Ch2 Financial Systems

Question 1

Real Economy vs. Financial Economy

Answer 1

• The real economy and the financial economy are deeply interconnected.
• Most economic decisions require some type of financial service.
• Examples: Buying a sandwich needs payment (financial service); Renting/buying a house might need a bank transfer or mortgage (financial service); Saving for education might use a savings account or ETF (financial service).

Question 2

Common Taxonomy of Financial Needs

Answer 2

• Monetary Needs: Facilitate value retention, payments, and fund transfers. Examples: money, ATMs, checks, checking accounts, credit/debit cards, bank transfers, PayPal.
• Allocation Needs: Suitable for allocating funds to productive agents/projects and transferring funds across time. Examples: loans, bonds, stocks, savings accounts, mortgages, leasing, factoring.
• Risk Management Needs: Suitable for transferring funds across different states of the world (e.g., health, injuries). Examples: insurance policies (health, car), financial derivatives (interest rate swaps, currency swaps, credit default swaps, futures, forwards, options), contingent convertible bonds.

Question 3

Institutions in a Modern Financial System

Answer 3

• Financial Markets: Stock Markets, Money Markets, Bond Markets, Derivatives, Commodity, and Currency Markets.
• Financial Intermediaries: Banks, Insurance Companies, Brokers, Rating Agencies, Others

Question 4

Functions of Financial Markets and Financial Intermediaries

Answer 4

1. Coordination of trades (e.g., exchanges, underwriting).
2. Transfer of funds and financial contracts (e.g., SWIFT, SEPA, PayPal).
3. Provision of liquidity (e.g., market makers, limit orders).
4. Allocation of capital (e.g., IPOs, SEOs).
5. Selection of market participants based on quality (e.g., solvency).
6. Information aggregation via price determination (e.g., credit spreads, CDS).
7. Transformation of financial contracts

Question 5

Functional Types of Financial Intermediaries

Answer 5

1. Appraisers: Provide information (e.g., rating agencies). (Newspapers can be classified as appraisers because they provide information)
2. Auctioneers: Establish contacts and guide price determination.
3. Market makers: Provide liquidity (e.g., clearing agent).
4. Producers: Generate new cash flows and create money (e.g., banks).

Question 6

Selected Institutions of a Modern Financial System

Answer 6

-Commercial Banks
- Investment Banks
- Finance Companies
- Mutual Funds
- Pension Funds
- Hedge Funds
- Sovereign Wealth Funds

Question 7

Commercial Banks

Answer 7

Most important financial intermediaries worldwide. Take deposits and provide loans. Their balance sheet primarily shows Credits/Loans as assets and Deposits as liabilities. The word “bank” comes from the Italian “banco” meaning table, referring to a money changer’s table.

Question 8

Investment Banks

Answer 8

Offer capital-market-oriented services like raising capital (equity/debt issuance), trading securities, underwriting, and M&A consulting. Note: They are not financed by deposits and are not directly involved in traditional lending like commercial banks.

Question 9

Finance Companies

Answer 9

Raise funds by selling commercial papers, stocks, and bonds. Lend funds to consumers and small businesses, providing credit for consumer goods/services.

Question 10

Mutual Funds

Answer 10

Acquire funds by selling shares to individuals, pooling proceeds to buy diversified portfolios of securities. Shareholders can sell shares, with value determined by the fund’s holdings (NAVs). There is risk-return participation. Money-Market Mutual Funds buy safe, liquid money-market instruments. Large institutional investors like BlackRock and Vanguard are examples and demonstrate common ownership. Common ownership (large stakes in competing firms by the same investors) can incentivize behavior that may lead to anti-competitive practices and reduced market efficiency, challenging shareholder value maximization.

Question 11

Pension Funds

Answer 11

Established by entities (company, government, union) to invest employees’ retirement funds. Aim for stable long-term growth to provide pensions.

Question 12

Hedge Funds

Answer 12

Pooled, privately organized investment vehicles managed by professionals with performance-based pay and significant own investment. Not widely available to the public. Operate outside certain securities regulations (like the Investment Company Act of 1940). Are not required to hold diversified portfolios, can trade on margin, use lock-up periods, charge high fees, and engage in derivative trading, making them flexible and effective active investors.

Question 13

Sovereign Wealth Funds

Answer 13

State-owned investment funds (e.g., Norway’s Government Pension Fund, China Investment Corporation).

Question 14

Central Banks

Answer 14

• Primary function is the management of a state’s currency, money supply, interest rates, and oversight of the banking system.
• Examples: European System of Central Banks (ESCB) including the ECB and National Central Banks, the U.S. Federal Reserve System, the Swiss National Bank (SNB).
• Central banks supply money today.

Question 15

Why are banks special

Answer 15

• Banks have larger balance sheets and higher leverage ratios.
• Banks hold intangible financial assets (e.g., loans, securities, etc.).
• Banks have no inventories.
• Banks have no intangible assets, such as patents.
• Banks have a higher ratio of external-to-internal financing (deposits).
• Banks have more opaque (difficult to monitor) assets.
• Banks are more regulated than corporations.

Question 16

How much is a basis point

Answer 16

1% = 100 basis points