Exam 2016, answers - 2030020 UNIVERSITY OF YORK BA and BSc Degree Examinations 2016
DEPARTMENT OF - Studocu
Exam 2016, answers - Lecture 11 and 12: The Theory of Financial Intermediation- asymmetric -
Studocu
Asymetric information-Adverse Selection and Moral Hazard - Asymmetric Adverse Selection and
Moral - Studocu
Structure and regulation of financial markets revision
Lecture 1: Introduction (direct finance, indirect finance, primary/secondary markets,
money/capital markets, financial intermediaries, regulation)
The main role of financial markets: to transfer funds from savers to investors. It is about
transferring excess funds (e.g. those from governments) to those who need funds (e.g.
businesses)
In 2020, the economy was hit by Covid-19, the stock market crashed and central banks stepped
in by lowering IR and provided massive liquidity to the financial system. This meant that financial
markets could operate efficiently and this is important because the banking and financial
markets is essential for the functioning of modern economies.
Direct finance: This is a method of financing where borrowers borrow funds directly from lenders in
the financial market (this is done by lenders selling borrowers securities) without using a third-party
service such as an intermediary. This is usually done to avoid the high interest rate of financial
intermediaries such as banks.
Example: where you apply for your car loan directly through a lender, such as a bank or financial
company. You will receive a personalised loan from the lender which you van use to explore
different dealerships.
A household buys a newly issued government bond through the services of a broker and this bond is
sold by the broker in its original state. While there is a financial intermediary in this case, no asset
transformation has taken place.
Promotes economic efficiency as there is the efficient allocation of capital, which increases
production. It is also much quicker than indirect finance which again increases efficiency.
It directly improves the well-being of consumers by allowing them to time purchases better. This
is because an economic agent with less income can borrow and those with more income can
save.
Indirect finance: This is where borrowers borrow funds from the financial market through indirect
means such as an intermediary. A financial intermediary takes money from the lender with an
interest rate and lends it to a borrower with a higher interest rate.
Financial Market Instruments:
Debt instruments: The maturity of a debt instrument is the number of years (terms) until that
instrument’s expiration date. It has regular fixed payments and an amount at the end of maturity.
Examples: mainly bonds, leases, promissory notes, mortgages, treasury bills.
Equities: They often make periodic payments (dividends) to their holders.
,Examples: Common stock, preferred stock, treasury stock
Primary and Secondary Markets:
Primary markets: A source of new securities. In this market, firms sell (float) new stocks and bonds
to the public for the first time.
Example: investment banks – they underwrite securities in primary markets. They guarantee a price
for a corporation’s securities and then sell them to the public.
Secondary markets: Where investors purchase securities or assets from other investors, rather than
from issuing companies themselves. Here, existing securities are resold.
Example: Brokers and dealers work in secondary markets. They buy and sell securities on behalf of
clients.
Secondary markets can be organised in 2 ways:
Exchanges: This is a marketplace where securities, commodities, derivatives and other financial
instruments are traded. Their core function is to ensure fair and orderly trading and the spreading of
price information for any securities for any securities trading on that exchange.
Examples: FTSE 100, Chicago Board of Trade for Commodities
OTC (over the counter) markets: This is the process of trading securities via a broker-dealer network
as opposed to on a centralised exchange like the New York Stock Exchange. OTC securities are
traded without being listed on an exchange. OTC trading helps promote equity and financial
instruments that would otherwise be unavailable to investors.
Examples: Foreign exchange, government bonds
Money and Capital Markets:
Money markets: Markets that deal in short-term debt instruments. It is those instruments that have
less than 1 year maturity, violently traded and more liquid assets.
Examples: Bank accounts including term certificates of deposit, interbank loans (loans between
banks), overnight reserves, commercial papers, U.S treasury bills, repurchase agreements.
All these have a high degree of safety and relatively low rates of return
Capital markets: The part of the financial system concerned with raising capital by dealing in shares,
bonds, and other long-term investments. These are longer term and equity instruments which are
less liquid and riskier. Therefore, these have higher rates of return.
Functions of financial intermediaries:
They:
Lower transaction costs (time and money spent in carrying out financial transactions) as there
are economies of scale and therefore high efficiency.
Reduce the exposure of investors to risk. This is done by risk sharing through asset
transformation. This is done by selling low risk assets to investors and then using the funds from
the sale to buy riskier assets. It can also be done by diversification. This is where intermediaries
invest in assets with low correlated returns.
Deal with asymmetric information problems by:
, Trying to avoid risky borrowers by gathering information about them
Ensuring the borrower will not engage in activities that will prevent him/her to repay the
loan. This is done by placing restrictive covenants which are agreement restrictions.
Types of financial intermediaries:
Depository institutions (banks) – page 7
Contractual savings institutions – page 7
Investment intermediaries: page 8
Regulation of the financial system:
Governments regulate financial markets primarily to promote the provision of information, and to
ensure the soundness (stability) of the financial system.
