Do You Understand?
Chapter 1:
1. The difference between primary and secondary markets?
Primary markets are markets in which users of funds (e.g., corporations) raise funds through new issues of
financial instruments, such as stocks and bonds. New issues of financial instruments are sold to the initial
suppliers of funds (e.g., households) in exchange for funds (money) that the issuer or user of funds needs.
Once financial instruments such as stocks are issued in primary markets, they are then traded—that is,
rebought and resold—in secondary markets.
2. The major distinction between money markets and capital markets?
Money markets are markets that trade debt securities or instruments with maturities of one year or less. In
the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy
money market instruments) to economic agents who have short-term needs or shortages of funds (i.e., they
sell money market instruments).Capital markets are markets that trade equity (stocks) and debt (bonds)
instruments with maturities of more than one year. Given their longer maturity, these instruments
experience wider price fluctuations in the secondary markets in which they trade than do money market
instruments.
3. What the major instruments traded in the capital markets are?
Figure 1-4 lists the major capital market instruments and their outstanding amounts by value. Notice that
corporate stocks or equities represent the largest capital market instrument, followed by residential
mortgages and corporate bonds. The relative size of capital market instruments outstanding depends on two
factors: number of securities issued and their market prices. One reason for the sharp increase in the amount
of equities outstanding is the bull market in stock prices in the 1990s. Stock values fell in the early 2000s as
the U.S. economy experienced a downturn—partly because of 9-11 and partly because interest rates began to
rise―As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen in value 53.8 percent in less
than 1 ½ years’ time, larger than the decline during the market crash of 1937-1938 when it fell 49 percent.
However, stock prices recovered along with the economy in the last half of 2009, rising 71.1 percent between
March 2009 and April 2010.
4. What happens to the dollar value of a U.S. investor’s holding of British pounds if the pound appreciates
(rises) in value against the dollar?
,If the foreign currency appreciates, or rises in value, relative to the U.S. dollar, the dollar value of cash flows
received on the foreign investment will increase.
5. What derivative security markets are?
Derivative securities markets are the markets in which derivative securities trade. A derivative security is a
financial security (such as a futures contract, option contract, swap contract, or mortgage-backed security)
whose payoff is linked to another, previously issued security such as a security traded in the capital or foreign
exchange markets. Derivative securities generally involve an agreement between two parties to exchange a
standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future.
6. The three major reasons that suppliers of funds would not want to directly purchase securities?
Once they have lent money in exchange for financial claims, suppliers of funds need to monitor continuously
the use of their funds. They must be sure that the user of funds neither steals the funds outright nor wastes
the funds on projects that have low or negative returns. Such monitoring is often extremely costly for any
given fund supplier because it requires considerable time, expense, and effort to collect this information
relative to the size of the average fund supplier’s investment. The resulting lack of monitoring increases the
risk of directly investing in financial claims.
The relatively long-term nature of many financial claims (e.g., mortgages, corporate stock, and bonds) creates
a second disincentive for suppliers of funds to hold the direct financial claims issued by users of funds.
Specifically, given the choice between holding cash and long-term securities, fund suppliers may well choose
to hold cash for liquidity reasons, especially if they plan to use their savings to finance consumption
expenditures in the near future and financial markets are not very developed, or deep, in terms of the number
of active buyers and sellers in the market.
Third, even though real-world financial markets provide some liquidity services, by allowing fund suppliers
to trade financial securities among themselves, fund suppliers face a price risk upon the sale of securities. The
price at which investors can sell a security on secondary markets such as the New York Stock Exchange
(NYSE) may well differ from the price they initially paid for the security either because investors change their
valuation of the security between the time it was bought and when it was sold and/or because dealers, acting
as intermediaries between buyers and sellers, charge transaction costs for completing a trade
7. What the asset transformation function of FIs is?
,FIs provide additional claims to fund suppliers, thus acting as asset transformers. FIs purchase the financial
claims issued by users of funds—primary securities such as mortgages, bonds, and stocks—and finance these
purchases by selling financial claims to household investors and other fund suppliers in the form of deposits,
insurance policies, or other secondary securities.
8. What delegated monitoring function FIs perform?
The monitoring function performed by the FI alleviates the “free-rider” problem that exists when small fund
suppliers leave it to each other to collect information and monitor a fund user. In an economic sense, fund
suppliers have appointed the FI as a delegated monitor to act on their behalf.
9. What the link is between asset diversification and the liquidity of deposit contracts?
FIs are able to diversify away some, but not all, of their investment risk. The concept of diversification is
familiar to all students of finance. Basically, as long as the returns on different investments are not perfectly
positively correlated, by spreading their investments across a number of assets, FIs can diversify away
significant amounts of their portfolio risk.
10. What maturity intermediation is?
FIs’ ability to reduce risk by diversification is their greater ability to bear the risk of mismatching the
maturities of their assets and liabilities than can small savers. Thus, FIs offer maturity intermediation services
to the rest of the economy. Specifically, by maturity mismatching, FIs can produce long-term of contracts such
as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability
contracts such as deposits.
