EFB201 Tutorial One Questions
1. Explain the key roles of the financial system. Why is it so important to the broader economy to have an efficient and effective financial system?
2. Compare and contrast debt and equity as a source of funds for financial claims.
3. What are some problems with direct financing that make indirect financing more attractive?
4. Explain how you believe economic activity would be affected if there were no financial markets and institutions.
5. What are the three sources of comparative advantage that financial institutions have over others in producing financial products?
6. Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?
7. What is the difference between primary and secondary markets?
8. Explain the differences between the money markets and the capital markets. Which market would Holden use to finance a new vehicle assembly plant? Why?
9. Discuss three forms of financial market efficiency. Why is it important that financial markets be efficient?
10. What are the major risks faced by financial institutions and why is it important that each is carefully managed?
11. Why is globalisation of the international markets important to the Australian financial system?
12. Discuss the four attributes of financial assets.
13. Discuss the major derivative products.
EFB201 Tutorial One Solutions
1. Explain the key roles of the financial system. Why is it so important to the broader economy to have an efficient and effective financial system?
Financial markets are the markets for buying and selling financial instruments. Financial markets have five primary functions:
1. Facilitating the flow of funds
2. providing the mechanism for the settlement of transactions
3. generating and disseminating information that assists decision making
4. providing means for the transfer and management of risk
5. provide ways of dealing with the incentive problems that arise in financial contracting
Having an efficient and effective financial system is critical as it facilitates commercial, retail and government transactions in a timely, low cost and reliable way. The opposite would be a system where funds take a long time to reach their destination (i.e. direct debits may take weeks), with high cost (significantly greater transactions costs) and with great risk (to either their value or likelihood of arrival). An efficient and effective financial system will also produce actual and timely information to enable effective financial decision making, which is also important in the complex financial world of today.
When one considers what we take for granted in the financial system (EFTPOS, Electronic Transfer, Direct Debit, etc.) in terms of its reliability) and consider the time and cost involved in doing this manually, one can see the importance of the financial system.
2. Compare and contrast debt and equity as a source of funds for financial claims.
Financial claims are sourced from either debt or equity funds. Debt funds are supplied in the form of a loan and are either short-term (referred to as money) or long-term (referred to as capital). Suppliers of loans face credit risk – the risk that the borrower will default on scheduled repayments as specified in the loan agreement. The lender is compensated for this with interest income. Equity funding involves the acquisition of an ownership share of a business, which is usually seen as a longer-term investment and hence referred to as capital investment. Equity investors face investment risk, the possibility that the investors expected return will not be realized, and are compensated with dividend payments and capital growth (where the value of the ownership share increases over time) for bearing this
3. What are some problems with direct financing that make indirect financing more attractive?
Direct financing requires a more or less exact match between the characteristics of the financial claims DSUs wish to sell and those the SSUs want to buy. Direct financing can thus involve a costly search and negotiation process, often complicated by information asymmetries concerning ultimate credit risk of the DSU. Intermediaries transform direct claims sold by DSUs and make them more attractive to SSUs, helping DSUs find financing and SSUs find appropriate investments.
4. Explain how you believe economic activity would be affected if there were no financial markets and institutions.
Financing relationships would arise only when preferences of SSUs and DSUs match. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize their savings. The “production possibilities frontier” of the society would be smaller.
5. What are the three sources of comparative advantage that financial institutions have over others in producing financial products?
(1) Economies of scale —large volumes of similar transactions; (2) transaction cost control—finding and negotiating direct investments less expensively; and (3) risk management expertise—bridging the “information gap” about DSUs’ creditworthiness.
6. Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?
Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, and then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus promoting the 3 forms of efficiency—allocational, informational, and operational.
7. What is the difference between primary and secondary markets?
Primary markets are those in which financial claims are initially sold by DSUs. All financial claims have primary markets. Secondary financial markets are like used-car markets; they let people exchange ‘used’ or previously issued financial claims for cash at will, and hence they provide liquidity for investors who own primary claims. Securities can only be sold once in a primary market; all subsequent transactions take place in secondary markets. The Australian Stock Exchange (ASX) is an example of a well-known secondary market.
8. Explain the differences between the money markets and the capital markets. Which market would Holden use to finance a new vehicle assembly plant? Why?
Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or “capital goods” are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to “store” cash in money market securities, which are generally, safe, liquid, and short-term.
