MN-1502 Finance Flashcards
1
Q
What are the 4 forces behind the expansion of the financial system?
A
- Globalisation
- Technology
- Deregulation
- Financial Innovation
2
Q
Give 3 positives on financial markets of globalisation
A
- Borrowers are no longer limited to their national markets
- Agents have more opportunities to invest
- Financial institutions can have global presence
3
Q
Give 4 negatives on financial markets of globalisation
A
- Problems with detecting wrongdoing
- Increased spillover between markets
- Stock and bond markets have increasing synchronisation
- Lack of local market knowledge
4
Q
Why is stock and bond markets have increasing synchronisation an issue?
A
Investors can’t diversify their portfolio
5
Q
Give 3 advantages on financial markets of improved technology
A
- Increased speed of trades
- Reduced costs of financial firms
- Created a broader range of trades
6
Q
Give 4 disadvantages on financial markets of improved technology
A
- Security and reliability weakened
- Large capital investment
- Backward compatibility
- Altered balance between fixed and variable costs
7
Q
Give 4 UK policies introduced in the 1980s to encourage more agents into the financial system
A
- Tax breaks for savers
- Shifted tax on income to expenditure
- Privatisation
- Kept financial products untaxed and increased indirect taxes
8
Q
Give an advantage of financial innovation
A
More customers in the market because of increased investment opportunities
9
Q
Give a negative of financial innovation
A
Often created in order to take advantage of tax loopholes
10
Q
Give the 5 types of Financial Innovation
A
- Market-Broadening Innovation
- Risk Management Innovation
- Arbitraging Innovation
- Pricing Innovation
- Marketing Innovation
11
Q
Explain risk management innovation as a type of financial innovation
A
People aim to shift the risk on them to others
12
Q
Explain arbitraging innovation
A
People taking advantage of tax loopholes
13
Q
Explain what is meant by marketing innovation
A
New methods and techniques to buy/sell new products
14
Q
Define ‘Financial System’
A
A channel of funds from entities with surplus funds to those with a shortage
15
Q
Give the 3 main roles of the Financial System
A
- Transfer of funds from surplus units to deficit units
- Provide a mechanism for the transfer of financial risk
- Introduce a concept of money into the economy
16
Q
Define Money
A
Anything that is generally accepted as payment for goods and services or for the repayment of debt
17
Q
Give the 3 roles of Money (same as from economics)
A
- Medium of Exchange
- Store of Value
- Unit of Account
18
Q
Explain what is meant by money being a ‘Store of Value’
A
It is a way of transferring purchasing power from present to the future
19
Q
Explain what is meant by money being a ‘Unit of Account’
A
It provides the terms in which prices are quoted and debt recorded
20
Q
What are the 4 ordered elements of the finance cycle?
A
Savers -> (financial markets) -> Borrowers
Borrowers -> (financial intermediaries) -> Savers
21
Q
Define ‘Financial Intermediary’
A
Economics agents who specialise in buying/selling financial contracts
22
Q
Define ‘Financial Markets’
A
Markets where funds are moved from those with an excess to those with a deficit
23
Q
Give the 2 basic principles of any financial transactions
A
- Time has value
- Information is the basis for decision making
24
Q
Why are financial transactions often weighted one way?
A
Because of asymmetry of information
25
Which of the following is not a benefit of globalisation on
financial services?
a) Borrowers can raise funds on both domestic and foreign
financial markets.
b) Loss of local knowledge.
c) Financial institutions seek to have global presence both as a
means of expansion and to retain their existing customers.
b
26
Investing in tax-exempt securities is an example of:
a) market-broadening innovation
b) risk-management innovation
c) arbitraging innovation
d) pricing innovation
e) marketing innovation
c
27
A deficit unit is one for whom ______ exceeds _______ .
a) saving; income
b) expenditure; saving
c) expenditure; income
d) income; expenditure
c
28
A surplus unit is one for whom income exceeds expenditure.
a) True
b) False
a
29
Which of the following are functions of a financial system?
1. The operation of a payments system.
2. Providing the mechanism for transfer of financial risk.
3. Helping to reduce unemployment.
4. Channeling funds between lenders and borrowers.
5. Helping speculators to bet on price movements.
1, 2, 4
30
Define 'Direct Finance'
The transfer of funds from surplus markets to deficit markets through financial markets
31
Define 'Indirect Finance'
The transfer of funds from surplus markets to deficit markets through a financial intermediary
32
What's the advantage of going through a financial intermediary instead of financial markets?
