TUTORIAL 1

OVERVIEW OF FINANCIAL SYSTEM

Part 1. Questions for review

1. What is the main function of financial markets
The basic function of financial markets is to channel funds from savers who
have an excess of funds to spenders who have a shortage of funds. Financial
markets can do this either through direct finance, in which borrowers borrow
funds directly from lenders by selling them securities, or through indirect
finance, which involves a financial intermediary that stands between the
lender-savers and the borrower-spenders and helps transfer funds from one to
the other. This channeling of funds improves the economic welfare of
everyone in society. Because they allow funds to move from people who have
no productive investment opportunities to those who have such opportunities,
financial markets contribute to economic efficiency. In addition, channeling of
funds directly benefits consumers by allowing them to make purchases when
they need them most.
2. Classify financial markets
Financial markets can be classified as debt and equity markets, primary and
secondary markets, exchanges and over-the-counter markets, and money and
capital markets.
3. List and distinguish the differences among financial instruments

4. Identify the differences among types of financial intermediaries (in terms of

primary liabilities and assets) using Table 3, page 40
Financial intermediaries are financial institutions that acquire funds by issuing
liabilities and, in turn, use those funds to acquire assets by purchasing securities or
making loans. Financial intermediaries play an important role in the financial system
because they reduce transaction costs, allow risk sharing, and solve problems created
by adverse selection and moral hazard. As a result, financial intermediaries allow
small savers and borrowers to benefit from the existence of financial markets, thereby
increasing the efficiency of the economy. However, the economies of scope that help
make financial intermediaries successful can lead to conflicts of interest that make the
financial system less efficient.
Part 1. Multiple-choice questions

1. Evidence from the United States and other foreign countries indicates that
A. Money growth is clearly unrelated to inflation
B. There is a strong positive association between inflation and growth rate of
money over long periods of times
C. Countries with low monetary growth rate tend to experience higher rates of
inflation, all else being constant
D. There is a little support for the assertion that “inflation is always and
everywhere a monetary phenomenon”

2. Economists group commercial banks, saving and loans associations, credit unions,
mutual funds, mutual savings banks, insurance companies, pension funds and finance
companies under the heading financial intermediaries. Financial intermediaries:
A. produce nothing of value and therefore a drain on society’s resources
 B. provide a channel for linking between those who want to save and those who
want to spend
C. can hurt the performance of the economy
D. have been a source of slow and resistant financial innovation

3. What is the basic activity of banks?

A. To sell shares of corporations to the general public
B. To facilitate the transfer of money from savers to borrowers
C. To represent the interest of insurance companies
D. To ensure everyone who wants a loan gets one
E. To equate future consumption with current consumption

4. Banks, savings and loans associations, mutual savings banks and credit unions
A. are no longer important players in financial intermediation
B. have been adept at innovating in response to changes in regulatory
environment
C. produce nothing of value and therefore a drain on society’s resources
D. since deregulation now provide services only to small depositors

5. Why are financial markets important to the health of the economy?

A. They channel funds from investors to savers
B. They identify and shut down inefficient firms
C. They eliminate the needs for financial intermediaries
D. They allow consumers to time their purchase better

6. These financial institutions are very small cooperative lending institutions

organized around a particular group: union members, employees of a firm and so
forth. They acquire funds from deposits called shares and primarily make consumer
loans. They are
A. Credit unions
B. Commercial banks
C. Savings and loan associations
D. Mutual fund

7. These financial intermediaries raise funds primarily by issuing checkable deposits,

savings deposits and time deposits. They then use these funds to make commercial,
consumer and mortgage loans, and to buy US government securities and municipal
bonds. They are
A. Credit union
B. Commercial bank
C. Savings and loan
D. Mutual fund

8. These instruments are typically overnight loans between banks of their deposits at
Federal Reserve.
A. Commercial paper
B. Treasury bills
C. Repurchase agreement
D. Federal Funds
E. Banker’s acceptances
9. Short-term debt instruments issued by large banks and well-known corporations
A. Commercial paper (thương phiếu) – short term, unsecured
B. Treasury bills
C. Repurchase agreement
D. Federal Funds
E. Banker’s acceptances

10. These instruments are effectively short-term loans (usually with maturity of less
than two weeks) for which Treasury bills serve as collateral, which the lender receives
if the borrower does not pay back the loan.
A. Commercial paper
B. Treasury bills
C. Repurchase agreement (Repo)
D. Federal Funds
E. Banker’s acceptances

11. A share of Microsoft common stock is:

A. a liability to the shareholder because it must be sold to realize a capital gain
B. an asset of Microsoft because it allows Microsoft to invest in capital
equipment or other companies
C. identical to a bond issued by Microsoft
D. an asset for its owner and a liability for Microsoft.
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12. A share of common stock is a claim on a corporationʹs
A) debt.
B) liabilities.
C) expenses.
D) earnings and assets.

13. The price paid for the rental of borrowed funds (usually expressed as a percentage 
of the rental of $100 per year) is commonly referred to as the
A) inflation rate.
B) exchange rate.
C) interest rate.
D) aggregate price level.

