Questions
1.Surplus and Deficit Units. Explain the meaning of surplus units and deficit units. Provide an
example of each. Which types of financial institutions do you deal with? Explain whether you are
acting as a surplus unit or a deficit unit in your relationship with each financial institution.
ANSWER: Surplus units provide funds to the financial markets while deficit units obtain funds from
This exercise allows students to realize that they constantly interact with financial institutions, and
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Chapter 1: Role of Financial Markets and Institutions 2
2. Types of Markets. Distinguish between primary and secondary markets. Distinguish between money
and capital markets.
ANSWER: Primary markets are used for the issuance of new securities while secondary markets are
3. Imperfect Markets. Distinguish between perfect and imperfect security markets. Explain why the
existence of imperfect markets creates a need for financial intermediaries.
ANSWER: With perfect financial markets, all information about any securities for sale would be
freely available to investors, information about surplus and deficit units would be freely available,
Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficit
4. Efficient Markets. Explain the meaning of efficient markets. Why might we expect markets to be
efficient most of the time? In recent years, several securities firms have been guilty of using inside
information when purchasing securities, thereby achieving returns well above the norm (even when
accounting for risk). Does this suggest that the security markets are not efficient? Explain.
ANSWER: If markets are efficient then prices of securities available in these markets properly reflect
all information. We should expect markets to be efficient because if they weren’t, investors would
Efficiency is often defined with regard to publicly available information. In this case, markets can be
5. Securities Laws. What was the purpose of the Securities Act of 1933? What was the purpose of the
Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment
decisions? Explain.
ANSWER: The Securities Act of 1933 was intended to assure complete disclosure of relevant
financial information on publicly offered securities, and prevent fraudulent practices when selling
6. International Barriers. If barriers to international securities markets are reduced, will a country’s
interest rate be more or less susceptible to foreign lending and borrowing activities? Explain.
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Chapter 1: Role of Financial Markets and Institutions 3
ANSWER: If international securities market barriers are reduced, a country’s interest rate will likely
become more susceptible to foreign lending and borrowing activities. Without barriers, funds will
7. International Flow of Funds. In what way could the international flow of funds cause a decline in
interest rates?
ANSWER: If a large volume of foreign funds was invested in the United States, it could place
8. Securities Firms. What are the functions of securities firms? Many securities firms employ brokers
and dealers. Distinguish between the functions of a broker and those of a dealer, and explain how
each is compensated.
ANSWER: Securities firms provide a variety of functions (such as underwriting and brokerage) that
9. Standardized Securities. Why do you think securities are commonly standardized? Explain why
some financial flows of funds cannot occur through the sale of standardized securities. If securities
were not standardized, how would this affect the volume of financial transactions conducted by
brokers?
ANSWER: Securities can be more easily traded when they are standardized because the specifics of
If securities were not standardized, the volume of financial transactions conducted by brokers would
10. Marketability. Commercial banks use some funds to purchase securities and other funds to make
loans. Why are the securities more marketable than loans in the secondary market?
ANSWER: Securities are more standardized than loans and therefore can be more easily sold in the
11. Depository Institutions. Explain the primary use of funds for commercial banks versus savings
institutions.
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Chapter 1: Role of Financial Markets and Institutions 4
ANSWER: Savings institutions have traditionally concentrated in mortgage lending, while
12. Credit Unions. With regard to the profit motive, how are credit unions different from other financial
institutions?
13. Nondepository Institutions. Compare the main sources and uses of funds for finance companies,
insurance companies, and pension funds.
ANSWER: Finance companies sell securities to obtain funds, while insurance companies receive
14. Mutual Funds. What is the function of a mutual fund? Why are mutual funds popular among
investors? How does a money market mutual fund differ from a stock or bond mutual fund?
ANSWER: A mutual fund sells shares to investors, pools the funds, and invests the funds in a
15. Impact of Privatization on Financial Markets. Explain how the privatization of companies in
Europe can lead to the development of new securities markets.
ANSWER: The privatization of companies will force these companies to finance with stocks and debt
Advanced Questions
16. Comparing Financial Institutions. Classify the types of financial institutions mentioned in this
chapter as either depository or nondepository. Explain the general difference between depository and
nondepository institution sources of funds. It is often stated that all types of financial institutions have
begun to offer services that were previously offered only by certain types. Consequently, many
financial institutions are becoming more similar. Nevertheless, performance levels still differ
significantly among types of financial institutions. Why?
ANSWER: Depository institutions include commercial banks, savings and loan associations, and
Even though financial institutions are becoming more similar, they often differ distinctly from each
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Chapter 1: Role of Financial Markets and Institutions 5
17. Financial Intermediation. Look in a recent business periodical for news about a recent financial
transaction that involves two financial institutions. For this transaction, determine the following:
a. How will each institution’s balance sheet be affected?
b. Will either institution receive immediate income from the transaction?
c. Who is the ultimate user of funds?
d. Who is the ultimate source of funds?
ANSWER: This exercise will force students to understand how the balance sheet and income
18. Role of Accounting in Financial Markets. Integrate the roles of accounting, regulations, and
financial market participation. That is, explain how financial market participants rely on accounting,
and why regulatory oversight of the accounting process is necessary.
ANSWER: Financial market participants rely on financial information that is provided by firms. The
19. Impact of Credit Crisis on Liquidity. Explain why the credit crisis caused a lack of liquidity in the
secondary markets for many types of debt securities. Explain how such a lack of liquidity would
affect the prices of the debt securities in the secondary markets.
