Week 1 Introduction to Financial System

True/False Questions
No.
1

Statement
Money is a medium of exchange that includes
attributes of divisibility and a store of value.

A modern financial system may be said to

comprise three major components: financial
institutions, instruments and markets.
The time-pattern of the cash flows attribute of
a financial asset refers to the term to maturity
of an instrument.
A well-functioning financial system is expected
to allocate savings to the most efficient suers
of the funds.
Financial assets incorporate a number of
attributes. The risk attribute refers to the
probability that suppliers of funds will not
purchase a particular asset when it is issued.
Monetary policy is the actions of a central
bank that influence the level of interest rates in
order to achieve certain economic objectives.
A principal role of investment banks is to
gather deposit savings from customers and
provide loans to their retail clients.
Finance companies are examples of
contractual savings institutions.

The matching principle contends that shortterm assets should be funded with equity.

10

Equity in a corporation represents an

ownership position that is represented by the
issue of ordinary shares.
Debt differs from equity in that debt normally
has a specified life and pays some form of
return to the debt holder.
A derivative contract is a hybrid security that
incorporates the characteristics of both debt
and equity.
The issue of new shares by a corporation
provides the firm with additional equity funding
and is an example of a primary market
transaction.
The issue of new money-market debt
securities by a borrower is said to be a
secondary market transaction.
In a direct financial flow the surplus entity
provides funds to the deficit entity and
acquires a primary claim from the user of the
funds.

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12

13

14

15

Answer (T/F)
True, characteristics of money: medium of
exchange, store of value, facilitates saving,
divisible
True, the three components of a modern
financial system are financial institutions,
financial and markets.
False, bonds have a time-pattern of cash flows
prior to the maturity of an instrument.
True, an efficient financial system allocates
savings to the most efficient users to assist in
economic development and growth.
False, the risk attribute refers to the probability
that actual return will deviate from the expected
return.
True, the central bank influences the interest
rate by targeting the cash rate in order to impact
on economic activity and the level of inflation.
False, investment banks specialise in advisory
services and usually advise or assist clients in
raising funds directly in capital markets.
False, finance companies raise funds by issuing
securities while contractual savings institutions
raise funds by collecting a premiums.
False, short term assets should be funded with
short term liabilities. Equity is a source of longterm funding.
True, equity can also be represented by hybrid
securities such as preference shares.
True, equity is a source of long-term funding that
does not need to be repaid.
False, derivate instruments do not provide
actual funds for a borrower, they facilitate the
management of risk.
True, primary market transactions are the issue
of new financial instruments.

False, secondary market transactions are the

purchase or sale of existing securities.
True, the surplus entity directly provides the
funds to the deficit entity.

Week 1 Introduction to Financial System

True/False Questions
No.
16

Statement
Three advantages of intermediated finance are
asset transformation, liquidity transformation
and maturity transformation.
Money-market securities are exclusively debt
instruments, and capital-market instruments
are exclusively equity securities.
Bills of exchange and promissory notes are
discount securities that may be traded in the
money markets.
Borrowers in the international markets obtain
long-term loans from the foreign exchange
market.
The corporate sector borrows to fund business
activities and therefore is typically a deficit
sector within the economy.

17

18

19

20

Answer (T/F)
True, these are three advantages, additionally,
credit risk diversification and economies of scale
are advantages.
False, the capital market has a number of
submarkets which are funded by debt.
True, bills of exchange and promissory notes
are both discount securities and can be traded in
the money markets.
True, the foreign exchange allows borrowers to
access long term loans in the international
capital markets.
True, businesses borrow in order to fund their
activities.

Essay Questions
2. Discuss the role of information in a financial system.
Timely and accurate financial and economic information are about to affect prices and investment
decisions.

4. The major financial institutions within the international markets fall into five classifications. Identify
and briefly explain each of these classifications. Give an example of different types of institution that
operate within a classification.
The five classifications of financial institutions are:
-

Depository financial institutions: commercial banks, i.e. ANZ, Commonwealth, etc.

Investment banks: advisory firms, i.e. Citi, JP Morgan
Contractual savings institutions: superannuation funds, insurance companies
Finance companies: i.e. Aussie Home Loans
Unit trusts: investors buy units issued by the trust

6. Financial instruments may be categorised as equity, debt or derivatives. Discuss each category in
your answer, make sure you explain the differences between debt, equity and derivatives.
In the case of equity, a long-term loan that does not usually require any repayment is issued in
exchange for an ownership interest in the asset.
On the other hand, debt is a loan that must be repaid, and debt instruments represent a contractual
claim against the borrower to make specified payments including periodic interest and principal
payments.
Derivatives are a financial instrument that facilitate and manage an exposure to an identified risk.
Debt and equity differ from derivatives as the latter does not provide actual funds for a borrower.

Week 1 Introduction to Financial System

Essay Questions
8.
(a) What are the differences between primary market and secondary market financial transactions?
In a primary market transaction, new financial instruments are issued to raise funds to purchase a
financial asset. On the other hand, a secondary market transaction involves the purchase or sale of
existing financial securities and instruments. In this case, no new funds are raised.

(b) Why is the existence of well-developed secondary markets important to the functioning of the
primary markets within the financial system?
The existence of well-developed secondary markets are important since they assist with the
marketability of primary market financial instruments. By providing a secondary market, savers are
able to maintain a level of liquidity in long-term assets or equity, which would not otherwise have a
maturity date.

10. Banks are the major providers of intermediated finance to the household and business sectors of
an economy. In carrying out the intermediation process, banks perform a range of important functions.
List these functions and discuss their importance for the financial system.
The functions that intermediaries perform include:
-

Asset transformation, which allow them to gather small savings from many savers who
would not otherwise have an incentive to save. They can then pool this into a larger amount
and make them available as loans.
Maturity transformation, which allows them to fund long term borrowing with a variety of
short term funding.
Credit risk diversification and transformation, which allows the savers credit risk to be
limited to the intermediary. The intermediarys risk is further limited due to their expertise in
assessing risk of potential borrowers.
Liquidity transformation, which allows savers to access their financial assets easily if they
are held in a highly liquid account.
Economies of scale, which allows financial intermediaries to develop cost-efficient
distribution systems due to the size and volume of business transacted.

12. Corporations often issue long-term debt instruments into the international capital markets to raise
funds. Explain the relationship between the issue of paper into the international capital markets and
the foreign exchange market and the derivatives market.
The foreign exchange market facilitates the buying and selling of foreign currencies necessary for the
conduct of international capital-market transactions.
If a long term debt instrument such as a commercial paper is issued on the international market it is
usually denominated in a foreign currency. The borrower may need to borrow foreign currency in
order to make periodic payments on the capital and principal.
To assist with managing the risk involved in a capital market transaction, borrowers may utilise the
derivatives market.