Section (4)

Chapter (2), Overview of the Financial System

1. Distinguish between direct financing and indirect financing?

Direct Financing

 Definition: In direct financing, borrowers obtain funds directly from lenders by selling
them financial instruments, such as securities.
 Participants: This method involves individual lenders (savers) and individual borrowers
(spenders).
 Mechanism: Borrowers issue securities (like stocks or bonds) to lenders. For example, a
corporation might issue bonds to raise funds, and investors buy these bonds directly.
 Ownership of Claims: The lender becomes a direct owner of the financial asset,
receiving interest or dividends directly from the borrower.
 Examples: A company selling bonds or shares directly to investors; a government issuing
treasury bonds.

Indirect Financing

 Definition: In indirect financing, financial intermediaries (such as banks or credit unions)

facilitate the flow of funds from savers to borrowers.
 Participants: This method involves savers depositing their funds with financial
intermediaries, which then lend the funds to borrowers.
 Mechanism: The intermediary collects funds from savers and then uses those funds to
provide loans to borrowers. The intermediary earns a profit by charging borrowers a
higher interest rate than what they pay to savers.
 Ownership of Claims: Savers typically do not have direct claims on the borrowers;
instead, they have a claim on the financial intermediary.
 Examples: A bank taking deposits and then lending those funds to individuals for
mortgages or to businesses for expansion.

Summary

 Direct Financing involves a direct transaction between savers and borrowers through
securities, while Indirect Financing relies on intermediaries to facilitate lending and
borrowing.
 Both methods play crucial roles in the financial system, allowing for efficient capital
allocation and access to funds for various economic activities.

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 2. Why is it so important for an economy to have fully developed
financial markets?
1. Efficient Allocation of Resources
Financial markets facilitate the movement of funds from savers (lender-savers) to
borrowers (borrower-spenders), enabling resources to be allocated to their most
productive uses. This promotes economic efficiency as funds are channeled to
those who can use them effectively, such as entrepreneurs and businesses with
profitable investment opportunities.
2. Access to Capital
Developed financial markets provide individuals and businesses with access to
capital that they might not have otherwise. For example, young families can secure
loans to purchase homes, and businesses can obtain financing for expansion,
enabling economic growth and improved living standards.
3. Encouraging Savings and Investment
A well-functioning financial market encourages savings by offering individuals a
safe place to invest their surplus funds and earn returns. This, in turn, increases the
pool of capital available for investment in various sectors of the economy.
4. Risk Management
Financial markets offer instruments that allow individuals and businesses to
manage risks. For instance, insurance products and derivatives can help mitigate
potential losses from unforeseen events, providing stability to the economy.
5. Facilitating Trade and Economic Growth
By providing mechanisms for borrowing and lending, financial markets facilitate
trade. They enable businesses to operate on credit, invest in new ventures, and
expand operations, contributing to overall economic growth.
6. Improving Consumer Welfare
Developed financial markets improve consumer welfare by allowing individuals to
time their purchases better. For instance, consumers can obtain loans for significant
purchases, like homes or cars, without having to wait to save the entire amount,
thus enhancing their quality of life.
7. Economic Stability
When financial markets are functioning well, they can absorb shocks and
contribute to economic stability. Conversely, when these markets break down, as

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seen in financial crises, they can lead to severe economic hardships and political
instability.
8. Information Efficiency
Financial markets aggregate information about investments, helping to determine
prices and inform investors. This transparency allows for more informed decision-
making, promoting trust and participation in the financial system.

3. Distinguish between primary markets and secondary markets?

Primary Markets

 Definition: The primary market is where new issues of securities (stocks,

bonds, etc.) are sold for the first time to initial buyers directly by the issuing
entity, such as a corporation or government agency.
 Function: In primary markets, the issuing entity raises funds by selling
securities. This is where the capital is generated for the issuer.
 Participants: The main participants include the issuing corporations or
governments and the investors (individuals or institutions) buying the newly
issued securities. Investment banks often facilitate these transactions by
underwriting the securities.
 Characteristics:
o New Issues: Securities are sold for the first time.
o Funds to Issuer: The issuer receives the proceeds from the sale.
o Less Public Visibility: Transactions often occur behind closed doors
and may not be widely known to the public.
o Pricing: The price of securities is often set by the underwriting
process and influenced by the expected demand.
 Examples: Initial public offerings (IPOs) of stocks, corporate bond
issuances, and government bond offerings.

