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CIMA BA1 Fundamentals of Business Economics > 4 The Financial System: Financial Markets > Flashcards

4 The Financial System: Financial Markets Flashcards

1
Q

What is the financial system?

A

System whereby households, firms and govt’s can borrow or invest funds

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2
Q

Why do financial intermediaries exist?

A

To make it easier for those with surplus funds who want to invest to be put in touch with those who have a shortage and want to borrow

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3
Q

What is the difference between direct and indirect finance?

A

Direct finance involves no intermediary whereas indirect finance does. It is also possible to invest/borrow funds directly in financial markets. This includes:

  1. Short term markets (money markets)
  2. Long term markets (equity and bond markets ref as capital markets)
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4
Q

What is synchronisation of payments and receipts?

A

To maintain a stable financial position - need to balance or match payments and receipts
- Not always possible to get the balance right => lack of synchronisation

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5
Q

What is a ‘lack of synchronisation’?

A

Financial intermediaries take money from lenders and re-lend same money to borrowers to balance lack of sync. Financial Intermediary is the ‘bank’. Lack of Sync between payments can happen in short, medium & long-term.

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6
Q

What is the ‘flow of funds’?

A

This is the movement of money between bodies in the economic system

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7
Q

What is financial intermediation?

A

There are net savers and net borrowers => bank provides a link between borrowers and savers.
- Most businesses have to make payments before the cash is received

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8
Q

What are examples of short-term finance sources?

A
  1. Bank Overdraft
  2. Credit Cards
  3. Credit agreements e.g. a lease or hire purchase agreement
  4. Bills of exchange - essentially an IOU from one business to another
  5. Commercial Papers
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9
Q

What are examples of long-term finance sources?

A
  1. Share capital/ equity (value of selling shares and from retaining profits in business)
  2. Long-term loans/bonds/debentures (generally secured on assets of the business)
  3. Venture Capital - High-risk enterprises whereby a venture capitalist finance risky ventures, capitalist demands high return due to risk involved
  4. Mezzanine Finance - combines aspects of debt and equity/shares. May be given as a loan and then converted into shares in the company if not paid back in time.
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10
Q

What are the examples of things the govt need to spend money on?

A
  1. Government employee salaries and pensions
  2. Providing public services e.g. NHS
  3. Purchase and repair of govt buildings
  4. Welfare payments such as unemployment benefits
  • Govt receives money from a number of sources (mostly different types of tax) Likely to have a lack of synchronisation as payments and receipts won’t be equal
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11
Q

What is a budget surplus?

A

Where govt revenue exceed expenditure

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12
Q

What is a budget deficit?

A

Where expenditure exceeds revenues

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13
Q

What are clearing banks as a financial intermediary?

A
  • ‘retail’ banks or ‘high street’ banks e.g. HSBC and provide a principal medium to help the general public with banking services.
  • Take deposits from those who have a surplus of funds and led these funds to those who are looking to borrow
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14
Q

What are building societies as a financial intermediary?

A
  • Similar to clearing banks but traditionally mutual orgs rather than companies
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15
Q

What are investment banks as a financial intermediary?

A
  • also ‘merchant banks’

- Provide services and products to firms and also sometimes wealthy individuals

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16
Q

What are insurance companies as a financial intermediary?

A

Bringing those who want to mitigate or eliminate risk together with those who are prepared to accept risk for an agreed price

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17
Q

What are unit trusts/investment trusts as a financial intermediary?

A

Invest in stocks and shares of businesses for clients

  • Provide funds for companies when new shares are issued
  • Long term means for investors to efficiently invest surplus funds
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18
Q

What are pension funds as a financial intermediary?

A

Use pension contributions of individuals and firms to invest in a range of financial assets (equities, bonds etc)

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19
Q

What are stock exchanges as a financial intermediary?

A

Provide trading platform to bring investors and borrowers in equities and bonds together

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20
Q

What are venture capitalists as a financial intermediary?

A

Provide finance for higher risk propositions e.g. start-up businesses and management buy outs

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21
Q

What are the benefits of using financial intermediaries?

