FBIM 602: Investments

Tutorial 1 suggested solutions

Question 1

As can be seen in the diagram, savings can be channelled into investment either
directly (through the issue of primary securities in the financial markets) or indirectly
(through the indirect securities issued by financial intermediaries).
Points that need to be discussed:
 What is direct financing and how does it work
 What are the problems associated with direct financing
 How does the financial intermediary resolve the problems associated with
direct financing (drawing attention to the difference between direct and
indirect claims)
 Explain how indirect financing works

Question 2
The advantages of intermediation include:
 Transformation of maturity, liquidity, risk and size:
o maturity: satisfies different time preferences of savers and borrowers
o liquidity: satisfies shorter-term preference of depositors for access to
funds, and of longer-term preference of borrowers for commitment
 of funds (by aggregating small amounts of funds for on-lending in
larger packages, liquidity is created for the lender)
o risk: confidence of depositors that they will be repaid in full;
spreading the risk by lending to a large number of borrowers (more
efficient diversification of risk than an individual is able to achieve)
o size: aggregate many small depositors; ability to obtain large loan
funds.
 Economies of scale: large financial institutions reap cost and efficiency
advantages through the scale of their operation e.g. standardised
documentation, pricing, technology based delivery systems.
 Specialisation: financial expertise and specialist skills in lending (e.g. credit
analysis) and investment (e.g. fund management).
 Efficiency: reduce search costs, transaction costs and information costs in
satisfying the needs of both lenders and borrowers.
 Risk management: both lenders and borrowers can manage their individual
liquidity, interest rate and credit risks.
 Technology: investment in sophisticated information, delivery and support
systems.
 Access to a larger savings pool: by providing liquidity and reducing risk,
financial intermediaries are able to tap into savings that would otherwise not
have been available.

Question 3
Instrument Risk Liquidity Return
T-Bill Lowest Highest Lowest
BA Medium Medium Medium
NCD Highest Lowest Highest

T-Bills have the lowest risk as they are issued by the state and backed by the assets
and revenues of the government; they are viewed as a proxy for a risk-free asset.
BA’s are issued by private sector companies, although backed by banks, and thus are
reasonably secure assets. In fact, in countries where the government is not viewed as
a credible and reliable institution, the BA rate may be used as a proxy for the risk-free
rate. NCDs, although issued by banks, have the most risk because they are unsecured
promissory notes i.e. they are not backed by the revenues and assets of the issuing
bank. This ranking order of the three instruments in terms of risk is mirrored with
respect to return because assets of greater risk must provide the potential investor
with incentives to purchase the financial instrument in question and thus NCDs
provide the highest return, then BA’s and finally T-Bills (T-Bills should really only
compensate investors for the inconvenience of being without their funds for the
investment period). The liquidity of an instrument; that is, how easily it can be
converted to cash without a significant loss in value is associated with the perceived
risk of an instrument. Thus, the secondary market for T-Bills is considerably more
active than that of BA’s and NCDs respectively, with the relative degree of liquidity of
the three instruments reflecting this.