INSTRUCTOR’S SOLUTIONS MANUAL
FINANCIAL MARKETS AND INSTITUTIONS
2024 EVERGREEN RELEASE
CHAPTER NO. 01: INTRODUCTION
ANSWERS TO THE QUESTIONS:
1. a. primary
b. primary
c. secondary
d. secondary
e. secondary
2. a. money market
b. money market
c. capital market
d. capital market
e. capital market
f. money market
g. money market
h. money market
i. capital market
j. money market
3. The capital markets are more likely to be characterized by actual physical locations such as the
New York Stock Exchange. Money market transactions are more likely to occur via telephone,
wire transfers, and computer trading.
4. According to Figure 1-4, federal funds and repurchase agreements, followed by Treasury bills,
and negotiable CDs, had the largest amounts outstanding in 2021.
5. The major instruments traded in capital markets are corporate stocks, mortgages, corporate
bonds, Treasury notes and bonds, state and local government bonds, U.S. government owned and
sponsored agencies, and bank and consumer loans.
6. According to Figure 1-5, corporate stocks represent the largest capital market instrument in
2021, followed by Treasury securities, mortgages, and corporate bonds.
7. The bank would be most concerned about a depreciation of the yen against the dollar.
,8. Financial institutions consist of:
Commercial banks - depository institutions whose major assets are loans and major liabilities are
deposits. Commercial banks’ loans are broader in range, including consumer, commercial, and
real estate loans, than other depository institutions. Commercial banks’ liabilities include more
nondeposit sources of funds, such as subordinate notes and debentures, than other depository
institutions.
Thrifts - depository institutions in the form of savings and loans, savings banks, and credit
unions. Thrifts generally perform services similar to commercial banks, but they tend to
concentrate their loans in one segment, such as real estate loans or consumer loans.
Insurance companies - financial institutions that protect individuals and corporations
(policyholders) from adverse events. Life insurance companies provide protection in the event of
untimely death, illness, and retirement. Property casualty insurance protects against personal
injury and liability due to accidents, theft, fire, etc.
Securities firms and investment banks - financial institutions that underwrite securities and
engage in related activities such as securities brokerage, securities trading, and making a market
in which securities can trade.
Finance companies - financial intermediaries that make loans to both individual and businesses.
Unlike depository institutions, finance companies do not accept deposits but instead rely on
short- and long-term debt for funding.
Mutual funds and hedge funds - financial institutions that pool financial resources of individuals
and companies and invest those resources in diversified portfolios of asset.
Pension funds - financial institutions that offer savings plans through which fund participants
accumulated savings during their working years before withdrawing them during their retirement
years. Funds originally invested in and accumulated in pension funds are exempt from current
taxation.
9. If there were no FIs then the users of funds, such as corporations in the economy, would have
to approach the savers of funds, such as households, directly in order to fund their investment
projects and fill their borrowing needs. This would be extremely costly because of the up-front
information costs faced by potential lenders. These include costs associated with identifying
potential borrowers, pooling small savings into loans of sufficient size to finance corporate
activities, and assessing risk and investment opportunities. Moreover, lenders would have to
monitor the activities of borrowers over each loan's life span, which is compounded by the free
rider problem. The net result is an imperfect allocation of resources in an economy.
,10. There are at least three reasons for this. First, once they have lent money in exchange for
financial claims, suppliers of funds need to monitor or check the use of their funds. They must be
sure that the user of funds neither absconds with nor wastes the funds on projects that have low
or negative returns. Such monitoring actions are often extremely costly for any given fund
supplier because they require considerable time, expense, and effort to collect this information
relative to the size of the average fund supplier’s investment.
Second, the relatively long-term nature of some financial claims (e.g., mortgages, corporate
stock, and bonds) creates a second disincentive for suppliers of funds to hold the direct financial
claims issued by users of funds. Specifically, given the choice between holding cash and
long-term securities, fund suppliers may well choose to hold cash for liquidity reasons,
especially if they plan to use savings to finance consumption expenditures in the near future and
financial markets are not very deep in terms of active buyers and sellers.
