Solution Manual for Financial Markets And Institutions 8th Edition Anthony Saunders

Saunders/Cornett/Erhemjamts Financial Markets and Institutions , 8e Copyright © 20 22 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. 1 Solution Manual for Financial Markets And Institutions 8th Edition Anthony Saunders Chapter 1 -25 Answers to Chapter 1 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, negotiable CDs, and commercial paper, had the largest amounts outstanding in 201 9. 5. The major instruments traded in capital markets are corporate stocks, mort gages, 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 1-4, corporate stocks represent the largest capital market instrument in 2019, followed by mortgages , Treasury securities, and corporate bonds. 7. The bank would b e most concerned about a depreciation of the yen against the dollar. 8. Financial institutions consist of: Commercial banks - depository institutions whose major assets are l oans 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 f unds, 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 t hey tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Saunders/Cornett/Erhemjamts Financial Markets and Institutions , 8e Copyright © 20 22 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. 2 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 underwri te 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 dep ository 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 re sources 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 origina lly invested in and accumulated in pension fund s are exempt from current taxation. 9. If there were no FIs then the users of funds, such as corporation s 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 potentia l 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 t he 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 t hree reasons for this. First, o nce 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 ar e 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, t he relatively long -term nature of some f inancial 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, f und 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 thou gh 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. T hat is, t he price at which investors can sell a secur ity 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 ―fr ee-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 Saunders/Cornett/Erhemjamts Financial Markets and Institutions , 8e Copyright © 20 22 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. 3 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 additio n 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 princ ipal 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 hig her 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 in vesting 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 invest ing 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 con strained 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 liq uid 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 borrow ers 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 t o 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 portfolio s. 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 s hares 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 port folios as well. 16. Other s ervices provided by FIs that benefit the overall economy include: Money Supply Transmission - Depository institutions are the conduit through which monetary policy actions impact the rest of the financial system and the econom y in general. Credit Allocation - FIs are often viewed as the major, and sometimes only, source of financing for a particular sector of the economy, such as farming and residential real estate. Intergenerational Wealth Transfers - FIs, especially life insurance companies and pension funds, provide savers the ability to transfer wealth from one generation to the next. Payment Services - The efficiency with which depository institutions provide payment services directly benefits the economy. Saunders/Cornett/Erhemjamts Financial Markets and Institutions , 8e Copyright © 20 22 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. 4 17. As fin ancial institutions perform the various services described above, they face many types of risk. Specifically, all FIs hold some assets that are potentially subject to default or credit risk (such as loans, stocks, and bonds). As FIs expand their services t o non -U.S. customers or even domestic customers with business outside the United States, they are exposed to both foreign exchange risk and country or sovereign risk as well. Further, FIs tend to mismatch the maturities of their balance sheet assets and li abilities to a greater or lesser extent and are thus exposed to interest rate risk. If FIs actively trade these assets and liabilities rather than hold them for longer -term investments, they are further exposed to market risk or asset price risk. Increasin gly, FIs hold contingent assets and liabilities off the balance sheet, which presents an additional risk called off -balance -sheet risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. All FIs are exposed to technology risk and operational risk because the production of financial services requires the use of real resources and back -office support systems (labor and technology combined to provide servi ces). Finally, the risk that an FI may not have enough capital reserves to offset a sudden loss incurred as a result of one or more of the risks it faces creates insolvency risk for the FI. 18. FIs provide various services to sectors of the economy. Fail ure to provide these services, or a breakdown in their efficient provision, can be costly to both the ultimate suppliers (households) and users (firms) of funds as well as the overall economy. For example, bank failures may destroy household savings and at the same time restrict a firm ‘s access to credit. Insurance company failures may leave households totally exposed in old age to catastrophic illnesses and sudden drops in income on retirement. In addition, individual FI failures may create doubts in saver s‘ minds regarding the stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs are regulated in an attempt to prevent these types of market failures. 