Financial Markets Week 1 Introduction
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Questions and Answers

What is the main function of financial markets?

Financial markets transfer funds from lender-savers to borrower-spenders, allowing lenders to earn interest on surplus funds and enhancing economic welfare through efficient interactions.

Which of the following are categories within the structure of financial markets?

  • Primary Market (correct)
  • Equity Market (correct)
  • Debt Market (correct)
  • Over-the-counter Market (correct)
  • Exchange Market (correct)
  • Secondary Market (correct)

What are the characteristics of the Debt Market?

Debt markets encompass short-term (maturity < 1 year), long-term (maturity > 10 years), and intermediate-term (maturity in between) debt securities. In 2009, the total value of debt securities was $52.4 trillion. If a company defaults on its debt, investors can recover up to 20% of its assets following bankruptcy.

Describe the purpose and key players of the Primary Market.

<p>The Primary market is where new securities, such as stocks and bonds, are initially sold to investors. Investment banks typically underwrite these offerings, providing liquidity and making these securities more attractive for companies to issue.</p> Signup and view all the answers

What is the Secondary Market, and provide examples?

<p>The Secondary Market, where previously issued securities are bought and sold, provides liquidity, allowing investors to quickly sell their holdings when needed. Major examples include the New York Stock Exchange (NYSE) and Nasdaq.</p> Signup and view all the answers

What role do Brokers play in the secondary market?

<p>Brokers act as intermediaries, facilitating trades between buyers and sellers without holding any inventory themselves. They execute buy and sell orders on behalf of clients, connecting them within the market.</p> Signup and view all the answers

What is the role of Dealers in the Secondary Market?

<p>Dealers directly buy and sell securities from their own inventory, providing liquidity and helping to stabilize prices for investors. They are a key factor in maintaining a smooth and efficient market.</p> Signup and view all the answers

Explain the difference between Exchange Markets and Over-the-Counter Markets.

<p>Exchange markets, like the New York Stock Exchange (NYSE) and Chicago Board of Trade (CBOT), have a centralized location where trades are conducted. In contrast, Over-the-Counter (OTC) markets are decentralized, with dealers and brokers at different locations facilitating trades.</p> Signup and view all the answers

The Treasury Securities Market is an example of an Exchange Market.

<p>False (B)</p> Signup and view all the answers

How do markets classify securities based on their maturity?

<p>Financial markets classify securities based on their maturity into Money Markets and Capital Markets. Money Markets focus on short-term instruments (maturity less than one year) and include equities, while Capital Markets cover longer-term securities (maturity exceeding one year) such as stocks and bonds.</p> Signup and view all the answers

What is the difference between foreign bonds and Eurobonds?

<p>Foreign bonds are denominated in a foreign currency and targeted at a foreign market. Eurobonds are also denominated in one currency, but are sold in a market different from the currency's origin. They may be issued in US dollars and sold in London, for example.</p> Signup and view all the answers

What is the Eurocurrency market?

<p>The Eurocurrency market is a global market for foreign currency deposits outside of their home countries. A prominent example is Eurodollars—U.S. dollars deposited in banks outside of the U.S., often in London. This market provides an alternative source of funding for U.S. borrowers.</p> Signup and view all the answers

Explain the advantage and disadvantage of emerging market countries issuing bonds in foreign currency.

<p>Issuing bonds in foreign currency like US dollars can attract a broader range of investors, potentially increasing demand and lowering borrowing costs for emerging market countries. However, this strategy also exposes them to exchange rate risk. If their local currency depreciates against the foreign currency, it becomes more expensive to repay the debt, increasing the risk of default and financial instability.</p> Signup and view all the answers

What defines Direct Finance?

<p>Direct finance involves borrowers accessing funds from lenders directly in financial markets by selling financial instruments, such as bonds or equity, which represent claims on their future income or assets.</p> Signup and view all the answers

Explain Indirect Finance and its necessity.

<p>Indirect finance involves borrowers accessing funds from lenders indirectly through financial intermediaries, such as banks, who act as go-betweens. Borrowers sell financial instruments to these intermediaries, who in turn issue their own financial instruments (like deposits) to lenders.</p> Signup and view all the answers

What is financial intermediation, and how does it benefit the economy?

