Money & Banking Ch. 3

How might broader access to finance benefit a country where access was previously very limited?

-lower transaction costs -facilitating the channeling of savings to the most productive uses -enabling greater specialization

Everything else being equal, which would be more valuable to you—a derivative instrument whose value is derived from an underlying instrument with a very volatile price history or one derived from an underlying instrument with a very stable price history?

The derivative based on the more VOLATILE underlying asset should have more value to you.

Can a financial instrument be bought and sold in both a primary and secondary financial market? Explain.

Yes. For instance a company can issue its shares in a primary market through an IPO, but later the shares can be sold by the initial buyer in a secondary market.

You decide to start a business selling covers for smart phones in a mall kiosk. To buy inventory, you need to borrow some funds. Why are you more likely to take out a bank loan than to issue bonds? A person starting up a small business would be more likely to take out a bank loan, because issuing bonds is a form of ________ finance and would require finding a buyer who would be willing to bear the __________ associated with the loan. For a small, unknown business these costs would usually ______ prohibitive. In the case of __________ , the lending organization acts as the counterparty to the transaction. These organizations overcome problems associated with asymmetric information by using their expertise to screen loan applicants and use standardized loan contracts to ________ transaction costs.

A person starting up a small business would be more likely to take out a bank loan, because issuing bonds is a form of DIRECT finance and would require finding a buyer who would be willing to bear the INFORMATION AND MONITORING COSTS associated with the loan. For a small, unknown business these costs would usually BE prohibitive. In the case of A BANK LOAN , the lending organization acts as the counterparty to the transaction. These organizations overcome problems associated with asymmetric information by using their expertise to screen loan applicants and use standardized loan contracts to DECREASE transaction costs.

You wish to buy an annuity that makes monthly payments for as long as you live. Describe what would happen to the purchase price of the annuity if (1) your age at the time of purchase goes up, (2) the size of the monthly payment rises, and (3) you are in poor health. As your age at the time of purchase goes up, the number of expected monthly payments _____ so the price of the annuity _______. The price of the annuity rises as each monthly payment is ______. Because of your good health your life expectancy is shorter, therefore, the number of expected monthly payments is _____ and the price of the annuity ______.

As your age at the time of purchase goes up, the number of expected monthly payments DECREASES so the price of the annuity DECREASES. The price of the annuity rises as each monthly payment is LARGER. Because of your good health your life expectancy is shorter, therefore, the number of expected monthly payments is HIGHER and the price of the annuity INCREASES.

You wish to buy an annuity that makes monthly payments for as long as you live. Describe what would happen to the purchase price of the annuity if (1) your age at the time of purchase goes up, (2) the size of the monthly payment rises, and (3) you are in poor health. As your age at the time of purchase goes up, the number of expected monthly payments _____ so the price of the annuity _______. The price of the annuity rises as each monthly payment is ______. Because of your poor health your life expectancy is shorter, therefore, the number of expected monthly payments is _____ and the price of the annuity ______.

As your age at the time of purchase goes up, the number of expected monthly payments DECREASES so the price of the annuity DECREASES. The price of the annuity rises as each monthly payment is LARGER. Because of your poor health your life expectancy is shorter, therefore, the number of expected monthly payments is LOWER and the price of the annuity DECREASES.

Commercial banks, insurance companies, investment banks, and pension funds are all examples of financial intermediaries. Identify the source of their funds and how they are used. Commercial banks a. receive deposits in checking and savings accounts and use these funds to make loans. b. receive regular contributions from firms, invest these funds in long-term assets, and pay benefits to firms' retirees. c. receive premium payments, which they invest in securities or other assets to earn income until claims are paid. d. charge fees for advising clients for preparing new stock and bond issues for the market. Insurance companies a. charge fees for advising clients for preparing new stock and bond issues for the market. b. receive premium payments, which they invest in securities or other assets to earn income until claims are paid. c. receive regular contributions from firms, invest these funds in long-term assets, and pay benefits to firms' retirees. d. receive deposits in checking and savings accounts and use these funds to make loans. Investment banks a. charge fees for advising clients for preparing new stock and bond issues for the market. b. receive regular contributions from firms, invest these funds in long-term assets, and pay benefits to firms' retirees. c. receive premium payments, which they invest in securities or other assets to earn income until claims are paid. d. receive deposits in checking and savings accounts and use these funds to make loans. Pension funds a. charge fees for advising clients for preparing new stock and bond issues for the market. b. receive premium payments, which they invest in securities or other assets to earn income until claims are paid. c. receive deposits in checking and savings accounts and use these funds to make loans. d. receive regular contributions from firms, invest these funds in long-term assets, and pay benefits to firms' retirees.

