Chapter 5

Question 1

splitting of wealth into many assets to reduce risk is known as

Answer 1

diversification

Question 2

the problem investors experience in distinguishing low-risk borrowers from high risk borrowers before making an investment

Answer 2

adverse selection

Question 3

problem investor experience in verifying that borrowers are using their funds as intended

Answer 3

moral hazard

Question 4

financial institutions given privileged control over the production and distribution of money and credit for a nation/group of nations

Answer 4

financial regulators

Question 5

it describes the situation in which one party to an economic transaction has better information than does the other party.

Answer 5

assymetric information

Question 6

costs that savers incur to determine creditworthiness of borrowers and to monitor how they use the funds acquired

Answer 6

information cost

Question 7

cost of a trade or financial transaction

Answer 7

transaction costs

Question 8

the chance that the value of financial assets will change relative to what one expects

Answer 8

risk

Question 9

three key services that the financial system provides to savers and borrowers

Answer 9

• risk sharing
• liquidity
• information

Question 10

market in which people trade financial securities and derivatives at low transaction cost

Answer 10

financial markets and institutions

Question 11

the financial system has increased the liquidity of many assets besides stocks and bonds through the process of

Answer 11

securitization

Question 12

two problems of assymetric information

Answer 12

1. adverse selection
2. moral hazard

Question 13

borrowers borrow funds directly from lenders in financial markets by selling them securities which are claims on the borrower’s future income or assets

Answer 13

direct finance

Question 14

how financial intermediaries reduce adverse selection?

Answer 14

1. requiring borrowers to dislose material information on their financial performance
2. collecting information on firms and selling the information to investors
3. convincing lenders to require borrowers to pledge some of their asset as collateral which the lender can claim of the borrowers defaults

Question 15

ease with which an asset can be exchanged for money which savers may view as a benefit

Answer 15

Liquidity

Question 16

Lender-savers

Answer 16

1. households
2. business firms
3. government
4. foreigners

Question 17

how financial intermediaries reduce transaction cost?

Answer 17

1. take advantage of economies of scale
2. take advantage of technology
3. increasingly rely on sophisticated software to evaluate credit worthiness of load applicants

Question 18

how financial intermediaries reduce moral hazard?

Answer 18

1. specializing in monitoring borrowers and developing effective techniques to ensure that the funds they loan are actually used for their intended purpose
2. imposing restrictive covenants

Question 19

key components of the financial system

Answer 19

financial instruments
financial markets and financial institutions
the central bank and other financial regulators

Question 20

Bank collect ____ to forecast their likelihood of repayment

Answer 20

information - key services of FI