Question

Task 1:

Financial intermediaries are playing a very important role in any financial system. Critically discuss the function of financial intermediaries in in the financial system of a country. The discussion should include the following:

Introduction with a proper overview of financial system and the financial

intermediaries.

 Critically discuss the types and characteristics of financial intermediaries.

 Critically analyse the disadvantages of financial intermediaries.

 Critically discuss the functions of financial intermediaries in the financial system.

 Proper conclusion giving summary and your opinion

 A list of references as per Harvard Referencing style with proper in text citation.

Task 2:

In the world of investment, there are many investment methods to help investor to reduce risk in his

investment, one of them is arbitrage. Critically discuss how arbitrage is used in investment

The discussion should include the following:

 Write introduction with a proper overview of arbitrage in finance.

 Critically discuss the types arbitrage and the arbitrage that exists in retail trading.

 Critically discuss how to invest in arbitrage fund and give examples of arbitrage trade

 Proper conclusion giving summary and your opinion

Answer 1

A financial system is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds. Financial systems exist on firm, 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.

Like any other industry, the financial system can be organized using markets, central planning, or some mix of both.

Financial markets involve borrowers, lenders, and investors negotiating loans and other transactions. In these markets, the economic good traded on both sides is usually some form of money: current money (cash), claims on future money (credit), or claims on the future income potential or value of real assets (equity). These also include derivative instruments. Derivative instruments, such as commodity futures or stock options, are financial instruments that are dependent on an underlying real or financial asset's performance. In financial markets, these are all traded among borrowers, lenders, and investors according to the normal laws of supply and demand.

A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank, investment bank, mutual fund, or pension fund. Financial intermediaries offer a number of benefits to the average consumer, including safety, liquidity, and economies of scale involved in banking and asset management. Although in certain areas, such as investing, advances in technology threaten to eliminate the financial intermediary, disintermediation is much less of a threat in other areas of finance, including banking and insurance.

A non-bank financial intermediary does not accept deposits from the general public. The intermediary may provide factoring, leasing, insurance plans or other financial services. Many intermediaries take part in securities exchanges and utilize long-term plans for managing and growing their funds. The overall economic stability of a country may be shown through the activities of financial intermediaries and the growth of the financial services industry.

Types and characteristics of financial intermediaries.

• Banks
• Credit Unions
• Pension Funds
• Insurance Companies
• Stock Exchanges

When it comes to financial intermediaries, there is a long list of those who qualify. Often times, people may not even realize that they are interacting with a middlemen who is just overseeing the transaction in question. Nevertheless, without these entities, the investment markets would be crippled and unable to operate.

1. Banks

Undoubtedly, banks are the most popular financial intermediaries in the world. They come in multiple specialties that include saving, investing, lending, and many other sub-categories to fit specific criteria. The most ancient way in which these institutions act as middlemen is by connecting lenders and borrowers. For instance, when someone raises a mortgage from a bank, they will be given the money that another person deposited into that bank for saving. Similarly, large companies also use banks to help find investors. Not to mention their role as the entities that people use to receive paychecks via direct deposits.

2. Credit Unions

Similar to the aforementioned, credit unions also bring together people who need money and those who have it. For instance, they are known to offer credit terms to people by using the money that other individuals deposited into savings accounts. So, when somebody needs a loan from a credit union, they will receive it because there are funds at credit union’s disposal that someone else contributed. The main difference between these entities and typical banks, however, is their role with consumer credit. Besides lending, they also oversee many credit-related inquiries.

3. Pension Funds

Full-time employees often meet another popular financial intermediary known as a pension fund. It is what millions of workers use to save for their retirement by investing. The way it works is based on a risk factor, matching contribution, and long-term investing. For instance, when somebody signs up for a pension fund, they choose how much of their salary will be put away. Often, their employer matches that contribution to a certain extent. Then, all of that money is used to purchase assets that will grow and have a good yield. Once the employee retires, they get all the contributions alongside any interest and realized gains.

4. Insurance Companies

Although there are several different types of insurance organizations, almost all of them operate in the exact same way. First, they find a large number of customers who need to obtain coverage. Whether it is a car, home, or health policy does not matter. Once those customers purchase their insurance coverage, all of the funds are added to a large pool of money. Later on, whenever somebody needs to make a claim and use the insurance company to request a payout, the insurance provider will access that pool of money. This means that there is no net inflow of cash to the market, per se.

5. Stock Exchanges

Buying corporate stocks can be a long and tedious process. In order to simplify it, stock exchanges were invented. They act as large platforms where people can make stock orders. After paying for them, the stock exchange will use that money to buy the actual stocks from corporations. Then, the customer gets their desired assets while the corporations get funding. In the meantime, the stock exchanges facilitate the entire process and every transaction. Hence why they are seen as the financial intermediary of the investment world. As with most other similar institutions, these exchanges earn revenues by adding transaction fees and interest rates.

Ultimately, absent financial middlemen, the entire investment and financial sector would suffer. People would be unable to make daily transactions and large companies would find it hard to get funding. Hence why it is important to understand how relevant the role of common financial intermediaries is.

characteristics of financial intermediaries

• They help in lowering the risk of an individual with surplus cash by spreading the risk via lending to several people. Also, they thoroughly screen the borrower, thus, lowering the default risk.
• They help in saving time and cost. Since these intermediaries deal with a large number of customers, they enjoy economies of scale.
• Since they offer a large number of services, it helps them customize services for their client. For instance, banks can customize the loans for small and long term borrowers or as per their specific needs. Similarly, insurance companies customize plans for all age groups.
• They accumulate and process information, thus lowering the problem of asymmetric information.

