Topic 1 - Introduction

Question 1

1.01 - What are the main functions of a nations’s financial markets?

Answer 1

* Primary financial markets - transfer of funds from surplus to deficit in economic units by the creation of new financial assets * Secondary financial markets - trade of existing financial assets.

Question 2

1.02 - What does a nation’s financial system comprise of?

Answer 2

* surplus economic units (lenders) * deficit economic units (borrowers) * financial institutions * financial markets * financial assets

Question 3

1.03 - Who are lenders? / borrowers?

Answer 3

* householders * companies * governments * rest of the world

Question 4

1.04 - What are surplus economic units?

Answer 4

Surplus economic units are individuals or small groups (households or business firms) who have more funds available than they require for immediate expenditure. Ie savers and potential lenders.

Question 5

1.05 - What are deficit economic units?

Answer 5

Deficit economic units are individuals or groups (eg individual households or business firms) who require additional funds to meet their expenditure plans. ie borrowers

Question 6

1.06 - What are financial institutions?

Answer 6

Financial institutions are organisations whose core business involves the borrowing and lending (financial intermediation) and/or the provision of financial services to other economic units.

Question 7

1.07 - What are financial assets? and what is their alternative name?

Answer 7

Financial assets represent a claim or right that a surplus economic unit holds over a deficit economic unit. Also called financial instruments.

Question 8

1.08 - What are the roles of the parties in the exchange of a financial asset?

Answer 8

* Issuer (party raising the funds) - the assets represent a liability or obligation. (Seller of financial assets) * Receiver (party receiving the financial asset) - it is a financial commitment or claim entitling the holder to future cash flows. (Buyer of financial assets).

Question 9

1.09 - When are financial assets created?

Answer 9

Financial assets are created whenever funds are lent and borrowed.

Question 10

1.10 - What do Primary market financial transactions involve?

Answer 10

An exchange as funds are exchanged for financial assets.

Question 11

1.11 - All financial assets have four different attributes which can provide a basis for comparison between different types of financial assets, what are they?

Answer 11

1) Return or yield 2) Risk 3) Liquidity 4) time pattern of return of cash flow

Question 12

1.12 - What is the relationship between return or yield with risk? and what is it with liquidity?

Answer 12

Return / yield - positive with risk Return / yield - inverse with liquidity

Question 13

1.13 - Financial assets that are created and exchanged can be divided into four broad types, what are they?

Answer 13

1) Debt 2) Equity 3) Hybrid 4) Derivatives

Question 14

1.14 - What are debt instruments?

Answer 14

Debt instruments obligation to repay the principal amount borrowed and interest in a specified manner over a defined period or on an event

Question 15

1.15 - What are four types of debt instrument and give an example of each?

Answer 15

1) Deposits - bank deposits 2) Contractual savings - life insurance, super 3) Discount securities - commercial bills 4) Fixed interest securities - bonds, debentures

Question 16

1.16 - What is equity when referring to it as a financial asset?

Answer 16

Equity represents an ownership claim over the profits and assets of a business. Eg ordinary shares.

Question 17

1.17 - What is a hybrid financial asset?

Answer 17

Hybrid financial assets comprises securities that combine features of both debt and equity. eg preference shares and convertible notes.

Question 18

1.18 - What is a financial market?

Answer 18

A mechanism which brings together buyers and sellers for the purpose of exchange (not necessarily locationally together).

Question 19

1.19 - What is the difference between a primary and a secondary financial market?

Answer 19

In a primary financial market new financial assets are created and traded in exchange for borrowed funds. In a secondary financial market existing financial assets are traded.

Question 20

1.20 - What is the term financial security used to describe in relation to financial markets?

Answer 20

Financial security is a financial asset that can be traded in a secondary market.

Question 21

1.21 - What is the difference between a money market and a capital market?

Answer 21

The money market is where funds are lent for a period of less than one year. Capital markets lend funds for one year or longer.

Question 22

1.22 - What are the different types of financial markets in Australia?

Answer 22

* The Money Market * The Debt-Capital Market * The Foreign Exchange Market * The Equity Market * The Derivatives Market

Question 23

1.23 - What is direct finance?

Answer 23

Funding obtained direct from the money markets and capital markets.

Question 24

1.24 - In direct finance, financial institutions frequently provide financial services to the parties. Who do they favour and what are they?

Answer 24

They favour the borrowers, and include: * Financial advice * Financial management and security documentation * Marketing * Sales negotiation * Provision and arrangements of underwriting facilities.

Question 25

1.25 - What is indirect finance?

Answer 25

It is a financial transaction conducted with a financial intermediary (eg bank deposits / loans). They are separate contractual loans.

Question 26

1.26 - What are the advantages of using a financial intermediary (indirect or intermediated finance)?

Answer 26

* Asset value transformation * Maturity transformation * Credit risk reduction and diversification * Liquidity transformation * Economies of scale.

