Topic 1 - A modern financial system - an overview

Question 1

1.01 - What is the purpose of money?

Answer 1

• To act as a medium of exchange
• To Allow specialisation in production
• To solve the divisibility problem (where the medium of exchange is not equal to the trade)
• To facilitate trading
• As a store of wealth

Question 2

1.02 - What is the GFC?

Answer 2

The global financial crisis of 2008 which was caused by the collapse of the housing market in the US (relating to mortgage-related securities).

Question 3

1.03 - What is the principle role of financial institutions and markets?

Answer 3

To bring together opposite parties to facilitate the exchange of goods and services and establishes the rates of exchange (prices).

Question 4

1.04 - What is a financial instrument?

Answer 4

It is a financial product issued by a party raising funds. It acknowledges a financial commitment and entitles the holder to specified future cash flows.

Question 5

1.05 - What does the flow of funds refer to?

Answer 5

Movement of funds through the financial system between savers (who have surplus units) to borrowers (who have deficit units), giving rise to financial instruments.

Question 6

1.06 - What does the financial system comprise of?

Answer 6

• financial institutions
• financial instruments
• markets
• financial transactions
• goods and services

Question 7

1.07 - What are the four attributes that financial asset have?

Answer 7

• return (yield)
• risk
• liquidity
• timing of cash flow

Question 8

1.08 - What are four signs of an efficient financial system?

Answer 8

• It encourages saving
• It directs saving to the most efficient users
• It implements monetary policy of governments by influencing interest rates
• It has a combination of assets and liabilities of varying attributes.

Question 9

1.09 - What are the chain of events which caused the GFC?

Answer 9

• 2000 - Dot.com collapse;
• Govt reduced interest rates to stimulate recovery
• This over inflated the real estate market
• Banks allowed loans to borrowers who under normal credit assessment would have been rejected (sub-prime mortgages)
• CDOs were sold containing these but there is no secondary market
• When the recession occurred, property prices fell and the value of these assets erased. Investors tried to liquidate assets but couldn’t.

Question 10

1.10 - What are CDOs?

Answer 10

Collaterised debt obligations which are portfolios of mortgages and loans arranged into tranches according to the risk. These are complex.

Question 11

1.11 - What were the main major risk exposures evident in the sub-prime crisis?

Answer 11

• credit risk
• liquidity risk
• capital risk
• foreign exchange risk
• interest rate risk
• country and sovereign risk
• investment risk

Question 12

1.12 - What was the fallout for the USA of the GFC

Answer 12

• Many companies lost independence or failed completely.
• Many individuals lost their homes and have high debt
• The Govt arranged a $700B bailout plan
• The Govt is still engaged in quantitative easing designed to encourage economic activity by pumping millions of dollars into the financial sector.

Question 13

1.13 - What did the Australian government do during the GFC?

Answer 13

• Banned short selling in Australia for a period
• Implemented a bank guarantee to prevent a run on the banks
• Implemented two stimulus packages totalling more than $50M in 2008 and 2009 to encourage economic activity.

Question 14

1.14 - Why was the GFC not as great in Australia?

Answer 14

Australia had faced the mini crisis after floating our currency in 83 and a number of bank collapses in the late 80’s and early 90’s and had as a result commissioned the Wallis inquiry. This inquiry in 1996 recommended a new structure moving away from institution based regulation and set up APRA, ASIC and RBA. Legislation and surveillance conducted by APRA and ASIC assisted.

Question 15

1.15 - What were the benefits of the Financial Services Reform Act, PDS Disclosure and MIS regulatory framework in the occurrence of a GFC?

Answer 15

• Fin Services Reform Act - encouraged strong regime for financial dealings and market integrity
• PDS disclosure - meant some risky options (sub-prime mortgages) were not introduced in Australia
• MIS regulatory framework - discourages Ponzi type schemes and makes them difficult to go undetected.

Question 16

1.16 - What is the important lesson to learn with the GFC?

