6.Outline the six core functions performed by the financial system. Answer: The six core functions performed by the financial system are: 1.To provide ways of managing risk. 2.To provide ways to transfer economic resources through time,across borders,and among industries. 3.To provide ways of clearing and settling payment to facilitate trade. 4.To provide a mechanism for the pooling of resources and for the subdividing of shares in various enterprises. 5.To provide ways of dealing with the incentive problems created when one party to a transaction has information that the other party does not,or when one party acts as an agent for another. 6.To provide price information to help coordinate decentralized decision making in various sectors of the economy. 7.Outline the basic types of financial assets that are traded in the markets. Answer: Debt instruments-issued by anyone who borrows money-firms,government,and households Equity-the claim of the owners of a firm.Corporations who issue equity securities are issuing common stock. Derivatives-such as options and futures contracts that derive their value from the prices of one or more other assets. 8.Describe how a banking panic can cause a"contagion"to set in the economy Answer: If there is a banking panic and if a bank does not have sufficient funds to pay off its depositors,then "contagion"can set in,and other banks are faced with a run.If there is a "flight to currency,then a contagion problem occurs for the banking system as a whole,and the people refuse to hold deposits of any bank and insist on having currency. 9. Discuss the rates of return and volatility of U.S.T-bills,U.S.Treasury bonds,and large stock over the period of 1926-2003. Answer: From a historical perspective,T-bills have proved to be the least risky asset class,whereas large stock has proved to be the most risky asset class. Large stocks (as measured in the S&P 500 stock portfolio)have provided an average rate of return of 12.25%between 1926 and 2003,whereas T-bills have provided an average rate of return of 3.79% and 5.64%for U.S.Treasury bonds. Large stock returns,with a standard deviation of 20.5%,have also been the most volatile asset class between 1926 and 2003.U.S.Treasury bonds had a standard deviation of 8.19%over the same period and U.S.bills have been the least volatile asset class,with a standard deviation of 3.18%. 2-202-20 6. Outline the six core functions performed by the financial system. Answer: The six core functions performed by the financial system are: 1. To provide ways of managing risk. 2. To provide ways to transfer economic resources through time, across borders, and among industries. 3. To provide ways of clearing and settling payment to facilitate trade. 4. To provide a mechanism for the pooling of resources and for the subdividing of shares in various enterprises. 5. To provide ways of dealing with the incentive problems created when one party to a transaction has information that the other party does not, or when one party acts as an agent for another. 6. To provide price information to help coordinate decentralized decision making in various sectors of the economy. 7. Outline the basic types of financial assets that are traded in the markets. Answer: Debt instruments – issued by anyone who borrows money – firms, government, and households. Equity – the claim of the owners of a firm. Corporations who issue equity securities are issuing common stock. Derivatives – such as options and futures contracts that derive their value from the prices of one or more other assets. 8. Describe how a banking panic can cause a “contagion” to set in the economy. Answer: If there is a banking panic and if a bank does not have sufficient funds to pay off its depositors, then “contagion” can set in, and other banks are faced with a run. If there is a “flight to currency,” then a contagion problem occurs for the banking system as a whole, and the people refuse to hold deposits of any bank and insist on having currency. 9. Discuss the rates of return and volatility of U.S. T-bills, U.S. Treasury bonds, and large stock over the period of 1926-2003. Answer: From a historical perspective, T-bills have proved to be the least risky asset class, whereas large stock has proved to be the most risky asset class. Large stocks (as measured in the S&P 500 stock portfolio) have provided an average rate of return of 12.25% between 1926 and 2003, whereas T-bills have provided an average rate of return of 3.79% and 5.64% for U.S. Treasury bonds. Large stock returns, with a standard deviation of 20.5%, have also been the most volatile asset class between 1926 and 2003. U.S. Treasury bonds had a standard deviation of 8.19% over the same period and U.S. bills have been the least volatile asset class, with a standard deviation of 3.18%