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Flashcards in End-chapter question chapter 1 Overview Deck (24):
1

1.  What is the role of the financial system and why is it important to the economy?

1.  What is the role of the financial system and why is it important to the economy?
 
The financial system facilitates the flow of saving to investment via direct and indirect financing relationships formed in financial markets with the frequent help of financial institutions.  Without it, financing relationships would arise only when preferences of SSUs and DSUs match as to amount, maturity, and risk.  DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilise savings.  The “production possibilities frontier” of society would be smaller.

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2.  What is a financial claim? How can a financial claim be both an asset and a liability at the same time?
 

2.  What is a financial claim? How can a financial claim be both an asset and a liability at the same time?
 
A financial claim (or “security” or “financial instrument”) is one’s claim against another’s wealth.  To its holder, it is a financial asset; to its issuer, a liability or obligation.  It may be debt (contractually promising repayment with interest on a certain schedule) or equity (part ownership rewarded by participation in profits).  DSUs issue claims in return for funds; SSUs exchange funds for claims

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3.  Explain what is meant by the term ‘financial intermediation’.

3.  Explain what is meant by the term ‘financial intermediation’.
 
Financial intermediation is the process by which financial institutions mediate unmatched preferences of DSUs and SSUs.  Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs.  Thus, financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs.   
 

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4.  Why is denomination divisibility an important intermediation service from the perspective of the typical household?

4.  Why is denomination divisibility an important intermediation service from the perspective of the typical household?
 
Typical households do not have enough cash to invest in direct credit markets, where minimum transactions are often $1 million.  Financial intermediaries facilitate indirect investment by households by offering financial claims with smaller denominations. Otherwise, households would have to accumulate large sums of money before investing. During the time this would take, the household would earn no interest income—a substantial opportunity cost, and a disincentive to save and invest.

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5.  What would be the implications for investment in physical assets such as oil refineries or long-distance telephone cable if financial intermediaries were not willing to invest money for long periods?

5.  What would be the implications for investment in physical assets such as oil refineries or long-distance telephone cable if financial intermediaries were not willing to invest money for long periods?
 
Suppose such a project costs $300 million and returns $30 million per year in cash flow. Over the long run, a 10 percent return seems attractive, but could the firm find enough direct investors
willing to commit to such a long payback period?  Such projects would have to be financed out of savings of the firms’ owners, many of whom would then be under-diversified and would demand a higher return, assuming they were willing in the first place to take the time to accumulate sufficient funds. Valuable projects could be delayed indefinitely, curtailing economic growth and social progress.
 
 

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6.  Why are economies of scale important to the viability and profitability of financial intermediaries?
 

6.  Why are economies of scale important to the viability and profitability of financial intermediaries?
 
Economies of scale give financial intermediaries a cost advantage.  If their average cost decreases as the size of the transaction increases, financial intermediaries can profitably engage in denomination intermediation while remaining adequately diversified.

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7.  Discuss the spread of banking assets across Australian financial institutions.

7.  Discuss the spread of banking assets across Australian financial institutions.
 
Banking assets in Australia are spread across a variety of different types of institutions including banks, credit unions, building societies and other financial institutions.  While there are more credit unions than any other type of institution, the banks dominate the percentage of assets held and within this the four big banks hold the clear majority and dominate the entire sector.  Indeed, these four institutions dominate much of our region with significant control over New Zealand and the Pacific Island countries.

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8.  Why have securitisers grown so fast compared with commercial banks and how do they differ from traditional mortgage originators? What impact did the GFC have on them?

8.  Why have securitisers grown so fast compared with commercial banks and how do they differ from traditional mortgage originators? What impact did the GFC have on them?
 
Securitisers raise funds through the capital markets and debt securities, which provides them with lower operating costs relative to traditional home loan lenders. This lower level of operating costs allows them to compete with their much larger bank rivals by providing competitive interest rates and fees which has led to high growth rates among such institutions.  The GFC hit securitisation activities significantly across the globe and the quality of the underlying mortgage portfolio’s weakened (due to decreasing property values and increasing loan defaults) to a point where the global mortgaged back securities market ground to a halt.

