Chapter 3
Financial Instruments, Financial Markets,
and Financial Institutions
Conceptual and Analytical Problems
1. As the end of the month approaches, you realize that you probably will not be able to pay the
might use to solve your dilemma. (LO1)
Answer:
Informal—borrow from family or friends.
2. *While we often associate informal financial arrangements with poorer countries where
arrangements rather than utilizing the formal financial sector? (LO1)
Answer: Informal financial arrangements are prevalent among certain ethnic groups in the
United States, where community ties are strong. (See for example P. Bond and R Townsend
informal arrangements are often more flexible than standardized formal loans.
3. If higher leverage is associated with greater risk, explain why the process of deleveraging
(reducing leverage) can be destabilizing. (LO2)
Answer: The problem arises if too many institutions try to reduce their leverage at the same
asset sales, potentially destabilizing those markets.
4. The Chicago Mercantile Exchange has announced the introduction of a financial instrument
buyer $1,000. Who could benefit from buying such a contract? Who could benefit from
selling it? (LO1)
Answer: Someone who benefits from above average rainfall could sell the contract, and
Hydroelectric companies could also sell the contracts, while people who benefit from dry
weather – like golf course operators – would buy them.
5. You wish to buy an annuity that makes monthly payments for as long as you live. Describe
Answer:
a. The number of expected monthly payments declines so the price of the annuity falls.
so the price of the annuity rises.
6. Which of the following would be more valuable to you: a portfolio of stocks that rises in
falls? Why? (LO1)
Answer: A portfolio of stocks that rises in value when your income falls is more valuable
7. Has the distinction between direct and indirect forms of finance become more or less
important in recent times? Why? (LO3)
Answer: The distinction has become less important. The increasing sophistication of the
8. Designated market makers, who historically have provided liquidity (that is, have stood by
this decline in terms of technology and global economic integration. (LO2)
Answer: Advances in technology have made it possible for investors from around the world
numerous examples of headline-making market disturbances associated with electronic
trading mishaps.
9. The design and function of financial instruments, markets, and institutions are tied to the
Answer: The design and function of financial instruments, markets, and institutions are tied
Financial institutions produce information to screen and monitor borrowers.
10. Suppose you need to take out a personal loan with a bank. Explain how you could be
2007-2009 financial crisis. (LO2)
Answer: The strains in the interbank market pushed up interbank lending rates, which
a loan at all.
11. *Advances in technology have facilitated the widespread use of credit scoring by financial
institutions in making their lending decisions. Credit scoring can be defined broadly as the
efficiency of the financial system? (LO3)
Answer: The use of credit scoring techniques standardizes the assessment of loan applicants
lending decisions, leading to a more efficient allocation of resources.
12. Commercial banks, insurance companies, investment banks, and pension funds are all
funds and an example of their use of funds. (LO3)
Answer: Commercial banks receive deposits in checking and savings accounts and borrow
assets to earn income until claims are paid.
some of the initial public offerings they distribute.
Pension funds receive regular contributions from companies providing for retirement
13. Life insurance companies tend to invest in long-term assets such as loans to manufacturing
for these differences? (LO3)
Answer: Automobile insurers generally need to have funds readily available when a
of their assets.
14. For each pair of instruments below, use the criteria for valuing a financial instrument to
choose the one with the highest value. (LO1)
a. A U.S. Treasury bill that pays $1,000 in six months or a U.S. Treasury bill that pays
when you are healthy, assuming you are equally likely to be ill or healthy.
Explain each of your choices briefly.
Answer:
a. The T-bill that pays out in three months, as the sooner the payment the more valuable.
most needed.
15. Joe and Mike purchase identical houses for $200,000. Joe makes a down payment of
payments are made), what would happen to Joe’s and Mike’s net worth? (LO2)
Answer: Mike is more highly leveraged as he has financed a larger part of his asset with
$180,000.
16. *Everything else being equal, which would be more valuable to you – a derivative instrument
choice. (LO2)
Answer: The primary use of derivatives is to transfer risk from one party to another. The
asset as some date in the future at a pre-determined price would have little value if the price
of that asset never changed over time.
17. You decide to start a business selling covers for smart phones in a mall kiosk. To buy
than to issue bonds? (LO3)
Answer: Issuing bonds is a form of direct finance and would require finding a buyer who
would be willing to bear the information and monitoring costs associated with the loan. For
expertise to screen loan applicants and use standardized loan contracts to reduce transaction
costs.
18. Splitland is a developing economy with two distinct regions. The northern region has great
mattresses. Explain how the development of the financial sector could benefit both regions
and promote economic growth in Splitland. (LO2)
Answer: In the absence of financial markets, resources are not being allocated to the best
prevented the southerners lending directly to the northerners in the past. The southerners
would benefit by earning a return on their savings while the northern region would benefit
19. What would you expect to happen to investment and growth in the economy if the U.S.
Answer: The role of the Securities and Exchange Commission (SEC) is to protect investors
less efficiently to the detriment of investment and growth.
20. Use Core Principle 3 from Chapter 1 to suggest some ways in which the problems associated
the future. (LO3)
Answer: Core Principle 3 states that information is the basis for decisions. Many of the
institutions, for example, could help mitigate the problems that arose.
21. What risks might financial institutions face by funding long-run loans such as mortgages to
borrowers (often at fixed interest rates) with short-term deposits from savers? (LO3)
Answer: If savers decide to withdraw in large numbers from the financial institution, the
to continue to attract deposits while the payments received from the mortgage loans stay the
same.
22. *As the manager of a financial institution, what steps could you take to reduce the risks
referred to in Problem 21? (LO3)
Answer: Some strategies include pooling mortgages into mortgage-backed securities and
off when interest rates rose.
23. Give two examples of how greater financial inclusion might benefit a small farmer who
Answer:
financial institution.
24. How might broader access to finance benefit a country where access was previously very
limited? (LO3)
Answer: Greater access to finance can boost economic growth by lowering transaction costs,
specialization.
Data Exploration
1. The broadest stock index in the United States is the Wilshire 5000. Plot this index (FRED
Answer: The requested data plot is:
Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/WILL5000PR, August 9, 2016.
2. Plot the percent change from a year ago of the Wilshire 5000 (FRED code: WILL5000PR).
which are indicated by the vertical, shaded bars on the graph. (LO2)
Answer: It is common for the index to fall prior to or coincident with the onset of recession
corporate sector more generally even as the economy grew. Finally, note that one of the
largest index swings was associated with the financial crisis of 2007-2009.
The requested data plot is:
Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/WILL5000PR, August 9, 2016.
3. Do changes in stock values affect the wealth of households? Beginning in 1971, plot on a
code: TNWBSHNO). Compare the two lines. (LO2)
Answer: The percentage swings in household net worth are smaller in amplitude than
those in the stock index. They usually move together (we say they are “positively
the value of housing since the 1930s in addition to the plunge of the stock index.
The requested data plot is:
Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/WILL5000PR, August 9, 2016.
4. The Dow Jones Industrial Average is a well-known index of equity prices, but includes only
30 stocks. Consider a much broader measure of the stock market — the market value of
did not rise above the peak of the Dot.Com bubble in 2000 until the second quarter of 2014.
5. In Data Exploration Problem 3, you looked at changes in household net worth. In Data
what other assets contribute to household net worth? (LO1)
Answer: While the value of housing and financial assets like equities and bonds are very
* indicates more difficult problems