Chapter 2 Flashcards
Direct Finance
borrowers borrow funds directly from lenders in financial markets by selling them securities
Function of Financial Markets
Promotes economic efficiency by producing an efficient allocation of capital, which increases production; directly improve the well-being of consumers by allowing them to time purchases better
Money markets
deal in short-term debt instruments
Capital markets
deal in longer-term debt and equity instruments
Foreign bonds
sold in a foreign country and denominated in that country’s currency
Eurobond
bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies
foreign currencies deposited in banks outside the home country
Eurodollars
U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
Indirect Finance
1) Lower transaction costs (time and money spent in carrying out financial transactions)
- Economies of scale
- Liquidity services
2) Reduce the exposure of investors to risk
- Risk Sharing (Asset Transformation)
- Diversification
3) Deal with asymmetric information problems:
Adverse Selection
(before the transaction) try to avoid selecting the risky borrower by gathering information about them
Moral Hazard
(after the transaction) ensure borrower will not engage in activities that will prevent him/her to repay the loan
-Sign a contract with restrictive covenants
Purposes of Financial System Regulation
1) To increase the information available to investors:
-Reduce adverse selection and moral hazard problems
-Reduce insider trading (SEC)
2)To ensure the soundness of financial intermediaries:
-Restrictions on entry (chartering process).
-Disclosure of information.
-Restrictions on Assets and Activities (control holding of risky assets).
-Deposit Insurance (avoid bank runs).
-Limits on Competition (mostly in the past):
+Branching
+Restrictions on Interest Rates