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9.  What is the difference between primary and secondary markets?

9.  What is the difference between primary and secondary markets?
 
Primary markets are those in which financial claims are initially sold by DSUs. All financial claims have primary markets. Secondary financial markets are like used-car markets; they let people exchange ‘used’ or previously issued financial claims for cash at will, and hence they provide liquidity for investors who own primary claims. Securities can only be sold once in a primary market; all subsequent transactions take place in secondary markets. The Australian Stock Exchange (ASX) is an example of a well-known secondary market.

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10.  Compare and contrast money and capital markets.

10.  Compare and contrast money and capital markets.
 
Money markets are markets in which commercial banks and other businesses adjust their liquidity position by borrowing, lending, or investing for short periods of time. Capital markets are where capital goods are financed with stock or long-term debt instruments. Compared to money market instruments, capital market instruments are less marketable; default risk levels vary widely between issuers and have maturities ranging from 5 to 30 years.
 

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11.  Discuss the importance of information efficiency to the markets.

11.  Discuss the importance of information efficiency to the markets.
 
Informational efficiency is important because with accurate price information, investors can determine which investments are the most valuable—providing the highest expected return for a given level of risk—and invest accordingly. Thus, informational efficiency ensures that the financial markets are allocationally efficient because households or business firms can get the information they need to make intelligent investment decisions.
 

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12.  Outline the major risks faced by financial institutions.

12.  Outline the major risks faced by financial institutions.
 
Credit Risk (or default risk) is the possibility that a borrower may not pay as agreed.

Interest Rate Risk is the likelihood that interest rate fluctuations will change a security’s price and reinvestment income.  

Liquidity Risk is the possibility that a financial institution may be unable to pay required  cash outflows.

Foreign Exchange Risk is the possibility of loss on fluctuations in exchange rates.            

Political Risk is the possibility that government action will harm an institution’s interests.
 
Reputational Risk is the potential for negative publicity to cause loss through decline in customer base, increased litigation and revenue reductions.
 
Environmental Risk is the actual and/or potential threat of adverse impact on asset values due to changes in the environment and/or oeganisational impacts on the environment.

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13.  Why is globalisation of the international markets important to the Australian financial system?

13.  Why is globalisation of the international markets important to the Australian financial system?
 

This is important due to the small size of the Australian system in global terms.  Hence internationalisation offers both additional sources of funds (from international investors), opportunities for Australian investors and institutions to diversify into offshore investments, and also a source of competition for domestic institutions which leads to improved efficiency of the domestic system.  The impact of these was seen in the GFC where international concerns heavily impacted the Australian financial system.  These impacts continued for a number of years as the higher cost of capital in the international markets (which the Australian banks rely upon for funding) put pressure on margins

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14.  Explain the key roles of the financial system. Why is it so important to the broader economy to have an efficient and effective financial system?
 

14.  Explain the key roles of the financial system. Why is it so important to the broader economy to have an efficient and effective financial system?
 
Financial markets are the markets for buying and selling financial instruments.  Financial markets have five primary functions:
 
1. facilitating the flow of funds

2. providing the mechanism for the settlement of transactions

3. generating and disseminating information that assists decision making

4. providing means for the transfer and management of  risk 

5. providing ways of dealing with the incentive problems that arise in financial contracting
 
Having an efficient and effective financial system is critical as it facilitates commercial, retail and government transactions in a timely, low cost and reliable way.  The opposite would be a system where funds take a long time to reach their destination (i.e. direct debits may take weeks), with high cost (significantly greater transactions costs) and with great risk (to either their value or likelihood of arrival).  An efficient and effective financial system will also produce actual and timely information to enable effective financial decision making, which is also important in the complex financial world of today.
 
