Chapter 03 - Financial Instruments, Financial Markets, and Financial Institutions

Chapter 3
Financial Instruments, Financial Markets,
and Financial Institutions

Chapter Overview

In this chapter the financial system is surveyed in three steps: 1) financial instruments or
securities are studied; 2) financial markets are considered; and 3) financial institutions are
examined.

Reading this chapter will prepare students to:

Define and describe financial instruments.
Explain the factors that affect the value of financial instruments.
Evaluate how essential financial markets are to the operation of an economic system.
Categorize financial markets.
Describe a well-functioning financial market.
Explain the brokerage and asset transformation functions performed by financial
institutions.

Important Points of the Chapter

The formal financial instruments of the modern world have their roots in the informal
arrangements that were the mainstays of the financial system centuries ago. Even in the most
primitive economies, people needed to borrow when their consumption needs exceeded their
income. Families or communities provided the lending with the understanding that if the needs
were reversed they would receive similar assistance. Today, the international financial system
exists to facilitate the design, sale, and exchange of a broad set of contracts and so fosters
production, employment, and consumption. Savings are funneled through the system so that
they can finance investment and the decisions of the people who do the saving direct the capital
to its most efficient uses, thus resulting in economic growth.

Application of Core Principles

Principle #2: Risk. Most financial instruments transfer risk between the buyer and seller. The
example of a wheat farmer selling a futures contract on his crop demonstrates that the farmer can
sell the instrument, setting the price that will be received for the crop regardless of how it turns
out, and so transfer the risk onto the buyer of the contract.

Principle #3: Information. Financial instruments communicate information by summarizing

certain essential information about the issuer. Financial instruments are designed to eliminate the
expensive and time-consuming process of collecting information on the issuer.

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Principle #1: Time. The sooner a payment is made the more valuable is the promise that it will
be made. This is because a payment that is received can be invested and will begin to earn a
return immediately; if one has to wait to make the investment potential returns are lost.

Principle #2: Risk. The more likely it is that a payment will be made the more valuable is the
financial instrument.

Principle #4: Markets. Financial markets offer liquidity, pool and communicate information and
allow risk sharing.

Principle #3: Information. In well-run financial markets the information that is pooled and
communicated is accurate and widely available. If this were not so, the markets would not
generate the correct prices for the instruments, and those prices are the link between the financial
markets and the real economy. Hence if the prices are wrong the economy will not operate as
effectively as it could.

Principle #3: Information. Standardized securities reduce the information costs of screening and
monitoring borrowers. Financial institutions thus curb information asymmetries and the
problems that go along with them, helping to ensure that resources flow into their most
productive uses.

Teaching Tips/Student Stumbling Blocks

Heres a good illustration of the benefits of a mutual fund; liken it to a deck of playing cards.
Would a consumer rather have one card in the deck or a piece of all the cards? This is
diversification.

Features in this Chapter

Lessons from the Crisis: Leverage

The use of borrowing to finance part of an investment is called leverage. Leverage played a key
role in the financial crisis of 2007-2009. Modern economies rely heavily on borrowing to make
investments. The more leverage, however, the greater the risk of that an unexpected adverse
event will lead to bankruptcy. Financial institutions are highly leveraged, typically owning
assets of ten times their net worth. During the financial crisis, this number was upwards of 30
times from some firms, meaning that a small drop in the value of asset prices could lead to
bankruptcy. Firms that are too highly leveraged will often try to reduce their leverage
deleverage by selling assets and issuing securities to raise their net worth. However, the
financial system cannot deleverage all at the same time. When it does, asset prices fall even
further, leading to more deleveraging and a spiral downward of asset prices.

Your Financial World: Disability Income Insurance

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Few people insure their most valuable asset, their ability to produce an income even though the
statistics say that the chances of becoming disabled are far greater than that of other calamities,
like your house burning down. The government provides some disability insurance through
Social Security and if youre injured on the job and cant work there is workers compensation
insurance. However, this may not be enough, so individuals should evaluate their needs and
consider whether they need to buy additional insurance. As noted in the text, surely this is one
risk you should transfer to someone else.