Secondary Markets

 Definition: The secondary market is where previously issued securities are

bought and sold among investors, allowing them to trade securities that are
already outstanding.
 Function: In the secondary market, securities change hands but the issuing
corporation does not receive any new funds from these transactions. Instead,
it provides liquidity to investors, allowing them to sell their holdings.
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  Participants: The main participants include individual and institutional
investors, brokers, and dealers. Brokers act as intermediaries to match
buyers and sellers, while dealers buy and sell securities at stated prices.
 Characteristics:
o Resale of Existing Securities: Securities that have been previously
issued are traded.
o No New Funds to Issuer: The issuer does not receive any money
from sales in the secondary market.
o Greater Visibility: Transactions are typically public and widely
reported, making them more known to investors and the market.
o Price Discovery: The secondary market helps determine the price of
securities, which influences the pricing of new issues in the primary
market.
 Examples: The New York Stock Exchange (NYSE), NASDAQ, bond
markets, foreign exchange markets, and options markets.

4. Distinguish between money markets and capital markets?

1. Maturity of Securities

 Money Markets:
o Focus on short-term debt instruments with original maturities of less
than one year.
o Common instruments include Treasury bills, commercial paper, and
certificates of deposit.
 Capital Markets:

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 o Deal with longer-term debt instruments (original maturity of one year
or more) and equity instruments.
o Examples include stocks, corporate bonds, and government bonds.

2. Liquidity

 Money Markets:
o Typically have higher liquidity due to the frequent trading of short-
term securities.
o Investors can easily convert their investments into cash without
significant price fluctuations.
 Capital Markets:
o Generally less liquid than money markets. While stocks can be traded
easily, longer-term bonds may not have the same level of liquidity.
o Price fluctuations can be more pronounced due to longer maturities
and varying market conditions.

3. Risk and Return

 Money Markets:
o Considered safer investments because they have smaller price
fluctuations and shorter maturities.
o Yield is generally lower compared to capital markets due to reduced
risk.
 Capital Markets:
o Involve greater risk as they include longer-term investments that are
subject to market volatility.
o Potential for higher returns, which attracts investors willing to take on
more risk for the possibility of greater rewards.

4. Participants

 Money Markets:
o Commonly used by corporations, banks, and governments to manage
short-term funding needs and invest surplus funds temporarily.
 Capital Markets:
o Attract a broader range of participants, including individual investors,
institutional investors (like insurance companies and pension funds),
and corporations looking to raise long-term capital.

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 5. What are some of the differences between an organized
exchange and an over-the-counter market?

1. Structure

 Organized Exchange:
o Has a central physical location (like a trading floor) where buyers and
sellers meet.
o Examples: New York Stock Exchange (NYSE), American Stock
Exchange (AMEX).
 Over-the-Counter Market:
o Operates without a central location. Dealers trade directly with each
other through electronic networks.

2. Trading Method

 Organized Exchange:
o Trades happen in a structured environment with clear rules.
o Prices are set through an order book where buy and sell orders are
matched.
 Over-the-Counter Market:
o Trades are done by dealers who quote prices based on what they have
in stock.
o Prices can vary between dealers.

3. Types of Securities

 Organized Exchange:
o Mainly trades stocks of larger companies that meet certain standards.
 Over-the-Counter Market:
o Trades a wider variety of securities, including smaller companies and
government bonds.

4. Liquidity

 Organized Exchange:
o Generally has higher liquidity (easier to buy and sell quickly) because
many buyers and sellers are involved.
 Over-the-Counter Market:

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 o Liquidity can be lower, and some securities may be harder to buy or
sell quickly.

5. Regulation

 Organized Exchange:
o Heavily regulated by government agencies to protect investors.
 Over-the-Counter Market:
o Faces less regulation, which can mean more risks for investors.

6. Price Transparency

 Organized Exchange:
o Prices are publicly available and updated in real-time, making it easy
to see what others are paying.
 Over-the-Counter Market:
o Prices may not be as clear. Investors often need to check with multiple
dealers to get a good sense of pricing.

Summary

In short, organized exchanges offer a more structured and regulated environment

for trading, primarily for larger companies, while OTC markets provide more
flexibility and access to a wider range of securities, albeit with less transparency
and regulation.

6. Why do corporations that issue new securities to raise capital

now conduct more of this business in financial markets in Europe
and Asia than in the United States?

1. Emerging Market Growth

 European and Asian markets have experienced significant growth, making

them attractive options for companies looking to raise capital. This growth is
driven by increased savings and investments in these regions.

2. Access to International Investors

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  By tapping into European and Asian markets, corporations can access a
broader base of international investors. This increases the potential for
raising larger amounts of capital and diversifies the sources of investment.

3. Currency Considerations

 Issuing securities in foreign markets allows companies to denominate their

securities in different currencies. This can be beneficial for managing
foreign exchange risks and aligning their capital structure with their global
operations.

4. Competition and Pricing

 The competitive nature of these markets may lead to more favorable pricing
for securities. Companies might find that they can issue bonds or stocks at
lower interest rates or better terms compared to the U.S. market.