Reasons to increase the information available to investors:
Reduce problems related to asymmetric information – adverse selection and moral hazard
Reduce insider trading which is regulated by the Securities Exchange Commission (SEC). Insider
trading occurs when people who have large stocks in companies have information which is not
publicly available, which gives them an upper hand when trading.
To ensure the soundness of financial intermediaries, there are restrictions which can be used:
Restrictions on entry where financial intermediaries have to meet certain requirements to
become one
Disclosure of information in which financial intermediaries have to report their activities.
Restrictions on assets and activities in order to control the holding of risky assets). Here, there
needs to be a balance of risk and return.
Deposit insurance (avoid bank runs). In the UK, the government insures up to £50,000.
Limits on competition which occurred mostly in the past as they thought more competition led
to more risk but evidence now shows the opposite.
, Lecture 2: An overview of financial structure (the 8 facts of global financial markets, capital
markets, first welfare theorem, exogenous/endogenous information, asymmetric information,
Adverse Selection, Enron scandal, Pooling equilibrium, moral hazard, Ex post State Verification.
The 8 basic facts about the global financial system:
1) Stocks are not the most important source of external financing for businesses.
2) Issuing marketable debt and equity securities is not the primary way in which businesses finance
their operations.
3) Indirect finance (borrowing from bank/financial intermediary) is many times more important than
direct finance (borrowing directly from financial markets).
4) Financial intermediaries, particularly banks, are the most important source of external funds used
to finance businesses.
5) The financial system is among the most heavily regulated sectors of the economy.
6) Only large, well-established corporations have easy access to securities markets to finance their
activities.
8) Debt contracts are complicated legal documents that place substantial restrictive covenants on
borrowers.
Capital markets:
They work efficiently and the first-welfare theorem holds under the following conditions:
Perfect competition – means firms are too small to influence prices
No externalities – there are no unpaid side effects e.g. pollution
Full information – there are no inequalities between agents that participate in market activities.
This is the pareto efficient outcome.
First welfare theorem: Capital markets will deliver a Pareto-efficient allocation of resources.
This implies that:
Banks (intermediaries) are redundant/ the structure of the financial system is irrelevant. This
means that intermediaries are not needed.
Regulation is not needed because the pareto-efficient outcome is reached.
Types of information:
Depending on whether the available information can be improved through research activities
information (auditing) is exogenous or endogenous.
Exogenous information: (cannot be improved through research)
This arises in retail markets for credit and financial services because:
The product traded is usually heterogenous so the price people are willing to pay depends on
quality and quantity in the form of financial advice.
The quality of the product or the advice is difficult to determine
The natural imbalance of information or expertise between sellers and buyers is hard to be
overcome effectively through research. Therefore, it is not worth engaging in research.
DEPARTMENT OF - Studocu
Exam 2016, answers - Lecture 11 and 12: The Theory of Financial Intermediation- asymmetric -
Studocu
Asymetric information-Adverse Selection and Moral Hazard - Asymmetric Adverse Selection and
Moral - Studocu
Structure and regulation of financial markets revision
Lecture 1: Introduction (direct finance, indirect finance, primary/secondary markets,
money/capital markets, financial intermediaries, regulation)
The main role of financial markets: to transfer funds from savers to investors. It is about
transferring excess funds (e.g. those from governments) to those who need funds (e.g.
businesses)
In 2020, the economy was hit by Covid-19, the stock market crashed and central banks stepped
in by lowering IR and provided massive liquidity to the financial system. This meant that financial
markets could operate efficiently and this is important because the banking and financial
markets is essential for the functioning of modern economies.
Direct finance: This is a method of financing where borrowers borrow funds directly from lenders in
the financial market (this is done by lenders selling borrowers securities) without using a third-party
service such as an intermediary. This is usually done to avoid the high interest rate of financial
intermediaries such as banks.
Example: where you apply for your car loan directly through a lender, such as a bank or financial
company. You will receive a personalised loan from the lender which you van use to explore
different dealerships.
A household buys a newly issued government bond through the services of a broker and this bond is
sold by the broker in its original state. While there is a financial intermediary in this case, no asset
transformation has taken place.
Promotes economic efficiency as there is the efficient allocation of capital, which increases
production. It is also much quicker than indirect finance which again increases efficiency.
It directly improves the well-being of consumers by allowing them to time purchases better. This
is because an economic agent with less income can borrow and those with more income can
save.
Indirect finance: This is where borrowers borrow funds from the financial market through indirect
means such as an intermediary. A financial intermediary takes money from the lender with an
interest rate and lends it to a borrower with a higher interest rate.
Financial Market Instruments:
Debt instruments: The maturity of a debt instrument is the number of years (terms) until that
instrument’s expiration date. It has regular fixed payments and an amount at the end of maturity.
Examples: mainly bonds, leases, promissory notes, mortgages, treasury bills.
Equities: They often make periodic payments (dividends) to their holders.
,Examples: Common stock, preferred stock, treasury stock
Primary and Secondary Markets:
Primary markets: A source of new securities. In this market, firms sell (float) new stocks and bonds
to the public for the first time.
Example: investment banks – they underwrite securities in primary markets. They guarantee a price
for a corporation’s securities and then sell them to the public.
