1.

The global financial system fulfils its various roles mainly through markets where the
financial claims and services are traded.
The comparison:
a) Money market versus capital market
Basis comparison Money market Capital market
Definition A segment of the A section of the financial
financial market where market where long-term
lending and borrowing of securities are issued and
short-term securities are traded.
done.
Risk factor Low Comparatively high
Financial instruments Treasury bills, Mortgage loans,
certificates of deposits, municipal bonds,
commercial paper. consumer loans.
Time horizon One year and less More than one year.

b) Primary versus secondary market

Basis comparison Primary market Secondary market
Definition The place where new The place where
securities is traded. previously issued
securities is traded.
Types of purchasing Direct Indirect
Buying and selling Company and investors Investors
between
Intermediary Underwrites Brokers
Function Raising financial capital To provide liquidity to
to support new security investors that is
investment in buildings, provide an avenue for
equipment, and converting financial
inventories. instruments into cash.

c) Open versus negotiated markets

Open markets
Some corporate bonds are sold to the
highest bidder and are bought and sold
any numbers of times before they
mature and are paid off.
In the market for corporate stocks there
are major stock exchange which
represent the open market.
Negotiated markets
For corporate bonds, securities
generally are sold to one or a few
buyers under private contract.
Negotiated market for stock, in which a
corporation may sell its entire stock
issue to one or a handful of buyers.
An individual who goes to the local
bakers to secure a loan for new
furniture enters the negotiated market
for personal loans.
3. Financial systems move scarce fund from those who save and lend to those who wish to
borrow and invest. The transfer of funds from saver to borrower can be accomplished in at least
three different ways.
Explain THREE methods of fund transfer with illustration.
a) Direct Finance
Flow of funds and other financial
services
Borrowers Lenders
(Loans of spending power for an
(deficit-budget (surplus-budget
agreed upon period of time)
units, or DBUs) units, or SBUs)
Primary securities

(Stocks, bonds, notes, etc.,

evidencing direct claims against
borrowers)

 Borrower and lender meet each other and exchange funds in return for financial
assets without the help of a third party to bring them together.
 Purchasing stock and bonds directly from the company issuing them.
 Usually call the claims arising from direct finance primary securities because
they flow directly from the borrower to the ultimate lender of funds.

Limitations:
 Both borrower and lender must desire to exchange the same amount of funds at
the same time.
 The lender must willingly accept the borrower’s IOU, which may be quite risky
or slow to mature.
 Both borrower and lender must frequently incur substantial information costs
simply to find each other. The borrower may have to contact many lenders
before finding the one surplus- budget unit (SBU).

b) Semi direct Finance

Borrowers (deficit- Security brokers, Lenders (surplus-

Primary securities Primary securities
budget units, or dealers, and budget units, or
DBUs) (direct claims investment bankers (direct claims SBUs)
against borrowers) against borrowers)

Proceeds of Flow of funds

security sales (less (loans of spending
fees and power) and other
commissions) and financial services
other financial
services
  Some individuals and business firms become securities brokers and dealers to bring
SBU and DBU units together and reducing information costs.
 A broker provides information concerning possible purchases and sales of securities.
 A dealer serves as a service channel between buyers and sellers.
Advantages:
 Lower the search costs for participants in the financial markets.
 Brokers and dealers facilitate the development of secondary markets in which securities
can be offered for resale.
 A dealer will split up a large issue of primary securities into smaller units affordable by
even buyers of modest means.

c) Indirect Finance

d) Primary securities Security brokers, Secondary Ultimate lenders

Ultimate
e)
borrowers securities
(deficit-budget dealers, and (surplus-budget
f) (direct claims units, or SBUs)
units, investment bankers
g) or DBUs) against borrowers
h) in the form of loan (indirect claims
contracts, stocks, against borrowers
i) bonds, notes) issued by financial
j) intermediaries in
the form of
v deposits, insurance,
policies, retirement
savings accounts)

Flow of funds Flow of funds

(loans of (loans of
spending power) spending power)

 Carried out with the help of financial intermediaries.

 Fundamental roles are to serve both ultimate lenders and borrowers but in a different
way than brokers and dealers do.
 Financial intermediaries issue securities of their own (secondary securities) to ultimate
lenders and at the same time accept IOUs from ultimate borrowers (primary securities).
Benefit: to smooth out consumption spending by households and investment spending by
businesses over time.
5. Recall FOUR characteristics of financial assets
 Financial assets are sought after because they promise future returns to their owners
and serve as a store of value (purchasing power).
 They cannot be depreciated because they do not wear out like physical goods.
 Their physical condition or form usually is not relevant in determining their market
value (price).
 They have little or no value as a commodity and cost of transportation and storage is
low.
  Financial assets are tangible - they can be easily changed in form and substituted for
other assets.
6. Classical theory of interest rates argues that the rate of interest in determined by two forces:
(1) Supply of savings by households and (2) demand for investment capital by business sector
Explain the statement above with example(s).
Supply of savings by households:
 Saving is simply abstinence from consumption spending.
 It is the difference between current income and current expenditure.
 An individual family’s overall wealth tends to raise their expenditure because their need
for additional savings to meet their savings target is reduced. This is referred to as the
wealth effect.
 By offering a higher rate of interest on current savings, future consumption would be
increased.
 For example, if the current rate of interest is 10 percent and a household saves $100
instead of spending it on current consumption, it will be able to consume $110 in goods
and services a year from now.
Demand for investment capital by business sector:
 The majority of business expenditures for these purposes consist of replacement
investment; that is, expenditures to replace equipment and facilities that are wearing
out or are technologically obsolete.
 Net investment: expenditure to acquire new equipment and facilities in order to increase
output.
 Gross investment is the sum of the replacement investment and net investment.