Tools of the Trade: Trading in Financial Markets

With todays electronic markets you can enter an order and watch as it is executed. If you want
to buy, you enter a bid, and if yours is the highest bid and someone is willing to sell at that price,
you trade immediately. Otherwise, your bid goes into an order book to wait for a seller. If you
sent your order through the New York Stock Exchange, it would have to go through a specialist
who would match the orders. To keep the market liquid so that people can both buy and sell and
so that prices are not overly volatile, specialists often trade on their own account.

In the News: Lessons of the Crisis One Year Later

This article summarizes the financial crisis of 2007-2009 and some of the lessons learned from
the crisis, noting that some of the statistics do not indicate an end to the crisis. The crisis began
with rising defaults among sub-prime mortgages and a drift downward of the stock market. A
stunning two-week period in September of 2008 included a rapid take-over of mortgage lending
giants Freddie Mac and Fannie Mae and insurer American International Group. Lehman
Brothers filed for bankruptcy, brokerage giant Merrill Lynch quickly merged with Bank of
America, and Washington Mutual was seized by government regulators.
The lessons from the crisis, according to the article, include that diversification doesnt always
protect investors, markets are interlocked more than ever, investors should understand every
investment they make, investors should ensure that their portfolios are as liquid as they need
them to be, the government can help the market, financial companies should not become too big
fail, and investors should know and understand the worst-case investing scenario.

Lessons of the Article: The article highlights the large swings in financial markets during the
financial crisis of 2007-2009. Before the crisis, professional investors had made their own
institutions and the overall financial system vulnerable by taking on too much risk (see
Chapter 3, Lessons from the Crisis: Leverage). When the crisis hit, they faced a shortfall of
liquidity (see Chapter 2, Lessons from the Crisis: Market Liquidity, Funding Liquidity, and
Making Markets). At the height of the crisis, panic purchases of Treasury bills constituted a
classic flight to safety by investors seeking the most liquid assets. Liquidity swings caused
many financial marketsincluding the stock marketto plunge and rebound together.

Lessons from the Crisis: Interbank Lending

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Interbank lending is a critical foundation of modern financial markets. In normal times, banks
lend to each other in large volumes at low costs for periods ranging from overnight to a few
months. These loans smooth the functions of markets by allowing banks to offset the fandom
ebbs of flows of deposits and loans. If banks did not have access to these loans, they would hold
more cash to insure against unanticipated changes in deposits or loan demand. The financial
crisis of 2007-2009 triggered much greater and more prolonged strains on interbank lending.
The government stepped in, however, to add liquidity and guarantee bank debt and the strains
eventually eased.

Lessons from the Crisis: Shadow Banks

Over the past few decades, financial intermediation and leverage in the United States has shifted
away from traditional banks and toward other financial institutions not subject to government
regulation, including brokerages, consumer and mortgage finance firms, insurers, and bank-
created asset-management firms. These firms are often called shadow banks because they
provide services that compete with or substitute for those supplied by traditional banks.
Financial innovation leading to broader markets, lower information costs, and new profit
opportunities all encouraged the development of new financial instruments and institutions.
Over time, leverage in the financial system as a whole increased, and the new financial
instruments made it easier to conceal leverage and risk-taking. The financial crisis of 2007-2009
transformed shadow banking and the future of shadow banking remains uncertain.

Your Financial World: Shop for a Mortgage

Getting the cheapest mortgage you can find will save you more money than a years worth of
bargain hunting in stores. Real estate agents can provide lists of mortgage providers in your
area, and there are websites that publish quotes for mortgages. Not all of the firms offering
mortgages are banks; some are mortgage brokers, firms that have access to pools of funds that
are earmarked for use as mortgages. It should make no difference to you where the funds come
from; a mortgage is a mortgage. But shop before you sign on the dotted line, and if you let
brokers know that you are shopping around, you may get a better deal.

