week 3

Question 1

What is the basic flow of funds in the financial system?

Answer 1

Funds flow from investors (savers) through financial institutions and markets to companies needing money for investment or expansion. Returns (like dividends or interest) flow back to investors.

Question 2

What is the difference between direct and indirect investment routes in the financial system?

Answer 2

Direct: Investors buy securities (e.g., stocks) directly. Indirect: Investors give money to intermediaries (e.g., pension funds, hedge funds) to invest on their behalf.

Question 3

What is the role of primary markets?

Answer 3

Primary markets are where new securities (stocks or bonds) are issued and sold directly to investors by the issuer.

Examples include IPOs (Initial Public Offerings) and SEOs (Seasoned Equity Offerings).

Question 4

Who are the main players in the primary market?

Answer 4

Issuers (e.g., companies), underwriters (investment banks), and investors. Investment banks help set prices and distribute shares. Institutional investors typically get priority access.

Question 5

What are some of the largest IPOs in history and what do they represent?

Answer 5

Saudi Aramco ($29.4bn), Alibaba ($25bn), Softbank ($23.5bn), GM ($23.1bn), ABC Bank ($22.1bn). Large IPOs represent high capital raised and often strong investor confidence.

Question 6

Why do companies often prefer to IPO in the US rather than the UK?

Answer 6

US markets offer greater liquidity, less strict regulations, higher global investor presence, and a higher risk appetite—especially for tech and high-growth firms.

Question 7

What are secondary markets and why are they important?

Answer 7

Markets where securities are traded between investors after issuance (e.g., LSE, NASDAQ). They provide liquidity, enable price discovery, and increase participation in primary markets.

Question 8

Who are the key players in secondary markets?

Answer 8

1. Financial markets (e.g., stock exchanges) 2. Securities brokers (full-service or discount) 3. Institutional investors and other fund suppliers

Question 9

What is the difference between money markets and capital markets?

Answer 9

Money markets: short-term debt instruments (<1 year), e.g., T-bills, CDs. Capital markets: long-term funding (>1 year), e.g., stocks, bonds, long-term notes.

Question 10

What is the role of financial institutions (FIs)?

Answer 10

FIs connect savers with borrowers and provide financial services like risk management, liquidity, maturity transformation, and cost reduction.

Question 11

How do financial institutions solve asymmetric information?

Answer 11

By evaluating creditworthiness, conducting due diligence, and monitoring borrowers to reduce adverse selection and moral hazard.

Question 12

How do financial institutions provide liquidity?

Answer 12

They allow savers to withdraw funds even if the money is lent out long-term, which encourages saving.

Question 13

What is maturity transformation and how do FIs perform it?

Answer 13

FIs convert short-term deposits from savers into long-term loans for borrowers (e.g., mortgages).

Question 14

How do financial institutions manage risk?

Answer 14

They use diversification, insurance, and derivatives to spread, transfer, or hedge financial risk.

Question 15

Give examples of how FIs use diversification.

Answer 15

Banks lend across sectors (real estate, retail), mutual funds invest globally, insurance firms underwrite various policies.

Question 16

Give examples of how FIs use insurance.

Answer 16

Deposit insurance (e.g., FDIC), reinsurance for catastrophe events, insuring against key-person risk.

Question 17

Give examples of how FIs use derivatives for risk management.

Answer 17

Interest rate swaps, currency futures, credit default swaps (CDS), options for hedging underwriting risks.

Question 18

How do financial institutions reduce costs?

Answer 18

By achieving economies of scale, lowering transaction and information costs for savers and borrowers.

Question 19

What factors affect interest rates on securities?

Answer 19

1. Inflation 2. Real risk-free rate 3. Default risk (credit rating) 4. Liquidity 5. Maturity (term structure) 6. Special features (e.g., callability)

Question 20

How does inflation affect interest rates?

Answer 20

Higher expected inflation → lenders demand higher rates to maintain purchasing power.

Question 21

What is the real risk-free rate?

Answer 21

The base return required with no inflation or default risk, reflecting pure time value of money.

