Financial Architecture and Economic Performance - Assignment Example

Finance Assessment Questions 1 & 2 Course Code Student’s Name Date of Submission Question one i. What are the primary elements and functions of a modern financial system in a developed country? Please explain in your own words. The modern financial system comprises of six elements that include; ultimate lenders, financial intermediaries, financial instruments, creation of money, financial markets, and price discovery (Allen, Chui & Maddaloni, 2004). The ultimate lenders comprises of the non-financial economic units that undertake the process of lending and borrowing. The ultimate lenders directly or indirectly lend to borrowers through financial intermediaries. The financial intermediaries are the intermediate during the process of borrowing and lending. The financial intermediaries position themselves between the borrowers and the lenders and earn a margin as the benefit of the intermediation. Financial instruments are instruments created by the ultimate borrowers to satisfy the financial needs of the participants in the financial system. The instruments offered can either be marketable such as treasury bills or nonmarketable such as retirement annuities. The creation of money through bank deposits by financial institutions such as banks is carried out to satisfy the demand for bank credit. Banks have the creation of money as a unique feature. Price discovery is the establishment in the financial markets that gives price to the money. In this case, the rate interest rate is the price of money lent by the financial institutions The modern financial system plays an important role in the economic growth and strengthening of the economy. Economic development and strengthening depends on the available infrastructure. In the absence of major industries such as power, oil, and coal, the development of other industries is affected. Financial services provide the needed funds from the growth of the infrastructure industries. Also, the financial system assists the government to raise short and long term funds through issuing bills and bonds. Therefore, the capital market, foreign exchange market and the money market enable the government to meet its credit needs. ii. In your own words discuss the function and purpose of both the primary and secondary markets in a modern financial system? The key function of the primary financial market is to facilitate capital growth by allowing participants to convert savings into investments. The primary market facilitates the issuing of new stock by companies to raise money directly from households to meet the financial obligations or for expansion (Tadasse, 2002). Also, the primary market facilitates how government raises funds by providing channels that the government can use to raise funds from the public to finance the projects in the public sector. Through primary markets, companies are able to issue initial public offers (IPOs). The IPOs are stock offerings that authorize a share of the company ownership to the extent of the value of the stock. The issuing of the IPOs can be at par or above par depending on the future prospects and past performance. Also, the primary market can be used by the government to directly issue securities to the public when seeking funds for the public works projects. Secondary market facilitates subsequent trading and selling of stock after the IPO. It is in the secondary market that investors buy securities from other investors rather than directly from the companies. Secondary market facilitates stock trading by proving highly liquid, safe, and readily available resale of stocks (Grinblatt & Titman, 2002). The secondary markets provides investors with a protection by organizing and regulating the financial market by ensuring fair and open market place that protects the investors from fraud and scams. Moreover, the secondary market is where facilitates the occurrence of bulk exchange trade. However, primary markets have a high volatility compared to secondary markets because of the difficulty of accurately gauging the demand of the investors for new securities until several days of trading. iii. Identify and explain in your own words the various categories and type of financial instrument used in a typical modern financial system in a developed country? Equities Equities are financial securities that represent company ownership. The equities are traded in stock market but can also be traded through the IPO route, that is, directly from the issuing company (Allen & Carletti, 2007). Investment on equities is a good long term investment options due to the high returns on equities. However, there are greater risks in investing on equities Mutual Funds Mutual funds are financial instruments that enable a group of people to pool money together and have the money professionally managed with an objective of a predetermined investment (Chen, Goldstein & Jiang, 2007). Mutual funds are cost effective and involve risk diversifications and sound regulations. The return of mutual funds vary according to the type of mutual fund selected by an investor Bonds A bond is an acknowledgment of debt by the issuer and represents a fraction of a loan provided by an issuer for whom the holder is entitled to receive interests or coupons. The basic principle of bonds includes; a specific loan term, an interest rate that gives right to payment of a periodic coupon, and redemption at maturity (Brusco & Castiglionesi, 2007). Bonds are particularly issued on the primary market. Holders subscribe to the bonds during a specified subscription period. Bonds may be issued at par, below par, or above par. The redemption value of bonds at maturity is often 100% of the nominal value. The main bond types include preferential bonds, subordinated bonds, and zero-coupon bonds. The preferential bond holders are refunded by priority in situations where the issuer is going under liquidation (Boot, 200). Subordinated bond holders are reimbursed after the preferential and ordinary creditors when the issue goes into liquidation. The zero coupon bond are featured by the absence of interests and are often issued below par where the investors pay less than the nominal value at the time of the zero coupon issue. Question Two i. In your own words, discuss the primary roles and functions of an efficient and well organized stock exchange