Question 27

1.27 - What is the value of using a financial intermediary to achieve asset value transformation?

Answer 27

Financial intermediaries are able to create secondary securities to use small individual savings and pool them together for the purpose of making larger loans.

Question 28

1.28 - What is the value added by a financial intermediary in regards to maturity transformation?

Answer 28

Financial intermediaries borrow for different time periods to what they lend, so can match the maturity preferences of clients.

Question 29

1.29 - What is the value added by a financial intermediary in regards to credit risk reduction and diversification?

Answer 29

Financial intermediaries use their expertise and knowledge to reduce risk and spread the small percentage of bad loans across the total portfolio.

Question 30

1.30 - What is the value added by a financial intermediary relating to liquidity provision?

Answer 30

Ability to convert financial assets into cash because of their size and specialisation.

Question 31

1.31 - What is the value added by a financial intermediary relating to increased quantity of national savings?

Answer 31

Greater savings are promoted which increases the supply of funds available to spenders which promotes economic growth

Question 32

1.32 - What are the disadvantages of financial intermediation?

Answer 32

There are generally: * increased costs of funds for borrowers * reduced return from lending for savers Also, it is less likely for secondary financial assets to be securitised (ie financial securities) in that they can be traded in a secondary market.

Question 33

1.33 - What is disintermediation?

Answer 33

It describes the recent increased reliance by large borrowers on direct rather than indirect (intermediated) finance.

Question 34

1.34 - What is the nature and role of financial institutions?

Answer 34

A business organisation whose core business is financial intermediation and/or the provision of financial services.

Question 35

1.35 - What are the two main types of financial institutions?

Answer 35

Deposit taking financial institutions Non Deposit taking financial institutions

Question 36

1.36 - What are Deposit taking financial institutions?

Answer 36

Attract savings of depositors and provide loans to borrowers - eg. commercial banks, building societies & credit cooperatives.

Question 37

1.37 - What are non-deposit taking financial institutions?

Answer 37

Generally do not provide loans or take deposits but provide managed funds under contractual arrangement (super) and provide wide range of financial services eg. investment banks, general insurance companies and super funds.

Question 38

1.38 - What is the most dominant financial institution? and which is the fastest growing financial institution?

Answer 38

Commercial banks. Superannuation funds.

Question 39

1.39 - Name six types of financial institutions?

Answer 39

Commercial banks Building societies & credit unions Investment banks and merchant banks Managed funds Life insurance offices & general insurance offices Finance companies and general financiers

Question 40

1.40 - What is the role of the commercial banks?

Answer 40

Commercial banks gather savings in order to provide loans for investment. Plus other functions such as underwriting and guarantor of financial products (bank bills)

Question 41

1.41 - What are building societies and credit unions?

Answer 41

Deposit taking financial institution. Accept deposit and loan (mainly housing). Credit unions have an association of its members (eg employment, industry or community)

Question 42

1.42 - What is the important role that investment and merchant banks play?

Answer 42

Investment and merchant banks raise funds in the capital markets but instead of providing intermediated finance, they advise their clients and assist them in obtaining funds direct from the domestic and international money markets and capital markets

Question 43

1.43 - What is the role of life insurance and general insurance providers?

Answer 43

Provide contracts that require, in return for periodic payments, the payment to the contract holder in a specific event

Question 44

1.44 - What is the role of the finance company?

Answer 44

Make loans, funds are raised by issuing financial securities, bonds etc. Eg GE

Question 45

1.45 - What is the role of the financial system?

Answer 45

It is to facilitate the operation of the overall economic system and in particular the output markets for goods and services.

Question 46

1.46 - What are the six macroeconomic objectives?

Answer 46

1) economic growth 2) full employment 3) price stability 4) external balance 5) efficient allocation of resources 6) equitable distribution of income and wealth

Question 47

1.47 - What are the three periods of government intervention in financial markets?

Answer 47

1) Regulation (pre 1980s) where direct controls were used 2) Deregulation (1980s) controls were removed 3) Post-deregulation (1990s) Strengthened government controls through regulators and rules.

Question 48

1.48 - What are the reasons for government intervention in the financial system?

Answer 48

* Macro economic objectives * An efficient, fair and competitive financial system * The promotion of financial safety

Question 49

1.49 - What are the ways in which a government will intervene in finance markets?

Answer 49

* Fiscal policy (taxes and govt spending) * Monetary policy (open market operations & reserve asset requirements) * External policy (exchange rate policy, conditions on exports and imports and other controls) * Wages policy (superannuation) * competition policy (ACCC) * consumer protection - voluntary and law * direct legislation (Corps Law)

Question 50

1.50 What is the purpose of money?

Answer 50

* To act as a medium of exchange * Allow specialisation in production * Solve the divisibility problem (non equal value trades) * Facilitates saving * Represents a store of wealth

Question 51

1.51 - What is the flow of funds?

Answer 51

Movement of funds through the financial system between savers and borrowers giving rise to financial instruments.