Tutorial 1:

1. What is the basic functions of financial markets?

Financial markets are markets in which financial assets are traded.

Financial markets facilitate borrowing and lending by facilitating the sale of newly issued financial
assets as well as being able to exchange previously issued financial assets. Examples of financial
markets include the New York Stock Exchange (resale of previously issued stocks), U.S. Treasury
market (resale of previously issued bonds), and U.S. Treasury bill auctions (sale of newly issued
Treasury bills).

Functions:

- Price determination

Financial markets perform the function of setting prices for various financial instruments that are
traded between buyers and sellers in financial markets. Market forces determine the price at which
a financial instrument is traded in the financial market, i.e. the supply and demand of the market.
Thus, financial markets provide a way to price both newly announced financial assets and existing
financial asset inventory.

- Funds mobilization

Not only does a financial instrument determine the price at which it is traded in the financial market,
but also the required return of the money invested by the investor is determined by the financial
market participants. The motivation of a fund seeker depends on the rate of return the investor
demands. Due to this feature, only the financial markets specify that funds available from lenders or
fund investors are distributed to those in need of funding, or by issuing financial instruments to
market financing. Thus, financial markets help investors mobilize their savings.

- Liquidity

The Financial Markets Liquidity feature gives investors the opportunity to sell financial instruments
for their total fair market value at any time during business hours. In the absence of liquidity
features in the financial markets, investors must hold financial securities or financial instruments
until conditions arise to allow these assets to be sold on the market or until the issuer of the
securities has to pay for the securities. According to the contract. The same is true during the
liquidation of the company until the company is voluntarily or involuntarily injured, i.e. the due date
of the debt instrument or in the case of equity instruments. Thus, in financial markets, investors can
easily sell securities and convert them into cash to provide liquidity.

- Risk sharing

Financial markets perform a risk-sharing function because investors are different from those who
invest in these investments. With the help of financial markets, risk is transferred from investors to
those who provide investment funds.

- Easy Access

Industry needs to be financed by investors, and investors require industry to invest money and make
a profit. Thus, financial markets platforms can easily serve potential buyers and sellers, saving you
time and money in finding potential buyers and sellers.
 - Reduction in Transaction Costs and Provision of the Information

Traders need different types of information when buying or selling securities. You need time and
money to acquire this information. However, financial markets help provide traders with all sorts of
information without spending money. Hence, the financial markets reduce the cost of transactions.

- Capital Formation

Financial markets are channels through which new investor savings flow into the country and
contribute to the country's accumulation of capital.

2. What are direct finance and indirect finance? Please discuss.

Direct finance:

Direct financing involves companies or individuals borrowing funds directly from investors. Direct
financing requires borrowers to contact investors directly, which increases the time it takes to raise
the desired financing. Methods used for direct financing include selling to investors or offering stocks
to issue bonds. By selling shares instead of paying interest, companies can pay dividends. Bonds
must continue to pay interest to bond holders at a fixed rate or a variable rate that varies according
to a fixed rate index associated with a variable rate.

Indirect finance:

Indirect financing occurs when a borrower (a company or individual) borrows money from a
financial intermediary such as a bank. The lender pays interest to the intermediary, and the
intermediary pays interest to the investor or depositor. In indirect financing, intermediaries bring
together multiple investors and perform due diligence on lenders to reduce investor risk and provide
a larger pool of funds for lenders to withdraw quickly.

3. Briefly discuss classification of financial markets.

Nature of claim:

- Debt market: It is a market where fixed bonds and debentures or bonds are exchanged
between investors.
- Equity market: It is a place for investors to deal with equity.

Maturity of claim:

- Capital market: It trades medium and long term financial assets.

Seasonality of claim:

- Primary market: Primary Market refers to the market, where the company lists security for
the first time or where the already listed company issues fresh security. This market involves
the company and the shareholders to transact with each other. The amount paid by
shareholders for the primary issue is received by the company. There are two major types of
products for the primary market, viz. Initial Public Offer (IPO) or Further Public Offer (FPO).
- Secondary market: Once a company gets the security listed, the security becomes available
to be traded over the exchange between the investors. The market that facilitates such
trading is known as the secondary market or the stock market.
Mode of delivery:

- Spot/cash market:
- Derivative market: They trades securities that determine its value from its primary asset.
The derivative contract value is regulated by the market price of the primary item — the
derivatives market securities, including futures, options, contracts-for-difference, forward
contracts, and swaps.