Additional Teaching Tools

Writing in The Wall Street Journal (May 27, 2004), Kaja Whitehouse reports that a financial
publishing firm (Moneypaper, Inc., based in Rye, New York) has launched an online gift registry
that allows brides and grooms to receive gifts of stock. Called giftsofstock.com, the plan focuses
on DRIPs or dividend reinvestment plans, whereby anyone with one or more shares can reinvest
the dividends and so increase their holdings. But buying the initial shares can be expensive,
which is where the registry comes in. Users of the site can choose from among 56 different
stocks. The companies were picked because they have no costs (or low costs) associated with
setup or additional cash investments and because they are good long-term investments. It costs
about $20 to buy the stock and register it in the recipients name.

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Virtual Tools

Do you own U.S. savings bonds? Find out what your savings bond is worth and keep a record of
your portfolio at this website from the U.S. Treasury Department:
http://www.treasurydirect.gov/BC/SBCPrice

Visit the homepage of the NYSE at:

http://www.nyse.com/

Visit NASDAQ at:

http://www.nasdaq.com/

You can find a mortgage calculator (as well as other information) on this site from lending
tree.com:
http://www.domania.com/calculators/index.jsp

Did you know you can also purchase historical stocks and bonds as gifts? Visit:
http://www.scripophily.net/

For More Discussion

Have students discuss the average persons portfolio of assets (does he or she have a checking
account? Mutual fund shares?). Evaluate the pros and cons of those items.

Chapter Outline

1. The informal arrangements that were the mainstay of the financial system centuries ago
have since given way to the formal financial instruments of the modern world.
2. Today, the international financial system exists to facilitate the design, sale, and exchange
of a broad set of contracts with a very specific set of characteristics.
3. We obtain the financial resources we need through this system in two ways: directly from
lenders and indirectly from financial institutions called financial intermediaries.
4. In the latter (called indirect finance) a financial institution (like a bank) borrows from
the lender and then provides funds to the borrower. If someone borrows money to buy a
car, the car becomes his or her asset and the loan a liability.
5. In direct finance, borrowers sell securities directly to lenders in the financial markets.
Governments and corporations finance their activities this way.
6. The securities become assets to the lenders who buy them and liabilities to the borrower
who sells them.
7. Financial development is inextricably linked to economic growth.
8. There arent any rich countries that have very low levels of financial development.

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I. Financial Instruments
A financial instrument is the written legal obligation of one party to transfer something of
valueusually moneyto another party at some future date, under certain conditions.
1. The fact that a financial instrument is a written legal obligation means that it is
subject to government enforcement; the enforceability of the obligation is an
important feature of a financial instrument.
2. The party referred to can be a person, company, or government.
3. The future date can be specified or can be when some event occurs.
4. Financial instruments generally specify a number of possible contingencies under
which one party is required to make a payment to another.
A. Uses of Financial Instruments
1. Stocks, loans, and insurance are all examples of financial instruments.
2. As a group, they have three functions or uses:
a. They can act as a means of payment.
b. They can be stores of value.
c. They allow for the taking of risk.
3. Most financial instruments involve some sort of risk transfer.
B. Characteristics of Financial Instruments: Standardization and Information
1. Financial instruments are complex contracts.
2. Standardized agreements are used in order to overcome the potential costs of
complexity.
3. Because of standardization, most of the financial instruments that we encounter on a
day-to-day basis are very homogeneous.
4. Another characteristic of financial instruments is that they communicate information.
5. Financial instruments summarize certain essential information about the issuer.
6. Financial instruments are designed to handle the problem of asymmetric
information, which comes from the fact that borrowers have some information that
they dont disclose to lenders.
C. Underlying versus Derivative Instruments
1. The two fundamental classes of financial instruments are underlying instrument
(sometimes called primitive securities) and derivative instruments.
2. Stocks and bonds are examples of underlying instruments.
3. Derivatives are so named because they take their value and their payoffs are derived
from the behavior of the underlying instruments.
4. Futures and options are examples of derivatives.

