Quiz 1

Question 1

What is the financial system

Answer 1

A financial system consists of financial institutions, markets and instruments that together provide financial services for the economy

Question 2

What is the settlement function

What are the two payment systems

Answer 2

the arrangements that can be used to settle commercial transactions. Check price and item… exchange money for item

Retail payment system and wholesale (high-value) payment system

Question 3

What is the flow of funds function

Outline two methods of financing

Answer 3

The supply of funds for a period usually on the basis the users compensate the suppliers for the use of their funds.

direct financing = Transactions in financial markets = Deficit units raise funds directly from surplus units by way of securities

indirect financing = Transactions with financial institutions = The flow of funds between surplus and deficit units travels through deposit-taking institutions = two sets of contracts

Question 4

What is the risk transfer function

what are two types of relevant risk

What do we use for transfering risk

Answer 4

Provide instruments for managing risk. Because risk cannot be eliminated, only traded for a different type of risk we call it ‘risk transfer’

default risk: The chance of loss resulting from financial obligations not being met
market risk: The chance of loss arising from an unexpected movement in a market variable (exchange rates, value of traded assets, interest rates)

derivatives

Question 5

What do we mean by overcoming information assymetry

Two ways of overcoming information assymetry

Answer 5

overcoming a situation where one party to a potential contract has an information advantage over the other party.

use of professional traders + financial regulation

Question 6

What do we mean by overcoming incentive problems

one way of overcoming incentive problems

Answer 6

Where parties to a transaction serve to gain through faulty or less than ideal transactions there exists moral hazard, as one of the contracting partners has an incentive to not act appropriately.

fiduciary duty

Question 7

What is the pooling of funds function

Consequence?

Answer 7

An arrangement that consolidates small amounts of funds to satisfy the demand for large amounts. Because usually deficit units seek large amounts repaid over a long time and surplus units seek to supply small amounts over short periods.

Consequence = improves flow of funds function too

Question 8

Define finance
Principal sources of finance
secondary principal source of finance
return formula?

Answer 8

The funds that are made available for use under agreed terms and conditions
principal = savings and income not spent
secondary principal = earnings retained by firms.

return formula = return = risk free rate + risk premium

Question 9

Which is cheaper debt or equity?
Define leverage?
capital structure?
rule of one price?

Answer 9

Debt is cheaper due partly to tax deductions
Leverage = ratio of debt to assets
Capital structure = equity to debt
One price = financial instruments should have one price where they can be traded in different markets

Question 10

What are ADIs
What authority do ADI’s require
what do they provide

Answer 10

ADI = authorised deposit taking institution = banks whether or not the ADI calls itself a bank

Require authority of APRA

provide indirect financing services and provide depositors with payment services = traditional banking services = retail customers, households, small businesses, organisation, wholesale customers (large businesses and organisations)

Question 11

What are non-banks

Answer 11

Merchant banks or shadow banks (non-bank lenders) = non-ADI financial institutions

Merchant banks = provide direct financing services to wholesale customers

shadow banks = arrange loans usually for prime borrowers, receive funding primarily through MBS which have been issued by an investment bank

Question 12

Three types of insurance companies?

what are fund managers?

Answer 12

life, general, medical

fund managers = financial institutions that contribute to direct financing by arranging the collective investment of investors’ funds in return for fees

Question 13

The money market?

Answer 13

(engaged in flow of funds): The market for short-term debt securities (discount securities) = discount because issued at discount to their face (future) value.

Question 14

The bond market

Answer 14

(engaged in flow of funds): contributes to the flow of funds through the issue of long-term securities, known as bonds.

Question 15

The share market

Answer 15

(engaged in flow of funds):: arranges trading in shares and other corporate securities

Question 16

The foreign exchange market

Answer 16

enables transactions to be made in different currencies because it arranges trading in foreign currencies.

Question 17

The market for derivatives

Answer 17

operate either in a similar fashion to the share market (where the derivative contracts are traded) or the contracts are arranged by wholesale customers with dealers who mainly work for banks

Question 18

APRA?
ASIC?
RBA?
Australian treasury?

Answer 18

APRA = an organisation to supervise financial institutions = ensure institution is able to meet obligations to customers 
ASIC = an organisation to regulate markets and to protect retail investors
RBA = an organisation responsible for implementing monetary policy, the issue of notes and to act as the banker to the Australian Government.  

Australian treasury = not a regulator, however it influences the framework for regulation

Question 19

Five main functions of RBA?

Answer 19

1. The implementation of monetary policy (the use of monetary variables, principally short-term interest rates, to help manage the economy.
2. The stability of the financial system
3. The regulation of the payment system
4. The issue of notes to the community (through the banks)
5. Banker to the commonwealth government

Question 20

What is a loan originator?
How were the original loans funded by banks prior to GFC?

