Chapter 1: an Overview of Financial Markets and Institutions

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CHAPTER 1: An Overview of Financial Markets and Institutions

Answers to End-of-Chapter Questions

1.Does it make sense that the typical household is a surplus spending unit (SSU) while the typical business firm is a deficit spending unit (DSU)? Explain.

The typical household begins as a SSU, has a deficit moments in the period when a home is purchased, autos are purchased, and tuition payments are made. For the most quarters (the typical flow of funds time unit) the household sector is an SSU. The non-financial corporate business sector varies from a SSU when internal cash flows exceeds real investment to a DSU when real investment exceeds internal cash flow, typically late in the expansion phase of the business cycle.

2.Explain the economic role of brokers, dealers, and investment bankers.

The major economic role of brokers, dealers, and investment bankers is that of market maker in the direct financial markets. When funds are raised and claims issued (primary market), they serve to bring lenders and borrowers together. In subsequent transactions of the claims (secondary markets), they serve as market makers, providing liquidity, price discovery, and other information processing functions.

3.Why are direct financing transactions more costly or inconvenient than intermediated transactions?

As long as financial intermediaries have the edge in informational efficiency (lower cost of information discovery), funds will flow through financial intermediaries. In the 1980's, as information and communications technology advanced, investment bankers claimed an increased share of the savings/investment throughout. Businesses issued commercial paper instead of borrowing from banks. Loans were divided into origination, service and funding cash flows and securitization began. Funds will flow to investment via the lowest cost route. Large commercial banks have turned to informational processing and risk intermediation via standby letters of credit, commitments, and OTC derivatives, such as swaps.

4.Explain how you believe economic activity would be affected if we did not have financial markets and institutions.

With no lending, borrowing or risk intermediation, economic development would progress very slowly. Business would have to wait until cash flows were earned before plant and equipment expenditures could go forth. Households would build their home one room and floor at a time as savings (non-consumption) were accumulated. Financing relationships would arise only when preferences of lenders and borrowers match. Borrowers would not always obtain timely financing for attractive projects and lenders would under-utilize their savings. The “production possibilities frontier” of the society would be smaller. 5.Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?

Financial intermediation is the process by which financial institutions mediate unmatched preferences of borrowers (DSUs) and lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, and then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus promoting the three forms of efficiency-allocational, informational, and operational.

6.How do financial intermediaries generate profits?

Intermediaries pay SSUs less than they earn from DSUs. Operating costs absorb part of this margin. Risks taken by the intermediary are rewarded by any remaining profit. Intermediaries enjoy three sources of comparative advantage: Economies of scale - large volumes of similar transactions; transaction costs control - finding and negotiating direct investments less...
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