FINA 465 EXAM 1 REVIEW QUESTIONS
AND ANSWERS 100% PASS 2026/2027
What are risks common to all financial institutions? - ANS Risks common to all financial
institutions include default or credit risk of assets, interest rate risk, liquidity risk, underwriting
risk, and operating risks.
Identify and explain three economic disincentives that would dampen the flow of funds
between household savers of funds and corporate users of funds in an economic world without
financial institutions. - ANS Investors generally are averse to directly purchasing securities
because of (a) monitoring costs, (b) liquidity costs, and (c) price risk. Monitoring the activities of
borrowers requires extensive time, expense, and expertise.
Identify and explain the two functions FIs perform that would enable the smooth flow of funds
from household savers to corporate users. - ANS FIs serve as conduits between users and
savers of funds by providing a brokerage function and by engaging in an asset transformation
function.
In what sense are the financial claims of FIs considered secondary securities, while the financial
claims of commercial corporations are considered primary securities? How does the
transformation process, or intermediation, reduce the risk, or economic disincentives, to the
savers? - ANS Funds raised by the financial claims issued by commercial corporations are
used to invest in real assets. These financial claims, which are considered primary securities, are
purchased by FIs whose financial claims therefore are considered secondary securities. Savers
who invest in the financial claims of FIs are indirectly investing in the primary securities of
commercial corporations. However, the information gathering and evaluation expenses,
@2026 ALLRIGHTS RESERVED 1
,monitoring expenses, liquidity costs, and price risk of placing the investments directly with the
commercial corporation are reduced because of the efficiencies of the FI.
Explain how financial institutions act as delegated monitors. What secondary benefits often
accrue to the entire financial system because of this monitoring process? - ANS By putting
excess funds into financial institutions, individual investors give to the FIs the responsibility of
deciding who should receive the money and of ensuring that the money is utilized properly by
the borrower. This agglomeration of funds resolves a number of problems. First, the large FI
now has a much greater incentive to collect information and monitor actions of the firm
because it has far more at stake than does any small individual household. In a sense, small
savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI
have a greater incentive to collect information, the average cost of collecting information is
lower. Such economies of scale of information production and collection tend to enhance the
advantages to savers of using FIs rather than directly investing themselves. Second, the FI can
collect information more efficiently than individual investors. The FI can utilize this information
to create new products, such as commercial loans, that continually update the information pool.
Thus, a richer menu of contracts may improve the monitoring abilities of FIs. This more frequent
monitoring process sends important informational signals to other participants in the market, a
process that reduces information imperfection and asymmetry between the ultimate providers
and users of funds in the economy. Thus, by acting as a delegated monitor and producing better
and more timely information, FIs reduce the degree of information imperfection and asymmetry
between the ultimate suppliers and users of funds in the economy.
What are five general areas of FI specialness that are caused by providing various services to
sectors of the economy? - ANS First, FIs collect and process information more efficiently than
individual savers. Second, FIs provide secondary claims to household savers which often have
better liquidity characteristics than primary securities such as equities and bonds. Third, by
diversifying the asset base FIs provide secondary securities with lower price risk conditions than
primary securities. Fourth, FIs provide economies of scale in transaction costs because assets
are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy
which allows the introduction of additional types of investment contracts, such as mortgage
loans, that are financed with short-term deposits.
@2026 ALLRIGHTS RESERVED 2
, What are agency costs? - ANS Agency costs occur when owners or managers take actions
that are not in the best interests of the equity investor or lender. These costs typically result
from the failure to adequately monitor the activities of the borrower.
How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy securities
issued by corporations - ANS FIs provide financial or secondary claims to household and
other savers. Often, these claims have superior liquidity attributes compared with those of
primary securities such as corporate equity and bonds.
How do financial institutions help individual savers diversify their portfolio risks? Which type of
financial institution is best able to achieve this goal? - ANS Money placed in any financial
institution will result in a claim on a more diversified portfolio. as long as the returns on
different investments are not perfectly positively correlated, by exploiting the benefits of size,
FIs diversify away significant amounts of portfolio risk—especially the risk specific to the
individual firm issuing any given security. This risk diversification allows an FI to predict more
accurately its expected return on its asset portfolio.
How can financial institutions invest in high-risk assets with funding provided by low-risk
liabilities from savers? - ANS FIs exploit the law of large numbers in their investments,
achieving a significant amount of diversification, whereas because of their small size, many
household savers are constrained to holding relatively undiversified portfolios. This risk
diversification allows an FI to predict more accurately its expected return on its asset portfolio.
A domestically and globally diversified FI may be able to generate an almost risk- free return on
its assets. As a result, it can credibly fulfill its promise to households to supply highly liquid
claims with little price or capital value risk.
How can individual savers use financial institutions to reduce the transaction costs of investing
in financial assets? - ANS By pooling the assets of many small investors, FIs can gain
economies of scale in transaction costs. This benefit occurs whether the FI is lending to a
corporate or retail customer, or purchasing assets in the money and capital markets.