Question 22

How does default risk affect interest rates?

Answer 22

Higher default risk → higher interest rate required by investors. Rated by agencies like S&P or Moody’s.

Question 23

How does liquidity affect interest rates?

Answer 23

Lower liquidity → higher interest rate to compensate investors for difficulty selling.

Question 24

How does maturity affect interest rates?

Answer 24

Longer maturities generally → higher interest rates due to greater risk over time.

Question 25

How do special bond features affect interest rates?

Answer 25

Features like callability (issuer can repay early) → higher interest rate required for added risk.

Question 26

Why do Financial Institutions (FIs) exist in a modern economy?

Answer 26

To bridge the gap between savers and borrowers, provide essential services (like liquidity and risk management), and increase financial system efficiency.

Question 27

What is asymmetric information, and how do FIs help resolve it?

Answer 27

Asymmetric info occurs when one party (usually borrowers) knows more than the other. FIs resolve it through credit assessments, monitoring, and due diligence.

Question 28

What are adverse selection and moral hazard?

Answer 28

Adverse selection: high-risk borrowers more likely to seek loans. Moral hazard: borrowers may act riskily after receiving funds. FIs mitigate both through screening and monitoring.

Question 29

Why is liquidity provision by FIs so important?

Answer 29

Liquidity lets savers withdraw funds any time, even if the money is loaned out. This stability builds trust and encourages saving.

Question 30

How does maturity transformation work in FIs?

Answer 30

FIs take short-term deposits and lend long-term (e.g., mortgages). This meets both saver and borrower needs while managing risk.

Question 31

Why is risk management critical in financial institutions?

Answer 31

It protects FIs from shocks (e.g., defaults, rate changes), allows stable returns, ensures regulatory compliance, and promotes financial system stability.

Question 32

What’s the value of diversification for FIs?

Answer 32

It spreads risk across sectors, regions, and products, reducing the chance of a single event causing major financial losses.

Question 33

Why do FIs use insurance, and how?

Answer 33

To protect against large losses (e.g., reinsurance for catastrophes). It shifts risk to third parties, supporting institutional resilience.

Question 34

How do derivatives help FIs manage risk?

Answer 34

They hedge interest rate, credit, and currency risks (e.g., interest rate swaps, CDS). They help lock in outcomes and protect capital.

Question 35

How do FIs reduce costs for the economy?

Answer 35

They lower transaction and information costs through scale, automation, and expertise—making financial access cheaper for all.

Question 36

How does inflation influence interest rates?

Answer 36

Higher inflation → lenders demand higher interest to maintain purchasing power (nominal rate = real rate + inflation expectation).

Question 37

What is the real risk-free rate and why is it a baseline?

Answer 37

It reflects the time value of money in a risk- and inflation-free world (e.g., US Treasury in stable times). It sets the floor for all other rates.

Question 38

What is default risk and how is it priced into interest rates?

Answer 38

The risk the borrower won’t repay. Higher default risk → higher interest required. Assessed by credit rating agencies (e.g., Moody’s, S&P).

Question 39

Why does liquidity affect interest rates on securities?

Answer 39

Less liquid securities are harder to sell. To compensate for this, investors demand higher returns.

Question 40

How does maturity impact interest rates (term structure)?

Answer 40

Longer-term investments carry more inflation/interest rate risk → require higher returns. This is shown in the yield curve (normal/inverted/flat).

Question 41

What is a callable bond and how does it affect interest rates?

Answer 41

A bond the issuer can repay early. Investors face reinvestment risk → demand higher interest as compensation for uncertainty.

Question 42

What is the yield curve and what does it indicate?

Answer 42

It plots interest rates by maturity. A normal curve indicates future growth; an inverted curve may signal recession.

Question 43

What does a steep yield curve suggest about future interest rates?

Answer 43

It indicates rising rates are expected, often tied to economic expansion and inflation risk.

Question 44

What does an inverted yield curve often signal?

Answer 44

It signals market expectation of lower future interest rates, often predicting an economic downturn or recession.