19. A major event that changed and reshaped the financial ser vices industry was the financial crisis of the late 2000s. As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of ―originate and hold‖ to ―originate to distribute.‖ In the traditional model, banks take short term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return -risk tradeoffs, banks have shifted to an underwriting model in which they originated or warehouse loans, and then quickly se ll them. When loans trade, the secondary market produces information that can subs titute for the information and monitoring of banks. Further, banks may have lower incentives to collect information and monitor borrowers if they sell loans rather than keep them as part of the bank‘s portfolio of assets. Indeed, most large banks are organ ized as financial service holding companies to facilitate these new activities. More recently activities of shadow banks, non -bank financial service firms that perform banking services, have facilitated the change from the originate and hold model of com mercial banking to the originate and distribute banking model. In the shadow banking system savers place their funds with money market mutual7 and similar funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases fr om shadow banks rather than from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and net borrowers. However, instead of the bank serving as the middleman, it is the nonbank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system, where the complete credit intermediation is performed by a single bank, in the shadow banking system it is performed through a series of steps involving many nonbank financial service firms. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking, they ha ve little incentive to screen and monitor activities of b orrowers to whom they originate loans. Thus, FIs role as specialists in risk measurement and management has been reduced . 20. The boom (―bubble‖) in the housing markets began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short -term interest rate that banks and other financial institutions pay in the Federal funds market and even made lender of last resort funds available to non -bank Saunders/Cornett/Erhemjamts Financial Markets and Institutions , 8e Copyright © 20 22 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. 5 FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by Central banks resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the deman d for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut -off points. Moreover, to boost their earnings, in the marke t now popularly known as the ―subprime market,‖ banks and other mortgage -supplying institutions often offered relatively low ―teaser‖ rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial step-up in rat es after the initial rate period expired two or three year later and if market rates rose in the future. Under the traditional banking structure, banks might have been reluctant to so aggressively pursue low credit quality borrowers for fear that the loans would default. However, under the originate -to-distribute model of banking, asset securitization and loan syndication allowed banks to retain little or no part of the loans, and hence the default risk on loans that they originated. Thus, as long as the bo rrower did not default within the first months after a loan‘s issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate leverage. 21. Measured as more than $ 1 trillion in international debt outst anding as of 201 9 the biggest issuers are France, Germany, the Netherlands, the United Kingdom, and t he United States. 22. China, France , Japan, the United Kingdom, and the United States have the biggest banks (in terms of total assets held in 201 9). Answers to Chapter 2 Questions : 1. The household sector (consumers) is one of the largest supplier of loanable funds. Households supply funds when they have excess income or want to reinvest a part of their wealth. For example, during times of high growth households may replace part of their cash holdings with earning assets. As the total wealth of the con sumer increases, the total supply of funds from that household will also generally increase. Households determine their supply of funds not only on the basis of the general level of interest rates and their total wealth, but also on the risk on financial s ecurities change. The greater a security ‘s risk, the less households are willing to invest at each interest rate. Further, the supply of funds provided from households will depend on the future spending needs. For example, near term educational or medical expenditures will reduce the supply of funds from a given household. Higher interest rates will also result in higher supplies of funds from the business sector. When businesses mismatch inflows and outflows of cash to the firm they have excess cash that t hey can invest for a short period of time in financial markets. In addition to interest rates on these investments, the expected risk on financial securities and the business ‘ future investment needs will affect the supply of funds from businesses. Loanabl e funds are also supplied by some government units that temporarily generate more cash inflows (e.g., taxes) than they have budgeted to spend. These funds are invested until they are needed by the governmental agency. Additionally, the federal government ( i.e., the Federal Reserve) implements monetary policy by influencing the availability of credit and the growth in the money supply. Monetary policy implementation in the form of increases the money supply will increase the amount of loanable funds availabl e. Finally, foreign investors increasingly view U.S. financial markets as alternatives to their domestic financial markets. When interest rates are higher on U.S. financial securities than on comparable securities in their home countries, foreign investors increase the supply of funds to U.S. markets. Indeed , the high savings rates of foreign households combined with relatively high U.S. interest rates compared to foreign rates, has resulted in foreign market participants as major suppliers of funds in U.S. financial markets. Similar to domestic suppliers of loanable funds, foreign suppliers assess not only the interest rate offered on financial securities, but also their total wealth, the risk on the security, and their future spending needs. Additionally, foreign investors alter their investment decisions as financial conditions in their home countries change relative to the U.S. economy. 