1.

Classify the following transactions as taking place in the primary or secondary markets: (LG 1-1)

a. IBM issues $200 million of new common stock. primary

b. The New Company issues $50 million of common stock in an IPO. primary

c. IBM sells $5 million of GM preferred stock out of its marketable securities portfolio. secondary?

d. The Magellan Fund buys $100 million of previously issued IBM bonds. secondary

e. Prudential Insurance Co. sells $10 million of GM common stock. secondary

2. Classify the following financial instruments as money market securities or capital market securities: (LG 1-2)

a. Banker’s acceptances MMS

b. Commercial paper MMS

c. Common stock CMS

d. corporate bonds CMS

e. Mortgages CMS

f. Negotiable certificates of deposit MMS

g. Repurchase agreements MMS

h. U.S. Treasury bills MMS

i. U.S. Treasury notes CMS

j. Federal funds MMS

3. How does the location of money markets differ from that of capital markets? (LG 1-2)

Money markets are said to be over-the-counter (OTC) markets. Meaning, they do not operate in a specific fixed
location, transactions occur via telephones, wire transfers, and computer trading. Capital markets, on the other hand,
operate in fix locations like stock market, the bond market, and the currency and foreign exchange markets.

4. Which of the money market instruments is the largest in terms of dollar amount outstanding in 2016? (LG 1-2)

Federal funds and repurchase agreements is the largest money market instrument in terms of dollar amount
outstanding in 2016. It is 45.8% of the $7.97 trillion outstanding or $3.65 trillion.

5. What are the major instruments traded in capital markets? (LG 1-2)

Major instruments traded in capital markets are: Corporate stocks, mortgages, corporate bonds, treasury
securities, state and local government bonds, U.S. government agency bonds, and consumer loans.

6. Which of the capital market instruments is the largest in terms of dollar amount outstanding in 2016? (LG 1-2)

In terms of dollar amount outstanding in 2016, the largest capital market instrument is the corporate stock. It is
49.6% of the $90.2 trillion outstanding or $44.74 trillion.

7. If a U.S. bank is holding Japanese yen in its portfolio, what type of exchange rate movement would the bank be most
concerned about? (LG 1-3)

If the Japanese yen depreciates (declines in value) relative to the U.S. dollar over the investment, the dollar value
of cash flows received will fall. So, it is the depreciation of the yen against the dollar that the bank would be most
concerned about.
8. What are the different types of financial institutions? Include a description of the main services offered by each. (LG 1-
5)

The different types of financial institution are:

a) Commercial banks – depository institutions whose major assets are loans and major liabilities are deposits.
Commercial banks’ loans are broader in range, including consumer, commercial, and real estate loans, than
other depository institutions. Commercial banks’ liabilities include more non-deposit types of non-deposit sources
of funds, such as subordinate notes and debentures, than other depository institutions.
b) Thrifts - depository institutions in the form of savings and loans, savings banks, and credit unions. Thrifts
generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment,
such as real estate loans or consumer loans.
c) Insurance Companies - financial institutions that protect individuals and corporations (policyholders) from
adverse events. Life insurance companies provide protections in the event of untimely death, illness, and
retirement. Property casualty insurance protects against personal injury and liability due to accidents, the ft, fire,
etc.
d) Securities firms and investment banks - financial institutions that underwrite securities and engage in related
activities such as securities brokerage, securities trading, and making a market in which securities can trade.
e) Finance Companies - financial intermediaries that make loans to both individual and businesses. Unlike
depository institutions, finance companies do not accept deposits but instead rely on short and long-term debt
for funding.
f) Investment funds - financial institutions that pool financial resources of individuals and companies and invest
those resources in diversified portfolios of asset.
g) Pension funds - financial institutions that offer savings plans through which fund participants accumulated
savings during their working years before withdrawing them during their retirement years. Funds originally
invested in and accumulated in a pension funds are exempt from current taxation.

9. How would economic transactions between suppliers of funds (e.g., households) and users of funds (e.g.,
corporations) occur in a world without FIs? (LG 1-6)

In a world without financial institutions, suppliers of funds (e.g., households), generating excess savings by
consuming less than they earn, would have a basic choice: they could either hold cash as an asset or directly invest that
cash in the securities issued by users of funds (e.g., corporations or households). In general, users of funds issue financial
claims (e.g., equity and debt securities or mortgages) to finance the gap between their investment expenditures and
their internally generated savings such as retained earnings. In such a world there would be a direct transfer of funds
(money) from suppliers of funds to users of funds. In return, financial claims would flow directly from users of funds to
suppliers of funds. In this economy without financial institutions, the level of funds flowing between suppliers of funds
(who want to maximize the return on their funds subject to risk) and users of funds (who want to minimize their cost of
borrowing subject to risk) is likely to be quite low.

