Chapter 2: An overview of the financial System

1. If I can buy a car today for $5000 and it is worth $10 000 in extra income to me next year
because it enables me to get a job as a travelling salesman, 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 make a case for legalizing
loan sharking?
Understand what loan sharking is.

2. Some economists suspect that one of the reasons economies in developing countries
grow so slowly is that they do not have well-developed financial markets. Does this
argument make sense?
Step 1. Introduction
Financial markets include all markets in which securities are traded. B. Stock markets,
bond markets, forex markets, derivatives markets, to name just a few. Financial markets
are necessary for the capitalist economy to function smoothly.

Step 2. Explanation
True, financial markets are crucial for economic progress; nonetheless, underdeveloped
economies' growth remains stagnate as a result. Due to the financial market's limited
reach, many producers must rely on middlemen and local money lenders for loans and
financial assistance. These intermediaries not only charge a higher rate of interest, but
they also generate debt bonds and interlink market conditions, resulting in product market
distortion. This type of situation poses a roadblock in the development of developing
economies.

3. Give at least three examples of a situation in which financial markets allow consumers to
better time their purchases.
Purchasing for durables, education expenses and emergency expenses are the three
cases in which financial markets allow consumers to better time their purchases.

4. 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?
If an individual or a company suspects that another company will go bankrupt next year,
then he/she would hold the bonds issued by the company rather than the equities issued
because bondholders are paid off before making payments to the equity holders, who are
the residual claimants or applicants.

5. Suppose that Toyota sells yen-denominated bonds in Tokyo. Is this debt instrument
considered a Eurobond? How would your answer change if the bond were sold in New
York?
This is not considered a Eurobond because a Eurobond is a bond denominated in a
currency other than that of the country in which they are sold.

6. Describe who issues each of the following money market instruments:

a. Treasury bills – Government of Canada
b. Certificates of deposit – Banks and Credit unions
 c. Commercial paper
The main issuers of commercial paper are finance companies and banks, but
also include corporations with strong credit, and even foreign corporations
and sovereign issuers. The main buyers of commercial paper are mutual funds,
banks, insurance companies, and pension funds.
d. Repurchase agreement
Repurchase agreements (repos) are the sale by a bank or dealer of a
government security with the simultaneous agreement to repurchase the
security on a later date. Repos are commonly used by public entities to secure
money market rates of interest.
e. Overnight funds
Banks are the largest participant in the overnight market, although some other
large financial institutions, e.g. mutual funds, also buy and sell on the overnight
market as a way to manage unanticipated cash needs or as a temporary haven for
money until the institution can decide on where to invest that money.

7. What is the difference between a mortgage and a mortgage-backed security?

Mortgages are loans, whereas mortgage-backed securities are bond-like debt
instruments.

8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a
railroad system. Why did this make both countries better off?
The U.S economy made both nations better off because the British were able to obtain
high-interest rates by lending to Americans, and were thus benefited. The Americans
benefited because railroads infrastructure helped in further economic growth by facilitating
the transportation of goods and people.

9. A significant number of European banks held large amounts of assets as mortgage-

backed securities derived from the U.S.
Step 1. Introduction
As the name suggests, the securities backed by mortgages are known as mortgage-
backed securities or MBS. It is an investment that is created by a bundle of mortgages.
These mortgages are sold by banks which issued them.
Step 2. Explanation
When European banks have huge amounts of assets in the form of mortgage-backed
securities, they are able to provide financial and capital support to people in the US
financial market through the exchange of these securities. It permits both parties, such as
European banks and US borrowers, to benefit from it.
The cost of internationalization is that the decline in the value of mortgage-backed
securities caused a financial crisis in the European market. So, even though housing
market collapse happened in the US, its affect was felt in Europe.

10. How does risk sharing benefit both financial intermediaries and private investors?
 Risk sharing benefits financial intermediaries because they are able to earn a spread
between the returns they earn on risky assets and they returns they pay on the less-risky
assets they sell. Investors benefit because they are able to invest in a better diversified
portfolio then would otherwise be available.

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

12. One of the factors contributing to the financial crisis of 2007–2009 was the widespread
issuance of subprime mortgages. How does this demonstrate adverse selection?
Lenders loaned money to a pool of potential homeowners with the highest credit risk and
lowest net wealth.