Third, even though real-world financial markets provide some liquidity services, by allowing
fund suppliers to trade financial securities among themselves, fund suppliers face a price risk
upon the sale of securities. That is, the price at which investors can sell a security on secondary
markets such as the New York Stock Exchange (NYSE) may well differ from the price they
initially paid for the security either because investors change their valuation of the security
between the time it was bought and when it was sold and/or because dealers, acting as
intermediaries between buyers and sellers, charge transaction costs for completing a trade.
11. A suppler of funds who directly invests in a fund user’s financial claims faces a high cost of
monitoring the fund user’s actions in a timely and complete fashion after purchasing securities.
One solution to this problem is for a large number of small investors to place their funds with a
single FI serving as a broker between the two parties. The FI groups the fund suppliers’ funds
together and invests them in the direct or primary financial claims issued by fund users. This
aggregation of funds resolves a number of problems. First, the “large” FI now has a much greater
incentive to hire employees with superior skills and training in monitoring. This expertise can be
used to collect information and monitor the ultimate fund user’s actions because the FI has far
more at stake than any small individual fund supplier. Second, the monitoring function
performed by the FI alleviates the “free-rider” problem that exists when small fund suppliers
leave it to each other to collect information and monitor a fund user. In an economic sense, fund
suppliers have appointed the financial institution as a delegated monitor to act on their behalf.
For example, full-service securities firms such as Morgan Stanley carry out investment research
on new issues and make investment recommendations for their retail clients (or investors), while
commercial banks collect deposits from fund suppliers and lend these funds to ultimate users
such as corporations.
12. In addition to information costs, FIs help small savers alleviate liquidity and price risk.
Often claims issued by financial institutions have liquidity attributes that are superior to those of
primary securities. For example, banks and thrift institutions (e.g., savings associations) issue
, transaction account deposit contracts with a fixed principal value and often a guaranteed interest
rate that can be withdrawn immediately, on demand, by investors. Money market mutual funds
issue shares to household savers that allow them to enjoy almost fixed principal (depositlike)
contracts while earning higher interest rates than on bank deposits, and that can be withdrawn
immediately. Even life insurance companies allow policyholders to borrow against their policies
held with the company at very short notice. Notice that in reducing the liquidity risk of investing
funds for fund suppliers, the FI transfers this risk to its own balance sheet. That is, FIs such as
depository institutions offer highly liquid, low price-risk securities to fund suppliers on the
liability side of their balance sheets, while investing in relatively less liquid and higher price-risk
securities—such as the debt and equity—issued by fund users on the asset side.
13. As long as the returns on different investments are not perfectly positively correlated, by
spreading their investments across a number of assets, FIs can diversify away significant
amounts of their portfolio risk. Thus, FIs can exploit the law of large numbers in making their
investment decisions, whereas due to their smaller wealth size, individual fund suppliers are
constrained to holding relatively undiversified portfolios. As a result, diversification allows an FI
to predict more accurately its expected return and risk on its investment portfolio so that it can
credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little
price risk. As long as an FI is sufficiently large, to gain from diversification and monitoring on
the asset side of its balance sheet, its financial claims (it issues as liabilities) are likely to be
viewed as liquid and attractive to small savers, especially when compared to direct investments
in the capital market. A mutual fund invested in a diverse group of stocks and fixed income
securities will best provide diversification for an investor.
14. If net borrowers and net lenders have different optimal time horizons, FIs can service both
sectors by mismatching their asset and liability maturities. That is, by maturity mismatching, FIs
can produce long-term contracts such as long-term, fixed-rate mortgage loans to households,
while still raising funds with short-term liability contracts such as deposits. In addition, although
such mismatches can subject an FI to interest rate, a large FI is better able than a small investor
to manage this risk through its superior access to markets and instruments for hedging the risks
of such loans.
15. Because they are sold in very large denominations, many assets are either out of reach of
individual savers or would result in savers holding highly undiversified asset portfolios. For
example, the minimum size of a negotiable CD is $100,000; commercial paper (short-term
corporate debt) is often sold in minimum packages of $250,000 or more. Individual savers may
be unable to purchase such instruments directly. However, by buying shares in a mutual fund
with other small investors, household savers overcome the constraints to buying assets imposed
by large minimum denomination sizes. Such indirect access to these markets may allow small
savers to generate higher returns on their portfolios as well.
