Elements and Role of Modern Financial System - Assignment Example

Elements and Role of Modern Financial System Name: Institution: Date: Elements and Role of Modern Financial System Question 1 a) The primary elements and functions of a modern financial system in a developed country The primary function of a modern financial system is facilitating investment by providing a platform for the transfer of resources from those with excess funds for investment to those requiring more funds to invest. The different components making up the financial system ensure that different financial activities are implemented harmoniously at all stages of the financial system (Neave, 2009). A modern financial system has got five components with each having its crucial role. The financial system will not operate if any component is not in place. Elements of a financial system Central bank: The central bank serves as the government’s bank with the duty to regulate and supervise the country’s financial system (Neave, 2009). It is responsible for executing of the monetary and financial policies towards promoting economic growth and stability. Banking system: Banks accept deposits and credits. By giving credit to creditworthy borrowers, the money is convertible to stable monetary base by acquisition of physical assets (Moser & Schips, 2013). Public finance: This is the proper and effective management of public finance in raising revenues controlling expenditure and servicing of the public debts. Strong currency: Strong money or strong currency is important to a country with developed economy. When the currency is not strong, as it happens during inflation, the economy is affected negatively. Well-functioning securities market: A modern financial system will require securities to finance government and business enterprises by facilitating the issue of new bonds, equity share. Security market provides liquidity for acquiring financial instruments/bonds. Securities are the major element in the financial system as noted in developed regions such as Europe (Moser & Schips, 2013). However, that does not mean the elements can be listed in any order since all are mutually dependent on each other and self-reinforcing. b) Functions and purpose of primary and secondary markets Capital markets are markets where one can sell or buy stock, equity, securities, and debt instruments such as bonds. In the capital market, there a two types of markets namely; primary and secondary. Each has got different functions from the other. Primary market is where a company brings a new issue of shares to the general public for subscription to raise funds for their long-term capital requirement. This is also known as floating of IPO (Neave, 2009). Primary markets act as catalyst in the mobilization of savings in the economy. Secondary market is a capital market where equity shares, debentures, bonds, commercial papers, and treasury bills are sold to investors. Trading can be through an auction market, over the counter, or through the stock exchange. Primary and secondary markets interrelate in their functionality. Primary market act as a supplier of funds to the investors through the sale of IPOS (Arvai & Heenan, 2008). Primary markets are used to analyse the market situation through scrutinising the financial securities that are floated compared to the ones that are sold. Primary markets are an item for attracting the general public to invest more on the capital market as the first issue of shares is in low transaction units. This attracts potential investor from the public. Secondary markets are used as the barometers of a country’s economy (Moser & Schips, 2013). The rise or fall in share prices indicates the state of the economy. Therefore, stock exchange is the economic mirror which reflects the economic status of a country. Secondary market helps in valuing of the securities, with the securities of companies that show potential of growth been valued higher as the demand is also high. Pricing and valuation of securities help investors to understand and know the value of their investment. Secondary markets help in economic growth. For instance, when companies are bought and sold, the process helps to reinvest in viable stocks and this leads to capital formation and eventually economic growth (Arvai & Heenan, 2008). Stock exchange encourages people to invest in securities by regulating new issues and ensuring fair trade practices. c) Categories and types of financial instruments used in a typical modern financial system in a developed country Financial instrument can be considered to be financial contracts of a different nature between two institutional units or individual in regard to full financial claims and liabilities between institutional units (Arvai & Heenan, 2008). It may include contingent liabilities like guarantees and commitments. Financial instrument has got two categories. The first one is the financial asset in which the contract involved does not change and has a value attached to it (Arvai & Heenan, 2008).The owner has financial claims and the ownership rights can be enforced over claims, and from the contract economic benefits can be awarded to the contract owner. The second category of financial instruments are financial contracts in which the owner has a claim to. Its authenticity is dependent on the commissioner of oaths. In liquefying the contract, the nominal value will depreciate and a fee charged on the same. There are different types of financial assets which include; monetary gold issued by the IMF and consists only of standard bullions of gold by the central bank of government as a reserve. Transactions involving are only done by official authorities dealing with monetary policy. SDRs are international reserve created by the IMF and held by members of the IMF and international banks (Arvai & Heenan, 2008). Transactions involving SDRs is between members of IMF and are treated as financial transactions. Holding SDRS has unconditional rights. Currency and deposits are the most liquid financial assets. Currency exists in form of notes and coins in circulation and are liabilities of the central bank. Currency is the most convenient way of making payments Transferable deposits are deposits that are subject to payment on demand and without penalty or restrictions (Arvai & Heenan, 2008). Can be used for direct payments by checks, payment orders and cards. Transferable deposits comprise transferable