Week 1: Financial Systems Flashcards
What is a financial system?
Financial systems channel funds from person or business without investment opportunities (lender-savers) to one who has them (borrower-spenders)
What are the three components of financial systems? Provide examples.
- Financial Markets e.g. money and capital markets, stock market, and foreign exchange market
- Financial Instruments e.g. shares, term deposits, loan contracts
- Financial Institutions e.g. banks, insurance offices, superannuation funds
Provide four examples of saver-lenders.
- Households
- Business Firms
- Governments
- Foreigners
Provide three examples of spender-borrowers.
- Business Firms
- Governments
- Foreigners
‘A highly developed and efficient financial system is essential to ongoing economic growth and prosperity.’ Please explain.
o Financial system supports economic transactions
o Encourages savings which provides funds for investment
o Provides a range of investment opportunities
o Provides a range of borrowing alternatives
o Efficient allocation of resources for economic growth
o Regulatory regimes provide strength and stability to a financial system
Who regulates financial systems?
o Overseen by central bank (e.g. Reserve Bank of Australia)
o Supervised by prudential regulator (e.g. Australian Prudential Regulation Authority)
What is a financial market?
Where financial instruments are traded, extending beyond physical locations to include electronic and virtual spaces.
What function to financial markets serve?
Facilitate exchange of goods and services by:
o Bringing opposite parties together
o Establishing rates of exchange (i.e. prices - asset price determined by supply and demand)
o Enabling the double coincidence of wants
Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them.
What is the difference between debt and equity markets?
- Debt markets - provide loan and receive interest on repayments
- Equity markets - represents an ownership claim in the firm and pays dividends
What is the matching principle?
Thematching principlestates that short-term assets should be funded by short-term liabilities/debt and long-term assets should be funded by long-term liabilities/debt.
What are the consequences if the matching principle is not adhered to?
o If short-term asset is funded by long-term debt, short-term asset cannot be rolled over and will have to search for new short-term asset – long-term debt also more expensive
o Long-term asset funded by short-term debt it is very risky, have to renew debt annually and the creditor may not renew
What is the difference between primary and secondary markets?
Primary Market
o Creation of new financial asset
o New security issued sold to Initial buyer
Secondary Market
o Sale and transfer of existing financial asset
o Shareholders trading amongst each other on a stock exchange
‘Existence of well-developed secondary market is important to the functioning of the primary markets within the financial system’. Please explain.
o Primary market transactions provide funds for business development and thus economic growth.
o Liquidity for investors - Investors will purchase primary market securities if they know that there are able to sell them in the deeply liquid secondary market later on.
o Price determined by supply and demand (current market value) of secondary market.
What is an exchange?
o Trades conducted in central locations.
o A company that creates the opportunity for potential buyers and sellers of a security to come together for trading.
o Products traded on the exchange must be well standardized.
What is an over-the-counter market?
o Bilateral contract in which two parties (or their brokers or bankers as intermediaries) agree on how a particular trade or agreement is to be settled in the future.
o It is usually from an investment bank to its clients directly. (e.g. Forwards and SWAPS)