When one considers what we take for granted in the financial system (EFTPOS, Electronic Transfer, Direct Debit, etc. in terms of its reliability) and consider the time and cost involved in doing this manually, one can see the importance of the financial system.

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15.  Does it make sense that the typical household is an SSU, while the typical business firm is a DSU? Explain your answer.

15.  Does it make sense that the typical household is an SSU, while the typical business firm is a DSU? Explain your answer.
 
Households are ultimately SSUs, but have deficit periods when a home or other “big ticket” item is purchased.  Businesses usually invest more in real assets than they receive in current operating cash flow

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16.  What are some problems with direct financing that make indirect financing more attractive?
 

16.  What are some problems with direct financing that make indirect financing more attractive?
 
Direct financing requires a more or less exact match between the characteristics of the financial claims DSUs wish to sell and those the SSUs want to buy.  Direct financing can thus involve a costly search and negotiation process, often complicated by information asymmetries concerning ultimate credit risk of the DSU.  Intermediaries transform direct claims sold by DSUs and make them more attractive to SSUs, helping DSUs find financing and SSUs find appropriate investments.
 

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17.  Why are direct financing transactions more costly or inconvenient than intermediated transactions?

17.  Why are direct financing transactions more costly or inconvenient than intermediated transactions?
 
The parties to direct finance have to find each other and negotiate a more or less exact match of preferences as to amount, maturity, and risk.  Intermediaries provide all parties choices about financial activity, and drive costs down through competition, diversification, and economies of scale

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18.  What impact did the GFC have on the global financial system? What will the longterm implications be for the members of the sector?

18.  What impact did the GFC have on the global financial system? What will the longterm implications be for the members of the sector?
 

The GFC brought the global financial system to the brink of collapse with significant impacts on:

• Asset values (share markets declined dramatically, bond values collapsed as interest rates were moved, international finance declined as international trade declined, mortgage finance stopped as asset value and available capital declined for example).

• Financial institutions around the world collapsed and many were either merged or required significant government bailouts to keep them afloat.  This also meant a great deal of job losses in the financial sector.

• confidence in the financial system declined and capital flows between institutions, into capital markets and across borders changed significantly.

• The required government intervention and extension of sovereign debt (to significant levels in some areas – particularly Europe), had a long term effect that will also drive government reregulation of the financial sector.

• A significant repricing of risk in all asset classes.
 
The long term effects were at the time of writing still being established, however several things are clear:

• Reregulation globally is likely to lead to more strigent control of risk, mix and type of operations and level of oversight of financial institutions.

• The medium to long term impact of government debt and ownership/intervention in the financial sector may subdue markets and economic activity (and therefore financial activity) for some time.

• The repricing of risk in all asset classes will change market behaviour for some time and  subdue both retail and wholesale market activity.

• The negativity surrounding the financial institutions has exacerbated consumer distaste and mistrust in financial institutions which will continue to be a public relations battle for some time.
 

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19.  What are the three sources of comparative advantage that financial institutions have over others in producing financial products?

19.  What are the three sources of comparative advantage that financial institutions have over others in producing financial products?
 
(1) Economies of scale —large volumes of similar transactions;

(2) transaction cost control— finding and negotiating direct investments less expensively;

and (3) risk management expertise—bridging the  “information gap” about DSUs’ creditworthiness.

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20.  Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?
 

20.  Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?
 
Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs).  Financial intermediaries buy financial claims with one set of characteristics from DSUs, and then issue their own liabilities with different characteristics to SSUs.  Thus, financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs.  This increases the amount and regularity of participation in the financial system, thus promoting the 3 forms of efficiency— allocational, informational, and operational.  

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21.  How do financial intermediaries generate profits?

