Week 1: Financial Systems

Question 1

What is a financial system?

Answer 1

Financial systems channel funds from person or business without investment opportunities (lender-savers) to one who has them (borrower-spenders)

Question 2

What are the three components of financial systems? Provide examples.

Answer 2

1. Financial Markets e.g. money and capital markets, stock market, and foreign exchange market
2. Financial Instruments e.g. shares, term deposits, loan contracts
3. Financial Institutions e.g. banks, insurance offices, superannuation funds

Question 3

Provide four examples of saver-lenders.

Answer 3

1. Households
2. Business Firms
3. Governments
4. Foreigners

Question 4

Provide three examples of spender-borrowers.

Answer 4

1. Business Firms
2. Governments
3. Foreigners

Question 5

‘A highly developed and efficient financial system is essential to ongoing economic growth and prosperity.’ Please explain.

Answer 5

o Financial system supports economic transactions
o Encourages savings which provides funds for investment
o Provides a range of investment opportunities
o Provides a range of borrowing alternatives
o Efficient allocation of resources for economic growth
o Regulatory regimes provide strength and stability to a financial system

Question 6

Who regulates financial systems?

Answer 6

o Overseen by central bank (e.g. Reserve Bank of Australia)

o Supervised by prudential regulator (e.g. Australian Prudential Regulation Authority)

Question 7

What is a financial market?

Answer 7

Where financial instruments are traded, extending beyond physical locations to include electronic and virtual spaces.

Question 8

What function to financial markets serve?

Answer 8

Facilitate exchange of goods and services by:
o Bringing opposite parties together
o Establishing rates of exchange (i.e. prices - asset price determined by supply and demand)
o Enabling the double coincidence of wants

Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them.

Question 9

What is the difference between debt and equity markets?

Answer 9

• Debt markets - provide loan and receive interest on repayments
• Equity markets - represents an ownership claim in the firm and pays dividends

Question 10

What is the matching principle?

Answer 10

Thematching principlestates that short-term assets should be funded by short-term liabilities/debt and long-term assets should be funded by long-term liabilities/debt.

Question 11

What are the consequences if the matching principle is not adhered to?

Answer 11

o If short-term asset is funded by long-term debt, short-term asset cannot be rolled over and will have to search for new short-term asset – long-term debt also more expensive
o Long-term asset funded by short-term debt it is very risky, have to renew debt annually and the creditor may not renew

Question 12

What is the difference between primary and secondary markets?

Answer 12

Primary Market
o Creation of new financial asset
o New security issued sold to Initial buyer

Secondary Market
o Sale and transfer of existing financial asset
o Shareholders trading amongst each other on a stock exchange

Question 13

‘Existence of well-developed secondary market is important to the functioning of the primary markets within the financial system’. Please explain.

Answer 13

o Primary market transactions provide funds for business development and thus economic growth.
o Liquidity for investors - Investors will purchase primary market securities if they know that there are able to sell them in the deeply liquid secondary market later on.
o Price determined by supply and demand (current market value) of secondary market.

Question 14

What is an exchange?

Answer 14

o Trades conducted in central locations.
o A company that creates the opportunity for potential buyers and sellers of a security to come together for trading.
o Products traded on the exchange must be well standardized.

Question 15

What is an over-the-counter market?

Answer 15

o Bilateral contract in which two parties (or their brokers or bankers as intermediaries) agree on how a particular trade or agreement is to be settled in the future.
o It is usually from an investment bank to its clients directly. (e.g. Forwards and SWAPS)

Question 16

What is the difference between money and capital markets?

Answer 16

• Money Market: Short-Term(maturity < 1 year) (e.g. negotiable certificates of deposit (CDs), Bank accepted bills, Treasury bills)
• Capital Market: Long-Term (maturity > 1 year) plus equities (e.g. Stocks, Bonds)

Question 17

Why is the development of domestic capital markets is extremely important for economic growth?

Answer 17

♣ Provide the long-term funds necessary for productive investment
♣ Forego current consumption
♣ Facilitate flow of capital from investors to company
♣ Companies are a key component of economic growth and capital is a key component of company growth
♣ Competing financial institutions is a characteristic of a developed capital market

Question 18

What is a financial institution?

Answer 18

Financial institutions provide a service as intermediaries of the capital and debt markets. They are responsible for transferring funds from investors to companies, in need of those funds.