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D. A Primer for Valuing Financial Instruments

1. Four fundamental characteristics influence the value of a financial instrument:
a. the size of the payment that is promised
b. when the promised payment is to be made
c. the likelihood that the payment will be made
d. the conditions under which the payment is to be made
2. People will pay more for an instrument that obligates the issuer to pay the holder a
greater sum. The bigger the size of the promised payment, the more valuable the
financial instrument.
3. The sooner the payment is made the more valuable is the promise to make it.
4. The more likely it is that the payment will be made, the more valuable the financial
instrument.
5. Payments that are made when we need them most are more valuable than other
payments.
E. Examples of Financial Instruments
1. Financial instruments that are used primarily as stores of value include:
a. Bank loans: a borrower obtains resources from a lender immediately in exchange
for a promised set of payments in the future.
b. Bonds: a form of a loan, whereby in exchange for obtaining funds today a
government or corporation promises to make payments in the future.
c. Home mortgages: a loan that is used to purchase real estate. The real estate is
collateral for the loan, which means it is a specific asset pledged by the borrower
in order to protect the interests of the lender in the event of nonpayment. If
payment is not made the lender can foreclose on the property.
d. Stocks: an owner of a share owns a piece of the firm and is entitled to part of its
profits.
e. Asset-backed Securities: shares in the returns or payments arising from specific
assets, such as home mortgages. Investors purchase shares in the revenue that
comes from these underlying assets. These are an innovation that allows funds in
one part of the country to find productive uses elsewhere.
2. Financial instruments that are used primarily to transfer risk include:
a. Insurance contracts: the primary purpose is to assure that
payments will be made under particular (and often rare) circumstances.

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b. Futures contracts: an agreement to exchange a fixed quantity of a

commodity, such as wheat or corn, or an asset, such as a bond, at a fixed price on
a set future date. It is a derivative instrument since its value is based on the price
of some other asset. It is used to transfer the risk of price fluctuations from one
party to another.
c. Options: derivative instruments whose prices are based on the
value of some underlying asset; they give the holder the right (but not the
obligation) to purchase a fixed quantity of the underlying asset at a predetermined
price at any time during a specified period.
II. Financial Markets
Financial markets are the places where financial instruments are bought and sold. They
enable both firms and individuals to find financing for their activities. They promote
economic efficiency by ensuring that resources are placed at the disposal of those who can
put them to best use. When they fail to function properly, resources are no longer channeled
to their best possible use and we all suffer. This section looks at the role of financial markets
and the economic justification for their existence.
A. The Role of Financial Markets
1. Financial markets serve three roles in our economic system: they offer savers and
borrowers liquidity; they pool and communicate information; and they allow risk
sharing.
2. Financial markets need to be designed in a way that keeps transactions costs low.
B. The Structure of Financial Markets
1. There are lots of financial markets and many ways to categorize them.
2. There are three possibilities for grouping financial markets:
a. Primary versus secondary markets: in a primary market a borrower obtains funds
from a lender by selling newly issued securities. Most of the action in primary
markets goes on out of public view. Most companies use an investment bank,
which will determine a price and then purchase the companys securities in
preparation for resale to clients; this is called underwriting. We hear more about
the secondary markets where people can buy and sell existing securities; these are
the prices reported in the news.
b. Centralized Exchanges, Over-the-Counter Markets, and Electronic Networks:
Secondary financial markets can be centralized exchanges (like the New York
Stock Exchange) or over-the-counter (or OTC) markets, which are electronic
networks of dealers who trade with one another from wherever they are located
(NASDAQ, for example). Today we can add electronic communications
networks (ECNs) to the list. Compared to centralized exchanges, electronic
markets have advantages and disadvantages: customers can see the orders, but
the speed of execution means errors can happen.

