CHAPTER 1

AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS

CHAPTER OVERVIEW AND LEARNING OBJECTIVES
This chapter introduces the concept of the financial system and explains its economic role
to channel savings into productive investment by bringing savers and borrowers together. A
reliable system of financial institutions and markets helps sustain economic prosperity.
This chapter identifies the participants in financial activity, classifies their relationships, and
defines basic terms for use throughout the course.
This study guide helps you organize your thinking about these new concepts and terms. Try
to link each topic to your own life, the news of the day, and the big picture. Are you a
depositor at a bank or credit union! "o you have insurance or student loans! #ave you
noticed headlines about interest rates or the stock market! The financial system affects
almost everyone, almost all the time.
Answer the $uestions or problems, compare your answers with the solutions, then re%read and
reinforce the material. &ake full use of each opportunity to use the 'all (treet )ournal and
the various online resources to which you will be directed.

CAREER PLANNING NOTE
*inance traditionally comprises + main career areas. Managerial finance involves financial roles within a
business or government. ,xamples of entry%level -obs in this area include financial analyst or budget
analyst. The Investment area involves products and services for the investing public, with opportunities
for analysts, brokers, and traders. Financial institutions offer a large array of entry%level finance -obs.
.anks, insurance companies, and regulators all recruit college graduates for well%defined career paths.
,very topic in the book represents a potential career path. *ind out more about opportunitiesand
working conditionsassociated with various financial institutions and markets. &any of your professors
have worked outside the ivory tower/ ask about their experiences. 0our academic advisor can point
you toward resourceson and off campusto help you learn more. And the worldwide web, of course,
is not far from your fingertips. *or the 12
st
%century college student, it3s never too early to start looking4
READING THE WALL STREET JOURNAL.
5is one of the best professional habits you can cultivate. As a student, you may $ualify for a discounted
subscription. Ask your instructor, or contact the Journal directly6
2.788.9:7.;:19
http6<<info.ws-.com<college<-umppage<
=hapter by chapter, this (tudy >uide will help you get the most from Journal, as both a companion to
your studies and a tool in your professional life.
2
TOPIC OUTLINE AND KEY TERMS
I. The financial system fac!"a"e# "he f!$% a&' a!!$ca"$& $f f(&'# "h)$(*h$(" "he ec$&$+,.
A. Ba#c c$+-$&e&"# $f "he f&a&ca! #,#"e+. markets a&' institutions.
2. Financial markets are markets for financial instruments, also called financial
claims or securities.
1. Financial institutions ?also called financial intermediaries@ facilitate flows of
funds from savers to borrowers.

B. Economic units %"h f&a&ca! &ee'#. Househols/ !usinesses/ a&' "o#ernments.
2. Households supply labor, demand products, and save for the future.
1. Businesses demand labor, supply products, and invest in productive assets.
+. Governments collect taxes and provide public goods ?e.g. education, defense@.
C. $u"et %ositions c)ea"&* f&a&ca! &ee'# f$) a *0e& -e)$'. Sur%lus $) eficit.
2. (urplus spending units ( SSUs) are economic units in a surplus budget position.
a. Ancome for the period exceeds planned expenditures, resulting in savings.
b. Bltimately, most ((Bs are households, who need to invest savings as
beneficially as possible.
c. Cther words for ((B include saver, lender, or investor.
1. eficit spending units (SUs) are economic units in a deficit budget position.
a. Dlanned expenditures for the period exceed income, resulting in funding
re!uirements.
b. Bltimately, most "(Bs are businesses or governments, who need to
finance planned expenditures as cost%effectively as possible.
c. Another word for "(B is borrower.
II. &inancial claims 1$) 2financial instruments' $) 2securities'3 a)#e a# SSU# !e&' "$ DSU#.
A. DSU# 4$))$% f)$+ SSU# a&' ##(e SSU# %)""e& -)$+#e# "$ -a, 4ac5 "he !$a&#.
2. 'ritten promises of payment, sometimes called ACBs, typically provide for
a. a specific sum of money ?the principal@,
b. plus a fee ?the interest rate@,
c. for a certain period of time ?the maturity@.
1. The resulting claim against the "(B by the ((B, is simultaneously
a. a liability to the "(B, who pays interest as a penalty for accelerating
consumption, and
b. an asset to the ((B, who earns interest as the reward for postponing
consumption.
+. A liability is someone else3s asset ?one3s payable is another3s receivable@
a. Assets arising in this way are called "financial assets#.
b. The system balances%%total financial assets e$ual total liabilities
1
B. (arketa!ility # "he ea#e %"h %hch a f&a&ca! a##e" +a, 4e #$!' "$ a&$"he) SSU.
2. &any ((Bs may buy and resell the claim, but the "(B still has use of the funds.
1. The ability to resell financial claims is important because it gives ((Bs choices6
a. &atch the maturity of the claim to the planned investment period/
b. .uy a claim with a longer maturity, but sell at the end of the period/ or
c. .uy a claim with a shorter maturity, then reinvest.
III. )irect financin" "$ DSU# f)$+ SSU# "he #+-!e#" %a, f$) f(&'# "$ f!$%.
A. 2D)ec" c)e'"6 +a)5e"# ca& &c)ea#e effce&c,.
2. "(Bs and ((Bs divide benefits of economic opportunities as they arise
a. "(Bs fund promising opportunities immediately.
b. ((Bs earn timely returns on savings.
1. "irect markets are wholesale markets.
a. Transactions are largetypically E2 million or more.
b. Anstitutional arrangements are therefore common.
B. I&#""("$&a! a))a&*e+e&"# c$++$& & ')ec" f&a&ce.
*ri#ate %lacements+ in#estment !ankers+ !rokers a&' ealers.

