Chapter 1
Role of Financial Markets and Institutions
Outline
Role of Financial Markets
Accommodating Corporate Finance Needs
Accommodating Investment Needs
Securities Traded in Financial Markets
Money Market Securities
Capital Market Securities
Derivative Securities
Valuation of Securities
Securities Regulations on Financial Disclosure
International Securities Transactions
Government Intervention in Financial Markets
Role of Financial Institutions
Role of Depository Institutions
Role of Nondepository Financial Institutions
Comparison of Roles among Financial Institutions
Relative Importance of Financial Institutions
Consolidation of Financial Institutions
Credit Crisis for Financial Institutions
Systemic Risk During the Credit Crisis
Government Response to the Credit Crisis
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
, Chapter 1: Role of Financial Markets and Institutions 2
Key Concepts
1. Explain the role of financial intermediaries in transferring funds from surplus units to deficit units.
2. Introduce the types of financial markets available and their functions.
3. Introduce the various financial institutions that facilitate the flow of funds.
4. Provide a preview of the course outline. Emphasize the linkages between the various sections of the
course.
POINT/COUNTER-POINT:
Will Computer Technology Cause Financial Intermediaries to Become
Extinct?
POINT: Yes. Financial intermediaries benefit from access to information. As information becomes more
accessible, individuals will have the information they need before investing or borrowing funds. They will
not need financial intermediaries to make their decisions.
COUNTER-POINT: No. Individuals rely not only on information, but also on expertise. Some financial
intermediaries specialize in credit analysis so that they can make loans. Surplus units will continue to
provide funds to financial intermediaries rather than make direct loans, because they are not capable of
credit analysis, even if more information about prospective borrowers is available. Some financial
intermediaries no longer have physical buildings for customer service, but they still require agents who
have the expertise to assess the creditworthiness of prospective borrowers.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: Computer technology may reduce the need for some types of financial intermediaries such as
brokerage firms, because individuals can make transactions on their own (if they prefer to do so).
However, loans will still require financial intermediaries because of the credit assessment that is needed.
Questions
1. Surplus and Deficit Units. Explain the meaning of surplus units and deficit units. Provide an
example of each. Which types of financial institutions do you deal with? Explain whether you are
acting as a surplus unit or a deficit unit in your relationship with each financial institution.
ANSWER: Surplus units provide funds to the financial markets while deficit units obtain funds from
the financial markets. Surplus units include households with savings, while deficit units include firms
or government agencies that borrow funds.
This exercise allows students to realize that they constantly interact with financial institutions, and
that they often play the role of a deficit unit (on car loans, tuition loans, etc.).
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
, Chapter 1: Role of Financial Markets and Institutions 3
2. Types of Markets. Distinguish between primary and secondary markets. Distinguish between money
and capital markets.
ANSWER: Primary markets are used for the issuance of new securities while secondary markets are
used for the trading of existing securities.
Money markets facilitate the trading of short-term (money market) instruments while capital markets
facilitate the trading of long-term (capital market) instruments.
3. Imperfect Markets. Distinguish between perfect and imperfect security markets. Explain why the
existence of imperfect markets creates a need for financial intermediaries.
ANSWER: With perfect financial markets, all information about any securities for sale would be freely
available to investors, information about surplus and deficit units would be freely available, and all
securities could be unbundled into any size desired. In reality, markets are imperfect, so that surplus and
deficit units do not have free access to information, and securities cannot be unbundled as desired.
Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficit
units. They have the information to provide this service and can even repackage deposits to provide
the amount of funds that borrowers desire.
4. Efficient Markets. Explain the meaning of efficient markets. Why might we expect markets to be
efficient most of the time? In recent years, several securities firms have been guilty of using inside
information when purchasing securities, thereby achieving returns well above the norm (even when
accounting for risk). Does this suggest that the security markets are not efficient? Explain.
ANSWER: If markets are efficient then prices of securities available in these markets properly reflect
all information. We should expect markets to be efficient because if they weren’t, investors would
capitalize on the discrepancy between what prices are and what they should be. This action would
force market prices to represent the appropriate prices as perceived by the market.
Efficiency is often defined with regard to publicly available information. In this case, markets can be
efficient, but investors with inside information could possibly outperform the market on a consistent
basis. A stronger version of efficiency would hypothesize that even access to inside information will
not consistently outperform the market.
5. Securities Laws. What was the purpose of the Securities Act of 1933? What was the purpose of the
Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment
decisions? Explain.
ANSWER: The Securities Act of 1933 was intended to assure complete disclosure of relevant financial
information on publicly offered securities, and prevent fraudulent practices when selling these securities.
The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It
also declared a variety of deceptive practices illegal, but does not prevent poor investments.
6. International Barriers. If barriers to international securities markets are reduced, will a country’s
interest rate be more or less susceptible to foreign lending and borrowing activities? Explain.