Answer 16

Financial crises tend to repeat over time. Lessons learned are eventually thought to be irrelevant. Reality is the fundamentals of risk management do not change. Risk needs to be identified, measured and managed.

Question 17

1.17 - What was the trigger cause of the Asian Financial Crisis?

Answer 17

Asia had been experiencing a boom, and was heading into a recession. Thailand could not support the sustained pressure on its fixed exchange rate and floated its currency in July 1997. This caused rates to drop, domestic prices rose. Other countries also fell victim to this.

Question 18

1.18 - What is the result of higher interest rates and lower economic activity?

Answer 18

Businesses will default on their credit and this will put pressure on capital ratios.

Question 19

1.19 - What were the four key underlying reasons for the Asian Financial Crisis?

Answer 19

• excessive bank credit available - encouraged over investment
• no recognition of the fragility of the financial system
• moral hazard existed - reliance on Govt to bail out
• reliance on volatile external financing & no hedge against foreign exchange risk.

Question 20

1.20 - What do financial institutions specialise in?

Answer 20

• taking deposits
• offering financial contracts
• providing advice to corporate or government clients
• facilitation of flow of funds between borrowers & lenders

Question 21

1.21 - Financial institutions are categorised based on source and use of funds?

Answer 21

• Depository financial institutions (commercial banks, building societies etc)
• Investment & merchant banks
• Contractual savings institutions
• Finance companies
• Unit trusts

Question 22

1.22 - What is the key source and use of funds for a depository financial institution?

Answer 22

Accept deposits and provide loans to borrowers (household and business)

Question 23

1.23 - What is the key source and use of funds for an investment or merchant bank?

Answer 23

Provide off-balance-sheet advice to corporate and government clients on mergers, acquisitions, portfolio restructuring, finance and risk management

Question 24

1.24 - What is the key source and use of funds for a contractual savings institution?

Answer 24

Provision of contract in exchange for periodic payments - funds are pooled and invested eg. superannuation and insurance companies.

Question 25

1.25 - What is the key source and use of funds for a finance company?

Answer 25

Funds are raised by issue of securities, bonds etc into money markets and capital markets. Funds are used for loans and finance.

Question 26

1.26 - What is the key source and use of funds for a unit trust?

Answer 26

Formed under a trust deed and managed by trustee, funds are raised by selling units, these are pooled and invested in accordance with the trust deed.

Question 27

1.27 - What are managed funds?

Answer 27

They are investment vehicles through which the pooled savings of individuals are invested.

Question 28

1.28 - What are mutual funds?

Answer 28

They are managed funds that are established under a corporate structure with investors purchasing shares in the fund (they are popular in the USA)

Question 29

1.29 - What are Trust funds?

Answer 29

They are managed funds established under a trust deed, managed by a trustee or responsible entity (popular in Australia).

Question 30

1.30 - What are the main categories of managed funds?

Answer 30

• Cash management trusts
• Public unit trusts
• Superannuation funds
• Life insurance offices
• Hedge funds

Question 31

1.31 - What are public unit trusts?

Answer 31

Investors purchase units in a trust, the pooled funds are invested in asset classes specified in the trust deed. The liquidity depends on whether they are listed or not.

Question 32

1.32 - What are hedge funds?

Answer 32

These invest in exotic financial products mainly for high net worth individuals and institutional investors. They are managed b y high-profile individuals or investment banks. The assets include equities, foreign exchange, bonds, commodities and derivatives.

Question 33

1.33 - What are the features of a cash management trust?

Answer 33

They have low / no fees, high liquidity, low returns and may include a personal cheque book.

Question 34

1.34 - Define an equity asset? including the claims it has and the types of equity assets available?

Answer 34

The sum of the financial interest an investor has in an asset, an ownership position. Claims include dividend (earnings) or liquidation of the assets. They include ordinary shares and hybrid securities (preferential shares or convertible notes).

Question 35

1.35 - Define a debt instrument, including the claims it has and the types of debt instruments available?