2. $rivate placements are the simplest form of direct finance.
a. A "(B sells a whole security issue to one investor or investor group.
b. Advantages include speed and low transactions costs.
1. Investment %ankers often underwrite new issues of securities/ they
a. buy entire issues from "(Bs, then
b. find ((Bs to buy the securities at a higher price, in order to
c. profit from the difference%%the underwriting spread.
+. Brokers and dealers help bring buyers and sellers of financial claims together.
a. .rokers buy or sell at the best possible price for their clients.
b. "ealers make markets by carrying inventories of securities.
?2@ "ealers buy securities at bid price and sell them at ask price.
?1@ The resulting bid%ask spread represents a dealer3s gross profit.
C. P)$4!e+ %"h ')ec" f&a&c&*. DSU# a&' SSU# ca&&$" a!%a,# +a"ch -)efe)e&ce#.
2. Fot every ((B can afford wholesale denominations of E2 million or more.
1. "(Bs and ((Bs often prefer different terms to maturity.
IV. ,nirect financin" 1financial intermeiation3 &0$!0e# a financial intermeiary.

A. &inancial intermeiaries 2")a&#f$)+6 c!a+# "$ +e'a"e (&+a"che' -)efe)e&ce#.

2. Antermediaries issue claims against themselves to ((Bs in exchange for funds.
1. Antermediaries use these funds to purchase claims issued by "(Bs.
+. The two sets of claims can have materially different characteristics, because
a. ((Bs have claims against intermediaries, not "(Bs, and
+
b. "(Bs are liable to the intermediaries, not ((Bs.
B. Da!, !fe &0$!0e# 7 c$++$& f&a&ca! &"e)+e'a)e# 14(" "he)e a)e +a&, +$)e3.
2. &ommercial %anks ?or other depository institutions@ take deposits and make
loansthe depositors are ((Bs and the borrowers are "(Bs.
1. Insurance companies issue policies, collect premiums, and invest in stocks and
bondsthe policyholders are ((Bs/ the "(Bs are businesses or governments
whose securities the insurance company holds.
C. )isintermeiation # "he )e0e)#e $f &"e)+e'a"$&88((Bs disintermediate when they
perceive it will be more beneficial take funds out of intermediaries and invest directly.
D. I&')ec" +a)5e"# "e&' "$ 4e 2)e"a!6 +a)5e"#9"he e&'8(#e)# )a)e!, &"e)ac" ')ec"!,.
V. The 4e&ef"# $f f&a&ca! &"e)+e'a"$& a)e a -)+a), )a"$&a!e f$) "he f&a&ca! #,#"e+.
A. F&a&ca! &"e)+e'a)e# !$%e) "he c$#" $f f&a&ca! #e)0ce# a# "he, -()#(e -)$f".