Elaborate on the effect of sub-prime housing loans and rising interest rates?

securitisation + effect?

flaws of US process of securitisation?

credit default swap + effect?

moral hazard of bailouts?

Answer 20

Loan originator = The person in charge of whether an applicant will receive a loan and on what terms.

Funding = by establishing a MBS and selling it off to an investor

sub prime and interest rates = lend to sub prime borrowers to expand market and make more money = include rising interest rates at a later date = everyone starts to default around same time = house prices fall = MBS loose value

securitisation = is the process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors.

effect = This process can encompass any type of financial asset and promotes liquidity in the marketplace.

flaws = information asymmetry = sub prime lenders + high interest rates

flaws = incentive problems = sell more mortgages = make more money

CDS = derivative for transferring risk of default on MBS to banks = done because banks did not predict all the defaults and thought this extra “unnecessary” insurance would just make them more money = effect of banks becoming bankrupt and so unable to payout for all of the CDS and so the CDS all became worthless and meaningless.

moral hazard of bailouts = leads top management to think they are immune and so they take riskier and riskier actions

Question 21

Exchange settlement account + main condition + main advantage?

Two steps for processing interbank payment orders?

Two sources responsible for settlement of trades in wholesale financial market?

Answer 21

ESA = account financial institutions have with the RBA to settle the payments they make to each other and with the RBA = condition of not being able to overdraw = main benefit is RBA pays interest on account balance + allows ADIS to provide payment services to customers + are a safe place for funds

interbank payment order process = 1)clearing = both parties agree to terms of transaction = 2) settlement = exchange of value

two sources = clearing house (logs issued securities and owners and clears trades) + SWIFT (operates network for exchange of payment and other financial messages between financial institutions)

Question 22

Elaborate on the purpose and instruments used for the retail payment system vs wholesale payment system

Answer 22

Retail = individual and normal business payments = more transactions = however, lower net value
wholesale = financial market transactions and transfers between ADIs and the RBA = less transactions = however, overall higher value

Retail = cash, cheques, credit/debit cards, etc. 
wholesale = real-time gross settlement

Question 23

in the case of the retail payment system, when is immediate and when is deferred settlement used? Also what are merchants fees?

Retail = two steps to DNS?

Retail = Advantage and disadvantage of DNS?

Payment orders + 4 types?

Answer 23

immediate settlement = cash and same-ADI payment orders
Deferred settlement = drawer and recipient use different ADI
merchants fees = fees for use of EFTPOS terminals and ADIs processing of payment orders ,etc.

DNS = net clearing (deducting payments from receipts when settling obligations between two parties) = settlement (transfer of net amounts at 9am next business day.
DNS advantage = uses net clearing to reduce number of overall transactions and to offset amounts owing and amounts owed (this reduces the amount of ES funds required as a bank which owes another bank $10 at 1pm and then is owed $5 by this same bank will then only have to pay $5 and so never required the full $10 in their ES account).

DNS disadvantage = settlement is not immediate

payment orders = instructions to ADi to pay stated amount to nominated party

• direct credits (+) and direct debits (-) = allows organisations to make payments to, and receive payments from, large groups
• cheques
• debit, credit and charge cards
• online payment orders

Question 24

Types of transactions in the wholesale payments system (3)?

Real-time gross settlement: Use and 4 steps?

Answer 24

1. wholesale financial market transactions from the FX, bond and money markets = two steps = 1) trade is made between the buyer and the seller that specifies the terms of the trade = 2) settlement occurs a specified number of days later then payment is made and ownership of the asset is transferred
2. Transfers between ADIs (including DNS transfers)
3. Payments are made with ES funds between ADIs and the RBA

Real-time gross settlement = Used by the wholesale system for clearing and settling

1. Instructions regarding the payments to be settled each day are received mostly from the clearinghouses in the debt markets (Austraclear) and FX market (SWIFT)
2. These payments are placed in a queue within the Reserve Bank Information and Transfer System (RITS) where they are processed individually throughout the day
3. Processing involves firstly the clearing of the payment – which is checking that the paying ADI has sufficient ES funds to enable payment
4. Once a payment is cleared it is immediately settled through a transfer of ES funds

Question 25

What is direct financing?

Elaborate on the parties involved (4)

elaborate on the mismatch between surplus and deficit unit preferences (4) categories/

Answer 25

Direct financing = is arranged through issuing securities to investors in the financial markets in order to raise funds for deficit units

(1) deficit units engage (2) major banks and investment banks to arrange issuance of securities. (3) surplus units invest alone (retail investors) or supply funds to (4) funds managers to pool and invest funds.

Amount of funds = Small (s) = large (d)
Contract length = flexible short (s) = inflexible long (d)
risk exposure = risk averse (s) = risk taker (d)
return/cost = high returns (s) = low cost (d)

Question 26

outline 2 costs incurred in the flow-of-funds

Answer 26

Spread: a spread exists between the cost of funds for deficit units and the returns to surplus units.

