TUTORIAL FOR FINANCIAL MARKETS & INSTITUTIONS

An Economic Analysis of Financial Structure

1. The presence of adverse selection problems keeps bond and stock markets from
effectively channelling funds from savers to borrowers. What does the statement mean?
Explain briefly.

2. Why do large corporations find it easier to raise funds in securities markets while small
businesses rely mostly on bank loans?

3. Would each of the following events increase or decrease the volume of bank loans?
Explain.

a. New regulations make it easier for shareholders to replace company directors.

b. A new law makes it a crime to default on a bank loan.

c. All the economy’s small firms are bought by large firms.

d. Mutual funds reduce their minimum balances for shareholders.

4. Suppose you have $1000 to lend and offer it for 10-percent interest. Someone promises to
pay 20 percent if you lend to him. Should you jump at this offer?

5. Suppose I am a good borrower. I need $10,000 to invest in a project that will pay a safe
6% rate of return next year. Suppose my neighbour is a bad borrower, his $10,000
project has a very low chance of success but the expected rate of return is 20%. The local
bank charges 10% interest rate on all its loans.
a. Will I be willing to borrow at this rate? Will my neighbour be willing to borrow
at this rate?
b. Assume all potential borrowers are either like me or like my neighbour. Explain
why the bank will end up issuing no loans and no projects will be funded.
c. How could the bank reduce this adverse selection problem?
6. What kind of moral hazard problems do banks worry about?

7. Suppose an all you can eat buffet costs $10. The buffet discovers that most of its
customers are sumo fighters. Is this a problem of adverse selection or moral hazard for
the restaurant? Explain.
 8. Why might you be willing to make a loan to your neighbour by putting funds in a savings
account earning a 5% interest rate at the bank and having the bank lend her the funds at a
10% interest rate rather than lend her the funds yourself?

Non-bank institutions

9. Why do property and casualty insurance companies have large holdings of municipal
bonds but life insurance companies do not?

10. Life insurance companies tend to invest in long-term assets such as loans to
manufacturing firms to build factories or to real estate developers to build shopping malls
and skyscrapers. Automobile insurers tend to invest in short-term assets such as Treasury
bills. What accounts for these differences?

11. List three types of financial intermediaries, give examples.

12. What explains the widespread use of deductibles in insurance policies?

13. Why might insurance companies restrict the amount of insurance a policyholder can buy?

14. Explain why shares in closed-end mutual funds typically sell for less than the market
value of the stocks they hold.

15. Will finance companies be replaced by commercial banks?

16. “Closed end funds tend to hold stocks that are less liquid than stocks held by open end
funds”. Comment on this.

17. Is investment banking a good career for someone who is afraid of taking risks? Why or
why not?

Investment banking is a good career for people afraid of taking risks since most times it doesn't
involve directly attachment to risks. Investment...

18. Should financial institutions be regulated in order to reduce their risk? Offer at least one
argument for regulation and one argument against regulation.
19. When a securities firm serves as an underwriter for an IPO, is the firm working for the
issuer or the institutional investors that may purchase shares? Explain the dilemma.