Question

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

(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) Explain whether each of the following situation involves adverse selection and moral hazard or not:

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)

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)

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

1. Financial Market is the major source of Capital for corporates and Govt units. Stock Market is the institution where the cmpanies those are listed can raise capital by issuing new shares in the market. The Financial institutions and banks provide debt capital, eith long term or working capital loan for debt funding of companies. Similarly corporates and Govt can issue Bonds for raising fuds and that is a very popular way of raising funds. So there are numerous ways in which Financial Markets provide capital for business.

2. Financial Market is a channel through which the productive use of capital takes place. In Financial Market those players can sustain who have good potential to perform well and have good financial track records. Financial institutions lend to those corporates having good ratings , similarly shares and bonds issues in exchange markets get godd sustainable price in primary and secondary market only when the issuing company performs well. In order to be successful in getting capital from financial market , a company needs to use the capital inan efficient way and perform well .

3.People invest in financial market in many ways. They can trade in exchanges, buy mutual funds , shares and bonds . People also put their savings in Banks and Financial Institutes. People chose the investment option based on their risk apetite and the growth they want. If people can chose the investment options correctly , they can get good returns from financial market.

4. The price of shares and bonds of corporations are guided by past performance of the company and also based on the future performance potential of the company. Investors consider many economic , social and technological factors to evaluate the price of stocks and bonds and that reflect the sentiment of the market . Similarly the debt interest also depends on the credibility and performance of the company .Therefore coprporate managers can get guidance on the way to proceed in mamanging the company and its returns from the clues received from financial market .

5. Financial market definitely generates a huge number of employments and income. The stock market, Financial Institutions, Banks , The regulatory bodies, Central bank etc are part of the financial market eco-system and all employe an huge number of people in various roles.

c) Asymmetric information occurs when on party involved in an economic transaction has some crucial information that the other party does not have . In the case of asymmetric information , the party not having full crucial information is always at risk.

d)

i) I am am withholding my student loan information for getting car loan , this is adverse selection as the car loan provider does not have full information about my financial status. The loan may be very risky and be suject to default causing a high cost to the lender.

ii) My action of taking all possible credit cards before quitting job and later using the cards upto limit and declare bankruptcy is moral hazard. I am withholding information to get the card an later changing behaviour to get unwanted benefit .

iii) This is not adverse selection or moral hazard. Here no information were hidded before loan or no change in behaviour happened after loan. This is genuine business failue due to higher than expected product cost and lower than expected sales. This can happen to any genuine business.