deposits to financial corporations and allow direct cash withdrawals but not direct transfers to third parties. Question 2 a) Roles and functions of an efficient and well-organized stock exchange such as the ASX Stock exchange is an organised market where government securities, equity shares, bonds, and debenture of trading units are put up for sale. Stock exchange provides a market place for buyers and sellers to trade. The stock exchange has numerous functions in a country. One of them is providing a ready market to speculators and investors who wish to trade in the stock commerce. The stock exchange quotes the prices through sensitive pricing mechanism (Papadopoulos, 2011). Constant quoting of prices puts investors at an advantage as they can predict the market prices. This also enables the provision of various indexes about the market performance. The stock exchange also safeguards the investors by giving accurate information to the investors and hence enabling them to make fair judgment about securities. The stock exchange operates a compensation fund where in case an investor suffers a loss because of the speculation dealing by the stock exchange they will be compensated (Papadopoulos, 2011). The premises of the stock exchange provides working facilities. This gives workers and other members to perform their daily activities within. The stock exchange approves new companies wishing to float their shares on the stock exchange to ensure that it qualifies for trading in the stock exchange. Stock exchange plays a role of stabilising and setting the equilibrium of demand and supply on various counters thus preventing fluctuation in the price of shares. Stock exchange helps banks in procurement of marketable securities, since the banks prefer to purchase large amount of securities from the stock exchange. Securities are marketable and better way of reserving accounts compared to reserving cash. Stock exchange promotes the habit of saving among the general public and this promotes the economic growth and investment for the public (Papadopoulos, 2011). Stock exchange advises the entire trade and commerce in the country. It creates opportunity to allow capital to flow into the most productive channels of the economy. b) Equity funding alternatives A listed company may be faced by debt, making it impossible to get equity funding from banks and other financial institutions. Although listed in the stock market, its counter is temporary closed thus cannot get funding from the stock market either. Such a firm will be forced to look for alternative means and channels for covering its capital obligations. Changing the ownership of the company through selling is one of the simplest and easiest way to raise equity (Papadopoulos, 2011). The new owner may have enough reserve to get the company out of the bad debts. It is a less risky model to undertake, especially for the technology enterprises. Start-ups can often tap into investment networks by finding high net-worth individuals to fund the business. It is a model that has worked for business with noble ideas and good business. Contribution by family and friends can be a source of equity funding but the amount contributed might be little compared to the expected amount. Another way a business can raise equity is through fund raising from private investors, a model that has proved to work with a number of individuals (Papadopoulos, 2011). A firm can opt to sell part of its assets to generate much equity for operation. However, this is a risky model because if the business environment does not favour the company, it will in a short period be required to sell the remaining assets, exiting the market with little capital to start up another company. c) The bond market structure and the structure and use of debentures and bonds Bond market is a financial market where participants are provided with the issuance and trading of debt securities. This basically includes government-issued securities and corporate debt securities, enabling transfer of capital from savers to the issuers (the government). The bond market has two types of markets. First is the primary market where new investors buy securities and the second is the secondary market were investors sell debt securities in form of bonds (Kim, 2003). Bonds are much more complex and versatile than they look at a glance. Bonds give the investor a number of options in any investment environment. Bonds can be used to preserve principal bonds because they are simply loan with a scheduled repayment and maturity period. Lender anticipate at the time of maturity the value of the bond will be as initial principal (Kim, 2003). Bond and debentures have been proven to provide the most secure approaches for saving of long-term, especially where interest of the bond is paid upon maturity, this attracts high returns. Bonds and debentures can be used to manage interest-rate risk and the risk associated with prevailing rates. This is the risk that exists due to cumulative approach of presenting the future value. This valuation therefore causes the bond’s current price and the prevailing rates to change. Bonds and debentures provide the corporate issuer with external funding to finance long-term capital projects. Individuals consider investing bonds and debenture to match a future expected cash need (Arvai & Heenan, 2008). Assuming that at the time of maturity the returns will match the duration, bonds and debentures can be used in future planning due to the benefit that bonds possess over other financial assets (Kim, 2003). Bonds have a predictable stream of income that can be used for funding of future projects. This is government’s use long-term bonds for their long-term planning. Debentures being a debt instrument does not require security backing, but the credit that a company gives acts like the underlying security. Funds raised by debentures are capital structure. References Arvai, Z. & Heenan, G. (2008). A Framework for Developing Secondary Markets for Government Securities. Geneva: International Monetary Fund. Kim, Y. (2003). Local Government Finance and Bonds Markets. New Delhi: Asian Development Bank. Moser, T. & Schips, B. (2013). EMU, Financial Markets and the World Economy. London: Springer. Neave, E. (2009). Modern Financial Systems: Theory and Applications. New York: John Wiley & Sons. Papadopoulos, P. (2011). Role and Function of Stock Markets. Michigan: GRIN Verlag. Read More