TRAINING

Part 1.2 Overview of the Financial System

Multiple Choice Questions

1) Financial markets have the basic function of

A) bringing together people with funds to lend and people who want to borrow funds.
B) assuring that the swings in the business cycle are less pronounced.
C) assuring that governments need never resort to printing money.
D) both A and B of the above.
E) both B and C of the above.

2) Which of the following can be described as involving indirect finance?

A) A corporation takes out loans from a bank.
B) People buy shares in a mutual fund.
C) A corporation buys commercial paper in a secondary market.
D) All of the above.
E) Only A and B of the above.

3) A country whose financial markets function poorly is likely to

A) efficiently allocate its capital resources.
B) enjoy high productivity.
C) experience economic hardship and financial crises.
D) increase its standard of living.

4) Which of the following statements about the characteristics of debt and equity are true?
A) They both can be long-term financial instruments.
B) They both involve a claim on the issuer's income.
C) They both enable a corporation to raise funds.
D) All of the above.
E) Only A and B of the above.

5) A debt instrument is called ________ if its maturity is greater than 10 years.

A) perpetual
B) intermediate-term
C) short-term
D) long-term

6) Which of the following are secondary markets?

A) The New York Stock Exchange
B) The U.S. government bond market
C) The over-the-counter stock market
D) The options markets
E) All of the above

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7) Which of the following statements about financial markets and securities are true?
A) Most common stocks are traded over-the-counter, although the largest corporations have their
shares traded at organized stock exchanges such as the New York Stock Exchange.
B) A corporation acquires new funds only when its securities are sold in the primary market.
C) Money market securities are usually more widely traded than longer-term securities and so
tend to be more liquid.
D) All of the above are true.
E) Only A and B of the above are true.

8) Which of the following statements about financial markets and securities are true?
A) Few common stocks are traded over-the-counter, although the over-the-counter markets have
grown in recent years.
B) A corporation acquires new funds only when its securities are sold in the primary market.
C) Capital market securities are usually more widely traded than longer-term securities and so
tend to be more liquid.
D) All of the above are true.
E) Only A and B of the above are true.

9) Bonds that are sold in a foreign country and are denominated in a currency other than that of
the country in which they are sold are known as
A) foreign bonds.
B) Eurobonds.
C) Eurocurrencies.
D) Eurodollars.

10) The country whose banks are the most restricted in the range of assets they may hold is
A) Japan.
B) Canada.
C) Germany.
D) the United States.

11) U.S. dollars deposited in foreign banks outside the United States or in foreign branches of
U.S. are referred to as
A) Eurodollars.
B) Eurocurrencies.
C) Eurobonds.
D) foreign bonds.

12) Intermediaries who are agents of investors and match buyers with sellers of securities are
called
A) investment bankers.
B) traders.
C) brokers.
D) dealers.
E) none of the above.

2
13) The main sources of financing for businesses, in order of importance, are
A) financial intermediaries, issuing bonds, issuing stocks.
B) issuing bonds, issuing stocks, financial intermediaries.
C) issuing stocks, issuing bonds, financial intermediaries.
D) issuing stocks, financial intermediaries, issuing bonds.

14) The reduction in transaction costs per dollar of transactions as the size (scale) of transactions
increases is known as
A) economies of scope.
B) economies of scale.
C) standardization.
D) market power.

15) Through risk-sharing activities, a financial intermediary ________ its own risk and
________ the risks of its customers.
A) reduces; increases
B) increases; reduces
C) reduces; reduces
D) increases; increases

16) When the potential borrowers who are the most likely to default are the ones most actively
seeking a loan, ________ is said to exist.
A) asymmetric information
B) adverse selection
C) moral hazard
D) fraud

17) Adverse selection is a problem associated with equity and debt contracts arising from
A) the lender's relative lack of information about the borrower's potential returns and risks of his
investment activities.
B) the lender's inability to legally require sufficient collateral to cover a 100 percent loss if the
borrower defaults.
C) the borrower's lack of incentive to seek a loan for highly risky investments.
D) none of the above.