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c. Debt and Equity versus Derivative Markets: equity markets are the markets for
stocks, which are usually traded in the countries where the companies are based.
Debt instruments can be categorized as money market (maturity of less than one
year) or bond markets (maturity of more than one year).
3. Exchanges are becoming more globalized as exchanges merge. With technologies
improving exchanges want to take advantage of lower cost and speedier transactions
afforded by mergers.
C. Characteristics of a Well-Run Financial Market
1. Well-run financial markets exhibit a few essential characteristics that are related to
the role we ask them to play in our economies.
a. They must be designed in a way that keeps transactions costs low.
b. The information the market pools and communicates must be both accurate and
widely available. If not, the prices will not be correct and those prices are the
link between the financial markets and the real economy.
c. Investors must be protected; a lack of proper safeguards dampens peoples
willingness to invest, and so governments are an essential part of financial
markets.
III. Financial Institutions
1) Financial institutions are the firms that provide access to the financial markets; they
sit between savers and borrowers and so are known as financial intermediaries.
Examples include banks, insurance companies, securities firms and pension funds.
2) A system without financial institutions would not work very well for three reasons:
a. Individual transactions between saver-lenders and borrower-spenders would be
extremely expensive.
b. Lenders need to evaluate the creditworthiness of borrowers and then monitor
them to ensure that they dont abscond with the funds, and individuals are not
equipped to do this.
c. Most borrowers want to borrow long term, while lenders favor short-term loans.
A. The Role of Financial Institutions
1. Financial institutions reduce transaction costs by specializing in the issuance of
standardized securities.
2. They reduce the information costs of screening and monitoring borrowers to ensure
that they are creditworthy and that they use the proceeds of a loan or security issue
properly.
3. Financial institutions curb information asymmetries and the problems that go along
with them, helping to ensure that resources flow into their most productive uses.

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4. Financial institutions make long-term loans but allow savers ready access to their
funds.
5. They provide savers with financial instruments that are both more liquid and less
risky than the individual stocks and bonds that savers would purchase directly in
financial markets.
B. The Structure of the Financial Industry
1. Financial institutions or intermediaries can be divided into two broad categories
called depository and nondepository institutions.
2. Depository institutions (commercial banks, savings banks, and credit unions) take
deposits and make loans.
3. Nondepository institutions include insurance companies, securities firms, mutual
fund companies, hedge funds, finance companies, and pension funds.
a. Insurance companies accept premiums, which they invest in securities and real
estate in return for promising compensation to policyholders should certain
events occur (like death, property losses, etc.).
b. Pension funds invest individual and company contributions into stocks, bonds
and real estate in order to provide payments to retired workers.
c. Securities firms (include brokers, investment banks, and mutual fund
companies): brokers and investment banks issue stocks and bonds to corporate
customers, trade them, and advise clients. Mutual fund companies pool the
resources of individuals and companies and invest them in portfolios of bonds,
stocks, and real estate. Hedge funds do the same for small groups of wealthy
investors.
d. Finance Companies: raise funds directly in the financial markets in order to
make loans to individuals and firms.
e. Government Sponsored Enterprises: federal credit agencies that provide loans
directly for farmers and home mortgages, as well as guarantee programs that
insure the loans made by private lenders. The government also provides
retirement income and medical care to the elderly (and disabled) through Social
Security and Medicare.
4. The monetary aggregates are made up of liabilities of commercial banks, so clearly
the financial structure is tied to the availability of money and credit.

Terms Introduced in Chapter 3

asset
asset-backed security
bond market

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centralized exchange
collateral
counterparty
debt market
derivative instrument
direct finance
electronic communications networks (ECNs)
equity market
financial instrument
financial institutions
financial markets
indirect finance
liability
money market
mortgage backed security
over-the-counter (OTC) market
portfolio
primary financial market
secondary financial market
underlying instrument
Lessons of Chapter 3
1. Financial instruments are crucial to the operation of the economy.
a. Financial arrangements can be both formal and informal. Industrial economies are
dominated by formal arrangements.
b. A financial instrument is the written legal obligation of one party to transfer something of
value, usually money, to another party at some future date, under certain conditions.
c. Financial instruments are used primarily as stores of value and as a means of trading risk.
They are less likely to be used as means of payment, although many of them can be.
d. Financial instruments are most useful when they are simple and standardized.
e. There are two basic classes of financial instruments: underlying and derivative.
i. Underlying instruments are used to transfer resources directly from one party to
another.
ii. Derivative instruments derive their value from the behavior of an underlying
instrument.
f. The payments promised by a financial instrument are more valuable
i. The larger they are.
ii. The sooner they are made.
iii. The more likely they are to be made.
iv. If they are made when they are needed most.
g. Common examples of financial instruments include
i. Those that serve primarily as stores of value, including bank loans, bonds, mortgages,
stocks, and asset-backed securities.

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ii. Those that are used primarily to transfer risk, including futures and options.

