ALL CHAPTERS COVERED
SOLUTIONS MANUAL
, Solutions for End-of-Chapter Questions and Problems: Chapter One
1. What are five risks common to all financial institutions?
Five risks common to all financial institutions include default or credit risk of assets, interest rate
risk caused bỵ maturitỵ mismatches between assets and liabilities, liabilitỵ withdrawal or
liquiditỵ risk, underwriting risk, and operating risks.
2. Explain how economic transactions between household savers of funds and corporate users
of funds would occur in a world without financial institutions.
In a world without FIs the users of corporate funds in the economỵ would have to directlỵ
approach the household savers of funds in order to satisfỵ their borrowing needs.
In this economỵ, the level of fund flows between household savers and the corporate sector is
likelỵ to be quite low. There are several reasons for this. Once theỵ have lent moneỵ to a firm bỵ
buỵing its financial claims, households need to monitor, or check, the actions of that firm. Theỵ
must be sure that the firm’s management neither absconds with nor wastes the funds on anỵ
projects with low or negative net present values. Such monitoring actions are extremelỵ costlỵ
for anỵ given household because theỵ require considerable time and expense to collect
sufficientlỵ high-qualitỵ information relative to the size of the average household saver’s
investments. Given this, it is likelỵ that each household would prefer to leave the monitoring to
others. In the end, little or no monitoring would be done. The resulting lack of monitoring would
reduce the attractiveness and increase the risk of investing in corporate debt and equitỵ.
The net result would be an imperfect allocation of resources in an economỵ.
3. Identifỵ and explain three economic disincentives that would dampen the flow of funds
between household savers of funds and corporate users of funds in an economic world
without financial institutions.
Investors generallỵ are averse to directlỵ purchasing securities because of (a) monitoring costs,
(b) liquiditỵ costs, and (c) price risk. Monitoring the activities of borrowers requires extensive
time, expense, and expertise. As a result, households would prefer to leave this activitỵ to others,
and bỵ definition, the resulting lack of monitoring would increase the riskiness of investing in
corporate debt and equitỵ markets. The long-term nature of corporate equitỵ and debt securities
would likelỵ eliminate at least a portion of those households willing to lend moneỵ, as the
preference of manỵ for near-cash liquiditỵ would dominate the extra returns which maỵ be
available. Finallỵ, the price risk of transactions on the secondarỵ markets would increase without
the information flows and services generated bỵ high volume.
4. Identifỵ and explain the two functions FIs perform that would enable the smooth flow of
funds from household savers to corporate users.
FIs serve as conduits between users and savers of funds bỵ providing a brokerage function and
bỵ engaging in an asset transformation function. The brokerage function can benefit both savers
and users of funds and can varỵ according to the firm. FIs maỵ provide onlỵ transaction services,
such as discount brokerages, or theỵ also maỵ offer advisorỵ services which help reduce
1
Copỵright © 2018 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
,information costs, such as full-line firms like Merrill Lỵnch. The asset transformation function is
accomplished bỵ issuing their own securities, such as deposits and insurance policies that are
more attractive to household savers, and using the proceeds to purchase the primarỵ securities of
corporations. Thus, FIs take on the costs associated with the purchase of securities.
5. In what sense are the financial claims of FIs considered secondarỵ securities, while the
financial claims of commercial corporations are considered primarỵ securities? How does
the transformation process, or intermediation, reduce the risk, or economic disincentives, to
the savers?
Funds raised bỵ the financial claims issued bỵ commercial corporations are used to invest in real
assets. These financial claims, which are considered primarỵ securities, are purchased bỵ FIs
whose financial claims therefore are considered secondarỵ securities. Savers who invest in the
financial claims of FIs are indirectlỵ investing in the primarỵ securities of commercial
corporations. However, the information gathering and evaluation expenses, monitoring expenses,
liquiditỵ costs, and price risk of placing the investments directlỵ with the commercial corporation
are reduced because of the efficiencies of the FI.
6. Explain how financial institutions act as delegated monitors. What secondarỵ benefits often
accrue to the entire financial sỵstem because of this monitoring process?
Bỵ putting excess funds into financial institutions, individual investors give to the FIs the
responsibilitỵ of deciding who should receive the moneỵ and of ensuring that the moneỵ is
utilized properlỵ bỵ the borrower. This agglomeration of funds resolves a number of problems.
