Questions
1. Exposure to Interest Rate Risk. Is the cost of funds obtained by finance companies very sensitive to
market interest rate movements? Explain.
ANSWER: The interest expenses on short-term funds obtained by issuing commercial paper and
2. Issuance of Commercial Paper. How are small and medium-sized finance companies able to issue
commercial paper? Why do some well-known finance companies directly place their commercial
paper?
3. Finance Company Affiliations. Explain why some finance companies are associated with
automobile manufacturers. Why do some of these finance companies offer below-market rates on
loans?
ANSWER: Some finance companies specialize in providing financing for customers of automobile
4. Uses of Funds. Describe the major uses of funds by finance companies.
5. Credit Card Services. Explain how finance companies benefit from offering consumers a credit
card.
ANSWER: Finance companies finance the purchase by the consumer, charging an interest rate that
6. Leasing Services. Explain how finance companies provide financing through leasing.
ANSWER: Finance companies purchase machinery or equipment for the purpose of leasing it to
7. Regulation of Finance Companies. Describe the kinds of regulations that are imposed on finance
companies.
ANSWER: Finance companies that act as or are owned by bank holding companies are federally
8. Liquidity Position. Explain how the liquidity position of finance companies differs from that of
depository institutions such as commercial banks.
ANSWER: Reliance on deposits by depository institutions can cause liquidity problems, because the
9. Exposure to Interest Rate Risk. Explain how the interest rate risk of finance companies differs from
that of savings institutions.
ANSWER: Since finance company assets and liabilities share somewhat similar interest
10. Exposure to Credit Risk. Explain how the default risk of finance companies differs from that of
other lending financial institutions.
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “During a credit crunch, finance companies tend to generate a large amount of business.”
When commercial banks cut back on the amount of loans that they provide, some potential
b. “Some finance companies took a huge hit as a result of the last recession because they opened
their wallets too wide before the recession occurred.”
Some finance companies were too liberal in providing loans; a high percentage of the borrowers
c. “During periods of strong economic growth, finance companies generate unusually high returns
without any hint of excessive risk; but their returns are at the mercy of the economy.”
When the economy is strong, the default rate on loans by finance companies is low. Given the
Managing in Financial Markets
As a manager of a finance company, you are attempting to increase the spread between the rate earned on
your assets and the rate paid on your liabilities.
a. Assume that you expect interest rates decline over time. Should you issue bonds or commercial
paper in order to obtain funds?
b. If you expect interest rates decline, will you benefit more from providing medium-term,
fixed-rate loans to consumers or floating-rate loans to businesses?
c. Why would you still maintain some balance between medium-term, fixed-rate loans and
floating-rate loans to businesses, even if you anticipate that one type of loan will be more
profitable under a cycle of declining interest rates?
There may not be sufficient demand for consumer loans to simply focus on consumer loans. Also,
you need to maintain good relations with businesses since there will be periods in which you
Flow of Funds Exercise
How Finance Companies Facilitate the Flow of Funds
Carson Company has sometimes relied on debt financing from Fente Finance Company. Fente has been
willing to lend money even when most commercial banks were not. Fente obtains funding from issuing
commercial paper and focuses mostly on channeling the funds to borrowers.
a. Explain how finance companies are unique by comparing Fente’s net interest income, noninterest
income, noninterest expenses, and loan losses to those of commercial banks.
Fente’s net interest income is higher than that of banks because it provides riskier loans and can
charge a higher interest rate on its loans. Fente’s noninterest income is lower than those of
b. Explain why Fente performs better than commercial banks in some periods.
Fente performs better than banks in some periods when the economy is strong, because its loan
c. Describe the flow of funds channeled through finance companies to firms such as Carson
Company. What is the original source of the money that is channeled to firms or households that
borrow from finance companies?
The original source of money is buyers of commercial paper that is issued by finance companies.