Organization structure:

- OTC: They manage public stock exchange, which is not listed on the NASDAQ, American
Stock Exchange, and New York Stock Exchange. The OTC market dealing with companies are
usually small companies that can be traded in cheap and has less regulation.

In these cases, buyers and sellers interact with each other. Generally, Over-the-counter
market transactions involve transactions for hedging of foreign currency exposure, exposure
to commodities, etc. These transactions occur over-the-counter as different companies have
different maturity dates for debt, which generally doesn’t coincide with the settlement dates
of exchange-traded contracts.

Over a period of time, financial markets have gained importance in fulfilling the capital
requirements for companies and also providing investment avenues to the investors in the
country. Financial markets provide transparent pricing, high liquidity, and investor
protection, from frauds and malpractices.
- Organized exchange: Exchange-Traded Market is a centralized market that works on pre-
established and standardized procedures. In this market, the buyer and seller don’t know
each other. Transactions are entered into with the help of intermediaries, who are required
to ensure the settlement of the transactions between buyers and sellers. There are standard
products that are traded in such a market, there cannot need specific or customized
products.

4. If there were no asymmetry in the information that a borrower and lender had, could
there still be a moral hazard problem?
Information asymmetry is a condition under which one business party possesses
more information than the other party they are dealing with. One party's access to more
relevant and up-to-date information can result in business imbalances and even exploitation.

Yes, because even if you know that a borrower is taking actions that might jeopardize paying
off the loan, you must still stop the borrower from doing so. Because that may be costly, you
may not spend the time and effort to reduce moral hazard, and so moral hazard remains a
problem.

5. Why might you be willing to make a loan to your neighbour by putting funds in a saving
account earning a 5% interest rate at the bank and having the bank lend her the funds at a
10% interest rate rather than lend her the funds yourself?
- Because the costs of making the loan to your neighbour are high (legal fees, fees for a credit
check, and so on), you will probably not be able to earn 5% on the loan after your expenses
even though it has a 10% interest rate. You are better off depositing your savings with a
 financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by
depositing your savings at the bank rather than lending them to your neighbour

6. How does risk sharing benefits both financial intermediaries and private sectors?
Risk sharing benefits financial intermediaries because they are able to earn a spread
between the returns they earn on risky assets and they returns they pay on the less-risky
assets they sell. Investors benefit because they are able to invest in a better diversified
portfolio then would otherwise be available.

- Sharing risk: helps ward against losing everything on a bad investment.

7. “Because corporation do not actually raise any funds in secondary markets, they are less
important to the economy than primary markets.” The statement is true or false. Please
discuss.
This statement is false. Prices in secondary markets determined the prices that firms issuing
securities receive in primarily markets. In addition, secondary markets make securities more
liquid and thus easier to sell in the primary markets. Therefore, secondary markets are, if
anything, more important than primary markets.

8. Some economists suspect that one of the reasons that economies in developing countries
grow so slowly is that they do not have well-developed financial markets. Does this
argument makes sense?
Yes, because the absence of financial markets means that funds cannot be channelled to
people who have the most productive use for them. Entrepreneurs then cannot acquire
funds to set up businesses that would help the economy grow rapidly.