7. What are the functions or roles played by the rate of interest in the economy and financial
system? Explain why each function or role that you list is important to the well-being of
individuals, businesses and governments?
(a) It facilitates the flow of current savings into investments that promote economic growth.
For example, banks can attract household savings by offering interest on deposits.
These funds are available to small businesses to expand their operations and increasing
employment and output.
(b) Interest rates allocate the available supply of credit to those investment projects with
the highest returns. A firm computes the rate of return on a project that would expand
its production line. If the interest rate is too high, then the cost of borrowing could cause
a profitable project to become a loser. Therefore, interest rates allow only those projects
with the greater profit potential to be funded.
(c) Adjustment in interest rate can bring the supply of money into balance with demand. A
household need money to conduct its purchases of goods and services. If there is more
money in supply in the economy than is demanded by households, a decrease in the
interest rate would occur that would reduce the opportunity cost of holding money and
increase the demand for money.
 (d) Interest rates are an important tool of government policy through their influence on the
volume of savings and investment. If the economy is growing too slowly and
unemployment is rising, the government can use its policy tools to lower the interest
rates in order to stimulate borrowing and investment. If the economy experiencing rapid
inflation has called for a government policy of higher rates to slow borrowing and
spending and encourage more saving.

9. The demand for money is one of the most important concepts in the Liquidity Preference
Theory of Interest. What are the THREE main components of the demand for money?
a) Transaction motive – economic units do not have a perfect balance of inflows and
outflows. Hold liquidity for purchase of goods and services and not overly sensitive to
interest rates.
b) Precautionary motive – cannot predict future expenditures precisely. For example, an
unanticipated medical expense may arise.
c) Speculative motive – demand due to uncertainty in future bond price. The risk of a
capital loss will cause many investors to demand money or near-money assets instead
of bonds.
11. An efficient market exists when all information that is relevant is used to value or price
financial assets. Explain further what is meant by the term efficient market and elaborate the
different levels of market efficiency.
An efficient market:
a) Each individual investor will rationally use all relevant information for valuation.
b) Neither wastes nor misuses information.
c) Do not systemically ignore information to earn profits.
Different levels of the EMH:
(a) Weak form – argues that the current price of a financial assets already reflects all its
price and trading volume history.
(b) Semi strong form – contends that the current price of a financial asset already reflects
all publicly available and relevant information.
(c) Strong form - argues that the current price of financial asset already captures all
relevant public and private information.
13. Differentiate between a broker and a dealer.
BROKER DEALER
A person who executes the trade on behalf of A person who tracks business on their own
others. behalf.
One who will buy and sell securities for their A person who will buy and sell securities on
clients. their accounts.
Is normally paid commissions for transacting Is not paid commissions and he/she is a
the businesses. primary principal.

14. List any 5 advantages of merger and acquisition.

 Elimination of duplication brings about the substantial operating cost savings.
  Broadening of services and customer segments accelerate revenue growth.
 Greater diversification reduces overall risk.
 Combination of expertise results in higher quality products and services.
 Greater efficiency in joint marketing and cross-selling.
15. What is the principal function of pension funds?
 Pension funds protect individuals and families against loss of income in their retirement
years by allowing workers to set aside and invest a portion of their current income.
18. Explain why pension fund institutions have been among the most rapidly growing financial
institutions in recent years.
 The relatively few retirees drawing pensions compared to the number of people
working and contributing to a pension program. The growing proportion of retired
individuals will threaten the solvency of many private pension funds and has already
created significant future funding problems for various government programs.
 Competition among employers for skilled management personnel, as firms have tried
to attract top-notch employees by offering attractive fringe benefits. This growth factor
is likely to persist into future due to a possible shortage of skilled entry level workers
as the population ages.
19. What advantages do investment companies offer the small saver?
By purchasing shares offered by an investment company, small saver gains:
(i) Greater diversifications
(ii) Risk sharing
(iii) Lower transaction costs
(iv) Opportunity for capital gains
(v) Indirect access to higher – yielding securities that can be purchased only in large blocks.
20. Discuss why there is a critical need within the economy and financial system to have money
market instruments available to anyone who can afford them.
Money market are needed because:
(a) To bridge the gap between receipts and expenditures of fund.
(b) Covering cash deficits with short-term borrowing when current expenditures exceed
receipts.
(c) Providing an investment outlet to earn interest income for units whose current receipts
exceed current expenditures.
(d) Inflows and outflows of cash are rarely in perfect harmony with each other. For
example, governments collect taxes from the public only at certain times of the year.
(e) Disbursement of cash must be made throughout the year to cover the wages and salaries
of government employees.
(f) The holding of idle surplus cash is expensive, as cash balances earn little or no income
for their owners.

10. Explain why debt security prices, such as prices attached to bonds and interest rates are
inversely related. Illustrate this inverse relationship with an appropriate diagram.