Question

1. What is the primary role of the financial system?

2. Compare and contrast debt and equity as a source of funds for financial claims.

3. What are some problems with direct financing that make indirect financing more attractive?

4. Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?

5. How do financial intermediaries generate profits?

6. Explain the differences between the money markets and the capital markets. Which market would Tesla use to finance a new vehicle assembly plant?

7. Explain the statement: “A financial claim is someone’s asset and someone else’s liability”.

8. What are the major risks faced by financial institutions and why is it important that each is carefully managed?

9. Discuss the three forms of financial market efficiency. Why is it important that financial markets be efficient?

Answer 1

What is the primary role of the financial system?

Ans). Financial system is a system that allows the exchange of funds between lenders, investors, and borrowers. Financial systems operate at national, global, and firm-specific levels.

Just to make a small list of what happens and how it affects the economy…

What are the roles to the economy?

• Financial systems allow the movement savings by collecting and pooling funds from various sources. They then create smaller instruments which provide opportunities for individuals to hold diversified portfolios. Without pooling individuals and households would have to buy and sell complete firms.
• They can also transform illiquid assets such as, penny stocks which are more difficult to turn into cash. With liquid financial markets savers and lenders can hold onto assets like equity or bonds, which can be easily converted into fiat money with purchasing power.
• For lenders, the services are commutable in terms of risk, return and liquidity provided by particular investments. Financial middlemen and markets make longer-term investments more attractive and manage investment in higher return and longer development investments. They provide different forms of leanding to borrowers. Financial markets provide debt or equity finance.

Financial systems are closely related with the growth of an economy

• They contribute to a nation's growth by ensuring an almost never ending flow of surplus funds to deficit units. To make it simpler, financial markets help to shift money from industry to industry or firm to firm based on the supply and demand for their products.
• Financial markets also create investment funds. By buying stocks and many other things, firms and individuals can invest in companies through financial markets.
• Entrepreneurship growth is also a key factor which comes from financial markets. They allow entrepreneurs and firms to access the funds needed to fulfill their investments.

2 )Compare and contrast debt and equity as a source of funds for financial claims.

Definition of Debt

Money raised by the company in the form of borrowed capital is known as Debt. It represents that the company owes money towards another person or entity. They are the cheapest source of finance as their cost of capital is lower than the cost of equity and preference shares. Funds raised through debt financing are to be repaid after the expiry of the specific term.

Debt can be in the form of term loans, debentures or bonds. Term loans are obtained from financial institutions or banks while debentures and bonds are issued to the general public. Credit Rating is mandatory for issuing debentures publicly. They carry fixed interest, which requires timely payments. The interest is tax deductible in nature, so, the benefit of tax is also available. However, the presence of debt in the capital structure of the company can lead to financial leverage.

Debt can be secured or unsecured. Secured Debt requires pledging of an asset as security so that if the money is not paid back within a reasonable time, the lender can forfeit the asset and recover the money. In the case of unsecured debt, there is no obligation to pledge an asset for getting the funds.

Definition of Equity

In finance, Equity refers to the Net Worth of the company. It is the source of permanent capital. It is the owner’s funds which are divided into some shares. By investing in equity, an investor gets an equal portion of ownership in the company, in which he has invested his money. The investment in equity costs higher than investing in debt.

Equity comprises of ordinary shares, preference shares, and reserve & surplus. The dividend is to be paid to the equity holders as a return on their investment. The dividend on ordinary shares (equity shares) is neither fixed nor periodic whereas preference shares enjoy fixed returns on their investment, but they are also irregular in nature. Although the dividend is not tax deductible in nature.

The difference between debt and equity capital, are represented in detail, in the following points:

1. Debt is the company’s liability which needs to be paid off after a specific period. Money raised by the company by issuing shares to the general public, which can be kept for a long period is known as Equity.
2. Debt is the borrowed fund while Equity is owned fund.
3. Debt reflects money owed by the company towards another person or entity. Conversely, Equity reflects the capital owned by the company.
4. Debt can be kept for a limited period and should be repaid back after the expiry of that term. On the other hand, Equity can be kept for a long period.
5. Debt holders are the creditors whereas equity holders are the owners of the company.
6. Debt carries low risk as compared to Equity.
7. Debt can be in the form of term loans, debentures, and bonds, but Equity can be in the form of shares and stock.
8. Return on debt is known as interest which is a charge against profit. In contrast to the return on equity is called as a dividend which is an appropriation of profit.
9. Return on debt is fixed and regular, but it is just opposite in the case of return on equity.
10. Debt can be secured or unsecured, whereas equity is always unsecured.