2. Antermediaries pay ((Bs less than they earn from "(Bs.
a. Cperating costs of the intermediary absorb part of this margin.
b. Gisks taken by the intermediary are rewarded by any remaining profit.
1. Drofitability of intermediaries is based on + sources of comparative advantage6
a. 'conomies of scale large volumes of similar transactions.
b. (ransaction cost controlfind and negotiate direct investments less
expensively.
c. )isk management e*pertisebridge information gap about "(B3s
creditworthiness.
+. =ompetition among intermediaries tends to force interest rates downward, so
a. *inancing is less costly.
b. Dro-ects have higher net present values.
c. Ancreased investment in real assets promotes economic growth.
B. F&a&ca! &"e)+e'a)e# -e)f$)+ : 4a#c #e)0ce# a# "he, ")a&#f$)+ c!a+#.
2. enomination ivisi%ilit+,
a. "(Bs prefer to borrow the full funding need all at once.
b. ((Bs tend to save small amounts, month by month or year by year.
c. Antermediaries pool savings of many small ((Bs into large investments.
1. &urrenc+ (ransformation,
a. *ew ordinary ((Bs will hold claims denominated in foreign currency.
b. (uccess in foreign trade is critical in modern economies.
c. Antermediaries can buy claims denominated in one currency while
issuing claims denominated in another.
+. Maturit+ Fle*i%ilit+,
a. "(Bs generally prefer longer%term financing.
b. ((Bs generally prefer shorter%term investments.
c. Antermediaries can offer different ranges of maturities to both.
H
H. &redit )isk iversification,
a. Antermediaries can afford to spread risk by holding many different
securities.
b. The less correlated the securities are with each other, the more stable the
portfolio3s value.
c. ((Bs, on their own, would have to leave more eggs in one basket.
9. -i!uidit+,
a. &ost economic units prefer that some of their assets be readily
convertible to money.
b. &any claims issued by intermediaries are highly li$uid.
c. =laims issued by "(Bs are marketable, but sub-ect to price fluctuation
and transactions costs.
C. F&a&ca! &"e)+e'a)e# *0e $"he) ec$&$+c (&"# ch$ce# a4$(" f&a&ca! #")a"e*,.
2. ((Bs can choose between direct or indirect investment.
1. "(Bs can decide whether a direct market or an intermediary is the cheapest
source of funds.
VI. F$() +a;$) ",-e# $f f&a&ca! &"e)+e'a)e# ")a&#f$)+ c!a+# "$ +ee" 0a)$(# &ee'#.
A. )e%osit-Ty%e or .)e%ository' ,nstitutions "a5e 'e-$#"# a&' +a5e !$a&#.
2. "epository institutions are the most familiar intermediaries in daily life.
a. =ommon deposit arrangements include
?2@ checking accounts or demand deposits,
?1@ savings accounts, and
?+@ time deposits ?such as certificates of deposit or ="s@.
b. =ommon loan purposes include
?2@ business loans for inventory or e$uipment
?1@ consumer loans for education, vehicles, or other big ticket
household items, and
?+@ real estate loans or mortgages.
c. An developed countries, deposits are safe and li$uid.
?2@ >overnment%mandated insurance protects most depositors.
?1@ &ost deposits may be withdrawn on demand, or on very short
notice at minimal cost.
1. Three main forms of depository institutions resemble each other, but differ in
some ways.
a. &ommercial Banks, the largest, most diversified, and most regulated
intermediaries
?2@ issue a wide variety of deposit products/
?1@ carry widely diversified portfolios of loans, leases and
government securities/ and
?+@ may offer trust or underwriting services.
9
b. (hrift Institutions resemble commercial banks in many respects but
?2@ concentrate more on real estate loans, especially residential
mortgage loans/ and
?1@ are called savings and loan associations or savings banks.
c. &redit unions resemble banks or thrifts in basic function but have H
uni$ue characteristics6
?2@ &utual ownershipowned by depositors or members.
?1@ =ommon bondmembers must share some meaningful
common association.
?+@ Fot%for%profit and tax%exemptany surplus must be used to
benefit members.
?H@ Gestricted mostly to small consumer loans.
B. /ontractual Sa#in"s ,nstitutions 4)&* !$&*8"e)+ #a0e)# a&' 4$))$%e)# "$*e"he).
2. =ommon contractual arrangements include
a. insurance, covering policyholders against some specified loss/ and
b. pension plans, under which workers save for retirement.
1. Three main forms of contractual institutions focus on long%term financial needs.
a. -ife Insurance &ompanies insure against lost income at death.
?2@ Dolicyholders pay premiums, which are pooled and invested in
stocks, bonds, and mortgages.
?1@ Anvestment earnings cover the costs and reward the risks of the
insurance company.
?+@ Anvestments are li$uidated to pay benefits.
b. &asualt+ Insurance &ompanies cover property against loss or damage.
?2@ (ources and uses of funds resemble those of life insurers, but
?1@ =asualty claims are not as predictable as death claims/ so
?+@ &ore assets are in short%term, easily marketable investments.
c. $ension Funds help workers plan for retirement.
?2@ 'orkers and<or employers make contributions, which are pooled
and invested in stocks, bonds, and mortgages.
?1@ Fet of administrative costs, investment earnings are reinvested
and compounded.
?+@ Getirement benefits replace paychecks ?at least partly@.
C. ,n#estment &uns he!- #+a!! &0e#"$)# #ha)e "he 4e&ef"# $f !a)*e &0e#"+e&"#.

2. .enefits to investors include denomination divisibility and diversification.
1. Two kinds of investment funds are especially popular among ordinary investors.
a. Mutual Funds provide intermediated access to various capital markets.
?2@ (hareholders3 money is pooled and invested toward an ob-ective.
?1@ =ommon fund classifications or investment ob-ectives include
i. Andex funds, which follow some ma-or index
?e.g. "ow )ones Andustrial Average or (ID 988@/ and
ii. (ector funds, which focus on particular investments
:
?e.g. bond funds, utility funds@.
b. Mone+ Market Mutual Funds ?&&&*s@ are close but uninsured
substitutes for deposit accounts.
?2@ &&&*s buy money market instruments wholesale
?1@ Anvestors receive interest and limited check%writing privileges.