10. Why would a world limited to the direct transfer of funds from suppliers of funds to users of funds likely result in
quite low levels of fund flows? (LG 1-6)

There are several reasons for this. First, once they have lent money in exchange for financial claims, suppliers of
funds need to monitor continuously the use of their funds. They must be sure that the user of funds neither steals the
funds outright nor wastes the funds on projects that have low or negative returns. Such monitoring is often extremely
costly for any given fund supplier because it requires considerable time, expense, and effort to collect this information
relative to the size of the average fund supplier’s investment. Given this, fund suppliers would likely prefer to leave, or
delegate, the monitoring of fund borrowers to others. The resulting lack of monitoring increases the risk of directly
investing in financial claims. Second, the relatively long-term nature of many financial claims (e.g., mortgages, corporate
stock, and bonds) creates another disincentive for suppliers of funds to hold the direct financial claims issued by users of
funds. Specifically, given the choice between holding cash and long-term securities, fund suppliers may well choose to
hold cash for liquidity reasons, especially if they plan to use their savings to finance consumption expenditures in the
near future and financial markets are not very developed, or deep, in terms of the number of active buyers and sellers in
the market. Third, even though real-world financial markets provide some liquidity services, by allowing fund suppliers
to trade financial securities among themselves, fund suppliers face a price risk upon the sale of securities. That is, the
price at which investors can sell a security on secondary markets such as the New York Stock Exchange (NYSE) may well
differ from the price they initially paid for the security either because investors change their valuation of the security
between the time it was bought and when it was sold and/or because dealers, acting as intermediaries between buyers
and sellers, charge transaction costs for completing a trade.
11. How do FIs reduce monitoring costs associated with the flow of funds from fund suppliers to fund investors? (LG 1-6)

When large number of small investors group their funds together by holding the claims issued by a financial
institution. First, the “large” FI now has a much greater incentive to hire employees with superior skills and training in
monitoring. This expertise can be used to collect information and monitor the ultimate fund user’s actions because the
FI has far more at stake than any small individual fund supplier. Second, the monitoring function performed by the FI
alleviates the “free-rider” problem that exists when small fund suppliers leave it to each other to collect information and
monitor a fund user. In an economic sense, fund suppliers have appointed the financial institution as a delegated
monitor to act on their behalf. For example, full-service securities firms such as Morgan Stanley carry out investment
research on new issues and make investment recommendations for their retail clients (or investors), while commercial
banks collect deposits from fund suppliers and lend these funds to ultimate users such as corporations. An important
part of these FIs’ functions is their ability and incentive to monitor ultimate fund users.

12. How do FIs alleviate the problem of liquidity and price risk faced by investors wishing to invest in securities of
corporations? (LG 1-6)

Liquidity risk occurs when savers are not able to sell their securities at demand. Commercial banks, for example,
are able to offer deposits that can be withdrawn at any time. Yet they are able to make long-term loans or invest in
illiquid assets because of two reasons: 1.) They are able to diversify their portfolios; 2.) They are able to better monitor
the performance of firms that have been given the loans or who have issued securities. The less diversified the assets of
the FI, the more likely it will hold liquid assets.

13. How do financial institutions help individuals diversify their portfolio risks? Which financial institution is best able to
achieve this goal? (LG 1-6)

As long as the returns on different investments are not perfectly positively correlated, by spreading their
investments across a number of assets, FIs can diversify away significant amount of their portfolio risk. Further, for equal
investments in different securities, as the number of securities in an FI's asset portfolio increase portfolio risk falls, albeit
at a diminishing rate. FIs can exploit the law of large numbers in making their investment decisions, whereas because of
their smaller wealth size, individual fund suppliers are constrained to holding relatively undiversified portfolios. As a
result, diversification allows an FI to predict more accurately its expected return and risk on its investment portfolio so
that it can credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little price risk. As long
as an FI is large enough to gain from diversification and monitoring on the asset side of its balance sheet, its financial
claims (its liabilities) are likely to be viewed as liquid and attractive to small savers—especially when compared to direct
investments in the capital market.

14. What is meant by maturity intermediation? (LG 1-6)

If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching
their asset and liability maturities. That is, the FI can offer the relatively short-term liabilities desired by households (say,
in the form of bank deposits) and also satisfy the demand for long-term loans (say, in the form of home mortgages). By
investing in a portfolio of long and short-term assets and liabilities, the FI can both reduce risk exposure through
diversification and manage risk exposure by centralizing its hedging activities.

15. What is meant by denomination intermediation? (LG 1-6)

Because they are sold in very large denominations, many assets are either out of reach of individual savers or
would result in savers holding highly undiversified asset portfolios. For example, the minimum size of a negotiable CD is
$100,000; commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more.
Individual savers may be unable to purchase such instruments directly. However, by buying shares in a mutual fund with
other small investors, household savers overcome the constraints to buying assets imposed by large minimum
denomination sizes. Such indirect access to these markets may allow small savers to generate higher returns on their
portfolios as well.