A financial intermediary performs the following functions:

• As said before, the biggest function of these intermediaries is to convert savings into investments.
• Intermediaries like commercial banks provide storage facilities for cash and other liquid assets, like precious metals.
• Giving short and long term loans is a primary function of the financial intermediaries. These intermediaries accept deposits from the entities with surplus cash and then loan them to entities in need of funds. Intermediaries give the loan at interest, part of which is given to the depositors, while the balance is retained as profits.
• Another major function of these intermediaries is to assist clients to grow their money via investment. Intermediaries like mutual funds and investment banks use their experience to offer investment products to help their clients maximize returns and reduce risks.

It is clear that financial intermediaries play a very important role in the economic development of the country. They play even bigger role in the developing countries, including helping the government to eliminate poverty and implement other social programs.However, given the complexity of the financial system and the importance of intermediaries in affecting the lives of the public, they are heavily regulated. Several past financial crises, like the sub-prime crisis, have shown that loose or uneven regulations could put the economy at risk.

References

https://www.investopedia.com/terms/f/financialintermediary.asp

https://en.m.wikipedia.org/wiki/Financial_system

Gurusamy, S. (2008). Financial Services and Systems 2nd edition, p. 3. Tata McGraw-Hill Education. ISBN 0-07-015335-3

Allen, Franklin; Gale, Douglas (2000-01-01). Comparing Financial Systems. MIT Press. ISBN 9780262011778.

Task 2 arbitrage in finance

Arbitrage is the process of simultaneously buying and selling a financial instrument on different markets, in order to make a profit from an imbalance in price.

An arbitrageur would look for differences in price of the same financial instruments in different markets, buy the instrument on the market with the lower price, and simultaneously sell it on the other market which bids a higher price for the traded instrument.

Since arbitrage is a completely risk-free investment strategy, any imbalances in price are usually short-lived as they are quickly discovered by powerful computers and trading algorithms

Types of Arbitrage

While arbitrage usually refers to trading opportunities in financial markets, there are also other types of arbitrage opportunities covering other tradeable markets. Those include risk arbitrage, retail arbitrage, convertible arbitrage, negative arbitrage and statistical arbitrage.

• Risk arbitrage – This type of arbitrage is also called merger arbitrage, as it involves the buying of stocks in the process of a merger & acquisition. Risk arbitrage is a popular strategy among hedge funds, which buy the target’s stocks and short-sell the stocks of the acquirer.
• Retail arbitrage – Just like on financial markets, arbitrage can also be performed with usual retail products from your favourite supermarket. Take a look at eBay for example, and you’ll find hundreds of products bought in China and sold online at a higher price on a different market.
• Convertible arbitrage – Another popular arbitrage strategy, convertible arbitrage involves buying a convertible security and short-selling its underlying stock.
• Negative arbitrage – Negative arbitrage refers to the opportunity lost when the interest rate that a borrower pays on its debt (a bond issuer, for example) is higher than the interest rate at which those funds are invested.
• Statistical arbitrage – Also known as stat arb, is an arbitrage technique that involves complex statistical models to find trading opportunities among financial instruments with different market prices. Those models are usually based on mean-reverting strategies and require significant computational power.

While retail traders could theoretically take advantage of financial instruments that are priced differently across brokers, it’s practically very hard to achieve.

The large competition among retail brokers ensures that their price-quotes are almost the same, and many brokers actually discourage and restrict arbitrage trades. Furthermore, if you take transactions costs (spreads) into account, arbitrage opportunities in the retail trading industry are almost non-existent.

Investing in arbitrage trade

Even as arbitrage opportunities are not easily exploited, investors can take advantage of arbitrage funds that try to profit on price imbalances between the stock and futures market. Arbitrage funds work on the mispricing of equity shares in the spot and futures market. Mostly, it takes advantage of the price differences between current and future securities to generate maximum returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives markets.They buy stock in the cash market and simultaneously sell a contract for it on the futures market if the market is bullish on the stock. If the market is bearish, then arbitrage funds purchase the lower-priced futures contracts and sell shares on the cash market for the higher current price

Example of an Arbitrage Trade

Complex trading concepts are best explained by examples.

Let’s say a stock of Company XY trades at $40 on the London Stock Exchange. An arbitrageur finds that the same stock is trading at $40.80 at the New York Stock Exchange (NYSE). The trader could simply buy the stock at LSE and sell it at NYSE for a profit of $0.80 per stock.

Since our investor is probably not the only one who has spotted the difference in price and the risk-free trading opportunity, (in fact, hedge funds and sophisticated arbitrage software would probably be in the trade immediately as the price difference reveals).

The increased demand for the lower priced stock would push its price higher in London, and similarly, the increased supply in New York would push the price of the higher-priced stock down.

Currencies are also a popular instrument for arbitrage opportunities. Unlike the stock market, currencies are not traded on centralised exchanges but on over-the-counter markets around the world, making currency arbitrage a popular way to profit on their exchange rate differences.

While arbitrage fund meaning can be a little difficult to understand, especially if you are new to the equity markets, it is a low-risk trading strategy. So, these funds are ideal for risk-averse investors.

A lot of equity mutual fund investors also switch to arbitrage funds when the market is volatile. Also, unlike mid-cap and small-cap equity funds that are ideal for investment horizons of 3-5 years and more, arbitrage funds can be considered for short to medium duration.