1 Describe the financial system and explain how it operates.
The financial system is a complex network of institutions, markets, and intermediaries that
facilitate the transfer of funds and risk between savers, investors, and borrowers. It includes
various components, such as banks, insurance companies, mutual funds, pension funds, stock
exchanges, bond markets, and regulatory bodies. The financial system operates at its core by
channeling funds from savers to borrowers through financial intermediaries and markets.
Financial intermediaries, such as banks, mutual funds, and pension funds, play a critical role in
the financial system by pooling funds from savers and lending them to borrowers. These
intermediaries help to reduce information asymmetry and transaction costs by performing due
diligence on borrowers, monitoring their performance, and managing risk through
diversification and hedging. Financial markets, such as stock exchanges and bond markets,
provide investors and borrowers with a platform to buy and sell financial instruments, such as
stocks, bonds, and derivatives. These markets help to determine the price of financial
instruments and provide liquidity to investors by enabling them to buy and sell their
investments quickly and easily. The financial system also operates through various mechanisms,
such as payment systems, credit rating agencies, and regulatory bodies. Payment systems
enable the transfer of funds between parties, while credit rating agencies provide information
about the creditworthiness of borrowers. Regulatory bodies, such as central banks and financial
regulators, oversee the financial system to ensure its stability, integrity, and efficiency.
2 a. Discuss the difference between a financial asset and a tangible asset.
b. Describe the two principle roles of financial assets.
c. Explain the roles/functions of financial intermediaries.
A. The main difference between a financial asset and a tangible asset is that a financial
asset represents a legal claim to some future benefit or cash flow, or a contractual right to
receive funds or other financial instruments. Common examples of financial assets include
stocks, bonds, derivatives, options and bank deposits. These assets can be bought, sold, or
traded in financial markets. On the other hand, a tangible asset is a physical asset that has a
physical presence and can be touched or felt. Tangible assets have inherent value due to their
physical substances or properties. Examples of tangible assets include real estate, machinery,
vehicles, equipment and inventory. These assets are typically used in production or are held for
investment purposes. Another difference is that financial assets are more liquid than tangible
assets, meaning they can easily converted to cash without losing much value. Tangible assets
are less liquid and may require time and effort to sell or transfer. Financial assets are also more
susceptible to market fluctuations and risks than tangible assets, as their value depends on
supply and demand, interest rates, inflation and other factors. Tangible assets tend to be more
stable and durable, as they do not experience depreciation due to wear and tear.
B. The two principal roles of financial assets are to transfer funds and to redistribute risk.
Financial assets transfer funds from those who have surplus funds to invest to those who need
funds to invest in tangible assets, such as businesses, governments, or individuals. For example,
a person who buys a bond from a corporation is lending money to the corporation, which can
use the funds to expand its business. A person who buys a stock from a company is becoming a
part-owner of the company, which can use the funds to finance its operations. A person who
buys a treasury bill from the government is providing funds to the government, which can use
the funds to pay for public goods and services. Financial assets also redistribute the
unavoidable risk associated with the cash flow generated by tangible assets among those
seeking and those providing the funds. This allows investors to diversify their portfolios and to
choose the level of risk and return that suits their preferences. For example, a person who
invests in a mutual fund that holds a variety of stocks and bonds is spreading the risk of losing
money across different sectors and markets. A person who invests in a hedge fund that uses
complex strategies and derivatives is taking on more risk in exchange for higher returns.
C. Financial intermediaries play an important role in the financial system by mobilizing
savings, reducing transaction costs, providing liquidity, and transformation of assets and risks.
Mobilizing Savings: Financial intermediaries, such as banks and credit unions, play a crucial role
in mobilizing savings from individuals and businesses. They encourage individuals to deposit
their excess funds, which can then be used to lend to borrowers for various purposes, including
investment, consumption, and business expansion. Financial intermediaries mobilize savings by
pooling funds from individual investors and investing them in a diversified portfolio of financial
assets. This allows for greater investment opportunities and risk diversification, which can lead
to higher returns for investors.
Reducing Transaction Costs: Financial intermediaries help reduce transaction costs by providing
efficient and cost-effective methods for financial transactions. They pool resources from various
individuals and businesses, allowing for economies of scale in the processing of transactions.
