Assignment 1

FNB-302: Financial market and institutions

“Chapter 1 and 2 Problem Solutions”

Submitted By:
Quazi Fahian Muntakim
ID: 1490, Batch: 9th
Department of Finance and Banking
Faculty of Business Studies

Submitted To:
Dr. Sheikh Abu Taher
Associate Professor
Department of Finance and Banking

18 January, 2021
 Chapter 1
1. Why are financial markets important to the health of the economy?

Answer: ​A financial market refers to a market where the trade of financial securities occurs. The
securities traded include bonds, stocks and commodities such as precious metals and raw
materials.

Financial markets are essential to the health of the economy in the following ways; they promote
the investment and savings culture in the economy as organizations in the savings industry
mobilize funds from individuals and pump the funds into long-term investments, helping grow
the economy. Without the financial markets no one would be there to provide capital for the
development of infrastructure. Financing for utility projects can be made available, and also the
allocation of the funds is more efficient because high return projects will receive more funding
from the financial markets. Another positive influence on the health of the economy is the
funding of private, public entities, which boosts the private sector as they increase the economic
productivity in a country. The healthy competition between public and private sectors helps grow
the economy as more goods and services will be available for sale and consumption. Without it
the economy would become stagnant and lacking in growth.

2. When interest rates rise, how might businesses and consumers change their economic
behavior?

Answer: ​Businesses would cut investment spending because the cost of financing this spending
is now higher, and consumers would be less likely to purchase a car or a house because the cost
of financing their purchase is higher.

3. How can a change in interest rates affect the profitability of financial institutions?

Answer: ​Interest rates and financial institutions are connected, with financial institutions
benefiting from higher interest rates. A change in interest rates affects the cost of acquiring funds
for financial institutions as well as changes the income on assets such as loans, both of which
affect profits. In addition, changes in interest rates affect the price of assets such as stock and
bonds that the financial institution owns that can lead to profits or losses.

When interest rates are higher, banks make more money, by taking advantage of the difference
between the interest banks pay to customers and the interest the bank can earn by investing.
4. Is everybody worse off when interest rates rise?

Answer: ​No, not everybody is worse off when interest rates rise. People who borrow to purchase
a house or a car are worse off because it costs them more to finance their purchase; however,
savers] benefit because they can earn higher interest rates on their savings. Of course net savers
who also have existing portfolios of debt instruments (bonds) will see the current value of their
portfolio decrease because when interest rates rise bond prices fall.

5. What effect might a fall in stock prices have on business investment?

Answer: ​A fall in stock prices might cause businesses to decrease investment. The lower price
for a firm’s shares means that it can raise a smaller amount of funds, and so investment in plant
and equipment will fall.

6. What effect might a rise in stock prices have on consumers’ decisions to spend?

Answer: ​When a stock price rises, the first thing that comes in a customer's mind is that
company is making growth. Higher stock prices mean that consumers’ wealth is higher and so
they will be more likely to increase their spending. Their sales will increase, profits will rise and
they will have more surplus for the quarter. This will cause more flow of cash. Profitable reports
will convince more shareholders to invest in the company, and the value of the company will
rise.

7. How does a decline in the value of the pound sterling affect British consumers?

Answer: ​Foreign goods are now relatively more​ expensive; British consumers are hurt. It makes
foreign goods more expensive and so British consumers will buy less foreign goods and more
domestic goods. With the price of domestic goods​ unchanged, these imports are now relatively
more expensive and British exports are relatively cheaper to foreign consumers.

8. How does an increase in the value of the pound sterling affect American businesses?

Answer: ​It makes British goods more expensive relative to American goods. American
businesses will find it easier to sell their goods in the United States and abroad, and the demand
for their products will rise. If, however, an American business depends on supplies/parts from
British companies these products will increase their costs.
9. How can changes in foreign exchange rates affect the profitability of financial
institutions?

Answer:

Changes in foreign exchange rates change the value of assets held by financial institutions and
thus lead to gains and losses on these assets. Also changes in foreign exchange rates affect the
profits made by traders in foreign exchange who work for financial institutions.

10. Looking at Figure 1.3, in what years would you have chosen to visit the Grand Canyon
in Arizona rather than the Tower of London?

Answer:

Comparing the rise and fall of the index on the graph depicting the years of 1975 to 2016, the
years thatI would have chosen visit the Grand Canyon instead of the Tower of London would
be:1978, 1981, 1991, 1995, 2008-2009, 2001-2012.Those years I have selected were the lowest
points during specific time frames in which the value of the US dollar had fallen making a trip
overseas more costly on the individual traveling.

11. What is the basic activity of banks?

Answer: Banks accept deposits and then use the resulting funds to make loans. Put in another
way, banks facilitate the transfer of money from savers to borrowers.
12. What are other important financial intermediaries in the economy besides banks?

Answer: ​Some of the other important financial intermediaries in the economy besides banks
include:

● Savings and loan associations,

● Mutual savings banks,
● Credit unions,
● Insurance companies,
● Mutual funds,
● Pension funds,
● Finance companies

13. Can you think of any financial innovation in the past 10 years that has affected you
personally? Has it made you better or worse off? In what way?

Answer: ​One of the most noteworthy financial innovations I can think of in the past 10 years is
the invention of ATM booths. They have made mine and everyone else's life immensely better
by allowing people to receive banking services without requiring to go to an office managed by
actual employees. This has made the experience much more pleasant and less time consuming.

