Financial Markets and Institutions Flashcards

1
Q

The Financial System consists of? Purpose?

A

Financial Markets (FM) and Financial Intermediaries (FI) whose main role is to provide a
mechanism by which funds are transferred and allocated to their most productive opportunities

FM and FI channel funds from Ultimate Lenders (UL) to Ultimate Borrowers (UB)
◦ UL: economic agents with financial surplus (Inc. − Exp. > 0)
who are willing to lend
◦ UB: economic agents with financial shortage (Inc. − Exp. < 0)
who need to borrow

Channelling funds increases economic efficiency by promoting a
better allocation of resources

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2
Q

Different markets?

A

Debt and Equity Markets
* Debt instrument: contractual agreement by the borrower to make
fixed regular payments (e.g. coupons) until maturity
* Equity instrument: claim to share in the profit and the assets of the
borrower
Primary and Secondary Markets
* Primary Market: market for newly issued securities
* Secondary Market: market for previously issued securities
(highly liquid; determines the price for new issues)
◦ Organised Exchange Markets: buyers and sellers meet in a
central location
◦ Over-the-Counter Markets: dealers at different locations trade
securities ‘over-the-counter’
Money and Capital Markets
* Money Markets: short-term debt instruments are traded
(highly liquid; small price fluctuations)
* Capital Markets: long-term debt and equity instruments are traded

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3
Q

Foreign bond? Eurobond? Eurocurrency?

A
  • Foreign Bond: sold in a foreign country and denominated in that
    country’s currency
    e.g. A UK firm sells a bond in the US denominated in $
  • Eurobond: denominated in a currency other than that of the country
    in which it is sold
    e.g. A bond denominated in $ sold in London
  • Eurocurrency: currency deposited in a bank outside the home country
    (Eurodollars)
    e.g. £s deposited in foreign banks outside UK or foreign branches of
    UK banks
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4
Q

FIs? role?

A

◃ F Is are entities that intermediate between UL and UB
◦ On Asset side, they hold large quantities of financial claims (e.g.
loans)
◦ On Liability side, they hold debt and equity but are highly
leveraged (i.e. assets relative to equity)
I Brokerage Function of F Is: help to reduce informational asymmetries
and transaction costs that are present in Direct Finance
I Qualitative Asset Transformation (QAT) Function of F Is:
reconfigure the attributes of financial claims

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5
Q

Benefits of FIs to UL and UB? how do banks allow these benefits to occur

A

F Is minimise transaction costs and costs due to informational
asymmetries

F Is match their financial needs- Risk, Liquidity and Size

F Is reduce Transaction Costs by exploiting Economies of Scale and
Economies of Scope-
◦ Economies of Scale: by increasing the volume of transactions,
the cost per unit of transaction decreases
◦ Economies of Scope: cost of producing products (share common
inputs) together is smaller than producing them separately

I F Is’ advantages in processing information
◦ Interpret subtle signals
◦ Take advantage of ’Cross-sectional’ (i.e. across transactions)
and ’Intertemporal’ (i.e. across time) Information Reusability
◃ Resolve Informational Asymmetries in transactions; Pre-contract and
Post-contract

Screening: F Is reduce Adverse Selection problems

F Is reduce Screening costs through Information Reusability

Monitoring ensures that informational asymmetries are not exploited
by one party against the interest of the other

  • F Is’ monitoring skills reduce Moral Hazard:
    ◦ Periodic examination of firms’ financial condition
    ◦ Obtain various types of financial information (e.g. performance
    reports, credit ratings by agencies)
    ◦ Send inspectors to monitor firms’ progress
  • Financial regulators monitor F Is activities
    I F Is can reduce Informational Asymmetries
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6
Q

QAT functions?

A

Through QAT, F Is match different financial needs; Size, Liquidity,
Risk
◦ Deposits: small-size, highly liquid, low risk
◦ Loans: large-size, illiquid, high risk

Size transformation:
Maturity transformation
Risk transformation

Through QAT, F Is create new financial assets and liabilities

Risk is an integral part of QAT

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7
Q

FI risks?

A

◦ (a) Inventory risk: purchase/sale of claims can not be perfectly
synchronised
◦ (b) Interest Rate and Liquidity risk: maturity mismatching of
assets and liabilities
◦ (c) Default (or Credit) risk

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8
Q

overall benefit to society, ul and ub

A

◃ Benefits to UL: ↓ Transaction costs & Information asymmetries, ↑
Liquidity, ↓ Risk, Marketable securities
◃ Benefits to UB: ↓ Transaction costs, ↑ Duration of loans, ↑ Size of
loans, ↓ Interest rate
◃ Benefits to Society: Efficient allocation of resources, more borrowing
and lending

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