Cecchetti 6e Chapter03 SM

Chapter 03 - Financial Instruments, Financial Markets, and Financial Institutions
Chapter 3
Financial Instruments, Financial Markets,
and Financial Institutions
Conceptual and Analytical Problems

1. As the end of the month approaches, you realize that you probably will not be able to pay the
next month’s rent. Describe both an informal and a formal financial instrument that you
might use to solve your dilemma. (LO1)
Answer:
Informal—borrowing money from family or friends.
Formal—obtaining a loan from a bank.
2. *While we often associate informal financial arrangements with poorer countries where
financial systems are less developed, informal arrangements often coexist within the most
developed financial systems. What advantages might there be to engaging in informal
arrangements rather than utilizing the formal financial sector? (LO1)
Answer: Informal arrangements are often more flexible than standardized formal loans.
Information and monitoring costs can be lower than for formal loans, as the parties to the
arrangement are generally known to each other. In addition, informal arrangements are often
more flexible than standardized formal loans. Informal financial arrangements are prevalent
among certain ethnic groups in the United States, where community ties are strong and social
and cultural factors help ensure the arrangements are honored. (See, for example, P. Bond
and R Townsend (1996) “Formal and Informal Financing in a Chicago Ethnic
Neighborhood” Economic Perspectives, Federal Reserve Bank of Chicago, July.)
3. If higher leverage is associated with greater risk, explain why the process of deleveraging
(reducing leverage) can be destabilizing. (LO2)
Answer: The problem arises if too many institutions try to reduce their leverage at the same
time. A large number of institutions selling assets will push down asset prices. With asset
values falling relative to liabilities, net worth falls, increasing leverage and prompting further
asset sales, potentially destabilizing those markets.
4. The Chicago Mercantile Exchange offers a financial instrument that is based on rainfall in
the state of Illinois. The standard agreement states that for each inch of rain over and above
the average rainfall for a particular month, the seller will pay the buyer $1,000. Who could
benefit from buying such a contract? Who could benefit from selling it? (LO1)
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Answer: Someone who benefits from above average rainfall could sell the contract, and
someone who is harmed by above average rainfall should buy the contract. Crops can benefit
from additional rainfall during certain times of the year, but may be harmed by too much rain
at other times; so, depending on the season, farmers could be buying or selling derivatives.
Hydroelectric companies could also sell the contracts, while people who benefit from dry
weather—like golf course operators—could buy them.
5. You wish to buy an annuity that makes monthly payments for as long as you live. Describe
what would happen to the purchase price of the annuity if (1) your age at the time of
purchase goes up, (2) the size of the monthly payment rises, and (3) your health improves.
(LO1)
Answer:
1. The number of expected monthly payments declines so the price of the annuity
falls.
2. The price of the annuity rises as each payment is larger.
3. The purchaser is expected to live longer; the number of expected monthly payments
rises so the price of the annuity rises.
6. Which of the following would be more valuable to you: a portfolio of stocks that rises in
value when your income rises or a portfolio of stocks that rises in value when your income
falls? Why? (LO1)
Answer: A portfolio of stocks that rises in value when your income falls is more valuable
because it pays off when you need it the most (when your marginal utility is high).
7. Has the distinction between direct and indirect forms of finance become more or less
important in recent times? Why? (LO3)
Answer: The distinction has become less important. The increasing sophistication of the
financial system has led to greater institutionalization, so that even direct finance transactions
usually involve a financial institution to some extent.
8. Designated market makers, who historically have provided liquidity (that is, have stood by
ready to buy and sell) in markets for specific stocks, have declined in importance. Explain
this decline in terms of technology and global economic integration. (LO2)
Answer: Advances in technology have made it possible for investors from around the world
to trade via electronic exchanges and communications networks. Large numbers of electronic
buyers and sellers create sufficient liquidity to replace the activities previously provided by
the designated market makers. However, complete elimination of these market makers would
require near-foolproof software to match the buy and sell orders. Instead, there have been
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numerous examples of headline-making market disturbances associated with electronic

trading mishaps.
9. The design and function of financial instruments, markets, and institutions are tied to the
importance of information. Describe the role played by information in each of these three
pieces of the financial system. (LO1, LO2, LO3)
Answer: The design and function of financial instruments, markets, and institutions are tied
to the importance of information. Financial instruments summarize essential information
about the borrower. Financial markets aggregate information from many sources and
communicate it widely. Financial institutions produce information to screen and monitor
borrowers.
10. Suppose you need to take out a personal loan with a bank. Explain how you could be
affected by problems in the interbank lending market such as those seen during the 2007-
2009 financial crisis. (LO2)
Answer: The strains in the interbank market pushed up interbank lending rates, which
increases the cost of funds to banks and would likely lead to an increase in the rate on your
personal loan. If your bank is having trouble obtaining short-term funding in the interbank
market, it may decide to hold more cash and reduce lending, impacting your ability to secure
a loan at all.
11. *Advances in technology have facilitated the widespread use of credit scoring by financial
institutions in making their lending decisions. Credit scoring can be defined broadly as the
use of historical data and statistical techniques to rank the attractiveness of potential
borrowers and guide lending decisions. In what ways might this practice enhance the
efficiency of the financial system? (LO3)
Answer: The use of credit scoring techniques standardizes the assessment of loan applicants
and reduces information costs. This allows financial institutions to lend to a broader range of
borrowers and facilitates the creation of asset-backed securities based on these loans.
Lending practices based on more objective criteria reduce subjectivity and discrimination in
lending decisions, leading to a more efficient allocation of resources.
12. Commercial banks, insurance companies, investment banks, and pension funds are all
examples of financial intermediaries. For each of these, give an example of a source of their
funds and an example of their use of funds. (LO3)
Answer: Commercial banks receive deposits in checking and savings accounts and borrow
from other entities. The funds they receive are used to make loans and purchase government
securities.
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Insurance companies receive premium payments, which they invest in securities or other
assets to earn income until claims are paid.
Investment banks charge fees for advising clients on mergers and acquisitions and for
preparing new stock and bond issues for the market. They may use funds to participate in
some of the initial public offerings they distribute.
Pension funds receive regular contributions from companies providing for retirement
promises. These funds are invested in assets that will later be used to pay retirement benefits
to company employees.
13. 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? (LO3)
Answer: Automobile insurers generally need to have funds readily available when a
policyholder makes a claim, and Treasury bills are highly liquid. Life insurance companies
have liabilities with a much longer horizon. A life insurance policy is expected to pay off in
30 years, say, so that assets with longer horizons correspond to their longer-term liabilities.
In general, insurers can limit their risks by matching the terms of their liabilities with the
terms of their assets.
14. For each pair of instruments below, use the criteria for valuing a financial instrument to
choose the one with the highest value. (LO1)
a. A U.S. Treasury bill that pays $1,000 in six months or a U.S. Treasury bill that pays
$1,000 in three months.
b. A U.S. government Treasury bill that pays $1,000 in three months or commercial
paper issued by a private corporation that pays $1,000 in three months.
c. An insurance policy that pays out in the event of serious illness or one that pays out
when you are healthy, assuming you are equally likely to be ill or healthy.
Explain each of your choices briefly.
Answer:
a. The T-bill that pays out in three months, as the sooner the payment the more valuable.
b. The T-bill is more valuable as the likelihood of the U.S government honoring its
debts is higher than a private corporation.
c. The insurance policy that pays out when you are ill, as this is when the payment is
most needed.
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15. Janet and Mike purchase identical houses for $400,000. Janet makes a down payment of
$80,000 while Mike only puts down $20,000; for each individual, the down payment is the
total of their net worth and they finance the remainder of the house price with a mortgage.
Assuming everything else equal, who is more highly leveraged? If house prices in the
neighborhood immediately fall by 10 percent (before any mortgage payments are made),
what would happen to Janet’s and Mike’s net worth? (LO2)
Answer: Leverage is defined as borrowing to finance part of an investment. Mike is more

