TUTORIAL FOR FINANCIAL MARKETS & INSTITUTIONS

An Economic Analysis of Financial Structure

1. The presence of adverse selection problem keeps bond and stock markets from
effectively channelling funds from savers to borrowers. What does statement mean?
Explain briefly.

Adverse selection: is asymmetric information before the transaction takesplace.

This statement means that

- In stock markets, adverse selection happens when high and low quality stocks are difficult
to distinguish. This will discourage lenders to enter the markets because they do not
know whether a stock has high profit potential or high risk.

- In bond markets, adverse selection happens when default risk is significant because separate
credit-worthy borrowers from non-credit worthy borrowers is difficult. Adverse selection in
financial markets occurs when the potential borrowers who are the most likely to produce an
undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek
out a loan and are thus most likely to be selected. A firm may know that its true default
risk is higher or lower than the public thinks and because adverse selection makes it
more likely that loans might be made to bad credit risks, lenders may decide not to
make any loans even though there are good credit risks in the market place.

2. Why do large corporations find it easier to raise funds in securities markets while small
businesses rely mostly on bank loans?

It is one of eight basic facts that only large, well-established corporations have access to
direct finance, which means large corporations often raise funds by issuing securities while
small businesses often take out bank loans. This is because of adverse selection lenders
lack the information needed to verify the quality of small newly-established businesses.
Moreover, financial intermediaries such as banks have an easier time ensuring accurate
complete information disclosure and banks can monitor the company activities hence
the reduction or elimination of adverse selection problems. In contrast, large well-
established firms make lenders more confidentabout their quality.

3. Would each of the following events increase or decrease the volume of bank loans?
Explain:

a. Newly regulations make it easier for shareholders to replace company directors.

Moral hazard problems are reduced. Stocks are more attractive to investors fewer
companies require bank loans for financing. Therefore, the volume of banks loans will
decrease
 b. A new law makes it a crime to default on a bank loan.

Less business will take loans to finance investment. People will take out more bonds and
the value of bank loans will decrease

c. All the economy’s small firms are bought by large firms.

Because the small firms cannot gain trust from investors so small firms require more
bank loans the decrease in small firms also decreases the bank loans.

d. Mutual funds reduce their minimum balances for shareholders.

Decreasing the balance for shareholders, causes small investors to buy shares in mutual
funds and not the bank, therefore the volume bank loans will decrease.

4. Suppose you have $1000 to lend and offer it for 10-percent interest. Someone promises to
pay 20 percent if you lend to him. Should you jump at this offer?

No I shouldn’t jump at this offer, because I didn’t have enough information about his earning
and the ability to pay off the loan. Moreover, 20% interest has very high default risk

5. Suppose I am a good borrower. I need $10,000 to invest in a project that will pay a safe
6% rate of return next year. Suppose my neighbour is a bad borrower, his $10,000
project has very low chance of success but the expected rate of return is 20%. The local
bank charges 10% interest rate on all its loans.
a. Will I be willing to borrow at this rate? Will my neighbour be willing to borrow
at this rate?

I unwilling because the bank changes 10%, which is much i=higher than my rate of
return, meanwhile my neighbour be willing to borrow because his rate of return is
higher than the bank loans

b. Assume all potential borrowers are either like me or like my neighbour. Explain
why the bank will end up issuing no loans and no projects will be funded.

Adverse selection happens when default risk is significant because separate credit-
worthy borrowers from non-credit worthy borrowers is difficult. Adverse selection in
financial markets occurs when the potential borrowers who are the most likely to
produce an undesirable (adverse) outcome—the bad credit risks—are the ones who
most actively seek out a loan and are thus most likely to be selected. Because
adverse selection makes it more likely that loans might be made to bad credit
 risks, lenders may decide not to make any loans even though there are good
credit risks in the market place.

c. How could the bank reduce with this adverse selection problem?

Bank will have to require collateral from the borrower to reduce the adverse selection
problem

6. What kind of moral hazard problems do banks worry about?

Moral hazard for lenders: undesirable behavior, default risk, lack of information. Some
measures to prevent moral hazard are monitoring the borrowers’ activities and restricting
risky behavior, requiring collateral, periodic auditing of the borrowers, etc.

7. Suppose all you can eat buffet costs $10. The buffet discovers that most of its customers
are sumo fighters. Is this a problem of adverse selection or moral hazard for the
restaurant? Explain.

This is a problem of both adverse selection and moral hazard for the restaurant. Adverse
selection happens because the restaurant did not know in advance that most of its customers
would be sumo fighters while they charged only $10 for average customer. Moral hazard
happens because the restaurant cannot know whether the sumo fighter will eat buffet within
the cost of $10 or more. In other words, the restaurant cannot know they will gain profit or
get loss

8. Why might you be willing to make a loan to your neighbour by putting funds in a savings
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?

We will avoid the asymmetric information. Bank is one of the financial institutions that
prevent the lender from risk of borrower’s default. In other words, we will not lose our
money when lending our neighbor funds through the bank’s system. The bank will help us to
monitor the loans and get the collateral from the borrower when she is not able to pay her
debt. We also save an amount of money in legal fees, fees for a credit check, and so on and
always receive the payment at the interval terms
Non-bank institutions

9. Why do property and casualty insurance companies have large holdings of municipal
bonds but life insurance companies do not?

10. Life insurance companies tend to invest in long-term assets such as loans to
manufacturing firms to build factories or to real estate developers to build shopping malls
and skyscrapers. Automobile insurers tend to invest in short-term assets such as Treasury
bills. What accounts for these differences?

11. List three types of financial intermediaries, give examples.

12. What explains the widespread use of deductibles in insurance policies?

13. Why might insurance companies restrict the amount of insurance a policyholder can buy?

14. Explain why shares in closed-end mutual funds typically sell for less than the market
value of the stocks they hold.

15. Will finance companies be replaced by commercial banks?

16. “Closed end funds tend to hold stocks that are less liquid than stocks held by open end
funds”. Comment on this.

17. Is investment banking a good career for someone who is afraid of taking risks? Why or
why not?

18. Should financial institutions be regulated in order to reduce their risk? Offer at least one
argument for regulation and one argument against regulation.

19. When a securities firm serves as an underwriter for an IPO, is the firm working for the
issuer or the institutional investors that may purchase shares? Explain the dilemma.