For example, banks facilitate the transfer of funds through electronic banking systems, reducing
the need for physical transportation of cash. They can reduce the costs of acquiring
information, analyzing risk, and monitoring investments, which can make it more affordable for
small investors to participate in the financial markets.
Liquidity Provision: Financial intermediaries serve as liquidity providers by transforming the
maturities of assets and liabilities. They accept short-term deposits and use these funds to
extend long-term loans or invest in illiquid assets, such as real estate or infrastructure projects.
This process provides liquidity to individuals and businesses that may face difficulty accessing
funds on short notice.
Transformation of assets and risks: Financial intermediaries transform the maturity, liquidity,
and risk characteristics of assets to better match the preferences and needs of investors and
borrowers. For example, banks collect short-term deposits from savers and use those funds to
provide longer-term loans to borrowers. This transformation function helps improve the
efficiency of the financial system by converting illiquid assets into more tradable forms and
managing risks through diversification and expertise.
3. a. Explain the three factors that have led to the globalization of financial markets.
b. Describe the three reasons why a corporation may seek to raise funds outside of its
domestic market (i.e. in foreign markets).
A. The globalization of financial markets can be attributed to three main factors:
deregulation or liberalization of financial markets, technological advances, and
increased institutionalization.
1. Deregulation or liberalization of financial markets:
Deregulation refers to the removal or relaxation of government regulations and controls on
financial markets, allowing for more flexibility and open access. It has played a significant role in
the globalization of financial markets as it has facilitated cross-border financial transactions.
Examples of deregulation include the lifting of capital controls, liberalization of foreign
exchange markets, and the elimination of restrictions on foreign investment.
2. Technological advances:
Technological advancements, particularly in information and communication technology, have
revolutionized the financial industry and contributed to the globalization of financial markets.
The development and widespread adoption of electronic trading platforms, high-speed internet
connectivity, and sophisticated computer systems have facilitated faster and more efficient
cross-border transactions. For example, the emergence of electronic trading platforms like
Bloomberg Terminal and Reuters Eikon has provided investors with real-time access to global
financial markets, enabling them to trade in various markets from a single platform. This has led
to increased integration and interconnectivity of financial markets worldwide.
3. Increased institutionalization:
Increased institutionalization refers to the growing involvement of institutional investors, such
as pension funds, insurance companies, and hedge funds, in global financial markets. These
institutional investors have substantial financial resources and are driven by the goal of
maximizing returns on their investments. Their increased participation has further fueled the
globalization of financial markets.
B. Three reasons why a corporation may seek to raise funds outside of its domestic market
(i.e. in foreign markets).
1. Access to larger investor base: By raising funds in foreign markets, corporations can tap into a
larger pool of potential investors. This allows them to attract more capital and potentially lower
the cost of borrowing. For example, a multinational company headquartered in the United
States may issue bonds in the European market to attract European investors who are looking
to diversify their bond portfolios.
2. Lower borrowing costs: In some cases, corporations may find that borrowing funds in foreign
markets is more cost-effective than raising funds domestically. This can occur when interest
rates are lower in foreign markets or when there is high demand for the corporation's securities
in a particular country. For instance, a Chinese company seeking to fund a project may issue
bonds in the US market if interest rates are lower and investor demand is high.
3. Currency diversification: Raising funds in foreign markets allows corporations to diversify
their currency exposure. By issuing bonds or shares denominated in different currencies,
corporations can hedge against currency fluctuations and reduce the risk associated with a
single currency. This is especially important for multinational corporations operating in multiple
countries. For instance, a German company with subsidiaries in the United States and Japan
may issue Eurobonds to raise funds in euros and mitigate currency risk.
4. a. Explain the role of government/regulators in financial markets [Refer to
Fabozzi Chapter 1: page 14-15].
b. Explain the concerns that regulators have regarding financial institutions
[Refer to Fabozzi Chapter 2: page 27-29].
A. The government/regulators play a crucial role in financial markets, primarily to protect
investors, maintain market integrity, and promote stability. Some of their key roles are:
1. To prevent issuers of securities from defrauding investors by concealing relevant
information:
This purpose focuses on protecting investors from fraudulent activities by ensuring that
companies accurately disclose all relevant information about their securities. It aims to
maintain transparency and integrity in the financial markets, enabling investors to make
informed decisions. The primary regulation addressing this is the Securities Act of 1933 in the
United States, which requires companies to register their securities and provide investors with
necessary information.