18) In financial markets, lenders typically have inferior information about potential returns and
risks associated with any investment project. This difference in information is called
A) comparative informational disadvantage.
B) asymmetric information.
C) variant information.
D) caveat venditor.

3
19) Which of the following financial intermediaries are depository institutions?
A) A savings and loan association
B) A commercial bank
C) A credit union
D) All of the above
E) Only A and C of the above

20) Which of the following are not investment intermediaries?

A) A life insurance company
B) A pension fund
C) A mutual fund
D) Only A and B of the above

21) The government regulates financial markets for two main reasons:
A) to ensure soundness of the financial system and to increase the information available to
investors.
B) to improve control of monetary policy and to increase the information available to investors.
C) to ensure that financial intermediaries do not earn more than the normal rate of return and to
improve control of monetary policy.
D) to ensure soundness of financial intermediaries and to prevent financial intermediaries from
earning less than the normal rate of return.

22) Asymmetric information can lead to the widespread collapse of financial intermediaries,
referred as financial
A) panic.
B) bubble.
C) asset.
D) transaction.

23) The major differences between financial regulation in the United States and abroad relate to
bank regulation. Specifically, in the past, the U.S. was the only industrialized country to subject
banks to restrictions on
A) branching.
B) lending.
C) assets they may hold.
D) the size they could grow to.

4
True/False

1) A critical function of financial markets is an efficient allocation of capital.

2) The capital market is a financial market in which only short-term debt instruments (generally
those with an original maturity of less than one year) are traded.

3) Corporations that issue new securities to raise capital now conduct more of this business in
financial markets in Europe and Asia than in the U.S.

4) A bond denominated in euros and issued in a country that uses the euro as its currency is an
example of a Eurobond.

5) A financial intermediary's risk-sharing activities are also referred to as asset transformation.

6) Adverse selection refers to those with high credit risks, being most aggressive in their search
for funds.

7) "Thrift institutions" include savings and loan associations, mutual savings banks, and credit
unions.

8) Unlike regulations in other countries, there are very few federal regulations governing who is
allowed to set up a financial intermediary.

5
Open Questions

1. Compare the performance of the emerging markets in Southeast Asia and the developed
markets in Western Europe in light of the recent global eco-nomic downturn.

2. What are the risks and rewards of investing in the stock market as compared to the bond
market?

3. Why do loan sharks worry less about moral hazard in connection with their borrowers than
some other lenders do?

4. “Financial intermediaries play a crucial role in an economic crisis, they are responsible for
both causing the market to crash and then helping it recover from the crisis.” Is this statement
true? Discuss with an example.

5. What is the main purpose of financial regulation? What kind of instruments may a government
use to protect the economy and country from financial panic?

6
TRAINING - Correction

Part 1.2 Overview of the Financial System

Multiple Choice Questions

1) Financial markets have the basic function of

A) bringing together people with funds to lend and people who want to borrow funds.
B) assuring that the swings in the business cycle are less pronounced.
C) assuring that governments need never resort to printing money.
D) both A and B of the above.
E) both B and C of the above.
Answer: A

2) Which of the following can be described as involving indirect finance?

A) A corporation takes out loans from a bank.
B) People buy shares in a mutual fund.
C) A corporation buys commercial paper in a secondary market.
D) All of the above.
E) Only A and B of the above.
Answer: E

3) A country whose financial markets function poorly is likely to

A) efficiently allocate its capital resources.
B) enjoy high productivity.
C) experience economic hardship and financial crises.
D) increase its standard of living.
Answer: C

4) Which of the following statements about the characteristics of debt and equity are true?
A) They both can be long-term financial instruments.
B) They both involve a claim on the issuer's income.
C) They both enable a corporation to raise funds.
D) All of the above.
E) Only A and B of the above.
Answer: D

5) A debt instrument is called ________ if its maturity is greater than 10 years.

A) perpetual
B) intermediate-term
C) short-term
D) long-term
Answer: D

6) Which of the following are secondary markets?