The risk is shifted to the financial intermediary
33
For surplus agents, which is larger, income or expenditure?
income > expenditure
34
For deficit agents, which is larger, income or expenditure?
expenditure > income
35
Which is more risk averse; surplus agents or deficit agents?
Surplus agents
36
What kind of horizons do surplus and deficit agents tend toward?
Surplus Agents -> Short-Term Horizons
| Deficit Agents -> Mid/Long-Term Horizons
37
Define Financial Security
Having a legal claim to future cash-flow
38
Each financial security has an ______ that agrees to make that future cash payment to the ______
'Issuer'
| 'Holder'
39
What is Equity?
A share representing a stake in a company where the holder is entitled to periodic dividends that can be sold to other parties at the market price
40
When a bank is loaning to a person, who is the issuer and who is the holder?
Issuer: Person
Holder: Bank
41
When a firm issues shares to an individual investor, who is the issuer and who is the holder?
Issuer: The Firm
Holder: The Individual
42
What are the 4 types of liability?
Type 1: amount known, timing known
Type 2: amount known, timing unknown
Type 3: amount unknown, timing known
Type 4: amount unknown, timing unknown
43
What type of liability would home insurance be?
Type 4: amount unknown, timing unknown
44
What type of liability would life insurance be?
Type 2: amount known, timing unknown
45
Give the 2 roles of financial markets
Pricing Function
| Discipline Function
46
Explain the pricing function of financial markets
Provides buyers and sellers with a fair valuation of what they're buying/selling
47
Explain the discipline function of financial markets
prevention of excessive risk-taking by banks through fear of adverse market reaction
48
What is a primary market?
The exchange of new securities
49
What 2 things are unique about a primary market?
- Must be 'underwritten'
| - Issuer received share proceeds
50
What is a secondary market?
The exchange of financial securities which have already been exchanged before
51
Give the 2 reasons why secondary markets are so significant
- Indicates to the original supplier the demand for their shares
- The liquidity provided by secondary markets decreases the cost of capital of the issuers
52
What is the role of 'market makers'?
Market makers provide liquidity to the market by quoting bid and ask prices continuously
53
What are the 2 main types of assets traded in financial markets?
Bonds
| Equity Shares
54
Give the 5 different ways that markets can be catagorised
- Maturity of Asset Traded
- Means of Settlement
- Obligation to Exchange
- Organisational Structure of Market
- Method of Sale/Pricing
55
Give the 2 types of markets categorised by 'maturity of asset traded'
Money Market or Capital Market
56
What is the maturity of the asset traded in the money market like?
They cater to short-term funding requirements
57
What is the maturity of the asset traded in the capital market like?
Long-term financial securities with maturity longer than a year
58
Give the 2 types of markets categorised by 'means of settlement'
Cash Market or Forward Market
59
What is the means of settlement in a Cash Market?
Immediate settlement with price agreed today
60
What is the means of settlement in a Forward Market?
An agreement made immediately but the actual transaction takes place some time in the future
61
Give the 2 types of markets categorised by 'obligation to exchange'
Future Markets or Options Market
62
What is the obligation to exchange in a Future Market?
The buyer is obliged to the future to exchange funds at an already agreed price
63
What is the obligation to exchange in an Options Market?
The buyer has the right to, but not the obligation to, buy the asset on the agreed date
64
Give the 2 types of markets categorised by 'organisational structure of the market'
Regulated Markets and Over the Counter Markets
65
What is the organisational structure of a Regulated Market?
Trading is organised by a broker
66
What is the organisational structure of an Over the Counter Market?
Buyers and sellers trade between themselves
67
What is the role of a broker?
An expert advisor
68
Give the 3 types of markets categorised by 'method of sale/pricing'
System of Market Makers, Over the Counter Markets and Pit Trading
69
What is the method of sale/pricing of a System of Market Markers?
Quote buy/sell prices of the product
70
What is the method of sale/pricing of an Over the Counter Market?
Tailor made assets are agreed between buyer and seller
71
What is the method of sale/pricing of Pit Trading?
Occurs inside the exchange
72
What is an Arbitrageur?
People who buy assets where there are pricing anomalies to make low-risk investments
73
What is a hedger?