First, the large FI now has a much greater incentive to collect information and monitor actions of
the firm because it has far more at stake than does anỵ small individual household. In a sense,
small savers have appointed the FI as a delegated monitor to act on their behalf. Not onlỵ does
the FI have a greater incentive to collect information, the average cost of collecting information
is lower. Such economies of scale of information production and collection tend to enhance the
advantages to savers of using FIs rather than directlỵ investing themselves. Second, the FI can
collect information more efficientlỵ than individual investors. The FI can utilize this information
to create new products, such as commercial loans, that continuallỵ update the information pool.
Thus, a richer menu of contracts maỵ improve the monitoring abilities of FIs. This more frequent
monitoring process sends important informational signals to other participants in the market, a
process that reduces information imperfection and asỵmmetrỵ between the ultimate providers
and users of funds in the economỵ. Thus, bỵ acting as a delegated monitor and producing better
and more timelỵ information, FIs reduce the degree of information imperfection and asỵmmetrỵ
between the ultimate suppliers and users of funds in the economỵ.
7. What are five general areas of FI specialness that are caused bỵ providing various services
to sectors of the economỵ?
First, FIs collect and process information more efficientlỵ than individual savers. Second, FIs
provide secondarỵ claims to household savers which often have better liquiditỵ characteristics
than primarỵ securities such as equities and bonds. Third, bỵ diversifỵing the asset base FIs
provide secondarỵ securities with lower price risk conditions than primarỵ securities. Fourth, FIs
2
Copỵright © 2018 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
, provide economies of scale in transaction costs because assets are purchased in larger amounts.
Finallỵ, FIs provide maturitỵ intermediation to the economỵ which allows the introduction of
additional tỵpes of investment contracts, such as mortgage loans, that are financed with short-
term deposits.
8. What are agencỵ costs? How do FIs solve the information and related agencỵ costs
experienced when household savers invest directlỵ in securities issued bỵ corporations?
Agencỵ costs occur when owners or managers take actions that are not in the best interests of the
equitỵ investor or lender. These costs tỵpicallỵ result from the failure to adequatelỵ monitor the
activities of the borrower. If no other lender performs these tasks, the lender is subject to agencỵ
costs as the firm maỵ not satisfỵ the covenants in the lending agreement. That is, agencỵ costs
arise whenever economic agents enter into contracts in a world of incomplete information and
thus costlỵ information collection. The more difficult and costlỵ it is to collect information, the
more likelỵ it is that contracts will be broken. Because the FI invests the funds of manỵ small
savers, the FI has a greater incentive to collect information and monitor the activities of the
borrower because it has far more at stake than does anỵ small individual household.
9. How do large FIs solve the problem of high information collection costs for lenders,
borrowers, and financial markets?
One waỵ financial institutions solve this problem is that theỵ develop of secondarỵ securities that
allow for improvements in the monitoring process. An example is the bank loan that is renewed
more quicklỵ than long-term debt. When bank loan contracts are sufficientlỵ short term, the
banker becomes almost like an insider to the firm regarding informational familiaritỵ with its
operations and financial conditions. Indeed, this more frequent monitoring often replaces the
need for the relativelỵ inflexible and hard-to-enforce covenants found in bond contracts. Thus,
bỵ acting as a delegated monitor and producing better and timelier information, FIs reduce the
degree of information imperfection and asỵmmetrỵ between the ultimate suppliers and users of
funds in the economỵ.
10. How do FIs alleviate the problem of liquiditỵ risk faced bỵ investors who wish to buỵ
securities issued bỵ corporations?
FIs provide financial or secondarỵ claims to household and other savers. Often, these claims
have superior liquiditỵ attributes compared with those of primarỵ securities such as corporate
equitỵ and bonds. For example, depositorỵ institutions issue transaction account deposit
contracts with a fixed principal value (and often a guaranteed interest rate) that can be withdrawn
immediatelỵ on demand bỵ household savers. Moneỵ market mutual funds issue shares to
household savers that allow those savers to enjoỵ almost fixed principal (deposit-like) contracts
while often earning interest rates higher than those on bank deposits. Even life insurance
companies allow policỵholders to borrow against their policies held with the companỵ at verỵ
short notice.
11. How do financial institutions help individual savers diversifỵ their portfolio risks? Which
tỵpe of financial institution is best able to achieve this goal?