Secondary markets: Where investors purchase securities or assets from other investors, rather than
from issuing companies themselves. Here, existing securities are resold.
Example: Brokers and dealers work in secondary markets. They buy and sell securities on behalf of
clients.
Secondary markets can be organised in 2 ways:
Exchanges: This is a marketplace where securities, commodities, derivatives and other financial
instruments are traded. Their core function is to ensure fair and orderly trading and the spreading of
price information for any securities for any securities trading on that exchange.
Examples: FTSE 100, Chicago Board of Trade for Commodities
OTC (over the counter) markets: This is the process of trading securities via a broker-dealer network
as opposed to on a centralised exchange like the New York Stock Exchange. OTC securities are
traded without being listed on an exchange. OTC trading helps promote equity and financial
instruments that would otherwise be unavailable to investors.
Examples: Foreign exchange, government bonds
Money and Capital Markets:
Money markets: Markets that deal in short-term debt instruments. It is those instruments that have
less than 1 year maturity, violently traded and more liquid assets.
Examples: Bank accounts including term certificates of deposit, interbank loans (loans between
banks), overnight reserves, commercial papers, U.S treasury bills, repurchase agreements.
All these have a high degree of safety and relatively low rates of return
Capital markets: The part of the financial system concerned with raising capital by dealing in shares,
bonds, and other long-term investments. These are longer term and equity instruments which are
less liquid and riskier. Therefore, these have higher rates of return.
Functions of financial intermediaries:
They:
Lower transaction costs (time and money spent in carrying out financial transactions) as there
are economies of scale and therefore high efficiency.
Reduce the exposure of investors to risk. This is done by risk sharing through asset
transformation. This is done by selling low risk assets to investors and then using the funds from
the sale to buy riskier assets. It can also be done by diversification. This is where intermediaries
invest in assets with low correlated returns.
Deal with asymmetric information problems by:
, Trying to avoid risky borrowers by gathering information about them
Ensuring the borrower will not engage in activities that will prevent him/her to repay the
loan. This is done by placing restrictive covenants which are agreement restrictions.
Types of financial intermediaries:
Depository institutions (banks) – page 7
Contractual savings institutions – page 7
Investment intermediaries: page 8
Regulation of the financial system:
Governments regulate financial markets primarily to promote the provision of information, and to
ensure the soundness (stability) of the financial system.
Reasons to increase the information available to investors:
Reduce problems related to asymmetric information – adverse selection and moral hazard
Reduce insider trading which is regulated by the Securities Exchange Commission (SEC). Insider
trading occurs when people who have large stocks in companies have information which is not
publicly available, which gives them an upper hand when trading.
To ensure the soundness of financial intermediaries, there are restrictions which can be used:
Restrictions on entry where financial intermediaries have to meet certain requirements to
become one
Disclosure of information in which financial intermediaries have to report their activities.
Restrictions on assets and activities in order to control the holding of risky assets). Here, there
needs to be a balance of risk and return.
Deposit insurance (avoid bank runs). In the UK, the government insures up to £50,000.
Limits on competition which occurred mostly in the past as they thought more competition led
to more risk but evidence now shows the opposite.
, Lecture 2: An overview of financial structure (the 8 facts of global financial markets, capital
markets, first welfare theorem, exogenous/endogenous information, asymmetric information,
Adverse Selection, Enron scandal, Pooling equilibrium, moral hazard, Ex post State Verification.
The 8 basic facts about the global financial system:
1) Stocks are not the most important source of external financing for businesses.
2) Issuing marketable debt and equity securities is not the primary way in which businesses finance
their operations.
3) Indirect finance (borrowing from bank/financial intermediary) is many times more important than
direct finance (borrowing directly from financial markets).
4) Financial intermediaries, particularly banks, are the most important source of external funds used
to finance businesses.
5) The financial system is among the most heavily regulated sectors of the economy.
6) Only large, well-established corporations have easy access to securities markets to finance their
activities.
8) Debt contracts are complicated legal documents that place substantial restrictive covenants on
borrowers.
Capital markets:
They work efficiently and the first-welfare theorem holds under the following conditions:
Perfect competition – means firms are too small to influence prices
No externalities – there are no unpaid side effects e.g. pollution
Full information – there are no inequalities between agents that participate in market activities.
This is the pareto efficient outcome.
First welfare theorem: Capital markets will deliver a Pareto-efficient allocation of resources.
This implies that:
Banks (intermediaries) are redundant/ the structure of the financial system is irrelevant. This
means that intermediaries are not needed.
Regulation is not needed because the pareto-efficient outcome is reached.
Types of information:
Depending on whether the available information can be improved through research activities
information (auditing) is exogenous or endogenous.
Exogenous information: (cannot be improved through research)
This arises in retail markets for credit and financial services because:
The product traded is usually heterogenous so the price people are willing to pay depends on
quality and quantity in the form of financial advice.
The quality of the product or the advice is difficult to determine
The natural imbalance of information or expertise between sellers and buyers is hard to be
overcome effectively through research. Therefore, it is not worth engaging in research.