ANSWER: If international securities market barriers are reduced, a country’s interest rate will likely
become more susceptible to foreign lending and borrowing activities. Without barriers, funds will flow
more freely in between countries. Funds would seek out countries where expected returns are high.
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
, Chapter 1: Role of Financial Markets and Institutions 4
Then, the amount of foreign funds invested in any country could adjust abruptly and affect interest rates.
7. International Flow of Funds. In what way could the international flow of funds cause a decline in
interest rates?
ANSWER: If a large volume of foreign funds was invested in the United States, it could place
downward pressure on U.S. interest rates. Without this supply of foreign funds, U.S. interest rates
would have been higher.
8. Securities Firms. What are the functions of securities firms? Many securities firms employ brokers
and dealers. Distinguish between the functions of a broker and those of a dealer, and explain how
each is compensated.
ANSWER: Securities firms provide a variety of functions (such as underwriting and brokerage) that
either enhances a borrower’s ability to borrow funds or an investor’s ability to invest funds.
Brokers are commonly compensated with commissions on trades, while dealers are compensated on
their positions in particular securities. Some dealers also provide brokerage services.
9. Standardized Securities. Why do you think securities are commonly standardized? Explain why
some financial flows of funds cannot occur through the sale of standardized securities. If securities
were not standardized, how would this affect the volume of financial transactions conducted by
brokers?
ANSWER: Securities can be more easily traded when they are standardized because the specifics of
the security transaction are well known. If securities were not standardized, transactions would be
slowed considerably as participants would have to negotiate all the provisions.
Some financial flows, such as most commercial loans, must be provided on a personal basis, since the
firms requesting loans have particular needs.
If securities were not standardized, the volume of financial transactions conducted by brokers would
be reduced, because the documentation would be greater.
10. Marketability. Commercial banks use some funds to purchase securities and other funds to make
loans. Why are the securities more marketable than loans in the secondary market?
ANSWER: Securities are more standardized than loans and therefore can be more easily sold in the
secondary market. The excessive documentation on commercial loans limits a bank’s ability to sell
loans in the secondary market.
11. Depository Institutions. Explain the primary use of funds for commercial banks versus savings
institutions.
ANSWER: Savings institutions have traditionally concentrated in mortgage lending, while
commercial banks have concentrated in commercial lending. Savings institutions are now allowed to
diversify their asset portfolio to a greater degree and will likely increase their concentration in
commercial loans (but not to the same degree as commercial banks).
12. Credit Unions. With regard to the profit motive, how are credit unions different from other financial
institutions?
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Role of Financial Markets and Institutions
Outline
Role of Financial Markets
Accommodating Corporate Finance Needs
Accommodating Investment Needs
Securities Traded in Financial Markets
Money Market Securities
Capital Market Securities
Derivative Securities
Valuation of Securities
Securities Regulations on Financial Disclosure
International Securities Transactions
Government Intervention in Financial Markets
Role of Financial Institutions
Role of Depository Institutions
Role of Nondepository Financial Institutions
Comparison of Roles among Financial Institutions
Relative Importance of Financial Institutions
Consolidation of Financial Institutions
Credit Crisis for Financial Institutions
Systemic Risk During the Credit Crisis
Government Response to the Credit Crisis
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
, Chapter 1: Role of Financial Markets and Institutions 2
Key Concepts
1. Explain the role of financial intermediaries in transferring funds from surplus units to deficit units.
2. Introduce the types of financial markets available and their functions.
3. Introduce the various financial institutions that facilitate the flow of funds.
4. Provide a preview of the course outline. Emphasize the linkages between the various sections of the
course.
POINT/COUNTER-POINT:
Will Computer Technology Cause Financial Intermediaries to Become
Extinct?
POINT: Yes. Financial intermediaries benefit from access to information. As information becomes more
accessible, individuals will have the information they need before investing or borrowing funds. They will
not need financial intermediaries to make their decisions.
COUNTER-POINT: No. Individuals rely not only on information, but also on expertise. Some financial
intermediaries specialize in credit analysis so that they can make loans. Surplus units will continue to
provide funds to financial intermediaries rather than make direct loans, because they are not capable of
credit analysis, even if more information about prospective borrowers is available. Some financial
intermediaries no longer have physical buildings for customer service, but they still require agents who
have the expertise to assess the creditworthiness of prospective borrowers.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: Computer technology may reduce the need for some types of financial intermediaries such as
brokerage firms, because individuals can make transactions on their own (if they prefer to do so).
However, loans will still require financial intermediaries because of the credit assessment that is needed.
Questions
1. Surplus and Deficit Units. Explain the meaning of surplus units and deficit units. Provide an
example of each. Which types of financial institutions do you deal with? Explain whether you are
acting as a surplus unit or a deficit unit in your relationship with each financial institution.
ANSWER: Surplus units provide funds to the financial markets while deficit units obtain funds from
the financial markets. Surplus units include households with savings, while deficit units include firms
or government agencies that borrow funds.
