week 1

Question 1

Function of financial market

Answer 1

Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets also improve the well-being of consumers, allowing them to time their purchases better

Question 2

Debt market

Answer 2

When you need funds you can issue a debt instrument, such as a bond or a mortgage, this is a contractual
agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals
(interest and principal payments) until a specified date (the maturity date), when a final payment is made.

Question 3

Equity market

Answer 3

Second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income and the assets of a business. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. Also you will receive voting rights.

Question 4

Interest Rates on Selected Bonds

Answer 4

• interest rate is higher on long term bonds because people require higher returns due to risk increasing over time
• three month treasury bills are much more volatile because this takes the average of three months and the long term takes the average return of one year.

Question 5

Primary market

Answer 5

On the primary market there is typically an investment bank involved who underwrites the offering. This means that they determine the starting share price and quantity.

Also they take part of the risk in the sense that, when not all of the shares introduced to the market are sold, the investment bank will buy up all excess shares.

Question 6

Secondary market

Answer 6

refers to the financial market where securities (such as stocks, bonds, and other financial instruments) are bought and sold after they have been issued in the primary market

Securities brokers and dealers are crucial to a well-functioning
secondary market.

Question 7

Brokers

Answer 7

agents of investors who match buyers with sellers of securities, they do not own the securities or assets that they trade.

Question 8

Dealers

Answer 8

Trades securities for their own account, link buyers and sellers by buying and selling securities at stated prices.

Question 9

Function of secondary market

Answer 9

1. They make it easier and quicker to sell financial instruments and raise cash, they make financial
   instruments liquid
2. They determine the price of the security that the issuing firm sells in the primary market

Question 10

Two types of secondary market

Answer 10

1. Exchanges: buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. For example The New York and American Stock Exchanges.
2. Over-the-Counter (OTC) market: in which dealers at different location who have an inventory of
   securities stand ready to buy and sell securities “over-the-counter” to anyone who comes to them
   and is willing to accept their prices. Over-the-counter dealers are in contact via computers.

Question 11

Distinguish money and capital markets

Answer 11

Another way of distinguishing between markets is on the basis of the maturity of the securities traded in each market.

• Money Market: Short Term (maturity < 1 year)
• Capital Market: Long Term (maturity > 1 year) plus equities

Question 12

Foreign bonds

Answer 12

are sold in a foreign country and are denominated in that country’s currency

German automaker Porsche sells a bond in the US denominated in US dollars

Question 13

Eurobonds

Answer 13

a bond denominated in a currency other than that of the country in which it is sold

Question 14

Eurocurrencies

Answer 14

which are foreign currencies deposited in banks outside the home country

Question 15

Eurodollars

Answer 15

which are US dollars deposited in foreign banks outside the US

Question 16

Direct finance

Answer 16

Borrowers borrow directly from lenders in financial markets by selling securities (financial instruments) which are claims on the borrower’s future income or assets.

Question 17

Indirect finance

Answer 17

refers to the process by which borrowers obtain funds through financial intermediaries, such as banks, insurance companies, pension funds, and mutual funds. These intermediaries act as middlemen between those who have surplus funds (lenders) and those who need funds (borrowers).

Question 18

What leads to lower transaction costs and why it is important?

Answer 18

A financial intermediary can substantially lower transaction costs, because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale.

Lower transaction costs can provide customers with liquidity services:

1. Banks provide depositors with checking accounts that enable them to pay their bills
2. Depositor can earn interest on checking/saving accounts and convert them into g&s

Another benefit of low transaction costs

3. It reduces the exposure of investor to risks

Question 19

Asset transformation

Answer 19

Financial intermediaries create and sell assets with lesser risk to one party in order to buy assets with greater risk from another
party

Question 20

Adverse selection

Answer 20

Problem created by asymmetric information before transaction occurs.

Potential borrowers
most likely to produce adverse outcome are ones most likely to seek a loan.

Question 21

Moral Hazard

Answer 21

Problem created by asymmetric information after transaction occurs

Hazard that borrower has
incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back

Question 22

List of depository institutions

Answer 22

1. Commericial banks
2. Savings and loan associations
3. Mutual savings banks
4. Credit unions

Question 23

List of Contractual savings institutions

Answer 23

1. Life insurance companies
2. Fire and casualty insurance companies
3. Pension funds, government retirement funds

Question 24

List of investment intermediaries

Answer 24

1. Finance companies
2. Mutual funds
3. Money market mutual funds

Question 25

Depository institutions (banks)

Answer 25

Financial intermediary that accept deposits from individuals and institutions and make loans

Question 26

Commercial banks

Answer 26

Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer, and mortgage loans.

Question 27

S&Ls & Mutual Savings Banks and Credit Unions

Answer 27

Savings and Loan Associations are financial institutions that primarily focus on accepting savings deposits and making home mortgage loans. Mutual Savings Banks are similar to savings and loan associations, but they have a slightly different organizational structure and focus. Credit Unions are nonprofit financial cooperatives owned by their members. Credit unions provide many of the same services as commercial banks, but they operate under a cooperative model and focus on providing benefits to their members rather than generating profits.

Question 28

Contractual Savings Institutions (CSIs)

Answer 28

All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.

Question 29

Finance Companies

Answer 29

sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations

Question 30

Mutual Funds

Answer 30

acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds.

Question 31

Money Market Mutual Funds

Answer 31

acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments.

Question 32

Main reason of having regulation on the financial system

Answer 32

to increase the information available to investors and to ensure the soundness of the financial system