14. What types of risks do financial institutions face?

Answer: The profitability of financial institutions is affected by changes in interest rates, stock
prices, and foreign exchange rates; fluctuations in these variables expose these institutions to
risk. Financial institutions also face credit risk to counterparties with whom the trade and clients
to whom they lend.

15. Why do managers of financial institutions care so much about the activities of the
Federal Reserve System?

Answer: Because the actions of the Federal Reserve affects interest rates, inflation, and business
cycles, all of which have an important impact on the profitability of financial institutions.
 Chapter 2

1. Why is a share of Microsoft common stock an asset for its owner and a liability for
Microsoft?

Answer: The share of Microsoft stock is an asset for its owner because it entitles the owner to a
share of the earnings and assets of Microsoft. The share is a liability for Microsoft because it is a
claim on its earnings and assets by the owner of the share.

2. If 1 can buy a car today for $5000 and it is worth $10000 next year in extra income to me
because it enable me to get a job as a traveling anvil seller, should I take out a loan from
Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I be
better or worse off as a result of taking out this loan? Can you take a case of legalizing
loan-sharking?

Answer: Yes, I should take out the loan, because I will be better off as a result of doing so. My
interest payment will be $4,500 (90% of $5,000), but as a result, I will earn an additional
$10,000, so I will be ahead of the game by $5,500. Since Larry's loan-sharking business can
make some people better off, as in this example, loan sharking may have social benefits. (One
argument against legalizing loan sharking, however, is that it is frequently a violent activity.)

3. Some economists suspect that one of the reasons that economies in developing countries
grow slowly is that they do not have well-developed financial markets. Does this argument
make sense?

Answer: Yes, because the absence of financial markets means that funds cannot be channeled to
people who have the most productive use for them. Entrepreneurs then cannot acquire funds to
set up businesses that would help the economy grow rapidly.

4. The U.S. economy borrowed heavily from the British in the nineteenth century to build a
railroad system. What was the principal debt instrument used? Why did this make both
countries better off?

Answer: The principal debt instruments used were foreign bonds which were sold in Britain and
denominated in pounds. The British gained because they were able to earn higher interest rates as
a result of lending to Americans, while the Americans gained because they now had access to
capital to start up profitable businesses such as railroads.
5. "Because corporations do not actually raise any funds in secondary markets, they are
less important to the economy than primary markets." Comment.

Answer: This statement is false. Prices in secondary markets determine the prices that firms
issuing securities receive in primary markets. In addition, secondary markets make securities
more liquid and thus easier to sell in the primary markets. Therefore, secondary markets are, if
anything, more important than primary markets.

6. If you suspect that a company will go bankrupt next year. which would you rather hold,
bonds issued by the company or equities issued by the company? Why?

Answer: You would rather hold bonds. because bondholders are paid off before equity holders,
who are the residual claimants.

7. How can the adverse selection problem explain why you are more likely to make a loan
to a family member than to a stranger?

Answer: Because you know your family member better than a stranger. you know more about
the borrower's honesty, propensity for risk taking. and other traits. There is less asymmetric
information than with a stranger and less likelihood of an adverse selection problem, with the
result that you are more likely to lend to the family member.

8. Think of one example in which you have had to deal with the adverse selection problem.

Answer: ​Adverse selection refers generally to a situation in which sellers have information that
buyers do not have, or vice versa, about some aspect of product quality—in other words, it is a
case where asymmetric information is exploited. Asymmetric information, also called
information failure, happens when one party to a transaction has greater material knowledge than
the other party. Adverse selection is most common in the insurance industry. A prime example of
adverse selection is if I run an insurance agency and a smoker successfully manages to obtain
insurance coverage as a nonsmoker.

9. Why do loan sharks worry less about moral hazard in connection with their borrowers
than some other lenders do?

Answer: Loan sharks can threaten their borrowers with bodily harm if borrowers take actions
that might jeopardize paying off the loan. Hence borrowers from a loan shark are less likely to
engage in moral hazard.
10. If you are an employer, what kinds of moral hazard problems might you worry about
with your employees?

Answer: They might not work hard enough while you are not looking or may steal or commit
fraud.

11. If there were no asymmetry in the information that a borrower and a lender had, could
there still be a moral hazard problem?

Answer: Yes, because even if you know that a borrower is taking actions that might jeopardize
paying off the loan, you must still stop the borrower from doing so. Because that may be costly,
you may not spend the time and effort to reduce moral hazard, and so moral hazard remains a
problem.

12. "In a world without information and transaction costs, financial intermediaries would
not exist." Is this statement true, false, or uncertain? Explain your answer.

Answer: True. If there are no information or transactions costs, people could make loans to each
other at no cost and would thus have no need for financial intermediaries.

13. Why might you be willing to make a loan to your neighbor by putting funds in a savings
account earning a 5% interest rate at the bank and having the bank lend her the funds at a
10% interest rate rather than lend her the funds yourself?

Answer: Because the costs of making the loan to your neighbor are high (legal fees, fees for a
credit check. and so on), you will probably not be able to earn 5% on the loan after your
expenses even though it has a 10% interest rate. You are better off depositing your savings with a
financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by
depositing your savings at the bank rather than lending them to your neighbor.

14. How does risk sharing benefit both financial intermediaries and private investors?

Answer: Risk sharing enables them to earn a profit on the spread between the returns they earn
on risky assets and the payments they make on the assets they have sold, and helping individuals
to diversify and thereby lower the amount of risk to which they are exposed.
15. Discuss some of the manifestations of the globalization of world capital markets.

Answer: Increased discussion of foreign financial markets in the U.S. press and the growth in
markets for international financial instruments such as Eurodollars and Eurobonds.