Commercial Banks a. receive deposits in checking and savings accounts and use these funds to make loans. Insurance Companies b. receive premium payments, which they invest in securities or other assets to earn income until claims are paid. Investment Banks a. charge fees for advising clients for preparing new stock and bond issues for the market. Pension Funds d. receive regular contributions from firms, invest these funds in long-term assets, and pay benefits to firms' retirees.

The design and function of financial instruments, markets, and institutions are tied to the importance of information. Describe the role played by information in each of these three pieces of the financial system. Financial Instruments a. produce information to screen and monitor borrowers. b. summarize essential information about the individual borrower. c. aggregate information from many sources and communicate it widely. Financial Markets a. aggregate information from many sources and communicate it widely. b. produce information to screen and monitor borrowers. c. summarize essential information about the individual borrower. Financial Institutions a. produce information to screen and monitor borrowers. b. summarize essential information about the individual borrower. c. aggregate information from many sources and communicate it widely.

Financial Instruments b. summarize essential information about the individual borrower Financial Markets a. aggregate information from many sources and communicate it widely Financial Institutions a. produce information to screen and monitor the borrowers

How do financial markets pool and communicate the information regarding issuers of financial instruments in a convenient way?

Financial markets pool and communicate information about the issuers of financial instruments, summarizing it in the form of a price. For example, if a company has good prospects for future growth and profits, then the stock price will be high. If a borrower is likely to repay a bond, then the bond is going to be priced higher.

Financial instruments used primarily to transfer risk would include all of the following, except: a. an insurance contract b. a futures contract c. options d. a bank loan

d. a bank loan

Reasons for the rapid structural change in financial markets in recent years include all of the following except: a. globalization b. technological advances in computing c. technological advances in communication d. high real interest rates

d. high real interest rates

Advances in technology have facilitated the widespread use of credit scoring by financial institutions in making their lending decisions. Credit scoring can be defined broadly as the use of historical data and statistical techniques to rank the attractiveness of potential borrowers and guide lending decisions. In what ways might this practice enhance the efficiency of the financial system?

The use of credit scoring helps to standardize the evaluation of loan applicants and it helps to reduce the cost of gathering other information. With credit scoring financial institutions can lend to a broader scope of people. They can also now create secured, asset-backed loans for those whose creditworthiness is low. Their is less subjectivity and discrimination in lending decisions so decisions are now made more cost and time efficient.

Has the distinction between direct and indirect forms of finance become more or less important in recent times? Why? a. Less important. The increasing sophistication of the financial system has led to greater institutionalization, so that even direct finance transactions usually involve a financial institution to some extent. b. More important. The decreasing sophistication of the financial system has led to greater institutionalization, so that even direct finance transactions usually involve a financial institution to some extent. c. Less important. The increasing sophistication of the financial system has led to less institutionalization, so that even direct finance transactions usually involve a financial institution to some extent. d. More important. The increasing sophistication of the financial system has led to greater institutionalization, so that even direct finance transactions usually involve a financial institution to some extent.

a. Less important. The increasing sophistication of the financial system has led to greater institutionalization, so that even direct finance transactions usually involve a financial institution to some extent.

