FIN111 Lecture Notes - Lecture 2: Financial Institution, Knowledge Economy, Promissory Note

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10 May 2018

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1. Role of the financial system

2. Function of direct and indirect financial markets

3. Different types of financial intermediaries

4. Types of financial markets

5. Money and capital markets

6. Risks faced by financial institutions

The financial system is a key influencer of the health and efficiency of an economy. The role of the

financial system is to gather money from people and businesses that currently have more money than

they need and transfer it to those that can use it for either business or consumer expenditures. This

flow of funds through financial markets and institutions in the economy is huge, affecting business

profits, the rate of inflation, interest rates and the production of goods and services.

The role of the financial system:

• Financial markets are the markets for buying and selling financial instruments.

• The financial system consists of financial markets, institutions and money.

• The roles of the financial system are:

• To facilitate the flow of funds

• The role of the financial system - financial markets, institutions, and money - is to permit the

flow and efficient allocation of funds throughout the economy.

• Financial instruments (assets that can be traded), as part of the financial system, allow the flow

of funds from savers or surplus spending units to borrowers or deficit spending units.

• Financial institutions are firms such as commercial banks, credit unions, life insurance, and

finance companies.

• Money as a medium of exchange is important to the efficiency of the financial system. It

overcomes the divisibility problem caused if the mediums of exchange are not equal.

SSUs and DSUs

Economic units can be classified as:

• Households

• Businesses

• Governments

Each economic unit must operate within a budget constraint imposed by its total income for the

period. E.g. households typically receive income in the form of wages and then make frequent

expenditures for food, clothing etc.

• Any economic unit can have one of three possible budget positions:

• A balanced budget position: income and planned expenditures are equal.

• A surplus position: income exceeds planned expenditure.

• A deficit position: planned expenditure exceeds income.

o A surplus unit is a unit whose income exceeds planned expenditure.

o A deficit unit is a unit whose expenditure exceeds its receipts.

o The flow of funds from SSUs (mainly households) to DSUs (mainly business firms and

governments) is a fundamental function of the financial system.

• To provide the mechanism to settle transactions

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Each transaction generates a transfer of funds that must be settled or completed within the system. A

key role of the financial system is to provide the mechanism for these settlements to occur through

what is known as the payments system.

• Many transactions in the payments system are settled immediately. Other transactions however

are much larger and are settled after the terms of the transaction have been agreed.

• An effective payments system is characterised by its efficiency, in terms of speed, cost and

stability.

• Without an efficient and stable payments system, the ability of the financial system to handle

this large volume of transactions and maintain the low of funds would be questionable.

• To generate and disseminate information

A further role of an efficient financial market is to provide sufficient economic and financial

information to enable participants to make informal investment decisions.

• In the knowledge economy we now operate in, this is a key function of financial markets, as

routine decisions in relation to investments, loans, insurance etc. require information to

facilitate them.

• To provide the means to transfer and manage risk

A key role of the financial system is to allow for financial risk to be managed and or transferred to

other parties.

• To provide ways of dealing with incentive problems

Dealing with incentive issues that arise in financial contracts, all of which undermine the financial

systems processes and create risk for parties to a financial contract. Three key examples of this are:

• Information asymmetry: where one party to a deal or transaction as access to better information

than the other parties.

• Moral hazard: where a party that is insulated from risk behaves differently to the way they

would were not protected.

• Agency problems:

Transferring funds from SSUs to DSUs:

The job of bringing DSUs and SSUs together can be done by direct financing or by indirect financing,

more commonly known as financial intermediation.

Direct financing:

• SSUs lend money to DSUs and accept a financial claim in return. A financial claim or security

is a financial asset claim on future cash flows. A claim may be a debt or equity

(ownership) claim. A borrower issues financial claims in return for funds; an investor

trades funds for a financial claim.

• In direct financing, this exchange takes place directly without an intermediary.

• Direct financing gives SSUs an outlet for their savings, which provides an expected return, and

DSUs no longer need to postpone current consumption or forgo promising investment

opportunities for lack of funds.

• The limitations of direct financing create a role for financial intermediaries to intervene

between DSU and SSU.

Indirect financing:

• Direct financing requires DSUs to find SSUs that want direct claims and the

denominations/value involved are usually very large.