Question 19

What are the five types of financial institutions?

Answer 19

1. Despository institutions
2. Contractual savings institutions
3. Finance companies
4. Investment institutions
5. Unit trusts (managed funds)

Question 20

What is a depository institution? Provide examples.

Answer 20

• Attract savings from depositors and investors and provide loans to borrowers (absorb deposits and pool money)
• E.g. commercial banks, credit unions, trust companies, and mortgage loan companies

Question 21

What is a contractual savings institution? Provide examples.

Answer 21

• Their liabilities (sources of funds) are contracts that generate periodic cash flows.
• Their accumulated funds are used to purchase both real and financial assets.
• E.g. insurance companies, pension funds

Question 22

What is the difference between a mutual fund and a hedge fund?

Answer 22

♣ Mutual fund: only purchase securities, uses passive strategy by mimicking return of S&P500
♣ Hedge fund: riskier than mutual fund – only invest in derivatives market (options, credit default swaps)

Question 23

What is a unit trust?

Answer 23

• Formed under a trust deed - investors purchase units issued by the trustee.
• The trust invests in specific asset classes (such as equity or property) within the terms of the trust deed.

Question 24

What is a financial instrument?

Answer 24

• Monetary contracts between parties - can be created, traded, modified and settled.
• Claims to specified future cash flows, issued by party raising funds to acknowledge financial commitment

Question 25

Name and explain the three categories of financial instruments.

Answer 25

* Equity: Stocks are securities that are a claim on the earnings and assets of a corporation * Debt: Debt instruments are assets that require a fixed payment to the holder, usually with interest. * Derivatives: Instruments which derive their value from the value and characteristics of one or more underlying entities such as an asset, index, or interest rate.

Question 26

What is the difference between debt and equity instruments?

Answer 26

* Debt: issuing a bond increases the debt burden of the bond issuer because contractual interest payments must be paid, unlike dividends * Equity: allows a company to acquire funds (often for investment) without incurring debt

Question 27

What are bonds?

Answer 27

• Type of debt – receive interest in repayments • Bond holders paid first • Bonds are considered to be less risky investments for at least two reasons: o First, bond market returns are less volatile than stock market returns. o Second, should the company run into trouble, bondholders are paid first, before other expenses are paid. Shareholders are less likely to receive any compensation in this scenario.

Question 28

What is direct finance?

Answer 28

• Funding obtained direct from money and capital markets (e.g. Share issues, corporate bonds, government securities).

Question 29

What are the advantages of direct finance?

Answer 29

o Removes the cost of intermediation o Allows for diversification of funding sources o Enables greater flexibility to match source to use of funds o May enhance company’s profile / reputation

Question 30

What are disadvantages of direct finance?

Answer 30

o Only available to companies with high credit ratings/reputation o May be difficult to assess risk associated with investment: default risk, liquidity risk o Transaction costs may be high

Question 31

What is intermediated finance?

Answer 31

* Financial intermediary takes an active position in the flow of funds * Intermediary is a party to the financial instruments created with (1) surplus units and (2) deficit units * Seek to bridge the mismatch between preferences of savers and borrowers risk, return and time-pattern of cash flows * Financial intermediaries expect to generate a profit (return) from being exposed to risks that savers seek to remove from their portfolios

Question 32

What are the three functions of intermediate finance?

Answer 32

1. Asset transformation 2. Maturity transformation 3. Credit transformation

Question 33

What is asset transformation?

Answer 33

* Pool individual savings into significant balances that can then be lent on a scale desired by borrowers (Generates economies of scale) * Creates an incentive to save for those with relatively small amounts of surplus funds

Question 34

What is maturity transformation?

Answer 34

• Savers prefer liquidity whereas borrowers prefer long-term commitment of funds • Financial intermediary exposed to mismatch between term to maturity on sources of funds (e.g. deposits) and use of funds (e.g. loans) o Unlikely that all depositors will withdraw funds simultaneously o Active liability management: adjust interest rates to attract deposits

Question 35

What is credit transformation?

Answer 35

• Credit risk exposure of saver is limited to the risk associated with the financial intermediary, not the ultimate borrower o Financial intermediaries specialise in making loans: develop expertise in assessing credit risk • Financial intermediary pools individual savings and invests in a well-diversified portfolio of financial assets