Chapter 23, Problem 1QFR

To determine

To explain:

The difference between direct andindirect finance method. The reasons for a borrower or a saver select any of these methods.

Explanation of Solution

The basic difference between direct finance and indirect finance is that former channels funds between ultimate savers and lenders and borrowers and spenders without involvement of third party. Conversely, later does the same thing but with involvement of the intermediary third party. Additionally, former is riskier than the later.

A firm or borrower and a saver might choose each of the direct and indirect finance methods. This is because of their respective advantages. These are discussed below:

Advantages of direct finance:

1. Direct finance reduces the cost of borrowing or lending since no intermediary third-party involvement exists there.
2. This allows diversification of funding resources through access of domestic as well as international money markets plus capital markets. So, this method is relatively beneficial for both parties.
3. Here, financial instruments used directly between needy and supplying groups are so much flexible and so it is convenient for both.

Advantages of indirect finance:

1. Direct finance faces the challenge of asymmetric information causing emergence of information costs and imbalance while making transactions. So, relatively, indirect finance method is suitable for transaction than direct finance.
2. Since the financial intermediaries take the duty of approaching investors and performing the further process, indirect financing is considered a faster way for businesses or firms to raise funds.

Economics Concept Introduction

Finance methods:

Direct and indirect finance methods are the methods of channelizing funds to the borrowers and spenders by the savers and lenders.In indirectfinancing, borrowers take resources by indirect way like financial intermediaries. This is different from direct financing method where the borrowers are directly related to thefinancial markets. The borrowers in direct financing methodissue securities directly in the market.