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Financial Markets > Intro to Financial Systems > Flashcards

Intro to Financial Systems Flashcards

1
Q

What are the five major functions performed by the financial system?

A
  1. The settlement of transactions.
  2. The flow of funds.
  3. Risk management
  4. To be efficient
  5. To be stable
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2
Q

What is a surplus unit?

A

A surplus spending unit can be a household, business, or any other entity that makes more than it spends for the purpose of sustaining itself.

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3
Q

What is a deficit unit?

A

A deficit spending unit, which spends more than it makes and has to borrow from surplus units to sustain itself.

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4
Q

What is direct financing?

A

Deficit units raise funds directly from surplus units through the issue of securities in the financial markets

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5
Q

What are securities?

A

Securities are contracts that specify the obligations of deficit units and the rights of surplus units

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6
Q

What is indirect financing?

A

Funds are supplied as deposits to financial institutions, which in turn supply funds as loans to deficit units

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7
Q

What are derivatives?

A

A derivative is a security whose underlying asset dictates its pricing, risk, and basic term structure. A risk-transfer contract.

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8
Q

What are the two main risks?

A
  1. Default risk (financial obligations are not met)
  2. Market risk (loss arising from unexpected market changes)
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9
Q

What are the three determinants of financial system efficiency?

A
  1. Decision-making that is mutually beneficial to the parties involved.
  2. The pooling of funds from individual suppliers
  3. The emergence of new and reliable financial instruments, services, and operating systems.
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10
Q

What is information asymmetry?

A

When one party to a potential contract has an information advantage over the other party

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11
Q

How are risks to information asymmetry addressed?

A
  1. By restricting participation in the market to professional traders.
  2. Through financial regulations that require the more informed party to provide certain information to the less informed supplier of funds.
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12
Q

What are decision-making incentive problems?

A

Financial contracting is influenced by the incentives faced by the parties involved
This can be a problem if incentives motivate bad behavior.

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13
Q

How does the system overcome these incentive problems?

A
  1. When financial institutions have a fiduciary duty to their customers.
  2. A practice by professional bodies that require members to adhere to a code of ethics.
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14
Q

What problem does the pooling of funds solve?

A
  1. Usually deficit units are seeking large amounts that will take a long time to repay.
  2. Usually surplus units want to supply small amounts for short periods.
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15
Q

How does the pooling of funds work?

A
  1. A bank accepts many small deposits and makes fewer large-value loans.
  2. A fund manager that pools investments from clients and invests these funds collectively in large value assets
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16
Q

How is stability in financial systems enforced?

A
  1. Central banks assist by being ‘lender-of-last-resort’ to solvent but illiquid banks
  2. International banking supervisions guidelines implemented by APRA
  3. The RBA is responsible for promoting stability in Australias financial system.
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17
Q

What is the definition of Finance?

A

Finance refers to the flow of funds function. Funds made available by surplus units for use by deficit units are subject to agreed terms and conditions.

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18
Q

What are the main benefits sought by suppliers of funds?

A
  1. Returns
  2. Liquidity
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19
Q

How are the returns from supplying funds supplied?

A
  1. Cash payments of interest or dividends.
  2. The change in value of a financial asset (capital gains and losses)
20
Q

What is yield?

A

Returns are expressed as yields which means an annual rate of growth.

21
Q

What is liquidity?

A

Liquidity is the access supplier of funds have to their money or the ability to realise the cash value of an asset.

22
Q

What is risk?

A

Investment returns are exposed to risk - that is the possibility that actual returns will be less than expected. Suppliers of funds are risk-averse so require higher returns to be induced into accepting risk.

23
Q

How is risk measured?

A
  1. Market values may indicate relative riskiness.
  2. Risk assessment by rating agencies.
  3. Credit spreads meaning the margin between the market yield for risky bonds and those of safe bonds.
24
Q

What are the two basic forms of finance?

A
  1. Debt
    2.Equity
25
Q

What is the relationship between Equity and risk?