Those who seek to buy/sell assets in future markets to reduce or eliminate existing risk by agreeing a fixed price on goods they will need in future
74
What is a speculator?
A risky trader who buys/sells assets in order to try and gain a big profit using information
75
Which 2 costs are incurred through 'direct lending' prior to the transaction?
- Search costs
| - Verification costs
76
Which 2 costs are incurred through 'direct lending' after the transaction?
- Monitoring costs
| - Enforcement costs
77
What are 'search costs'?
The cost of searching for borrowers, obtaining information about them and negotiating a contract
78
What are 'verification costs'?
The cost of evaluating borrowing proposals
79
What are 'monitoring costs'?
The cost of monitoring the actions of borrowers after the loan has been made
80
What are 'enforcement costs'?
The cost relating to enforcing the terms of the contract if the borrower defaults
81
What 2 problems arise from asymmetric information?
- Adverse selection
| - Moral hazard
82
What is the problem of 'adverse selection'?
Where the worst potential borrowers who are most likely to default are most likely to seek loans
83
What is the problem of 'moral hazard'?
Where the borrower has incentive to engage in immoral activities, making it more likely they won't repay the loan
84
Due to the 4 types of cost of direct lending and 2 arising from information asymmetry, what alternative do investors regularly turn to?
Financial intermediaries
85
Give the 6 roles of financial intermediaries
- Risk transformation
- Size transformation
- Maturity transformation
- Liquidity provision
- Cost reduction
- Provision of a payments system
86
Explain the 'risk transformation' role of financial intermediaries
Financial intermediaries are more willing to take on bigger risks that individual investors aren't
87
Give 4 ways in which financial intermediaries transform risk
- Screen out bad risks using credit ratings
- Diversify risk by lending to different types
- Holding sufficient capital to meet losses
- Pooling risk
88
What is meant by the term 'pooling risk'?
Giving out huge amounts of small loans so that a few defaulting will still leave them in profit
89
Explain the 'size transformation' role of financial intermediaries
They bridge the gap between lenders having small sums of money and borrowers desiring large loans
90
Explain the 'maturity transformation' role of financial intermediaries
They bridge the gap between lenders wanting short-term loans and borrowers wanting long-term loans
91
Explain the 'liquidity provision' role of financial intermediaries
Lenders want their money liquid whilst borrowers prefer long-term loans. Financial intermediaries help to bridge this
92
Explain the 'cost reduction' role of financial intermediaries
Intermediaries are able to lower transaction costs due to their vast network of links and also benefit from economies of scale
93
Explain the 'provision of a payment system' role of financial intermediaries
Intermediaries facilitate payments from a vast number of methods (cash, cheque...)
94
How do intermediaries help reduce (but not solve) the problem of 'adverse selection'?
They produce more information on the borrower's circumstances
95
Why do Intermediaries not suffer from the free-rider problem?
As their transactions are private
96
What do Intermediaries use to reduce the 'moral hazard' problem?
Restrictive covenants
97
What is a restrictive covenant?
A clause in an agreement to fix what the person taking out the loan can use it for
98
Why do banks have an advantage over individual investors in terms of restrictive covenants?
Individual investors will struggle to enforce it
99
What does the role of Intermediaries as 'delegated monitors' refer to?
Their role in enforcing protective covenants
100
What is the free-rider problem?
Where a party follows another party who has done their research to reduce information asymmetry at no cost
101
Give the 5 types of Intermediaries
- Deposit Institutions
- Insurance Companies
- Mutual Funds
- Investment Trusts
- Pension Funds
102
What is a deposit institution?
An intermediary that accepts deposits that's then lend to borrowers
103
What is the main type of deposit institution?
Commercial banks
104
For the deposit institution, which of assets and liabilities are loans and deposits?
```
Assets = loans
Liabilities = deposits
```
105
Where does the profit come from for a deposit institution?
The spread between the interest rate they charge for loans and the interest rate they provide in their deposit accounts
106
Name the 4 types of risks faced by deposit institutions
- Default risk
- Funding risk
- Regulatory risk
- Liquidity risk
107
What's the 'default risk' for a deposit institution?
The risk that borrowers bankrupt
108
What's the 'funding risk' for a deposit institution?
The risk that adverse moments in the interest rate will reduce profits
109
What's the 'regulatory risk' for a deposit institution?
The risk that new regulation will come into place and impact profits
110
What's the 'liquidity risk' for a deposit institution?
