All Things Finance - Intro Flashcards
- What infrastructure is necessary for the development of financial markets? Explain each item.
- Legal system (contracts & securities) (property rights) – the most important. If you have an asset and you don’t know who the owner is you can’t trade it.
- Physical markets & networked markets (fixed costs) – somebody has to put down a trading floor. System of dealers that work to maintain flow in the markets.
- Information investment- markets don’t work without information. You need information to analyze an investment. Ex: real estate. It can be expensive to not have info.
- Reputation investment (safety) – safety has value.
- Inventory investment (immediacy): dealers vs. brokers- dealer has inventory, info and reputation investment, broker doesn’t but they have an info and reputation investment. A bank can be both.
Describe and explain operational efficiency
- It answers: are transactions quick and cheap? It’s measured with the bid-ask spread: dealer’s ask minus bid prices.
- Is the cost of trading an asset as low as it could be? A large component is the price of immediacy or liquidity.
- Lower costs equate to greater efficiency.
List and explain the characteristics of dealers, and the characteristics of brokers, and how they are different.
- broker buys and sells securities for their clients
- Dealers are people or firms who buy and sell securities for their own account through a broker or otherwise.
- Dealers have all the rights and freedom regarding the buying and selling of securites, brokers dont.
Explain informational efficiency (and the three types).
info must be properly incorporated into prices
- Weak form efficiency- does the asset price reflect all relevant historical information about the asset?
- Semi strong form efficiency- Does the asset price reflect all relevant public information about the asset?
- Strong form efficiency: does the price reflect all information, public and private?
Explain allocational efficiency.
- Happens when parties can use the accurate and readily available data reflected in the market to make decisions about how to utilize their resources.
List and explain problems that might hinder allocational efficiency.
- Some Problems raising the needed investment dollars:
- Individual wealth is limited (denomination concerns)
- The lender may want liquidity before the project is done
- Borrower may not be well-known
- Investment opportunity may be hard to understand – lenders might not have enough info to analyze the property
- These can be overcome by financial institutions or intermediation.
Explain the primary goal of a financial manager and how market efficiency might influence this goal.
- To maximize shareholder wealth (maximize stock price)
- Market efficiency = stock’s price reflects all the available info about the firm
- If markets are efficient, then individuals will want to invest the necessary infrastructure (creating institutions)
Explain what is meant by the term “nexus of contracts.”
- What the corporation represents:
- Employees/managers, society, government, suppliers, customers, etc.
What is financial intermediation and give several reasons why it may be necessary. Explain your reasons.
- Indirect financing.
- Ex: a bank and a checking account; securities underwriting
- The intermediary can provide reputation, denomination, liquidity, and information that the borrower may find too costly to produce on its own.
- Primary motive is to capture transaction costs. Profits are made through economies of scale/scope, and investment in expertise/reputation which is why there’s so much indirect financing.
- Help create efficient markets and lower the cost of doing business
Explain the term “asymmetric information” in the context of financial economics: what is it, what is moral hazard and what is adverse selection? How do these concepts apply to “real world” situations?
- Asymmetric information- when one party in a contract has more info than another party.
- It causes 2 problems: adverse selection & moral hazard.
- Adverse selection: a “lemons” problem, fix with bonding. Lack of information prior to the contract.
o if you can’t differentiate between people who know what they’re doing and people who don’t from their resume, a recruiter won’t hire anybody. Ex: a smoker and a nonsmoker go to file for life insurance, but they have to fill out a questionnaire. The smoker lies because if they are honest, they will incur higher insurance premiums. Adverse selection because the life insurance company will charge the same premium to both. - Moral hazard: risk-shifting, fix with monitoring. When there’s asymmetric info and there’s change in behavior from one party after an agreement between both parties is done because they don’t think they’ll face consequences.
o Happens a lot in insurance industry. Ex: a person that lives in a flood zone get flood insurance to prepare for floods, after his house is insured, his behavior changes. He cancels and does less to prepare for potential flooding. The insurance company is now at a bigger risk of having a claim filed against them as a result of damage from flooding.
What is a “lemons” problem? What causes it? Give two detailed examples of lemons problems and how to fix them using specific bonding or monitoring mechanisms.
- Issues that arise regarding the value of an investment or product because of asymmetric information held by the buyer and seller.
- Ex: used car markets. The seller has more information about the true value of the vehicle than the buyer. The buyer doesn’t want to pay more than the average price of the car even if it’s premium quality. This benefits the seller if the car is a lemon (slang term for a car that has many defects) but is a disadvantage if the car is good quality.
- Fix a lemons problem through bonding: increase cost to seller for lying
What is monitoring and what is bonding? Give specific examples.
- Key to adverse selection is to increase cost to people that would lie about their car. (bonding) ex: people unwilling to work, getting a reputation to work underpaid.
o Bond the used car market by using warranties. If you have a good car you won’t mind putting a warranty on it because nothing will happen. - Monitoring: watching very closely. Expensive. Institutions will monitor as part of their services.
How can we fix a moral hazard problem using debt contracts?
- Borrowers may have incentives to take too much risk after the loan is made. Debt contracts have lower moral hazard risks. Can solve it by:
o Net worth: bonds interests of borrower to interests of lender (borrower has something at stake)
o Monitoring and enforcement of restrictive covenants
o Intermediation
o Economies of scale in monitoring
o Economies of scale in contracting & collateral documentation
Explain the principal/agent problem and at least three methods that can be used to fix it.
- Managers may have incentives to change the risk of stock once it’s been bought by shareholders.
- Costly to monitor and provide incentives to managers so they won’t always behave in accordance with shareholder interests.
- Can solve it by monitoring, in general:
o Production of information by individuals
o Govt. regulation regarding disclosure of information
o Intermediation: venture capital
o Use of debt contracts
Explain the role of government in fixing asymmetric information problems. Be very careful with this one.
government can’t fix the problems by itself. They can help reduce the free rider problem. Key part of fixing is certification. Government can tell people how much information needs to be provided but can’t certify anything. It can work with private sectors to acquire financial documents but can’t say oh we’re gonna outlaw this.
