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Transcript
Chapter 1: ANSWERS TO DO YOU UNDERSTAND QUESTIONS DO YOU UNDERSTAND? 1. What is the role of the financial system and why is it important to the economy. Solution: The financial system serves three major purposes in support of the real economy: a) to facilitate the flow of saving to investment via direct and indirect financial markets, b) to provide an efficient payments system to facilitate trade (real and financial), and c) to provide a means (contracts) to manage risk. The combination of competition, application of technology, and limited regulation enhances the efficiency of the financial system. 2. What is a financial claim? How can a financial claim be both an asset and a liability at the same time? Solution: A financial claim or security is a financial asset claim on future cash flows. A claim may be a debt or equity (ownership) claim. A borrower issues financial claims in return for funds; an investor trades funds for a financial claim. 3. What are some problems with direct financing that make indirect financing a more attractive alternative? Solution: For direct financing to take place, there must be an exact match between the characteristics of the financial claims that DSUs wish to sell and those of the financial claims SSUs want to buy. Direct financing can involve a costly search process to arrange transactions. Financial intermediaries transform the direct claims sold by DSUs and make them more attractive to SSUs, making it easier for DSUs to find financing and for SSUs to find appropriate investment vehicles. 4. Explain what is meant by the term financial intermediation. Solution: Financial intermediation is the routing of savings to investment through financial intermediaries. The process involves two contracts: an IOU issued by the financial intermediary to the saver/supplier of funds and the purchase of a direct security (loan) from a borrower or investor in real investment. With two contracts, each may be tailored to the needs of the customer of the financial intermediary. The financial intermediary bears the risk of intermediation, which provides the basis for its return to its stockholders. 5. What are investment banks (IB) and what role do they play in the financial system? Solutions: Investment banking is a service provided a security issuer in direct financial markets whereby securities issued are purchased (inventory) by the IB and resold/marketed to investors. IB provides issuers a way to issue securities to a broad array of investors and provides investors information and new investments. DO YOU UNDERSTAND? 1. Why is denomination divisibility an important intermediation service from the perspective of the typical household? Solution: Typical households do not have sufficient cash to invest in the direct credit markets, where minimum transactions are often $1 million. Financial intermediaries facilitate indirect investment by households by offering financial claims with smaller denominations. Otherwise, households would have to accumulate large sums of money before they could invest. During the time required to accumulate, say, $1 million, the household would earn no interest income—a substantial opportunity cost! 2. What are the three sources of comparative advantage that financial institutions have over others in producing financial products? Solution: Financial Intermediaries (FI) can achieve economies of scale with specialization, with competition transactions costs involved in the flow of savings to investment is reduced, and FI with specialization can generate better information about borrowers and reduce bad debt losses. 3. What would be the implications for investment in physical assets such as oil refineries or long-distance telephone cable if financial intermediaries were not willing to invest money for long periods of time? Solution: Suppose such a project takes $300 million to build, but returns only $30 million per year in cash flow. Over the long run, a 10 percent return looks pretty good, but how could the firm repay the investors if they insisted on receiving the cash plus interest in only one year? The bottom line is that the projects would have to be financed out of the savings of the firms’ owners, and it is therefore likely to take them a long time to accumulate sufficient funds to undertake the project. Valuable projects could be delayed indefinitely and society would be worse off. 4. Why are economies of scale important to the viability and profitability of financial intermediaries? Solution: Economies of scale give financial intermediaries a cost advantage over households, governments, and business firms in providing financial services. For example, if their average cost decreases as the size of the transaction increases, financial intermediaries can profitably engage in denomination intermediation. DO YOU UNDERSTAND? 1. Why do casualty insurance companies devote a greater percentage of their investments to liquid U.S. government securities than do life insurance companies? Solution: Because the timing of cash outflows at casualty insurance companies are less certain than at life insurance companies, casualty insurance companies hold a more liquid asset portfolio. U.S. Government securities have a more active secondary market than other investment securities, so they can be converted to cash quickly. 2. What are credit unions and how do they differ from a commercial bank? Solution: Credit unions are organized as mutuals; banks as stock corporations. Credit unions must be created around a "common bond," such as employee, church members, etc., rather than serving the general public as commercial banks do. Commercial banks were traditionally "commercial" lenders only, providing the need and opportunity for savings associations and credit unions to get their start. Banks moved into consumer finance after the 1930's. 3. Why have mutual funds grown so fast as compared to commercial banks? Solution: As capital market security performance increased in the last twenty years, especially equities, funds, traditionally kept in bank deposits (safety) were lured (intermediated) into mutual funds, providing individuals higher rates of return for the risk assumed. Banks, for many years, could not provide capital market opportunities for average individuals and the securities industry, who could not issue demand deposits and did not want the regulation of banking, slowly but surely transferred the flow of funds away and around the depository institutions. 4. For a consumer, what is the difference between holding a checking account at a commercial bank and holding a money market mutual fund? Solution: The major difference is the deposit insurance provided by the deposit account versus the likely higher rate of return on the MMMF. While providing liquidity, return, and low, but slightly higher risk, MMMF has attracted billions of funds from commercial banks over the last twenty years.