<p>Financial intermediation is the process by which financial institutions facilitate the flow of funds from savers to borrowers. It involves the creation of financial instruments and markets that enable borrowers to access capital efficiently.</p> Signup and view all the answers

Explain how financial intermediaries achieve low transaction costs?

<p>Financial intermediaries achieve low transaction costs through economics of scale. They utilize a standardized contract for numerous transactions, significantly reducing the costs associated with individual transactions.</p> Signup and view all the answers

What are the key advantages of using indirect finance through financial intermediaries?

<p>Indirect finance provides key advantages: liquidity services, allowing savers to readily access their funds while also enabling borrowers to obtain long-term financing; risk sharing, reducing the impact of potential losses for individual investors by spreading risk across a diversified portfolio; and asset transformation, transforming illiquid, risky, or long-term assets into more liquid, lower-risk, or shorter-term assets suitable for investors' needs.</p> Signup and view all the answers

Define risk sharing and its significance in financial markets.

<p>Risk sharing involves financial intermediaries distributing and managing risk among different participants, ensuring that no individual bears an excessive risk burden. This process creates a more stable and balanced financial system.</p> Signup and view all the answers

What is asset transformation, and explain its impact on the economy?

<p>Asset transformation is the process by which financial intermediaries convert illiquid, high-risk, or long-term assets, like mortgages, into more liquid, low-risk, or short-term assets, like savings deposits. This transformation makes it easier for savers to access their funds while also providing borrowers with access to long-term financing.</p> Signup and view all the answers

How do banks generate profits?

<p>Banks generate profits through what is often called the 'riding the yield curve' business model. They gather deposits from customers at relatively low interest rates and then leverage these funds to lend to borrowers or purchase longer-term securities with higher interest rates, generating a spread between the two sides.</p> Signup and view all the answers

Explain how financial intermediaries create asset diversification.

<p>Financial intermediaries pool funds from multiple investors and invest in a diversified range of assets across different sectors and industries. This diversification reduces the risk of a single investment performing poorly, lowering individual investors' overall risk exposure.</p> Signup and view all the answers

Which of the following are types of asymmetric information problems?

<p>Moral Hazard (C), Adverse Selection (D)</p> Signup and view all the answers

What is adverse selection, and provide an example.

<p>Adverse selection is an asymmetric information problem that occurs before a transaction. It arises because those most likely to benefit from a transaction are also the most likely to seek it out, creating a situation where the party with less information faces a higher risk.</p> Signup and view all the answers

What is moral hazard, and provide an example.

<p>Moral hazard is an asymmetric information problem that occurs after a transaction. It occurs when one party to a transaction changes their behavior in a way that is harmful to the other party, knowing that they are protected by the transaction.</p> Signup and view all the answers

What is the Diamond-Dybvig Model, and why did it win the Nobel Prize in Economics?

<p>The Diamond-Dybvig Model is a theoretical model that explains how banks and financial institutions can create social welfare by resolving liquidity issues and mitigating moral hazard concerns.</p> Signup and view all the answers

What are the key assumptions of the Diamond-Dybvig Model?

<p>Long-term investment return tomorrow = R &gt; 1 (A), The utility of impatient investors receiving money tomorrow is very small (B), The bank had to make investment choices yesterday (C), Players: Depositors and a bank (D), Two investment opportunities for the bank (E), If the long-term investment is liquidated today, the return = L &lt; 1 (F), The utility of patient investors receiving money today is high (G), Short-term investment return = 1 (H), Depositors placed money in the bank yesterday (I), Depositors have a probability 'p' of needing the money today and 'q' of needing it tomorrow (J), Bank invests in a short-term investment (reserves) and a long-term investment (illiquid) (K), Three points in time (yesterday, today, tomorrow) (L)</p> Signup and view all the answers

Which of the following are types of financial intermediaries?

<p>Investment Intermediaries (B), Depository Institutions (I), Contractual Savings Institutions (J)</p> Signup and view all the answers

Which of the following are examples of depository institutions?

<p>Commercial Banks (D), Savings and Loan Associations (E), Mutual Savings Banks (A), Credit Unions (B)</p> Signup and view all the answers

What is the primary function of depository institutions?

<p>Depository institutions accept deposits from individuals and businesses and then use these funds to make loans to other individuals and businesses.</p> Signup and view all the answers

Which of the following are types of contractual savings institutions?