A
  1. Equity is referred to as risk capital because its returns are uncertain
  2. Shareholders have the lowest payment priority (a residual claim - The rights of shareholders to the remaining assets once the fixed claims on a business have been met)
26
Q

What is leverage?

A

The use of debt by a firm or investor is a form of leverage, the amount of leverage is indicated by the debt-to equity ratio, where higher ratios indicate greater leverage.
1. Leverage can increase the return on equity (because debt is cheaper than equity)
2. Leverage increases risk (because higher levels of debt increase the likelihood of insolvency)

27
Q

What is future value?

A

If a firm will pay $1000 in five years time, that is the future value.

28
Q

What is the present value?

A

The amount you are willing to pay today for future value. That is, the present value will always be less because you require a return on your investment.

29
Q

What is the interest rate?

A

The interest rate determines the relationship between present and future values.

30
Q

What are the main components of a financial system?

A
  1. Financial institutions (Deposit-taking institutions, investment banks, fund managers)
  2. Financial markets (arrange trading in securities, foreign exchange, and derivative contracts)
  3. Regulators (Oversee institutions and markets)
31
Q

What dominates Australian financial make-up?

A
  1. Banks
  2. Fund managers
32
Q

What is a Bank?

A

Banks (aka authorised deposit-taking institutions, or ADIs) are financial institutions that are authorised by APRA to undertake banking business (i.e. to accept deposits, make loans and provide other financial services)

33
Q

Who are Australian banks?

A
  1. The four major banks (ANZ, CBA, NAB and Westpac)
  2. Credit unions and building societies that mainly serve households
  3. Institutions that provide investment banking services to large businesses
34
Q

What is a shadow bank?

A

Non-bank financial institutions that compete with banks (Merchant banks, finance companies, mortgage originators)

35
Q

What is a fund manager?

A

Fund managers provide investment management services for their clients in return for fees. They manage:
1. Superannuation funds
2. Public unit trusts
3. Insurance companies

36
Q

Which markets in Australia arrange direct financing?

A
  1. The money market
  2. The bond market
  3. The share market
37
Q

What is the foreign exchange market?

A

The foreign exchange (FX) market enables transactions to be made in different currencies because it arranges trading in foreign currencies

38
Q

What is the market for derivative contracts?

A

The markets for derivative contracts (such as futures and options) trade contracts that can be used to manage forms of financial risk and for speculation

39
Q

Who are Australia’s financial regulators?

A
  1. APRA (Australian Prudential Regulation Authority)
  2. ASIC (Australian Securities and Investments Commission)
  3. RBA (Reserve Bank of Australia)
40
Q

Who forms the council of financial regulators?

A

APRA, ASIC, RBA and The Treasury.

41
Q

What is the RBA and what are its main functions?

A

The reserve bank of Australia is Australia’s central bank. It has 6 functions:
1. Implementing monetary policy
2. Issuing banknotes and coins
3. Acting as banker to the Commonwealth Government
4. Monitoring the stability of the financial system
5. Regulating the payment system
6. Managing Australia’s reserves of foreign exchange

42
Q

What does APRA do?

A

APRA is the prudential regulator of banks, insurance companies, and superannuation fund trustees
- they seek to ensure an institution is able to meet its obligations to its customers
- they apply the recommendations of the Basel Committee on Banking Supervision (BCBS)

43
Q

What does ASIC do?

A

ASIC enforces company and financial services laws to protect consumers, investors and creditors

44
Q

What does the Australian Treasury do?

A

The Australian Treasury is not a regulator but represents the government on issues of financial regulation

45
Q

What did we learn from the US financial crises?

A
  1. Financial systems are fragile, and crises impose serious costs on households, businesses and economies generally
  2. Incentive problems, information asymmetries, excessive leverage and non-prudent lending add to that fragility and point to a need for greater regulation
  3. Crisis in major financial systems can become global
46
Q

Debt financing can be raised by firms in which markets?

A

Money and Bond markets

Financial Markets (7 decks)

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