2. Financial markets are essential to the operation of our economic system.

a. Financial markets:
i. Offer savers and borrowers liquidity, so that they can buy and sell financial
instruments easily.
ii. Pool and communicate information through prices.
iii. Allow for the sharing of risk.
b. There are several ways to categorize financial markets:
i. Primary markets that issue new securities versus secondary markets where existing
securities are bought and sold.
ii. Physically centralized exchanges versus dealer-based electronic systems (over-the-
counter markets), or electronic networks.
iii. Debt and equity markets (where instruments that are used primarily for financing are
traded) versus derivative markets (where instruments that are used to transfer risk are
traded).
c. A well-functioning financial market is characterized by
i. Low transactions costs and sufficient liquidity.
ii. Accurate and widely available information.
iii. Legal protection of investors against the arbitrary seizure of their property.

3. Financial institutions perform brokerage and asset transformation functions.

a. In their role as brokers, they provide access to financial markets.
b. In transforming assets, they provide indirect finance.
c. Indirect finance reduces transaction and information costs.
d. Financial institutions, also known as financial intermediaries, help individuals and firms
to transfer and reduce risk.

Chapter 3:

Conceptual Problems
1. As the end of the month approaches, you realize that you probably will not be able to pay the
next months rent. Describe both an informal and a formal financial instrument that you
might use to solve your dilemma.

Answer:
Informalborrow from family or friends.
Formalobtain a loan from a bank.

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2. *While we often associate informal financial arrangements with poorer countries where
financial systems are less developed, informal arrangements often co-exist with even the
most developed financial systems. What advantages might there be to engaging in informal
arrangements rather than utilizing the formal financial sector?

Answer: Informal financial arrangements are prevalent among certain ethnic groups in the
US, where community ties are strong. (See for example Bond P. and R Townsend (1996)
Formal and Informal Financing in a Chicago Ethnic Neighborhood Economic Perspectives,
Federal Reserve Bank of Chicago, July.) Information and monitoring costs can be lower than
for formal loans, as the parties to the arrangement are generally known to each other and
social and cultural factors will ensure the arrangements are honored. In addition, informal
arrangements are often more flexible than standardized formal loans.

3. If higher leverage is associated with greater risk, explain why the process of deleveraging
(reducing leverage) can be destabilizing.

Answer: The problem arises if too many institutions try to reduce their leverage at the same
time. A large number of institutions selling assets will push down asset prices. With asset
values falling relative to liabilities, net worth falls, increasing leverage and prompting further
asset sales, potentially destabilizing those markets.

4. The Chicago Mercantile Exchange has announced the introduction of a financial instrument
that is based on rainfall in the state of Illinois. The standard agreement states that for each
inch of rain over and above the average rainfall for a particular month, the seller will pay the
buyer $1,000. Who could benefit from buying such a contract? Who could benefit from
selling it?

Answer: Someone who benefits from above average rainfall could sell the contract, and
someone who is harmed by above average rainfall should buy the contract. Crops can benefit
from additional rainfall during certain times of the year, but may be harmed by too much rain
at other times; so, depending on the season, farmers could be buying or selling derivatives.
Hydroelectric companies could also sell the contracts, while people who benefit from dry
weather like golf course operators would buy them.

5. Consider an annuity that makes monthly payments for as long as someone lives. Describe
what happens to the purchase price of the annuity as (1) the age of the purchaser goes up,
(2) the size of the monthly payment rises, and (3) the health of the purchaser improves.

Answer:
1. The number of expected monthly payments declines so the price of the annuity
falls.
2. The price of the annuity rises.
3. The purchaser is expected to live longer; the number of expected monthly
payments rises so the price of the annuity rises.

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6. Consider the investment returns to holding stock. Which of the following would be more
valuable to you: Stocks that rise in value when your income rises or stocks that rise in value
when your income falls? Why?

Answer: Stocks that rise in value when your income falls are more valuable because they pay
off when you need it the most (when your marginal utility is high).

7. The Wall Street Journal has a daily listing of what are called "Money Rates or interest rates
on short-term securities. Locate it either in a recent issue of the newspaper by looking at the
index on page 1 of the Money and Investing section, or in the Market Data Center of
www.wsj.com. The most important money rates are the prime rate, the federal funds rate,
and the Treasury bill rate. Describe each of these and report the current rate quoted in the
paper.

