Chapter 3: Financial Markets, Instruments, and Institutions

Chapter 3: Financial Markets, Instruments, and Institutions

Chapter Summary
This chapter explains how financial markets function and surveys different types of financial instruments and institutions involved in those markets. It also discusses the roles of financial intermediaries and the implications of automated financial trading for both domestic and world financial markets. Financial markets channel funds from those who save to those who wish to make capital investments. Financial markets can be divided into primary and secondary markets. The former deal with newly issued financial instruments, whereas the latter deal with transactions of previously issued financial instruments. Financial markets can also be divided into money and capital markets. Financial instruments in money markets have maturities under one year. Examples of money market instruments are U. . Treasury bills, commercial paper, bank certificates of deposit, Eurodollar deposits, and federal funds loans. Financial instruments in capital markets have maturities e!ual to or greater than one year. Examples of capital market instruments are business e!uities, corporate bonds, U. . Treasury notes and bonds, mortgage loans, and consumer and commercial loans. "ybertrading of financial instruments using Internet brokers and other automated trading systems has speeded up financial exchanges both within and across national markets. #evelopment in cross$border financial exchange using automated trading systems has raised regulatory concerns from different nations. Financial intermediaries serve to reduce problems associated with asymmetric information in financial transactions. %symmetric information can lead to potential problems stemming from adverse selection and moral ha&ard. Financial intermediaries may also allow savers to benefit from economies of scale as a result of lower average costs of fund management. The ma'ority of financial institutions are depository institutions, which include commercial banks, savings banks and savings and loan associations, and credit unions. (on$depository financial institutions include insurance companies, pension funds, mutual funds, finance companies, brokers, investment banks, and government$sponsored institutions such as the Federal Financing )ank and mortgage$financing institutions.

Key Terms and Concepts

%dverse selection

Chapter 3: Financial Markets, Instruments, and Institutions

%nnuities %symmetric information )anker*s acceptance )rokers "apital goods "apital markets "ertificates of deposit "ommercial banks "ommercial loans "ommercial paper "ommon stock "onsumer loans "orporate bonds "redit union #irect finance #ividends #utch auction Economies of scale E!uities Federal funds market Finance company Financial instruments Financial intermediation Insurance companies Indirect finance Interest Intermediate$term maturity International financial diversification Investment Investment banks +ong$term maturity ,aturity ,oney market ,oral ha&ard ,ortgage$backed securities ,ortgage loans ,unicipal bonds ,utual funds (ational %ssociation of ecurities #ealers %utomated -uotation .(% #%-/ 0ver$the$counter .0T"/ stocks 1ension funds 1referred stock 1rimary market avings and loan associations avings bank aving

Chapter 3: Financial Markets, Instruments, and Institutions

econdary market ecurities hort$term maturity tock exchanges Treasury bills .T$bills/ Treasury bonds Treasury notes 2inner*s curse 2orld index fund

Multiple-Choice Questions
3. 2hich of the following is not a financial instrument4 %/ )/ "/ #/ Treasury bill. 5eal estate. ,ortgage loan. Federal funds loan.

6. The time until final principal and interest payments are due to holders of a financial instrument is the instrument*s time until %/ )/ "/ #/ expiration. maturity. execution. li!uidation.

7. Financial instruments with maturities of less than one year are traded in the %/ )/ "/ #/ e!uity market capital market. money market. fixed$income market.

8. % 79$year Treasury bond that was issued in last year is sold in a I. money market

Chapter 3: Financial Markets, Instruments, and Institutions

II. III. I:. %/ )/ "/ #/

capital market primary market secondary market )oth I and III. )oth I and I:. )oth II and III. )oth II and I:.

;. ,arkets for newly issued financial instruments with maturities shorter than one year are I. II. III. I:. %/ )/ "/ #/ money markets capital markets primary markets secondary markets )oth I and III. )oth I and I:. )oth II and III. )oth II and I:.

<. 2hich of the following is a money market instrument4 %/ )/ "/ #/ % Treasury note. % federal funds loan. % corporate bond. % mortgage loan.

