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Chapter 2: Q. 10 (page 97)

How does risk sharing benefit both financial intermediaries and private investors?

Short Answer

Expert verified

The private investors and intermediaries are likely to invest in more diversified way.

Step by step solution

01

Step 1. Introduction

A financial intermediary, such as a commercial bank, investment bank, mutual fund, or pension fund, acts as a go-between for two parties in a financial transaction.

02

Step 2. Explanation

Private investors can decrease their dangers through risk-sharing and diversification of portfolios. It reduces the risk exposure and they can invest in a more diverse portfolio that consists of both high-risk as well as low-risk assets.

Through risk-sharing financial intermediaries can spread the returns they earn on high-risk assets and return from low-risk assets. they can carry risks at a low transaction cost and earn from a diversified portfolio of assets.

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Most popular questions from this chapter

Some economists suspect that one of the reasons economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense?

Give at least three examples of a situation in which financial markets allow consumers to better time their purchases.

Why would a life insurance company be concerned about the financial stability of major corporations or the health of the housing market?

Suppose you have just inherited \(10,400 and are considering the following options for investing the money to maximize your return:

Option 1: Put the money in an interest-bearing checking account that earns 3%. The FDIC insures the account against bank failure.

Option 2: Invest the money in a corporate bond with a stated return of 6%, although there is a 10% chance the company could go bankrupt.

Option 3: Loan the money to one of your friend’s roommates, Ayesha, at an agreed-upon interest rate of 7%, but you believe there is a 7% chance that she will leave town without repaying you.

Option 4: Hold the money in cash and earn zero return.

a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event and then add them up.)

b. Assume that Option 3 and Option 4 are your only choices. If you could pay your friend \)50 to find out extra information about Ayesha that would indicate with certainty whether she will leave town without paying, would you pay the $50? What does this say about the value of better information regarding risk?

Describe who issues each of the following money market instruments:

a. Treasury bills

b. Certificates of deposit

c. Commercial paper

d. Repurchase agreement

e. Fed funds
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