FINANCIAL MARKET AND INSTITUTIONS HOME FINAL EXAM

 

ARBA MINCH UNIVERSITY

SCHOOL OF POST GRADUATE STUDIES DEPARTMENT OF ACCOUNTING ANDFINANCE

FINANCIAL MARKET AND INSTITUTIONS HOME TAKEEXAM

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Exam Date: 12/01/2013E.C

Exam Time allowed: 3:00 - 11:00 hrs Total Weight: 70%

Instructor: Lisanework A. (Assistant Professor)

NAME: ALPHAABEJE ID.NO. PEBE/065/12

ECTION:

SIGNATURE __

DISCUSSIONQUESTIONS (70%)

Discuss the following questions critically, clearly andprecisely.

A group of individuals (as a partnership) wants to run a business activity in the financial sector of Ethiopia but they don’t know about the sectors procedure how they are going to open the business. Therefore, they need your consultancy service about where the request/process is started, who is the apex bank, the nature, function and the credit control objectives of this bank.

The government is responsible for Financial Institutions because they are responsible for enormous amount of investors’ money and the financial sector is in charge with the crucial role of allocating financial capital to its most productive use. Therefore, what are the objectives and types of governmentregulation?

What is the standard classification of FinancialInstitutions?

If one of your relatives asks you about further sub categorization of Depository institutions with respect to the market they serve, their primary source of funding, type of ownership, how they are regulated and the geographic extent of their market, how could you elaborate forhim/her?

A certain group of individual argues about depository institutions. Some of them argued that these institutions don’t have risk income only; others argued no, they have both income and risk. As a finance man, what is your suggestion about the aboveargument?

If depository institutions are working actively, no need for having non-depository institutions. Yes/No? If you say No, discuss the types of non-depositoryinstitutions.

Discuss briefly what do by mean financial system and components of financialsystem.

State the difference between Eurobond and foreign bond and what bond Ethiopia issues for renaissance dam.Why?

Do you think, is the financial system has played a great role in an economy? If yes, discuss the role of financial system very clearly andprecisely.

If one of your friends from other department asks you about finance how could you respond tohim?

Distinguish between Physical asset and financialasset?

State the characteristics of financial asset.

Explain the difference between direct finance, indirect finance and Semi direct finance diagrammatically.

All financial intermediaries are financial institutions but all financial institutions are not financial intermediaries. Yes/No;how?

Explain at least seven major types of money marketinstruments.

Discuss at least four types of corporatebonds.

What is the difference between Primary and secondarymarket?

What do by mean derivatives and discuss the three basic forms of derivatives, which are the building blocks for many complex derivativesinstruments.

What are the participants in derivative markets? (explain at least threeparticipants)

What do by mean financialsystem?

NAME:-ALPHA ABEJE ID:-PEBE/065/12

DEPARTMENT: - ACCOUNTING AND FINANCE POSTGRADUATE PROGRAM:-EVENING ANSWER SHEET

The request process is started in the centralbank.

A financial sector is formed as a share company and its memorandum and articles of association must obtain approval from the National Bank of Ethiopia. The following are the Preconditions need to be fulfilled in order to obtain banking business license:

Completed application and other accompanyingdocuments;

Investigation fee paid during submissionapplication;

Publish a notice of intention to engage in banking business in widely circulating newspapers;

A minimum of one-fourth of the subscribed shares shall be fully paid incash;

Minimum paid-up capital paid in cash and deposited in a blocked account in a bank in the name of the prospective bank; (recently the National Bank has raised the minimum paid up capital to half a billion birr from 75 millionbirr.)

Directors, the chief executive officer and senior executive officers of the bank shall meet the qualification criteria prescribed by the NationalBank;

The premises, security arrangements and cash vault meeting National Bank standard. After accepting the completed application, required information and payment of licensing fee, the NBE decides on the licensing application within 90 days. It is called by different names in different countries: The bank of England, The Federal Reserve System in America, National Bank of Ethiopia. The Central bank is the apex bank in a country. A Central bank, reserve bank,  or monetary authority is a banking institution granted the exclusive privilege to lend a government its currency.

Functions of central bank

Regulator ofcurrency

Banker, Fiscal Agent and Advisor to theGovernment

Custodian of Cash reserve of CommercialBanks

Custody and Management of Foreign ExchangeReserves

Lender of Lastresort

Clearing House for transfer andsettlement

Controller ofCredit

The central bank to achieve the following objectives

To stabilize the internal pricelevel

To stabilize the rate of foreignexchange

To protect the outflow ofgold

To control businesscycles

To meet businessneeds

To have growth with stability.

