Principle of Banking and Finance (PBF) Chapter 2 Suggested Tutorial Answers IMPORTANT ‘The solutions provided herein are meant to illustrate what constitute a good answer and not ‘meant to be referred as "Model Answer”. To score well in an examination, one of the most important things that the students should do in an examination is to answer the question that has been asked, not answer one that they wish had been asked, or similar question they have “learned” the answer to. ‘Students are encouraged to discuss with the lecturer their doubts on the questions. 1. What is financial system? Frame your answer in both a structural and a functional perspective. Financial systems perform the essential economic function of channelling funds from lender-savers to borrower-spenders. The most important lender-savers are usually households; while the typical borrower- spenders are firms and the government The channelling of funds from savers to spenders is important for two main reasons: First, lender-savers (with excess of available funds) do not frequently have profitable investment ‘opportunities, while borrower-spenders have investment opportunities but lack of funds. % Second, even for purposes other than investment opportunities in businesses, borrower-spenders may want to invest in excess of their current income orto adjust the composition oftheir wealth (reconciliation of the preferences for current versus future consumption) In direct finance, borrower-spenders borrow funds directly from lenders in the financial markets by selling them securities. In indirect finance, a financial intermediary stands between the lender-savers and the borrower-spenders: the intermediary helps to transfer funds from one to the other. This suggests that financial markets and intermediaries are alternatives that perform more or less the same function but in different ways Last but not least, financial systems perform a monetary function. The introduction of money in the ‘economy enables savers/spenders to separate the act of sale from the act of purchase and enables them to ‘overcome the main problem of barter, which isthe ‘double coincidence of want In short, the main functions of financial systems are to: ‘provide the mechanisms by which funds can be transferred from units in surplus to nits in shortage of funds, which isto facilitate lending and borrowing 4 enable wealth holders to adjust the composition of their portfolios 4 provide payment mechanisms.From a structural point of view a financial system can be seen in terms of the entities that compose the system. A financial system comprises of + Financial markets, % securities “financial intermediaries. Financial markets are markets in which funds are moved from people who have an excess of available funds (and lack of investment opportunities) to people who have investment opportunities (and lack of funds). They also have direct effects on personal wealth, and the behaviours of businesses and consumers ‘Therefore, they contribute to increase in production and efficiency in the overall economy. Financial markets (such as bond and stock markets) are markets in which securities are traded, Securities (also called financial instruments) are financial claims on the issuer’s future income or assets. They represent financial liabilities for the individual or firm that sells them (borrower or issuer of the financial claim in return for money), and financial assets for the buyer (lender or investor in the financial claim). By definition therefore the sum of financial assets in exisience will exactly equal the sum of liabilities. Governments and corporations raise funds to finance their activites by issuing debt instruments (bonds) and equity instruments (shares, known in the USA as stocks). Bonds are securities that promise 10 make periodic payments of a sum of money for a specified period of time. Stocks are securities that representa share of ownership inthe firm, Financial intermediaries are economic agents who specialise in the activities of buying and selling (at the ‘same time) financial contracts (loans and deposits) and securities (bonds and stocks). Note that financial securities are easily marketable, while financial contracts cannot be easily sold (marketed). Banks are the largest financial institution in our economy. They accept deposits (loans by individuals or firms to banks) and make loans (sums of money lent by banks to individuals or firms): therefore, they borrow deposits from people who have saved and in tum make loans to others. In recent years, other financial intermediaries, such as mutual funds, pension funds, insurance companies and investment banks, have been ‘growing at the expense of banks. With reference to the US financial system, we provide a taxonomy of each of these three entities as follows: Financial intermediaries comprise depository institutions (commercial banks, savings and loan associations, and credit unions), contractual savings institutions (insurance companies and pension funds), and investment intermediaries (mutual funds, finance companies, investment banks and securities firms). 4 Financial securities traded in financial markets ate debt instruments (bonds, notes and bills), and ‘equity instruments (common and preferred stocks) Financial markets can be classified as primary versus secondary markets, organised exchanges versus over-the-counter markets, and capital markets versus money markets2, What is the primary function of depository institutions? How does this function compare with the primary function of insurance companies? Depository institutions and insurance companies are financial intermediaries. Depository institutions derived significant proportion of their funds from customer deposits, while insurance ‘companies are contractual saving institutions that acquire funds at periodic intervals on a contractual basis. In USA, the depository institutions are banks, savings and loans associations, and credit unions. ‘The main function of a depository institution is to take deposits from savers; or lenders; and use these funds to issue loans to firms, governments and individuals; or borrowers. The profits they make come from the differences in interest rates offered to both of these parties. They will pay lenders a rate of interest for placing funds into their institution, and receive an interest on the loans they have issued. The deposits are liabilities of the depository institutions while the loans are assets, ‘The primary function of an insurance company is to protect individuals and firms (known as policyholders) from adverse events. Insurance companies receive premiums from policyholders, and promise compensation to policyholders if particular events occur. There are two main segments in the industry: life insurance on the one hand, and property and causality insurance on the other hand. Life insurance protects the policy holder in the event of death, illness or retirement. The insurance company acquires premiums from the policyholders and uses them mainly to buy corporate bonds, mortgages and stocks (amount limited by the legislation) Property and causality insurance provides protection against personal injury and liabilities such {as accidents, theft and fire. In comparison to life insurance companies, they hold more liquid assets because of higher probability of loss of funds in case of major disasters. Q3. What is a mutual fund? What are the differences between short term and long term mutual funds? Where do mutual funds rank in terms of asset size among all financial intermediaries in the USA? Mutual fund is a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). When you invest in a mutual (und, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund. ‘There are two segments in the mutual fund industry: long term funds and short term funds. Long- term funds comprise bond funds (funds that contain fixed-income debt securities), equity funds (funds that contain stock securities) and hybrid funds (funds that contain both debt and stock securities). Short-term funds are represented by money market mutual funds, funds that contain various mixes of money market securities and partially allow shareholders to write cheques against the value of their holdings: the presence of deposittype accounts makes money market mutual funds to some extent similar to depository institutions. Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in. By pooling money together in a mutual fund, investors can purchase ‘stocks or bonds with much lower trading costs than if they tried to do it on their own. The biggest advantage to mutual funds is diversification. Diversification is the idea of spreading out your money across many different types of investments. When one investment is down another might be up. Choosing to diversify your investment holdings reduces your risk tremendously. Mutual funds are set up to buy many stocks (even hundreds or thousands). Mutual funds automatically diversify in a predetermined category