1. 'A highly developed and efficient financial system is essential to ongoing economic growth and prosperity.' Discuss the component parts that form a financial system and the relevance of the above statement. Financial institutions: service providers who permit the flow of funds between lenders and borrowers. May be in the form of depository, investment and merchant (OBS such as advisory, portfolio restructuring, finance and risk management), contractual savings (contracted liabilities in return for periodic payments such as insurance and superannuation) or unit trusts (Funds raised by selling units to the public under a trust deed). Financial Instruments: Issued by a party raising funds, acknowledging a financial commitment and entitling the holder to specified future cash flows. May be equity (ownership interest), debt (contractual commitments), derivatives (synthetic security providing future rights that derives its price from physical market commodity such as oil or financial security) Financial markets: trading of financial securities, commodities and other assets of value. Matching principle (short term assets should be financed with short term liabilities), Primary market (issue of new financial instruments) and Secondary market (trading of existing financial instruments), Direct finance (funds direct from relationship with providers), Intermediated finance (two separate contractual agreements; finance through an external intermediary), Wholesale (direct between institutional investors and borrowers), Retail (conducted through intermediaries by household and smaller business), Money (wholesale markets where short term securities are issued & traded) and Capital (longer term funding excess of 12 months includes equity, corporate and government debt). 2. a) Discuss the role of information in a financial system. The way in which information is generated, exchanged and used to allocate resources has been important. Information is needed to analyse and evaluate where allocation of resources is most efficient, and hence determine the optimal point of operations. The price of financial instruments in the market should reflect all information, including its risk and scarcity, and its value. It is critical that information in a financial system is updated as the market and speculators thrives on relevant information on trading instruments. 3. The major financial institutions within the international markets fall into five classifications. Identify and briefly explain each of these classifications. Give an example of different types of institution that operate within a classification. Depository Financial Institution: funds provided by saver deposits and loaned out for borrowers. (e.g. commercial banks and credit unions) Investment and merchant banks: provision of advisory and special financial services for their corporate and government clients.
Contractual savings Institution: offer financial contracts which specifies
periodic payments made to the institution and payout when an event occurs. (e.g. Insurance, superannuation) Finance companies and general financiers: funded by issuing financial instruments such as commercial paper, medium-term notes and bonds in the money and capital markets. Or borrow directly from the market to loan or lease to public. Unit Trusts: sell units in a trust to the public and invest those funds in assets in the deed. (e.g. equity, property and mortgage trust.) 8. a) What are the differences between primary market and secondary market financial transactions? Primary market is where financial instruments are first issued in the market. The main characteristic is that new financial instrumentals are created and the issuer receives the funds. For example, a corporation issues new ordinary shares or an individual borrows money from a bank. Secondary market involves transactions with existing financial instruments. Essentially a transfer of ownership, the original issuer of the instrument does not receive the fund. b) Why is the existence of well-developed secondary markets important to the functioning of the primary markets within the financial system? Secondary markets help over two problems: these are the saver's preference for liquidity and aversion to risk. Without secondary markets, the purchasers of initial have to hold onto the financial instruments until maturity. While not directly involved in the process, secondary market enhances the primaryinstruments marketability and liquidity, making them attractive to savers and hence increase the pool of fund. 9. Explain the meaning of the terms 'financial assets', 'financial instruments' and 'securities'. What is the difference between these terms? Give examples of financial instruments and securities. Financial assets: an asset that derives value because of contractual claim. (e.g. stocks, bonds, deposits) Financial instruments: issued by a party raising funds which acknowledges a financial commitment and entitling the holder specified future cash flows. It give rise to assets for one party and a liability or equity for another. The instrument becomes an asset on the balance sheet of the provider of funds. (e.g. customer deposits in a bank, the bank acknowledges this deposit and issue a receipt that states the amount provided, the maturity date of repayment, rate of interest and time of interest payment; derivatives, contracts, notes.) Securities: financial asset that are traded in the secondary market such as a stock exchange. (e.g. ordinary share in a publicly listed company; are generally stock, shares, bonds) 10. Banks are the major providers of intermediated finance to the household and business sectors of an economy. In carrying out the intermediation process,
banks perform a range of important functions. List these functions and discuss this importance for financial system.
asset transformation: ability of financial intermediaries to provide a range
of products that meet customers' portfolio preferences maturity transformation: offers products with a range of terms to maturity credit risk diversification and transformation: savers' credit risk exposure is limited to the intermediary; the intermediary is exposed to the credit risk of the ultimate borrower liquidity transformation: measured by the ability to convert financial instruments into cash economies of scale: financial and operational benefits gained from organisational size, expertise and volume of business.