This exercise allows students to realize that they constantly interact with financial institutions, and
that they often play the role of a deficit unit (on car loans, tuition loans, etc.).
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
, Chapter 1: Role of Financial Markets and Institutions 3
2. Types of Markets. Distinguish between primary and secondary markets. Distinguish between money
and capital markets.
ANSWER: Primary markets are used for the issuance of new securities while secondary markets are
used for the trading of existing securities.
Money markets facilitate the trading of short-term (money market) instruments while capital markets
facilitate the trading of long-term (capital market) instruments.
3. Imperfect Markets. Distinguish between perfect and imperfect security markets. Explain why the
existence of imperfect markets creates a need for financial intermediaries.
ANSWER: With perfect financial markets, all information about any securities for sale would be freely
available to investors, information about surplus and deficit units would be freely available, and all
securities could be unbundled into any size desired. In reality, markets are imperfect, so that surplus and
deficit units do not have free access to information, and securities cannot be unbundled as desired.
Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficit
units. They have the information to provide this service and can even repackage deposits to provide
the amount of funds that borrowers desire.
4. Efficient Markets. Explain the meaning of efficient markets. Why might we expect markets to be
efficient most of the time? In recent years, several securities firms have been guilty of using inside
information when purchasing securities, thereby achieving returns well above the norm (even when
accounting for risk). Does this suggest that the security markets are not efficient? Explain.
ANSWER: If markets are efficient then prices of securities available in these markets properly reflect
all information. We should expect markets to be efficient because if they weren’t, investors would
capitalize on the discrepancy between what prices are and what they should be. This action would
force market prices to represent the appropriate prices as perceived by the market.
Efficiency is often defined with regard to publicly available information. In this case, markets can be
efficient, but investors with inside information could possibly outperform the market on a consistent
basis. A stronger version of efficiency would hypothesize that even access to inside information will
not consistently outperform the market.
5. Securities Laws. What was the purpose of the Securities Act of 1933? What was the purpose of the
Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment
decisions? Explain.
ANSWER: The Securities Act of 1933 was intended to assure complete disclosure of relevant financial
information on publicly offered securities, and prevent fraudulent practices when selling these securities.
The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It
also declared a variety of deceptive practices illegal, but does not prevent poor investments.
6. International Barriers. If barriers to international securities markets are reduced, will a country’s
interest rate be more or less susceptible to foreign lending and borrowing activities? Explain.
ANSWER: If international securities market barriers are reduced, a country’s interest rate will likely
become more susceptible to foreign lending and borrowing activities. Without barriers, funds will flow
more freely in between countries. Funds would seek out countries where expected returns are high.
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
, Chapter 1: Role of Financial Markets and Institutions 4
Then, the amount of foreign funds invested in any country could adjust abruptly and affect interest rates.
7. International Flow of Funds. In what way could the international flow of funds cause a decline in
interest rates?
ANSWER: If a large volume of foreign funds was invested in the United States, it could place
downward pressure on U.S. interest rates. Without this supply of foreign funds, U.S. interest rates
would have been higher.
8. Securities Firms. What are the functions of securities firms? Many securities firms employ brokers
and dealers. Distinguish between the functions of a broker and those of a dealer, and explain how
each is compensated.
ANSWER: Securities firms provide a variety of functions (such as underwriting and brokerage) that
either enhances a borrower’s ability to borrow funds or an investor’s ability to invest funds.
Brokers are commonly compensated with commissions on trades, while dealers are compensated on
their positions in particular securities. Some dealers also provide brokerage services.
9. Standardized Securities. Why do you think securities are commonly standardized? Explain why
some financial flows of funds cannot occur through the sale of standardized securities. If securities
were not standardized, how would this affect the volume of financial transactions conducted by
brokers?
ANSWER: Securities can be more easily traded when they are standardized because the specifics of
the security transaction are well known. If securities were not standardized, transactions would be
slowed considerably as participants would have to negotiate all the provisions.
Some financial flows, such as most commercial loans, must be provided on a personal basis, since the
firms requesting loans have particular needs.
If securities were not standardized, the volume of financial transactions conducted by brokers would
be reduced, because the documentation would be greater.
10. Marketability. Commercial banks use some funds to purchase securities and other funds to make
loans. Why are the securities more marketable than loans in the secondary market?
ANSWER: Securities are more standardized than loans and therefore can be more easily sold in the
secondary market. The excessive documentation on commercial loans limits a bank’s ability to sell
loans in the secondary market.
11. Depository Institutions. Explain the primary use of funds for commercial banks versus savings
institutions.
ANSWER: Savings institutions have traditionally concentrated in mortgage lending, while
commercial banks have concentrated in commercial lending. Savings institutions are now allowed to
diversify their asset portfolio to a greater degree and will likely increase their concentration in
commercial loans (but not to the same degree as commercial banks).
12. Credit Unions. With regard to the profit motive, how are credit unions different from other financial
institutions?
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
