flows of funds through the financial system description

Financial markets involve various players, including borrowers, lenders, and investors that negotiate loans
for investment purposes. The borrowers and lenders tend to trade money in exchange for a return on the
investment at some future date. Derivative instruments are also traded in the financial markets as well,
which are contracts that are determined based on an underlying asset’s performance.
When determining the guidelines of raising capital within a financial system, the project being funded and
who funds them are decided upon by the planner, who can be a business manager. Thus, the financial
system is typically organized through central planning, a market economy, or a combination of both.
A centrally planned economy is structured around a central authority, such as a government, which makes
economic decisions regarding the manufacturing and distribution of products for a specific country. A
market economy is when the pricing of goods and services is dictated by the aggregated decision of
citizens and business owners, often resulting in the effects of supply and demand.
Financial markets operate within a government regulatory framework that filters the sort of transactions
that can be conducted. Financial systems are heavily regulated due to their influence and facilitation
capabilities to contribute to the growth of real assets.
The main (1) functions of financial systems are to:
• provide the (2) mechanisms by which funds can be transferred from units in surplus to units with a
shortage of (3) funds in order to directly or indirectly facilitate lending and borrowing
• enable wealth holders to (4) adjust the composition of their portfolios
• provide (5) payment mechanisms, e.g. cheques, debit cards and credit cards
• provide mechanisms for risk (6) transfer, e.g. insurance contracts allow a party such as a firm or
household to transfer the risk of loss of wealth due to (7) theft or fire to another party such as an (8)
insurance company.
From a (9) structural point of view a financial system can be seen in terms of the (10) entities that
compose the system. A financial system comprises financial markets, securities and financial
intermediaries.
Financial markets can be classified on the basis of several (11) parameters: the nature of the financial
securities traded ((12)primary versus (13) secondary markets), forms of organisation ((14) organised
exchanges versus (15) over-the-counter markets), maturity of the financial instruments traded ((16)
capital markets versus (17) money markets).
Financial securities traded in financial markets are (18) debt instruments (bonds, notes and bills), and
(19) equity instruments (common and preferred stocks).
Financial intermediaries comprise (20) depository institutions (commercial banks, savings and loan
associations and credit unions), (21) contractual savings institutions (insurance companies and pension
funds), and (22) investment intermediaries (mutual funds, finance companies, investment banks and
securities firms).
Financial systems, i.e. financial intermediaries and financial markets, are important for economic
growth. They can lead to a more efficient (2) allocation of resources because they reduce the (3) costs of
moving funds between borrowers and lenders, and help overcome an (4) information asymmetry
between borrowers and lenders. If they do not function well the economy can not operate efficiently and
economic growth will be negatively affected.
Financial markets and intermediaries are alternatives that perform more or less the same functions but in
different ways. Broadly speaking, financial markets provide lower cost arm’s length debt or equity
finance to a smaller group of firms able to obtain such finance, while financial intermediaries offer
finance with a higher cost reflecting the expense of uncovering information and ongoing monitoring.
Financial systems fall in between the two extremes. The UK and the USA are examples of market-based
financial systems, where markets are more important than banks; while Japan and Germany are examples
of bank-based financial systems, where the opposite situation occurs. Several other financial systems are
intermediate cases, where both markets and banks are important like France, Italy and Spain.
The two types of financial systems have different implications for:
• Households’ asset allocation: in the market-based systems, equity is a much more important
component of household assets than in the bank-based systems; the reverse is true for cash, cash
equivalents and bonds.
• The role of indirect intermediation (pension funds, insurance companies, mutual funds): individuals’
indirect investments through intermediaries are dominant in the bank-based systems, whereas
individuals’ direct participation to the stock market is high in the market-based systems, especially the
USA.
• Firms’ financing: in the bank-based systems, loans from financial intermediaries are more important
for corporate finance than marketable securities, but at a lesser extent than in the market-based systems.
) Money market securities are short-term instruments with an original (2) maturity of less than one year.
These securities include Treasury bills, (3) commercial paper, federal funds, repurchase agreements,
negotiable certificates of deposit, banker’s acceptances, and (4) Eurodollars.
- Money market securities are used to “warehouse” funds until (5) needed. The returns earned on these
investments are low due to their (6) low risk and (7) high liquidity.
- (8) Treasury bill returns are the lowest because they are virtually devoid of default risk. (9) Banker’s
acceptances and (10) negotiable certificates of deposit are next lowest because they are backed by the
creditworthiness of large money center banks.
Foreign exchange rates are important because they affect the (11) price of domestically produced goods
sold abroad and the (12) cost of foreign goods bought domestically.
The theory of purchasing power parity suggests that long-run changes in the exchange rate between two
countries’ (13) currencies are determined by changes in the relative (14) price levels in the two
countries. Other factors that affect exchange rates in the long run are tariffs and quotas, import demand,
export demand, and (15) productivity.
(16) Forecasts of foreign exchange rates are very valuable to (17) managers of financial institutions
because these rates influence (18) decisions about which assets (19) denominated in foreign currencies
the institutions should hold and what kinds of trades should be made by their (20) traders in the foreign
exchange market
1. The capital markets exist to provide financing for long-term capital assets. Households, often through
investments in pension and mutual funds, are net investors in the capital markets.
2. The three main capital market instruments are bonds, stocks, and mortgages. Bonds represent
borrowing by the issuing firm. Stock represents ownership in the issuing firm. Mortgages are long-term
loans secured by real property. Only corporations can issue stock. Corporations and governments can
issue bonds. In any given year, far more funds are raised with bonds than with stock.
3. We compute the value of bonds by finding the present value of the cash flows, which consist of
periodic interest payments and a final principal payment.
4. The value of bonds fluctuates with current market prices. If a bond has an interest payment based on a
5% coupon rate, no investor will buy it at face value if new bonds are available for the same price with
interest payments based on 8% coupon interest. To sell the bond, the holder will have to discount the
price until the yield to the holder equals 8%. The amount of the discount is greater the longer the term to
maturity.
2. Stocks are valued as the present value of the dividends.
5. An alternative method for estimating a stock price is to multiply the firm’s earnings per share times the
industry price earnings ratio.
Differences in preferences Transaction Liquidity needs Asymmetric information
of lenders and borrowers costs Adverse Moral hazard
selection Equity Debt
markets markets