<p>Fire and Casualty Insurance Companies (A), Government Retirement Funds (B), Pension Funds (C), Life Insurance Companies (E)</p> Signup and view all the answers

What is the characteristic behavior of contractual savings institutions?

<p>Contractual savings institutions collect funds from clients on a regular basis, based on contracts that specify future payouts. This allows them to invest in longer-term assets and guarantee payouts to their policyholders or beneficiaries.</p> Signup and view all the answers

Which of the following are examples of investment intermediaries?

<p>Mutual Funds (A), Money Market Mutual Funds (D), Finance Companies (E)</p> Signup and view all the answers

Which type of financial intermediary is the largest and has the most diversified asset portfolios?

<p>Commercial banks are the largest financial intermediaries and hold the most diversified portfolios of assets, making them essential players in the financial system.</p> Signup and view all the answers

What are ‘thrifts’?

<p>Thrifts are a collective term for savings and loan associations, mutual savings banks, and credit unions.</p> Signup and view all the answers

How do Mutual Savings Banks and Credit Unions differ in how they issue deposits?

<p>Unlike commercial banks, Mutual Savings Banks and Credit Unions issue deposits as shares owned by their depositors. This means depositors have a stake in the institution and can vote on decisions relating to its operation. Credit unions are often further restricted by their member base, usually people associated with specific groups.</p> Signup and view all the answers

Why can life insurance companies invest in less liquid assets such as corporate securities and mortgages?

<p>Life insurance companies can invest in less liquid assets due to their predictable payouts based on actuarial analysis, which estimates the timing and magnitude of future claims based on the probability of death among their policyholders.</p> Signup and view all the answers

Why should fire and casualty insurance companies invest in more liquid government and corporate securities?

<p>Fire and casualty insurance companies face a higher degree of uncertainty regarding the timing and magnitude of their future payouts. They need liquid assets to quickly meet obligations when unforeseen events occur.</p> Signup and view all the answers

What is the primary function of finance companies?

<p>Finance companies raise funds through the issuance of commercial paper, bonds, and stocks. They then use these funds to provide loans to consumers for durable goods purchases and to small businesses for operational financing.</p> Signup and view all the answers

What is the purpose of mutual funds?

<p>Mutual funds pool money from individual investors, primarily through retirement accounts. They then use these funds to construct a large, diversified portfolio of stocks and bonds, aiming to generate a return for their investors.</p> Signup and view all the answers

What are hedge funds, and what distinguishes them from mutual funds?

<p>Hedge funds are similar to mutual funds but have fewer regulations and typically take on greater risk. They often have higher minimum investment amounts (e.g., $100,000) and are only accessible to high-net-worth individuals or institutions.</p> Signup and view all the answers

What specific limitation do money market mutual funds have?

<p>Money market mutual funds are restricted to investing in highly liquid, short-term debt assets. This limits their risk exposure and is designed to make them relatively safe investment options.</p> Signup and view all the answers

What are the primary reasons governments regulate financial markets?

<p>Increase information to investors (C), Ensure the soundness of financial intermediaries (D)</p> Signup and view all the answers

Which of the following are prominent regulatory agencies in the US?

<p>Federal Reserve System (Fed) (B), Office of the Comptroller of the Currency (OCC) (C), Securities and Exchange Commission (SEC) (D), Federal Deposit Insurance Corporation (FDIC) (E)</p> Signup and view all the answers

What are the main objectives of the Securities and Exchange Commission (SEC)?

<p>The SEC regulates organized exchanges and financial markets in the US. Its objectives include promoting transparency through information disclosure, preventing insider trading, and protecting investors from fraud.</p> Signup and view all the answers

What does the Office of the Comptroller of the Currency (OCC) regulate, and what are its responsibilities?

<p>The OCC charters and examines the books of federally chartered commercial banks and thrift institutions. It imposes restrictions on the assets they can hold and ensures their adherence to regulatory standards.</p> Signup and view all the answers

What is the purpose of the Federal Deposit Insurance Corporation (FDIC), and what services does it provide?

<p>The FDIC provides insurance of up to $250,000 for each depositor at an insured bank. It also examines the books of insured institutions and imposes restrictions on their asset holdings, working to maintain financial stability.</p> Signup and view all the answers

What is the primary regulatory role of the Federal Reserve System (Fed)?

