13. What is the purpose of financial markets?

How
can this purpose be accomplished
efficiently?
The purpose of financial markets in an economy is
to allocate savings efficiently to ultimate users. If
those economic units that saved were the same as
those that engaged in capital formation, an
economy could prosper without financial markets.
In modern economies, however, most nonfinancial
corporations use more than their total savings for
investing in real assets. Most households, on the
other hand, have total savings in excess of total
investment. Efficiency entails bringing the ultimate
investor in real assets and the ultimate saver
together at the least possible cost and
inconvenience.
14. Discuss the functions of financial
intermediaries.
The flow of funds from savers to investors in real
assets can be direct; if there are financial
intermediaries in an economy, the flow can also be
indirect. Financial intermediaries consist
of financial institutions, such as commercial banks,
savings institutions, insurance companies,
pension funds, finance companies, and mutual
funds. These intermediaries come between
ultimate borrowers and lenders by transforming
direct claims into indirect claims. Financial
intermediaries purchase direct (or primary)
securities and, in turn, issue their own indirect
(or secondary) securities to the public. For
example, the direct security that a savings and
loan association purchases is a mortgage; the
indirect claim issued is a savings account or a
certificate of deposit. A life insurance company, on
the other hand, purchases corporate
bonds, among other things, and issues life
insurance policies.

Financial intermediation is the process of savers

depositing funds with financial intermedi-
aries (rather than directly buying stocks and
bonds) and letting the intermediaries do the

lending to the ultimate investors. We usually think

of financial intermediation making the
markets more efficient by lowering the cost and/or
inconvenience to consumers of financial
services.
Among the various financial intermediaries, some
institutions invest much more heavily
in the securities of business firms than others. In
what follows, we concentrate on those
institutions involved in buying and selling
corporate securities.
15. A number of factors give rise to different
interest rates or yields being observed for dif-
ferent types of debt instruments. What are these
factors?

16. What is meant by making the financial markets

more efficient? More complete?
Market efficiency refers to the degree to which
market prices reflect all available, relevant
information. If markets are efficient, then all
information is already incorporated into prices,
and so there is no way to "beat" the market
because there are no undervalued or overvalued
securities available.