Week 1: Overview Of Financial System

Question 1

5 parts of financial system

Answer 1

Money
Financial instruments
Financial markets
Financial institutions
Central banks

Question 2

5 principles of financial system

Answer 2

Time has value
Risk requires compensation
Information is the basis for decisions
Markets determine prices and allocate resources
Stability improves welfare

Question 3

Flow of funds through the financial system

Answer 3

Lenders either provide indirect through financial intermediaries

or direct finance through financial markets.

These providers will then provide funds for borrowers/spenders.

Question 4

What is direct finance, and who does it?

Answer 4

Borrowers sell securities directly to lenders in financial markets. (NOT FINANCIAL INTERMEDIARIES WHICH ARE INDIRECT FINANCE)

Direct financing usually for governments and corporations

Question 5

Indirect finance

Answer 5

An third party facilitates a transaction between the lender and borrower.

E.g loan from a bank to buy a car.

Question 6

Who are the users of the financial system? (2)

Answer 6

Ultimate lenders - agents whose excess income creates a surplus they are willing to lend (e.g bank depositors)
Ultimate borrowers - agents excess expenditure creates a deficit they wish to meet by borrowing. (those seeking loans from the bank)

Question 7

4 preferences of borrowers and lenders

Answer 7

They have conflicting preferences
Borrowers:
Low liquidity (do not want to make frequent payments)
Minimum cost
Minimum risk
Minimum transaction costs

Lenders:
High liquidity (want faster repayments as lower risk, and can also re-lend funds to maximise profits)
Maximum return
Minimum risk
Minimum transaction costs

Question 8

3 functions of money

Answer 8

Unit of account (prices expressed as money)
Store of value (transfer purchasing power into future)
Medium of exchange/means of payment

Question 9

Liquidity

Answer 9

Ease of which an asset can be converted into cash.

Question 10

2 types of liquidity

Answer 10

Market liquidity - ability to sell assets
Funding liquidity - ability to borrow money

Question 11

How did the liquidity spiral link to the finanical crisis

Answer 11

Market liquidity (ability to sell assets fell) due to the uncertainty, so price of securities fell, and the falling asset prices further reduced confidence and funding liquidity (ability to borrow) fell.

This continued, causing a cycle called the liquidity spiral.

Question 12

Primary cause of inflation

Answer 12

Too much money in circulation

Question 13

Money types

Answer 13

M1 - narrow money
M2 - intermediate money
M3 - broad money

Question 14

M1 narrow money is made of 2 components

Answer 14

Money in circulation
Overnight deposits

Question 15

M2 intermediate money - 3 components

Answer 15

M1 (money circulating+overnight deposits)
Short term time deposits
Deposits redeemable at notice of 3 months max.

Question 16

M3 broad money (2 components)

Answer 16

Sum of M2 and long term deposits

Question 17

Composition of money aggregates in EU, UK and US

Answer 17

EU only goes up to M3

UK goes up to M4

US up to M2

Question 18

CPI

Answer 18

FIXED EXPENDITURE WEIGHT INDEX - measuring changes in purchasing power

Question 19

CPI formula

Answer 19

Cost of basket current
/
Cost of basket in base year

x 100 for percentage form

Question 20

Financial instruments

Answer 20

The written legal obligation of one party to transfer something of value to another party at a future date.

Question 21

2 classes of financial instruments

Answer 21

Underlying instruments
Derivative instruments

Question 22

3 functions of financial assets

Answer 22

Means of payment - stock options as payment
Store of value - financial instruments can be held
Transfers risk from one person to another

(So not a unit of account unlike money)

Question 23

Which financial instruments are used primarily as a store of value (4)

Answer 23

Bank loans
Bonds
Mortgages
Stocks

Question 24

Which financial instruments are used primarily to transfer risk? (3)

Answer 24

Insurance contracts
Futures contracts
Options

Question 25

Role of financial markets

Answer 25

Where finanical instruments are bought and sold.

Question 26

3 functions of financial markets

Answer 26

Market liquidity - ensure can buy and sell easily Information sharing Risk sharing - provide place to buy and sell risk

Question 27

5 classifications of financial markets

Answer 27

Nature of claims Maturity of claims Seasoning of claims Delivery time Organisational structure

Question 28

Types of financial intermediaries (provide examples)

Answer 28

Deposit takers (banks) Non deposit takers (insurance companies, pension funds, securities firms etc)

Question 29

Role of financial intermediaries (5)

Answer 29

Pool resources of small savers Provide safekeeping and accounting services Supply liquidity by converting savers balances directly into a means of payment whenever needed Diversify risk Collect and process info to reduce information costs.

Question 30

Pooling savings: what must they do to do this? (2)

Answer 30

Must attract a substantial number of savers (since deposits are small) Must convince potential depositors of the institutions soundness (to be willing to put money in)

Question 31

Why are financial intermediaries beneficial, and how?

Answer 31

They provide a reliable and inexpensive payments system, helping economy function efficiently. How? They have E.O.S

Question 32

Providing liquidity: what must intermediaries be able to do?

Answer 32

Must be able to handle sudden withdrawals by holding enough funds in short term. E.g through ATMS can be used.

Question 33

Diversifying risk: how?

Answer 33

Banks use the deposits and make loans with them. So each depositor has a small stake in each one of the loans.

Question 34

Why do banks collect and process information?

Answer 34

Borrowers have more information lenders to not have. Lenders do not know whether the borrowers are trustworthy, this is asymmetric information. By collecting and processing information, we can reduce problems of asymmetric information e.g knowing credit scores etc.

Question 35

What do markets require to work well, and what can halt this?

Answer 35

Sophisticated information. If the cost of information is too high, markets cease to function.

Question 36

Results of asymmetric information (2)

Answer 36

Adverse selection arises before transaction occurs - asymmetric info means one makes an undesirable decision (e.g decision to make loan) Moral hazard occurs after the transaction - when the borrower gets the money, the burden of risk on is the lender. Which can influence the way they use the money (may not use as they claim!)

Question 37

What does adverse selection imply the need for

Answer 37

To distinguish between bad and good credit risks.

Question 38

When does moral hazard arise?

Answer 38

When we can’t observe people’s actions

Question 39

What does moral hazard affect?

Answer 39

Equity and bond financing

Question 40

Moral hazard in equity finance

Answer 40

How do you know the share capital will be used in away to increase value for you (THE SHAREHOLDER)? Could go to dividends etc.

Question 41

What is this problem known as

Answer 41

Principle agent problem (manager making decisions may be different from principle i.e shareholders)

Question 42

Moral hazard in debt finance - why does it exist

Answer 42

Debt finance allow owners to keep all profits since no shareholders like equity, encouraging greater risk taking. Only have to pay of their loan, doesn’t change proportionate to their success! They receive the full benefit of the payoff, while the downside is limited to their collateral.

Question 43

Solutions to adverse selection (4)

Answer 43

Government required information disclosure. Private collection of info Pledging collateral to insure lenders against borrowers default. Requiring borrowers to invest substantial resources of their own

Question 44

Solutions to moral hazard (3)

Answer 44

Required managers to report to owners (solve principle agent problem) Requiring managers to invest substantial resources of their own Covenants (agreements) that restrict what borrowers can do with borrowed funds