16. What other services do FIs provide to the financial system? (LG 1-6)
 Other services that FIs provide to the financial system:

a) The transmission of Monetary Policy - Because depository institutions are instrumental in determining the size
and growth of the money supply, they have been designated as the primary conduit through which monetary
policy actions by the Federal Reserve impact the rest of the financial sector and the economy in general.
b) Credit Allocation - FIs are often viewed as the major, and sometimes only, source of financing for a particular
sector of the economy, such as farming and residential real estate.
c) Intergenerational Wealth Transfers or Time Intermediation -   FIs, especially life insurance companies and
pensions funds, provide savers the ability to transfer wealth from one generation to the next.
d) Payment Services - The efficiency with which depository institutions provide payment services directly benefits
the economy

17. What types of risks do FIs face? (LG 1-7)

FIs face a lot of risk. FIs hold some assets that are potentially subject to default or credit risk (such as loans,
stocks, and bonds). As FIs expand their services to non-U.S. customers or even domestic customers with business outside
the United States, they are exposed to both foreign exchange risk and country or sovereign risk as well. Further, FIs tend
to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed
to interest rate risk. If FIs actively trade these assets and liabilities rather than hold them for longer term investments,
they are further exposed to market risk or asset price risk. Increasingly, FIs hold contingent assets and liabilities off the
balance sheet, which presents an additional risk called off-balance-sheet risk. Moreover, all FIs are exposed to some
degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. All FIs
are exposed to technology risk and operational risk because the production of financial services requires the use of real
resources and back-office support systems (labor and technology combined to provide services). Finally, the risk that an
FI may not have enough capital reserves to offset a sudden loss incurred as a result of one or more of the risks it faces
creates insolvency risk for the FI.

18. Why are FIs regulated? (LG 1-8)

FIs provide various services to sectors of the economy. Failure to provide these services, or a breakdown in their
efficient provision, can be costly to both the ultimate suppliers (households) and users (firms) of funds as well as the
overall economy. For example, bank failures may destroy household savings and at the same time restrict a firm's access
to credit. Insurance company failures may leave households totally exposed in old age to catastrophic illnesses and
sudden drops in income on retirement. In addition, individual FI failures may create doubts in savers' minds regarding the
stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs are regulated in attempt
to prevent these types of market failures.

19. What events resulted in banks’ shift from the traditional banking model of originate-and-hold to a model of
originate-and-distribute? (LG 1-6, LG 1-7, LG 1-8)
  A major event that changed and reshaped the financial services industry was the financial crisis of the late
2000s. As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a
dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model
from that of "originate and hold" to "originate to distribute." In the traditional model, banks take short term
deposits and other sources of funds and use them to fund longer term loans to businesses and consumers.
Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower
activities even after a loan is made. However, the traditional banking model exposes the institution to potential
liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-
risk tradeoffs, banks have shifted to an underwriting model in which they originate or warehouse loans, and
then quickly sell them. When loans trade, the secondary market produces information that can substitute for
the information and monitoring of banks. Further, banks may have lower incentives to collect information and
monitor borrowers if they sell loans rather than keep them as part of the bank's portfolio of assets. Indeed, most
large banks are organized as financial service holding companies to facilitate these new activities.

More recently, activities of shadow banks, non-bank financial service firms that perform banking services, have
facilitated the change from the originate-and-hold model of commercial banking to the originate-and-distribute
banking model. In the shadow banking system, savers place their funds with money market mutual and similar
funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow
banks rather than from banks. Like the traditional banking system, the shadow banking system intermediates
the flow of funds between net savers and net borrowers. However, instead of the bank serving as the
middleman, it is the nonbank financial service firm, or shadow bank, that intermediates.

These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet
and to other parts of the financial system. Since the FIs, acting as underwriters, are not exposed to the credit,
liquidity, and interest rate risks of traditional banking, they have little incentive to screen and monitor activities
of borrowers to whom they originate loans. Thus, FIs' role as specialists in risk measurement and management
has been reduced.

20. How did the boom in the housing market in the early and mid-2000s exacerbate FIs’ transition away from their role
as specialists in risk measurement and management? (LG 1-6, LG 1-7, LG 1-8)

• The boom ("bubble") in the housing markets began building in 2001, particularly after the terrorist
attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial
markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term interest rate that banks
and other financial institutions pay in the federal funds market. Perhaps not surprisingly, low interest rates and the
increased liquidity provided by the central bank resulted in a rapid expansion in consumer, mortgage, and corporate debt
financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt
grew, especially among those who had previously been excluded from participating in the market because of their poor
credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the market now
popularly known as the "subprime market," banks and other mortgage-supplying institutions often offered relatively low
"teaser" rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial rate
increases once the initial rate period expired (two or three year later) if market rates increased. Under the traditional
banking structure, banks might have been reluctant to so aggressively pursue low credit quality borrowers for fear that
the loans would default. However, under the originate-to-distribute model of banking, asset securitization and loan
syndication allowed banks to retain little or no part of the loans, and hence the default risk on loans that they originated.
Thus, as long as the borrower did not default within the first months after a loan's issuance and the loans were sold or
securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result
was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate
leverage.

21. What countries have the most international debt securities outstanding? (LG 1-9)

Measured as more than $1000 billion in international debt outstanding the biggest issuers are France, Germany,
the Netherlands, the United Kingdom, and the United States.

22. What countries have the largest commercial banks? (LG 1-9)
China, the United States, France, Japan, and United Kingdom have the biggest banks (in terms of total assets).