Chapter 1

Role of Financial Markets and Institutions

Specific Objectives

Describe the types of financial markets that accommodate various transactions

Describe the role of financial institutions within financial markets
Introduce the concept of security valuation within financial markets
Identify the types of financial institutions that facilitate transactions in financial markets

Key Terms Matching

In the following exercise, place a letter from the right column with the correct number in the left
column.

Key Term Definition

____ 1. Bid-ask spread
____ 2. Bonds
____ 3. Broker
____ 4. Capital market
____ 5. Dealer
____ 6. Derivative securities
____ 7. Financial market
____ 8. Liquidity
____ 9. Money market
____ 10. Money market
mutual fund
____ 11. Organized exchange
____ 12. Over-the-counter
(OTC) market
____ 13. Perfect market
____ 14. Primary market
____ 15. Privatization
____ 16. Secondary market
____ 17. Stocks
a. the sale of government-owned firms to individuals
b. the fee charged by a broker
c. financial contracts whose values are derived from the values
of underlying assets
d. a visible marketplace for secondary market transactions
e. a person making a market in specific securities by adjusting
his inventory of securities
f. a telecommunications network facilitating financial market
transactions
g. a person or institution executing securities transactions
between two parties
h. a mutual fund concentrating in money market securities
i. long-term debt obligations issued by corporations and
government agencies to support their operations
j. a market that facilitates the issuance of new securities
k. a market that facilitates the trading of existing securities
l. a market that facilitates the flow of short-term funds with
maturities of less than one year
m. a market that facilitates the flow of long-term funds
n. a market in which financial assets (securities) can be bought
or sold
o. the degree to which securities can easily be sold without a
loss of value
p. a market in which all information about any securities for
sale in primary and secondary markets is continuously and
freely available to investors
q. certificates representing partial ownership in a firm

1
 Definitional Problems

1. Financial market participants that provide funds are called ________________, while
participants that need to obtain funds are called __________________.

2. A market in which financial assets (securities) such as stocks and bonds can be purchased or
sold is a(n) ____________ market.

3. ________________ securities are securities with maturities of more than one year;
________________ securities are securities with maturities of one year or less.

4. In general, money market securities have a higher degree of _____________ than capital
market securities.

5. A market in which existing securities are traded is called a _____________ market, while a
market that facilitates the issuance of new securities is called a ______________ market.

6. Two primary uses of derivative securities are ___________ and __________.

7. A visible marketplace for secondary market transactions is known as a(n) _______________.

8. The _________________ is an example of an organized exchange.

9. The _________________ is an example of the over-the-counter (OTC) market.

10. The ______________ market facilitates the exchange of currencies.

11. __________ are long-term debt obligations issued by corporations and government agencies
to support their operations.

12. Long-term debt securities tend to have a higher expected return than money market securities,
but they have ____________ risk as well.

13. Derivative securities are ___________ whose values are derived from the values of
underlying assets.

14. When particular securities are perceived to be overvalued by the market, their prices
____________ as these securities are sold.

15. The valuation of a security is measured as the _________ of its expected cash flows.

16. When security prices fully reflect all available information, the market for these securities is
said to be _______________.

17. The sale of government-owned firms to individuals is commonly referred to as

_________________.

18. If buyers and sellers do not have full access to information and cannot always break down
securities to the precise size they desire, the markets for these securities are ____________.
 Chapter 1/Role of Financial Markets and Institutions 3

19. Savings institutions, sometimes also referred to as ______ institutions, are a type of
depository financial institution.

20. The fee charged by a(n) ________ is reflected in the difference between her bid and ask
quotes.

21. In addition to brokerage services, securities firms often act as _____________, making a
market in specific securities by adjusting their inventory of securities.

22. Many of the transactions between financial institutions and deficit units are executed by
______________________.

23. In recent years, financial institutions have consolidated to capitalize on both

______________________ and ______________________.

24. The introduction of the _______, a single European currency, has reduced concerns about
exchange rate risk for European firms.

True/False Problems

____ 1. A financial market is a market in which financial assets can be purchased or sold.

____ 2. The federal government commonly acts as a surplus unit.

____ 3. Households are the main providers of funds.

____ 4. Those financial markets that facilitate the flow of short-term funds (with maturities of
less than one year) are known as capital markets, while those that facilitate the flow of
long-term funds are known as money markets.

____ 5. Primary markets facilitate the trading of existing securities.

____ 6. An organized exchange is a telecommunications network.

____ 7. Bonds are long-term debt obligations issued by corporations and government agencies
to support their operations.

____ 8. Long-term debt securities tend to have lower risk but a higher return than money
market securities.

____ 9. Derivative securities are financial contracts whose values are derived from the values
of underlying assets.

____ 10. While all investors rely on valuation to make investment decisions, they derive
different valuations of a security based on the existing set of information.

____ 11. Since markets are efficient, institutional and individual investors should ignore the
various investment instruments available.
4 Chapter 1/Role of Financial Markets and Institutions

____ 12. Speculating with derivative contracts on an underlying asset typically results in both
higher risk and higher returns than speculating in the underlying asset itself.

____ 13. The Internet expedites the adjustment in security prices to new information.

____ 14. When security prices fully reflect all available information, the markets for these
securities are said to be perfect.

____ 15. Securities that are not as safe and liquid as other securities are never considered for
investment by anyone.

____ 16. By requiring full disclosure of information, securities laws prevent investors from
making poor investment decisions.

____ 17. When financial information is fully disclosed, the asymmetric information problem is
completely eliminated.

____ 18. Circuit breakers are used to temporarily halt the trading of some securities or contracts
in order to reduce market volatility.

____ 19. Even with regulatory oversight, there continue to be cases in which some investors
have an unfair advantage over others because they have better access to information.

____ 20. An efficient financial market is one in which all information about any securities for
sale in primary and secondary markets is continuously and freely available to investors.

____ 21. If markets are imperfect, securities buyers and sellers to not have full access to
information and cannot always break down securities to the precise size they desire.

____ 22. When a depository institutions offers a loan, it is acting as a creditor.

____ 23. Savings institutions are the most dominant financial institution.

____ 24. While commercial banks concentrate on commercial loans, credit unions have
concentrated on residential mortgage loans.

____ 25. Most mutual funds obtain funds by issuing securities, then lend the funds to individuals
and small businesses.

____ 26. A broker executes securities transactions between two parties and charges a fee
reflected in the bid-ask spread.

____ 27. Many corporations and government agencies offer their employees pension plans that
are entirely funded by the employer.

____ 28. Economies of scope represent a reduction in the average cost per unit due to increased
volume.

____ 29. Among others, deficit units receive funding from insurance companies and pension
funds.
 Chapter 1/Role of Financial Markets and Institutions 5

____ 30. Many of the transactions between financial institutions and deficit units are executed by
securities firms.

____ 31. Institutional investors not only provide financial support to companies but exercise
some degree of corporate control over them.

____ 32. In recent years, financial institutions have consolidated to capitalize on economies of
scale and on economies of scope.

____ 33. The euro increased business between European countries and created a less competitive
environment in Europe.

____ 34. Many financial institutions engage in international mergers so that they can serve
clients throughout Europe and provide a wider variety of services.

Multiple Choice Problems

1. According to your text, which of the following are not main participants in financial market
transactions?
a. households
b. financial institutions
c. governments
d. businesses
e. all of the above are main participants in financial market transactions

2. Financial markets
a. facilitate the flow of funds from deficit to surplus units.
b. facilitate the flow of funds from surplus to deficit units.
c. are markets in which financial assets such as stocks and bonds can be purchased and sold.
d. None of the above are true.
e. Only answers b and c are correct.

3. Financial markets facilitating the flow of short-term funds with maturities of less than one
year are known as
a. money markets.
b. capital markets.
c. primary markets.
d. secondary markets.
e. none of the above.

4. Financial markets facilitating the trading of existing securities are known as

a. money markets.
b. capital markets.
c. primary markets.
d. secondary markets.
e. none of the above.
6 Chapter 1/Role of Financial Markets and Institutions

5. Which of the following is not an organized exchange?

a. New York Stock Exchange
b. American Stock Exchange
c. Nasdaq
d. All of the above are organized exchanges.

6. Which of the following transactions would not be considered a secondary market transaction?
a. An individual investor purchases some existing shares of IBM stock through his broker.
b. An institutional investor sells some Disney stock through his broker.
c. Microsoft issues new shares of common stock using its investment bank.
d. All of the above would occur in the secondary market.

7. According to your text, which of the following is not considered a money market security?
a. Treasury bills
b. Treasury notes
c. retail CD
d. bankers acceptance
e. commercial paper

8. ________________ are not considered capital market securities.

a. Repurchase agreements
b. Municipal bonds
c. Corporate bonds
d. Equity securities
e. Mortgages

9. ____________ are long-term debt obligations issued by corporations and government

agencies to support their operations.
a. Common stock
b. Derivative securities
c. Bonds
d. None of the above

10. Long-term debt securities tend to have a ___________ expected return and _________ risk
than money market securities.
a. lower; lower
b. lower; higher
c. higher; lower
d. higher; higher

11. If investors speculate in derivative contracts rather than the underlying asset, they will
probably achieve ____________ returns, and they are exposed to relatively ___________
risk.
a. lower; lower
b. lower; higher
c. higher; lower
d. higher; higher
 Chapter 1/Role of Financial Markets and Institutions 7

12. When security prices fully reflect all available information, the markets for these securities
are said to be
a. inefficient.
b. efficient.
c. perfect.
d. imperfect.
e. none of the above.

13. When particular securities are perceived to be ______________ by the market, their prices
decrease when they are sold by investors.
a. undervalued
b. overvalued
c. fairly priced
d. efficient
e. none of the above

14. Which of the following statements is incorrect?

a. Much of the information used to value securities issued by firms is provided by the
managers of those firms.
b. A firms managers possess information about its financial condition that is not necessarily
available to investors.
c. Even when information is disclosed, an asymmetric information problem may still exist.
d. The financial statements of firms with closely-held stock must be audited once a year by
certified public accountants.

15. According to your text, the most pronounced changes in international integration have
occurred in
a. Latin America.
b. Asia.
c. Europe.
d. Africa.

16. If financial markets were _____________, all information about any securities for sale in
primary and secondary markets would be continuously and freely available to investors.
a. inefficient
b. efficient
c. perfect
d. imperfect
e. none of the above

17. Which of the following is not a reason why depository institutions are popular financial
institutions, according to your text?
a. They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
b. They repackage funds received from deposits to provide loans of the size and maturity
desired by deficit units.
c. They accept the risk on loans provided.
d. They have more expertise than individual deficit units in evaluating the creditworthiness
of surplus units.
e. All of the above are reasons why depository institutions are popular financial institutions.
8 Chapter 1/Role of Financial Markets and Institutions

18. Which of the following are not considered depository financial institutions?
a. finance companies
b. commercial banks
c. savings institutions
d. credit unions
e. All of the above are depository financial institutions.

19. According to your text, credit unions differ from commercial banks and savings institutions
because they
a. are profit-oriented.
b. concentrate on residential mortgage loans.
c. restrict their business to credit union members.
d. are larger than commercial banks and savings institutions.

20. Which of the following are considered depository financial institutions?

a. credit unions
b. mutual funds
c. securities firms
d. pension funds

21. Securities firms

a. sometimes act as a broker.
b. provide investment banking services.
c. often act as a dealer.
d. sometimes provide advisory services.
e. all of the above.

22. Many corporations offer their employees pension plans in which funds are periodically
contributed by
a. the employers.
b. the employees.
c. both employers and employees.
d. the U.S. government.
e. Answers a, b, and c can be correct.

23. _________________ maintain a larger amount of assets than the other types of depository
institutions.
a. Finance companies
b. Commercial banks
c. Life insurance companies
d. Savings institutions
e. Credit unions

24. ________________ accept deposits from households, businesses, and government agencies
and purchase government and corporate securities.
a. Commercial banks
b. Savings institutions
c. Finance companies
d. Money market funds
e. Answers a and b are correct.
 Chapter 1/Role of Financial Markets and Institutions 9

25. The main source of funds for ________________ is proceeds from selling securities to
households and businesses, while their main use of funds is providing loans to households
and businesses.
a. savings institutions
b. commercial banks
c. mutual funds
d. finance companies
e. pension funds

26. According to your text, which of the following is not a financial service provided by
Citigroup?
a. commercial loans
b. advisory services for corporations planning to restructure
c. consumer loans
d. credit cards
e. All of the above are financial services provided by Citigroup.

27. Which of the following is not a reason why depository financial institutions are popular?
a. They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
b. They repackage funds received from deposits to provide loans of the size and maturity
desired by deficit units.
c. They accept the risk on loans provided.
d. They use their information resources to act as a broker, executing securities transactions
between two parties.
e. They have more expertise than individual surplus units in evaluating the creditworthiness
of deficit units.

Answers to Key Terms Matching

1. b 10. h
2. i 11. d
3. g 12. f
4. m 13. p
5. e 14. j
6. c 15. a
7. n 16. k
8. o 17. q
9. l

Answers to Definitional Problems

1. surplus units; deficit units 8. New York Stock Exchange (NYSE)

2. financial 9. Nasdaq
3. capital market; money market 10. foreign exchange
4. liquidity 11. bonds
5. secondary; primary 12. more
6. speculation; risk management 13. financial contracts
7. organized exchange 14. decrease
10 Chapter 1/Role of Financial Markets and Institutions

15. present value 20. broker

16. efficient 21. dealers
17. privatization 22. securities firms
18. imperfect 23. economies of scale; economies of scope
19. thrift 24. euro

Answers to True/False Problems

1. T 18. T
2. F 19. T
3. T 20. F
4. F 21. T
5. F 22. T
6. F 23. F
7. T 24. F
8. F 25. F
9. T 26. T
10. T 27. F
11. F 28. F
12. T 29. T
13. T 30. T
14. F 31. F
15. F 32. T
16. F 33. F
17. F 34. T

Answers to Multiple Choice Problems

1. e 15. c
2. e 16. c
3. a 17. d
4. d 18. a
5. c 19. c
6. c 20. a
7. b 21. e
8. a 22. e
9. c 23. b
10. d 24. e
11. d 25. d
12. b 26. e
13. b 27. d
14. d