D. Other ",-e# $f &"e)+e'a)e# &c!('e &inance /om%anies a&' &eeral A"encies.
2. Finance &ompanies make loans but do not take deposits.
a. =onsumer finance companies make personal installment loans.
b. .usiness finance companies make loans and leases to businesses.
c. (ales finance companies finance retail purchases of products.
d. (ources of loanable funds to finance companies include
?2@ (hareholders, and
?1@ =ommercial Daper, a short%term ACB described in =hapter ;.
1. Federal .gencies can function as financial intermediaries.
a. =ertain agencies channel low%cost credit to targeted economic sectors by
?2@ issuing agency securities backed by the government and
?1@ lending at sub%market rates to selected households or businesses.
b. Jarious agencies promote various socioeconomic interests
?e.g. home ownership, small business, agriculture, exports@.

VII. F&a&ca! &"e)+e'a)e# 4(, a&' #e!! c!a+# & f&a&ca! +a)5e"# c!a##fe' & #e0e)a! %a,#.
A. *rimary a&' Seconary Ma)5e"# )e-)e#e&" "he #"a*e# $f a f&a&ca! c!a+<# 2!fe6.

2. $rimar+ markets are where financial claims are bornoriginally issued.
a. "(Bs receive funds ?e.g., A.& raises capital by selling bonds@.
b. =laims are issued ?e.g., an investment banker buys the bonds@.
1. Secondar+ markets are where financial claims liveare resold and repriced.
a. All subse$uent purchases or sales of a claim are in a secondary market.
b. (econdary markets offer li$uidity6 ((Bs set their own holding periods.
c. (econdary markets determine prices and yields of widely held securities.
B. Or"ani0e a&' O#er-the-/ounter Ma)5e"# 'ffe) a# #ec$&'a), +a)5e" #che+e#.

2. /rgani0ed '*changes are physical and relatively exclusive.
a. A physical trading floor and facilities are exclusively available
?2@ to mem%ers of the exchange,
?1@ for securities listed on the exchange.
b. *amous examples of organized exchanges include the
?2@ Few 0ork (tock ,xchange, founded in 2;K1, and
?1@ =hicago .oard of Trade ?for futures contracts@, founded in 27H7.
1. /ver1the1&ounter ("/(&#) Markets are virtual and relatively inclusive.
a. A decentralized information and trading network is available
?2@ To any licensed dealer willing to buy access and obey the rules,
?1@ *or a wide range of securities registered for public issue.
b. The FA("AL, founded in 2K;2, is a famous CT= market.
;
c. The Fational Association of (ecurities "ealers licenses dealers and
polices their behavior.
C. S%ot a&' &utures Ma)5e"# &0$!0e 'ffe)e&" "+&* $f -)c&* a&' 'e!0e),.
2. Spot Markets involve immediate pricing for immediate delivery.
1. Futures Markets involve immediate pricing for a promise of future delivery.
a. 'hile in effect, the right to delivery is itself transferable and valuable.
b. Dractical finance vocabulary distinguishes between futures and
forward contracts.
?2@ *utures contracts are standardized in terms of amounts,
instruments, and dates.
i. *utures contracts trade on organized exchanges
?such as the =hicago .oard of Trade@.
ii. The futures exchange guarantees contracts negotiated
through its auspices.
?1@ *orward contracts are individualized between parties with
particular needs.
i. *orward contracts typically do not trade on organized
exchanges.
ii. *orward contracts typically serve purposes more
operational then financial ?e.g., an electrical utility may
purchase fuel on forward contracts to stabilize costs@.

D. O%tion Ma)5e"# &0$!0e 'ffe)e&" )*h"# & (&'e)!,&* #ec()"e# $) c$++$'"e#.
2. An option writer and option buyer or owner make an option contract
concerning some underlying security, commodity, or property.
a. The writer grants the owner some exclusive right for a certain time.
b. 'hile in effect, the option itself is transferable and valuable.
c. Cptions on listed securities or widely traded commodities trade on
organized exchanges.
1. The main types of options are $uts ?options to sell@ and &alls ?options to buy@.
E. &orei"n E1chan"e Ma)5e"# a)e %he)e 'ffe)e&" &a"$&#< c())e&ce# a)e e=cha&*e'.

2. *oreign exchange ?*orex@ involves spot, future, forward, and option markets.
1. Any currency is convertible to any other at some exchange rate.
a. &arkets set exchange rates among widely held currencies ?e.g. B(
dollar, euro, .ritish pound, )apanese yen, (wiss franc@.
b. ,xchange rates among lesser%held currencies may be set contractually for
a particular transaction, or by central bank action.

