Solutions for E nd-of-Chapter Q uestions and Problems: C hapter O ne 1. What are five risks common to financial institutions?
Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating cost risks. 2. Explain how economic transactions between household savers of fundsand corporate users of funds would occur in a world without financial intermediaries.
In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs. This process would be extremely costly because of the up-front information costs faced by potential lenders. Cost inefficiencies wouldarise with the identification of potential borrowers, the pooling of small savings into loans of sufficient size to finance corporate activities, and the assessment of risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrowers over each loan's life span. The net result would be an imperfect allocation of resources in an economy. 3. Identify and explainthree economic disincentives that probably would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial intermediaries.
Investors generally are averse to directly purchasing securities because of (a) monitoring costs, (b) liquidity costs, and (c) price risk. (a) Monitoring the activities of borrowers requires extensive time,expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. (b) The long-term nature of corporate equity and debt securities would likely eliminate at least a portion of those households willing to lend money, as the preference of manyfor near-cash liquidity would dominate the extra returns which may be available. (c) The price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume. 4. Identify and explain the two functions in which FIs may specialize that would enable the smooth flow of funds from household savers to corporate users.
FIs serve asconduits between users and savers of funds by providing a brokerage function and by engaging in an asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also may offer advisory services which help reduce information costs, such as full-linefirms like BMO Financial Group. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities.
In what sense are the financial claimsof FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?
Funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are consideredprimary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the...
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