A) The New York Stock Exchange
B) The U.S. government bond market
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C) The over-the-counter stock market
D) The options markets
E) All of the above
Answer: E

7) Which of the following statements about financial markets and securities are true?
A) Most common stocks are traded over-the-counter, although the largest corporations have their
shares traded at organized stock exchanges such as the New York Stock Exchange.
B) A corporation acquires new funds only when its securities are sold in the primary market.
C) Money market securities are usually more widely traded than longer-term securities and so
tend to be more liquid.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: D

8) Which of the following statements about financial markets and securities are true?
A) Few common stocks are traded over-the-counter, although the over-the-counter markets have
grown in recent years.
B) A corporation acquires new funds only when its securities are sold in the primary market.
C) Capital market securities are usually more widely traded than longer-term securities and so
tend to be more liquid.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: B

9) Bonds that are sold in a foreign country and are denominated in a currency other than that of
the country in which they are sold are known as
A) foreign bonds.
B) Eurobonds.
C) Eurocurrencies.
D) Eurodollars.
Answer: B

10) The country whose banks are the most restricted in the range of assets they may hold is
A) Japan.
B) Canada.
C) Germany.
D) the United States.
Answer: D

11) U.S. dollars deposited in foreign banks outside the United States or in foreign branches of
U.S. are referred to as
A) Eurodollars.
B) Eurocurrencies.
C) Eurobonds.
D) foreign bonds.
Answer: A

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12) Intermediaries who are agents of investors and match buyers with sellers of securities are
called
A) investment bankers.
B) traders.
C) brokers.
D) dealers.
E) none of the above.
Answer: C

13) The main sources of financing for businesses, in order of importance, are
A) financial intermediaries, issuing bonds, issuing stocks.
B) issuing bonds, issuing stocks, financial intermediaries.
C) issuing stocks, issuing bonds, financial intermediaries.
D) issuing stocks, financial intermediaries, issuing bonds.
Answer: A

14) The reduction in transaction costs per dollar of transactions as the size (scale) of transactions
increases is known as
A) economies of scope.
B) economies of scale.
C) standardization.
D) market power.
Answer: B

15) Through risk-sharing activities, a financial intermediary ________ its own risk and
________ the risks of its customers.
A) reduces; increases
B) increases; reduces
C) reduces; reduces
D) increases; increases
Answer: B

16) When the potential borrowers who are the most likely to default are the ones most actively
seeking a loan, ________ is said to exist.
A) asymmetric information
B) adverse selection
C) moral hazard
D) fraud
Answer: B

17) Adverse selection is a problem associated with equity and debt contracts arising from
A) the lender's relative lack of information about the borrower's potential returns and risks of his
investment activities.
B) the lender's inability to legally require sufficient collateral to cover a 100 percent loss if the
borrower defaults.
C) the borrower's lack of incentive to seek a loan for highly risky investments.
D) none of the above.
Answer: A
9
18) In financial markets, lenders typically have inferior information about potential returns and
risks associated with any investment project. This difference in information is called
A) comparative informational disadvantage.
B) asymmetric information.
C) variant information.
D) caveat venditor.
Answer: B

19) Which of the following financial intermediaries are depository institutions?

A) A savings and loan association
B) A commercial bank
C) A credit union
D) All of the above
E) Only A and C of the above
Answer: D

20) Which of the following are not investment intermediaries?

A) A life insurance company
B) A pension fund
C) A mutual fund
D) Only A and B of the above
Answer: D

21) The government regulates financial markets for two main reasons:
A) to ensure soundness of the financial system and to increase the information available to
investors.
B) to improve control of monetary policy and to increase the information available to investors.
C) to ensure that financial intermediaries do not earn more than the normal rate of return and to
improve control of monetary policy.
D) to ensure soundness of financial intermediaries and to prevent financial intermediaries from
earning less than the normal rate of return.
Answer: A

22) Asymmetric information can lead to the widespread collapse of financial intermediaries,
referred as financial
A) panic.
B) bubble.
C) asset.
D) transaction.
Answer: A

23) The major differences between financial regulation in the United States and abroad relate to
bank regulation. Specifically, in the past, the U.S. was the only industrialized country to subject
banks to restrictions on
A) branching.
B) lending.
C) assets they may hold.
10
D) the size they could grow to.
Answer: A

11
True/False

1) A critical function of financial markets is an efficient allocation of capital.