11. Why the need for denomination intermediation arises?
Because many assets are sold in very large denominations, they are either out of reach of individual savers or
would result in savers holding very undiversified asset portfolios. For example, the minimum size of a
negotiable CD is $100,000, while commercial paper (short-term corporate debt) is often sold in minimum
packages of $250,000 or more. Individual small savers may be unable to purchase such instruments directly.
However, by buying shares in a mutual fund with other small investors, small savers overcome constraints to
, buying assets imposed by large minimum denomination size. Such indirect access to these markets may allow
small savers to generate higher returns (and lower risks) on their portfolios as well.
12. The two major sectors that society has identified as deserving special attention in credit allocation?
In the United States regulators have identified residential real estate as needing special attention. This has
enhanced the specialness of those FIs that most commonly service the needs of that sector. In the United
States, savings associations and savings banks must emphasize mortgage lending. Sixty-five percent of their
assets must be mortgage related for thrifts to maintain their charter status (see Chapter 12). In a similar
fashion, farming is an especially important area of the economy in terms of the overall social welfare of the
population.
13. Why monetary policy is transmitted through the banking system?
The highly liquid nature of bank and thrift deposits has resulted in their acceptance by the public as the most
widely used medium of exchange in the economy.
14. The payment services that FIs perform?
Depository institutions such as banks and thrifts are also special in that the efficiency with which they
provide payment services directly benefits the economy. Two important payment services are check-clearing
and wire transfer services.
15. What the trends are in the growth of global financial markets since the 1990s?
The significant growth in foreign financial markets is the result of several factors. First is the increase in the
pool of savings in foreign countries (e.g., the European Union). Second, international investors have turned to
U.S. and other markets to expand their investment opportunities and improve their investment portfolio risk
and return characteristics. This is especially so as the value of public pension plans has declined in many
European countries and investors have turned to private pension plans instead. Third, information on foreign
investments and markets is now more accessible and thorough—for example, via the Internet. Fourth, some
U.S. FIs—such as specialized mutual funds—offer their customers opportunities to invest in foreign securities
and emerging markets at relatively low transaction costs. Fifth, while the euro has had a significant effect
throughout Europe, it is also having a notable impact on the global financial system. Despite challenges
resulting from the Greek (and to some extent the European) debt crisis of the 2010s, the euro is still one of
the world’s most important currencies for international transactions. Finally, deregulation in many foreign
Chapter 1:
1. The difference between primary and secondary markets?
Primary markets are markets in which users of funds (e.g., corporations) raise funds through new issues of
financial instruments, such as stocks and bonds. New issues of financial instruments are sold to the initial
suppliers of funds (e.g., households) in exchange for funds (money) that the issuer or user of funds needs.
Once financial instruments such as stocks are issued in primary markets, they are then traded—that is,
rebought and resold—in secondary markets.
2. The major distinction between money markets and capital markets?
Money markets are markets that trade debt securities or instruments with maturities of one year or less. In
the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy
money market instruments) to economic agents who have short-term needs or shortages of funds (i.e., they
sell money market instruments).Capital markets are markets that trade equity (stocks) and debt (bonds)
instruments with maturities of more than one year. Given their longer maturity, these instruments
experience wider price fluctuations in the secondary markets in which they trade than do money market
instruments.
3. What the major instruments traded in the capital markets are?
Figure 1-4 lists the major capital market instruments and their outstanding amounts by value. Notice that
corporate stocks or equities represent the largest capital market instrument, followed by residential
mortgages and corporate bonds. The relative size of capital market instruments outstanding depends on two
factors: number of securities issued and their market prices. One reason for the sharp increase in the amount
of equities outstanding is the bull market in stock prices in the 1990s. Stock values fell in the early 2000s as
the U.S. economy experienced a downturn—partly because of 9-11 and partly because interest rates began to
rise―As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen in value 53.8 percent in less
than 1 ½ years’ time, larger than the decline during the market crash of 1937-1938 when it fell 49 percent.
However, stock prices recovered along with the economy in the last half of 2009, rising 71.1 percent between
March 2009 and April 2010.
4. What happens to the dollar value of a U.S. investor’s holding of British pounds if the pound appreciates
(rises) in value against the dollar?
,If the foreign currency appreciates, or rises in value, relative to the U.S. dollar, the dollar value of cash flows
received on the foreign investment will increase.
5. What derivative security markets are?
Derivative securities markets are the markets in which derivative securities trade. A derivative security is a
financial security (such as a futures contract, option contract, swap contract, or mortgage-backed security)
whose payoff is linked to another, previously issued security such as a security traded in the capital or foreign
exchange markets. Derivative securities generally involve an agreement between two parties to exchange a
standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future.
