2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.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 Capital Market Securities Derivative Securities Valuation of Securities Securities Regulations on Financial Disclosure International Financial Markets Government Intervention in Financial Markets

Role of Financial Institutions Role of Depository Institutions Role of Nondepository Financial Institutions Comparison of Roles among Financial Institutions Relative Importance of Financial Institutions Consolidation of Financial Institutions

Systemic Risk Among Financial Institutions

(Financial Markets & Institutions, 13e Jeff Madura) (Solution Manual all Chapters) 1 / 4

Chapter 1: Role of Financial Markets and Institutions ❖ 2

© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Key Concepts

• Explain the role of financial intermediaries in transferring funds from surplus units to deficit units.

• Introduce the types of financial markets available and their functions.

• Introduce the various financial institutions that facilitate the flow of funds.

• Provide a preview of the course outline. Emphasize the linkages between the various sections of the

course.

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 intermediaries specialize in credit analysis so that they can make wise choices when offering loans.Surplus units will continue to provide funds to financial intermediaries rather than make direct loans, because they are not capable of credit analysis, even if more information about prospective borrowers is available. Some financial intermediaries no longer have physical buildings for customer service, but they still require agents who have the expertise to assess the creditworthiness of prospective borrowers.

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 brokerage firms, because individuals can make transactions on their own (if they prefer to do so).However, loans will still require financial intermediaries because of the credit assessment that is needed.

Questions

• 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 the financial markets. Surplus units include households with savings, while deficit units include firms or government agencies that borrow funds.

This exercise allows students to realize that they constantly interact with financial institutions, and that they often play the role of a deficit unit (on car loans, tuition loans, etc.). 2 / 4

Chapter 1: Role of Financial Markets and Institutions ❖ 3

© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

• 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 used for the trading of existing securities.

Money markets facilitate the trading of short-term (money market) instruments while capital markets facilitate the trading of long-term (capital market) instruments.

• 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 securities could be unbundled into any size desired. In reality, markets are imperfect, so that surplus and deficit units do not have free access to information, and securities cannot be unbundled as desired.

Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficit units. They have the information to provide this service and can even repackage deposits to provide the amount of funds that borrowers desire.

• 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 capitalize on the discrepancy between what prices are and what they should be. This action would force market prices to represent the appropriate prices as perceived by the market.

Efficiency is often defined with regard to publicly available information. In this case, markets can be efficient, but investors with inside information could possibly outperform the market on a consistent basis. A stronger version of efficiency would hypothesize that even access to inside information will not consistently outperform the market.

• 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 information on publicly offered securities and prevent fraudulent practices when selling these securities.The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It also declared a variety of deceptive practices illegal but does not prevent poor investments.

• 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 expertise. Commercial banks, insurance companies, and securities firms have expanded through international mergers. An international merger between financial institutions enables 3 / 4

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© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.the merged company to offer the services of both entities to its entire customer base.

• 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 price of a stock at a future point in time. Investors often rely on financial statements by firms in order to assess how stock prices might change in the future. In particular, investors rely on accounting reports of a firm’s revenue, expenses, and earnings as a basis for estimating its future cash flows. Firms with publicly traded stock are required to disclose financial information and financial statements.

• 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 either enhances a borrower’s ability to borrow funds or an investor’s ability to invest funds.

Brokers are commonly compensated with commissions on trades, while dealers are compensated on their positions in particular securities. Some dealers also provide brokerage services.

• 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 they were positioned to capitalize on the expected growth in this market. Many investors wanted to benefit from this potential growth and quickly purchased the stocks of companies in the industry. However, some investors did not carefully check the business plan, operations, or financial condition of these companies. Consequently, the strong demand by investors for stocks of marijuana companies without much experience caused their stock prices to increase dramatically, only to crash upon a closer review.

• 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 secondary market. The excessive documentation on commercial loans limits a bank’s ability to sell loans in the secondary market.

• Depository Institutions. Explain the primary use of funds for commercial banks versus savings

institutions.

ANSWER: Savings institutions have traditionally concentrated in mortgage lending, while commercial banks have concentrated in commercial lending. Savings institutions are now allowed to diversify their asset portfolio to a greater degree and will likely increase their concentration in commercial loans (but not to the same degree as commercial banks).

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