Direct finance and Indirect finance

Internationalization of Financial Markets

• Foreign Bonds—sold in a foreign country and denominated in that country’s currency
• Foreign bonds may be used to avoid exchange-rate risk
• Eurobond—bond denominated in a currency other than that of the country in which it is sold
• Eurocurrencies—foreign currencies deposited in banks outside the home country
• Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets
• London, Tokyo and other foreign stock exchanges have grown in importance

Function of Financial Intermediaries: Indirect Finance

• Lower transaction costs
• Economies of scale
• Liquidity services
• Reduce Risk
• Risk Sharing (Asset Transformation)
• Diversification
• Asymmetric Information
• Adverse Selection (before the transaction)—more likely to select risky borrower
• Moral Hazard (after the transaction)—less likely borrower will repay loan

Function of Financial Intermediaries: Indirect Finance

• Adverse Selection: Individuals who are willing to accept a financial (or other) contract are of lower “quality” than a typical individual in the population
• 1. Before transaction occurs
• 2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
• Moral Hazard: The existence of a contract causes one party to alter their behavior in a manner detrimental to the other party
• 1. After transaction occurs
• 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
• Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

Types of financial intermediaries

• Depository institutions
• Commercial banks
• Savings and Loan Associations
• Mutual savings banks
• Credit unions
• Contractual savings institutions
• Life insurance companies
• Fire and casualty insurance companies
• Pension funds and government retirement funds
• Investment intermediaries
• Finance companies
• Mutual funds
• Money market mutual funds
• Investment banks