Jamille P.

Icalina, BSA – 3

Financial Markets

1. How can brokers and dealers make money? Which activity is riskier? Why? (20points)

Broker executes orders on behalf of client. They help clients buy or sells a security (bonds or
stocks). Brokers make money through their clients’ brokerage fees or commission.

Dealer facilitates trades on behalf of itself. Dealer profits by earning the bid-ask spread or the
difference between the buy and sell price. A dealer buys securities (bonds and stocks) and sells
it to other investors at a price higher than the buying price (bid-ask spread).

The dealer’s activity is riskier than the broker’s since he will shoulder all the risk of the securities
whether likable or unlikable because the trade facilitates on behalf of himself. If the security of
the dealer is risky, the value of the inventory can fluctuate with market prices. It is treated as
the dealer is the owner of the securities because the activity of the dealer is buying and selling
securities and other. Unlike the broker where the broker is just a middleman between his clients
and the investors.

2. What does an asset transformer do? Why is asset transformation a risky activity? (20 points)

An asset transformer is a person who buys one security from a customer or creates a
separate claim to raise funds. Asset transformation in general, is the process of transforming
bank liabilities (deposits) into bank assets (loans).

This activity is risky because the asset acquired or bought is prone to more risk than that of a
security used to raised funds because intermediary hopers to profit on the spread between
the rate earned on the asset claim and the rate paid on the liability claim. The main risk with
this type of approach for banks, is if a large long term loan is funded by a large number of
small short term deposits, the bank may experience problems meeting the demands of
depositors if large numbers decide to withdraw their deposit. The mismatch between the
terms of depositors and borrowers is problematic as the loans may not be redeemable in the
short term and this creates liquidity issues. In essence, there may not be enough cash
immediately available to allow depositors to withdraw their savings.

3. How can using indirect finance rather than direct finance reduce agency costs associated with
monitoring funds demanders? (10 points)

Indirect finance is where borrowers borrow funds from the financial market through indirect
means, such as through a financial intermediary. A large financial institution (FI) has a greater
incentive to monitor the behavior of funds' demanders in indirect financing. The FI hires and
trains experts who know how to collect information about a funds demander and evaluate
 whether the funds demander is proper. In direct finance, a funds demander sells claims to the
public at large. With this, there is little incentive for an individual holder to monitor and
attempt to enforce good behavior on the part of the fund's user. The benefit of monitoring
and enforcement is shared among all its holder, but the cost would be borne or shoulder by
the sole individual. This is called the "free-rider" problem. If the monitoring of borrower
behavior is improved, the problem with regards to agency costs would likely be reduced

4. You are a corporate treasurer seeking to raise funds for your firm. What are some advantages
of raising funds via a financial intermediary (FI) rather than by selling securities to the public?
(20 points)

Financial intermediaries serve as middlemen for financial transactions, generally between

banks or funds. The possible advantages of raising funds through financial are the following:

Speed: funds can normally be raised more quickly through financial intermediaries.
 Registration process/cost: Raising funds via financial intermediaries can be less
expensive, particularly for smaller capital needs or when funds are needed for only a
short period. Through a financial intermediary, savers can pool their funds, enabling
them to make large investments, which in turn benefits the entity in which they are
investing. They reduce the costs of the many financial transactions an individual
investor would otherwise have to make if the financial intermediary did not exist.
 Nonstandard terms can be negotiated with financial intermediaries but are difficult to
sell to the public. For example, if a borrower can only begin paying interest after 2
years, they would have a difficult time selling bonds to the public.
 There is a greater ability to renegotiate terms if necessary. Terms of public issue
generally cannot be changed outside of court.
 Less information is made public since there is a direct relationship between two
parties. A non-bank financial intermediary does not accept deposits from the public.

5. How can a depository intermediary afford to purchase long-term risky direct claims from
funds demanders and finance these purchases with safe, liquid, short-term, low-
denomination deposits? What can go wrong in this process? (30 poits)

DIs can afford to do so because the rate they must pay to attract funds is lower than the rate
they can charge on their riskier assets. A depository provides security and liquidity in the
market, uses money deposited for safekeeping to lend to others, invests in other securities, and
offers a funds transfer system. A depository must return the deposit in the same condition upon
request. However, a lot can go wrong:

1) If the money lent to its costumer is not repaid on time, it may not be able to repay its
depositors on demand or on time that would lead the costumers to distrust the DI.

2) The difference between the rate earned on assets and the rate paid on liabilities is called the
net interest margin (NIM), and can turn negative if interest rise or if rates on long-term
securities fall below the interest rates risk on short-term securities. The result of it will have a
great impact to the intermediary since they will have a negative return due to the rate paid in
liability is greater than the rate earned from assets.

3) As we know, assets and liabilities are different, so it is possible for the value of the asset to
drop resulting in an insolvent risk while its liabilities to rise more than its asset and because the
financial instruments are assets, their value can be unstable or changing from time to time due
to the changes in the market.

4) This may attract many savers with a small amount of capital, and then invest in investments
that cannot be immediately liquidated, so if the savers lose confidence in the DI, they will seek
to withdraw their money due to the performance of the DI or how they perceive it, which can
cause a liquidity crisis and even insolvency.