• These problems are resolved through the involvement of a financial intermediary.

• Financial intermediaries purchase direct claims from DSUs, transform them into indirect

claims(make the claims more attractive) and sell them to SSUs. This process is called financial

intermediation.

Benefits of financial intermediation:

They enjoy three sources if comparative advantage:

• Can achieve economies of scale because of their specialisation.

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Document Summary

Role of the financial system, function of direct and indirect financial markets, different types of financial intermediaries, types of financial markets, money and capital markets, risks faced by financial institutions. The financial system is a key influencer of the health and efficiency of an economy. The role of the financial system is to gather money from people and businesses that currently have more money than they need and transfer it to those that can use it for either business or consumer expenditures. This flow of funds through financial markets and institutions in the economy is huge, affecting business profits, the rate of inflation, interest rates and the production of goods and services. It overcomes the divisibility problem caused if the mediums of exchange are not equal. Economic units can be classified as: households, businesses, governments. Each economic unit must operate within a budget constraint imposed by its total income for the period.

Related Questions

Position A: Financial Institutions' role as specialists in risk measurement and management is reduced.

Position B: Financial Institutions' role as specialists in risk measurement and management is increased.

Required:

Read the âbackgroundâ below. After reading, select the position you agree with and write a position paragraph supporting either Position A or Position B.

Background: A major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As Financial Institutions adjusted to regulatory changes brought about in the 1980s and 1990s, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of âoriginate and holdâ to âoriginate to distribute.â In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk trade-offs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial services holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate-and-hold model of commercial banking to the originate-and-distribute banking model. In the shadow banking system, savers place their funds with money market mutuals and similar funds, which invest these funds in the liabilities of other shadow banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and borrowers. However, instead of the bank serving as the middleman, it is the non-bank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system where the complete credit intermediation is performed by a single bank, in the shadow banking system, it is performed through a series of steps involving many non-bank financial service firms. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Thus, the financial institutions, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking.

In your own words, explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Why or Why not? Explain.

1. Different financial institutions have different levels of service. What is the main reason for this?

a. The Federal regulations relating to the institutions make them provide the services at different levels.

b. Levels of financial service are determined in part by the ownership structure of the financial institution, and different financial institutions have different ownership structures.

c. Financial services require specific expertise and the design of financial institutions favors one type of institution over the other.

d. None of these explain the difference between levels of service at different institutions.

2. Which of the following is not an example of a financial intermediary?

a. Savings and Loans.

b. Commercial banks.

c. Pension funds.

d. Stock markets.

e. All of these are examples of financial intermediaries.

3. Which of the following branches of the Federal Reserve Bank has a permanent seat on the Federal Open Market Committee?

a. New York

b. Cleveland

c. St. Louis

d. Boston

e. None of these.

4. Who owns the Federal Reserve Banking system?

a. No one, it owns itself.

b. The member banks.

c. The US Government.

d. The Chinese Government.

e. The shareholders of the Federal Reserve Corporation.

5. Who is the most important member of the Federal Open Market Committee and often thought of as the second most powerful person in the United States?

a. The President of the United States

b. The Treasury Secretary.

c. The Chairman of the Federal Reserve Bank.

d. The President of the Federal Reserve Bank of New York.

e. None of these.

6. Which of the following markets is the most stable?

a. The market for corporate bonds.

b. The real estate market.

c. The market for Treasury bonds.

d. The New York Stock Exchange.

e. The Chicago Mercantile Exchange.

7. All of the following show interactions between markets except:

a. Purchase of a mortgage issued by Freddie Mac by the Federal Reserve Bank.

b. Sale of stock to raise equity for a new company to an insurance provider.

c. Increase in short term target rates by the Fed on the bond market resulting in stock market increases when announced in the press.

d. Restrictions in bank lending as the result of increasing capital requirements resulting in lower real estate prices and fewer sales on the real estate market.

e. All of these are examples of market interactions.

8. Which of the following acts was repealed by the Gramm-Leach-Bliley Act of 1999:

a. The Depository Institutions Deregulation and Monetary Control Act of 1980.

b. The Banking Act of 1933.

c. The Garn-St Germain Depositary Institutions Act of 1982.

d. The Civil Rights Act of 1964

e. None of these.

