Download Chapter 1: ANSWERS TO DO YOU UNDERSTAND

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.