If they are using MRS.=price ratio, same scheme 2. For this question, you will either have to provide a definition or carefully explain your answer. In both cases, please keep your answer concise and clear. (i) if 0, that is there are 10 goods, what is the probability of a successful exchange in a barter economy and in a monetary economy. [1 marks] In a BE, it is J 21 = 100-10= -2 Nina ME, twist-1 – 9 0. 5 mark for each 90 (ii) Carefully explain what functions a financial asset provide to society [2 marks] Financial assets provide two important economic functions. The first is risk- sharing.

Financial assets allow risks to be spread among different parties instead of one party bearing all the risks. The second is to transfer funds from entities who have surplus funds to invest to those who need funds to invest in tangible assets. (iii) What do the terms adverse selection, moral hazard and costly state verification mean? Provide an example within the context of a financial transaction/market [4 marks] Adverse selection and moral hazard are two market failures that arise in the credit market. Financial transactions are intrinsically characterized by asymmetric information.

Borrowers generally have private information that is more accurate than the information possessed by lenders nice they can more easily assess their own risks compared to the lender. Lenders can try to protect themselves from bad borrowers (“lemons”) by setting the contractual terms in a manner that reflects the average quality of their loan applicants. However, by doing so, they run the risk that high risk borrowers will be encouraged to self-select into their loan applicant pool while at the same time low risk borrowers will be encouraged to self-select out of this pool.

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The resulting adverse effects on the quality of their loan applicant pool constitutes an example of adverse selection. Moral hazard arise in credit markets because borrowers may decide to engage in riskier projects once its demand for a loan has been approved. Once their project/loan is approved, borrowers may have a bigger incentive to engage in riskier investment projects with higher returns since they stand to lose the same if the project fails but stand to gain more if the project succeeds.

This problem is exacerbated with higher interest rates. Costly enforcement of contracts arise because it takes resources to monitor borrowers to ensure that the amount borrowed is repaid back at the end of the interact. For example, someone borrows money from a financial institution. The financial institution in turn has to monitor the borrower and make sure that the latter is paying back her loan. 1. 5 marks for adverse selection and 1. 5 for moral hazard and 1 for costly enforcement. Cake sure they write a sensible answer, otherwise don’t give them the marks. (iv) “Financial intermediaries provide an essential maturity and liquidity transformation service”. In your own words, carefully explain what this statement means. [3 marks] Financial intermediaries do not only pool savings but hey also engage in maturity and liquidity transformation. The proceeds banks receive from depositors (savings) are used to grant loans to 3 other economic agents (households, firms, government).

The deposits represent financial claims that the financial intermediary issues (secondary securities) whereas the loans represent the financial claims that the financial intermediary purchases and owns (primary securities). Most of the secondary securities (savings) are highly liquid and can be withdrawn at any time. They have short maturity. On the other hand, primary securities (loans) are very illiquid and eve long maturity. There is thus a maturity and liquidity mismatch between these primary and secondary securities.

Financial intermediaries by providing this maturity and liquidity transformation provide an important device as they provide savers the ability to withdraw their funds at any point in time while providing borrowers long with much longer duration. Financial intermediaries can provide this maturity and liquidity transformation only if a portion of savers withdraw their funds in the short-run and only if savers are confident that the will be able to withdraw their funds when needed. What is important in the answer is that they explain maturity and liquidity.

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