Chapter 1
Role of Financial Markets and Institutions
Outline
Role of Financial Markets
Accommodating Corporate Finance Needs
Accommodating Investment Needs
Securities Traded in Financial Markets
Money Market Securities
Role of Financial Institutions
Role of Depository Institutions
Systemic Risk Among Financial Institutions
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Key Concepts
1. Explain the role of financial intermediaries in transferring funds from surplus units to deficit units.
2. Introduce the types of financial markets available and their functions.
POINT/COUNTER-POINT:
Will Computer Technology Cause Financial Intermediaries to Become
Extinct?
POINT: Yes. Financial intermediaries benefit from access to information. As information becomes more
accessible, individuals will have the information they need before investing or borrowing funds. They will
not need financial intermediaries to make their decisions.
COUNTER-POINT: No. Individuals rely not only on information, but also on expertise. Some financial
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: Computer technology may reduce the need for some types of financial intermediaries such as
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
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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, and all
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
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
6. International Expansion. Discuss why many financial institutions have expanded internationally in
recent years. What advantages can be obtained through an international merger of financial
institutions?
ANSWER: Many financial institutions have expanded internationally to capitalize on their
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7. Stock Valuation. What type of information do investors rely on in order to determine the proper
value of stocks?
ANSWER: Since the valuation of a stock at a future point in time is uncertain, so is the selling
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
type of professional is compensated.
ANSWER: Securities firms provide a variety of functions (such as underwriting and brokerage) that
9. Mis-valuation of Marijuana Stocks. Explain why some stocks in the marijuana industry were mis-
valued when several states legalized the recreational use of marijuana.
ANSWER: Recently, as several states legalized the recreational use of marijuana, some
companies with very little experience in any business related to marijuana announced that
10. Marketability. Commercial banks use some funds to purchase securities and other funds to make
loans. Why are the securities more marketable than the 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.
ANSWER: Savings institutions have traditionally concentrated in mortgage lending, while
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12. Credit Unions. With regard to the profit motive, how are credit unions different from other financial
institutions?
ANSWER: Credit unions are non-profit 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. Secondary Market for Debt Securities. Why is it important for long-term debt securities to have an
active secondary market?
ANSWER: An active secondary market is especially desirable for debt securities that have a
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 institutions as 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
credit unions. These institutions differ from nondepository institutions in that they accept deposits.
17. Financial Intermediation. Look in a recent business periodical for news about a recent financial
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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. Factors That Influence Liquidity. Which factors influence a security’s liquidity?
ANSWER: Debt securities with shorter maturities are more liquid. Debt securities and stocks with a
20. Impact of Credit Crisis on Institutions. Explain why mortgage defaults during the credit crisis in
2008 and 2009adversely 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. Impact of Fraudulent Financial Reporting on Market Liquidity Explain why financial
markets may be less liquid if companies are not forced to provide accurate financial reports.
ANSWER: If companies are allowed to engage in fraudulent financial reporting by exaggerating
earnings or hiding debt, this could cause investors to overpay when purchasing securities issued by
22. Impact of a Country’s Laws on Its Market Liquidity Describe how a country’s laws can
influence the degree of its financial market liquidity.
ANSWER: The financial markets are much more developed in some countries than in others, and
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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, whereas 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
25. Impact of Systemic Risk Different types of financial institutions commonly interact. Specifically,
they may 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 these
kinds of 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 institution fails, it defaults on
26. Uncertainty Surrounding Stock Price Assume that your publicly traded company attempts to
be completely transparent about its financial condition, and provides thorough information
about its debt, sales, and earnings every quarter. Explain why there still may be much
uncertainty surrounding your company’s stock price.
ANSWER: The value of a company is based on the present value its future cash flows. Investors may
27. Financial Institution’s Roles as Intermediaries Explain how each type of financial
institution serves as a financial intermediary.
ANSWER: Deposits from surplus units are transformed by depository institutions into loans for
deficit units. Purchases of securities (commercial paper) issued by finance companies that are
government agencies.
28. Systemic Risk During a Financial Crisis Explain why financial institutions are highly
exposed to systemic risk during a financial crisis.
ANSWER: Systemic risk exists because financial institutions invest their funds in similar types
of securities and therefore have similar exposure to large declines in the prices of these
securities. For example, in the credit crisis of 2008 and 2009, mortgage defaults affected
CRITICAL THINKING QUESTION
Impact of a Financial Crisis on Market Liquidity During a financial crisis, liquidity in financial
markets declines dramatically, and many surplus units no longer participate in financial markets.
Nevertheless, if the markets are efficient, securities prices should decline due to existing economic
Chapter 1: Role of Financial Markets and Institutions ❖ 9
conditions, which should make these securities appealing to potential investors. Yet, many investors
typically are no longer willing to participate in the financial markets under these conditions. Write a
short essay that explains the logic behind why participants may temporarily disappear during a
financial crisis even though security prices are low, causing illiquidity in financial markets.
ANSWER: Even if the market prices reflect existing conditions, a crisis can cause fear that prices will
decline substantially. While this might allow the possibility for large profits from pronounced changes in
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 Apple stock will not be affected by the announcement that its earnings have
increased as expected.”
The earnings level was anticipated by investors, so that Apple’s stock price already reflected this
anticipation.
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?
You could attempt to borrow $70 million from commercial banks, savings institutions, or finance
companies in the form of commercial loans. Alternatively, you may issue debt securities.
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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?
Individuals provide funds to financial institutions in the form of bank deposits, investment in
mutual funds, purchases of insurance policies, or investment in pensions. The financial
institutions may channel the funds toward the purchase of debt securities (and even equity
securities) that were issued by large corporations, such as the one where you work.
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 has assets valued at approximately $50 million and generates sales of nearly $100
million per year. Some of its growth is attributed to its acquisitions of other firms. Because it expects the
economy to be strong in the future, Carson plans to grow by expanding its business and making more
a. In what way is Carson a surplus unit?
Carson invests in Treasury securities and therefore is providing funds to the Treasury, the issuer
of those securities.
b. In what way is Carson a deficit unit?
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c. How might finance companies facilitate Carson’s expansion?
Finance companies can provide loans to Carson so that Carson can expand its operations.
d. How might commercial banks facilitate Carson’s expansion?
e. Why might Carson have limited access to additional debt financing during its growth phase?
Carson may have already borrowed up to its capacity. Financial institutions may be unwilling to
lend more funds to Carson if it has too much debt.
f. How might securities firms facilitate Carson’s expansion?
g. How might Carson use the primary market to facilitate its expansion?
It could issue new stock or bonds to obtain funds.
h. How might it use the secondary market?
i. If financial markets were perfect, how might this factor 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