21.  How do financial intermediaries generate profits?
 
Intermediaries pay SSUs less than they earn from DSUs.  Operating costs absorb part of this margin.  Risks taken by the intermediary are rewarded by any remaining profit.  Intermediaries enjoy 3 sources of comparative advantage:  Economies of scale —large volumes of similar transactions; transaction cost control—finding and negotiating direct investments less expensively; and risk management expertise—bridging the “information gap” about DSUs’ creditworthiness

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22.  Explain the differences between the money markets and the capital markets. Which market would Holden use to finance a new vehicle assembly plant? Why?

22.  Explain the differences between the money markets and the capital markets. Which market would Holden use to finance a new vehicle assembly plant? Why?
 
Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term.  Money markets tend to be wholesale OTC markets made by dealers.  Capital markets are where real assets or “capital goods” are permanently financed, and involve a variety of wholesale and retail arrangements, both on organised exchanges and in OTC markets.  GM would finance its new plant by issuing bonds or stock in the capital market.  Investors would purchase those securities to build wealth over the long term, not to store liquidity.  GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds).  GM would use the money market to “store” cash in money market securities, which are generally, safe, liquid, and short-term.

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23.  Discuss three forms of financial market efficiency. Why is it important that financial markets be efficient?

23.  Discuss three forms of financial market efficiency. Why is it important that financial markets be efficient?
 
There are three forms of market efficiency: allocational efficiency, informational efficiency, and operational efficiency.  Allocational efficiency is a form of economic efficiency that implies that funds will be allocated to (i.e., invested in) their highest valued use (the funds could not have been allocated in any other way that would have made society better off).  This is important as it promotes investment in the projects offering the highest risk-adjusted rates of return and that households invest in direct or indirect financial claims offering the highest yields for given levels of risk. Informational efficiency relates to the ability of investors to obtain accurate information about the relative values of different financial claims (or securities). In an informationally efficient market, securities’ prices are the best indicators of relative value because market prices reflect all relevant information about the securities. This is important as it allows investors to determine which investments are the most valuable and ensures that the financial markets are allocationally efficient because households or business firms can get the information they need to make intelligent investment decisions. A market is operationally efficient if the costs of conducting transactions are as low as possible. This is important because if transaction costs are high, fewer financial transactions will take place, and a greater number of otherwise valuable investment projects will be passed up. Thus, high transaction costs can prevent firms from investing in all desirable projects. The forgone investment opportunities mean that fewer people are employed and economic growth slows or declines. Society becomes worse off.
 

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24.  What are the major risks faced by financial institutions and why is it important that each is carefully managed?

24.  What are the major risks faced by financial institutions and why is it important that each is carefully managed?
 
Credit Risk (or default risk) is the possibility that a borrower may not pay as agreed.  Management of credit risk is important as excessive credit risk will lead to higher regulatory costs (credit based capital adequacy requirements to be discussed later in the text) and may lead to the failure of the firm through cash flow and non-performing loans problems.  

Interest Rate Risk is the likelihood that interest rate fluctuations will change a security’s price and reinvestment income.  As a significant part of financial institutions investments and sources of funds are interest-bearing and profits are generated on the margin between these, managing both the investment and funding portfolio’s for interest rate risk is important for profits, cash flows and the stability of the institution.  

Liquidity Risk is the possibility that a financial institution may be unable to pay required cash outflows.  If a financial institution is unable to meet its short-term obligations because of inadequate liquidity, the firm will fail even though over the long run the firm may be profitable.
 
Foreign Exchange Risk is the possibility of loss on fluctuations in exchange rates.  These fluctuations can cause gains or losses in the currency positions of financial institutions, and they cause the Australian dollar values of non-Australian financial investments to change.
 
Political Risk is the possibility that government action will harm an institution’s interests.  This includes changes in regulation, appropriation of assets, changes to foreign investment and currency transfer and trading rules, all of which can influence the earnings and value of a financial institution.
 
Reputational Risk is the potential for negative publicity to cause loss through decline in customer base, increased litigation and revenue reductions.
 
Environmental Risk is the actual and/or potential threat of adverse impact on asset values due to changes in the environment and/or organisational impacts on the environment.