For each pair of instruments below, use the criteria for valuing a financial instrument to choose the one with the highest value: a. A U.S. Treasury bill that pays $1,000 in six months or a U.S. Treasury bill that pays $1,000 in three months. b. A U.S. government Treasury bill that pays $1,000 in three months or commercial paper issued by a private corporation that pays $1,000 in three months. c. An insurance policy that pays out in the event of serious illness or one that pays out when you are healthy, assuming you are equally likely to be ill or healthy.

a. The Treasury bill that pays in THREE MONTHS because a payment that is received SOONER in the future is more valuable b. The U.S. TREASURY BILL is more valuable because the payment is MORE likely to be made. c. The insurance policy that pays out when you are SERIOUSLY ILL because this is when the payment is needed the MOST

Asymmetric information in financial markets is a potential problem usually resulting from: a. borrowers having more information than the lenders b. lenders having more information than borrowers c. the fact that people are basically dishonest d. the uncertainty about Federal Reserve monetary policy

a. borrowers having more information than the lenders

Roles served by financial markets include the following, except: a. eliminating risk b. providing liquidity c. pooling and communicating information d. sharing of risk

a. eliminating risk

The New York Stock Exchange (NYSE) originated as: a. a decentralized electronic market made up of dealers all over the world. b. an example of a centralized exchange c. a financial market where nearly 100 million shares of stock are traded every business day d. the only centralized stock exchange in the world

b. an example of a centralized exchange

Sue has a checking account at the First National Bank; her checking account is a(n): a. asset to the bank and a liability to Sue. b. asset to Sue and a liability to the bank. c. asset to Sue but actually a liability to the Federal Reserve. d. liability to Sue until she spends the funds.

b. asset to Sue and a liability to the bank

Financial institutions: a. raise the level of transaction costs relating to borrowing/lending b. can lower the information asymmetry involved with borrowing/lending c. decrease the liquidity to savers d. are required for all financial transactions

b. can lower the information asymmetry involved with borrowing/lending

The high volume of shares of stock that are traded on a normal day on stock markets reflects the: a. high transaction costs associated with these financial markets b. low transaction costs and high liquidity associated with these markets c. low transaction costs and low liquidity associated with these markets d. high transactions costs and low liquidity associated with these markets

b. low transaction costs and high liquidity associated with these markets

A primary financial market is: a. located only in New York, London, and Tokyo but can handle transactions anywhere in the world. b. one where the borrower obtains funds directly from the lender for newly issued securities. c. a market where U.S. Treasury bonds are traded. d. one that can only deal in the highest investment grade securities.

b. one where the borrower obtains funds directly from the lender for newly issued securities.

The most prominent of asset-backed securities is: a. shares of stock in corporations since stockholders own the assets b. securities backed by home mortgages c. U.S. Treasury bonds since they are backed by all public assets d. movie box-office receipts

b. securities backed by home mortgages

Standardization of financial instruments has occurred as a result of: a. the rule of 70 b. the law of demand c. economies of scale d. the law of supply

c. economies of scale

All of the following are depository institutions, except: a. commercial banks b. credit unions c. insurance companies d. savings banks

c. insurance companies

Most of the buying and selling in primary markets: a. is in the public view b. is highly transparent and closely monitored by the SEC c. involve an investment bank d. is done by the federal reserve

c. involve an investment bank

Agencies exist which rate bonds based on characteristics of the borrower. Such bond rating agencies are an example of a financial market response designed to: a. increase information asymmetry b. decrease the real return to bondholders c. provide a lower cost solution to the high cost of information d. transfer risk from the buyer to the rating agency

c. provide a lower cost solution to the high cost of information

Considering the value of a financial instrument, the sooner the promised payment is made: a. the less valuable is the promise to make it since time is valuable b. the greater the risk, therefore the promise has greater value c. the more valuable is the promise to make it d. the less relevant is the likelihood that they payment will be made

c. the more valuable is the promise to make it

The fundamental characteristics influencing the value of a financial instrument include each of the following except: a. the size of the payment promised b. when the promised payment will be made c. where the instrument is traded d. the likelihood of payment

c. where the instrument is traded