The risk that the difference between short term deposits and long term loans could bankrupt them
111
What are insurance companies and how do they act as Intermediaries?
Non-deposit institutions who carry out the intermediary function by collecting funds from policyholders periodically and invest it
112
What benefit do insurance companies give to consumers?
They provide compensation provided the event being insured against occurs
113
How do insurance companies calculate their premiums?
Using the person's history, the likelihood of that event occuring and the magnitude of the payment they'd have to make should the event occur
114
How liquid are insurance company's reserves?
They are invested but liquidly
115
How is the Intermediary function carried out by a Mutual Fund?
They pool funds from the public and invest them into equity and bond markets
116
Why are mutual funds able to provide investors with better returns that if they were to invest themselves?
They benefit from economies of scale and can diversify
117
Which 2 areas does income from investing in mutual funds come from?
- Share capital appreciation of fund comprised funds
| - Share in the flow of income generated by the assets comprised in the fund
118
What do Investment Trusts do?
Buy and sell stocks with banks
119
What unique characteristic do Investment Trusts have?
They're 'closed ended'
120
What is meant by Investment trusts being 'closed ended'?
It's possible to invest in them only through buying shares from current shareholders
121
How do pension funds act as intermediaries?
They accumulate funds over a worker's life which is invested by the pension fund to keep up with inflation
122
Why are pension funds separate from the company?
To ensure that if the company bankrupts, the assets can't be claimed by creditors
123
Who pays into a pension fund?
Both the worker and the employer
124
What is a 'financial claim'?
A legal claim to a future cash flow
125
In a transaction, who is the issuer?
The person who has financial liability
126
In a transaction, who is the holder?
The person who has the financial asset
127
Give the 7 characteristics of Financial Claims
- Risk
- Liquidity
- Maturity
- Expected Return
- Real Value Certainty
- Divisibility
- Currency Denomination
128
Define liquidity
The ease and speed at which a financial instrument can be converted to cash without loss
129
Which 2 terms separate the liquidity of a good?
- Redeemable
| - Marketable
130
What is meant by an asset's 'maturity'?
The time it takes for an asset to expire
131
What 2 things do an asset's term to maturity depend on?
- Expectations of interest rate changes
| - Loss of liquidity in long-term holding
132
What is meant by the 'real value certainty' of a financial instrument?
Its susceptibility to loss from inflation
133
For which type of financial securities is the 'real value certainty' particularly significant?
Those with a long maturity
134
What is meant by the 'divisibility' of a financial instrument?
The degree to which it can be divided into smaller units
135
What is divisibility a determinant of?
Liquidity
136
What is meant by financial instruments having 'currency denomination'?
They earn an additional return/loss in non-domestic markets in the form of the exchange rate
137
Why has the significance of 'currency denomination' increased in the last 50 years?
Globalisation
138
What financial securities are 'debt' instruments?
Those where a sum of money is lended from one party to another
139
What financial securities are 'equity' instruments?
Those that provide a share of ownership in a company
140
Give the 4 types of Debt Instruments studied
- Treasury Bills
- Commercial Papers
- Bonds
- Debentures
141
What are Treasury Bills?
Short term-, government issued debt instruments for which interest is paid upon full maturity
142
What are Commercial Papers?
Short-term, firm issued debt instruments with high risk
143
Why are Commercial Papers risky?
If the firm defaults, they aren't going to be repaid in the liquidation process
144
When a company goes into liquidation, who is paid first: debt holders or shareholders?
Debt holders
145
What are Bonds?
Long-term, firm or government issued debt instruments
146
What are Bonds known as when they're government issued?
Coupons
147
How do the government sometimes encourage investment into 'Coupons' (Government issued Bonds)?
Afford investors certain tax breaks
148
What are Debentures?
Medium to Long-Term corporate debt assets
149
Name the 2 types of Equity Instruments
- Ordinary shares
| - Preference shares
150
What is the alternative name for Ordinary Shares?
Common stock
151
Is Common Stock long term or short term?
Long term
152
Who has priority in the situation of liquidation: preference shareholders or common stock holders?
Preference shareholders
153
Who has priority in the situation of liquidation: preference shareholders or debt holders?
Debt holders
154
What incentive is there for Preference Shares over Common Stock?
Fixed dividend payments
155
What are Bond Ratings?
A measure of investment risk of interest and repayment
156
Who rates Bond Ratings?