A
  1. Risk Management - individual borrowers and savers shielded from bad debt risk
  2. Aggregation - can take small amounts from investors and lend on in larger packages.
  3. Maturity Transformation - provide investors and borrowers with instruments that match their desired timescales
  4. Matching borrowers and lenders - borrower will normally be able to find an intermediary who is prepared to provide them with some funds even if market conditions aren’t that favourable
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22
Q

What is a financial instrument?

A

This is term to describe any form of funding medium. Most often used to describe short term money market financing mediums but also long-term too.

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23
Q

What are cash instruments?

A

E.g. shares and bonds etc

- The value is determined directly by the market

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24
Q

What are derivative instruments?

A

e. g. option futures etc

- value derives from some underlying asset

25
Q

What are common financial contracts/assets?

A
  1. Credit agreements
  2. Mortgages
  3. Bills of Exchange
  4. Certificates of Deposit
  5. Equities
  6. Bonds
  7. Mezzanine Finance
  8. Venture Capital
26
Q

What are credit agreements?

A

Whereby a party can obtain goods or services now but make payment at a later date or repayments over a period of time
- e.g. credit cards, loans, leasing, supplier credit terms

27
Q

What are mortgages?

A

This is a loan that is generally secured over property e.g. mortgagor can take control of property

28
Q

What are bills of exchange?

A
  • used in commercial business trading esp for sales to a customer in diff country
  • the lender draws up a bill for specified amount and repayment date, borrower signs the bill as acceptance of the terms
  • there is an active market for trading these bills so that the lender does not want to wait 90 days for money they sell it on the secondary market for an amount which is slightly less than face value
29
Q

What are certificates of deposit?

A
  • this is a time deposit
  • similar to savings account = insured & risk-free
  • different from savings a/c as has a specific, fixed term and fixed int rate
  • Held until maturity and then withdrawn together with accrued interest
  • some issued in ‘negotiable’ form => actively traded at any point up until maturity date
30
Q

What are equities?

A
  • Raised through issue of shares
  • Ordinary shares normally - holders of business & irredeemable (can’t be sold back to business once traded)
  • preference share = contain both debt & equity - less likely to give owner a right to vote at GM than ordinary share.
    Examples include:
    1. Cumulative (if dividend not paid, paid in later yrs)
    2. Redeemable (may have rights to be bought back at later date)
    3. Participating (right to a share in any excess profits over and above a certain amount)
31
Q

What are bonds?

A
  • Long-term debt instrument issued by govt or companies
  • Written legal agreement with stated terms and conditions
  • also known as debentures (secured bonds) or loan stock (unsecured bonds)
  • mostly irredeemable
  • UK issued bonds, pay owner interest based on the bonds ‘coupon rate’ every 6 months
32
Q

What are eurobonds?

A
  • These are issued in UK but not dominated by £
  • Pay interest annually
  • Coupon rates also known as ‘bill rates’
33
Q

What are government bonds?

A
  • Referred in UK as GILTS
34
Q

What are corporate bonds?

A
  • Slightly higher risk, than govt bonds => give better yield to investor
35
Q

What are commercial papers (type of bond)?

A

Defined as source of finance, can be traded on the market as well

36
Q

What is mezzanine finance?

A

Type of debt finance which is used in higher risk lending situations

  • Carries higher interest rate than normal secured bank borrowings
  • May be equity warrants attached to the debt => holder to purchase some equity shares in the company at a fixed price at some later date
37
Q

What is venture capital?

A

Equity financing for higher risk investment scenarios

38
Q

What is the impact on a company for gearing?

A

Company that uses large proportion of debt finance relative to equity finance is sometimes referred to as highly geared.

39
Q

What is the future value of an investment?

A

If you invest money => normally get back your investment plus the interest you have earned

40
Q

What is simple interest?

A

This is the interest earned on amount of original investment only, equal amount of interest is earned each year

41
Q

What is compound interest?

A

This is the idea that interest is calculated an paid on the original amount PLUS any accrued interest earned and received upto that point.
- This means interest earned will increase each year.

42
Q

What is the formula for compound interest?

A 
S = X {1 + r} n
X = Initial investment
S = Investment's value at the end of n periods
r = interest rate as decimal

(based on compound basis)

43
Q

What should you assume about interest rates in an exam?