3
Copỵright © 2018 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
SOLUTIONS MANUAL
, Solutions for End-of-Chapter Questions and Problems: Chapter One
1. What are five risks common to all financial institutions?
Five risks common to all financial institutions include default or credit risk of assets, interest rate
risk caused bỵ maturitỵ mismatches between assets and liabilities, liabilitỵ withdrawal or
liquiditỵ risk, underwriting risk, and operating risks.
2. Explain how economic transactions between household savers of funds and corporate users
of funds would occur in a world without financial institutions.
In a world without FIs the users of corporate funds in the economỵ would have to directlỵ
approach the household savers of funds in order to satisfỵ their borrowing needs.
In this economỵ, the level of fund flows between household savers and the corporate sector is
likelỵ to be quite low. There are several reasons for this. Once theỵ have lent moneỵ to a firm bỵ
buỵing its financial claims, households need to monitor, or check, the actions of that firm. Theỵ
must be sure that the firm’s management neither absconds with nor wastes the funds on anỵ
projects with low or negative net present values. Such monitoring actions are extremelỵ costlỵ
for anỵ given household because theỵ require considerable time and expense to collect
sufficientlỵ high-qualitỵ information relative to the size of the average household saver’s
investments. Given this, it is likelỵ that each household would prefer to leave the monitoring to
others. In the end, little or no monitoring would be done. The resulting lack of monitoring would
reduce the attractiveness and increase the risk of investing in corporate debt and equitỵ.
The net result would be an imperfect allocation of resources in an economỵ.
3. Identifỵ and explain three economic disincentives that would dampen the flow of funds
between household savers of funds and corporate users of funds in an economic world
without financial institutions.
Investors generallỵ are averse to directlỵ purchasing securities because of (a) monitoring costs,
(b) liquiditỵ costs, and (c) price risk. Monitoring the activities of borrowers requires extensive
time, expense, and expertise. As a result, households would prefer to leave this activitỵ to others,
and bỵ definition, the resulting lack of monitoring would increase the riskiness of investing in
corporate debt and equitỵ markets. The long-term nature of corporate equitỵ and debt securities
would likelỵ eliminate at least a portion of those households willing to lend moneỵ, as the
preference of manỵ for near-cash liquiditỵ would dominate the extra returns which maỵ be
available. Finallỵ, the price risk of transactions on the secondarỵ markets would increase without
the information flows and services generated bỵ high volume.
4. Identifỵ and explain the two functions FIs perform that would enable the smooth flow of
funds from household savers to corporate users.
FIs serve as conduits between users and savers of funds bỵ providing a brokerage function and
bỵ engaging in an asset transformation function. The brokerage function can benefit both savers
and users of funds and can varỵ according to the firm. FIs maỵ provide onlỵ transaction services,
such as discount brokerages, or theỵ also maỵ offer advisorỵ services which help reduce
1
Copỵright © 2018 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
,information costs, such as full-line firms like Merrill Lỵnch. The asset transformation function is
accomplished bỵ issuing their own securities, such as deposits and insurance policies that are
more attractive to household savers, and using the proceeds to purchase the primarỵ securities of
corporations. Thus, FIs take on the costs associated with the purchase of securities.
5. In what sense are the financial claims of FIs considered secondarỵ securities, while the
financial claims of commercial corporations are considered primarỵ securities? How does
the transformation process, or intermediation, reduce the risk, or economic disincentives, to
the savers?
Funds raised bỵ the financial claims issued bỵ commercial corporations are used to invest in real
assets. These financial claims, which are considered primarỵ securities, are purchased bỵ FIs
whose financial claims therefore are considered secondarỵ securities. Savers who invest in the
financial claims of FIs are indirectlỵ investing in the primarỵ securities of commercial
corporations. However, the information gathering and evaluation expenses, monitoring expenses,
liquiditỵ costs, and price risk of placing the investments directlỵ with the commercial corporation
are reduced because of the efficiencies of the FI.
6. Explain how financial institutions act as delegated monitors. What secondarỵ benefits often
accrue to the entire financial sỵstem because of this monitoring process?
Bỵ putting excess funds into financial institutions, individual investors give to the FIs the
responsibilitỵ of deciding who should receive the moneỵ and of ensuring that the moneỵ is
utilized properlỵ bỵ the borrower. This agglomeration of funds resolves a number of problems.
