Chapter 2 - The Financial Management Environment

Question 1

What is financial intermediation ?

Answer 1

Companies need to raise money in order to finance their operations. However it is often difficult for them to raise money directly from private individuals and therefore they turn to institutions like banks that marry up firms that require investment with individuals who want to invest

Question 2

What are the benefits of financial intermediation

Answer 2

1 Aggregation - lots of individuals who want to deposit (usually small) amounts with a bank and companies that want to borrow large amounts so the bank aggregates the small amounts up and therefore lend bigger amounts

Maturity transformation - many lots of people want to deposit small amounts for a short time, maybe 6 months before they withdraw whereas companies may want to borrow for 10 years so with the bank as they have lots of people lending for short periods and it’s continual so they always have money coming in for short periods

3. Diversification of risk - if an individual lends directly to company there is risk of company going bust and losing money however if with a bank, due to the diversification of investments the banks do, some win so lose so won’t effect the individual

Question 3

Besides a bank, what are other examples of financial intermediaries ?

Answer 3

Pension funds
Investment trusts / unit trusts
State saving banks

Question 4

What are the types of financial markets

Answer 4

Capital markets - buying shares on stock exchange

Money markets - borrowing money

Question 5

What activities take place on financial markets ?

Answer 5

Primary market activity - the selling of new issues to raise new funds

Secondary market activity - trading of existing financial instruments

Question 6

What are the main capital markets ?

Answer 6

The official list on the London stock exchange

The alternative investment market (AIM) which has fewer regulations and less cost than the official list therefore attracting smaller companies

The Eurobond market where bonds denominated in any currency other that that of the national currency of the issuer are traded. Eurobonds are generally issued by large international companies and have a 10 to 15 year term

Question 7

What are the main money markets ?

Answer 7

Money market is not actually a physical market but is the term used to describe the trading between financial institutions. Primarily done over the phone ( the below are for short term less than a year funding, medium term funding is usually done via a bank)

Discount market - where bills of exchange are traded

Inter bank market - where banks lend each other short term funds

The Eurocurrency market - where banks trade in all foreign currencies usually in the form of certificates of deposit

The certificate of deposit market - where certificates of deposit are traded

Local government market - where local authorities trade in debt instruments

Inter company markets - companies lend directly between themselves

The financial house market - where short term loans raised by financial houses are traded

Question 8

What is the function and purpose of the stock exchange

Answer 8

1. Only suitable companies are allowed to have their securities traded on the stock exchange
2. All relevant information is made public ally available as soon as possible in this way investors can make informed decisions
3. All investors deal on the same terms and at the same rate
4. The more efficient and fair the stock market the more people will be willing to use it

Question 9

How are shares valued ?

Answer 9

Shares are valued at which there is as many willing sellers as there are buyers

Question 10

Types of traders ?

Answer 10

A bull is someone who believes the price will rise and buys them in the hope of making a profit in the future

A bear is someone who believes the price will fall so sells them in the hope to buy them again cheaper in the future.

When there are more bulls than bears share prices rise and vida versa.

Question 11

What is the main difference between an efficient market and a perfect market

Answer 11

An efficient market is one which the market price of all securities traded on it reflects all the available information. A perfect market is one which responds immediately to the information made available to it

Question 12

What is the efficiency market hypothesis ?

Answer 12

The EMH considers whether market prices reflects all information about the company and three levels of efficiency are considered

Weak form efficiency
Semi Strong form efficiency
Strong for efficiency

Question 13

What is weak form efficiency

Answer 13

Share prices reflect all the information contained in the record past prices. Share prices follow a random walk and will move up or down depending on what information about the company next which is the market. If this level of efficiency exist it should not be possible to forecast price movements by reference to past trends

Question 14

What is semi strong form efficiency

Answer 14

Share prices reflect all information currently publicly available. Therefore the price will alter only when new information is published. If this level of efficiency has been reached price movements could only be forecast if on published information were known. This would be known as insider dealing

