Answer 1

1. Transfers can be made through a financial intermediary such as a bank, an insurance

company, or a mutual fund. Financial intermediaries include:a.
Commercial banks
b.
Thrift institutions
c.
Investment companies
d.
Pension funds
e.
Insurance companies
f.
Finance companies
2. Function of Financial Intermediaries. Fin intermediaries obtain funds from savers in
exchange for its securities. The intermediary uses this money to buy and hold
businesses securities, while the savers hold the intermediarys securities. For example,
a saver deposits dollars in a bank, receiving a certificate of deposit; then the bank lends
the money to a business in the form of a mortgage loan. Thus, intermediaries literally
create new forms of capitalin this case, certificates of deposit, which are safer and
more liquid than mortgages and thus are better for most savers to hold. The existence
of intermediaries greatly increases the efficiency of money and capital markets.

Answer 2
The prices of goods and services must cover their costs. Costs include labor, materials,
and capital. Capital costs to a borrower include a return to the saver who supplied the
capital, plus a mark-up (called a spread) for the financial intermediary that brings the
saver and the borrower together. The more efficient the financial system, the lower the
costs of intermediation, the lower the costs to the borrower, and, hence, the lower the
prices of goods and services to consumers
Answer 3

Short-term interest rates are more volatile because:(1) Govt operates mainly in the short-term sector, hence state bank intervention has its
major effect here
(2) Long-term interest rates reflect the average expected inflation rate over the next 20
to 30 years, and this average does not change as radically as year-to-year
expectations.
Answer 4
Interest rates will fall as the recession takes hold because

(1) Business borrowings will decrease

(2) The State Bank will increase the money supply to stimulate the economy.
Thus, it would be better to borrow short-term now, and then to convert to long-term
when rates have reached a cyclical low.
Answer 5
1. Inflation Premium. IP is equal to the average expected inflation rate over the life of the
security. The expected future inflation rate is not necessarily equal to the current
inflation rate, so IP is not necessarily equal to current inflation.
2. Default risk premium. This premium reflects the possibility that the issuer will not pay
interest or principal at the stated time and in the stated amount.
3. Liquidity Premium. This is a premium charged by lenders to reflect the fact that some
securities cannot be converted to cash on short notice at a reasonable price. LP is
very low for securities issued by large, strong firms, but it is relatively high on securities
issued by very small firms.
4. Maturity Risk Premium. Longer-term bonds, even Treasury bonds, are exposed to a
significant risk of price declines, and a maturity risk premium is charged by lenders to
reflect this risk.
5. Short-term treasury securities include only an inflation premium.
6. Long-term treasury securities contain an inflation premium plus a maturity risk
premium. Note that the inflation premium added to long-term securities will differ from
that for short-term securities unless the rate of inflation is expected to remain constant.
7. The rate on short-term corporate securities is equal to the real risk-free rate plus
premiums for inflation, default risk, and liquidity. The size of the default and liquidity
premiums will vary depending on the financial strength of the issuing corporation and its
degree of liquidity, with larger corporations generally having greater liquidity because of
more active trading.
8. The rate for long-term corporate securities also includes a premium for maturity risk.
Thus, long-term corporate securities generally carry the highest yields of these four
types of securities.