9. Which of the following problems was a reason for bank panics prior to the establishment of the Federal Reserve bank:

a. Currency was not uniform in value.

b. Currency was not backed by the full faith and credit of the United States Government.

c. Currency could become worthless if the issuing bank went bankrupt.

d. Lack of regulation of the financial markets often led to bank runs.

e. All of these were elements of the bank panics that occurred prior to the establishment of the Federal Reserve system.

10. Why is the Federal Reserve Bank considered to be relatively but not completely free of political influence in the United States?

a. The Federal Reserve Chairman must be appointed by the President and confirmed by the Senate.

b. The Federal Reserve is not owned by the US Government.

c. The Federal Reserve System is designed to divide power among member banks from different regions of the country.

d. The Federal Reserve appointments are for sufficient length of time that it takes at least 8 years for a majority of members to be appointed by one President.

e. All of these are important in defining the degree of independence of the Federal Reserve from political influence.

11. Which of the following examples is an illustration of interest rate risk?

a. A consumer buys a house with a fixed mortgage that will not change for 30 years.

b. A consumer buys a car with a fixed rate loan at 5.99% for five years.

c. A bank borrows funds from the Federal Reserve discount window for 0.25% and lends that money to a consumer for a car or auto loan of longer duration.

d. A consumer opens a passbook savings account.

e. None of these illustrate interest rate risk

12. If the yield curve is said to be steep, this means:

a. Banks will make a lot of money lending at long term rates that are higher than the short term rates at which they borrow money.

b. The bond market expects inflation to increase in the future.

c. The bond market expects that the economy will grow in the immediate future.

d. None of these are conclusions that can be reached from a steep yield curve.

e. a, b and c are all conclusions that can be reached when the yield curve is steep.

13. According to the expectations theory of interest rates:

a. The total interest rate is equal to the sum of the real interest rate and the expected inflation rate.

b. The total interest rate is equal to the sum of the real interest rate, the expected inflation rate, and a series of additional premiums based on the risks taken in the instrument of interest.

c. The Fed sets interest rates, which cannot be changed by the market.

d. The interest rate in the economy is a balance between the supply and demand of funds.

e. None of these are true.

14. If the real interest rate in the economy is 3% and the expected inflation is 2% per year over a five year period, assuming the maturity risk premium is 0, what is the interest rate that the expectations theory would predict for a five year Treasury note?

a. 10%

b. 3%

c. 2%

d. 6%

e. 5%

15. What is the most important economic function of the money markets?

a. To provide an efficient means of liquidity adjustment for businesses, individuals and governments.

b. To provide a place where buyers and sellers can negotiate a price of funds.

c. To provide a social interaction between borrowers and sellers of funds, allowing for easier relationship-based transactions in the future.

d. To provide a place where stocks and bonds can be sold.

e. None of these are important economic functions of the money markets.

16. The ideal instrument sold in a money market has all of the following characteristics except:

a. High liquidity

b. Low Default Risk

c. Are long term obligations

d. Are short term obligations

e. None of these are characteristics of an ideal money market instrument.

17. What is the reason for the 35% rule in the bid process for Treasury securities?

a. It prevents a single entity from controlling the interest rate in the market.

b. It allows regular consumers access to the treasury market through non-competitive bids.

c. It prevents the government from controlling and regulating banks.

d. It prevents the Chinese from buying too many treasury bills.

e. None of these are reasons for the establishment of the 35% rule.

18. What is the name for the risk that a financial institution might not receive promised cash flows in the form of interest and principal payments from its borrowers?

a. Interest Rate Risk

b. Financial Payment and Principal Risk

c. Market Risk

d. Credit Risk

e. None of these are the correct term.

19. The risk that a financial institution might have to sell a lot of assets in a short period of time at below market prices to pay obligations demanded by its creditors is called:

a. Liquidity Risk

b. Market Risk

c. Credit Risk

d. Interest Rate Risk

e. None of these

20. What is the main difference between firm-specific and systemic credit risk?

a. Firm specific risk can be managed by proper underwriting and diversification in a loan portfolio.

b. Systemic risk affects all borrowers.

c. Firm-specific risk is determined by the individual circumstances of the firm involved.

d. Derivitives can be used to manage systemic risk

e. The Federal Reserve Bank of New York uses open market operations to manage firm-specific risk.

