral hazard are both examples of

Answer 9

Asymmetrical information between buyer and seller. This leads to market failure

Question 10

Adverse selection

Answer 10

• Called “hidden types”
• Problem that occur BEFORE contract is written. E.g., trading partner cannot observe the quality of other partner
• Mitigate problem: Signaling, screening

Question 11

Moral Hazard

Answer 11

• Problem that occur AFTER the contract is written. E.g., trading partner cannot be sure if the other is behaving OK after the contract is written
• Called “hidden actions”
• Mitigate: Monitoring
• No moral hazard in one-shot transactions: A seller does not need to worry about how a buyer treats a good after it is sold

Question 12

How can adverse selection and moral hazard be related? Example in health care

Answer 12

Health care.

Insured person may chose to act more unhealthy due to insurance. Makes the insurance more attractive for the person that are insured.

Adverse: The person has a lot of info about his health before signing

Moral hazard: Acts different after signing

Question 13

When is there no moral hazard, and why?

Answer 13

One shot transactions. A seller does not need to worry about how a buyer treats a good after it is sold

Question 14

does moral hazard and adverse selection overlap?

Answer 14

Every case of moral hazard has adverse selection at least to some extent

Question 15

How does every situation involving moral hazard also involve adverse selection to some extent?

Answer 15

The person who potentially will indulge in risk-taking behavior will have prior information about his/her risk-taking tendencies

Question 16

How can financial institutions mitigate Risk-Shifting Moral Hazard?

Answer 16

1) Credit bureau: Credit information
2) Credit rating: Evaluation of creditworthiness
3) Collateral

Question 17

What is Credit Bureau?

Answer 17

Company that collects info and provides consumer credit information.

Question 18

What is Credit Rating?

Answer 18

Evaluation of the creditworthiness of a debtor, a business or a government, but not individual consumers. A credit rating agency evaluates the debtor’s ability to pay back and the likelihood of default.