ANSWER: Investors were less willing to invest in many debt securities because they were concerned
20. Impact of Credit Crisis on Institutions. Explain why mortgage defaults during the credit crisis
adversely affected financial institutions that did not originate the mortgages. What role did these
institutions play in financing the mortgages?
ANSWER: Some financial institutions participated by issuing mortgage-backed securities that
21. Regulation of Financial Institutions. Financial institutions are subject to regulations to ensure that
they do not take excessive risk and they can safely facilitate the flow of funds through financial
markets. Nevertheless, during the credit crisis, individuals were concerned about using financial
institutions to facilitate their financial transactions. Why do you think the existing regulations were
ineffective at ensuring a safe financial system?
ANSWER: During the credit crisis in 2008, the failure of some financial institutions caused concerns
that others might fail, and disrupted the flow of funds in financial markets. The primary cause was
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Chapter 1: Role of Financial Markets and Institutions 6
22. Impact of the Greece Debt Crisis. European debt markets have become integrated over time, so that
institutional investors (such as commercial banks) commonly purchase debt issued in other European
countries. When the government of Greece experienced problems in meeting its debt obligations in
2010, some investors became concerned that the crisis would spread to other European countries.
Explain why integrated European financial markets might allow a debt crisis in one European country
to spread to other countries in Europe.
ANSWER: Integration results in more international trade and capital flows, including loans extended
from European banks to Greece. The crisis in Greece may prevent the Greek government from
23. Global Financial Market Regulations. Assume that countries A and B are of similar size, that they
have similar economies, and that the government debt levels of both countries are within reasonable
limits. Assume that the regulations in country A require complete disclosure of financial reporting by
issuers of debt in that country, but that regulations in country B do not require much disclosure of
financial reporting. Explain why the government of country A is able to issue debt at a lower cost than
the government of country B.
ANSWER: Investors are more willing to invest in debt securities issued by the government of country
A because there is more transparent information that would suggest country A can cover its payments
24. Influence of Financial Markets Some countries do not have well established
markets for debt securities or equity securities. Why do you think this can limit
the development of the country, business expansion, and growth in national
income in these countries?
ANSWER: Businesses rely on financial markets to expand. If they cannot issue
debt or equity securities, they cannot obtain funding to expand. Local investors
25. Impact of Systemic Risk different types of financial institutions commonly
interact. They provide loans to each other, and take opposite positions on many
different types of financial agreements, whereby one will owe the other based on
a specific financial outcome. Explain why their relationships cause concerns
about systemic risk.
ANSWER:When financial institutions interact through transactions, the failure of
one financial institution can cause financial problems for others. As one financial
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Chapter 1: Role of Financial Markets and Institutions 7
Interpreting Financial News
“Interpreting Financial News” tests your ability to comprehend common statements made by Wall Street
analysts and portfolio managers who participate in the financial markets. Interpret the following :
a. “The price of IBM stock will not be affected by the announcement that its earnings have
increased as expected.”
b. “The lending operations at Bank of America should benefit from strong economic growth.”
c. “The brokerage and underwriting performance at Goldman Sachs should benefit from strong
economic growth.”
High economic growth may result in a large volume of stock transactions in which Goldman
Sachs may serve as a broker. Also, Goldman Sachs underwriters new securities that are issued
Managing in Financial Markets
As a financial manager of a large firm, you plan to borrow $70 million over the next year.
a. What are the more likely alternatives for you to borrow $70 million?
b. Assuming that you decide to issue debt securities, describe the types of financial institutions that
may purchase these securities.
Financial institutions such as mutual funds, pension funds, and insurance companies commonly
c. How do individuals indirectly provide the financing for your firm when they maintain deposits at
depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?
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Chapter 1: Role of Financial Markets and Institutions 8
Individuals provide funds to financial institutions in the form of bank deposits, investment in
Flow of Funds Exercise
Roles of Financial Markets and Institutions
This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in
the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the
flow of funds in the business and financial environment. At the end of every chapter, this exercise provides
a list of questions about Carson Company that require the application of concepts learned within the
chapter, as related to the flow of funds.
Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson
family. It was initially financed with an equity investment by the Carson family and ten other individuals.
Over time, Carson Company has obtained substantial loans from finance companies and commercial
banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months.
Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a
bank in case it suddenly needs to obtain funds for a temporary period. It has purchased Treasury securities
that it could sell if it experiences any liquidity problems.
Carson Company has assets valued at about $50 million and generates sales of about $100 million per
year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a
strong U.S. economy, Carson plans to grow in the future by expanding its business and through
acquisitions. It expects that it will need substantial long-term financing, and plans to borrow additional
funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds in
the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows
and cash outflows and thereby affect its value.
a. In what way is Carson a surplus unit?
b. In what way is Carson a deficit unit?
c. How might finance companies facilitate Carson’s expansion?
d. How might commercial banks facilitate Carson’s expansion?
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Chapter 1: Role of Financial Markets and Institutions 9
e. Why might Carson have limited access to additional debt financing during its growth phase?
f. How might securities firms facilitate Carson’s expansion?
g. How might Carson use the primary market to facilitate its expansion?
h. How might it use the secondary market?
i. If financial markets were perfect, how might this have allowed Carson to avoid financial
institutions?
It would have been able to obtain loans directly from surplus units. It would have been able to
j. The loans that Carson has obtained from commercial banks stipulate that Carson must receive the
banks’ approval before pursuing any large projects. What is the purpose of this condition? Does
this condition benefit the owners of the company?
The purpose is to prevent Carson from using the funds in a manner that would be very risky, as
Carson may default on its loans if it takes excessive risk when using the funds to expand its
business. The owners of the firm may prefer to take more risk than the lenders will allow, because
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.