Question

 

(a) Explain how the financial system performs the economic function of channelling funds among economic agents. Discuss the significance of its contribution.

(b) Discuss the economic contribution of money as a medium of exchange.

(c) Briefly explain (i) repurchase agreements; and (ii) federal funds.

(d) What is the difference between Euro dollar bonds and foreign bonds?

Answer 1

A) A financial system acts as an intermidiate between flow of funds from the individual to who are willing to save a part of their income and those who are planning to invest into productive resorces. An financial is able channelize funds through it's financial components such as Financial Interemederies such as banks and other financial institutions, financial market and financial assets e.g. money, bonds, stock or equity etc.

Financial Institution or bodies collect savings from from others and issue it in return claims against themselves and thus these becomes debts or loans.

Where as financial market is the place where savers and investors meet and they are linked through either capital market or money market.

The third component of the organisation of the financial system is financial assets or instrument. They represent claims on a stream of income and assets of another economic unit and are held as a store of value and for the return that is expected. e.g bonds , debentures, T bills, Money, equity etc.

Financial system facilitates growth and economic development of the economy. It puts a country's savings into productive pool and puts them into productive use. It helps in create savings means of diverse financial instrument and services and investing the same as such that highest return is yielded at a given risk in the market. With growth in ecocnomy , export, import also increases leading to stronger and stable economy with a high standart of living and fast paced GDP.

B) Money is basically the economic unit that functions as recognised medium of exchange for transactional purpose in an economy as it accepted globally as medium of exchange. Money is basically called currency globally and different governments have their own monetary sytem. e.g US has dollars, UK has pounds and Japan has Yen.

The economic contribution of money is that it is a stable medium of exchange and recognized across the globe as an accepted medium of doing transaction making a transaction easly to take place. Money should also be fungible and portable for being useful , that's why it makes transaction across borders also easy to take place.

Thus money facilitates economic growth and productivity as there is a stable exchange medium, it also promotes investment. it also helps a country to do trade internationally across the borders, increases import and exports leading economic prosperity and stable income generation in the economy. Thus leads to more employment oppurtunity and higher spending among the people in the economy.

C) A repurchase agreement (repo) is a short-term borrowings dealing with government securities like T bills or Govt bonds. In the case of a repo, a participant sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate. Repos ae usually used to raise short-term funds. They are usually used by central banks e.g. Federal Bank in open market operation.

whereas federal funds are excess reserves that commercial banks and other financial institutions deposit at a Federal Reserve banks; these excess funds can to offered or lent to other financial institution with insufficient cash and are out of reserves. The loans are unsecured and are made at a relatively low interest rate, called the federal funds rate or overnight rate. Thus, fed funds helps banks and other financial institutiion maintain daily cash or reserve requirement with the federal or central bank.

D) Euro Dollar bonds are the bonds which have US-Dollar denomination and are issued by overseas company or by foreign institution located outside US or the home country of the issuer. Where as a foreign bond are issued in a domestic market by a foreign entity in the domestic currency itself. e.g Bulldog bonds, samurai bonds etc.

Eurobonds are less risky but foreign bonds have higher risk as it interest risk, inflation risk and currency riska attached to it and also has political risk if there is any political turmoil or instable goverment in the market where it is issued.

So it can be said unlike eurobonds, foreign bonds are issued by international company to a investor denominated in the foreign currency of the country where it is issued.

A foreign borrower issues foreign bonds in a host country’s financial market and the host country’s currency. These bonds are subject to the regulations imposed on all securities traded in the national market. In case of Eurobond multinational firms can raise capital using this bonds, this helps in recucing risk arisinf out of variation in exchange rates. e.g. If a Japanese company holds dollar-denominated bond issued by a Indian company, it would be considered as euro dollar bonds.