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Questions and Answers
What is one of the primary functions of financial markets?
What is one of the primary functions of financial markets?
What do financial markets help to mobilize?
What do financial markets help to mobilize?
How do funds primarily flow from lenders to borrowers in financial markets?
How do funds primarily flow from lenders to borrowers in financial markets?
Which of the following instruments is primarily traded in the money market?
Which of the following instruments is primarily traded in the money market?
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Which of the following statements is inaccurate regarding financial markets?
Which of the following statements is inaccurate regarding financial markets?
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Who are considered the principal lender-savers in a financial system?
Who are considered the principal lender-savers in a financial system?
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Which type of financial market involves short-term, highly marketable debt securities?
Which type of financial market involves short-term, highly marketable debt securities?
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Which financial instrument represents a claim on the borrower's future income or assets?
Which financial instrument represents a claim on the borrower's future income or assets?
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What is the primary purpose of government regulation in financial markets?
What is the primary purpose of government regulation in financial markets?
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What does moral hazard refer to?
What does moral hazard refer to?
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Which term describes the issue where one party in a negotiation has more relevant information than the other?
Which term describes the issue where one party in a negotiation has more relevant information than the other?
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Which of the following contributes to moral hazard in financial markets?
Which of the following contributes to moral hazard in financial markets?
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How does government regulation aim to enhance market efficiency?
How does government regulation aim to enhance market efficiency?
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What main aspect does the financial system encompass?
What main aspect does the financial system encompass?
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Why is asymmetric information detrimental in financial markets?
Why is asymmetric information detrimental in financial markets?
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What role do financial markets mainly serve in an economy?
What role do financial markets mainly serve in an economy?
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What is a banker’s acceptance?
What is a banker’s acceptance?
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Which of the following accurately describes the primary market?
Which of the following accurately describes the primary market?
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Which characteristic is true about corporate bonds?
Which characteristic is true about corporate bonds?
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What does financial intermediation primarily involve?
What does financial intermediation primarily involve?
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What is the role of risk pooling in financial intermediation?
What is the role of risk pooling in financial intermediation?
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Which of the following defines equity securities?
Which of the following defines equity securities?
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What is disintermediation in financial markets?
What is disintermediation in financial markets?
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How do financial assets derive their value?
How do financial assets derive their value?
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Study Notes
The Financial System
- Set of frameworks, institutions, and players facilitating financial transactions in an economy.
- Includes financial markets, institutions, economic agents, legal/regulatory frameworks, and transaction execution systems.
Regulation of the Financial System
- Heavily regulated due to its crucial role in economic health.
- Government regulation aims to:
- Increase information available to investors.
- Ensure the safety and soundness of the financial system.
Increasing Information Available to Investors
- Asymmetric information in markets can lead to adverse selection and moral hazard, hindering efficiency.
- Risky firms may exploit investors, leading to adverse selection and discouraging investment.
- Borrowers may engage in risky activities or fraud due to moral hazard.
Moral Hazard
- Occurs when a party takes risks knowing they are protected from consequences.
- Motivated by the desire for profits or lack of information about potential losses.
Adverse Selection
- Occurs when one party has more information than the other, leading to skewed decisions.
- Can result in businesses focusing on riskier or less profitable segments due to information asymmetry.
Functions of Financial Markets
- Price Determination: Market forces (demand and supply) determine prices for newly issued and existing financial assets.
- Funds Mobilization: Markets facilitate the mobilization of investors' savings.
- Liquidity: Investors can easily convert securities into cash, providing liquidity.
- Risk Sharing: Financial markets transfer investment risks from those who undertake them to those who provide funds.
- Easy Access: Platforms connect buyers and sellers efficiently, saving time and money.
- Reduced Transaction Costs and Information Provision: Markets provide readily available information to traders.
- Capital Formation: New savings flow into the country, supporting capital formation.
Flow of Funds in a Financial System
- Lender-savers: Primarily households, but can include firms and governments with excess funds.
- Borrower-spenders: Typically businesses and governments, but households can also participate.
- Direct Finance: Borrowers sell securities to lenders in financial markets, creating claims on future income or assets.
Types of Financial Markets
- Money and Capital Markets: Distinguished based on maturity of instruments (short-term vs. long-term).
- Primary and Secondary Markets: Primary markets deal with first-time issuance of securities, while secondary markets handle subsequent trading.
- Debt and Equity Markets: Debt markets involve borrowing and lending of money (bonds), while equity markets represent ownership stakes (stocks).
- Exchanges and Over-the-Counter Markets: Exchanges provide centralized trading platforms, while over-the-counter markets involve direct transactions between parties.
- Internationalization of Financial Markets: Growing interconnectedness and globalization of financial markets.
Money Markets
- Handle short-term, highly marketable debt securities.
- Instruments typically traded in large denominations, not suitable for individual investors.
- Treasury bills: Highly marketable, short-term government debt.
- Certificates of deposit: Time deposits with banks, paying interest and principal upon maturity.
- Commercial paper: Short-term unsecured debt notes issued by large corporations.
- Eurocurrency: Foreign currency deposits held in local banks (e.g., Eurodollar deposit).
- Bankers' acceptances: Order to a bank to pay a sum at a future date, similar to a postdated check.
Capital Markets
- Deal with long-term debt and equity securities for long-term financing needs.
- Treasury (Government) bonds: Issued by governments to borrow from the public.
- Eurobonds: Bonds issued in foreign currency.
- Corporate bonds: Issued by companies to raise debt finance, can be unsecured (debentures), secured, callable or convertible.
Primary and Secondary Markets
- Primary Market: Market for new, first-time issuance of financial securities.
- Secondary Market: Market for subsequent trading of existing securities, providing liquidity and supporting primary market operations.
Financial Intermediation
- Intermediation: Financial transactions facilitated by intermediaries (banks, dealers).
- Disintermediation: Transactions directly between parties bypassing intermediaries.
Main Functions of Intermediaries
- Bringing together savers and borrowers: Provide liquidity.
- Risk Pooling and Reduction: Pooling assets and reducing risk through diversification.
- Repackaging Finance: Transform financial instruments to meet specific needs.
- Maturity Transformation: Convert short-term liabilities into long-term assets.
- Efficient Allocation of Information: Provide information and expertise to market participants.
- Provide Clearing Houses: Settle trades efficiently.
Financial Assets
- Financial assets: Claims on income or ownership of real assets.
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Fixed Income Securities (Debt securities): Provide periodic income payments at fixed rates.
- Short-term debt securities: Money market instruments.
- Long-term debt securities: Capital market instruments.
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Equity Securities: Represent ownership stake in a business.
- Value fluctuates with firm performance.
- Riskier than debt securities.
- Residual claim on income and assets.
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