Lecture 2 Overview Of The Financial System

Question 1

Function of the financial system

Answer 1

Channel funds from those who have excess money to those who want to invest and don’t have any money

Question 2

Indirect finance

Answer 2

Savers such as households, business firms and government put their money into financial intermediaries such as banks. Financial intermediaries allocate funds to borrowers such as businesses, government and households.

Question 3

Direct finance

Answer 3

Borrowers borrow funds from lenders through financial markets. The borrowers issue and sell securities.

Ie a bond.

Bond is an asset for the buyer and a liability to the company issuing.

Question 4

Assets

Answer 4

A resource which produces future economic cash. Wealth can be held.

Question 5

Liability

Answer 5

Something that is owed to another party.

An obligation which is expected to be an outflow of cash.

Question 6

How do financial markets promote economic efficiency?

Answer 6

1) If desired consumption is more than current income.

Borrow money

Become better off

Lender is better off as they earn interest on which would have been unproductive funds.

2) If current income is more than desired consumption

Lend money

Lender is better off because it earns interest

Borrow is better off because they can invest in capital and increase productivity.

Question 7

What would happened without markets?

Answer 7

Stuck with the status quo.

Consumers would be forced to consume less. Consumer can’t spread consumption optimally over time.

Businesses would produce less because it would be hard to finance investment.

Society would be worse off

Question 8

What is a Debt market?

Answer 8

Debt securities are issued and traded such as, bonds.

A debt security is a contractual agreement where the borrower has to make payments and intervals with interest to the lender who holds the bond.

Maturity of the debt is the length of time until the contract expires.

Question 9

What is an equity market?

Answer 9

Where shares of stock are issued and traded.

A stock = a residual claim on the net income and assets of a
corporation.

Question 10

What is a Primary Market?

Answer 10

Where new issues of a security are sold to initial buyers.
• The selling often takes place behind closed doors through investment
banks, which underwrite securities
– (i.e. guarantee a certain price for a company’s securities and then sell
these securities to the public).
• Corporations use primary markets to raise funds

Question 11

What is a Secondary Market?

Answer 11

Where securities previously issued are bought and sold by the public.
• Trading in the secondary market does not yield new funds for the
company.
• However, they make securities more liquid, and therefore more
attractive in the primary market

Question 12

What are organized markets?

Answer 12

Buyers and sellers (or their agents) meet in
one central location to conduct trades.
• Examples: NYSE, London SE, Frankfurt SE

Question 13

What are over the counter markets?

Answer 13

Dealers at different locations stand ready to buy/sell “over the
counter” to anyone who’s willing to accept their prices (bid-ask).
• Dealers are in computer contact and know the prices set by one
another (strong competition).
• Examples: Nasdaq, foreign exchange market, bond markets

Question 14

What are Treasury Bills?

Answer 14

Short/term debt instruments issued by the government
No interest payments
High degree of liquidity, high trading volume
Very low chance of default

Question 15

What are Certificates of Deposits?

Answer 15

Short/term (1 to 5 years) debt instruments sold by banks to depositors
Interest payments

Question 16

What is a Commercial Paper?

Answer 16

Short/term (2 to 30 days) debt instrument issued by large banks and
corporations
No interest payments

Question 17

What are repurchase agreements?

Answer 17

Party A sells some securities to party B and promises to buy them back at
a higher price
The securities act as collateral, and the effect is that B lends money to A

Question 18

What are commercial bonds?

Answer 18

Long/term debt instruments issued by corporations
Interest payments
Medium degree of liquidity
Default risk varies considerably across issuers

Question 19

What are Government Bonds?

Answer 19

Long/term debt instruments issued by governments
Interest payments High degree of liquidity, high trading volume
Default risk varies considerably across countries
Risk that borrower will not be able/willing to meet its obligations

Question 20

Why is Indirect Finance so Important?

Answer 20

Financial intermediation addresses 3 major issues that
may reduce the effectiveness of financial markets:
1. It reduces transaction costs
2. It reduces risk exposure through risk sharing
3. It mitigates asymmetric information problems
– Adverse selection
– Moral hazard

Question 21

How have transaction costs made intermediaries?

Answer 21

Existence of financial intermediaries may be explained by
the existence of transaction costs.
– Example: you have some savings (£100)
– you want to find a productive use for them
– you need to find someone willing to pay to “rent” your funds
– Problems:
• This amount is too small to be interesting/relevant for businesses
• Need time and money to carry out this financial transaction!

Question 22

Example of Transaction Costs

Answer 22

Assume that by sheer luck you’ve found a potential
borrower (lend £100, interest = £10)
• Now you have to hire a lawyer to write up the
loan contract! (cost=£500)
Lending your funds would be unprofitable!
(the transaction will not take place!)

Question 23

How do banks reduce transaction cost?

Answer 23

A bank, instead, could reduce transaction costs through
economies of scale:
–Bank hires a lawyer to write a standard loan contract that can be used 1000
times
–Unit cost of loan contract = £500/1,000 = £0.5
–If you lend your funds to the bank and then the bank lends these funds to the
borrower  transaction will take place  everyone will benefit!

Question 24

What is risk sharing?

Answer 24

Intermediaries can create and sell to the public assets with
low risk characteristics  then use the funds to invest in
much riskier assets (asset transformation).
Intermediaries can help people reduce exposure to risk
through diversification.
– Financial institutions typically hold large and well
diversified portfolios
– Idea: you shouldn’t put all your eggs in one basket.
– Without intermediaries, it would be very difficult for small savers to
spread risk across many investments.

Question 25

What is asymmetric information?

Answer 25

Asymmetric information: potential borrowers have better
information than potential lenders about the borrower’s
credit risk.
Borrowers have better information about how borrowed
money will be used:
– Will the funds be invested in a safe or risky project?

Question 26

How Can Financial Intermediaries can Mitigate

Asymmetric Information Problems?

Answer 26

Financial intermediaries (e.g. banks) are better equipped to
screen out bad credit risks from good ones before making
loans  screening can mitigate adverse selection issue
They also develop expertise in monitoring borrowers’
behavior after the loan is made, so that they can mitigate
the moral hazard problem
– Indeed, this is the business of banking!

Question 27

What is a depository institution? How do they raise funds?

What do they do with their money?

Answer 27

•Raise fund by accepting deposits:
– 1. Checkable deposits: payable on demand, and checks can be written on them.
– 2. Savings deposits: payable on demand, but do not allow owner to write checks
– 3. Time deposits: with fixed terms to maturity
•The funds are then used to
– make loans to businesses and individuals.
– invest in corporate and government bonds.

Question 28

What are pension funds? How do they raise funds? What do they do with their money?

Answer 28

– Collect funds through contributions from employees and their employers
– Funds are invested in debt and stock market
– When employees retire they receive retirement income in
the form of annuities

Question 29

What are finance companies? How do they raise funds? What do they do with their money?

Answer 29

•Raise funds by issuing commercial paper, stocks, bonds
•The funds are then used to make consumer loans (cars,
vacations, home improvements, etc) and lend to small businesses.

Question 30

What are Investment Banks? How do they raise funds? What do they do with their money?

Answer 30

– Provide advice to corporations on how to raise funds in financial markets
through the issue of equities/bonds
– Purchase securities in primary market from the issuer and then sell them to
the general public through their networks

Question 31

What are money market mutual funds? How do they raise funds? What do they do with their money?

Answer 31

– Sell shares to acquire funds to buy money market instruments
– Interest on these instruments is paid out to the shareholders
– They also offer deposit-type accounts
– Shareholders can write checks against the value of their shareholdings