Araña, Charmaine H

BSAC 2B

FINANCIAL MARKETS
Assignment

6. Describe the three important functions of the financial system, namely;

A. Risk sharing

Answer:

Risk-sharing is the ability of the financial system to distribute the risk to the individual
savers. This increases the willingness of individual savers and borrowers to invest/buy and
borrow different financial assets. This also allows savers to hold many assets.

B. Liquidity

Answer:

Liquidity is the ability of assets to be easily liquidated. It is the ease which savers can easily
exchange assets for money, which savers view as benefit. Example of the liquid assets
created by financial systems are stocks, bonds or checking account, and etc.

C. Information gathering & sharing

Answer:

Information is predominant in a financial system to forecast the likelihood of borrowers

on repaying their loans. Financial markets channels information to both savers and
borrowers by determining stock prices, bonds, and other securities. The availability of
these information is a crucial feature of a well-functioning financial market.

7. Explain what asymmetric information is

Answer:

An asymmetric information is a situation in which one party has better information of

economic transactions than that of the other party. If associated in financial transactions,
it means that the borrower has more information than the lender.

8. Describe the two problems arising from asymmetric information, namely;

A. Adverse selection

Answer:

Adverse selection is a problem investors run into in distinguishing low-risk borrowers from
high-risk borrowers before making an investment.
B. Moral hazard

Answer:

Moral hazard is a problem that investors come across in verifying that borrowers are using
funds as stated.

9. What are transaction and information costs?

Answer:

Transaction costs are the cost of a trade or a financial transaction. Example is the
commission charge of brokerage for buying or selling a financial asset.

Information costs is a cost that savers incur to determine the creditworthiness of the
borrowers and to monitor how the funds acquired are being used.

10. Explain how financial intermediaries

A. Reduce “adverse selection”

Answer:

The problem of adverse selection can be minimized by requiring borrowers to disclose

material information, collecting information on firms and selling that information to
investors, and convincing lenders to require borrowers to pledge some of their assets as
collateral which the lender can claim of the borrower defaults.

B. Moral “hazard problem”

Answer:

Difficulties of moral hazard problems can be reduced by adopting procedures in

monitoring the borrowers on how they use the funds. The procedures include: Specializing
in monitoring borrowers, and developing effective techniques, imposing restrictive
covenants. These techniques ensure that the funds they borrowed are actually used for
their intended purpose.

C. Reduce “transaction and information costs”

Answer:

Problems arising from transaction costs can be reduced by adopting techniques like:
taking advantage of economies of scale which reduces in average costs that results from
an increase in volume of good or services produced, relying on standardized legal
contracts, so that the costs of writing contracts can be spread to many loans, and reduced
the time required to process loans and the cost per loan, taking advantage of technology
to provide financial services, such as automated teller machine that network provides, and
increasing the reliance on sophisticated software to evaluate the credit worthiness of loan
applicants.