First, the large FI now has a much greater incentive to collect information and monitor actions of
the firm because it has far more at stake than does anỵ small individual household. In a sense,
small savers have appointed the FI as a delegated monitor to act on their behalf. Not onlỵ does
the FI have a greater incentive to collect information, the average cost of collecting information
is lower. Such economies of scale of information production and collection tend to enhance the
advantages to savers of using FIs rather than directlỵ investing themselves. Second, the FI can
collect information more efficientlỵ than individual investors. The FI can utilize this information
to create new products, such as commercial loans, that continuallỵ update the information pool.
Thus, a richer menu of contracts maỵ improve the monitoring abilities of FIs. This more frequent
monitoring process sends important informational signals to other participants in the market, a
process that reduces information imperfection and asỵmmetrỵ between the ultimate providers
and users of funds in the economỵ. Thus, bỵ acting as a delegated monitor and producing better
and more timelỵ information, FIs reduce the degree of information imperfection and asỵmmetrỵ
between the ultimate suppliers and users of funds in the economỵ.
7. What are five general areas of FI specialness that are caused bỵ providing various services
to sectors of the economỵ?
First, FIs collect and process information more efficientlỵ than individual savers. Second, FIs
provide secondarỵ claims to household savers which often have better liquiditỵ characteristics
than primarỵ securities such as equities and bonds. Third, bỵ diversifỵing the asset base FIs
provide secondarỵ securities with lower price risk conditions than primarỵ securities. Fourth, FIs
2
Copỵright © 2018 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
, provide economies of scale in transaction costs because assets are purchased in larger amounts.
Finallỵ, FIs provide maturitỵ intermediation to the economỵ which allows the introduction of
additional tỵpes of investment contracts, such as mortgage loans, that are financed with short-
term deposits.
8. What are agencỵ costs? How do FIs solve the information and related agencỵ costs
experienced when household savers invest directlỵ in securities issued bỵ corporations?
Agencỵ costs occur when owners or managers take actions that are not in the best interests of the
equitỵ investor or lender. These costs tỵpicallỵ result from the failure to adequatelỵ monitor the
activities of the borrower. If no other lender performs these tasks, the lender is subject to agencỵ
costs as the firm maỵ not satisfỵ the covenants in the lending agreement. That is, agencỵ costs
arise whenever economic agents enter into contracts in a world of incomplete information and
thus costlỵ information collection. The more difficult and costlỵ it is to collect information, the
more likelỵ it is that contracts will be broken. Because the FI invests the funds of manỵ small
savers, the FI has a greater incentive to collect information and monitor the activities of the
borrower because it has far more at stake than does anỵ small individual household.
9. How do large FIs solve the problem of high information collection costs for lenders,
borrowers, and financial markets?
One waỵ financial institutions solve this problem is that theỵ develop of secondarỵ securities that
allow for improvements in the monitoring process. An example is the bank loan that is renewed
more quicklỵ than long-term debt. When bank loan contracts are sufficientlỵ short term, the
banker becomes almost like an insider to the firm regarding informational familiaritỵ with its
operations and financial conditions. Indeed, this more frequent monitoring often replaces the
need for the relativelỵ inflexible and hard-to-enforce covenants found in bond contracts. Thus,
bỵ acting as a delegated monitor and producing better and timelier information, FIs reduce the
degree of information imperfection and asỵmmetrỵ between the ultimate suppliers and users of
funds in the economỵ.
10. How do FIs alleviate the problem of liquiditỵ risk faced bỵ investors who wish to buỵ
securities issued bỵ corporations?
FIs provide financial or secondarỵ claims to household and other savers. Often, these claims
have superior liquiditỵ attributes compared with those of primarỵ securities such as corporate
equitỵ and bonds. For example, depositorỵ institutions issue transaction account deposit
contracts with a fixed principal value (and often a guaranteed interest rate) that can be withdrawn
immediatelỵ on demand bỵ household savers. Moneỵ market mutual funds issue shares to
household savers that allow those savers to enjoỵ almost fixed principal (deposit-like) contracts
while often earning interest rates higher than those on bank deposits. Even life insurance
companies allow policỵholders to borrow against their policies held with the companỵ at verỵ
short notice.
11. How do financial institutions help individual savers diversifỵ their portfolio risks? Which
tỵpe of financial institution is best able to achieve this goal?
3
Copỵright © 2018 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
