The financial system

Question 1

what is a financial security?

Answer 1

a piece of paper which is a claim on an issuer’s future income or an issuers asset.

Question 2

What are basic securities? (2)

Answer 2

1. Bond: is a debt security that promises to make payments periodically for a specified period of time example: one year, ten years. People that have bonds (bondholders) receive coupons.
2. Stock (or equity): is a security that is a claim on the earnings and the assets of the corporation. People that own stocks (stockholders) receive if any, dividends.

Question 3

What is the difference between bonds and stocks? (4)

Answer 3

1. bonds represent borrowing whilst stocks represent ownership
2. Bond: debt security, stock: share of ownership
3. Bond: fixed maturity, stock: no maturity
4. Bond: contractual payment, stock: no contractual payments

Question 4

What do financial markets serve for?

Answer 4

• Financial markets channel excess funds from lenders, ex: businesses or individuals who want to invest their money to borrowers (i.e. those who need capital).
• Firms can finance their investments by issuing debts or stock
• Governments or municipalities can finance their expenditures by issuing debt (not stocks).

Question 5

What is a primary and secondary market ?

Answer 5

1. Primary market: is a financial market in which new issues of a security are sold to initial buyers
2. Secondary market: is a financial market in which securities that have been previously issued can resold or rebought.

Question 6

How are secondary markets organised? (2)

Answer 6

1. Exchange-traded market: buyers and sellers of securities meet in one central location to conduct trades.
2. Over the counter market (OCT): an intangible organisation which is a telephone based and computer linked network of traders who work for a financial institution. Important actors in this domain: brokers which are typically investment banks.

Question 7

What are market makers? (4)

Answer 7

a person (typically works in an investment bank) that is always prepared to quote:

1. A bid price (price at which MM buys)
2. An offer price (price at which MM sells)
3. They must buy and sell at their quoted prices
4. The bid-ask spread (ask minus bid) is their source of profit

Question 8

What is the purpose of secondary markets? (2)

Answer 8

1. Establish a price for the securities
2. Provide liquidity: making it easy to buy and sell the securities at the current market price. Example: as a shareholder, it would be difficult to sell your shares without a secondary market.

Question 9

What are broker dealers? (2)

Answer 9

financial institution (ex: investment bank) that engages in the trading of securities for its own account (proprietary trading) or on behalf of its customers.
Broker: when executing trade orders on behalf of a client.
Dealer: when executing trades for its own account.

Question 10

what is a money market? (1+ex)

Answer 10

1. a financial market in which only short-term debt instruments (with less than 1 year maturity) are traded.

Example: US treasury bills (short term debts of US government to finance the federal government), or commercial paper: short-term debt instrument issued by large banks and well-known corporations.

Question 11

What is a capital market? (1+ex)

Answer 11

The market which long-term debt and equity instruments are traded.

Example: stocks, corporate bonds and US government securities (long-term debt instruments to finance the fed government).

Question 12

What are derivatives? (2+ex)

Answer 12

1. it is a financial instrument (contract) whose value are derived from the values of underlying assets (example: stocks)
2. they are typically used to reduce or eliminate a risk – risk management,

examples: forward contracts, futures, options, swaps, credit default swaps (most derivatives belong to the OCT market)

Question 13

What are the quotations for: stocks, bonds and short term debt products? (3)

Answer 13

1. For a stock: simply the price in euro.
2. For a bond: the price may be quoted as a percentage of the nominal (or principle) example: 95%
3. For short-term debt products: price may be quoted as a yield, that is the rate of return.

Question 14

What is the difference between arbitrage and speculation? (2)

Answer 14

1. Arbitrage: involves locking a riskless profit at no cost: can be seen as deterministic money-making operation. It means something is wrong with the market, such as mispricing.
2. Speculation: involves risky positions in the market, the investor is betting that the price of an asset will go in favourable direction for him/her.

Question 15

What are financial intermediaries?

Answer 15

Are financial institutions that connect those who want to invest their money (surplus agent) with those who need it. Such as: banks, mutual funds, insurance companies. (indirect finance)
- We need FI’s because transaction costs arise due to time and money required to match buyers with lenders. Since the information is asymmetric.

Question 16

What two problems arise in asymmetric information? (2)

Answer 16

1. Adverse selection: occurs before transaction between two parties is completed.
2. Moral hazard: may arise after the transaction between two parties is completed. (post contractual opportunism). Conflict of interest, in which one party has an incentive to act in its own interest. It occurs because one party can’t observe the action of the other counterparty. – can occur in debt contracts

Question 17

What are the types of financial intermediaries? (3)

Answer 17

1. Depository institutions (banks)
2. Contractual savings institutions (life insurance companies)
3. Investment intermediaries (finance companies, mutual funds, money market mutual funds).

Question 18

What are the main reasons for regulating the financial industry? (2)

Answer 18

1. Increase information to investors (greater transparency)

2. Ensure soundness of financial intermediaries

Question 19

Who should be regulated? (1)

Answer 19

1. Banks: since they sit at the centre of the payments network and failure of one bank can lead to a domino effect (could be caused by a bank run generated through a rumour or self-fulfilling prophecy)
   - Systemic risk: risk of the collapse of the whole financial system

Question 20

What are the tricks to prevent bank runs? (2)

Answer 20

1. Lender of last resort (LOLR): typically, a central bank such as the ECB.
2. Existence of a deposit insurance scheme: FDIC, being insured up to a certain amount of money per account.

Question 21

What is financial stability? (1)

Answer 21

A condition in which the financial system (intermediaries, markets and infrastructures) can withstand shocks without major disruption in financial intermediation and in the effective allocation of savings to productive investments.

Question 22

What three characteristics display stability? (3)

Answer 22

1. System should be able to efficiently and smoothly transfer resources from savers to investors
2. Financial risks should be assessed and priced reasonably accurately and should be well managed
3. Should be in state to absorb financial and real economic surprised and shocks.

Question 23

What is financial crisis?

Answer 23

An important disruption in financial markets that are characterised by sharp declines in asset prices and the failure of many financial institutions.