<p>The Fed regulates all depository institutions, including commercial banks. It examines the books of commercial banks that are members of the system, sets reserve requirements, and plays a central role in monetary policy.</p> Signup and view all the answers

What are the six primary types of regulations implemented to protect stakeholders from financial panics?

<p>Restrictions on Entry (A), Deposit Insurance (B), Limits on Competition (E), Disclosure Requirements (F), Restrictions on Assets and Activities (H), Restrictions on Interest Rates (I)</p> Signup and view all the answers

What empirical evidence exists concerning the role of financial intermediaries during a financial crisis?

<p>Empirical evidence suggests that bank lending often decreases during financial crises, particularly impacting financially constrained firms. These firms are disproportionately affected by a crisis, as banks often tighten lending standards, leading to a decrease in credit supply.</p> Signup and view all the answers

Flashcards

What is financial intermediation?

The process by which financial institutions act as intermediaries between individuals or entities with excess funds (savers) and those who need funds (borrowers).

What is risk sharing?

The process by which financial intermediaries distribute and manage risk among different participants, ensuring that no single party bears excessive risk.

What is asset transformation?

Financial intermediaries sell illiquid, risky, or long-term assets (e.g., mortgages) to a party in order to buy more liquid, lower-risk, or short-term assets (e.g., savings deposits). This transformation allows savers to access their funds while enabling borrowers to receive long-term financing.

What is financial intermediation?

The process by which financial intermediaries act as intermediaries between individuals or entities with excess funds (savers) and those who need funds (borrowers).

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What is Direct Finance?

Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower's future income or assets.

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What is Indirect Finance?

Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower's future income or assets.

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What is Adverse Selection?

Before transaction occurs, potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan because banks cannot observe whos more high risk. Similar problems occur with insurance where unhealthy people want their known medical problems covered.

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What is Moral Hazard?

After transaction occurs, the hazard that the borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back. Again, with insurance, people may engage in risky activities only after being insured.

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What is a secondary market?

The market where securities previously issued are bought and sold. Examples include the NYSE and Nasdaq.

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What is a primary market?

The market where new security issues are sold to initial buyers.

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What do Dealers do?

Facilitate trading by buying and selling securities from their own inventory, providing liquidity and helping stabilize prices for investors.

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What do Brokers do?

Act as intermediaries who execute buy and sell orders on behalf of clients, connecting buyers and sellers without holding inventory themselves.

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What are Exchange markets?

The market where trades are conducted in central locations (e.g., New York Stock Exchange, CBOT).

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What are Over-the-counter markets?

Dealers & Brokers at different locations buy and sell. Often used for customized or less standardized securities. Less regulated and more flexible compared to exchange markets.

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What is the Money Market?

Short-Term (maturity < 1 year) plus equities

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What are the characteristics of the Long-Term Debt Market?

Long-Term (maturity > 10 year)

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What are the characteristics of the Short-Term Debt Market?

Short-Term (maturity < 1 year)

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What are Eurobonds?

Denominated in a foreign currency, but sold in a different market. Over 80% of new bonds are this type of bond.

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What are foreign bonds?

Denominated in a foreign currency, targeted at a foreign market.

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What is the Eurocurrency market?

Foreign currency deposited outside of home country. Eurodollars are U.S. dollars deposited in, say, London. Gives U.S. borrowers an alternative source for dollars.

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What do depository institutions do?

Accept deposits and make loans.

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What are some depository institutions?

Commercial banks, savings and loan associations, mutual savings banks, credit unions.

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What do contractual savings institutions do?

They require funds from clients at periodic intervals on a contract, predictable future payout requirement (when they have to give bank the money to the customer

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What are some types of contractual savings institutions?

Life insurance companies, fire and casualty insurance companies, pension funds, government retirement funds.

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What are some investment intermediaries?

Finance companies, mutual funds, money market mutual funds.

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What do mutual funds do?

Mutual funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds.

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What are Hedge Funds?

Less regulation, quite risky, very high minimum investment amount i.e. $100,000

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Study Notes

Financial Markets: Week 1 Introduction

  • Core Function: Transfer funds from lenders (savers) to borrowers (spenders), enhancing economic welfare through efficient interactions. Lenders earn interest on surplus funds.

Market Structure

  • Debt Market: Includes short-term (under 1 year), long-term (over 10 years), and intermediate-term securities; valued at $52.4 trillion in late 2009. In case of bankruptcy, debt holders are prioritized.