F. ,nternational a&' )omestic Ma)5e"# a)e )e-)e#e&" *!$4a! f&a&ca! ch$ce#.
2. Anternational markets help participants diversify both sources and uses of funds.
1. 'urodollar and 'uro%ond markets are examples of ma-or international markets.
a. ,urodollars are B.(. dollars deposited outside the B.(.
b. ,urobonds are issued outside the B.(. but denominated in B( dollars.
G. (oney a&' /a%ital Ma)5e"# )e-)e#e&" 'ffe)e&" &"e&"$&# a&' "+e h$)>$&#.
7
2. Mone+ markets are wholesale markets for debt claims closely resembling money
itself.
a. &oney markets help participants ad-ust li$uidity.
?2@ "(Bs borrow%short%term to finance current operations.
?1@ ((Bs lend short%term to avoid holding idle cash.
b. &oney market instruments typically share + common characteristics
?2@ (hort maturities ?usually K8 days or less@.
?1@ #igh li$uidity ?active secondary markets@.
?+@ Mow risk ?and conse$uently low yield@.
c. &oney markets are wholesale and over%the%counter in character.
?2@ &inimum primary market transaction is usually E2 million.
?1@ There is no organized exchange/ brokers and dealers specialize
in various instruments.
d. &a-or money market instruments described later in =hapter ; include
?2@ (reasur+ BillsACBs auctioned weekly by the B.(. Treasury.
?1@ 2egotia%le &ertificates of epositlarge, marketable ="s sold
by a few large banks.
?+@ &ommercial $aperunsecured ACBs issued by large,
creditworthy businesses.
?H@ Federal Funds ("Fed Funds#)excess reserves of depository
institutions in the *ederal Geserve (ystem.
1. &apital markets are where capital goods are permanently financed.
a. =apital goods are real assets held long%term to produce wealth ?e.g.
land, buildings, e$uipment, or proprietary rights or technology@.
b. =apital markets help participants build wealth.
?2@ "(Bs seek long%term financing for capital pro-ects ?systems of
capital goods@.
?1@ ((Bs seek to invest at the highest possible return for a given
level of risk.
c. =apital market instruments differ from money market instruments
?2@ Mong maturities ?usually 9 to +8 years@.
?1@ Mess li$uidity ?secondary markets are active but more volatile@.
?+@ #igher risk in most cases ?and therefore higher potential yield@.
?H@ 'idely traded wholesale and retail on organized exchanges
and in CT= markets.
d. &a-or capital market instruments described later in Dart AAA of the Text
include
?2@ &ommon stockshares of ownership in a business corporation
and its profits.
?1@ &orporate %ondslong%term debt securities issued by large
corporations.
?+@ Municipal %ondslong%term debt securities issued by state and
local governments.
K
?H@ Mortgageslong%term loans secured by real estate ?land or
buildings@.
VIII. Efficiency # a& +-$)"a&" a#-ec" $f a f&a&ca! +a)5e"<# c$&")4("$& "$ "he ec$&$+,.

A. Allocational Efficiency # "he e="e&" "$ %hch f(&'# f&' "he) h*he#" a&' 4e#" (#e.
2. .usinesses try to fund pro-ects offering the highest ratio of benefit to cost.
1. #ouseholds try to invest for the best possible return for a given maturity and risk.
B. ,nformational Efficiency # "he e="e&" "$ %hch -)ce# )ef!ec" )e!e0a&" &f$)+a"$&.
2. Anformationally efficient markets reprice $uickly in response to new information/
1. Anformationally inefficient markets offer opportunities to profit from buying
underpriced assets or selling overpriced assets.
C. O%erational Efficiency # "he e="e&" "$ %hch ")a&#ac"$&# c$#"# a)e +&+>e'.
I?. F&a&ca! &#""("$&# +a&a*e a&' 4a!a&ce : 4a#c )#5#.