9. Discuss three forms of financial market efficiency. Why is it important that financial markets be efficient?
There are three forms of market efficiency: allocational efficiency, informational efficiency, and operational efficiency. Allocational efficiency is a form of economic efficiency that implies that funds will be allocated to (i.e., invested in) their highest valued use (the funds could not have been allocated in any other way that would have made society better off). This is important as it promotes investment in the projects offering the highest risk-adjusted rates of return and that households invest in direct or indirect financial claims offering the highest yields for given levels of risk.
Informational efficiency relates to the ability of investors to obtain accurate information about the relative values of different financial claims (or securities). In an informationally efficient market, securities’ prices are the best indicators of relative value because market prices reflect all relevant information about the securities. This is important as it allows investors to determine which investments are the most valuable and ensures that the financial markets are allocationally efficient because households or business firms can get the information they need to make intelligent investment decisions.
A market is operationally efficient if the costs of conducting transactions are as low as possible. This is important because if transaction costs are high, fewer financial transactions will take place, and a greater number of otherwise valuable investment projects will be passed up. Thus, high transaction costs can prevent firms from investing in all desirable projects. The forgone investment opportunities mean that fewer people are employed and economic growth slows or declines. Society becomes worse off.
10. What are the major risks faced by financial institutions and why is it important that each is carefully managed?
Credit Risk (or default risk) is the possibility that a borrower may not pay as agreed. Management of credit risk is important as excessive credit risk will lead to higher regulatory costs (credit based capital adequacy requirements to be discussed later in the text) and may lead to the failure of the firm through cash flow and non-performing loans problems.
Interest Rate Risk is the likelihood that interest rate fluctuations will change a security’s price and reinvestment income. As a significant part of financial institutions investments and sources of funds are interest-bearing and profits are generated on the margin between these, managing both the investment and funding portfolio’s for interest rate risk is important for profits, cash flows and the stability of the institution.
Liquidity Risk is the possibility that a financial institution may be unable to pay required cash outflows. If a financial institution is unable to meet its short-term obligations because of inadequate liquidity, the firm will fail even though over the long run the firm may be profitable.
Foreign Exchange Risk is the possibility of loss on fluctuations in exchange rates. These fluctuations can cause gains or losses in the currency positions of financial institutions, and they cause the Australian dollar values of non-Australian financial investments to change.
Political Risk is the possibility that government action will harm an institution’s interests. This includes changes in regulation, appropriation of assets, changes to foreign investment and currency transfer and trading rules, all of which can influence the earnings and value of a financial institution.
Reputational Risk is the potential for negative publicity to cause loss through decline in customer base, increased litigation and revenue reductions.
Environmental Risk is the actual and/or potential threat of adverse impact on asset values due to changes in the environment and/or organisational impacts on the environment.
11. Why is globalisation of the international markets important to the Australian financial system?
This is important due to the small size of the Australian system in global terms. Hence internationalisation offers both additional sources of funds (from international investors), opportunities for Australian investors and institutions to diversify into offshore investments, and also a source of competition for domestic institutions which leads to improved efficiency of the domestic system. The impact of these was seen in the GFC where international concerns heavily impacted the Australian financial system. These impacts continued to a number of years as the higher cost of capital in the international markets (which the Australian banks rely upon for funding) put pressure on margins.
12. Discuss the four attributes of financial assets.
A financial asset has four attributes:
Return or yield
Risk
Liquidity of asset
Time-pattern of cash flows
The average saver likes return and liquidity, dislikes risk and prefers reliable cash flows.
13. Discuss the major derivative products.
There are four basic types of derivative contracts:
Forward contract
This is a contract to buy or sell a specified amount of an asset at a price decided upon today. The delivery and payment for the asset, however, will occur on a future date.
These contracts are traded over the counter (a private contract between two parties).
Futures contract
This contract is similar to a forward contract but it is traded on a futures exchange.
Having a secondary market means the contract can be traded out of at any time (i.e. a futures buyer would sell to get out and a futures seller would buy to get out)
Option contract
This is a contract which gives the buyer of the contract the right to buy (Call Option) or sell (Put Option) an asset at a predetermined price before or on a future date.
Unlike a futures or forward contract the buyer does not have the obligation to proceed with the contract.
The buyer must pay the seller (writer) of the contract a premium (or price) for the right.
Swap contract
This is an arrangement to swap specified future cash flows.
An interest rate swap occurs when there is an exchange (or swap) of interest rate payments at future dates.
These interest payments are based on a notional principal.
A cross currency swap occurs when there is an exchange of cash flows denominated in different currencies at a fixed exchange rate.
The initial and final principal loan payments as well as interest payments are exchanged.
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