, Chapter 2
The Financial Environment and the Level of Interest
Rates
Learning Objectives
1. Discuss the primary role of the financial system in the economy, and describe the
two basic ways in which fund transfers take place.
The primary role of the financial system is to transfer money from those that have more
money than they need to spend (surplus spending units, or SSUs) to businesses and
consumers who need to borrow money (deficit spending units, or DSUs). The more
efficient the financial system, the more likely it is that consumers will get the highest
possible interest rate on their savings, businesses will be able to borrow at the lowest
possible cost, and the most desirable investment opportunities with the highest rates of
return will be funded.
Money is transferred from SSUs to DSUs in two basic ways: (1) directly, through
financial markets or (2) indirectly, through intermediation markets. The direct markets are
wholesale markets in which large public corporations transact. Smaller business firms, as
well as consumers, secure most of their financial services from commercial banks and
other financial intermediaries because their transactions are too small for the wholesale
markets.
2. Discuss direct financing and the important role that investment banks play in this
process.
1
, Direct markets are wholesale markets where large public corporations transact. These
corporations sell securities, such as stocks and bonds, directly to investors in exchange
for money, which they use to invest in their businesses. Investment banks are important
in the direct markets because they help firms sell their new security issues. The services
provided by investment bankers include origination, underwriting, and distribution.
3. Describe the primary and secondary markets, and explain why secondary markets
are so important to businesses.
Primary markets are markets in which new securities are sold for the first time.
Secondary markets provide the aftermarket for securities previously issued. Not all
securities have secondary markets. Secondary markets are important because they enable
investors to convert securities easily to cash. Business firms whose securities are traded
in secondary markets are able to issue securities at a lower cost than they otherwise could
because investors are willing to pay a premium price for securities that have secondary
markets.
4. Explain why money markets are important financial markets for large
corporations.
Large corporations use money markets to adjust their liquidity because cash inflows and
outflows are rarely perfectly synchronized. Thus, on the one hand, if cash expenditures
exceed cash receipts, the firm can borrow short term by issuing commercial paper or, if
the firm holds a portfolio of money market instruments, some of the securities can be sold
for cash. On the other hand, if cash receipts exceed expenditures, the firm can
2
, temporarily invest the funds in short-term money market instruments such as Treasury
bills, negotiable CDs, or commercial paper issued by other corporations. Businesses are
willing to invest large amounts of idle cash in money market instruments because of their
high degree of marketability and their low default risk.
5. Discuss the most important stock market exchanges and indexes.
Capital markets are the wholesale markets where capital assets, such as plant and
equipment, are financed. The two most important capital market instruments are
corporate bonds and common stock. Compared with money market instruments, capital
market instruments are less marketable and carry more default risk.
6. Explain how financial institutions serve consumers and small businesses that are
unable to participate in the direct financial markets and describe how corporations
use the financial system.
The problem with direct financing is that it takes place in a wholesale market. Most small
businesses and consumers do not have the professional skills or the money to transact in
this market. In contrast, a large portion of the intermediation market focuses on providing
financial services to consumers and small businesses. For example, commercial banks
collect money from consumers in small dollar amounts by selling them checking
accounts, savings accounts, and consumer CDs. They then aggregate the funds and make
loans in larger amounts to consumers and businesses. The financial services bought or
sold by intermediaries are tailor made to fit the needs of the market they serve.
3
The Financial Environment and the Level of Interest
Rates
Learning Objectives
1. Discuss the primary role of the financial system in the economy, and describe the
two basic ways in which fund transfers take place.
The primary role of the financial system is to transfer money from those that have more
money than they need to spend (surplus spending units, or SSUs) to businesses and
consumers who need to borrow money (deficit spending units, or DSUs). The more
efficient the financial system, the more likely it is that consumers will get the highest
possible interest rate on their savings, businesses will be able to borrow at the lowest
possible cost, and the most desirable investment opportunities with the highest rates of
return will be funded.
Money is transferred from SSUs to DSUs in two basic ways: (1) directly, through
financial markets or (2) indirectly, through intermediation markets. The direct markets are
wholesale markets in which large public corporations transact. Smaller business firms, as
well as consumers, secure most of their financial services from commercial banks and
other financial intermediaries because their transactions are too small for the wholesale
markets.
2. Discuss direct financing and the important role that investment banks play in this
process.
1
, Direct markets are wholesale markets where large public corporations transact. These
corporations sell securities, such as stocks and bonds, directly to investors in exchange
for money, which they use to invest in their businesses. Investment banks are important
in the direct markets because they help firms sell their new security issues. The services
provided by investment bankers include origination, underwriting, and distribution.
3. Describe the primary and secondary markets, and explain why secondary markets
are so important to businesses.
Primary markets are markets in which new securities are sold for the first time.
Secondary markets provide the aftermarket for securities previously issued. Not all
securities have secondary markets. Secondary markets are important because they enable
investors to convert securities easily to cash. Business firms whose securities are traded
in secondary markets are able to issue securities at a lower cost than they otherwise could
because investors are willing to pay a premium price for securities that have secondary
markets.
4. Explain why money markets are important financial markets for large
corporations.
Large corporations use money markets to adjust their liquidity because cash inflows and
outflows are rarely perfectly synchronized. Thus, on the one hand, if cash expenditures
exceed cash receipts, the firm can borrow short term by issuing commercial paper or, if
the firm holds a portfolio of money market instruments, some of the securities can be sold
for cash. On the other hand, if cash receipts exceed expenditures, the firm can
2
, temporarily invest the funds in short-term money market instruments such as Treasury
bills, negotiable CDs, or commercial paper issued by other corporations. Businesses are
willing to invest large amounts of idle cash in money market instruments because of their
high degree of marketability and their low default risk.
5. Discuss the most important stock market exchanges and indexes.
Capital markets are the wholesale markets where capital assets, such as plant and
equipment, are financed. The two most important capital market instruments are
corporate bonds and common stock. Compared with money market instruments, capital
market instruments are less marketable and carry more default risk.
6. Explain how financial institutions serve consumers and small businesses that are
unable to participate in the direct financial markets and describe how corporations
use the financial system.
The problem with direct financing is that it takes place in a wholesale market. Most small
businesses and consumers do not have the professional skills or the money to transact in
this market. In contrast, a large portion of the intermediation market focuses on providing
financial services to consumers and small businesses. For example, commercial banks
collect money from consumers in small dollar amounts by selling them checking
accounts, savings accounts, and consumer CDs. They then aggregate the funds and make
loans in larger amounts to consumers and businesses. The financial services bought or
sold by intermediaries are tailor made to fit the needs of the market they serve.
3
