The Financial System
1. When financial markets channel funds from savers to investors, who benefits?
Explain.
ANSWER: With a well-functioning financial system, both parties to the transaction
benefit when funds are channeled from savers to investors. Investors are able to con-
duct projects that generate profits and savers are able to earn a positive return on
their funds by gaining access to some of these profits. The benefits of well-function-
ing financial markets go beyond the gains that accrue to the immediately involved
parties—here, the savers and investors. Since financial markets aid in the realization
of new investment projects—for example, the building of new factories—workers and
consumers also gain. The true benefit of financial markets lies in their supporting role
in fostering economic growth as measured by real GDP.
2. Suppose an owner of a corporation needs $1 million to finance a new investment.
If his total wealth is $1.2 million, would it be better to use his own funds for the in-
vestment or to issue stock in the corporation? What if the owner’s wealth is $1 billion?
ANSWER: The principle of diversification suggests that the owner of the corporation
will have a stronger interest in financing the new investment through issuing stock
when his wealth is lower. The owner with the $1.2 million wealth would have to put
all of his or her eggs into one basket if the investment were financed using only their
own funds. With the larger wealth, a number of projects can be financed with his or
her funds and diversification will take place without any stock issued.
3. Suppose you were required to put all your retirement savings in the securities of
one company. What company would you choose, and why? Would you choose the
company you work for? Would you buy stock or bonds?
ANSWER: Putting all retirement savings in the securities of one company violates the
principle of diversification. But if you were required to choose just one company, you
could choose one company that is already fairly diversified. Maybe you choose a
multinational company that operates in many different locations, or you choose a
company that produces a variety of products. Choosing the company you work for will
compound problems in the event that your company goes out of business. Not only
will you lose your retirement savings but also your job. Whether you buy stocks or
bonds issued by the company will depend on how comfortable you are with more
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risky securities (stocks) versus safer securities (bonds). Generally, buying a mix of
stocks and bonds will help in diversifying.
4. Suppose there are two investors. One has a project to build a factory; the other has
a project to visit a casino and gamble on roulette. Which investor has a greater in-
centive to issue bonds? Which investor’s bonds are better deals for savers?
ANSWER: Gambling with other people’s money is very appealing. The potential gains
are big and no losses accrue to the gambler (plus roulette itself is probably a fun ac-
tivity for the gambler). Building a factory, however, is sure to require long, hard hours
of work. Thus, the gambler has a greater incentive to issue bonds in order to get ac-
cess to funds. The “gambling project” is fun to engage in, while the “factory project”
is a very costly undertaking for the investor (at least in terms of time and energy if no
personal funds are used). Savers will be better off buying a bond from the investor
who builds the factory. This investor will be less likely to default on the bonds issued
because the more costly factory project will only be conducted with a great likelihood
of success and in the event of failure the factory can function as collateral. This sce-
nario illustrates the principle of adverse selection.
5. Suppose a company raises funds by issuing short-term bonds (commercial paper).
It uses the funds to make private loans. Such a firm is called a finance company. Is
a finance company a type of bank?
ANSWER: No, a finance company is not a type of bank. Banks are defined as fi-
A-2 CHAPTER 1 The Financial System
