ECON 2411 Ch. 2 - An Overview of the Financial System
Given the following business plan information: I need to borrow $5,000 for a car because it enables me to get a job as a traveling anvil seller. Larry the Loan Shark will loan me the $5,000 at an interest rate of 90%. Principle and interest are due in exactly 12 months. With the car, I will be able to earn $10,000 in extra income over the next 12 months. What is the net cash flow by taking out the loan? The net cash flow is ____.
$500 (Net cash flow = Extra income - Principle: $10,000 - $9,500 = $500) Principle = $5,000 (1 + .90) = $9,500 after 1 year
Which of the following is a long-term financial instrument? (*)
A U.S. Treasury bond
Match each international financial instrument with its description: Foreign bond Eurocurrency Eurodolars Eurobonds
FB - Bonds sold in foreign country and denominated in that country's currency. EC - Foreign currencies deposited in banks outside the home country. ED - US dollars deposited in foreign banks outside the United States or in foreign branches of US banks. EB - A bond denominated in a currency other than that of the country in which it is sold - for example, a bond denominated in US dollars sold in London.
Match each regulatory agency with its description: Federal Reserve FDIC Office of Thrift Supervision Comptroller of the Currency SEC
FR - Examines the books of commercial banks that are members of the Federal Reserve System and sets reserve requirements for all banks. FDIC - Provides insurance of at $250,000 for each depositor at a bank, examines the books of insured banks, and imposes restrictions on assets they can hold. OTC - Examines the books of savings and loan associations and imposes restrictions n assets they can hold. CC - Charters and examines the books and federally charted commercial banks and imposes restrictions on assets they can hold. SEC - Requires disclosure of information of financial instruments traded in organized exchanges.
Which of the following is not a function or service provided by secondary markets?
Matching lenders (savers) with borrowers in need of funds.
_____ are financial intermediaries that acquire funds by selling shares to many individuals and using the proceeds to purchase diversifies portfolios of stocks and bonds. (*)
Mutual funds
Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest rate than lend her the funds yourself?
The costs of writing up the loan contract might exceed the 5% difference between your deposit rate and the bank lending rate.
Which of the following statements about financial markets and securities is true ? (*)
The maturity of a debt instrument is the number of years (term) to that instrument's expiration date.
How do financial intermediaries benefit by providing risk-sharing services?
They are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold.
If you were going to get a loan to purchase a new car, which financial intermediary would you use? (Check all that apply)
a credit union a pension fund
Which of the following benefit directly from any increase in the corporations profitability? (*)
a shareholder
Choose the correct description for the following money market instrument. Commercial paper is :
a short-term debt instrument issued by large banks and well-known corporations.
Increasing the amount of information available to investors helps to reduce the problems of ____ and ____ in the financial markets. (*)
adverse selection; moral hazard
Financial markets perform the basic function of:
assuring that government need never resort to printing money to finance their expenditure.
If you suspect that an airline will go bankrupt next week, which would you rather hold, bonds issued by the company, or equities issued by the company? You would prefer to hold ____.
bonds
Financial markets improve economic welfare because: (*)
both A and B are correct (they channel funds from savers to investors and they allow customers to time their purchases better)
The primary liabilities of a commercial bank are ____. (*)
deposits.
The provision of several types of financial services by one firm may be beneficial because of:
economies of scope and problematic because of conflicts of interest.
Financial intermediaries have a role to play in matching savers and borrowers for all of the following reasons except:
information symmetries
The higher a security;s price in the secondary market the ____ funds a firm can raise by selling securities in the _____ market. (*)
more; primary
a corporation acquire new funds only when its securities are sold in the _____. (*)
primary market by an investment bank.
Prices of money market instruments undergo the least price fluctuations because of ____.(*)
the short terms to maturity for the securities.
Match each financial intermediary with its description: Commercial Bank Savings and Loan Credit Union Mutual Fund
CB - These financial intermediaries raise funds primarily by issuing checkable deposits, savings deposits, and time deposits. They then use these funds to make commercial, consumer, and mortgage loans and to buy U.S. government securities and municipal bonds. S&L - These depository institutions obtain funds primarily through savings deposits (often called shares) and time and checkable deposits. In the past, these institutions were constrained in their activities and mostly made mortgage loans for residential housing. CU - These financial institutions are very small cooperative lending institutions organized around a particular group: union members, employees of a firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans. MF - These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversifies portfolios of stocks and bonds.
How do conflicts of interest make the asymmetric information problem worse?
Competing interest may lead a financial institution to conceal information disseminate misleading information, which prevent financial markets from channeling funds into the most productive investment opportunities.
