Financial Markets and Institutions

Question 1

The Financial System consists of? Purpose?

Answer 1

Financial Markets (FM) and Financial Intermediaries (FI) whose main role is to provide a
mechanism by which funds are transferred and allocated to their most productive opportunities

FM and FI channel funds from Ultimate Lenders (UL) to Ultimate Borrowers (UB)
◦ UL: economic agents with financial surplus (Inc. − Exp. > 0)
who are willing to lend
◦ UB: economic agents with financial shortage (Inc. − Exp. < 0)
who need to borrow

Channelling funds increases economic efficiency by promoting a
better allocation of resources

Question 2

Different markets?

Answer 2

Debt and Equity Markets
* Debt instrument: contractual agreement by the borrower to make
fixed regular payments (e.g. coupons) until maturity
* Equity instrument: claim to share in the profit and the assets of the
borrower
Primary and Secondary Markets
* Primary Market: market for newly issued securities
* Secondary Market: market for previously issued securities
(highly liquid; determines the price for new issues)
◦ Organised Exchange Markets: buyers and sellers meet in a
central location
◦ Over-the-Counter Markets: dealers at different locations trade
securities ‘over-the-counter’
Money and Capital Markets
* Money Markets: short-term debt instruments are traded
(highly liquid; small price fluctuations)
* Capital Markets: long-term debt and equity instruments are traded

Question 3

Foreign bond? Eurobond? Eurocurrency?

Answer 3

• Foreign Bond: sold in a foreign country and denominated in that
  country’s currency
  e.g. A UK firm sells a bond in the US denominated in $
• Eurobond: denominated in a currency other than that of the country
  in which it is sold
  e.g. A bond denominated in $ sold in London
• Eurocurrency: currency deposited in a bank outside the home country
  (Eurodollars)
  e.g. £s deposited in foreign banks outside UK or foreign branches of
  UK banks

Question 4

FIs? role?

Answer 4

◃ F Is are entities that intermediate between UL and UB
◦ On Asset side, they hold large quantities of financial claims (e.g.
loans)
◦ On Liability side, they hold debt and equity but are highly
leveraged (i.e. assets relative to equity)
I Brokerage Function of F Is: help to reduce informational asymmetries
and transaction costs that are present in Direct Finance
I Qualitative Asset Transformation (QAT) Function of F Is:
reconfigure the attributes of financial claims

Question 5

Benefits of FIs to UL and UB? how do banks allow these benefits to occur

Answer 5

F Is minimise transaction costs and costs due to informational
asymmetries

F Is match their financial needs- Risk, Liquidity and Size

F Is reduce Transaction Costs by exploiting Economies of Scale and
Economies of Scope-
◦ Economies of Scale: by increasing the volume of transactions,
the cost per unit of transaction decreases
◦ Economies of Scope: cost of producing products (share common
inputs) together is smaller than producing them separately

I F Is’ advantages in processing information
◦ Interpret subtle signals
◦ Take advantage of ’Cross-sectional’ (i.e. across transactions)
and ’Intertemporal’ (i.e. across time) Information Reusability
◃ Resolve Informational Asymmetries in transactions; Pre-contract and
Post-contract

Screening: F Is reduce Adverse Selection problems

F Is reduce Screening costs through Information Reusability

Monitoring ensures that informational asymmetries are not exploited
by one party against the interest of the other

• F Is’ monitoring skills reduce Moral Hazard:
  ◦ Periodic examination of firms’ financial condition
  ◦ Obtain various types of financial information (e.g. performance
  reports, credit ratings by agencies)
  ◦ Send inspectors to monitor firms’ progress
• Financial regulators monitor F Is activities
  I F Is can reduce Informational Asymmetries

Question 6

QAT functions?

Answer 6

Through QAT, F Is match different financial needs; Size, Liquidity,
Risk
◦ Deposits: small-size, highly liquid, low risk
◦ Loans: large-size, illiquid, high risk

Size transformation:
Maturity transformation
Risk transformation

Through QAT, F Is create new financial assets and liabilities

Risk is an integral part of QAT

Question 7

FI risks?

Answer 7

◦ (a) Inventory risk: purchase/sale of claims can not be perfectly
synchronised
◦ (b) Interest Rate and Liquidity risk: maturity mismatching of
assets and liabilities
◦ (c) Default (or Credit) risk

Question 8

overall benefit to society, ul and ub

Answer 8

◃ Benefits to UL: ↓ Transaction costs & Information asymmetries, ↑
Liquidity, ↓ Risk, Marketable securities
◃ Benefits to UB: ↓ Transaction costs, ↑ Duration of loans, ↑ Size of
loans, ↓ Interest rate
◃ Benefits to Society: Efficient allocation of resources, more borrowing
and lending