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ECS3701 Assignment 2 (COMPLETE ANSWERS) Semester 2 2024
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ECS3701 Assignment 2(COMPLETE
ANSWERS) Semester 2
2024 (833935) - DUE 27
September 2024
, ECS3701 Assignment 2 (COMPLETE ANSWERS)
Semester 2 2024 (833935) - DUE 27 September 2024
2.01Discuss how collateral and indirect finance are used in
explaining the basic facts about financial structure around the
world. [10]
Collateral and Indirect Finance in Explaining Financial Structure
Collateral and indirect finance play crucial roles in shaping the financial structures of
economies around the world. Both mechanisms address fundamental issues related to the
allocation of capital and the reduction of risks in financial transactions.
1. Collateral and Financial Structure
Collateral is an asset that a borrower offers to a lender to secure a loan. It serves as a form of
security, ensuring that if the borrower defaults on the loan, the lender can recover part or all of
the loan amount by seizing and selling the collateral.
How Collateral Explains Financial Structure:
Mitigating Asymmetric Information: One of the core issues in finance is the problem
of asymmetric information, where lenders lack sufficient knowledge about the
creditworthiness of borrowers. Collateral helps reduce this information gap. By requiring
collateral, lenders can offset the risk associated with lending to potentially unknown or
risky borrowers, thus facilitating lending.
Increasing Access to Credit: Collateral expands access to credit, particularly for
individuals or firms with limited credit history or those considered high-risk. Even in
underdeveloped financial systems, the presence of assets that can serve as collateral
increases the likelihood of receiving financing.
Lowering Interest Rates: Lenders are more likely to offer lower interest rates to
borrowers who provide collateral. This is because collateral reduces the lender’s risk
exposure. Thus, collateralized lending tends to be more prevalent in financial systems
with a higher level of credit risk, reflecting its importance in shaping financial markets
globally.
2. Indirect Finance and Financial Structure
Indirect finance involves the use of financial intermediaries (e.g., banks, insurance companies,
mutual funds) that stand between savers and borrowers. Unlike direct finance, where borrowers
issue securities directly to lenders (e.g., bonds, stocks), indirect finance relies on these
intermediaries to facilitate the flow of funds.
How Indirect Finance Explains Financial Structure:
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