2. To promote competition and fairness in the trading of financial securities:
This purpose aims to foster a level playing field for all participants in the financial markets. It
involves regulations that prevent market manipulation, insider trading, and unfair practices,
ensuring fair and equitable access to information and opportunities. Key legislation addressing
this includes the Securities Exchange Act of 1934, which created the SEC and regulates
securities exchanges and brokers.
3. To promote the stability of financial institutions:
This purpose focuses on safeguarding the stability and integrity of financial institutions to
maintain overall economic stability. Regulations are in place to prevent excessive risk-taking,
ensure adequate capital requirements, and establish supervisory frameworks. One prominent
example is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, enacted
in response to the 2008 financial crisis.
4. To restrict the activities of foreign concerns in domestic markets and institutions:
This purpose involves regulations that govern the involvement of foreign entities in domestic
markets and institutions. These regulations may include restrictions on ownership, licensing
requirements, and reporting obligations for foreign entities. The specifics vary across
jurisdictions and can be found within each country's regulatory framework.
5. To control the level of economic activity:
Regulations are sometimes used to manage the overall level of economic activity. This can be
done through measures such as monetary policy implemented by central banks, fiscal policy
enacted by governments, and regulatory interventions to control specific sectors or industries.
These regulations aim to promote economic stability, manage inflation, and address systemic
risks.
B. Here are the concerns that regulators have regarding financial institutions.
1. Liquidity risk: Regulators are concerned about a financial institution's ability to meet its short-
term obligations, such as funding operational expenses or customer withdrawals, without
incurring significant losses or resorting to fire sales of assets. They ensure that institutions have
sufficient liquidity buffers, appropriate funding plans, and adequate access to funding sources
to manage liquidity risk.
2. Credit risk: Regulators focus on the risk that a borrower or counterparty will fail to fulfill its
contractual obligations, leading to potential losses for the financial institution. They expect
institutions to have robust credit risk management processes, including thorough credit
assessments, proper risk rating methodologies, and prudent underwriting standards, to
mitigate the impact of credit losses.
3. Market risk: Regulators are concerned about financial institutions' exposure to potential
losses resulting from adverse market movements, such as changes in interest rates, foreign
exchange rates, or equity prices. They ensure that institutions have appropriate risk
management frameworks, including effective measurement, monitoring, and control systems,
to mitigate market risk exposure.
4. Settlement risk: Regulators focus on the risk of transactional losses arising from failures in
settlement processes, such as delayed or failed delivery of securities or funds. They require
institutions to have robust settlement systems, including strict controls, effective collateral
management, and appropriate risk mitigation measures, to reduce settlement risk.
5. Operational risk: Regulators are concerned about the potential losses arising from
inadequate or failed internal processes, people, systems, or external events. They expect
institutions to have comprehensive frameworks for identifying, assessing, and managing
operational risks, including the implementation of sound operational controls, proper incident
management procedures, and adequate business continuity plans.
6. Legal risk: Regulators focus on the risk of loss resulting from legal disputes, violations of laws,
or inadequate legal documentation. They expect financial institutions to have robust legal risk
management practices, including compliance with relevant laws and regulations, proper
governance structures, and effective legal documentation and contracts.
5. a. Explain the categories of financial innovation. [Refer to Fabozzi Chapter 1:
page 15-16].
1. Increased volatility of interest rates, inflation, equity prices, and exchange rates:
This cause relates to the increased uncertainty and fluctuation of various financial indicators. To
manage risks associated with these fluctuations, financial institutions have developed new
financial instruments and strategies to hedge against them. Innovations such as interest rate
swaps, futures contracts, and options have emerged to address these needs.
2. Advances in computer and telecommunication technologies:
Advancements in technology have enabled financial institutions to develop complex financial
models, process vast amounts of data, and execute trades at high speeds. These developments
have enabled the creation of new financial instruments and markets, such as algorithmic
trading and high-frequency trading.
3. Greater sophistication and educational training among professional market participants:
As financial markets have become more complex, financial professionals have invested in
education and training to develop specialized knowledge and skills. This has led to the
development of new financial products and strategies, such as securitization and credit default
swaps.
4. Financial intermediary competition:
Competition among financial intermediaries, such as banks, investment firms, and insurance
companies, has led to the development of new financial products and services. This has
resulted in increased access to credit, investment opportunities, and risk management tools for
consumers and businesses.
