Finance

Question 1

Introduction

1. Financial System definition

Answer 1

The financial system consists of all financial intermediaries and financial markets and their relations
with respect to the flow of funds to and from households, governments, business firms, foreigners, as well as the financial infrastructure.

Question 2

Direct finance

Answer 2

Direct finance occurs if a sector in need of funds borrows from another sector via a financial market.

• A financial market is a market where participants issue and trade securities.
• In direct financing borrowers and savers exchange money and financial instruments directly.

Question 3

Indirect finance,

Answer 3

With indirect finance, a financial intermediary obtains
funds from savers and uses these savings to make loans to a sector in need of finance.
-Financial intermediaries are coalitions of agents that combine to provide financial services, such as banks, insurance companies, finance companies, mutual funds, pension funds, etc

Question 4

Function of the Financial System

Answer 4

-The main task of the financial system is to channel funds from sectors that have a surplus to sectors that have a shortage of funds.
-In doing so, the financial sector performs a number of
functions:
-Financial system works as an effective conduit for
optimum allocation of financial resources in an economy.
-Helps in establishing a link between savers and investors.
-Allows ‘asset-liability transformation’. Banks create
claims (liabilities) against themselves when they accept
deposits from customers but also create assets when they provide loans to clients.
-Economic resources (i.e., funds) are transferred from one party to another through financial system.
-Ensures the efficient functioning of the payment
mechanism in an economy. All transactions between the buyers and sellers of goods and services are effected smoothly because of financial system.
-Helps in risk transformation by diversification
-Enhances liquidity of financial claims.
-Helps price discovery of financial assets resulting from the interaction of buyers and sellers e.g, prices of securities are determined by demand and supply forces in the capital market.
-Helps reducing the cost of transactions.

Question 5

Role of Financial System

Answer 5

-The role of the financial system is to gather or pool
money from people and businesses that have more than they need currently and transmit those funds to
those who can use them for either consumption or
investment.
-The larger the flow of funds and the more efficient
their allocation is, the better the economic output and welfare of the economy and society.
-Savings: The financial system allows you to place your excess money into a savings account in a bank of your choice. Keeping your money in a bank safeguards your savings, and the bank pays you interest based on the amount you keep in your account.
-Loans: Money in deposit accounts, like savings accounts, is used to provide loans for a wide range of projects to people and businesses. Mortgages, car loans and student loans are financed largely by deposits in banks, savings institutions and credit unions.
-Investments: The financial system also facilitates the transfer of money from investors to businesses. When businesses raise capital, they sell stock to investors. Investors give their money to the company in exchange for ownership in the company.
-Business Growth: Businesses may expand their operations or finance growth by issuing debt instruments called bonds. Bonds are bought and sold through the financial system.
-Government Expenditure: Governments may finance programs or deficit spending through the financial system by issuing bonds to raise money.

Question 6

Role of Government

Answer 6

A well-functioning financial system requires particular
government actions.
1.government regulation is needed to protect property rights and to enforce contracts.
2.government regulation is needed to encourage proper information provision so that providers of funds can take better decisions on how to allocate their money.
3.government should arrange for regulation and supervision of financial institutions in order to ensure their soundness.
4. governments are responsible for competition policy to ensure competition.

Question 7

Overview of the Financial Systems and Its Components

Answer 7

(Slide)

Question 8

Financial Markets

Answer 8

-The financial system consists of financial markets and institutions.
-Financial markets are where people buy and sell, win
and lose, bargain and argue about the price and the
product/services.

Question 9

Financial institutions

Answer 9

Financial institutions, as part of financial system, also play an important role in economic development by facilitating the flow of funds from surplus unit (savers) to the deficit unit (borrowers). They are firms such as credit unions, commercial banks, finance institutions, insurance companies etc.

Question 10

Functions of Financial Markets

Answer 10

-Financial markets serve six basic functions. These functions are briefly listed below:
-Borrowing and Lending: Financial markets permit the
transfer of funds (purchasing power) from one agent to
another for either investment or consumption purposes.
-Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.
-Information Aggregation and Coordination: Financial
markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.
-Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.
-Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.
-Efficiency: Financial markets reduce transaction costs and information costs.