A. /reit Risk 1$) efault risk3 # "he -$##4!", "ha" a 4$))$%e) +a, &$" -a, a# a*)ee'.
2. Any "(B except the B.(. >overnment is assumed to offer credit risk.
1. *inancial institutions manage credit risk in + concurrent ways6
a. "iversification among different borrowers representing different risks.
b. =redit analysis of each borrower to assess ability and willingness to pay.
c. Gegular monitoring of each borrower while debt is outstanding.
B. ,nterest Rate Risk # "he !5e!h$$' "ha" &"e)e#" )a"e f!(c"(a"$&# %!! cha&*e a
#ec()",<# -)ce a&' )e&0e#"+e&" &c$+e.
2. Any fixed%rate financial instrument carries interest rate risk ?see =hapter 9@.
1. Any portfolio including such instruments is sub-ect to interest rate risk.
+. *inancial institutions must manage interest rate risk/ they both lend and borrow.
C. Li2uiity Risk # "he -$##4!", "ha" a f&a&ca! &#""("$& +a, 4e (&a4!e "$ -a,
)e@()e' ca#h $("f!$%#.
2. ((Bs expect to be able to redeem their claims on relatively short notice.
1. "(Bs expect timely decisions about financing proposals.
+. Alli$uid institutions can fail, even if they are profitable in the long run.
H. Alli$uidity is a common historical cause of bank failures ?see =hapter 2:@.
". &orei"n E1chan"e Risk # "he -$##4!", $f !$## $& f!(c"(a"$&# & e=cha&*e )a"e#.
2. Marge financial institutions both lend and borrow in multiple currencies.
1. 'idely held currencies float against each other ?do not exchange at a fixed rate@.
,. *olitical Risk # "he -$##4!", "ha" *$0e)&+e&" ac"$& %!! ha)+ a& &#""("$&<#
&"e)e#"#.
2. "omestically, B.(. financial institutions are both heavily regulated by
government and heavily invested in government securities.
1. Anternationally, large B.(. institutions operate in many foreign countries.
+. As regulators, governments vary in integrity and competence.
a. An some cases the rule of law is well%established and well%respected.
b. An other cases government interferes with contracts or property without
due process of law, or for corrupt purposes.
c. >overnment often prefers political expediency to economic efficiency.
28
H. As borrowers, governments vary in credit risk.
a. A government can unilaterally repudiate or reschedule its debts.
b. A private firm has limited recourse against a government.
COMPLETION AUESTIONS
2. Bltimately, most ((Bs are NNNNNNNNNNNNNNNNNNN .
1. NNNNNNNNNNNNNNN is the ease with which a financial asset may be sold before maturity to another
((B.