Objectives of Government Regulation

Governments have many objectives when intervening in the financial Markets. These include:

Promoting financialstability

To provide protection for investors against fraud or the dissemination of misleading or inadequateinformation

Desire to promote fair and healthy competition to ensure competitive price for consumers

To control the activities of FIs in order to exert some degree of control over the level of economic activities, particularly with respect to monetarypolicy

Types of government regulations

DisclosureRegulation

FinancialActivities

Liquidityrequirement

Capital adequacyrequirement

Foreign entrantsregulation

Licensingrequirement

Financial institutions are classified as:-Depository and Non-depositoryinstitutions

Examples of depository institutions are; commercial bank, saving and loan associations, saving banks, credit union etc.

Examples of non-depository institutions: Insurance companies, pension funds, investment companies, investment banks

Depository institution includes commercial banks, saving and loan associations, saving banks and credit union. Commercial bank are governmentowned.

Regulations of CBs

Safety and soundnessregulation,

Monetary policyregulation,

Credit allocationregulation,

Consumer protectionregulation,

Investor protection,and

Entry and charteringregulation,

SERVICE PROVIDED BY CB

Individual bankingservice

Institutional bankingservice

Global bankingservice

FUNDING

Deposit

Non-deposit

Common stock

Retainedearning

Saving & loan Association

The basic purpose of establishing saving and loans associations was pooling the savings of local residents for financing the construction and purchase of a homes. The collateral for the loan would be the home being financed. Saving and loans are either mutually owned (means there is no stock outstanding) or have corporate stock ownership, so technically the depositors are the owners.

Regulation

It also expanded the Fed’s control over the money supply by imposing deposit reserve requirements on S&Ls. Subsequent legislation not only granted thrifts the right to offer money market demand accounts, but also broadened the types of assets in which S&Ls could invest. Permission to raise funds in the money market and the bond market was granted by the Federal.

Funding of saving and loan associations

Raise fund from moneymarket

Borrow from federalfund

Borrow from federal homeloan

The principal source of funds for saving and Loans Associations consisted of passbook savings accounts and timedeposits.

Then it was expanded to negotiable order of withdrawal (NOW) account, which is similar with demandaccount.

Saving banks

Saving banks are institutions similar to saving and loans associations even though they are much older than S & Ls. Originally, they were established to provide a means for small depositors and earn a return on their deposits. They can be either mutually owned (i.e., mutually saving banks) or stockholder owned. However, most saving banks are of the mutual form. The principal source of funds for saving banks is deposits which are very similar with S & Ls. They have obtained funds primarily by tapping the savings of households.

Credit Unions

They are the smallest & nonprofit depository institution. They can obtain either a state or federal charter. Their unique aspect is the “common bond” requirement for membership, such as:

the employees of a particularcompany,

unions,

religious affiliations orwho

live in a specific areaetc.

They are governed by a board ofvolunteers

Credit Unions are either cooperatives or mutually owned. There is no corporate stock ownership. Since they are nonprofit and owned by their customers, they charge lower loan rates and pay higher interest rates on savings. Therefore, the dual purpose of credit unions is to serve their members saving and borrowing needs.

Depository institution have its own risk, these are:-credit risk, regulatory and fundingrisk

Credit risk (Default risk) refers to the risk that a borrower will default on a loan obligation or that the issuer of the security that the DIs holds willdefault

Regulatory risk is the risk that regulators will change the rules and affect the earnings of the institutionsunfavourably

Funding risk is the risk that the interest rate movement may move in such a manner that profits will be adverselyaffected.

No. Non-depository institutions are financial institutions that do not mobilizedeposits:

These include (among others):

Insurancecompanies

Mutual funds

Pensionfunds

Investment BankingFirm

Insurance companies are non-depository institutions that can compensate individuals and corporations (policyholders) if perceived adverse event occur, in exchange for premium paid to the insurer by policyholder. Insurance companies are risk bearer. They accept or underwrite the risk for an insurance premium paid by the policyholder or owner of the policy.

Mutual fund (in US) or unit trust (in UK and India) raise funds from the public and invests the funds in a variety financial asset, mostly equity both domestic and overseas and also in liquid money and capital market. Mutual funds are investment companies that pool money from investors at large and offer to sell and buy back its shares on a continuous basis and use the capital thus raised to invest in securities of differentcompanies

Pension funds are major institutional investors and participants in the financial markets. Pension plan is established for the eventual payment of retirementbenefits

Investment BankingFirms

It is a financial institution engaged in securities business. They perform activities related to the issuing of new securities and the arrangement of financial transactions. They mainly involve in primary markets, the market in which new issues are sold and bought for the first time. They are also involved in planning  and executing other types of financial transactions such as merger, acquisition and restructuring.

