Capital Markets and Financial Institutions: Major Players, Practices, and Services - Prof., Study notes of Financial Market

Download Capital Markets and Financial Institutions: Major Players, Practices, and Services - Prof. and more Study notes Financial Market in PDF only on Docsity! Chapter 01 - Introduction Answers to Chapter 1 Questions 1. a. primary b. primary c. secondary d. secondary e. secondary 2. a. money market b. money market c. capital market d. capital market e. capital market f. money market g. money market h. money market i. capital market j. money market 3. The capital markets are more likely to be characterized by actual physical locations such as the New York Stock Exchange or the American Stock Exchange. Money market transactions are more likely to occur via telephone, wire transfers, and computer trading. 4. According to Figure 1-3, the money market instrument that has had the largest growth is the Federal funds and repurchase agreements which grew from 18.1% of the total value of money market securities outstanding in 1990 to 32.4% in 2007. 5. The major instruments traded in capital markets are corporate stocks, residential mortgages, commercial and farm mortgages, corporate bonds, Treasury notes and bonds, state and local government bonds, U.S. government owned agencies, U.S. government sponsored agencies, and bank and consumer loans. 6. In recent years public confidence in the integrity of the IPO process has eroded significantly. Investigations have revealed that certain underwriters of IPOs have engaged in misconduct contrary to the best interests of investors and the markets. Among the most harmful practices that have given rise to public concerns are “spinning” (in which certain underwriters allocate “hot” IPO issues to directors and/or executives of potential investment banking clients in exchange for investment banking business) and “biased” recommendations by research analysts (due to their compensation being tied to the success of their firms’ investment banking business). This was culminated in the Spring of 2003 with an agreement between securities regulators and 10 of the nation’s largest securities firms, in which they agreed to pay a record $1.4 billion in penalties to settle charges involving investor abuses. The settlement centered on civil charges that securities firms routinely issued overly optimistic stock research to investors in order to gain favor with corporate clients and win their investment banking business. The agreement also settled charges that some major firms improperly allocated IPO shares to corporate executives to win investment banking business from their firms. The agreement has forced brokerage companies to make 1-1 Chapter 01 - Introduction structural changes in the way they handle research—preventing, for example, analysts from attending certain meetings relating to investment banking. 7. The answer to this S&P question will vary depending on the date of the assignment. 8. The bank would fear a depreciation of the yen against the dollar. 1-2 Chapter 01 - Introduction 12. A suppler of funds who directly invests in a fund user=s financial claims faces a high cost of monitoring the fund user=s actions in a timely and complete fashion after purchasing securities. One solution to this problem is for a large number of small investors to place their funds with a single FI serving as a broker between the two parties. When acting as a pure broker, the FI acts as an agent for the fund suppliers in providing information about the fund users. The FI groups the fund suppliers= funds together and invests them in the direct or primary financial claims issued by fund users. This aggregation of funds resolves a number of problems. First, the large FI now has a much greater incentive to collect information and monitor the fund user=s actions because the FI has far more at stake than any small individual fund supplier. This alleviates the problem that exists when small fund suppliers leave it to each other to collect information and monitor a fund user=s use of the funds it raises. In a sense, fund suppliers have appointed the FI as a delegated monitor to act on their behalf. 1-5 13. In addition to information costs, FIs also help small savers alleviate liquidity risk. Liquidity risk occurs when savers are not able to sell their securities at demand. Commercial banks, for example, are able to offer deposits that can be withdrawn at any time. Yet they are able to make long-term loans or invest in illiquid assets because of two reasons: 1) they are able to diversify their portfolios; 2) they are able to better monitor the performance of firms that have been given the loans or who have issued securities. The less diversified the assets of the FI, the more likely it will hold illiquid assets. 14. As long as the returns on different investments are not perfectly positively correlated, by spreading their investments across a number of assets, FIs can diversify away significant amounts of their portfolio risk. Further, for equal investments in different securities, as the number of securities in an FI=s asset portfolio increases portfolio risk falls, albeit at a diminishing rate. What is really going on here is that FIs can exploit the law of large numbers in making their investment decisions, whereas due to their smaller wealth size, individual fund suppliers are constrained to holding relatively undiversified portfolios. As a result, diversification allows an FI to predict more accurately its expected return and risk on its investment portfolio so that it can credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little price risk. A good example of this is a bank=s ability to offer highly liquid, instantly withdrawable demand deposits as liabilities while investing in risky, nontradable, and often illiquid loans as assets. As long as an FI is sufficiently large, to gain from diversification and monitoring on the asset side of its balance sheet, its financial claims (it issues as liabilities) are likely to be viewed as liquid and attractive to small saversCespecially when compared to direct investments in the capital market. A mutual fund invested in a diverse group of stocks and fixed income securities will best provide diversification for an investor. 15. If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities. That is, the FI can offer the relatively short-term liabilities desired by households (say, in the form of bank deposits) and also satisfy the demand for long-term loans (say, in the form of home mortgages). By investing in a portfolio of long-and short-term assets and liabilities, the FI can both reduce risk exposure through diversification and manage risk exposure by centralizing its hedging activities. 16. Because they are sold in very large denominations, many assets are either out of reach of individual savers or would result in savers holding highly undiversified asset portfolios. For example, the minimum size of a negotiable CD is $100,000; commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more. Individual savers may be unable to purchase such instruments directly. However, by buying shares in a mutual fund with other small investors, household savers overcome the constraints to buying assets imposed by large minimum denomination sizes. Such indirect access to these markets may allow small savers to generate higher returns on their portfolios as well. 17. Services provided by FIs that benefit the overall economy include: Money Supply Transmission - Depository institutions are the conduit through which monetary policy actions impact the rest of the financial system and the economy in general. Credit Allocation - FIs are often viewed as the major, and sometimes only, source of financing for a particular sector of the economy, such as farming and residential real estate. Intergenerational Wealth Transfers - FIs, especially life insurance companies and pension funds, provide savers the ability to transfer wealth from one generation to the next. Payment Services - The efficiency with which depository institutions provide payment services directly benefits the economy. 18. FIs provide various services to sectors of the economy. Failure to provide these services, or a breakdown in their efficient provision, can be costly to both the ultimate suppliers (households) and users (firms) of funds as well as the overall economy. For example, bank failures may destroy household savings and at the same time restrict a firm=s access to credit. Insurance company failures may leave households totally exposed in old age to catastrophic illnesses and sudden drops in income on retirement. In addition, individual FI failures may create doubts in savers= minds regarding the stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs are regulated in an attempt to prevent these types of market failures. 19. The answer to this S&P question will vary depending on the date of the assignment. 20. Measured as more than $500 billion in international debt outstanding the biggest issuers are France, Germany, Italy, the Netherlands, the United Kingdom, and the United States. 21. Japan, France, Switzerland, the United Kingdom, and the United States have the biggest banks (in terms of total assets).