1) For direct financing: deficit units pay returns to surplus units plus fees to institutions. Returns to surplus units are net of fees paid to funds managers.
2) For indirect financing: the spread is the difference between the interest paid on loans from an ADI and the rate earned by the ADI’s depositors and other lenders

Question 27

What is the primary market for?
who regulates the issuing of securities?
why use investment/merchant banks?

Answer 27

primary market = direct financing through the issuing of securities

regulation = ASIC

investment/merchant banks = because primary issues are a complicated process for which the services of professionals are required.

Question 28

best efforts?

Answer 28

securities are mainly issued in Australia under contracts known as best efforts
- The investment bank undertakes to arrange the issue and the tasks involved depend on the type of securities. The investment banks will earn fees (normally commission) but they do not guarantee all the securities will be sold – such a guarantee can be provided with an additional standby underwriting contract whereby unsold shares will be purchased by the investment bank to ensure all shares are sold.

Question 29

Clearing house? + australian clearinghouse in debt markets?

Answer 29

A clearing house is an intermediary between buyers and sellers of financial instruments. Further, it is an agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data.

Austraclear

Question 30

composition of secondary markets (3)?

Elaborate on time taken for trading and settlement?

Answer 30

secondary markets are comprised of: (1) a trading platform that enables trading, (2) trading rules and procedures to promote efficient and fair trading, (3) settlement arrangements to organise payments

trades = instant (electronic services), settlement = few days after trade.

Question 31

Distinguish the features of security exchange markets and OTC markets

Answer 31

Exchange = share markets (some derivatives) brokers (agents for traders who earn commission and hold responsibility for settlement of clients trades). = order driven (trading is on basis of orders from traders) (order specifies buying or selling intention, security, quantity, price) = limit price (maximum buying price or minimum selling price) or at market price (best available price) = stored orders and trading opportunities (when limit orders are not cancelled they provide other traders with trading opportunities) = transparency (electronic trading system records every trade which can be monitored) = automated trading systems (computer based trading) (replaced open outcry because cheaper and location-less)

OTC = money, bond and FX markets (some derivatives) = dealers act as principals for buying and selling on their own behalf = trade with each other and wholesale clients = automated trading systems = hold inventory of securities (their position) (exposed to price risk) = quote driven (bid and offer quotes) = dealers are market makers = earn a trading spread on a round trip transaction = dealer to client market (buy low and sell high but must stay relevant) and dealer to dealer market (trade with dealers to manage position) = market spread comprises highest bid and lowest offer = dealer spread comprises individual bid and offer prices

Question 32

Clearing and settlement in financial markets?

Answer 32

Settlement is arranged on its due date by the market’s clearinghouse based on details provided by the ‘back office’ of each dealer or broker involved in a trade - Settlement means the seller is paid and the security registry is updated with the new owner

Question 33

market rules in financial markets? what and set by who?

Answer 33

market rules are set by AFMA or the ASX and include trading hours, pricing practices, trading protocols, transaction sizes. Listed-companies are required by the ASX to provide market-sensitive information in a timely fashion

Question 34

how secondary markets assist primary markets

Answer 34

1. By providing investors with liquidity (transforming the maturity of funds in the market). A securities liquidity is indicated by its: daily turnover or turnover ratio – (higher ratios indicate greater liquidity), bid-ask spread (where liquidity is indicated by narrow spreads), price resilience (liquidity varies inversely with the impact)
2. By performing the price-discovery process through which the market judges the value of the traded securities. most effectively performed by efficient and liquid markets. This information allows investors to monitor the value of their investments, and informs potential issuers of securities of their expected proceeds.

Question 35

EMH? 3 levels of informational efficiency?

Answer 35

EMH = The efficient market hypothesis (EMH) purports that security markets efficiently use information to generate ‘fair’ prices that move randomly = represent fair value = adjust quickly in response to new price sensitive information = change randomly since the flow of new price sensitive information is random = today’s price is best indicator of tomorrows price

weak form = use past price data
semi-strong = use all published information
strong form = reflect all available information including inside information

Question 36

Evidence against market efficiency (3)

Answer 36

Prices should follow a random walk = should not be able to achieve excess returns over sustained period = however, some people have done this.

Price bubbles = prices exceed fair value and are followed by a sharp correction = bubbles demonstrate that traders sentiment distorts their expectations

Bull and bear markets = reflect conditions in the economy, such as the business cycle, however increase in share prices (bull markets) or decreases in share prices (bear markets) do not always reflect corporate profits (do not reflect available information).

Question 37

What is volatility in regard to market risk?

Answer 37

Volatility is the degree of movement in a variable that can be measured by its variance (or standard deviation) around the average value = variables that are more volatile are riskier while offering a greater potential for higher returns