5. Market Trends and Investor Preferences

 There is a growing interest among global investors in diversifying their

portfolios with international assets. This trend encourages corporations to
seek capital in markets that align with investor preferences.

6. Strategic Globalization

 As businesses expand globally, they often need to raise funds in the regions
where they plan to invest or operate. Issuing securities in European and
Asian markets aligns funding with their strategic initiatives and local market
conditions.

7. What are some of the major foreign stock exchanges? Is

following their returns important to U.S. investors? Why or why
not?

Financial intermediaries are crucial to an economy because they facilitate the

efficient flow of funds from savers to borrowers, which supports productive
investment and economic growth. Here’s why they’re so important:

1. Reducing Transaction Costs: Financial intermediaries, such as banks, have

the expertise and economies of scale to minimize transaction costs. This

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 reduction enables them to lend money more cost-effectively than individual
lenders could. By reducing these costs, intermediaries make it possible for
small savers to contribute funds to productive investments without the
burdensome expenses they would face on their own.
2. Providing Liquidity Services: Financial intermediaries offer liquidity
services that make transactions easier for customers. For instance, banks
allow depositors to use checking accounts to pay bills or withdraw funds
easily, maintaining access to their savings while also earning interest. This
liquidity is essential for individuals and businesses, allowing them to meet
short-term financial needs without selling long-term investments.
3. Risk Sharing: By pooling resources and offering diversified financial
products, intermediaries reduce the risk exposure of individual investors.
Through risk-sharing mechanisms, such as asset transformation and
diversification, intermediaries turn riskier investments into safer products for
customers. This enables people to invest with greater confidence and helps
spread financial risks more broadly across the economy.
4. Solving Information Asymmetries (Adverse Selection and Moral
Hazard): Financial intermediaries address information-related issues by
screening potential borrowers and monitoring their activities. They help
reduce adverse selection (the risk of lending to bad borrowers) by using their
expertise to distinguish between high- and low-risk applicants. They also
mitigate moral hazard (the risk of borrowers taking excessive risks after
receiving funds) by monitoring loan recipients. This ensures that funds are
directed toward productive uses, boosting economic efficiency.
5. Improving Economic Efficiency: By effectively channeling funds from
those who save to those with investment opportunities, financial
intermediaries foster economic growth. They ensure that available resources
are allocated to investments that yield the highest returns, which is critical
for an economy to reach its full potential.

8. What are adverse selection and moral hazard?

Adverse selection and moral hazard are two problems in financial markets that
arise due to asymmetric information—when one party in a financial transaction has
more or better information than the other. Here’s a breakdown of each:
Adverse Selection
Adverse selection occurs before a financial transaction takes place. It refers to a
situation where those who are most likely to produce an undesirable outcome, such
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as being a bad credit risk, are the ones who are more actively seeking loans or
insurance. For instance, riskier borrowers might be more motivated to apply for
loans than safer ones. This makes it challenging for lenders to distinguish between
good and bad risks, potentially leading them to lend to high-risk individuals or
deny credit altogether. This misallocation occurs because the lender lacks full
knowledge of the borrower’s risk level beforehand.
Moral Hazard
Moral hazard arises after the transaction has occurred. It is the risk that the
borrower will engage in behaviors that are undesirable from the lender’s
perspective, making it less likely that the loan will be repaid. For example, once a
loan is given, a borrower may take on additional risk, such as using the loaned
funds for speculative investments instead of the agreed-upon purpose, because they
no longer bear the full consequences of those risks. This creates a conflict of
interest, where the borrower might prioritize personal gain over the lender’s
security.
In essence, adverse selection deals with hidden information before an agreement,
while moral hazard involves risky behavior after an agreement. Both issues can
lead to inefficiencies in financial markets, making it hard for lenders and investors
to trust they will be fairly compensated or protected. Financial intermediaries, like
banks, help mitigate these problems by screening potential clients (reducing
adverse selection) and monitoring their behavior after lending (reducing moral
hazard).

9. Why can a financial intermediary's risk-sharing activities be

described as asset transformation?

A financial intermediary's risk-sharing activities can be described as "asset

transformation" because it involves the intermediary creating assets with different
risk characteristics that appeal to investors. This transformation process allows
intermediaries to convert high-risk assets into safer, more stable assets for lenders,
effectively catering to investors' preferences for lower-risk investments.

For example, banks and other financial institutions might pool a large number of
loans or investments, some of which carry high risk, and then use this pooled set of
assets to back the issuance of lower-risk, more predictable securities for their

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customers. These securities, such as savings accounts or low-risk investment funds,
offer a more stable return and are more likely to be redeemed at face value. By
doing so, financial intermediaries allow investors to participate in lending activities
or invest in broader markets without directly bearing the risk associated with each
individual loan or security.