6. The three major reasons that suppliers of funds would not want to directly purchase securities?
Once they have lent money in exchange for financial claims, suppliers of funds need to monitor continuously
the use of their funds. They must be sure that the user of funds neither steals the funds outright nor wastes
the funds on projects that have low or negative returns. Such monitoring is often extremely costly for any
given fund supplier because it requires considerable time, expense, and effort to collect this information
relative to the size of the average fund supplier’s investment. The resulting lack of monitoring increases the
risk of directly investing in financial claims.
The relatively long-term nature of many financial claims (e.g., mortgages, corporate stock, and bonds) creates
a second disincentive for suppliers of funds to hold the direct financial claims issued by users of funds.
Specifically, given the choice between holding cash and long-term securities, fund suppliers may well choose
to hold cash for liquidity reasons, especially if they plan to use their savings to finance consumption
expenditures in the near future and financial markets are not very developed, or deep, in terms of the number
of active buyers and sellers in the market.
Third, even though real-world financial markets provide some liquidity services, by allowing fund suppliers
to trade financial securities among themselves, fund suppliers face a price risk upon the sale of securities. The
price at which investors can sell a security on secondary markets such as the New York Stock Exchange
(NYSE) may well differ from the price they initially paid for the security either because investors change their
valuation of the security between the time it was bought and when it was sold and/or because dealers, acting
as intermediaries between buyers and sellers, charge transaction costs for completing a trade
7. What the asset transformation function of FIs is?
,FIs provide additional claims to fund suppliers, thus acting as asset transformers. FIs purchase the financial
claims issued by users of funds—primary securities such as mortgages, bonds, and stocks—and finance these
purchases by selling financial claims to household investors and other fund suppliers in the form of deposits,
insurance policies, or other secondary securities.
8. What delegated monitoring function FIs perform?
The monitoring function performed by the FI alleviates the “free-rider” problem that exists when small fund
suppliers leave it to each other to collect information and monitor a fund user. In an economic sense, fund
suppliers have appointed the FI as a delegated monitor to act on their behalf.
9. What the link is between asset diversification and the liquidity of deposit contracts?
FIs are able to diversify away some, but not all, of their investment risk. The concept of diversification is
familiar to all students of finance. Basically, as long as the returns on different investments are not perfectly
positively correlated, by spreading their investments across a number of assets, FIs can diversify away
significant amounts of their portfolio risk.
10. What maturity intermediation is?
FIs’ ability to reduce risk by diversification is their greater ability to bear the risk of mismatching the
maturities of their assets and liabilities than can small savers. Thus, FIs offer maturity intermediation services
to the rest of the economy. Specifically, by maturity mismatching, FIs can produce long-term of contracts such
as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability
contracts such as deposits.
11. Why the need for denomination intermediation arises?
Because many assets are sold in very large denominations, they are either out of reach of individual savers or
would result in savers holding very undiversified asset portfolios. For example, the minimum size of a
negotiable CD is $100,000, while commercial paper (short-term corporate debt) is often sold in minimum
packages of $250,000 or more. Individual small savers may be unable to purchase such instruments directly.
However, by buying shares in a mutual fund with other small investors, small savers overcome constraints to
, buying assets imposed by large minimum denomination size. Such indirect access to these markets may allow
small savers to generate higher returns (and lower risks) on their portfolios as well.
12. The two major sectors that society has identified as deserving special attention in credit allocation?
In the United States regulators have identified residential real estate as needing special attention. This has
enhanced the specialness of those FIs that most commonly service the needs of that sector. In the United
States, savings associations and savings banks must emphasize mortgage lending. Sixty-five percent of their
assets must be mortgage related for thrifts to maintain their charter status (see Chapter 12). In a similar
fashion, farming is an especially important area of the economy in terms of the overall social welfare of the
population.
13. Why monetary policy is transmitted through the banking system?
The highly liquid nature of bank and thrift deposits has resulted in their acceptance by the public as the most
widely used medium of exchange in the economy.
14. The payment services that FIs perform?
Depository institutions such as banks and thrifts are also special in that the efficiency with which they
provide payment services directly benefits the economy. Two important payment services are check-clearing
and wire transfer services.
15. What the trends are in the growth of global financial markets since the 1990s?
The significant growth in foreign financial markets is the result of several factors. First is the increase in the
pool of savings in foreign countries (e.g., the European Union). Second, international investors have turned to
U.S. and other markets to expand their investment opportunities and improve their investment portfolio risk
and return characteristics. This is especially so as the value of public pension plans has declined in many
European countries and investors have turned to private pension plans instead. Third, information on foreign
investments and markets is now more accessible and thorough—for example, via the Internet. Fourth, some
U.S. FIs—such as specialized mutual funds—offer their customers opportunities to invest in foreign securities
and emerging markets at relatively low transaction costs. Fifth, while the euro has had a significant effect
throughout Europe, it is also having a notable impact on the global financial system. Despite challenges
resulting from the Greek (and to some extent the European) debt crisis of the 2010s, the euro is still one of
the world’s most important currencies for international transactions. Finally, deregulation in many foreign
