Functions of Financial System

Question 1

What is the Secondary Market

Answer 1

The Secondary Market is where previously issued shares are traded amongst investors

Question 2

Why is the Secondary Market important?

Answer 2

Because it provides LIQUIDITY and INFORMATION to investors

Question 3

What is an Order-Driven Market?

Answer 3

Centralized, book contains all bids and asks of participants for different securities. Best for stocks and standardized securities.
(typical stock exchanges)

Question 4

What is a Price-Driven Market?

Answer 4

Not centralized, network of dealers providing bids and ask prices they are willing to trade at. Best for bonds and customized securities.
(OTC Markets)

Question 5

Advantage of Order-Driven Markets

Answer 5

Less costly, because system is centralized, fully integrated, and settlement is automatic once the trade is done.

Question 6

Advantages of Price-Driven Markets

Answer 6

Offers more liquidity: dealers act as market makers, trading large quantities.

Question 7

Describe Function 1: Channeling of Funds

Answer 7

Investment Channel - creating investment opportunities for savers to lenders
Consumption Channel - Smooths consumption over time

Question 8

Describe Function 2: Managing Asymmetric Information

Answer 8

Lenders have less information than Borrowers and this can hinder channeling of funds. Financial Systems must find ways to manage this.

Question 9

Describe Function 3: Transfer of Risk

Answer 9

Through Capital Markets and Financial Institutions, investors can transfer risk (1) across time and (2) across uncertain parts of the world

Question 10

Describe Function 4: Pooling Individual Resources

Answer 10

Investment projects require large resources, investors want to minimize risks (diversifying): financial systems allow pooling of resources

Question 11

Describe Function 5: Providing Liquidity

Answer 11

Secondary Markets - allows participants to cover (un)expected liquidity needs by exchanging between securities and cash

Question 12

Describe Function 6: Providing Information

Answer 12

Secondary Markets - Investors can observe daily quotations for prices, interest rates, which bankers, politicians, and managers can use to improve the real economy

Question 13

Define Capital Markets

Answer 13

Markets where the demand and supply of financial securities meet

Question 14

Define Financial Institutions

Answer 14

Companies that produce financial products and services (banks, insurance companies etc.)

Question 15

‘Blank’ offer a promise of interest payments for specified periods

Answer 15

Debt Securities

Question 16

‘Blank’ provide an uncertain stream of dividends and an ownership claim in the company

Answer 16

Corporate Stocks

Question 17

Largest financial institution in the US is:

1. Mutual Funds
2. Commercial Banks
3. Pension Funds

Answer 17

2. Commercial Banks ( $17,352B in 2019)

Question 18

What is the most important function of the financial system?

Answer 18

Channeling of funds

Question 19

A good financial system channels funds from _____ to ______.

Answer 19

from Savers to Borrowers

Question 20

What is the most important source of external financing, Capital Markets or Financial Institutions?

Answer 20

Financial Institutions

Question 21

What are the two problems of asymmetric information?

Answer 21

Adverse selection, and moral hazard

Question 22

Describe the adverse selection problem

Answer 22

Investors propose an average price or rate.

Good borrowers may refuse to issue securities if prices drop too low.

Investors will refuse to lend because only bad borrowers are left in the market.

Result: inefficient market

Question 23

Describe the Moral Hazard problem

Answer 23

Describes a situation where there is incentive for engaging in risky activity.

Example: Banks take more risks, the government bails them out because it cannot let them fail, banks take more risks because they know they will be bailed out.

Question 24

What are the 3 functions of money?

Answer 24

1. Medium of exchange (vs barter economy)
2. Unit of account (comparing prices)
3. Store of value (financial asset)

Question 25

What are the two jobs of the central bank?

Answer 25

1. Monetary Policy: setting the right quantity of money (impacts inflation and economic output)
2. Lender of Last Resort (lends to financial institutions in times of crisis)

Question 26

What is Quantitative Easing?

Answer 26

In Quantitative Easing, the central bank purchases longer-term securities to affect long-term interest rates.

Question 27

Why perform Quantitative Easing?

Answer 27

Lower long-term interest rates, decrease borrowing costs for firms, reduce new and refinanced mortgages, and improve banks financial health.

Question 28

How is monetary policy conducted today?

Answer 28

The size of reserves has increased, and the Fed has agreed to pay interest on these reserves. Higher interests means banks are less likely to lend and more likely to keep the reserves; Lower interests means banks are more likely to lend and less likely to sit on the reserves.