Chapter 2

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.

Component parts of a financial system:
-financial institutions—example: banks, insurance offices, superannuation funds
-financial instruments—example: shares, term deposits, loans
-financial markets—money and capital markets, stock market, foreign exchange market

Discussion:
-financial system supports economic transactions
-encourages savings which provides funds for investment
-provides a range of investment opportunities
-provides a range of borrowing alternatives
-efficient allocation of resources for economic growth
-regulatory regimes provide strength and stability to a financial system

2. (a) Discuss the role of money in a financial system.
-money is a financial asset that facilitates financial and economic transactions
-a medium of exchange—swapped for goods and services
-a store of value—wealth is held or measured in money terms
-a standard of deferred payment—used to record indebtedness
-a unit of account—transactions are priced in money terms
-currency is generally divisible, portable and durable (b) Does money have to be currency? If not, what are some alternatives?
-money is anything that is universally acceptable as a medium of exchange
-further, money generally has the characteristics of being divisible and a store of value
-examples: currency, EFTPOS, digital money

3. Having recently inherited some money from a rich uncle, you are considering investing the funds in financial assets.
You are aware that financial assets exhibit four main attributes.
List and discuss these attributes. In your answer give examples to explain your points.
Four attributes are:
-return or yield
-risk
-liquidity
-time-pattern of the cash flows

Examples:
1. Term deposit with a bank: generally pays a fixed interest rate until maturity guaranteed by the bank—low risk (low return) funds usually are not available until maturity (less liquidity) interest paid periodically; principal repaid at maturity 2. Shares in a corporation: generally pay a dividend twice a year—amount determined by board no performance guarantees—higher risk (expect higher return) usually easy to sell shares at current price through the stock exchange dividends received half-yearly, if declared

6. (a) What are the differences between primary market and secondary market financial transactions?
-primary market transactions relate to the creation of a new financial asset—for example, a company issues new shares or the government issues Treasury bonds—new funds being raised secondary market transactions r-late to the sale and transfer of existing financial assets; for example, a shareholder sells their shares to another investor and receives value—transfer of ownership; no new funds raised (b) Why is the existence of well-developed secondary markets important to the functioning of the primary markets within the financial system?
-primary market transactions provides funds for business development and thus economic growth
-investors will purchase primary market securities if they know that there is a deep and liquid secondary market in which they are able to sell the securities at a later date, if necessary
-secondary market transactions provide price discovery in that the securities will be sold at the current market value

8. A large corporation is to seek funding direct from the international capital markets
. What is direct finance and why might the corporation wish to raise funds directly from the capital markets?
-international capital markets are overseas financial markets that provide medium-to-longer-term funds—for example, an Australian company borrowing in the USA
-finance is said to occur when the provider of funds and the user of funds contract directly with each other
-removes the cost of the financial intermediary; that is, the bank’s profit margin
-provides access to different funding sources
-reduces the risk of borrowing from a single funding source
-enables greater flexibility in the types of funding instruments used by a borrower
-employ more sophisticated funding strategies
-increase the profile of the corporation in the international markets