What are some problems with direct financing that make indirect financing more attractive?

Direct and Indirect Financing

1. Direct and Indirect Financing Presenters
2. Finance Definitions "Finance" is the study of how money is managed and the actual process of acquiring needed funds. Because individuals, businesses and government entities all need funding to operate, the field is often separated into three sub-categories: personal finance, corporate finance and public finance.
3. Public Finance The government helps prevent market failure by overseeing allocation of resources, distribution of income and stabilization of the economy. To stabilize the economy Govt gets taxes borrow from banks it receives grants and earning dividends from its companies also help finance the government. In addition, user charges from ports, airport services and other facilities; fines resulting from breaking laws; revenues from licenses and fees, such as for driving; and sales of government securities are also sources of public finance.
4. Corporate Finance Businesses bring in financing through equity investments and credit arrangements, and by purchasing securities, and established companies may sell stocks or bonds. Businesses may purchase dividend-paying stocks, blue-chip bonds or interest-bearing bank deposits. Acquiring and managing debt properly can help a company expand and become more profitable.
5. 5. Personal Finance  Earning more money and spending less money is the basis of personal finance. Individuals may earn more money by starting a business, taking on additional jobs or investing. Spending less money can be done by deciding whether what is being purchased is truly worth the price being paid. For example, instead of purchasing coffee every day from a cafe, a person can buy bags of coffee at a grocery store and make the coffee at home for much less money.
6. Direct Financing Borrowing money from friends; borrowing money directly from investors by selling stocks or bonds in this financing method a company or entity didn’t pay interest rate.
7. Indirect Finance Borrowing money from a bank. The bank lends out depositors money to borrowers at a profit. Indirect finance is where borrowers borrow funds from the financial market through indirect means, such as through a financial intermediary.
8. What is 'Financing' Financing is the act of providing funds for business activities, making purchases or investing. Financial institutions and banks are in the business of financing as they provide capital to businesses, consumers and investors to help them achieve their goals.
9. The Financial Sector: An Overview All economic units can be classified into one of the following groups: households, business firms, and governments. Each economic unit must operate within a budget constraint imposed by its total income for the period, and can have one of three possible budget positions: a balanced budget position, a surplus position, and a deficit position. The mismatch between income and spending for individuals and organizations creates an opportunity to trade.
10. Direct Financing You engage in direct financing when you borrow money from a friend, or when you purchase stocks or bonds directly from the corporate issuing them. These direct financial arrangements take place through financial markets, markets in which lenders (investors) lend their savings directly to borrowers. Brokers, dealers and investment bankers play important roles in direct financing.
11. Indirect Financing  Financial intermediaries purchase direct claims with one set of characteristics from borrowers and transform them into direct claims with a different set of characteristics, which they sell to the lenders. In producing financial commodities, intermediaries perform the following asset transformation services: (1) Denomination Divisibility (2) Maturity Flexibility (3) Diversification (4) Liquidity.
12. Financial Intermediaries is an institution or individual that serves as a middleman for different parties in a financial transaction
13. Types of Financial Intermediaries 1. Commercial Banks 2. Investment Banks 3. Insurance Companies 4. Brokerages 5. Investment Companies 6. NBFI
14. Types of Financial Intermediaries 7. Credit Unions 8. Capital Market 9. Money Market 10. Venture Capitalists.

Financial intermediation is a productive activity in which an institutional unit incurs liabilities on its own account for the purpose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating

Financial depth does not fully reflect how well the financial intermediaries serve to economic agents in stimulating economic growth. Additional aspects of financial system such as access, efficiency and stability should be taken into account in order to shed light into the relationship between finance and economic growth. In our paper we capture the four aspects of finance – depth, access, efficiency and stability – to investigate the impact of financial development and economic growth. Our results suggest that the impact of four parameters of financial development differs depending on the level of financial development and has an inverted S-shape function.