A financial system may be defined as a set of institutions, instruments and markets which fosters savings and channels them to their most efficient use. Financial system is defined as a function as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. The financial system or the financial sector of any country consistsof

specialized and non-specialized financial institutions,

organized and unorganized financial markets,and

financial instruments and services which facilitate transfer of funds,

procedures and practices adopted in the marketsand

Financial relationships are also parts of thesystem.

The FINANCIAL system consists of individuals (savers), intermediaries, markets and users of savings (government, public and private sector entities)

Five basic component of financial system are:

Financial Institutions: Financial institutions facilitate smooth working of the financial system by making investors and borrowers meet. They mobilize the savings of investors either directly or indirectly via financial markets, by making use of different financial instruments as well as in the process using the services of numerous financial servicesproviders.

Financial Markets: A financial market is the place where financial assets are created or transferred. It can be broadly categorized into money markets and capital markets. Money market handles short-term financial assets (less than a year) whereas capital markets take care of those financial assets that have maturity period of more than ayear.

The key functions are:

Assist in creation and allocation of credit andliquidity.

Serve as intermediaries for mobilization ofsavings.

Help achieve balanced economicgrowth.

Offer financialconvenience.

Financial Instruments: This is an important component of financial system. The products which are traded in a financial market are financial assets, securities or other type of financial instruments. There is a wide range of securities in the markets since the needs of investors and credit seekers are different. They indicate a claim on the settlement of principal down the road or payment of a regular amount by means of interest or dividend. Equity shares, debentures, bonds, etc. are someexamples.

Financial Services: Financial services consist of services provided by Asset Management and Liability Management Companies. They help to get the necessary funds and also make sure that they are efficiently deployed. They assist to determine the financing combination and extend their professional services up to the stage of servicing of lenders. They help with borrowing, selling and purchasing securities, lending and investing, making and allowing payments and settlements and taking care of risk exposures in financialmarkets.

Money: Money is understood to be anything that is accepted for payment of products and services or for the repayment of debt. It is a medium of exchange and acts as a store ofvalue.

Traditional instruments in the international bond market are known as Foreign Bonds. Foreign bonds are issued in foreign countries and are denominated in that country’s currency. While morerecentinnovationintheinternationalbondmarketistheEurobond,abonddenominated

inacurrencyotherthanthatofthecurrencyinwhichitissold. Foreign bond because the Ethiopian birr is denominated by foreigncurrency.

Yes. Financial systems, i.e. financial intermediaries and financial markets, are important for economic growth. They can lead to a more efficient allocation of resources becausethey

Reduce the costs of moving funds between borrowers and lenders,and

Help overcome information asymmetry between borrowers andlenders.

Finance is the art and science of managing money. Virtually all individuals and organizations earn or raise money and spend or invest money. Finance is important to individuals, business and government to achieve their economic objectives. Finance plays a pivotal role to every general person to earn and invest money; for business to raise and invest funds; and to the government to plan expenses and incomes, to execute goals of government and to achieve development of a country. Finance deals with procurement of funds and their effective utilization. That is, it is the study of how to raise money and invest itproductively.

Physical asset

Financial asset

does not have a corresponding

liability

have a correspondingliability

this provide productive capacity ofits

economy the goods and services

They do not directly contribute tothe

productive capacity of the economy.

Real assets appear only on the left side (asset side) of the balancesheet

Financial assets always appear on both sides of the balancesheet.



Real asset are income generating

assets,

Financial assets define the allocation of income or wealth amonginvestors.

Money-ness

Reversibility

Divisibility anddenomination

Cash flow and returnpredictability

Term ofmaturity

Convertibility

Liquidity

When borrowers indirectly borrow funds from the lenders in the financial markets through the use of financial intermediaries is known as an Indirect Financing. When borrowersdirectly

borrow funds from the lenders in the financial markets by issuing them variety of securities, which are claims against the future earnings and assets of borrowers is known as Direct Financing.

