Financial Markets (Chapter 5)

KYLA R.
DAYAWON BSA-2A
FINANCIAL MARKETS AND INSTITUTION
REVIEW QUESTIONS (CHAPTER 5)
1. Why is there a need for an efficient financial system for a country to have a strong economy?
- There a need for an efficient financial system for a country to have a strong economy to makes or
channels fund people who to save to have productive investment opportunities. A developed
economy also relies on financial markets and institution for efficient transfer of funds. A strong
financial system is also a necessary ingredients for a growing and prosperous economy and also it
is required for the companies raising capital to finance capital expenditures and investors saving to
accumulate funds for future use.
2. What comprises financial systems?

- The financial systems is complex, comprising many different types of private sector financial
institutions, including bank, insurance companies, finance companies, mutual funds, and
investment banks, all of which are regulated by the government.
3. Explain the nature and main objective of the financial system.

- The nature of financial system is consists of all financial intermediaries and financial markets and
their relations with respect to the flow of funds to and from households government, business firms
as well as the finance infrastructure. The main objective is that having a well financial system in
place that directs funds to their most productive uses is crucial prerequisites for economic
development.
4. Explain the basic flow of funds through the financial system.

- In the flow of funds through the financial system the principal lender-savers are households, but
business enterprise and the government (particularly state and local government), as well as
foreigners and their governments, sometimes also find themselves with excess funds and so lend
them out and the most important borrower-spenders are businesses and the government
(particularly the national government), but households and foreigners also borrow finance to
purchase of cars, furniture, and houses. The fund flow from lender-savers to borrower-spenders via
two routes.
In direct finance borrowers borrow funds directly from lenders in financial markets by selling them
securities or the financial instruments, which are claims on the borrower’s future income or assets.
Securities are assets for the person who buys them buy liabilities or the IOU’s or debts for the
individual or firm that sells (issues) them.
5. What are the key components of the financial systems?
 Financial Instruments
 Financial Markets and Institutions
 The Central Bank and Other Finance Regulators.
6. Describe the three important functions of the financial systems.
- RISK SHARING. Risk is the chance that the value of the financial assets will change relative to
what one expects. One advantage of using the financial system to match the individual savers and
borrowers and that it allows the sharing of risk. The financial system provides risk sharing by
allowing savers to hold many assets. Hence, the ability of the financial system to provide risk
sharing make savers more willing to buy stocks, bonds, and other financial assets. This willingness
in turn increases the ability of borrowers to raise funds in the financial system.
- LIQUIDITY. Liquidity is the ease with which an asset can be exchanged for money which savers
view as benefit. Generally, assets created by the financial system such as stocks, bonds, or checking
accounts, are more liquid than physical assets such as cars, machinery or real state. Financial
markets and intermediaries help financial assets more liquid.
- INFORMATION, GATHERING AND SHARING. Facts about the borrower’s expectation of

returns on financial assets. Bank collect information on borrowers to forecast their livelihood of
repaying loans. Because the bank specializes in collecting and processing information, it costs for
information gathering are lower than yours would be if you tried to gather information about a pool
of borrowers. Financial markets convey information to both savers and borrower by determining
the prices of stocks, bonds, and other securities. This information can help decide whether to
continue investing in the securities previously purchased or to sell more stock or bonds to finance
a planned expansion. The incorporation of available information into assets prices is an important
feature of well-functioning financial markets.
7. Explain what Asymmetric information is.

- Asymmetric information describes the situation in which one party to an economic transaction has
better information than does the other party. In financial transactions, typically the borrower has
more information than does the lender.
8. Describe the problem arising from asymmetric information

- ADVERSE SELECTION. This is the problem investors experience in distinguishing low-risk
borrowers before making an investment. The information asymmetry before the contract is agreed
upon arises because borrowers generally know more about their investment projects than the
lenders. Borrowers most eager to engage in transaction are the most likely ones to produce an
undesirable outcome for the lender (adverse selection).
- MORAL HAZARD. This is the problem investors experience in verifying that borrowers are using
their funds as intended. Even after the lender has gathered information on whether the borrower is
a good borrower or a lemon borrower, the lender’s information problems haven’t intended. There
is still a possibility that after the lender makes a loan to what appears to be a good borrower, the
borrower will not use the fund on what is intended. Moral hazards arises because of asymmetric
Information: the borrower knows more than the lender does about how the borrowed funds will
actually be used.
9. What are transaction and information costs?

- TRANSACTION COSTS. The cost of trade or a financial transactions; for example the brokerage
commission charged for buying and selling a financial asset.
- INFORMATION COSTS. The costs that savers incur to determine the creditworthiness of
borrowers and to monitor how they used the funds acquired.
*Because of the transaction costs and information costs, savers received a lower return on their
investments and borrowers must pay more than the funds they borrow. Although transaction
costs and information costs reduce the efficiency of financial system, they also create a profit
opportunity for individuals and firms that can discover ways to reduce costs.
10. Explain how financial Intermediaries
A. Reduce Adverse Selection.

*Requiring borrower to disclose material information on the financial performance and financial
position. Financial market participants and the government have taken steps to try reduce problems
of adverse selection in financial markets
* Collecting Information on firms and selling that information to investors.
* 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 Problems”

* Specializing in monitoring borrowers and developing effective techniques to ensure that the funds
they laon are actually used for their intended purpose.
* Imposing Restrictive Covenants. Restrictive covenants may involve placing limitations on the
uses of funds borrowed or requiring the borrowers to pay off the debt ven before maturity date if
the borrower’s net worth drop below the certain level.
C. Reduce Transaction Costs.

* Financial intermediaries take advantage of economies of scale, which refers to the reduction in
average cost that results from an increase in the volume of goods and services produced.
* Financial intermediaries can also take advantage of economies of scale in other ways.
* Financial intermediaries also take advantage of technology to provide financial services such as
those that automated teller machine networks provide.
* Financial intermediaries also increasingly rely on sophisticated software to evaluate the
creditworthiness of loan applicants.

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KYLA R.

REVIEW QUESTIONS (CHAPTER 5)

2. What comprises financial systems?

3. Explain the nature and main objective of the financial system.

4. Explain the basic flow of funds through the financial system.

5. What are the key components of the financial systems?

- INFORMATION, GATHERING AND SHARING. Facts about the borrower’s expectation of

7. Explain what Asymmetric information is.

8. Describe the problem arising from asymmetric information

9. What are transaction and information costs?

A. Reduce Adverse Selection.

B. Moral “Hazard Problems”

C. Reduce Transaction Costs.

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