@2026 ALLRIGHTS RESERVED 3
AND ANSWERS 100% PASS 2026/2027
What are risks common to all financial institutions? - ANS Risks common to all financial
institutions include default or credit risk of assets, interest rate risk, liquidity risk, underwriting
risk, and operating risks.
Identify and explain three economic disincentives that would dampen the flow of funds
between household savers of funds and corporate users of funds in an economic world without
financial institutions. - ANS Investors generally are averse to directly purchasing securities
because of (a) monitoring costs, (b) liquidity costs, and (c) price risk. Monitoring the activities of
borrowers requires extensive time, expense, and expertise.
Identify and explain the two functions FIs perform that would enable the smooth flow of funds
from household savers to corporate users. - ANS FIs serve as conduits between users and
savers of funds by providing a brokerage function and by engaging in an asset transformation
function.
In what sense are the financial claims of FIs considered secondary securities, while the financial
claims of commercial corporations are considered primary securities? How does the
transformation process, or intermediation, reduce the risk, or economic disincentives, to the
savers? - ANS Funds raised by the financial claims issued by commercial corporations are
used to invest in real assets. These financial claims, which are considered primary securities, are
purchased by FIs whose financial claims therefore are considered secondary securities. Savers
who invest in the financial claims of FIs are indirectly investing in the primary securities of
commercial corporations. However, the information gathering and evaluation expenses,
@2026 ALLRIGHTS RESERVED 1
,monitoring expenses, liquidity costs, and price risk of placing the investments directly with the
commercial corporation are reduced because of the efficiencies of the FI.
Explain how financial institutions act as delegated monitors. What secondary benefits often
accrue to the entire financial system because of this monitoring process? - ANS By putting
excess funds into financial institutions, individual investors give to the FIs the responsibility of
deciding who should receive the money and of ensuring that the money is utilized properly by
the borrower. This agglomeration of funds resolves a number of problems. First, the large FI
now has a much greater incentive to collect information and monitor actions of the firm
because it has far more at stake than does any small individual household. In a sense, small
savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI
have a greater incentive to collect information, the average cost of collecting information is
lower. Such economies of scale of information production and collection tend to enhance the
advantages to savers of using FIs rather than directly investing themselves. Second, the FI can
collect information more efficiently than individual investors. The FI can utilize this information
to create new products, such as commercial loans, that continually update the information pool.
Thus, a richer menu of contracts may improve the monitoring abilities of FIs. This more frequent
monitoring process sends important informational signals to other participants in the market, a
process that reduces information imperfection and asymmetry between the ultimate providers
and users of funds in the economy. Thus, by acting as a delegated monitor and producing better
and more timely information, FIs reduce the degree of information imperfection and asymmetry
between the ultimate suppliers and users of funds in the economy.
What are five general areas of FI specialness that are caused by providing various services to
sectors of the economy? - ANS First, FIs collect and process information more efficiently than
individual savers. Second, FIs provide secondary claims to household savers which often have
better liquidity characteristics than primary securities such as equities and bonds. Third, by
diversifying the asset base FIs provide secondary securities with lower price risk conditions than
primary securities. Fourth, FIs provide economies of scale in transaction costs because assets
are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy
which allows the introduction of additional types of investment contracts, such as mortgage
loans, that are financed with short-term deposits.
@2026 ALLRIGHTS RESERVED 2
, What are agency costs? - ANS Agency costs occur when owners or managers take actions
that are not in the best interests of the equity investor or lender. These costs typically result
from the failure to adequately monitor the activities of the borrower.
How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy securities
issued by corporations - ANS FIs provide financial or secondary claims to household and
other savers. Often, these claims have superior liquidity attributes compared with those of
primary securities such as corporate equity and bonds.
How do financial institutions help individual savers diversify their portfolio risks? Which type of
financial institution is best able to achieve this goal? - ANS Money placed in any financial
institution will result in a claim on a more diversified portfolio. as long as the returns on
different investments are not perfectly positively correlated, by exploiting the benefits of size,
FIs diversify away significant amounts of portfolio risk—especially the risk specific to the
individual firm issuing any given security. This risk diversification allows an FI to predict more
accurately its expected return on its asset portfolio.
How can financial institutions invest in high-risk assets with funding provided by low-risk
liabilities from savers? - ANS FIs exploit the law of large numbers in their investments,
achieving a significant amount of diversification, whereas because of their small size, many
household savers are constrained to holding relatively undiversified portfolios. This risk
diversification allows an FI to predict more accurately its expected return on its asset portfolio.
A domestically and globally diversified FI may be able to generate an almost risk- free return on
its assets. As a result, it can credibly fulfill its promise to households to supply highly liquid
claims with little price or capital value risk.
How can individual savers use financial institutions to reduce the transaction costs of investing
in financial assets? - ANS By pooling the assets of many small investors, FIs can gain
economies of scale in transaction costs. This benefit occurs whether the FI is lending to a
corporate or retail customer, or purchasing assets in the money and capital markets.
@2026 ALLRIGHTS RESERVED 3