+. The process by which investment bankers help "(Bs issue new securities is called
NNNNNNNNNNNNNNN .
H. *inancial intermediaries NNNNNNNNNNNNNNNN claims.
9. NNNNNNNNNNNNNNNNNNNNNNNNNNNN is the reverse of intermediation.
:. NNNNNNNNNNNNNNNNNNNNNNNNNNNN are the largest, most diversified, and most regulated
intermediaries.
;. NNNNNNNNNNNNNNNNNNNNNNNNNNNN make loans but do not take deposits.
7. NNNNNNNNNNNNNNNNNNNNNNNNNNNN are where financial claims are resold and repriced.
K. (ynonyms for financial claims include NNNNNNNNNNNNNNNNNNNNNNNNNNNN or
NNNNNNNNNNNNNNNNNN .
28. NNNNNNNNNNNNNNNNNNNNNNNNNNN is the possibility that a borrower may fail to pay as agreed.
TRUE8FALSE AUESTIONS
T * 2. .usinesses are never "(Bs.
T * 1. An ((B must hold a claim until its scheduled maturity.
T * +. Drivate placements are the simplest form of direct finance.
T * H. =ompetition among financial intermediaries tends to force interest rates
downward.
T * 9. ,very asset is someone else3s liability, but not every liability is someone else3s
asset.
T * :. Agency securities carry relatively low risk.
T * ;. Crganized exchanges are less exclusive than over%the%counter markets.
T * 7. *oreign exchange may involve spot, future, forward, or option transactions.
T * K. &oney markets depend on organized exchanges.
22
T * 28. Cperational efficiency has to do with the speed at which transactions are
executed.
MULTIPLE8CHOICE AUESTIONS
2. .ob and Fancy >utierrez have been married for 28 years and are both executives at *ortune 988
corporations. They have a son, 7 and a daughter, 9. The >utierrez family is most likely a
a. business b. financial institution c. household d. deficit unit
1. "uring 188K, .ob and Fancy expect total income of about E119,888 and are budgeting total
expenditures of about E278,888. *or this budget period, the >utierrez family is most specifically a?n@
a. "(B b. business c. ((B d. household
+. "uring 188K, .ob and Fancy deposit E+,;98 per month into a savings account at .ank of America.
,very + months, they take E28,888 from savings and buy a 2%year =" from . of A. These uses of funds
may be most precisely characterized as
a. financial intermediation
b. direct finance
c. indirect finance
d. disintermediation
e. a or c
H. "uring &ay of 188K, .ank of America makes a +%year E+;9,888 e$uipment loan to =D =onstruction
=ompany, in which the 1 shareholders are Andrea =hang and &ar-orie Datel. 'hat benefit?s@ to %oth the
>utierrez family and =D =onstruction are clearl+ evident!
a. denomination divisibility
b. maturity flexibility
c. credit risk diversification
d. li$uidity
e. all of the above
f. a I b
9. "uring )uly of 188K, Andrea and &ar-orie each withdraw E298,888 from personal savings accounts at
.ank of America, and invest the money in =D =onstruction by purchasing new shares of common stock
in the company. This transaction is
a. a primary market transaction
b. an e$uity transaction
c. an example of disintermediation
d. all of the above
:. The difference between brokers and dealers is that
a. brokers carry an inventory of securities/ dealers don3t.
b. dealers carry an inventory of securities/ brokers don3t.
c. dealers care what the ask price is/ brokers don3t.
d. brokers care what the ask price is/ dealers don3t.
;. Drofitability of financial intermediaries derives from all of the following except
a. government regulation of interest rates
b. economies of scale
c. ability to manage credit risk
d. control of transactions costs
21
7. =urrency transformation is an important service because
a. most ((Bs want to invest in more than one currency
b. all financial institutions operate internationally
c. few ordinary investors care to hold claims denominated in foreign currency
d. "(Bs can3t export unless they can borrow in the currency of the importing country
K. The only deposit%type institutions that do not operate for profit are
a. thrift institutions b. credit unions c. pension funds d. commercial banks
28. &oney market instruments and capital market instruments differ appreciably in
a. maturity
b. li$uidity
c. availability to ordinary individual investors
d. all of the above
SUPPLEMENTARY MATERIAL. WORDS AND MEANINGS
*inancial vocabulary is often a matter of context. *amiliar words take on new meanings, different words
take on the same meaning, or the same word can have different meanings. #ere are some examples6
Defc" and #()-!(#, as used here, have little to do with financial health. They merely relate
cash inflows and outflows. .usinesses, no matter how profitable, usually invest more in productive assets
than they collect in operating cash flow. The key is financing those assets wisely. The B.(. >overnment
has both the largest deficit and the best credit rating in the world. =an you find out why!
B$))$%&*, !e&'&*, 'e4", and e@(",. (ome financing is debt6 a "(B borrows/ an
((B lends/ interest and principal are paid on schedule. An intermediary may play a role. (ome financing
is e$uity6 An ((B buys part ownership in a "(B and shares profits or losses indefinitely. =hapter 2
speaks generally of borrowing, lending, and ACBs because those terms are familiar, and most
financing does in fact take this general form. &oney market instruments ?=hapter ;@, bonds ?=hapter 7@
and mortgages ?=hapter K@ are all debt to their issuers. ,$uity securities ?=hapter 28@, however, are
also financial claims against "(Bs ?the corporations issuing the shares@ by ((Bs ?the shareholders@.
F&a&ca! c!a+, f&a&ca! &#")(+e&", and #ec()",. These terms are interchangeable for
all practical purposes. (ometimes, though, securities connotes instruments issued to many investors at
once in a standard legal form and evidenced by a standard certificate, such as bonds or shares of stock.
F&a&ca! a##e". A claim, instrument, or security is an asset to the SSU. At3s some kind of
obligation of the "(B. Geal assets, unlike financial assets, arise from production or purchase, not
claims. They include tangibles such as inventory, land, buildings, and e$uipment, and intangibles
such as goodwill, patents, trademarks, or copyrights. 'e don3t make a parallel distinction for liabilities6
Any liability is by definition financialan ACB to someone else.
I&0e#"+e&" commonly suggests the notion of buying securities such as stocks or bonds.
#owever, these forms of financial investment are available only because they are useful ways of
financing real investment. )eal investment is the commitment of funds to real assets ?distinguished
from financial assets above@. This crucial distinction is a sobering reminder that wealth is created by
production in the real sector, not by any activity in the financial sector. The financial sector ultimately