Answer 35

These specify conditions of a loan agreement, issuer/borrower, amount, return, timing of cash flows, maturity date etc and the debt must be repaid. They have periodic interest repayments, repayment of the principal and they rank ahead of equity. They include short term (money market), long term (capital market), secured/ unsecured and negotiable/non-negotiable assets

Question 36

1.36 - What is a derivative investment and list some of the different types?

Answer 36

It is a synthetic security that derives its price from a physical market, commodity or security. It is mainly used to manage risk exposures. They include futures contracts, forward contracts, option contracts and swap contracts.

Question 37

1.37 - What is the matching principle?

Answer 37

This states that short-term assets should be funded with short-term liabilities and that longer term assets should be funded with longer term liabilities and equity. This is why there are so many types of financial instruments and markets.

Question 38

1.38 - What are the two types of transactions in a financial market?

Answer 38

• Primary market transactions - the issue of a new financial instrument, funds are obtained by the issuer: business, governments or individuals
• Secondary market transactions - the buying and selling of existing financial securities, transfer of ownership occurs and no new funds are raised by the issuer. This enables liquidity.

Question 39

1.39 - Financial instruments (primary or secondary) generate a flow of funds through the market. This can occur in what two ways?

Answer 39

• Direct finance - through primary markets via a direct relationship with providers (savers)
• Intermediated finance - through two separate contractual agreements a) for the saver and then b) for the borrower

Question 40

1.40 - What are the advantages of direct finance?

Answer 40

• Avoids cost of intermediation
• Increases access to diverse markets
• Greater flexibility in range of securities users can issue for different needs

Question 41

1.41 - What are the disadvantages of direct finance?

Answer 41

• Matching of preferences
• Liquidity and marketability of securities
• Search and transaction costs
• Assessment of risk (especially default)

Question 42

1.42 - What are the advantages of intermediated finance?

Answer 42

• Asset transformation - range of products offered
• Maturity transformation - range offered
• Credit risk diversification
• Liquidity transformation
• Economies of scale offered

Question 43

1.43 - What are the disadvantages of intermediated finance?

Answer 43

• Costs of intermediary

* Some markets are not available.

Question 44

1.44 - What is a wholesale market?

Answer 44

Where direct financial flow transactions between institutional investors and borrowers occur involving larger transactions.

Question 45

1.45 - What is a retail market?

Answer 45

Where transactions are conducted primarily with financial intermediaries by the household and small to medium sized business sectors and involve smaller transactions.

Question 46

1.46 - Both the money markets and the capital markets have a primary /secondary market and have both a domestic and international markets. Define what a money market is?

Answer 46

It is a wholesale market in which short-term securities are issued and traded.

Question 47

1.47 - What are the features of a money market?

Answer 47

• Securities are highly liquid and standard
• There is a deep secondary market
• There is no specific infrastructure or trading place.

Question 48

1.48 - Both the money markets and the capital markets have a primary /secondary market and have both a domestic and international markets. Define what a capital market is?

Answer 48

It is for longer term funding and includes equity, corporate debt and government debt and is supported by the foreign exchange and derivatives market. Participants are individuals, businesses, government and overseas sectors.

Question 49

1.49 - What is the sectorial flow of funds and what participants does it include?

Answer 49

The flow of funds between surplus and deficit sectors in an economy. It includes:

• businesses
• households
• Financial corporations
• Government and
• The rest of the world

Question 50

1.50 - The net borrowing and net lending of the sectors in the sectorial flow of funds vary by country and are influenced by what?

Answer 50

• Impact of fiscal and monetary policy

* Policy and regulation eg. compulsory superannuation.

Question 51

1.51 - How did the GFC impact on the flow of funds?

Answer 51

• Significantly
• Interrupted the function of the financial system
• Inflicted serious damage on the ‘real’ economy in many countries

Question 52

1.52 - What broadly is the role of the regulators in regards to the financial system?

Answer 52

To balance the benefits of a free financial system against the costs of instability.