21. A credit crisis in the financial markets can improve bank efficiency by:

a. Focusing the bank underwriting department on firm-specific risk factors associated with default.

b. Forcing banks to reduce staffing needs by eliminating wasteful or unnecessary functions.

c. Marking banks compete more rigorously for customers in a tougher market.

d. None of these are reasons that a recession helps improve bank efficiency.

e. Items a, b and c are all reasons that a bank improves efficiency during a recession.

22. A mutual fund that invests only in Treasury funds has which of the following risk exposures?

a. Interest Rate Risk

b. Liquidity Risk

c. Default Risk

d. Treasuryâs are risk free, so a mutual fund that invests in them is also risk free.

e. Credit risk

23. Foreign Stocks carry additional risks beyond those of US companies for US investors. Which of the following risks is not an additional risk that a US investor in foreign stocks faces?

a. Interest Rate Risk

b. Foreign Currency Risk

c. Sovereignty Risk

d. Both a and b are additional risks faced by these investors.

e. All of these risks (a, b and c) are faced by investors in domestic and foreign stocks.

24. According to the theory of Purchasing Power Parity, if the price of a widget in the US is $3.00 and the Euro is worth $1.50, the price of the widget in Germany would be:

a. â¬5.00

b. â¬3.00

c. â¬4.50

d. â¬7.00

e. â¬10.00

25. For many years, the current account of the United States has been in deep deficit. In theory, this should lead to a weak dollar. What factors could counteract the effect of the current account deficit on the strength of the dollar?

a. Foreigners use dollars as stores of value

b. When inflation is expected to be low in the USA and interest rates are high, foreigners want to invest here, driving up the price of the dollar.

c. The Dollar is king in the world currency markets

d. Dollars are backed by the full faith and credit of the US Government and therefore maintain a constant value on the market.

e. None of these explains the relative strength of the dollar in the global currency market.

pinkkangaroo996

The study of finance consists of the following interrelated area(s):

a) Financial markets and institutions

b) Financial services

c) Investments

d) Managerial (business finance)

e) All of the above

The liquidity asset is one that can be easily converted to __________ without significant loss of its original value.

a) Bonds

b) Cash

c) Gold

d) Liquid

e) Silver

A goal of financial intermediaries is to improve the economic well-being. Other benefits include:

a) Diversification (risk)

b) Financial flexibility

c) Funds divisibility/pooling

d) Reduced costs

e) Related services

f) All of the above

4.____________ represents the current value of some future amount.

a)Assumed value

b)Future value

c)Present value

d)Zero value

The cost of money (interest rates) is based on (1) the rate of return that borrowers expect to earn on their investments, (2) saversâ preferences to spend income in the current period rather than delay consumption until some future period, _____________________________, and (4) expected inflation.

a) the level of economic activity

b) the risks associated with investments/loans

c) the trade deficit

d) the yield, or return that is earned on an investment

6.Short-term debt includes all of the following EXCEPT:

a)Bankerâs Acceptances

b)Certificates of Deposits (CDâs)

c)Commercial Paper

d)Eurodollar Deposits

e)Federal Funds

f)Government Bonds

g)Money Market Mutual Funds

h)Repurchase Agreements (Repos)

i)Treasury Bills (T-bills)

7.Common stockholders are usually referred to as the owners of the firm because investors in common stock have certain rights and privileges generally associated with ________________.

a)Contracts

b)Income stocks

c)Property ownership

d)Treaties

8.The concept of reducing the stand-alone risk of an individual investment by combining it with other investments to form a portfolio is called ______________.

a)Correlation coefficient

b)Diversification

c)Realized rate of return

d)Risk aversion

9.A _____________ is defined as the cash flows that could be generated from assets the firm already owns if they are not used for the project in question.

a)Balance Sheet

b)Budget

c)Income Statement

d)Opportunity Cost

e)Sunk Cost

To determine its required rate of return, the firm must compute the cost of each source of funds of capital that investors provide; that is, the firm must compute the ___________, the cost of preferred stock, the cost of retained earnings, and the cost of new common equity.

a) Cost of debt

b) Cost of equity

c) Cost of living

d) Cost of unemployment

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FIN111 Lecture Notes - Lecture 2: Financial Institution, Knowledge Economy, Promissory Note

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