Chapter 2

Question 1

Adverse selection

Answer 1

is the problem created by asymmetric information before
the transaction occurs. Adverse selection in financial markets occurs when the
potential borrowers who are the most likely to produce an undesirable (adverse)
outcome—the bad credit risks—are the ones who most actively seek out a loan and
are thus most likely to be selected.

Question 2

Asset transformation

Answer 2

risky assets are turned into safer assets for investors. Low transaction costs allow financial intermediaries to share risk
at low cost, enabling them to earn a profit on the spread between the returns they
earn on risky assets and the payments they make on the assets they have sold.

Question 3

Assymetric information

Answer 3

when one party often does not know
enough about the other party to make accurate decisions

Question 4

Brokers

Answer 4

are agents of investors who match buyers with sellers of securities; dealers
link buyers and sellers by buying and selling securities at stated prices.

Question 5

Capital

Answer 5

(wealth, either financial or physical,
that is employed to produce more wealth),

Question 6

Capital market

Answer 6

is the market in which longer-term debt
(generally with original maturity of one year or greater) and equity instruments are
traded.

Question 7

Conflicts of interest

Answer 7

are a type of moral hazard problem that arises when a person
or institution has multiple objectives (interests) and, as a result, has conflicts
between those objectives.

Question 8

Dealers

Answer 8

dealers
link buyers and sellers by buying and selling securities at stated prices.

Question 9

Diversification

Answer 9

entails investing in a collection (portfolio) of assets whose returns
do not always move together, with the result that overall risk is lower than for individual assets. RISK MANAGEMENT

Question 10

Dividends

Answer 10

periodic payments

Question 11

Economies of scale

Answer 11

the reduction in transaction costs
per dollar of transactions as the size (scale) of transactions increases.

Question 12

Economies of scope

Answer 12

lower the cost of information production for
each service by applying one information resource to many different services. Ex An
investment bank, for example, can evaluate how good a credit risk a corporation is when making a loan to the firm, which then helps the bank decide whether it would
be easy to sell the bonds of this corporation to the public.

Question 13

Equities

Answer 13

common
stock, which are claims to share in the net income (income after expenses and
taxes) and the assets of a business.

Question 14

Eurobond

Answer 14

a
bond denominated in a currency other than that of the country in which it is sold—for example, a bond denominated in U.S. dollars sold in London.

Question 15

Eurocurrencies

Answer 15

e foreign currencies
deposited in banks outside the home country.

Question 16

Eurodollars

Answer 16

which are U.S. dollars deposited in foreign banks
outside the United States or in foreign branches of U.S. banks.

Question 17

Exchanges

Answer 17

where buyers and sellers of securities (or their agents or brokers) meet
in one central location to conduct trades.

Question 18

Financial intermediation

Answer 18

is the primary route for moving funds from lenders to borrowers.

Question 19

Financial panic

Answer 19

widespread collapse of financial intermediaries

Question 20

Foreign bonds

Answer 20

sold in a foreign country and are denominated in that
country’s currency. For example, if the German automaker Porsche sells a bond in
the United States denominated in U.S. dollars, it is classified as a foreign bond.

Question 21

Intermediate term

Answer 21

1-2 years

Question 22

Investment bank

Answer 22

financial institution that assists in the initial sale of securities in the primary market

Question 23

Liabilities

Answer 23

(IOUs or debts)

Question 24

Liquid

Answer 24

raising cash

Question 25

Liquidity services

Answer 25

services that make it easier for customers to conduct transactions.

Question 26

Long term

Answer 26

several years

Question 27

Maturity

Answer 27

the number of years (term) until that instrument’s expiration date.

Question 28

Money market

Answer 28

a financial market in which
only short-term debt instruments (generally those with original maturity of less than
one year) are traded

Question 29

Moral hazard

Answer 29

is the risk (hazard) that the
borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back.

Question 30

OTC market

Answer 30

dealers at different locations 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.

Question 31

Portfolio

Answer 31

collection of assets

Question 32

Primary market

Answer 32

is a financial market in which new issues of a security, such as
a bond or a stock, are sold to initial buyers by the corporation or government agency
borrowing the funds.

Question 33

Risk

Question 34

Risk sharing

Answer 34

create and sell assets with risk
characteristics that people are comfortable with, and the intermediaries then use
the funds they acquire by selling these assets to purchase other assets that may
have far more risk.

Question 35

Secondary market

Answer 35

is a financial market in which securities
that have been previously issued can be resold.

Question 36

Short term

Answer 36

short time period

Question 37

Thrift institutions

Answer 37

savings and loan associations, mutual savings banks,
and credit unions

Question 38

Transaction costs