9. Is a Treasury bond issued 29 years ago with 6 months remaining before it matures a
money market instrument?
Money market securities have an original maturity of less than one year, so the bond would
not be considered a money market security.
10. Why does the U.S. Government use the money markets?
The U.S. government sells large numbers of securities in the money markets to support
government spending. Over the past several decades, the government has spent more each
year than it has received in tax revenues. It makes up the difference by borrowing. Part of
what it borrows comes from the money markets.
11. Why do banks not eliminate the need for money markets?
Banks have higher costs than the money market owing to the need to maintain reserve
requirements. The lower cost structure of the money markets, coupled with the economies
of scale resulting from high volume and large-denomination securities, allows for higher
interest rates.
12. Why do businesses use the money markets?
 Businesses both invest and borrow in the money markets. They borrow to meet short-term
cash flow needs, often by issuing commercial paper. They invest in all types of money
market securities as an alternative to holding idle cash balances.
13. Which of the money market securities is the most liquid and considered the most risk-
free? Why?
Treasury bills are usually viewed as the most liquid and least risky of securities because they
are backed by the strength of the U.S. government and trade in extremely large volumes.
14. Does the Federal Reserve directly set the federal funds interest rate? How does the Fed
influence this rate?
The Federal Reserve cannot directly set the federal funds rate of interest. It can influence
the interest rate by adding funds to or withdrawing reserves from the economy.
15. Who issues commercial paper and for what purpose?
Large businesses with very good credit standings sell commercial paper to raise short-term
funds. The most common use of these funds it to extend short-term loans to customers for
the purchase of the firm's products.
16. Contrast investor's use of capital markets with their use of money markets.
Investors use capital markets for long-term investment purposes. They use money markets,
which have lower yields, primarily for temporary or transaction purposes.
17. What are primary capital market securities, and who are the primary purchasers of these
securities?
Stocks and bonds. Most of these are purchased by and owned by households.
18. In addition to Treasury securities, some agencies of the government issue bonds. List three
such agencies and state what the funds raised by the bond issues are used for.
Ginny Mae (Government National Mortgage Association), Federal Housing Administration,
the Veteran Administration, the Fannie Mae (Federal National Mortgage Association), and
Sallie Mae (Student Loan Marketing Association). The first 4 fund mortgage loans and the
last funds college student loans.
19. A call provision on a bond allows the issuer to redeem the bond at will. Investors don't like
call provisions and so require higher interest on callable bonds. Whom do issuers continue
to issue callable bonds anyway?
Firms like having the flexibility to adjust their capital structure by paying off a debt they no
longer need. They also need to pay off debt to remove restrictive covenants. Call provisions
permit both these actions at the issuer's discretion.
20. What is a sinking fund? Do investors like bonds that contain this feature?
A sinking fund contains funds set aside by the issuer of the bond to pay for the redemption
of the bond when it matures. Because a sinking fund increases the likelihood that a firm will
have the funds to pay off the bonds as required, investors like the feature. As a result,
interest rates are lower on securities with sinking funds.
21. What is the document called that lists the terms of a bond?
Bond Indenture
22. Discuss the features that differentiate organized exchanges from the over-the-counter
market.
Organized exchanges have a physical building where business is conducted. They generally
have a governing board that establishes rules for trading. The organized exchanges tend to
have larger firms listed on them than trade over the counter.
23. Most mortgage loans once had balloon payments; now most current mortgage loans fully
amortize. What is the difference between a balloon loan and an amortizing loan?
 Balloon loans require that a large final payment is made to pay off the remaining principal
balance. Amortizing loans are structured so that equal monthly payments are made such
that the total of all payments covers both interest and principal over the lifetime of the loan.
24. What are discount points and why do some mortgage borrowers choose to pay them?
Discounts point paid when a loan is initiated result in a reduced interest rate. If the borrower
plans to hold on to the loan long enough for the value of the reduced interest rate to exceed
the up-front cost of the points, it is a good idea to elect to pay them.
25. What is the purpose of requiring that a borrower make a down payment before receiving a
loan?
Down payments are intended to make the borrower less likely to default on the loan. A
borrower who does not make a down payment could walk away from the house and the
loan and lose nothing. Furthermore, if real estate prices drop even a small amount, the
balance due on the loan will exceed the value of the collateral. The down payment reduces
moral hazard for the borrower.
26. What kind of insurance do lenders usually require of borrowers who have less than an 80%
loan-to-value ratio?
Private mortgage insurance (PMI)
27. Lenders tend not to be as flexible about the qualifications required of mortgage customers
as they can be for other types of bank loans. Why is this so?
Because most lenders sold their mortgage loans to one of a few federal agencies in the
secondary mortgage market. These agencies established very precise guidelines that had to
be followed before they would accept the loan. If the lender gave a mortgage loan to a
borrower who did not fit these guidelines, the lender would not be able to resell the loan.
That tied up the lender's funds.
28.