exists to channel savings into real investment. *inancial investment is merely a useful way of doing so.
2+
F&a&ca! I&#""("$& and F&a&ca! I&"e)+e'a),. Clder books often differentiated these
terms/ newer ones tend not to. Traditionally, a financial institution was any firm devoted chiefly to
providing any financial service/ a financial intermediary was a financial institution that completely
transformed claims. An investment banker was an institution but not an intermediary ?investment bankers
don3t transform claims, they -ust help issue them@ and a commercial bank was both. Today we usually
interchange these terms because financial services are more integrated. Cn =itigroup3s organizational
chart are examples of practically every institution and service mentioned in =hapter 2 ?except credit
unions and federal agencies@. "uring much of the 18
th
century, however, institutions and services were
segregated by regulators. *or example, commercial banks could not underwrite securities, thrifts could
not make commercial loans or offer checking accounts, and insurance companies could not offer products
resembling deposits. Anstitutional investor sounds interchangeable with financial institution, but
actually refers to a relative handful of institutions6 mutual funds, pension funds, and insurance companies.
U&'e)%)"&* chiefly connotes the process by which investment bankers help issue new
securities to the investing public. Cther financial workplaces, however, use this word. 'hen a lending
officer at a depository institution underwrites a loan, she -ustifies the credit decision and documents its
conformity to the institution3s standards. 'hen an insurance company underwrites a risk, it agrees to
cover that risk for the policyholder under specified terms and conditions.
Ba&5 and 4a&5&* refer in everyday life to the business of taking deposits and making loans.
(trictly speaking, though, this is commercial banking. All depository institutions exemplify it. They
have different names ?banks, (IMs, credit unions@ because they have different charters and focus on
different types of loans. &ortgage bankers don3t take deposits/ they sell their mortgages in secondary
markets. Anvestment bankers say they are in banking and rarely say investment banking themselves.
An other countries banking has almost always meant commercial and investment banking together.
(wiss banks are examples, as are the great banking houses of .ritain, >ermany, and )apan. =entral
banking is a uni$ue topic, to which we turn in =hapters 1 and +.
SUPPLEMENTARY ASSIGNMENT. THE FLOW OF FUNDS
The flow of funds is more than theory. The *ederal Geserve (ystem ?or *ed@ tracks actual
flows of funds among the sectors of the economy and publishes the Flo3 of Funds .ccounts $uarterly.
Gead (he U,S, Flo3 of Funds .ccounts and (heir Uses by Albert &. Teplin at
http6<<www.federalreserve.gov<pubs<bulletin<1882<8;82lead.pdf /
then attempt an examination of the last 1 or + $uarters of (tatistical Gelease O.2%% Flo3 of Funds
.ccounts of the United States at http6<<www.federalreserve.gov<releases<O2< . 'hile you3re at the *ed3s
web site, order or download a free copy of (he Federal )eserve S+stem4 $urposes and Functions4
http6<<www.federalreserve.gov<pf<pf.htm
This free, short, and highly informative book will be a big help to you as you take up =hapters 1 and +.
SOLUTIONS TO COMPLETION AUESTIONS
2. households
1. &arketability
+. underwriting
2H
H. transform
9. "isintermediation
:. =ommercial banks
;. *inance companies
7. (econdary markets
K. financial instruments/ securities
28. =redit risk ?or default risk@
SOLUTIONS TO TRUE8FALSE AUESTIONS
2. * .usinesses are usually "(Bsthey usually want to invest more in productive assets than they
collect in operating cash flow.
1. * &ost financial claims are marketable to some extentthey may be resold to other ((Bs.
+. T Drivate placements are the simplest form of direct finance.
H. T =ompetition among intermediaries tends to force interest rates downward.
9. * Actually, the reverse is true6 ,very liability is someone else3s asset, but many assets are real
assets, not financial assets.
:. T Agency securities carry relatively low risk because they are backed by the B.(. >overnment.
;. * Crganized exchanges are more exclusive than CT= markets/ participants must be members and
securities must be listed.
7. T *orex may involve spot, future, forward, or option transactions.
K. * There are no organized exchanges in the money markets/ brokers and dealers specialize in various
money market instruments and trade them in wholesale transactions.
28. * Cperational efficiency has to do with minimizing transactions costs.
SOLUTIONS TO MULTIPLE CHOICE AUESTIONS
2. c #ousehold, although not every household is such a traditional family. Adults living alone, single%
parent families, and domestic partnerships are other possible examples of households.
1. c. ((B, to the extent of some EH9,888 by which expected income exceeds planned spending.
+. a. *inancial intermediation. The deposit accounts are claims by .ob and Fancy against a
depository institution.
29
H. f. a I bdenomination divisibility and maturity flexibility are the benefits clearl+ evident to %oth
the ((B ?the >utierrez family@ and the "(B ?=D =onstruction@. The bank has pooled the funds
of the >utierrez family and other depositors to provide =D =onstruction with one large loan, for
a maturity that exceeds that of the >utierrez family3s deposits. =redit risk diversification
and li$uidity are additional benefits to an ((B, but are irrelevant to a "(B.
9. d. All of the abovethe investment of funds directly in a business is a primary market transaction/ the
ac$uisition of common stock is an e$uity transaction, and the withdrawal of funds from a deposit%
type institution for the purpose of financing a direct investment is an act of disintermediation.
:. b. "ealers carry an inventory of securities, brokers don3t. .rokers simply execute their clients3 buy or
sell orders at the best possible price. Accordingly, brokers care at least as much as dealers about the
ask price, which is the price at which dealers sell securities5.to brokers, among other buyers.
;. a. The B.(. government hasn3t regulated interest rates since the early 2K78s.
7. c. *ew ordinary investors care to hold claims denominated in foreign currencythe reverse of a.
Fot all financial institutions operate internationally. Fot all "(Bs export.
K. b. =redit unions are the only deposit%type institutions that are not%for%profit. Dension funds are not
deposit%type institutions.
28. d. All of the above. =apital market securities typically have longer maturities and relatively less
li$uidity, and are traded both wholesaleand retail on organized exchanges and in CT= markets.
2: