Question

Question 1 (25 marks / Financial Systems)

1. (a) What are the five functions of a financial market?

2. (b) Usually, basic financial markets have five basic functions in a capitalistic economy:

   For each of the functions cited below, explain how financial markets perform each function in detail.

   1. They make it possible for corporations and governmental units to raise capital.

   2. They help to allocate capital toward productive uses.

   3. They provide an opportunity for people to increase their savings by investing in them.

   4. They reveal investors’ judgments about the potential earning capacity of corporations, thus

giving guidance to corporate managers. 5. They generate employment and income.

(c) Explain what is meant by asymmetric information.

(d) Explainwhethereachofthefollowingsituationinvolvesadverseselectionandmoralhazardor not:

1. i) I am financing a new car. In applying for a loan, I withhold information about my student loan, and the loan does not show up on my credit report. (2.5 marks)

2. ii) Just before quitting my job, I take out all the credit cards I can. I plan to run them up to the5 limit and declare bankruptcy. (2.5 marks)

3. iii) I take out a loan to manufacture a product. My costs end up being higher than expected, and there seems to be little market for my product. I am unable to repay the loan on time.

Answer 1

(a) Financial market is a place where that provides platform to the traders to buy and sell financial securities and instruments and also several other assets and commodity such as shares, bonds, options, futures etc. Financial market performs several functions that are as follows:

1. Mobilization of savings:Financial market helps in connecting those with money with those who needs money.It make sure that the capital of the economy does not left idle and it is put towards productive use.
2. Price Determinations: The interaction between these two participants and other market forces helps to determine the price in the market.
3. Ensures liquidity: It means that investors can easily sell those assets and covert them into cash whenever they want .Financial market provide high liquidity.
4. Saves time and money: Financial market is economical and also time saving as investor can easily find the opponent.
5. Capital formation: Financial market leads to formation of the capital of the country by mobilising the savings of persons in productive use.

(b) Five basic functions of the capitalistic economy are as follows:

(i) They make it possible for corporations and governmental units to raise capital- Financial market provide channel through which the new savings of the investors flow in th country which aid in the capital formation of the country.This function therefore helps the corporations and government to raise capital and put them in productive uses.

(ii)They help to allocate capital toward productive uses- Financial markets helps in mobilization of the savings of the investors to the productive uses for the growth of the country.The person who has excess amount they invest there amount in the market and those who nees the amount they borrow from the market this is how funds flows from investors to the prospective buyers.

(iii)They provide an opportunity for people to increase their savings by investing in them- Yes ofcourse by saving they increase their savings because they earn the interest and return on the investments made by them.So the return is the motivating factor that people invest in market and thereby their savings also get increased.

(iv)They reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers- Financial market is very transparent market and therefore investor do the deep study before they put there amount in the market therefore by studying the market investor came to know about the earning capacity of corporations because ofcourse they will not put their money under risk.

(v)They generate employment and income- Financial markets allow lenders to earn interest and dividend on their surplus invissible funds thus contributing in individual and nation income.Also this market generate emploment in the various fields like brokers, financial managers etc.

(c) Asymmetric information is also called as information failure occurs when one party to an economic transaction possesses greater material knowledge than the other party.It means when one party has more better information than other for making particular decision or transaction.This information exist in the financial markets and gives the buyer and seller the opportunity to make profit from purchase or sell of securities or assets.This information is not synchronized.

(d) Moral hazard is a situation where one party involved in the risk and the other party will have to bear the cost.Adverse selection means when the seller have information that buyer does not have or vice versa.

In the given cases:

(i)I am financing a new car. In applying for a loan, I withhold information about my student loan, and the loan does not show up on my credit report- It is adverse selection because borrower being aware of the information hide it from the lender.

(ii)Just before quitting my job, I take out all the credit cards I can. I plan to run them up to the5 limit and declare bankruptcy- It is moral hazard because one party is involved in risk and take advantage of other and other will have to bear the risk.

(iii)I take out a loan to manufacture a product. My costs end up being higher than expected, and there seems to be little market for my product. I am unable to repay the loan on time-  It is also adverse selection .