14. ___________ occurs when the potential borrowers who are the most likely to
produce an undesirable (adverse) outcome – the bad credit risks – are the ones who
most actively seek out a loan and are thus most likely to be selected.
A. Adverse selection
B. Asymmetric information
C. Moral hazard
D. Credit ratings

15. A situation where one party often does not know enough about the other party to
make accurate decisions
A. Adverse selection
B. Asymmetric information
C. Moral hazard
 D. Credit ratings

16. A situation where the borrower might engage in activities that are undesirable
from the lender’s point of view because they make it less likely that the loan will be
paid back.
A. Adverse selection
B. Asymmetric information
C. Moral hazard
D. Credit ratings
( Restrictive covenant )
17. Which of the following is a true statement?
A) Money or the money supply is defined as Federal Reserve notes.
B)The average price of goods and services in an economy is called the aggregate price
level
C) he inflation rate is measured as the rate of change in the federal government budget
deficit.
D) The aggregate price level is measured as the rate of change in the inflation rate.

18. Equity holders are a corporationʹs ________.  That means the corporation must
pay all of its debt holders before it pays its equity holders.
A) debtors
B) brokers
C) residual claimants
D) underwriters

19. A corporation acquires new funds only when its securities are sold in the
A) secondary market by an investment bank.
B) primary market by an investment bank.
C) secondary market by a stock exchange broker.
D) secondary market by a commercial bank.

20. Which of the following statements about financial markets and securities is true?
A) Many common stocks are traded over-the-counter, although the largest
corpotations usually have their shares traded at organized stock exchanges such as
such as the New York Stock Exchange.
B)As a corporation gets a share of the brokerʹs commission, a corporation acquires
new funds whenever its securities are sold.
C) Capital market securities are usually more widely traded than shorter-
term securities and so tend to be more liquid.
D) Because of their short term to maturity, the prices of money market instruments
tend to fluctuate widely.

Part 2: Questions and applications

Chapter 2: Questions 3, 4, 6, 10
 Examples of how financial
3.

markets allow consumers to

better time their purchases
include:
● The purchase of a
durable good, like a car or
furniture
● Paying for tuition
● Paying the cost of
repairing a flooded
basement
In all three cases, consumers
were able to pay for a good
or service (education or the
reparation of a flooded
basement) without having to
wait to save enough and
only then being
able to afford such goods
and services.

Examples of how financial

markets allow consumers to
better time their purchases
include:
● The purchase of a
durable good, like a car or
furniture
● Paying for tuition
● Paying the cost of
repairing a flooded
basement
In all three cases, consumers
were able to pay for a good
or service (education or the
reparation of a flooded
basement) without having to
wait to save enough and
only then being
able to afford such goods
and services.
Examples of how financial
markets allow consumers to
better time their purchases
include:
● The purchase of a
durable good, like a car or
furniture
● Paying for tuition
● Paying the cost of
repairing a flooded
basement
In all three cases, consumers
were able to pay for a good
or service (education or the
reparation of a flooded
basement) without having to
wait to save enough and
only then being
able to afford such goods
and services.
Question 3: Give at least three examples of a situation in which financial markets
allow consumers to better time their purchases.

Examples of how financial markets allow consumers to better time their purchases
include:
● The purchase of a durable good, like a car or furniture
● Paying for tuition
● Paying the cost of repairing a flooded basement
In all three cases, consumers were able to pay for a good or service (education or the
reparation of a flooded basement) without having to wait to save enough and only
then being able to afford such goods and services.
Question 4: If you suspect that a company will go bankrupt next year, which would
you rather hold, bonds issued by the company or equities issued by the company?
Why?

You would rather hold bonds, because bondholders are paid off before equity holders,
who are the residual claimants.

Question 6: Describe who issues each of the following money market instruments:
a. Treasury bills
Treasury bills are short-term debt instruments issued by the (United States) government to
cover immediate spending obligations, i.e. finance deficit spending.
Issued for terms of 4, 13, 26, and 52 weeks Most liquid money market security
> Very actively traded
Very safe security
Held by banks, households, corporations, other intermediaries
In NL: Dutch State Treasury Agency issues Dutch Treasury Certificates

b. Certificates of deposit
Certificates of deposit (CDs) are issued (supplied) by banks and sold to depositors bank pays
annual interest of given amount and at maturity pays back to the depositor the original
purchase price plus the total annual interest earned.
Often negotiable, meaning they can be traded, can be resold in a secondary market liquidity
Covered by deposit insurance Fixed term typically pays higher rate than savings accounts

c. Commercial paper
Unsecured short-term debt instrument
Corporations and large banks issue commercial paper as a method of short- term funding in
debt markets
Only the largest and most creditworthy corporations Interest rate reflects issuer's level of risk

d. Repurchase agreement
Repos are a form of collateralized loan issued primarily by banks.
Mostly very short-term (less than 1 month maturity)
Lenders are other banks or institutional investors such as money market funds
Collateral: an asset that the lender receives as security if the borrower does not pay back the
loan

e. Fed funds

Question 10: How does risk sharing benefit both financial intermediaries and private
investors?
Financial intermediaries benefit by carrying risk at relatively low transaction costs.
Since higher-risk assets on average earn a higher return, financial intermediaries can
earn a profit on a diversified portfolio of risky assets. Individual investors benefit by
earning returns on a pooled collection of assets issued by financial intermediaries at
lower risk. The financial intermediary lowers the risk to individual investors through
the pooling of assets.