5. Incentives to get around existing regulation and tax laws:
In some cases, financial innovation has been driven by incentives to circumvent existing
regulation and tax laws. This has led to the development of complex financial structures, such
as offshore tax havens and shadow banking systems, which can pose significant risks to financial
stability.
6. Changing global patterns of financial wealth:
As global wealth has become more concentrated, financial institutions have responded by
developing new products and services to cater to the needs of high net worth individuals and
institutions. This has led to the development of new markets, such as hedge funds and private
equity, and new financial products, such as structured products.
b. Discuss the motivation for financial innovation.
1. Arbitraging instrument: This category of financial innovation involves the
development of new financial instruments or strategies that exploit pricing discrepancies or
market inefficiencies. These instruments are designed to take advantage of arbitrage
opportunities, where an investor can simultaneously buy and sell similar assets in different
markets to earn a risk-free profit.
2. Market broadening instrument: This category focuses on the creation of financial
instruments or structures that allow investors to access new or previously inaccessible markets.
These instruments aim to increase market participation and liquidity by expanding the range of
investment opportunities available to a broader range of investors.
3. Risk management instrument: Financial innovation in this category involves the development
of tools and techniques that help manage and mitigate various types of financial risk. These
instruments aim to provide better risk management options for investors and businesses,
allowing them to hedge against risks such as interest rate movements, market fluctuations,
credit default, and currency exchange rate fluctuations.
6. Discuss the importance of studying financial institutions [Refer to Mishkin & Eakins
Chapter 7].
One of the key reasons for studying financial institutions is to understand how they contribute
to the overall health and stability of the economy. Financial institutions are an important source
of credit to businesses, households, and governments. They also help to allocate capital
efficiently by channeling funds to the most productive uses. Another reason for studying
financial institutions is to understand the impact of monetary policy. Central banks use a variety
of tools to influence the money supply and interest rates in the economy. These tools have a
direct impact on financial institutions, which in turn affect the overall economy. Understanding
how financial institutions respond to changes in monetary policy is essential for policymakers.
Additionally, studying financial institutions can help to identify sources of financial instability
and prevent financial crises. Financial institutions are vulnerable to a variety of risks, including
credit risk, interest rate risk, and liquidity risk. Understanding how these risks are managed and
mitigated by financial institutions is essential for maintaining financial stability. Finally, studying
financial institutions can help individuals and businesses make informed financial decisions.
Understanding the different types of financial institutions and the services they provide can
help individuals and businesses choose the best financial products and services to
meet their needs.
Bibliography
Allen, F. and Gale, D., 2009. Understanding financial crises. OUP Oxford.
Fabozzi, F.J., 2015. Capital markets: institutions, instruments, and risk management. MIT Press.
Fabozzi, F. J., Modigliani, F., & Jones, F. J. (2010). Foundations of financial markets and institutions.
Pearson Education.
Factors Driving Global Economic Integration -- by Michael Mussa ... - IMF
(https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp082500
GLOBALIZATION OF FINANCIAL MARKETS | Following the Money: U.S ...
(https://nap.nationalacademies.org/read/2134/chapter/3)
The globalisation of financial markets - European Central Bank
(https://www.ecb.europa.eu/press/key/date/2000/html/sp000912_2.en.html
Investopedia. (2019). Financial System: Definition, Types, and Market Components. Retrieved from
https://www.investopedia.com/terms/f/financial-system.asp
Investopedia: Tangible Assets vs. Intangible Assets: What's the Difference?
https://www.investopedia.com/ask/answers/012815/what-difference-between-tangible-and-intangible-
assets.asp
Mishkin, F. S., & Eakins, S. G. (2012). Financial markets and institutions. Pearson.
Saunders, A., & Cornett, M. M. (2016). Financial institutions management: a risk management approach.
McGraw-Hill Education.
https://blog.myrawealth.com/insights/financial-assets
https://ivyyiwang.wordpress.com/tag/financial-assets/
Wikipedia. (2021). Financial system. Retrieved from https://en.wikipedia.org/wiki/Financial_system
https://www.entrepreneur.com/money-finance/the-pros-and-cons-of-international-funding/166530
https://www.investor.gov/introduction-investing/investing-basics/investment-products/international-
investing
https://seekingworldlywisdom.files.wordpress.com/2011/08/the-handbook-of-financial-instruments-
fabozzi.pdf
