Chapter 2

Question 1

What are functions of financial intermediaries?

Answer 1

Lower transaction costs through economies of scale and liquidity services.

Reduce risk through risk sharing (asset transformation) and diversification

Reduces information costs of screening and monitoring borrowers - adverse selection and moral hazard

Question 2

What is adverse selection and moral hazard?

Answer 2

Adverse selection (before transaction) more likely to select risky borrower

Moral hazard (after transaction) - less likely borrower repays loan

Question 3

What are functions of financial markets?

Answer 3

Channel funds from economic agents that have saved surplus funds
(lender-savers) to those that have a shortage of funds (borrower-investors-
spenders).

Promote economic efficiency by producing an efficient allocation of
capital, increasing production.

Directly improve the well-being of consumers by allowing them to plan the
timing of consumption better.

Question 4

What is direct finance?

Answer 4

borrowers borrow funds directly from lenders in financial markets by selling them securities.

Question 5

What is indirect finance?

Answer 5

financial intermediary stands between lenders and
borrowers.

Question 6

what is an asset?

Answer 6

something of value that is owned

Question 7

what is a liability?

Answer 7

something of value that is owed

Question 8

debt and equity markets?

Answer 8

financial claims are bought and sold for immediate cash payment

Question 9

What are debt instruments?

Answer 9

contractual agreements by borrowers to make regular payments to the holders
(principal payment and interest) until maturity date.
Maturity is the number of years to expiration date of the debt.

Question 10

What is equity?

Answer 10

claims to share the net income (dividends) and assets of a business

Question 11

what are derivative markets?

Answer 11

financial claims are based on underlying assets.
These are bought and sold for payment at a future date.

Question 12

What is the difference between primary and secondary markets?

Answer 12

primary markets trade in newly issued securities

secondary markets trade in existing securities

Question 13

Describe brokers and dealers?

Answer 13

Brokers: agents matching buyers with sellers of
securities (buy/sell for their clients).

Dealers: link buyers and sellers by buying/selling
securities at stated prices (buy/sell on their own
account).

Question 14

what is the maturity in money and capital markets?

Answer 14

money markets deal in short term (<1 year) debt instruments

capital markets deal in longer term (>1 year) debt and equity

Question 15

Money market instruments:

Answer 15

Government bonds (Treasury bills)
Bank certificates of deposit
Commercial paper
Repurchase agreements (Repo)
Eurodollars
Banker’s acceptances

Question 16

capital market instruments:

Answer 16

Government securities and bonds (long-term)
Corporate stocks
Corporate bonds
Mortgages and mortgage-backed securities
Bank commercial loans

Question 17

What are the primary assets and liabilities of commercial banks?

Answer 17

liabilities: deposits

assets: business and consumer loans, mortgages, US government securities, and municipal bonds

Question 18

What are primary assets and liabilities of savings and loan associations?

Answer 18

liabilities: deposits

assets: mortgages

Question 19

What are primary assets and liabilities of mutual savings banks?

Answer 19

liabilities: deposits

assets: mortgages

Question 20

What are primary assets and liabilities of credit unions?

Answer 20

liabilities: deposits

assets: consumer loans

Question 21

What are primary assets and liabilities of Finance companies?

Answer 21

liabilities: commercial paper, stocks, bonds

assets: Consumer and business loans

Question 22

What are primary assets and liabilities of mutual funds?

Answer 22

liabilities: shares

assets: stocks, bonds

Question 23

What are primary assets and liabilities of money market mutual funds and hedge funds?

Answer 23

money market mutual funds
liabilities: shares
assets: money market instruments

hedge funds
liabilities: partnership participation
assets: stocks, bonds, loans, foreign currencies, and many other assets

Question 24

What are the contractual savings institutions and list their liabilities and assets?

Answer 24

Life insurance companies
liabilities: premiums from policies
asset: corporate bonds and mortgages

fire and casualty insurance companies
liabilities: premiums from policies
assets: municipal bonds, corporate bonds and stock, and US government securities

pension funds, government retirement funds:
liabilities: Employer and employee contributions
assets: corporate bonds and stocks

Question 25

Reasons to regulate the financial system?

Answer 25

To increase information available to investors

to ensure soundness of financial intermediaries