Chapter 3: Financial Markets, Instruments, and Institutions

Chapter 3: Financial Markets, Instruments, and Institutions

Chapter Summary
This chapter explains how financial markets function and surveys different types of financial instruments and institutions involved in those markets. It also discusses the roles of financial intermediaries and the implications of automated financial trading for both domestic and world financial markets. Financial markets channel funds from those who save to those who wish to make capital investments. Financial markets can be divided into primary and secondary markets. The former deal with newly issued financial instruments, whereas the latter deal with transactions of previously issued financial instruments. Financial markets can also be divided into money and capital markets. Financial instruments in money markets have maturities under one year. Examples of money market instruments are U.S. Treasury bills, commercial paper, bank certificates of deposit, Eurodollar deposits, and federal funds loans. Financial instruments in capital markets have maturities equal to or greater than one year. Examples of capital market instruments are business equities, corporate bonds, U.S. Treasury notes and bonds, mortgage loans, and consumer and commercial loans. Cybertrading of financial instruments using Internet brokers and other automated trading systems has speeded up financial exchanges both within and across national markets. Development in cross-border financial exchange using automated trading systems has raised regulatory concerns from different nations. Financial intermediaries serve to reduce problems associated with asymmetric information in financial transactions. Asymmetric information can lead to potential problems stemming from adverse selection and moral hazard. Financial intermediaries may also allow savers to benefit from economies of scale as a result of lower average costs of fund management. The majority of financial institutions are depository institutions, which include commercial banks, savings banks and savings and loan associations, and credit unions. Non-depository financial institutions include insurance companies, pension funds, mutual funds, finance companies, brokers, investment banks, and government-sponsored institutions such as the Federal Financing Bank and mortgage-financing institutions.

Key Terms and Concepts

Adverse selection

Chapter 3: Financial Markets, Instruments, and Institutions

Annuities Asymmetric information Bankers acceptance Brokers Capital goods Capital markets Certificates of deposit Commercial banks Commercial loans Commercial paper Common stock Consumer loans Corporate bonds Credit union Direct finance Dividends Dutch auction Economies of scale Equities Federal funds market Finance company Financial instruments Financial intermediation Insurance companies Indirect finance Interest Intermediate-term maturity International financial diversification Investment Investment banks Long-term maturity Maturity Money market Moral hazard Mortgage-backed securities Mortgage loans Municipal bonds Mutual funds National Association of Securities Dealers Automated Quotation (NASDAQ) Over-the-counter (OTC) stocks Pension funds Preferred stock Primary market Savings and loan associations Savings bank Saving

Chapter 3: Financial Markets, Instruments, and Institutions

Secondary market Securities Short-term maturity Stock exchanges Treasury bills (T-bills) Treasury bonds Treasury notes Winners curse World index fund

Multiple-Choice Questions
1. Which of the following is not a financial instrument? A) B) C) D) Treasury bill. Real estate. Mortgage loan. Federal funds loan.

2. The time until final principal and interest payments are due to holders of a financial instrument is the instruments time until A) B) C) D) expiration. maturity. execution. liquidation.

3. Financial instruments with maturities of less than one year are traded in the A) B) C) D) equity market capital market. money market. fixed-income market.

4. A 30-year Treasury bond that was issued in last year is sold in a I. money market

Chapter 3: Financial Markets, Instruments, and Institutions

II. III. IV. A) B) C) D)

capital market primary market secondary market Both I and III. Both I and IV. Both II and III. Both II and IV.

5. Markets for newly issued financial instruments with maturities shorter than one year are I. II. III. IV. A) B) C) D) money markets capital markets primary markets secondary markets Both I and III. Both I and IV. Both II and III. Both II and IV.

6. Which of the following is a money market instrument? A) B) C) D) A Treasury note. A federal funds loan. A corporate bond. A mortgage loan.

7. Which of the following is a capital market instrument? A) B) C) D) A certificate of deposit. A federal funds loan. Commercial paper. A Treasury bond.

8. Which of the following is the most popular U.S. money market instrument by value of holdings? A) B) C) D) Treasury bill. Eurodollar. Federal fund. Bankers acceptance.

9. An example of asymmetric information in financial markets is that A) the borrower knows more than the lender.

Chapter 3: Financial Markets, Instruments, and Institutions

B) the lender knows more than the borrower. C) the borrower has a long-term goal while the lender has a short-term goal. D) the borrower and lender have different expectations about financial markets. 10. The problem associated with asymmetric information before the financial transaction occurs is known as A) B) C) D) moral hazard. adverse selection. free-riding. inside trading.

11. As a result of the adverse selection problem, A) B) C) D) lenders will tend to finance only low-risk projects. lenders will become reluctant to finance otherwise low-risk projects. only borrowers with good credit history are likely to seek loans. only borrowers with high net worth are likely to seek loans.

12. Moral hazard is a problem that arises A) B) C) D) only in primary markets. only in secondary markets. before a financial transaction is made. after a financial transaction is made.

13. Which of the following is a major reason for the existence of financial intermediaries? A) B) C) D) The existence of long-term financial instruments. Problems related to asymmetric information. The ability to borrow funds directly from savers. To avoid government regulation in other financial markets.

14. Which of the following requires financial intermediaries? A) B) C) D) Direct finance. Indirect finance. Direct purchase of retail goods. None of the above.

15. Mutual funds permit those who desire to save to pool their funds together for the purpose of purchasing financial instruments with large denominations. As a result, the average fund management costs are lower than they would be if individual savers tried to manage their funds individually. This is an example of A) moral hazard.

Chapter 3: Financial Markets, Instruments, and Institutions

B) adverse selection. C) asymmetric information. D) economies of scale. 16. Which of the following is a depository financial institution? A) B) C) D) A savings bank. An investment bank. A finance company. A pension fund.

17. Which of the following is not a depository financial institution? A) B) C) D) A savings and loan association. A credit union. A mutual fund company. A commercial bank.

18. Which of the following is an example of financial intermediation? A) B) C) D) An Internet company issues stock by selling shares directly to buyers. A woman opening a new business borrows funds from her uncle. A professor purchases shares of stock directly from a corporation. A bank extends a mortgage loan to a household.

19. Which of the following financial intermediaries specialize in extending credit to small, higherrisk businesses? A) B) C) D) Commercial banks. Savings and loan associations. Finance companies. Insurance companies.

20. Which of the following financial intermediaries specialize in making mortgage loans? A) B) C) D) Pension funds. Savings and loan associations. Finance companies. Insurance companies.

Short-Answer Questions
1. What is the range of maturities for money market instruments?

Chapter 3: Financial Markets, Instruments, and Institutions

2. What is the range of maturities for capital market instruments? 3. What is the name of the markets where previously issued financial instruments are traded? 4. What type of financial markets are U.S. Treasury bills traded in? 5. What type of financial markets are corporate bonds traded in? 6. What is the problem in which one party in a financial transaction has information that is not available to the other party in the transaction? 7. What is the term for the possibility that a borrower may behave in a more risky manner after receiving a loan? 8. What is the problem in which those who desire to borrow funds may plan to use them for risky projects? 9. What is the name of a situation in which a winning bidder in an auction receives a lower return than at least one participant who submitted a weaker bid? 10. What liabilities exist in depository institutions but not in other financial institutions?

Chapter 3: Financial Markets, Instruments, and Institutions

Chapter 3: Financial Markets, Instruments, and Institutions