13. Why do loan sharks worry less about moral hazard in connection with their borrowers than
some other lenders do?
Loan sharks are businesses or individuals that are willing to take on credit risks in
exchange for a high interest rate. Because repayment is generally reinforced with
threats of violence and extortion rather than a formal, contractual duty, these sharks
are less concerned about moral hazard.

14. If you are an employer, what kinds of moral hazard problems might you worry about with
regard to your employees?
You'd worry about their incentives and motivation to actually work, depending on
compensation for tasks.
As an example, a moral hazard is the risk that an employee who is enrolled in their
company's dental insurance plan may be less concerned about their oral hygiene,
whereas someone who knowingly has a high-risk lifestyle is making an adverse selection
by taking out a life insurance policy.
A moral hazard refers to scenarios where an individual has incentives to take actions that
lead toward a negative or undesirable outcome. This is commonly addressed in insurance
policies, where insurance companies won't agree to cover a disastrous outcome unless
both parties have an incentive to avoid the disastrous outcome. Because employees have
less of a stake in their employment location than the employer, the damage to image,
brand, or property by an employee will hurt the employer more than the employee.
Employees may not consider the full consequences of a potentially risky action on their
employment as they are alienated from their labor and have no ownership of their
workplace.

15. If there were no asymmetry in the information that a borrower and a lender had, could a
moral hazard problem still exist?
 Yes, since even if you are aware that a borrower is putting the loan in jeopardy, you must
intervene to prevent the borrower from doing so.
Moral hazard occurs when there is asymmetric information between two parties and
a change in the behavior of one party occurs after an agreement between the two
parties is reached. Asymmetric information refers to any situation where one party to a
transaction has greater material knowledge than the other party.

16. “In a world without information costs and transaction costs, financial intermediaries would
not exist.” Is this statement true, false, or uncertain? Explain your answer.
Information costs and transaction costs are two reasons why financial intermediaries exist.

17. Why might you be willing to make a loan to your neighbour by putting funds in a savings
account earning a 5% interest rate at the bank and having the bank lend them the funds
at a 10% interest rate rather than lend them the funds yourself?
On the other hand, there is a higher risk associated with the neighbor, as if neighbor
defaults over the money, and then there is no way to get funds back. This is why the
person would be highly willing to deposit the funds at the bank, and then neighbor can
obtain a loan from the bank.

18. How do conflicts of interest make the asymmetric information problem worse?
This exacerbates the asymmetric information problem because conflicting incentives
encourage individuals or institutions to withhold or misrepresent information.

19. How can the provision of several types of financial services by one firm be both beneficial
and problematic?
The provision of several types of financial services by one firm may be beneficial because
of: economies of scope and problematic because of conflicts of interest.

20. If you were going to get a loan to purchase a new car, which financial intermediary would
you use: a credit union, a pension fund, or an investment bank?
Credit union, pension fund, or an investment bank? You would likely use a credit union if
you are a member, since their primary business is consumer loans.

21. Why would a life insurance company be concerned about the financial stability of major
corporations or the health of the housing market?
They are concerned because a large share of income is spent on buying shares,
bonds, equities and debentures.

22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit
on insured losses to bank depositors from $100 000 per account to $250 000 per account.
How would this help stabilize the financial system?
The major benefit of raising the limit was, it helps in saving the economy from financial
panic.
23. Financial regulation is similar, but not exactly the same, in industrialized countries. Discuss
why it might be desirable—or undesirable—to have the same financial regulation across
industrialized countries.
It is desirable to have same financial regulation so that the manufacturers do not have to
migrate their business.
Step 1. Introduction
Financial regulations guard consumers' investments. Regulations save you monetary
fraud and restriction the dangers monetary establishments can take with their investors'
money. Financial regulators oversee 3 most important monetary sectors: banking,
monetary markets, and consumers
Step 2. Explanation
It might be useful to have monetary rules which can be same in all international locations
to keep away from monetary markets individuals emigrate their commercial enterprise to
international locations with fewer rules. On the alternative side, all international locations
are exclusive and designing a not unusual place set of monetary rules appears to be a
alternatively hard task.