FINANCIAL MARKETS AND INSTITUTIONS
2024 EVERGREEN RELEASE
CHAPTER NO. 01: INTRODUCTION
ANSWERS TO THE QUESTIONS:
1. a. primary
b. primary
c. secondary
d. secondary
e. secondary
2. a. money market
b. money market
c. capital market
d. capital market
e. capital market
f. money market
g. money market
h. money market
i. capital market
j. money market
3. The capital markets are more likely to be characterized by actual physical locations such as the
New York Stock Exchange. Money market transactions are more likely to occur via telephone,
wire transfers, and computer trading.
4. According to Figure 1-4, federal funds and repurchase agreements, followed by Treasury bills,
and negotiable CDs, had the largest amounts outstanding in 2021.
5. The major instruments traded in capital markets are corporate stocks, mortgages, corporate
bonds, Treasury notes and bonds, state and local government bonds, U.S. government owned and
sponsored agencies, and bank and consumer loans.
6. According to Figure 1-5, corporate stocks represent the largest capital market instrument in
2021, followed by Treasury securities, mortgages, and corporate bonds.
7. The bank would be most concerned about a depreciation of the yen against the dollar.
,8. Financial institutions consist of:
Commercial banks - depository institutions whose major assets are loans and major liabilities are
deposits. Commercial banks’ loans are broader in range, including consumer, commercial, and
real estate loans, than other depository institutions. Commercial banks’ liabilities include more
nondeposit sources of funds, such as subordinate notes and debentures, than other depository
institutions.
Thrifts - depository institutions in the form of savings and loans, savings banks, and credit
unions. Thrifts generally perform services similar to commercial banks, but they tend to
concentrate their loans in one segment, such as real estate loans or consumer loans.
Insurance companies - financial institutions that protect individuals and corporations
(policyholders) from adverse events. Life insurance companies provide protection in the event of
untimely death, illness, and retirement. Property casualty insurance protects against personal
injury and liability due to accidents, theft, fire, etc.
Securities firms and investment banks - financial institutions that underwrite securities and
engage in related activities such as securities brokerage, securities trading, and making a market
in which securities can trade.
Finance companies - financial intermediaries that make loans to both individual and businesses.
Unlike depository institutions, finance companies do not accept deposits but instead rely on
short- and long-term debt for funding.
Mutual funds and hedge funds - financial institutions that pool financial resources of individuals
and companies and invest those resources in diversified portfolios of asset.
Pension funds - financial institutions that offer savings plans through which fund participants
accumulated savings during their working years before withdrawing them during their retirement
years. Funds originally invested in and accumulated in pension funds are exempt from current
taxation.
9. If there were no FIs then the users of funds, such as corporations in the economy, would have
to approach the savers of funds, such as households, directly in order to fund their investment
projects and fill their borrowing needs. This would be extremely costly because of the up-front
information costs faced by potential lenders. These include costs associated with identifying
potential borrowers, pooling small savings into loans of sufficient size to finance corporate
activities, and assessing risk and investment opportunities. Moreover, lenders would have to
monitor the activities of borrowers over each loan's life span, which is compounded by the free
rider problem. The net result is an imperfect allocation of resources in an economy.
,10. There are at least three reasons for this. First, once they have lent money in exchange for
financial claims, suppliers of funds need to monitor or check the use of their funds. They must be
sure that the user of funds neither absconds with nor wastes the funds on projects that have low
or negative returns. Such monitoring actions are often extremely costly for any given fund
supplier because they require considerable time, expense, and effort to collect this information
relative to the size of the average fund supplier’s investment.
Second, the relatively long-term nature of some financial claims (e.g., mortgages, corporate
stock, and bonds) creates a second disincentive for suppliers of funds to hold the direct financial
claims issued by users of funds. Specifically, given the choice between holding cash and
long-term securities, fund suppliers may well choose to hold cash for liquidity reasons,
especially if they plan to use savings to finance consumption expenditures in the near future and
financial markets are not very deep in terms of active buyers and sellers.