Indirect finance

Financial intermediaries

Lender -saver

Household

Businessfirm

Government

Foreigner



Financial

market Borrower-spender

Businessfirms

Government

Households

Foreigners

Direct finance

Yes. Because, a financial institution is an organization that raises and lends money to those who need them and earn interest as their main income. Financial intermediary on the other hand do not directly lend money but facilitate borrowing. They possess knowledge about the product and relationships with financial institutions. They render valuable services usually to the borrowers for a fee. This fee may be paid either by the borrower or the financialinstitution.

15.

Treasurybills

FederalFunds

Repurchase Agreements

Negotiable Certificates of Deposits(CDs)

CommercialPapers

BankersAcceptances

Eurodollars

T-bills are one of the debt securities that a government issues having a great advantage of liquidity. The Treasury Bill market is the only active primary market inEthiopia.

Federal funds:-Are short-term funds transferred among financial institutions usually for a period of oneday.

Repos are much like federal funds except that non-banks can participate. In repos a firm can sell treasury securities by agreeing to buy them back at a specified futuredate.

A negotiable CD is a bearer instrument that whoever holds the instrument at the date of maturity can receive the principal andinterest.

CP securities are unsecured promissory notes issued by corporations that mature in no more than 270 days (9months).

A banker’s acceptance is an order to pay a specified amount of money to the bearer on a givendate.

Eurodollar: - are deposits may be expropriated some large London based banks responded by offering to hold dollar denominated deposits in Britishbanks.

A. Bearer bonds:- coupons attached that are presented by the holder to the issuer for interest payments whendue

Registered bonds: - the owner of the bond is recorded by the issuer and coupon payments are mailed to the registeredowner

Term bonds: - entire issue matures on a singledate

Serial bonds:-mature on a series ofdates

Mortgage bonds:- issued to finance specific projects which are pledged ascollateral

Primary market deals with the new financial claim or new securities are traded while secondary market deals with securities that are already issued or outstanding. The securities that are formerly issued in a market are referred to as primary market, whereas, when the company gets listed on a recognized stock exchange for trading, then the stocks are traded in secondary market. Depending upon the demand and supply of the securities traded the prices in the secondary market vary. While in primary market the prices are fixed. The primary market provides financing to the new and the old companies for their expansion and diversification while the secondary market does not provide financing to companies as they are not involved in any transactions. In primary market the investors can purchase the shares directly from the company, whereas in secondary market, the investors buy and sell the securities (shares and bonds) among themselves.In case of primary market, investment bankers do the selling. Conversely in secondary market, the broker acts as an intermediary while the trading is done.In primary market, the company will gain from the sale of security. While in secondary market, investor will gain from thesecurities.

The term “derivatives” is used to refer to financial instruments which derive their value from some underlying assets. Derivatives can be traded either on a regulated exchange, such as the NYSE or off the exchanges, i.e., directly between the different parties, which is called “over- the-counter” (OTC)trading

The following are the three basic forms of derivatives, which are the building blocks for many complex derivativesinstruments

Forwards

Futures

Options

A forward contract or simply a forward is a contract between two parties to buy or sellan

asset at a certain future date for a certain price that is pre-decided on the date of the contract.

The future date is referred to as expiry date and the pre-decided price is referred to as Forward Price.

It may be noted that Forwards are private contracts and their terms are determined by the partiesinvolved.

Options: Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price. Based on the option type, the buyer can exercise the option on the maturity date (European options) or on any date before thematurity.

Swaps: Swaps are derivative contracts that allow the exchange of cash flows between two parties. The swaps usually involve the exchange of a fixed cash flow for a floating cash flow. The most popular types of swaps are interest rate swaps, commodity swaps, and currencyswaps.

The participants in the derivatives market can be broadly categorized into the following four groups:

Hedgers

Hedging is when a person invests in financial markets to reduce the risk of price volatility in exchange markets, i.e., eliminate the risk of future price movements. Derivatives are the most popular  instruments in the sphere of hedging. It is because derivatives are effective hedges in correspondence with their respective underlyingassets.

Speculators

Speculation is the most common market activity that participants of a financial market take part in. It is a risky activity that investors engage in. It involves the purchase of any financial instrument or an asset that an investor speculates to become significantly valuable in the future. Speculation is driven by the motive of potentially earning lucrative profits in the future.

Arbitrageurs

Arbitrage is a very common profit-making activity in financial markets that comes into effect by taking advantage of or profiting from the price volatility of the market. Arbitrageurs make a profit from the price difference arising in an investment of a financial instrument such as bonds, stocks, derivatives, etc.

A financial system is a set of institutions, such as banks, insurance companies, and stock exchangesthatpermittheexchangeoffunds.Financialsystemsexistonfirm,regional,and

global levels. Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets. The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals.