Solution and Answer Guide
Financial Markets and Institutions 14E
Chapter No. 01: Role of Financial Markets and Institutions
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. Describe some of fintech’s adoptions in financial institutions.
5. Provide a preview of the course outline. Emphasize the linkages between the
various sections of the course.
POINT/COUNTERPOINT:
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.
COUNTERPOINT: No. Individuals rely not only on information, but also on expertise.
Some financial intermediaries specialize in credit analysis so that they can make wise
choices when offering 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. With the emergence of fintech, many of the services traditionally done
by intermediaries are now handled by computers. The answers provided by the
students will vary, as long as they provide logical arguments to support the
position they are taking.
,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. (LO1)
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.).
2. Types of Markets. Distinguish between primary and secondary markets.
Distinguish between money and capital markets. (LO2)
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. (LO3)
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. (LO2)
, 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. (LO2)
ANSWER: The Securities Act of 1933 was intended to ensure 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. Investment decisions are individual choices not
related to laws.
6. International Expansion. Discuss why many financial institutions have
expanded internationally in recent years. What advantages can be obtained
through an international merger of financial institutions? (LO3)
ANSWER: A merger between the two entities allows the U.S. bank to provide
its services to the European customer base (clients of the European securities
firm) and allows the European securities firm to offer its services to the U.S.
customer base.
7. Stock Valuation. What type of information do investors rely on when
determining the proper value of stocks? (LO2)
ANSWER: Since the valuation of a stock at a future point in time is uncertain,
so is the selling price of a stock at a future point in time. Investors often rely
on financial statements by firms in order to assess how stock prices might
change in the future. In particular, investors rely on accounting reports of a
firm’s revenue, expenses, and earnings as a basis for estimating its future cash
flows. Firms with publicly traded stock are required to disclose financial
information and financial statements.
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 type of professional is
compensated. (LO3)
, ANSWER: Securities firms provide a variety of functions (such as underwriting
and brokerage) that either enhance 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. Misvalued Meme Stocks. Explain why some meme stocks were misvalued by
investors.
ANSWER: Many investors relied on social media posts to make investment
decisions and wanted to benefit from the potential profits. They quickly
purchased the stocks dubbed as meme stocks just because those stocks were
hyped on social media sites and Reddit. However, some investors did not
carefully check the business plan, operations, or financial condition of these
companies. Consequently, the strong demand by investors for meme stocks
caused the stock prices to increase dramatically, only to crash upon a closer
review.
10. Marketability. Commercial banks use some funds to purchase securities and
other funds to make loans. Why are the securities more marketable than the
loans in the secondary market? (LO3)
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 by commercial banks
versus savings institutions. (LO3)
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? (LO3)
ANSWER: Credit unions are nonprofit financial institutions that provide
services to their members. Usually, they are much smaller and have narrower
services than other depository institutions.
13. Nondepository Institutions. Compare the main sources and uses of funds for
finance companies, insurance companies, and pension funds. (LO3)
ANSWER: Finance companies sell securities to obtain funds, while insurance
companies receive insurance premiums and pension funds receive
employee/employer contributions. Finance companies use funds to provide
direct loans to consumers and businesses. Insurance companies and pension
funds purchase securities.
Financial Markets and Institutions 14E
Chapter No. 01: Role of Financial Markets and Institutions
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. Describe some of fintech’s adoptions in financial institutions.
5. Provide a preview of the course outline. Emphasize the linkages between the
various sections of the course.
POINT/COUNTERPOINT:
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.
COUNTERPOINT: No. Individuals rely not only on information, but also on expertise.
Some financial intermediaries specialize in credit analysis so that they can make wise
choices when offering 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. With the emergence of fintech, many of the services traditionally done
by intermediaries are now handled by computers. The answers provided by the
students will vary, as long as they provide logical arguments to support the
position they are taking.
,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. (LO1)
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.).
2. Types of Markets. Distinguish between primary and secondary markets.
Distinguish between money and capital markets. (LO2)
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. (LO3)
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. (LO2)
, 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. (LO2)
ANSWER: The Securities Act of 1933 was intended to ensure 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. Investment decisions are individual choices not
related to laws.
6. International Expansion. Discuss why many financial institutions have
expanded internationally in recent years. What advantages can be obtained
through an international merger of financial institutions? (LO3)
ANSWER: A merger between the two entities allows the U.S. bank to provide
its services to the European customer base (clients of the European securities
firm) and allows the European securities firm to offer its services to the U.S.
customer base.
7. Stock Valuation. What type of information do investors rely on when
determining the proper value of stocks? (LO2)
ANSWER: Since the valuation of a stock at a future point in time is uncertain,
so is the selling price of a stock at a future point in time. Investors often rely
on financial statements by firms in order to assess how stock prices might
change in the future. In particular, investors rely on accounting reports of a
firm’s revenue, expenses, and earnings as a basis for estimating its future cash
flows. Firms with publicly traded stock are required to disclose financial
information and financial statements.
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 type of professional is
compensated. (LO3)
, ANSWER: Securities firms provide a variety of functions (such as underwriting
and brokerage) that either enhance 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. Misvalued Meme Stocks. Explain why some meme stocks were misvalued by
investors.
ANSWER: Many investors relied on social media posts to make investment
decisions and wanted to benefit from the potential profits. They quickly
purchased the stocks dubbed as meme stocks just because those stocks were
hyped on social media sites and Reddit. However, some investors did not
carefully check the business plan, operations, or financial condition of these
companies. Consequently, the strong demand by investors for meme stocks
caused the stock prices to increase dramatically, only to crash upon a closer
review.
10. Marketability. Commercial banks use some funds to purchase securities and
other funds to make loans. Why are the securities more marketable than the
loans in the secondary market? (LO3)
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 by commercial banks
versus savings institutions. (LO3)
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? (LO3)
ANSWER: Credit unions are nonprofit financial institutions that provide
services to their members. Usually, they are much smaller and have narrower
services than other depository institutions.
13. Nondepository Institutions. Compare the main sources and uses of funds for
finance companies, insurance companies, and pension funds. (LO3)
ANSWER: Finance companies sell securities to obtain funds, while insurance
companies receive insurance premiums and pension funds receive
employee/employer contributions. Finance companies use funds to provide
direct loans to consumers and businesses. Insurance companies and pension
funds purchase securities.
