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Introduction to the Financial System

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.