1, 4, 12 2, 7, 9 3 6, 8, 11 5, 8, 8, 10, 11,
11, 13 14

1. Screening loan applications 2. Economies of scale

3. Liquidity insurance 4. Diversifying risk
5. Debt contracts 6. Private production and sale of information
7. Expertise 8. Financial intermediaries
9. Economies of scope 10. Monitoring and enforcement of restrictive covenants
11. Government regulation 12. Pooling risks
13. Monitoring 14. Making debt contracts incentive-compatible
1. Rank the following bank assets from most to least liquid:
a. Commercial loans
b. Securities The rank from most to least liquid is (c), (b), (a), (d).
c. Reserves
d. Physical capital
2. If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should
you automatically turn the customer down, explaining that you don’t have any excess reserves to loan
out? Why or why not? What options are available for you to provide the funds your customer needs?
No. When you turn a customer down, you may lose that customer’s business forever, which is
extremely costly. Instead, you might go out and borrow from other banks, corporations, or the
Fed to obtain funds so that you can make the customer’s loan. Alternatively, you might sell
negotiable CDs or some of your securities to acquire the necessary funds.

3. If you are a banker and expect interest rates to rise in the future, would you want to make short-term or
long-term loans? You should want to make short-term loans. Then, when these loans mature, you
will be able to make loans at higher interest rates, which will generate more income for the bank.
4. “Bank managers should always seek the highest return possible on their assets.” Is this statement true,
false, or uncertain? Explain your answer. False. If an asset has a lot of risk, a bank manager might not
want to hold it even if it has a higher return than other assets. Thus a bank manager has to consider
risk as well as the expected return when deciding to hold an asset.
5. “Banking has become a more dynamic industry because of more active liability management.” Is this
statement true, false, or uncertain? Explain your answer.
True. Banks can now pursue new loan business much more aggressively than in the past because
when they see profitable loan opportunities, they can use liability management to acquire new
funds and expand the bank’s business.
46. Explain why the credit risk associated with a loan portfolio is less than the sum of the credit risk
associated with each of the loans in the portfolio. =>Solution: All the loans in the portfolio will not
default at the same time. The principals of modern portfolio theory teach us that there are
diversification benefits to diversifying our asset portfolio.
47. Explain how liquidity risk can lead to a bank’s failure.=>Solution: If a bank has insufficient funds
to meet its depositor’s withdrawals, it must close its doors. Banks fail, therefore, because they are
unable to meet their legal obligations to depositors and other creditors.
1. When the euro appreciates, are you more likely to drink California or French wine?
- You are more likely to drink California wine because the euro appreciation makes French wine
relatively more expensive than California wine.
2. If the Indian government unexpectedly announces that it will be imposing higher tariffs on
foreign goods one year from now, what will happen to the value of the Indian rupee today?
- The Indian rupee will appreciate. The announcement of tariffs will raise the expected future exchange
rate for the rupee and so increase the expected appreciation of the rupee. This means that the demand for
rupee denominated assets will increase, shifting the demand curve to the right, and the rupee exchange
rate therefore rises.
3. “A country is always worse off when its currency is weak (falls in value).” Is this statement true,
false, or uncertain? Explain your answer.