A

Unless you are told otherwise, assume interest rates you are given in the exam are compound interest rates.
- If amount of capital increases/ decreases due to additions/withdrawals then you should break the calculation down into segments for each addition/withdrawal.

44
Q

What is the APR (Annual Percentage Rates)?

A 
This is effective rate of interest for a given monthly/ quarterly rate. 
(1 + R) = (1 + r)n
Therefore: R = (1 + r)n - 1
R = APR
r = Interest rate for the period
n = NUMBER OF PERIODS IN THE YEAR

Sometimes the annual rate of interest is quoted as the ‘nominal rate’ rather than the effective rate LOOK AT NOMINAL RATE EXAMPLE ON PAGE 47

45
Q

What is a yield on financial instruments?

A

A yield = return to the investor

- When placing a value on an investment both the return generated and risks will need to be taken into account.

46
Q

What is the running/current yield?

A

Running yield = annual coupon (coupon rate)/ market price

47
Q

What is the nominal (flat) yield defined as?

A

Coupon/ Nominal (face or par value) value

48
Q

What are treasury bills?

A

These are short term government bonds, which purchased by investors a price below face value and then redeemed at face value.

  • The return to the investor is represented as the difference between face value and purchase price.
  • Two types of yield = Discount Yield & Investment Yield
49
Q

What is a discount yield and it’s equation?

A

Discount yield is the return you get quoted as a % of the face value

F-P/ F x 360/M

F = Face value
P = Purchase price
M = Maturity period in days (91 for a three month and 182 for a six month)
50
Q

What is a investment yield and it’s equation?

A

This is the return you get as a % of the purchase price

F-P/ P x 365/M

F = face value
P = purchase price
M = Maturity period in days
51
Q

What is the dividend yield?

A
  • Similar to running yield but in relation to shares rather than bonds
  • shows current % dividend return in relation to existing share price

Dividend Yield = annual dividend/ market price (share price)

  • The overall return for investor on equities can be measured via the total shareholder return (TSR) = dividend in the year + change in share price/ share price at the beginning of the year => expressed as a %
52
Q

What is risk vs return?

A

The higher perceived risk in any investment the higher the required return will be

53
Q

What are the order of risk of financial instruments from low to highest risk?

A
  1. Treasury Bills (s/t govt securities)
  2. Government bonds (longer term)
  3. Corporate bonds
  4. Equities
  • ShortT treasury bills are considered to have zero risk as little chance of govt defaulting on its short term borrowings
  • Ord shares (equities) highest risk because
    a) dividends may not be paid
    b) you may not be able to sell the shares
54
Q

What is the yield curve?

A

This is a graphical representation of the relationship between
a) Interest rates on financial securities (e.g. bonds) and b) Term to maturity (how long until the underlying debt matures)

55
Q

Why is it normal to expect bonds with longer term maturity to offer higher yield?

A
  1. If an investor wants to cash up in longer period of time - need to be compensated for lack of liquidity (liquidity preference
  2. Investor need to be compensated for additional risk of investing longer term => greater degree of uncertainty surrounding future performance of economy/companies
  3. Uncertainty as to what inflation will do over a longer period
56
Q

How does the yield curve normally look?

A

It is normally an upward sloping line (see graph on page 50)

  • Depends on interaction of no. of diff forces including market expectations as to what int rates might do over the short/medium & long-term
  • And supply & demand for borrowing for different lengths of time
57
Q

What is the function of the central bank?

A

One function = set short term interest rates and this => direct impact on the yields on other financial securities e.g. shares and bonds
- Achieved through ‘open market operations’ => bank buys and sells short term instruments in primary markets
- Bank might seek to boost spending in an economy that is lacking consumer confidence by purchasing assets of govt.
=> Reduce interest rates via pushing up asset prices & lowering yields => spending is encouraged again
= QUANTITATIVE EASING

58
Q

What effect does interest rates and inflation have on a return/yield?

A
  • Return or yield on an investment is eroded away by inflation - rate of return after inflation = ‘real interest rate’
  • Rate before adjusting for inflation = ‘nominal’ rate or ‘money’ rate

1 + real interest rate = 1 + money rate/ 1 + inflation rate

CIMA BA1 Fundamentals of Business Economics (8 decks)

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