Answer: The prime rate is the base rate for corporate loans offered by at least 70% of the
largest banks in the U.S. The federal funds rate is the rate at which banks lend reserves to
each other overnight. The Treasury bill rate is the discount from face value of short-term
government securities. On February 11, 2010, the prime rate was 3.25%, the federal funds
rate target was 0-0.25% and the rate for the 3-month T-bill was 0.101%.

8. You are asked for advice by the government of a small, less developed country interested in
increasing its rate of economic growth. You notice that the country has no financial markets.
What advice would you give?

Answer: Developing financial markets is an essential component of economic growth. The

prices generated in the financial markets will help to direct resources to their most efficient
resources, which will foster economic growth. To support the development of financial
markets, the government needs to create laws requiring accurate disclosure of information,
prohibiting trading on information that is not public, and ensuring that borrowers pay back
lenders. These laws need to be strictly enforced.

9. The design and function of financial instruments, markets, and institutions are tied to the
importance of information. Describe the role played by information in each of these three
pieces of the financial system.

Answer: Financial instruments summarize essential information about the borrower.

Financial markets aggregate information from many sources and communicate it widely.
Financial institutions produce information to screen and monitor borrowers.

10. Suppose you need to take out a personal loan with a bank. Explain how you could be
affected by problems in the interbank lending market such as those seen during the 2007-
2009 financial crisis.

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Answer: The strains in the interbank market pushed up interbank lending rates which
increases the cost of funds to banks and would likely lead to an increase in the rate on your
personal loan. If your bank is having trouble obtaining short-term funding in the interbank
market, it may decide to hold more cash and reduce lending, impacting your ability to secure
a loan at all.

11. *Advances in technology have facilitated the widespread use of credit scoring by financial
institutions in making their lending decisions. Credit scoring can be defined broadly as the
use of historical data and statistical techniques to rank the attractiveness of potential
borrowers and guide lending decisions. In what ways might this practice enhance the
efficiency of the financial system?

Answer: The use of credit scoring techniques standardizes the assessment of loan applicants
and reduces information costs. This allows financial institutions to lend to a broader range of
borrowers and facilitates the creation of asset-backed securities based on these loans.
Lending practices based on more objective criteria reduce subjectivity and discrimination in
lending decisions, leading to a more efficient allocation of resources.

Analytical Problems

12. For each pair of instruments below, use the criteria for valuing a financial instrument to
choose the one with the highest value.
a. A U.S. Treasury bill that pays $1,000 in six months or a U.S. Treasury bill that pays
$1,000 in three months.
b. A U.S. Treasury bill that pays $1,000 in three months or commercial paper issued by
a private corporation that pays $1,000 in three months.
c. An insurance policy that pays out in the event of serious illness or one that pays out
when you are healthy, assuming you are equally likely to be ill or healthy.
Explain each of your choices briefly.

Answer:
a. The T-bill that pays out in three months, as the sooner the payment the more
valuable.
b. The T-bill is more valuable as the likelihood of the US government honoring its
debts is higher than a private corporation.
c. The insurance policy that pays out when you are ill, as this is when the payment is
most needed.

13. Consider a situation where there is a huge influx of inexperienced, reckless drivers into your
area. Assuming this increase is large enough to influence the market in which your insurance
company operates, explain why the price of your car insurance policy will go up even though
your driving record hasnt changed.

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Answer: The insurance company bases the price of the financial instrument it offers on the
likelihood of accidents among a large group of drivers. If the likelihood of accidents goes
up, so will the cost of your insurance. The price of the financial instrument depends on the
likelihood a payment will be made.

14. Suppose Joe and Mike purchase identical houses for $200,000. Joe makes a down payment
of $40,000 while Mike only puts down $10,000. Assuming everything else equal, who is
more highly leveraged? If house prices in the neighborhood immediately fall by 10 percent
(before any mortgage payments are made), what would happen to Joes and Mikes net
worth?