  • Equity Market: Represents ownership claims in firms; dividends are paid, although not guaranteed; issues total of $20.5 trillion in value (late 2009). Shareholders have less priority in bankruptcy than debt holders.

  • Primary Market: New securities are issued to initial buyers; often facilitated by investment banks. This increases liquidity and attractiveness for issuing companies to access capital markets.

  • Secondary Market: Existing securities are bought and sold; includes exchanges (e.g., NYSE, Nasdaq) and over-the-counter markets. Brokers and dealers play key roles in facilitating these transactions.

  • Dealers: Facilitate trading by holding securities in inventory, providing liquidity, and stabilizing prices.

  • Brokers: Act as intermediaries, executing buy/sell orders without holding inventory.

  • Exchange Markets: Securities are traded in central locations.

  • Over-the-Counter (OTC) Markets: Decentralized markets for less standardized securities; less regulated than exchange markets, prevalent in Treasury Securities. Differences between exchanges and OTC markets are becoming smaller.

  • Money Market: Focuses on short-term securities (maturity < 1 year).

  • Foreign Bonds: Issued in a foreign country, but denominated in a foreign currency.

  • Eurobonds: Issued in one currency, but sold in another market; larger than the US corporate bond market.

  • Eurocurrency Market: Foreign currency deposited outside the issuing country; Eurodollars are a prominent example.

  • Emerging Market Bond Issues: Can increase demand in foreign currency, if issuers choose USD, for example.

  • Risk of Foreign Currency Borrowing: Increased exchange rate risk arising from local currency depreciation. Increased cost of debt repayment, potential for default leading to financial issues.

Direct vs. Indirect Finance

  • Direct Finance: Borrowers borrow directly from lenders in financial markets by selling financial instruments.

  • Indirect Finance: Borrowers borrow indirectly from lenders through financial intermediaries. Intermediaries source loanable funds and opportunities. Needed to deal with transaction costs, risk sharing, and asymmetric information.

Financial Intermediation

  • Process: Matching funds from savers and borrowers through financial institutions.

Financial Intermediary Advantages

  • Low Transactions Costs: Economies of scale, uniform contracts.

  • Risk Sharing: Financial intermediaries pool risk among participants, reducing individual risk.

  • Asset Transformation: Converting illiquid assets into liquid assets, enabling access to funds and facilitating long-term borrowing.

Banks' Profitability

  • Yield Curve Strategy: Banks accept short-term deposits (lower yields) to finance longer-term loans with higher returns.

Financial Intermediary Diversification

  • Asset Diversification: Pooling numerous investors' funds to purchase a variety of assets (stocks and bonds), reducing overall investment risk.

Asymmetric Information

  • Adverse Selection: Before a transaction occurs; potential borrowers with higher risk are more likely to seek loans; financial institutions cannot always observe borrower risk.

  • Moral Hazard: After a transaction occurs; borrowers may engage in riskier behavior once they have a loan; incentives for default.

Diamond-Dybvig Model

  • Theoretical framework highlighting moral hazard and liquidity concerns in financial markets. Bank runs are an example of liquidity risk.

Financial Intermediary Types

  • Depository Institutions (Banks): Commercial banks, savings & loans, mutual savings banks, credit unions

  • Contractual Savings Institutions: Life insurance companies, fire/casualty insurance companies, pension funds

  • Investment Intermediaries: Finance companies, mutual funds, money market mutual funds.

Financial Market Regulation

  • Goal: Increase information, ensure financial stability, and prevent financial crises.
  • Includes regulations on entry, disclosure, assets, activities, deposit insurance, competition, and interest rates.

Regulatory Agencies

  • Securities and Exchange Commission (SEC): Regulates exchanges, information disclosure, trading restrictions,

  • Office of the Comptroller of the Currency (OCC): Regulates federally chartered banks.

  • Federal Deposit Insurance Corporation (FDIC): Insures deposits, examines banks, controls assets.

  • Federal Reserve System: Regulates member commercial banks and sets reserve requirements

Empirical Evidence on Financial Crises

  • During financial downturns, banks decrease lending to financially constrained firms.

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Explore the core functions and structures of financial markets in this Week 1 introduction. Learn about the debt and equity markets, the primary and secondary markets, and their roles in transferring funds and enhancing economic welfare. This quiz will provide you with a foundational understanding of market dynamics.

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