highly leveraged as he has financed a larger part of his asset with borrowing (95 percent
compared with Janet’s 80 percent). Assuming they have no other assets or liabilities, if
house prices fall by 10 percent, Janet’s net worth would still be positive at $40,000 but
Mike’s would be negative. He would owe $380,000 on his mortgage for a house worth
$360,000.
16. *Everything else being equal, which would be more valuable to you —a derivative
instrument whose value is derived from an underlying instrument with a very volatile price
history or one derived from an underlying instrument with a very stable price history?
Explain your choice. (LO2)
Answer: The primary use of derivatives is to transfer risk from one party to another. The
more volatile the price of the instrument upon which the derivative is based, the higher the
risk, everything else being equal. Therefore, the derivative based on the more volatile
underlying asset should have more value to you. For example, an option to buy a particular
asset as some date in the future at a pre-determined price would have little value if the price
of that asset never changed over time.
17. You decide to start a business selling covers for smartphones in a mall kiosk. To buy
inventory, you need to borrow some funds. Why are you more likely to take out a bank loan
than to issue bonds? (LO3)
Answer: Issuing bonds is a form of direct finance and would require finding a buyer who
would be willing to bear the information and monitoring costs associated with the loan. For a
small, unknown business, these costs would usually be prohibitive. In the case of a bank
loan, the lending institution becomes the counterparty to the transaction. These financial
institutions overcome problems associated with asymmetric information by using their
expertise to screen loan applicants and use standardized loan contracts to reduce transaction
costs.
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18. Splitland is a developing economy with two distinct regions. The northern region has great
investment opportunities, but the people who live there need to consume all of their income
to survive. Those living in the south are better off than their northern counterparts and save a
significant portion of their income. The southern region, however, has few profitable
investment opportunities and so most of the savings remain in shoeboxes and under
mattresses. Explain how the development of the financial sector could benefit both regions
and promote economic growth in Splitland. (LO2)
Answer: In the absence of financial markets, resources are not being allocated to the best
investment opportunities available—in this case, to the northern region. The introduction of a
financial intermediary, for example, could channel the available savings from the southerners
to the most productive investment opportunities that are available in the northern region. The
presence of the intermediary would reduce the information costs that may have prevented the
southerners lending directly to the northerners in the past. The southerners would benefit by
earning a return on their savings while the northern region would benefit from the increased
investment. Splitland would benefit from higher economic growth as the available resources
are allocated more efficiently.
19. What would you expect to happen to investment and growth in the economy if the U.S.
government decided to abolish the Securities and Exchange Commission? (LO2)
Answer: The role of the Securities and Exchange Commission (SEC) is to protect investors
by working to insure that all investors have access to certain knowledge about companies.
(See www.sec.gov for further details.) According to Core Principle 3 from Chapter 1,
information is the basis for decisions. If the SEC were abolished, it would be more difficult
for investors to make good, well-informed decisions. Capital markets would likely function
less efficiently to the detriment of investment and growth.
20. Use Core Principle 3 (information is the basis for decisions) to suggest some ways in which
the problems associated with the shadow banking sector during the 2007-2009 financial crisis
might be mitigated in the future. (LO3)
Answer: Many of the problems in the shadow banking sector during the financial crisis arose
because investors and trading partners lacked information about activities of the shadow
banks. Measures to improve the transparency of shadow banking activities, through increased
regulation of these institutions, for example, could help mitigate the problems that arose.
21. What risks might financial institutions face by funding long-run loans such as mortgages to
borrowers (often at fixed interest rates) with short-term deposits from savers? As the
manager of a financial institution, what steps could you take to reduce these risks? (LO3)
Answer: If savers decide to withdraw in large numbers from the financial institution, the
institution may not have sufficient funds readily available for them if the funds had been lent
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out as a 30-year mortgage, for example. (Assume the mortgage is held on the balance sheet
of the institution in question.) Moreover, long-term mortgage loans are often made at fixed
interest rates while rates on short-term deposits fluctuate with the market. The financial
institution faces the risk that interest rates will rise, requiring higher interest rates to be paid
to continue to attract deposits while the payments received from the mortgage loans stay the
same.
Some strategies to reduce these risks include pooling mortgages into mortgage-backed
securities and selling them or using derivative instruments to transfer the risk associated with
interest rate increases. This could be done, for example, by purchasing a derivatives
instrument that pays off when interest rates rise.
22. Give two examples of how greater financial inclusion might benefit a small farmer who
previously did not have access to modern finance. (LO3)
Answer:
1) Access to savings instruments offered by the financial system facilitates the management
of risk.
2) Participation in the financial system creates information that can help judge the
creditworthiness of a potential borrower and so can help the farmer borrow from a
financial institution.
23. How might broader access to finance benefit a country where access was previously very
limited? (LO3)
Answer: Greater access to finance can boost economic growth by lowering transaction costs,
facilitating the channeling of savings to the most productive uses and enabling greater
specialization.
24. Secondary-market trading in stocks has become increasingly decentralized. Identify some
reasons why you might expect this trend to continue. (LO2)
Answer: Technological advances have mitigated the necessity to physically gather in a

common location to trade. Although electronically decentralized exchange brings its own set
of problems, further system and technological improvements may mitigate these
disadvantages in the future. Moreover, decentralized trading avoids the operational risk
associated with trading on a centralized trading floor.
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Chapter 03 - Financial Instruments, Financial Markets, and Financial Institutions

Conceptual and Analytical Problems

numerous examples of headline-making market disturbances associated with electronic

Answer: Leverage is defined as borrowing to finance part of an investment. Mike is more

Answer: Technological advances have mitigated the necessity to physically gather in a

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