=. 2hich of the following is a capital market instrument4 %/ )/ "/ #/ % certificate of deposit. % federal funds loan. "ommercial paper. % Treasury bond.

>. 2hich of the following is the most popular U. . money market instrument by value of holdings4 %/ )/ "/ #/ Treasury bill. Eurodollar. Federal fund. )anker*s acceptance.

?. %n example of asymmetric information in financial markets is that %/ the borrower knows more than the lender.

Chapter 3: Financial Markets, Instruments, and Institutions

)/ the lender knows more than the borrower. "/ the borrower has a long$term goal while the lender has a short$term goal. #/ the borrower and lender have different expectations about financial markets. 39. The problem associated with asymmetric information before the financial transaction occurs is known as %/ )/ "/ #/ moral ha&ard. adverse selection. free$riding. inside trading.

33. %s a result of the adverse selection problem, %/ )/ "/ #/ lenders will tend to finance only low$risk pro'ects. lenders will become reluctant to finance otherwise low$risk pro'ects. only borrowers with good credit history are likely to seek loans. only borrowers with high net worth are likely to seek loans.

36. ,oral ha&ard is a problem that arises %/ )/ "/ #/ only in primary markets. only in secondary markets. before a financial transaction is made. after a financial transaction is made.

37. 2hich of the following is a ma'or reason for the existence of financial intermediaries4 %/ )/ "/ #/ The existence of long$term financial instruments. 1roblems related to asymmetric information. The ability to borrow funds directly from savers. To avoid government regulation in other financial markets.

38. 2hich of the following re!uires financial intermediaries4 %/ )/ "/ #/ #irect finance. Indirect finance. #irect purchase of retail goods. (one of the above.

3;. ,utual funds permit those who desire to save to pool their funds together for the purpose of purchasing financial instruments with large denominations. %s a result, the average fund management costs are lower than they would be if individual savers tried to manage their funds individually. This is an example of %/ moral ha&ard.

Chapter 3: Financial Markets, Instruments, and Institutions

)/ adverse selection. "/ asymmetric information. #/ economies of scale. 3<. 2hich of the following is a depository financial institution4 %/ )/ "/ #/ % savings bank. %n investment bank. % finance company. % pension fund.

3=. 2hich of the following is not a depository financial institution4 %/ )/ "/ #/ % savings and loan association. % credit union. % mutual fund company. % commercial bank.

3>. 2hich of the following is an example of financial intermediation4 %/ )/ "/ #/ %n Internet company issues stock by selling shares directly to buyers. % woman opening a new business borrows funds from her uncle. % professor purchases shares of stock directly from a corporation. % bank extends a mortgage loan to a household.

3?. 2hich of the following financial intermediaries speciali&e in extending credit to small, higher$risk businesses4 %/ "ommercial banks. )/ avings and loan associations. "/ Finance companies. #/ Insurance companies. 69. 2hich of the following financial intermediaries speciali&e in making mortgage loans4 %/ 1ension funds. )/ avings and loan associations. "/ Finance companies. #/ Insurance companies.

Short-Answer Questions
3. 2hat is the range of maturities for money market instruments4

Chapter 3: Financial Markets, Instruments, and Institutions

6. 2hat is the range of maturities for capital market instruments4 7. 2hat is the name of the markets where previously issued financial instruments are traded4 8. 2hat type of financial markets are U. . Treasury bills traded in4 ;. 2hat type of financial markets are corporate bonds traded in4 <. 2hat is the problem in which one party in a financial transaction has information that is not available to the other party in the transaction4 =. 2hat is the term for the possibility that a borrower may behave in a more risky manner after receiving a loan4 >. 2hat is the problem in which those who desire to borrow funds may plan to use them for risky pro'ects4 ?. 2hat is the name of a situation in which a winning bidder in an auction receives a lower return than at least one participant who submitted a weaker bid4 39. 2hat liabilities exist in depository institutions but not in other financial institutions4

Chapter 3: Financial Markets, Instruments, and Institutions

Chapter 3: Financial Markets, Instruments, and Institutions