BUSTAMANTE, JILIAN KATE A.

BSBA FM 3C

WEEK 1

1. Give additional examples of real-life situations involving adverse selection and

moral hazard.
Adverse Selection
A vehicle salesman is aware that he has a $1,000 car with a defect. The buyer, on the
other hand, is completely unaware of these flaws. They believe it is in good functioning
order and are willing to pay $2,000 for it. The deal is completed, but the customer is left
with a defective car that is only worth half of what they paid for it, resulting in adverse
selection.

Moral Hazard
A driver who has automobile insurance may drive with less caution than someone who
does not have car insurance. If a driver has automobile insurance, he or she is aware
that the insurance company will cover the majority of the financial expenditures incurred
as a result of the collision.

2. Whenever a company goes bankrupt, consumers prefer to hold bonds because the
chances of receiving their money back are higher for bondholders than for shareholders
because bondholders get paid first. Furthermore, if a company goes bankrupt, its assets
will not be sufficient to satisfy both bondholders and stockholders; therefore
bondholders will be paid even if it is only a portion of their money, whereas stockholders
may receive nothing. As a result, owning a bond is preferable to owning stock because
bond holders are paid first.

3. How does risk sharing benefit both financial intermediaries?

Financial intermediaries benefit from risk sharing because they can earn a spread
between the returns on hazardous assets and the returns on less risky assets they
offer. Investors win because they can invest in a well-diversified portfolio than they
could otherwise.

4. Think of one example in which you have had to deal with the adverse selection
problem?
Forcing everyone to participate is one way to cope with adverse selection. States, for
example, frequently mandate drivers to carry automobile insurance. As a result, vehicle
insurance providers may be able to charge a premium that matches the average claim
amount. Participants who are unlikely to file a claim, on the other hand, may think that
being compelled to subsidize those who are likely to file a claim is unjust. Another
approach to dealing with adverse selection is to group individuals using indirect
information, such as statistical discrimination. Because insurance firms can't get people
to admit whether they're good or poor drivers, they create statistical profiles of good and
bad drivers.

5. The U.S. economy borrowed heavily from the British in the nineteenth century
to build a railroad system. What was the principal debt instrument used? Why did
this make both countries better off?
Foreign bonds, which were offered in the United Kingdom and denominated in pounds,
were the most common debt instruments used. The British benefited because they
could earn greater interest rates by lending to Americans, while the Americans
benefited because they now had access to finance to create profitable industries like
railroads.

Multiple Choice.
1. A.
2. D.
3. B.
4. B.
5. D.

WEEK 2

1. B.
2. D.
3. C.
4. C.
5. A.
6. D.
7. D.
8. A.
9. B.
10. B.

ESSAY:
1. How do regulators help to ensure the soundness of financial intermediaries?
People who contribute funds to financial intermediaries are not always able to
assess the financial stability of the institutions that keep the cash. If the financial
intermediaries are questioned, the fund providers may decide to withdraw their funds,
causing a financial panic. To protect the public and the economy from financial panics,
the government has put in place a variety of regulators. The first regulator is an entry
restriction. The state banking and insurance commissions have enacted strict
restrictions controlling who is permitted to establish a financial intermediary, requiring
groups or individuals to get a state or federal government charter. To start a financial
intermediary, these persons must be upstanding citizens with flawless credentials and a
considerable sum of starting funds. Disclosures are another regulator that ensures the
soundness of financial intermediaries by requiring that bookkeeping and reporting follow
rigorous instructions, that the books be inspected on a regular basis and that specific
information be made available to the public. Financial intermediaries are also limited in
terms of how they can handle assets and the types of assets they can own. Restriction
of some dangerous activity is one strategy to ensure financial intermediaries'
trustworthiness. Deposit insurance is the fourth regulator that helps ensure the
soundness of financial intermediaries. If the intermediary fails, the government can
cover the depositors so that they do not suffer a significant financial loss. The
competition that financial intermediaries confront is also limited. Uncontrolled
competition among financial intermediaries, according to politicians, encourages failures
that harm the public. The government has placed restrictions on the establishment of
new branches. Finally, interest rates are regulated by regulators. Competition has been
hampered by regulations that limit the amount of interest that may be paid on deposits.
These regulators help the public and the economy by ensuring the soundness of
financial intermediaries.

2. Throughout the financial world, financial intermediaries are common. A financial

intermediary is a company that borrows money from people who have saved and then
lends it to others, functioning as a go-between for investors and companies looking to
raise capital. Commercial banks, credit unions, insurance firms, mutual funds, and
finance businesses are common entities that perform intermediate acts. These
institutions are critical to the global financial market's general health and operation.
The three roles that financial intermediaries undertake are: maturity
transformation, risk transformation, and convenience denomination. Intermediaries use
maturity transformations to turn short-term obligations into long-term assets. This
conversion is widespread among banks and other financial institutions that offer liquidity
to businesses, matching a short-term debt with a long-term loan. Rather of examining
short-term loan choices and rolling over the debt balance on a regular basis, a longer-
term commitment can be made that locks in a cheaper rate for both parties.
Intermediaries can also provide risk transformation, which allows hazardous
investments to be converted into relatively risk-free investments by lending to numerous
borrowers to distribute the risk. The intermediary – such as a mutual fund – inherently
offers diversity and tolerance against a single investment creating bad consequences by
combining the funds of numerous participants. Finally, a middleman provides
convenience denomination. Because a financial intermediary has a large number of
deposits, it may match small deposits with big loans and larger deposits.