such as ASX Stock exchange is an exchange where traders and brokers trade stocks, bonds and other securities. Stock exchanges provide the market participants with facilities for issue and redemption of securities. Stock exchange has the role of raising capital for businesses, contributing towards economic growth, offering safety transactions, and pricing securities and shares. Stock exchange assists in the valuation of securities using the demand and supply factors. Companies that are more profitable and show tremendous growth value their securities higher because there is a demand for the securities (Boot, 2000). In stock exchange, only the listed securities are traded and the exchange authorities indicate the company names in the list after verifying the soundness of the company. The listed companies must operate within strict rules and regulations set by the stock exchange authorities. The major function of stock exchange is the provision of ready market for security trading. Stock exchange market presences provide an assurance to investors that their investments can be converted to cash whenever they may want it (Buckle & Thompson, 2005). In most cases, investors can invest in long term investment because the stock exchange can convert them long term investments into either short or medium term. Securities of different companies are traded in stock exchange. The process of selling and buying of company shares is termed as disinvesting and reinvesting which helps in ensuring productive investments proposals that lead to formation of capital and economic growth. ii. In your own words, discuss the equity funding alternatives available to an established listed firm One of the main ways for an established listed company to access financing is through the IPO which is one of the common sources of equity financing. Companies can raise capital through the IPO by offering different classes of shares to trade to institutions and individual investors (Gorton & Winton, 2003). IPO is mostly used by listed private firms to support growth. The companies convert themselves into public company and trade share on the stock exchange market. Once the company is floated, it changes to a public limited company and the share are freely trade in the market it was first listed. Listed companies have high growth potential and strong records of profitability making them capable of obtaining equity financing through venture capital. Venture capital is a common equity funding whereby the finance is offered in larger sums than those acquired through partnerships. Venture capital provides an ownership state in the business and a higher control level over the company’s daily business operations. In venture capital, the firm’s pools investment dollars from companies, large corporations, and pension funds and used the funds to invest in high risk startup businesses that are highly profitable (Boot, 2000). Since the investments have high risks, the high returns are realized by selling the stock back to the company or through the public stock exchange in the future. The aim of venture capital is rapid growth and development of technology companies. Other alternative equity financing include Private Equity where the private investment houses take a significant stake of a part or whole business. The Houses aim at putting the business into a position that it can sell the stake as part of an Initial Public Offer. iii. In your own words, describe the bond market and the structure and use of debentures and bonds A bond market is a financial market where the market participants issue new debts in a primary market or trade debt securities in a secondary market. The bond market includes the securities issued by the government and the debt securities issued by corporate entities (Boot, 2000). Moreover, the bond market facilitates the transfer of capital from households to the organizations or issuers in need of capital for government-sponsored projects or business expansions. Debentures are a source of finance used by companies as a regular earning to serve debts. Debentures have a high proportion of fixed asset in the asset structure that provides security and motivates investors. However, the company has to ensure prudent ratio of debt and equity. Debentures and bonds play a significant role in the capital structure of a company. Bonds and debenture provides finance for a fixed period of time and helps the company to adjust its investment plans to take into account the available funds (Grinblatt & Titman, 2002). The debentures improved the earnings of the equity holders through financial leverage operations. Lastly, in a weakening market conditions, debentures have the function of providing an efficient source of finance. Particularly debentures are beneficial to the issues because it does not allow the debenture holders to have control over the business. . References Allen, F., M. Chui & A. Maddaloni, (2004). “Financial Systems in Europe, the USA, and Asia,” Oxford Review of Economic Policy 20, 490-508. Carletti, E. (2004). “The Structure of Bank Relationships, Endogenous Monitoring and Loan Rates,” Journal of Financial Intermediation 13, 58-86. Tadassee, S. (2002). “Financial Architecture and Economic Performance: International Evidence,” Journal of Financial Intermediation, 11, 429-54. Grinblatt, M. & Titman, S. (2002) Financial Markets and Corporate Strategy (Boston, London: McGraw-Hill/Irwin, 2002) second edition [ISBN 9780072294330] Chapters 4, 5, 6, 9 and 10 Buckle, M. & Thompson. J. (2005) The UK Financial System. (Manchester: Manchester University Press, 2004) fourth edition [ISBN 9780719067723] Chapters 1, 2 and 17. Chen, Q., I. Goldstein, & W. Jiang (2007). “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Flows,” working paper, University of Pennsylvania. Allen, F. & E. Carletti (2007). “Mark-to-Market Accounting and Liquidity Pricing,” Journal of Accounting and Economics, forthcoming. Boot, A. (2000). “Relationship banking: What do we know?” Journal of Financial Intermediation 9, 7-25. Brusco S. & F. Castiglionesi (2007). “Liquidity Coinsurance, Moral Hazard and Financial Contagion,” Journal of Finance 62, 2275-2302. Gorton, G. & A. Winton (2003). “Financial Intermediation,” in G. Constantinides, M. Harris, and R. Stulz (eds.), Handbook of the Economics of Finance, Volume 1A, Chapter 8, North Holland, Amsterdam, 431-552. Read More