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

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