Answer: Mike is more highly leveraged as he has financed a larger part of his asset with
borrowing (95% compared with Joes 80%). Assuming they have no other assets or
liabilities, if house prices fall by 10%, Joes net worth would still be $20,000 but Mikes
would be negative. He would owe $190,000 on his mortgage for a house worth $180,000.

15. *Everything else being equal, which would be more valuable to you a derivative instrument
whose value is derived from an underlying instrument with a very volatile price history or
one derived from an underlying instrument with a very stable price history? Explain your
choice.

Answer: The primary use of derivatives is to transfer risk from one party to another. The
more volatile the price of the instrument upon which the derivative is based, the higher the
risk, everything else being equal. Therefore, the derivative based on the more volatile
underlying asset should have more value to you. For example, an option to buy a particular
asset as some date in the future at a pre-determined price would have little value if the price
of that asset never changed over time.

16. Explain why a person starting up a small business is more likely to take out a bank loan than
to issue bonds.

Answer: Issuing bonds is a form of direct finance and would require finding a buyer who
would be willing to bear the information and monitoring costs associated with the loan. For
a small, unknown business, these costs would usually be prohibitive. In the case of a bank
loan, the lending institution becomes the counterparty to the transaction. These financial
institutions overcome problems associated with asymmetric information by using their
expertise to screen loan applicants and use standardized loan contracts to reduce transaction
costs.

17. Splitland is a developing economy with two distinct regions. The northern region has great
investment opportunities, but the people who live there need to consume all of their income
to survive. Those living in the south are better off than their northern counterparts and save a
significant portion of their income. The southern region, however, has few profitable
investment opportunities and so most of the savings remain in shoeboxes and under

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mattresses. Explain how the development of the financial sector could benefit both regions
and promote economic growth in Splitland.

Answer: In the absence of financial markets, resources are not being allocated to the best
investment opportunities available in this case, to the northern region. The introduction of
a financial intermediary, for example, could channel the available savings from the
southerners to the most productive investment opportunities that are available in the northern
region. The presence of the intermediary would reduce the information costs that may have
prevented the southerners lending directly to the northerners in the past. The southerners
would benefit by earning a return on their savings while the northern region would benefit
from the increased investment. Splitland would benefit from higher economic growth as the
available resources are allocated more efficiently.

18. Suppose the U.S. government decided to abolish the Securities and Exchange Commission.
What would you expect to happen to investment and growth in the economy?

Answer: The role of the Securities and Exchange Commission (SEC) is to protect investors
by working to insure that all investors have access to certain knowledge about companies.
(See http://www.sec.gov/ for further details.) If the SEC were abolished, it would be more
difficult for investors to make good, well-informed decisions. Capital markets would likely
function less efficiently to the detriment of investment and growth.

19. Use Core Principle 3 from Chapter 1 to suggest some ways in which the problems associated
with the shadow banking sector during the 2007-2009 financial crisis might be mitigated in
the future.

Answer: Core principle 3 states that information is the basis for decisions. Many of the
problems in the shadow banking sector during the financial crisis arose because investors and
trading partners lacked information about activities of the shadow banks. Measures to
improve the transparency of shadow banking activities, through increased regulation of these
institutions, for example, could help mitigate the problems that arose.

20. What risks might financial institutions face by funding long-run loans such as mortgages to
borrowers (often at fixed interest rates) with short-term deposits from savers?

Answer: If savers decide to withdraw in large numbers from the financial institution, the
institution may not have sufficient funds readily available for them if the funds had been lent
out as a 30-year mortgage, for example. (Assume the mortgage is held on the balance sheet
of the institution in question.)
Moreover, long-term mortgage loans are often made at fixed interest rates while rates on
short-term deposits fluctuate with the market. The financial institution faces the risk that
interest rates will rise, requiring higher interest rates to be paid to continue to attract deposits
while the payments received from the mortgage loans stay the same.

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21. *As the manager of a financial institution, what steps could you take to reduce the risks
referred to in question 20?

Answer: Some strategies include pooling mortgages into mortgage-backed securities and
selling them or using derivative instruments to transfer the risk associated with interest rate
increases. This could be done, for example, by purchasing a derivatives instrument that paid
off when interest rates rose.

* indicates more difficult problems

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