Tutorial 02 (Questions & Answers)

FINANCIAL MA MARKETS & INSTITUTIONS

LECTURE 2: 2: TH THE IM IMPORTANCE OF OF FI FINANCIAL IN INSTITUTIONS   TUTORIAL 2 

1.

How can econom economies ies of scale scale help explain explain the the existence existence of financia financiall intermediar intermediaries? ies? Financial intermediaries can take advantage of economies of scale and thus lower transaction costs. For  example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks’ large scale allows them to keep legal and computing costs  per transaction low. Economies of scale which help financial intermediaries lower transaction costs explains why financial intermediaries exist and are so important to the economy.

2.

Describe Describe two ways ways in which financial financial interme intermediarie diariess help lower transac transaction tion costs costs in the economy economy.. Financial intermediaries develop expertise in such areas as computer technology so that they can inexpensive inexpensively ly provide provide liquidity liquidity services such as checking checking accounts accounts that lower transaction transaction costs for  depositors. Financial intermediaries can also take advantage of economies of scale and engage in large transactions that have a lower cost per dollar of investment.

3.

Woul Would d mora morall haza hazard rd and and adve adverse rse select selectio ion n stil stilll aris arisee in fina financ ncia iall mar maret etss if infor informa matio tion n were were not not asymmetric? !xplain.  No. f the lender knows as much about the borrower as the borrower does, then the lender is able to screen out the good from the bad credit risks and so adverse selection will not be a problem. !imilarly, if  the lender knows what the borrower is up to, then moral ha"ard will not be a problem because the lender  can easily stop the borrower from engaging in moral ha"ard.

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Which Which firms are most most liely to use ban ban financi financin# n# rather rather than to issue issue bonds or stocs stocs to finance finance their  their  activities? Why?  !maller firms that th at are not well known are the most likely to use bank financing. !ince it is harder h arder for  investors investors to acquire acquire information information about these firms, it will be hard for the firms to sell securities securities in the  financial markets. #anks that speciali"e in collecting information about smaller firms will then be the only outlet these firms have for financing their activities.

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Would Would you be more willin# willin# to lend lend to a friend friend if she put put all of her her life savin#s savin#s into her her business business than than you would if she had not done so? Why? $es. $es. %he person who is putting her life savings into her business has more to lose if the business takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. !o she will  act more in the interest of the lender, making it more likely that the loan will be paid off.

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Why can the provisi provision on of several several types types of financial financial services services by one firm firm lead to to a lower cost cost of information information  production?  #ecause one information resource can be used in providing several services, thus lowering the cost for  each.

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FINANCIAL MARKETS & INSTITUTIONS

LECTURE 2: THE IMPORTANCE OF FINANCIAL INSTITUTIONS   TUTORIAL 2 

&.

How does the provision of several types of financial services by one firm lead to conflicts of interest? &onflicts of interest arise because higher profits might arise in providing one kind of service if the service provider misuses, provides false information, or conceals information when providing another  kind of service.

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How can conflicts of interest mae financial service firms less efficient? &onflicts of interest lead to a substantial reduction in the quality of information so that asymmetric information problems become worse, which prevents financial markets from channeling funds into  productive investment opportunities. %he result is that financial markets become less efficient.

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Describe two conflicts of interest that occur when underwritin# and research are provided by a sin#le investment firm. a.

'esearch analysts in investment banks might distort their research to please issuers of securities so underwriters in the investment bank can get their business.

b.

nvestment banks might engage in spinning, a form of kickback in which they allocate hot, but  underpriced, ()s to executives in return for their companies’ future business.

1). Describe two conflicts of interest that occur in accountin# firms. a.

&lients may be able to pressure auditors into skewing their opinions in order to get fees for other  accounting services.

b.

*uditors may be auditing information systems or structuring +tax and financial advice put in place by their non-audit counterparts within the firm, and thus may be reluctant to critici"e this advice or  systems.

c.

*uditors may provide overly favorable opinions in order to solicit or retain business.

Source: Question 1, 2, 3, 6, 8, 13, 14, 15, 16, 18 Financial Markets & Institutions, Mishkins, Eakins, 7 th Eition

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