Match each concept with its description: Adverse selection Asymmetric information Moral hazard
AS - Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome - the bad credit risks - are the ones who most actively seek out a loan and are thus most likely to be selected. AI - A situation where one party often does not know enough about the other party to make accurate decisions. MH - A situation where the borrower might engage in activates that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back.
Suppose that you buy, and one year later sell, a foreign (British) bond under the following circumstances: When you buy the bond the exchange rate is $2.00 = 1 pound. You pay 45 pounds ($90.00) for the British bond. You sell the bond for 50 pounds. No interest payment was expected or received. When you sell the bond, the exchange rate is $1.70 = 1 pound. What is your gain or loss in dollars? ____
Buy ( $2.00 x 45 pounds = $90) Sell ($1.70 x 50 pounds = $85) Answer: $85 - $90 = - $5.00 loss
The US economy borrowed heavily from the British in the nineteenth century to build a railroad system. What was the principal debt instrument used? ______ were the principal debt instrument used to financial the railroad system.
Foreign bonds
A share of Microsoft common stock is:
an asset for its owner, which Microsoft shows as shareholder equity on its balance sheet.
A significant number of European banks held large amount of assets as mortgage-backed securities derived from the U.S. housing market, which crashed after 2006. Which s the following statements correctly describes the benefits of the internationalization of financial markets. (Check all that apply) Which of the following statements correctly describes a disadvantage of the internationalization of financial markets?
B. European banks provided needed capital to U.S. financial markets to support borrowing for new home construction. D. The European banks that held U.S. mortgages earned a return on those holdings. With the sharp decline in the U.S. housing market, the value of mortgage-backed securities held by European banks fell sharply.
Complete the following table related to the structure of financial markets: Direct finance to Savers: ______ Direct finance to Borrowers: _____ Indirect finance to Savers: ______ Indirect finance to Borrowers: ____
Buy Securities Sell Securities Make deposits Take out loans
Match each regulated institution with its regulatory agency: Commodities Futures Trading Commission ___ Office of Thrift Supervision ____ Comptroller of the Currency ___ SEC ___
Futures market exchanges Savings and loan associations Federally charted commercial banks Organized exchanges and financial markets
Match each capital market instrument with its description: Government Security Stocks Agency Securities Corporate Bonds Mortgages
GS - These long-term debt instruments are issued by the U.S. Treasury to finance the deficits of the federal government. S - These are equity claims on the net income and of a corporation. AS - These long-term bonds are issued by institutions such as Ginnie Mae, the Federal Farm Credit Bank, and the TVA. Many of these securities are guaranteed by the federal government. CB - These long-term bonds are issued by corporations with very strong credit ratings. M - These are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans.
In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit on insured losses to bank depositors from $100,000 per account to $250,000 per account. How would this help stabilize the financial system?
It would reassure depositors that their money was safe in banks and prevent a possible bank panic.
One of the factors contributing to the financial crisis of 2007-2009 was the widespread issuance of subprime mortgages. How does this demonstrate adverse selection?
Lenders loaned money to a pool of potential homeowners with the highest credit risk and lowest net wealth.
The maturity of a debt instrument is the number of years (term) until that instrument's expiration date. Identify the term to maturity of the following financial instruments: A 30-year corporate bond: _____ A money-market instrument with a maturity of 6 months: _____ A Treasury note with a maturity of 5 or 10 years: ______ A 90-dau Treasury bill: _____
Long-term Short-term Intermediate-term Short-term
What is the difference between a mortgage and a mortgage-backed security?
Mortgages are loans, whereas mortgage-backed securities are bond-like debt instruments.
Why would a life insurance company e concerned about the financial stability of major corporation or the health of the housing market?
Most life insurance companies hold large amount of corporate bonds and mortgage assets.
Match each financial market with its description: Primary Market Capital Market Money Market Secondary Market Debt Market
PM - A financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. CM - A market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded. MM - A financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded. SM - A financial market in which securities that have been previously issued can be resold. DM - A market where bonds or mortgages, which are contractual agreements by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date when a final payment is made, are traded.
Suppose you have inherited $10,400 and are considering different options for investing the money to maximize your return. If you are risk-neutral (that is, neither see out or shy away from risk), which of the following options should you choose to maximize your expected return? Suppose the only possibility is to loan the money to one of your friends' roommates. If you could pay your friend $200 to find out extra information about Mike that would indicate with certainty whether he will leave town without paying or not, would you pay the $200? What does the previous answer say about the value of better information regarding risk?
Put the money in an interest-bearing checking account, which earns 3%. The FDIC insures the account against bank failure. Yes, it is worth it, because it increases your expected return and reduces the downside risk that the loan will default. Paying a small amount to improve risk assessment can be very beneficial.