2. Households (although they are net suppliers of funds) borrow funds in financial markets. The demand for loanable funds by households comes from their purchases of homes, durable goods (e.g., cars, appliances), and nondurable goods (e.g., education expenses, medical expenses). In addition to the interest rate on borrowed funds, the greater Saunders/Cornett/Erhemjamts Financial Markets and Institutions , 8e Copyright © 20 22 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. 6 the utility the household re ceives from the purchased good, the higher the demand for funds. Additionally, nonprice conditions and requirements (discussed below) affect a household =s demand for funds at every level of interest rates. Businesses often finance investments in long -term (fixed) assets (e.g., plant and equipment) and in short -
term assets (e.g., inventory and accounts receivable) with debt and other financial instruments. When interest rates are high (i.e., the cost of loanable funds is high), businesses prefer to finance investments with internally generated funds (e.g., retained earnings) rather than through borrowed funds. Further, the greater the number of profitable projects available to businesses, or the better the overall economic conditions, the greater the demand for loanable funds. Governments also borrow heavily in financial markets. State and local governments often issue debt to finance temporary imbalances between operating revenues (e.g., taxes) and budgeted expenditures (e.g., road improvements, school cons truction). Higher interest rates cause state and local governments to postpone such capital expenditures. Similar to households and businesses, state and local governments‘ demand for funds vary with general economic conditions. The federal government is a lso a large borrower partly to finance current budget deficits (expenditures greater than taxes) and partly to finance past deficits. In contrast to other demanders of funds , the federal government‘s borrowing is not influenced by the level of interest rat es. Expenditures in the federal government‘s budget are spent regardless of the interest cost. Finally, foreign participants might also borrow in U.S. financial markets. Foreign borrowers look for the cheapest source of funds globally. Most f oreign borrowing in U.S. financial markets comes from the business sector. In addition to interest costs, foreign borrowers consider nonprice terms on loanable funds as well as economic conditions in the home country. 3. Factors that affect the supply of funds include total wealth , risk of the financial security, future spending needs, monetary policy objectives, and economic conditions. Wealth. As the total wealth of financial market participants (households, business, etc.) increases the absolute dollar value available for investment purposes increases. Accordingly, at every interest rate the supply of loanable funds increases, or the supply curve shifts down and to the right. The shift in the supply curve creates a disequilibrium in this financial marke t. As competitive forces adjust, and holding all other factors constant, the increase in the supply of funds due to an increase in the total wealth of market participants results in a decrease in the equilibrium interest rate, and an increase in the equili brium quantity of funds traded. Conversely, as the total wealth of financial market participants decreases the absolute dollar value available for investment purposes decreases. Accordingly, at every interest rate the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve again creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the decrease in the supply of funds due to a decrease in the total wealth of market participants results in an increase in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded. Risk. As the risk of a financial security decreases, it becomes more attractive to supplier of f unds. Accordingly, at every interest rate the supply of loanable funds increases, or the supply curve shifts down and to the right . The shift in the supply curve creates a disequilibrium in this financial market. As competitive forces adjust, and holding a ll other factors constant, the increase in the supply of funds due to a decrease in the risk of the financial security results in a decrease in the equilibrium interest rate, and an increase in the equilibrium quantity of funds traded. Conversely, as the risk of a financial security increases, it becomes less attractive to supplier of funds. Accordingly, at every interest rate the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve creates a dise quilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the decrease in the supply of funds due to an increase in the financial security ‘s risk results in an increase in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded. Near -term Spending Needs. When financial market participants have few near -term spending needs, the absolute dollar value of funds available to invest increases. Accordingly, at every interest rate t he supply of loanable funds increases, or the supply curve shifts down and to the right. The financial market, holding all other factors constant, reacts to this increased supply of funds by decreasing the equilibrium interest rate, and increasing the equi librium quantity of funds traded. Conversely, when financial market participants have near -term spending needs, the absolute dollar value of funds available to invest decreases. At every interest rate the supply of loanable funds decreases, or the supply c urve shifts up and to the left. The shift in the supply curve creates a disequilibrium in this financial market that, when