Question 15

Strong form efficiency

Answer 15

Share prices reflect all information published and an published that is relevant to the company. If this level of efficiency has been reached share prices cannot be predicted and gains through insider dealings are not possible as the market already knows everything. Given that there are still strict rules outlawing inside a dealing game through such dealings must still be possible and therefore the stock market is the best only semi strong form efficient

Question 16

How does the level of efficiency of the stock market have implications for financial managers

Answer 16

1. The timing of new issues - unless the market is fully efficient the timing of new issues remains important. This is because the market does not reflect all the relevant information and hence advantage could be obtained by making an issue at a particular point in time just before or after additional information becomes available to the markets
2. Project evaluation - if the market is not fully efficient the price of a share is not fair and therefore the rate of return required for the company by the market cannot be accurately known. If this is the case it is not easy to decide what rate of return to use to evaluate new projects.

Creative accounting - Unless a market is fully efficient creative accounting and still be used to mislead investors

Mergers and takeovers -, When I market it’s fully efficient the price of Paul shares is fair. Hence if a company is taking over at its current share value the purchaser cannot hope to make any game less economies can be made to scale or rationalisation when operations are merged. Unless these economies are very significant acquire should not be willing to pay a significant premium over the current share price

Validity of current market price - if the market is fully efficient the share price is fair. In other words an investor receives a fair risk/return combination for his investment and company can raise funds at a fair cost. If this is the case there should be no need to discount new issues to attract investors

Question 17

What factors determine this money market interest rates

Answer 17

Different financial instruments after different interest rates in order to understand why this is it is necessary to appreciate the factors which determine the appropriate interest rates for particular financial instrument

1. The general level of interest rates in the economy
2. The level of risk - is the risk/ return trade off high or low ?
3. The duration of the loan - longer the loan the higher the interest rate, like with mortgages. This is because there is additional risks for the lender like defaults increasing
4. The need for the financial intermediaries to make a profit - those who save with a bank are given a lower interest rate than those who want to borrow
5. Size - If a large sum of money is lent the administrative savings. Hence a higher rate of interest can be paid to a lender and a lower rate of interest can be charged to a borrower that would normally be the case

Question 18

What are yield curves

Answer 18

The yield of a security will alter according to the length of time before the security matures. This is known as the term structure of interest rates

Question 19

How can the yield curve be explained

Answer 19

1. Expectations theory - If interest rates are expected to increase in the future a curve such as that’s above may result the curve may inverted interest rates are expected to decline everything else being equal a flat curve results if interest rates are not expected to change
2. Liquidity preference theory - Yields will need to rise as the term to maturity increases as by investing for a long period the investor requires compensation for deferring the use of cash invested. The longer the period for which they are deprived of cash the more compensation they require.
3. Segmentation theory - Different investors are interested in different segments of the yield curve. Short-term Yields for example of interest to financial intermediaries such as banks. Hence the shape of the curve in that segment is a reflection of the attitudes of the investors active in the sector. Where to sectors meet there is often a disturbance or apparent discontinuity in the yield curve shown in the above graph

Question 20

How does the stock exchange work?

Answer 20

Companies may raise money by issuing shares

Once the company has raised the money and invested in new project or whatever that in a sense in the end of it for the company

For a quoted company, you can sell your shares to someone else in stock exchange

The person who fixes the price is the dealer to make sure there are the same amount who wants to buy as to sell

Question 21

How to calculate total shareholder return

Answer 21

It is the dividend received, plus/minus the change in the share price over the year expressed as a percentage of the share price at the beginning of the year.

For example if at the start of the year the share price is $4.80 and at the end of the year it was $5.10 and the dividends was $.20 per share then they have made $.50 per share and therefore $.50÷$4.80 equals 10.42%

Question 22

What is Fintech

Answer 22

Fintech describes the use of technology to improve financial activities

Fintech is being used to automate banking services trading and shares investing et cetera and it’s traditional methods are needing to change. 

Question 23

What are two possible dangers of Fintech (financial technology)

Answer 23

Security threat due to hacking et cetera

Government regulation. Traditional financial services are highly regulated by the relevant states and the states need to ensure that the regulations are updated sufficiently to include the new Fintech operators. In particular the regulations relating to money laundering