Commercial Organisations
157
What does a high grade Bond Rating mean?
There's low possibility that they won't meet the contracted terms
158
On the stock market, does market value equal nominal value?
No
159
What are 'Pre-Emption Rights'?
Selling an equity before it goes onto the public market
160
Who bears the residual risk of ordinary shares?
The Shareholder
161
The cost of ______ is higher than the cost of preference shares or debt
Equity
162
What is equity financing?
The sale of equity for finance
163
How is equity finance good for current shareholders?
Gives them a way out of their investment through the secondary market
164
Give 5 disadvantages of equity finance
- Listing costs
- Shareholder Expectation
- Short termism
- Public scrutiny
- Open to takeover bids
165
How often do Common Stock holders receive dividends?
At the discretion of management
166
Do Preference Shareholders actually have ownership of the firm?
No
167
Where are shares traded?
The Stock Exchange
168
What does the market value of shares depend on?
Their supply and demand
169
What will happen to the quoted price on the stock exchange if the capital market is efficient?
It will reflect market expectations
170
Give the 4 reasons for government intervention in the financial sector
- Externalities
- Asymmetric information
- Moral Hazard
- Principal Agent Problem
171
Explain how Externalities cause a problem whereby the government need to intervene
Problems in the financial sector will impact the economy as a whole
172
Explain how Asymmetric Information causes a problem whereby the government need to intervene
It created the problem of insider trading
173
Explain how the Moral Hazard can cause a problem whereby the government need to intervene
People spending recklessly puts depositors at risk which the government aim to stop
174
Explain how The Principal Agent Problem can cause the government to intervene
To prevent foul play, Intermediaries are obliged to disclose information on the firm's financial performance
175
What is insider trading?
The purchase of a security by someone with more information that's not publically available
176
Give the 5 objectives of government intervention
- Promote financial stability
- Protect investors against fraud
- Prevent dissemination of misleading information
- Promote competition
- Control activity of financial institutions
177
Give the 3 types of government intervention
- Structural
- Prudential
- Investor Protection
178
Explain structural government intervention
Limiting the activities of financial institutions, limiting activities, products and geographical boundaries
179
Explain prudential government intervention
Limits on internal management
180
Explain investor protection
Protecting investors from fund mismanagement, malpractice and fraud
181
Name the 5 types of risks Commercial Banks face
- Systemic risk
- Financial conjugation
- Interest rate increases
- Price risk
- Fraud and mismanagement
182
What is systemic risk?
Risk of bank runs (many people withdrawing at once)
183
What is financial conjugation?
The transfer of economic shock from one entity to another (bank, country...)
184
What is the price risk faced by Commercial Banks?
Fluctuations in the financial markets (i.e. currency, interest rate...)
185
What is statutory regulation?
Where a government agency is in charge of market regulation
186
Define self regulation
Where an industry sponsored agency regulates the market
187
Give 3 advantages of self regulation to the market
- More flexible and quickly adaptable
- Has potential to be more effective
- Higher production standard
188
Give 2 disadvantages of self regulation to the market
- More sympathetic to the industry over consumers
| - Has potential inside interests
189
In what year were the first Basel Accords put into place?
1988
190
Give the 2 aims of the First Basel Accords
- Ensure greater consistency of capital adequacy ratios between banks across the world
- Try to reflect the risk profile of different banks
191
What percentage do the Basel Accounts require Core Capital to be at?
8%
192
Give the 3 main criticisms of the First Basel Accounts
- Arbitrary weighting system
- All commercial loans being treated as equal
- Banks in all economies being treated equally
193
What did the First Basel Accords lead many Commercial Banks to do?
Sell off riskier loans to reduce their capital reserve requirements
194
What is Regulatory Arbitrage?
Taking advantage of regulatory treatment across different countries
195
In what year were the Seconds Basel Accords introduced?
2004
196
What did the Second Basel Accords do differently to the First?
Made things more flexible and divided itself into 3 pillars
197
What did Pillar I of the Second Basel Accords do?
Gave banks a choice of using either the standardised approach or an internal ratings based approach
198
What 3 risks do Banks face?
- Market risk
- Operational risk
- Credit risk
199
What did Pillar II of the Second Basel Accords do?
Ensured that banks using the internal ratings based system report to a supervisory body that they are covering all risk
200
What did Pillar III of the Second Basel Accords do?
Required banks to disclose information on their risk levels
