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121 Midterm 1

121 Midterm 1 - Topic 1 Financial Markets Function to...

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Topic 1 Financial Markets Function to channel funds from the people who have saved surplus funds to people with a shortage of funds. Allow people who have spent less than their income to grow their savings. Allow people with growth opportunities, which lack internal capital sources, to expand. Flow of Funds Functions of Financial Markets 1. Aggregate and centralize buyers and sellers of financial assets to facilitate price formation. Facilitates competition amongst sellers and pools savings from buyers. 2. Provides a mechanism for investors to sell a financial asset. 3. Reduction of search and information costs of transacting in financial assets. Prices reflect the aggregate information collected by market participants. Information costs are incurred in assessing the value or investment merits of an asset. Search costs may be explicit such as advertising costs or implicit such as the time spent locating a counterparty. Ultimately reduces information asymmetries 4. Create small denomination or aggregated instruments (i.e. shares in a company). Without these instruments households could not invest in firms without buying and selling the entire firm
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Allows investors to hold a diversified portfolio at low cost and low minimum investment requirements Can aggregate and restructure asset attributes such as liquidity or holding period The Role of Financial Intermediaries 1. Liquidity Provision and Economies of Scale Expertise and size of intermediaries allows them to complete transactions at a lower cost Provide liquidity services such as providing chequing accounts for ease of paying bills or credit cards for ease of purchase 2. Mitigation of Adverse Selection Costs Information asymmetries arise between borrowers and lenders, managers of the firm know more about the firm’s prospects than investors A firm’s prospects is communicated to investors via financial statements, media releases and other commentary Ability to interpret and evaluate firm communications varies across investors Uniformed investors may elect not to invest due to adverse selection costs or may misallocate savings at an inappropriate price Financial intermediaries, with greater expertise in analyzing financial information, can act on behalf of investors providing advice or managing savings on behalf of investors (example: mutual funds). 3. Mitigation of Moral Hazard Moral hazard problems arise due to information asymmetries after the investment is made. Payoffs between firm managers and investors may not always align. Both clearly gain from strong performance by the firm but firm managers may also seek personal payoffs that do not equally benefit investors (example: flying first class as opposed to economy on business trips). Monitoring the actions of managers is time consuming and costly.
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121 Midterm 1 - Topic 1 Financial Markets Function to...

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