This "transformation" enables a process where the financial intermediary takes on

the riskier side of the asset by holding or managing the underlying loans or
investments. Meanwhile, investors receive a transformed, safer asset, benefiting
from steady returns and liquidity. This activity is fundamental to the intermediary's
role in the financial system, as it promotes risk-sharing, increases investment in the
economy, and facilitates capital flow from lenders to borrowers.

10. Discuss the differences between depository institutions,

contractual savings institutions, and investment intermediaries.

Depository institutions, contractual savings institutions, and investment

intermediaries each serve distinct roles in the financial system, differing in their
primary sources of funds, asset allocations, and functions.

1. Depository Institutions:
o Examples: Commercial banks, savings and loan associations, mutual
savings banks, and credit unions.
o Sources of Funds: Depository institutions mainly acquire funds
through deposits, which can include checkable deposits (allowing
checks to be written), savings deposits (payable on demand), and time
deposits (with a fixed maturity).
o Uses of Funds: These institutions primarily make loans (such as
commercial, consumer, and mortgage loans) and invest in securities
like government and municipal bonds. Their activities involve holding
liquid assets to meet potential withdrawals.
o Function: Depository institutions act as traditional banks, taking
deposits and providing loans, thereby facilitating liquidity and
transactional services for their clients.
2. Contractual Savings Institutions:
o Examples: Life insurance companies, fire and casualty insurance
companies, and pension funds.
o Sources of Funds: These institutions collect funds on a contractual
basis, meaning they receive periodic payments from policyholders or

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 contributions from employers and employees. Since they have
predictable future payouts, they face less risk of rapid withdrawal.
o Uses of Funds: Contractual savings institutions invest in long-term
assets, such as corporate bonds, stocks, and mortgages. Life insurance
companies, for example, invest primarily in bonds and mortgages,
while pension funds invest heavily in corporate bonds and stocks.
o Function: They provide long-term financial products, such as life
insurance or retirement income, and invest in longer-term securities,
leveraging their ability to hold less-liquid assets due to predictable
payout obligations.
3. Investment Intermediaries:
o Examples: Finance companies, mutual funds, money market mutual
funds, and investment banks.
o Sources of Funds: Investment intermediaries raise funds through
various channels, like selling commercial paper (short-term debt),
issuing stocks and bonds, or selling shares in mutual funds.
o Uses of Funds: Investment intermediaries channel these funds into
loans to consumers and businesses, or into diversified portfolios of
stocks, bonds, and money market instruments. For instance, finance
companies lend to consumers and small businesses, while mutual
funds invest in diversified portfolios, and money market funds hold
very liquid instruments.
o Function: Investment intermediaries offer investors access to
diversified investment portfolios or loans and help reduce transaction
costs through pooled resources. They also enable investors to
participate in financial markets with greater liquidity and flexibility.

In summary, while depository institutions focus on taking deposits and making

loans, contractual savings institutions provide long-term investment and
insurance products, and investment intermediaries facilitate investment and
borrowing by offering diversified portfolios or financing options. Each category
serves a unique purpose, helping to meet the varied needs of borrowers and
investors within the financial system.

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 11. List some of the regulatory agencies of the U.S. and their
primary role.

The U.S. financial system has multiple regulatory agencies responsible for
ensuring its stability and protecting investors. Here are some key agencies and their
primary roles:

1. Securities and Exchange Commission (SEC):

o Role: Oversees securities markets by requiring companies that issue
securities to disclose financial information and by preventing insider
trading. The SEC was created in response to the 1929 stock market
crash to protect investors and increase market transparency.
2. Federal Deposit Insurance Corporation (FDIC):
o Role: Insures deposits at banks and savings institutions up to $250,000
per account. Established in 1934, the FDIC’s role is to prevent bank
runs and protect depositors by providing deposit insurance, funded
through premiums paid by banks.
3. Office of the Comptroller of the Currency (OCC):
o Role: Charters, regulates, and supervises national banks and federal
savings associations. The OCC is responsible for ensuring these
institutions operate safely, have strong capital, and serve their
communities.
4. Federal Reserve System (The Fed):
o Role: Acts as the central bank of the U.S., responsible for monetary
policy, supervising and regulating banks, providing financial services,
and stabilizing the economy. It also oversees interest rate policies to
ensure economic stability.
5. National Credit Union Administration (NCUA):
o Role: Regulates and supervises federal credit unions and insures
deposits in credit unions through the National Credit Union Share
Insurance Fund (NCUSIF), similar to the FDIC for banks.
6. Commodity Futures Trading Commission (CFTC):
o Role: Regulates commodity futures and options markets to protect
against fraud, abusive practices, and systemic risks. It oversees trading
activities in agricultural and financial commodities, promoting
transparency in derivatives markets.

These agencies work together to protect the financial system by improving

transparency, protecting depositors, overseeing safe lending practices, and ensuring
fair market conduct.
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