Third, even though real-world financial markets provide some liquidity services, by allowing
fund suppliers to trade financial securities among themselves, fund suppliers face a price risk
upon the sale of securities. That is, the price at which investors can sell a security on secondary
markets such as the New York Stock Exchange (NYSE) may well differ from the price they
initially paid for the security either because investors change their valuation of the security
between the time it was bought and when it was sold and/or because dealers, acting as
intermediaries between buyers and sellers, charge transaction costs for completing a trade.
11. A suppler of funds who directly invests in a fund user’s financial claims faces a high cost of
monitoring the fund user’s actions in a timely and complete fashion after purchasing securities.
One solution to this problem is for a large number of small investors to place their funds with a
single FI serving as a broker between the two parties. The FI groups the fund suppliers’ funds
together and invests them in the direct or primary financial claims issued by fund users. This
aggregation of funds resolves a number of problems. First, the “large” FI now has a much greater
incentive to hire employees with superior skills and training in monitoring. This expertise can be
used to collect information and monitor the ultimate fund user’s actions because the FI has far
more at stake than any small individual fund supplier. Second, the monitoring function
performed by the FI alleviates the “free-rider” problem that exists when small fund suppliers
leave it to each other to collect information and monitor a fund user. In an economic sense, fund
suppliers have appointed the financial institution as a delegated monitor to act on their behalf.
For example, full-service securities firms such as Morgan Stanley carry out investment research
on new issues and make investment recommendations for their retail clients (or investors), while
commercial banks collect deposits from fund suppliers and lend these funds to ultimate users
such as corporations.
12. In addition to information costs, FIs help small savers alleviate liquidity and price risk.
Often claims issued by financial institutions have liquidity attributes that are superior to those of
primary securities. For example, banks and thrift institutions (e.g., savings associations) issue
, transaction account deposit contracts with a fixed principal value and often a guaranteed interest
rate that can be withdrawn immediately, on demand, by investors. Money market mutual funds
issue shares to household savers that allow them to enjoy almost fixed principal (depositlike)
contracts while earning higher interest rates than on bank deposits, and that can be withdrawn
immediately. Even life insurance companies allow policyholders to borrow against their policies
held with the company at very short notice. Notice that in reducing the liquidity risk of investing
funds for fund suppliers, the FI transfers this risk to its own balance sheet. That is, FIs such as
depository institutions offer highly liquid, low price-risk securities to fund suppliers on the
liability side of their balance sheets, while investing in relatively less liquid and higher price-risk
securities—such as the debt and equity—issued by fund users on the asset side.
13. As long as the returns on different investments are not perfectly positively correlated, by
spreading their investments across a number of assets, FIs can diversify away significant
amounts of their portfolio risk. Thus, FIs can exploit the law of large numbers in making their
investment decisions, whereas due to their smaller wealth size, individual fund suppliers are
constrained to holding relatively undiversified portfolios. As a result, diversification allows an FI
to predict more accurately its expected return and risk on its investment portfolio so that it can
credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little
price risk. As long as an FI is sufficiently large, to gain from diversification and monitoring on
the asset side of its balance sheet, its financial claims (it issues as liabilities) are likely to be
viewed as liquid and attractive to small savers, especially when compared to direct investments
in the capital market. A mutual fund invested in a diverse group of stocks and fixed income
securities will best provide diversification for an investor.
14. If net borrowers and net lenders have different optimal time horizons, FIs can service both
sectors by mismatching their asset and liability maturities. That is, by maturity mismatching, FIs
can produce long-term contracts such as long-term, fixed-rate mortgage loans to households,
while still raising funds with short-term liability contracts such as deposits. In addition, although
such mismatches can subject an FI to interest rate, a large FI is better able than a small investor
to manage this risk through its superior access to markets and instruments for hedging the risks
of such loans.
15. Because they are sold in very large denominations, many assets are either out of reach of
individual savers or would result in savers holding highly undiversified asset portfolios. For
example, the minimum size of a negotiable CD is $100,000; commercial paper (short-term
corporate debt) is often sold in minimum packages of $250,000 or more. Individual savers may
be unable to purchase such instruments directly. However, by buying shares in a mutual fund
with other small investors, household savers overcome the constraints to buying assets imposed
by large minimum denomination sizes. Such indirect access to these markets may allow small
savers to generate higher returns on their portfolios as well.