Answer: TRUE

2) The capital market is a financial market in which only short-term debt instruments (generally
those with an original maturity of less than one year) are traded.
Answer: FALSE

3) Corporations that issue new securities to raise capital now conduct more of this business in
financial markets in Europe and Asia than in the U.S.
Answer: TRUE

4) A bond denominated in euros and issued in a country that uses the euro as its currency is an
example of a Eurobond.
Answer: FALSE

5) A financial intermediary's risk-sharing activities are also referred to as asset transformation.

Answer: TRUE

6) Adverse selection refers to those with high credit risks, being most aggressive in their search
for funds.
Answer: TRUE

7) "Thrift institutions" include savings and loan associations, mutual savings banks, and credit
unions.
Answer: TRUE

8) Unlike regulations in other countries, there are very few federal regulations governing who is
allowed to set up a financial intermediary.
Answer: FALSE

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Open Questions

1. Compare the performance of the emerging markets in Southeast Asia and the developed
markets in Western Europe in light of the recent global eco-nomic downturn.

The emerging markets of Southeast Asia were not exposed to the economic crisis of 2007 as the
exotic financial instruments that were backed by toxic assets were not used in daily transactions
within Asian financial markets. On the other hand, banks in the developed markets of Western
Europe were dealing with toxic financial instruments that were deemed good on paper on a
regular basis, which in turn severely exposed them to the financial crisis. The result was that the
Southeast Asian economy remained strong despite the global scale of the financial crisis that had
badly hit Western Europe and the developed economies.

2. What are the risks and rewards of investing in the stock market as compared to the bond
market?

Rewards of investing in the stock market compared to the bond market:

a) The market participants—individual retail investors, institutional investors, and publicly
traded corporations—are equity owners as compared to bond holders (bond is a debt in nature).
b) The investor will receive dividend income once or twice a year where the amount can be
high based on the performance of the company as compared to bond interest which is fixed in
nature.
c) Investors have the opportunity to invest in blue-chip stocks that generate high dividends
or capital gains in comparison to bonds which are highly sensitive to the fluctuating interest
rates.

Risks of investing in the stock market compared to the bond market:

a) Stocks are volatile financial instruments compared to bonds which are more stable.
b) Sometimes stocks are not able to generate dividends but bonds can generate fixed interest
income for the bond holder.

3. Why do loan sharks worry less about moral hazard in connection with their borrowers than
some other lenders do?

Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might
jeopardize paying off the loan. Hence borrowers from a loan shark are less likely to engage in
moral hazard.

4. “Financial intermediaries play a crucial role in an economic crisis, they are responsible for
both causing the market to crash and then helping it recover from the crisis.” Is this statement
true? Discuss with an example.

Economic crisis mainly manifests at the level of financial intermediaries. These institutions can
be banking institutions, insurance companies, investment companies, financial intermediation
companies, or financial conglomerates. Financial intermediaries contribute to the efficient
transfer of funds from surplus agents to deficit agents. They can cause markets to crash by
influencing interest rates and the price of assets. The collapse of one financial intermediary may
13
also lead the market to collapse predominantly through the domino effect by damaging the trust
between them and the public at large. Financial intermediaries can help an economy recover
from a crisis if the management of these financial intermediaries become more proactive in
retaining and raising capital for financial institutions in distress and by channeling funds that
have been offered as assistance by governments to financial intermediaries during times of
distress to good and profitable investment opportunities that may be starved of capital.

5. What is the main purpose of financial regulation? What kind of instruments may a government
use to protect the economy and country from financial panic?

The main purpose of financial regulation is to make more information available for market
participants, and hence protect investors from adverse selection, reduce the asymmetry of
information, and ensure the soundness of financial intermediaries. To protect the public and the
economy from financial panics, the government has implemented six types of regulations:
restrictions on entry of financial intermediaries, stringent reporting requirements for financial
intermediaries, restrictions on assets and activities of financial intermediaries, insurance of
people’s deposits by the government if the financial intermediary should fail, limitations on
competition among financial intermediaries, and restrictions on interest rates that can be paid on
deposits by financial intermediaries.

14