Introduction to the Financial System

Question 0

What is corporate finance?

Answer 0

The financial decision making by firms.

Question 1

What is finance?

Answer 1

• Financial decision making under conditions of uncertainty.

* The allocation of resources over time.

Question 2

What is the financial system?

Answer 2

• The set of financial institutions, markets and securities that manage financial contracting and the exchange of financial assets and risks.
• Arranged by financial institutions (acting as principals) and financial markets (where institutions act as agents).
• Financial systems are constantly innovating.

Question 3

What are the 6 functions that developed financial systems perform?

Answer 3

1. Settle commercial transactions (domestically and internationally).
2. Arrange the flow if funds (that is, financing)
3. Transfer and manage risk.
4. Generate information to assist decision making.
5. Deal with incentive problems in contracting.
6. Pooling if funds.

Question 4

What is a security?

Answer 4

A financial contract that can be traded in a financial market.

• Asset involved: commodity (e.g. gold), hard asset (e.g. property), financial asset (e.g. shares).
• Quantity and unit: thousand shares, ounce of gold.
• Price.
• Date.
• Payment/settlement terms.

Question 5

What is a transaction?

Answer 5

An arrangement between a buyer and a seller to exchange an asset or service for payment.

Question 6

What is the settlement of a transaction?

Answer 6

• Settlement is when value (=purchasing power) and title are transferred.
• Organised network of connections: the payment system.
• Transaction and settlement can be different (e.g. payment by cheque).
• Supervised by the Reserve Bank.

Question 7

What are surplus and deficit units?

Answer 7

Surplus units are investors or depositors. Excess funds.

Deficit units are borrowers. They need funds.

Question 8

What are the different preferences of surplus and deficit units?

Answer 8

Return on funds: surplus want high, deficit low.

Length of contract: surplus flexible and short, deficit inflexible and long.

Risk: surplus varies, but many are risk averse. Deficit are risk takers.

Amount: surplus small, deficit large.

Question 9

What role do intermediaries and markets have in the flow of funds?

Answer 9

Overcome differences in preferences between surplus and deficit.

Question 10

What is risk in finance?

Answer 10

The chance that expected outcome is not achieved.

Types of risk are - Credit, market, operational and shocks.

Question 11

What is credit risk?

Answer 11

The possibility that borrower will not meet scheduled repayments -> Default on loan obligations.

Question 12

What is market risk?

Answer 12

The possibility of unexpected movement in the market -interest rates, exchange rates, security prices, oil prices, etc.

Question 13

What is operational risk?

Answer 13

The failure of process or controls - e.g. credit card fraud

Question 14

What are some risk management alternatives?

Answer 14

Avoidance (but has an opportunity cost).

Elimination (costs of risk prevention).

Acceptance/management (e.g. A lender can reduce credit risk by requiring a mortgage over property).

Insurance payout to cover loss).

Transfer.

Question 15

What are some risk transfer mechanisms?

Answer 15

1. Match the risk appetites of participants in the financial system e.g. Derivatives - establish a future price.
2. Unbundle a financial contract so that risk and flow of funds are separated e.g. Mortgage covers risk.

Question 16

What is information asymmetry?

Answer 16

• parties do not have equal access to information

- can result in ‘adverse selection’ when one party contracts on the wrong basis.

Question 17

How can you overcome asymmetric information risk?

Answer 17

• apply credit standards
• provide investors with relevant information
• rely on market forces

Question 18

What is a moral hazard?

Answer 18

Arises when a contract changes incentives so one party may not act responsibly. (e.g. insurance, bank Liam approvals)

Question 19

What are agency problems?

Answer 19

• arise when an agent acts in own interest, rather than those of the principal(s)
  e. g. Shareholders hire managers, investors use brokers, issuers employ investment banks.

Question 20

Relationship between risk and return.

Answer 20

Investors have to be compensated to accept risk.

Question 21

Introduction to intermediaries.

Answer 21

• flow of funds through institutions
• performed by ADI (authorised deposit-taking istitutions)
• deposit accounts, low risk, low return, highly liquid.
• loans, relatively low interest, can be for a long time, large amount.
• interest rate spread/service fees

Question 22

Introduction to markets

Answer 22

• deficit units sell securities to investors
• securities are contracts that can be traded in a financial market
• major domestic markets are money, bond and share.
• other financial markets are foreign exchange, commodities and housing

Question 23

Difference between primary and secondary markets.

Answer 23

• primary arranges for issue of new securities (issuers hire investment banks to sell the securities)
• subsequent trading in existing securities occurs in the secondary market

Question 24

How do secondary markets assist primary markets?

Answer 24

• provide liquidity (investors more likely to buy new securities if it can be sold in the secondary)
• perform price discovery
• develop the ‘supply of investment funds.’

Question 25

What is debt (or credit)?

Answer 25

• borrowed funds with agreed interest cost and repayment date.
• debt payments have priority over equity payments.
• repayment default is the source of credit risk.

Question 26

What is equity?

Answer 26

• funds that acquire part ownership of a business (supplied through issue of ordinary shares, and retention if profits)
• riskier than the returns to debt holders

Question 27

What are the main firms if financial institutions in Australia?

Answer 27

• Banks, insurance companies, fund managers.

- The biggest financial conglomerates (who provide banking, insurance and fund manage my) are the big 4 banks.

Question 28

What is the RBA?

Answer 28

• The RBA is the Reserve Bank of Australia

- Implement monetary policy

Question 29

What is APRA?

Answer 29

• The Australian Prudential Regulation Authority

- Regulate financial institutions

Question 30

What is ASIC?

Answer 30

• The Australian Securities and Investments Commission

- Protect consumers, investors and creditors

Question 31

What is the Australian Treasury?

Answer 31

• The main economic department of the Australian government.

- Advice on government economic policy