- False. Although a weak currency has the negative effect of making it more expensive to buy foreign
goods or to travel abroad, it may help domestic industry. Domestic goods become cheaper relative to
foreign goods, and the demand for domestically produced goods increases. The resulting higher sales of
domestic products may lead to higher employment, a beneficial effect on the economy.
What rights does ownership interest give stockholders? Answer: Stockholders have the right to vote
on issues brought before the stockholders, be the residual claimant, that is, receive a portion of any net
earnings of the corporation, and the right to sell the stock.

Explain why you would be more or less willing to buy long-term bonds under the following
circumstances: a. Trading in these bonds increases making them easier to sell; b. Stock prices are
expected to decline; c. Broker fees on stocks goes down; d. You expect interest rates to rise; e. Broker
fees on bonds goes down.

a) More, because it has become more liquid;

(b) less, because it has become riskier;
(c) more, because its expected return has risen;
(d) more, because its expected return has risen relative to the expected return on long-term bonds, which
has declined.
2. How many types of financial instruments? What are them?
Financial instruments can be classified generally as equity based, representing ownership of the asset, or
debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange
instruments comprise a third, unique type of instrument. 
Evidences of share/ equity: represent ownership of companies and pay dividends.
Evidences of debt: represent the relationship between creditor and debtor and pay interest.
Evidences of deposits: liabilities of specialist companies (mostly banks) and carry a different risk profile.
Evidences of investments vehicle:
Derivative instruments: security whose price is dependent upon or derived from 1 or more underlying
assets
Ex: future contracts, forward contracts, option, swaps ...

T F 41. A high positive GAP is riskier than a high negative GAP.

Explain: A large GAP in either direction subjects the bank to significant interest rate risk.
T F 42. Developing and maintaining long-term customer relationships help to reduce
banks’ costs of screening and monitoring borrowers.
T F 4 3. Excess reserves may be used to meet liquidity needs.
Explain: By definition, excess reserves are among the most liquid bank assets.
T F 44. Credit rationing reduces adverse selection problems.
T F 45. Banks need liquidity for both deposit withdrawals and loan demand.
Explain: A bank has to supply liquidity on both sides of the balance sheet.

share instruments debt instruments

Characteristics - reflect the ownership of the issuers.
-the issuers pay the investor an amount
based on earnings.
- reflect a loan the investors have
made to the issuers( borrowers-
lenders relation)
-the issuers pay the investor interest
plus repay the amount borrowed.

Maturities no time limit fixed maturities

The issuers corporate sector, foreign sector Household sector, corporate,

government and foreign sector.

Advantages:

-for the issuer: Flexibility, low cost of finance, Predictability, independence from
reputation shareholders’ influence

-for the investor: High expected return Low risk

Disadvantages:

-for the issuer: Shareholder dependence, short- Debt servicing obligation

sightedness, market volatility
influencing management decisions

-for the investor: High risk Low returns

Share and debt are the two common instruments of financial ones. The classification of debt and share is
especially important for two reasons. Firstly, in the case of bankruptcy of the issuer, the investor in debt
instruments has a priority on the claim to the issuer’s asset over equity instruments. Secondly, the tax
treatment of the payments by the issuer can differ depending on the type of financial instrument class