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Chapter 1—Overview of the financial system
TRUE/FALSE
1. The term finance refers to a field of study as well as to the transfer of funds over time.
ANS: T
The textbook is being studied mainly because it supports learning in a university course of study, and
it deals mainly with the arrangements that transfer funds over time and the associated risks.
PTS: 1
REF: p 7 (1.2 An introduction to finance)
2. The main components of the financial system are financial institutions, instruments, markets, users
and suppliers of funds, and financial regulators.
ANS: T
Households, companies and other organisations are the main clients of financial institutions and
users of markets that are involved in allocating funds and managing risk using various financial
instruments.
PTS: 1
REF: p 3–6 (1.1 Financial functions)
3. All transactions are settled by a cash payment from the buyer to the seller.
ANS: F
A transaction is settled when there is a transfer of value (money) from the buyer to the seller. Money
includes other types of payment instruments in addition to cash.
PTS: 1
REF: p 3 (1.1.1 The settlement function)
4. The term ‘flow of funds’ refers to the exchange of value required to settle commercial transactions.
ANS: F
The flow of funds is the allocation of finance from surplus to deficit units.
PTS: 1
REF: p 3 (1.1.2 The flow of funds function)
5. The flow of funds is arranged directly when funds are deposited with banks, and indirectly when
funds are invested in securities.
ANS: F
The flow of funds through banks is referred to as indirect financing since the funds are lent to banks,
which in turn lend to deficit units. Direct financing occurs when funds are supplied directly to deficit
units through the sale of securities.
PTS: 1
REF: p 4 (1.1.2 The flow of funds function)
6. The efficiency of the flow of funds is enhanced when the associated risks can be managed.
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ANS: T
The development of risk-transfer instruments and markets has helped banks and deficit and surplus
units to manage the risks they face, and so has assisted in the development of the flow of funds.
PTS: 1
REF: p 5–6 (1.1.3 The risk transfer function)
7. The risk that the value of bonds falls because of an unexpected increase in interest rates is known as
default risk.
ANS: F
The chance of loss as a result of an unexpected change in a market variable (an interest rate,
exchange rate of market traded assets) is market risk. Default risk is the chance of loss resulting from
a financial obligation not being met.
PTS: 1
REF: p 5 (1.1.3 The risk transfer function)
8. Moral hazard problems arise in the financial system because people are fundamentally dishonest.
ANS: F
Moral hazard refers to arrangements that create an incentive for people to modify their behaviour,
such as to not act responsibly.
PTS: 1
REF: p 6 (1.1.5 Overcoming incentive problems)
9. The Reserve Bank of Australia (RBA) controls Australia’s financial system.
ANS: F
The RBA is responsible for the implementation of monetary policy, among other things, and other
regulatory bodies have responsibilities relating to the financial system, but they do not individually
or collectively control the financial system.
PTS: 1
REF: p 17–18 (1.4 The financial regulators)
10. Derivative contracts can be used to both increase and decrease exposure to risk.
ANS: T
We concentrate on their use in risk-reduction (‘hedging’) but derivatives can also be used for
investment/speculative purposes.
PTS: 1
REF: p 17 (1.3 The structure of Australia’s financial system)
11. Information asymmetry arises where a contract distorts incentives to behave appropriately.
ANS: F
Information asymmetry arises where one party to a potential contract is better informed than the
other party.
PTS: 1
REF: p 6 (1.1.4 Overcoming information asymmetry)
12. The settlement function can be defined as ‘the instruments that can be used to settle transactions’.
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ANS: F
The settlement function relates to the arrangements that can be used to settle commercial
transactions.
PTS: 1
REF: p 3 (1.1.1 The settlement function)
13. The goal of the flow of funds function is to achieve an efficient use of funds having regard to the risk
involved.
ANS: T
This provides surplus units a higher return than could be achieved if they retained possession of their
surplus funds.
PTS: 1
REF: p 4 (1.1.2 The flow of funds function)
14. Surplus units prefer not to have liquidity.
ANS: F
Surplus units prefer to have liquidity.
PTS: 1
REF: p 5 (1.1.2 The flow of funds function)
15. Risk-averse investors are indifferent with regards to the amount of risk assumed in generating an
investment return and instead focus solely on an investment’s expected return.
ANS: F
Risk-averse investors place a negative value on taking risk.
PTS: 1
REF: p 5 (1.1.2 The flow of funds function)
16. Australia went through a process of increasing regulations on the financial system in the 1980s.
ANS: F
Deregulation in the 1980s removed many regulations on banks and financial markets and
contributed to greater efficiency in the flow of funds.
PTS: 1
REF: p 7 (1.2 An introduction to finance)
17. The bond market trades discount securities.
ANS: F
The bond market trades bonds whereas discount securities are traded in the money market.
PTS: 1
REF: p 16 (1.3 The structure of Australia’s financial system)
18. All else the same, the risk associated with an unsecured loan is greater than the risk associated with
an otherwise identical secured loan.
ANS: T
The lender in a secured loan arrangement has greater protection than the lender in an unsecured loan
arrangement.
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PTS: 1
REF: p 8–9 (1.2.1(a) Debt finance)
19. The lending rate less the risk premium is equal the default-free rate.
ANS: T
Recall r = r default free + r risk premium , rearranging: r – r risk premium = r default free.
PTS: 1
REF: p 9 (1.2.1(a) Debt finance)
20. There exists an inverse relationship between risk and expected return.
ANS: F
There exists a positive relationship between risk and expected return—investors expect higher
returns for exposure to greater risks.
PTS: 1
REF: p 9–10 (1.2.1(a) Debt finance)
21. Equity is considered riskier than debt because the returns to its suppliers are non-enforceable.
ANS: T
Dividends are paid at the discretion of the company whereas interest and principal repayments on
debt are a legal obligation of the company.
PTS: 1
REF: p12 (1.2.1(c) Debt versus equity)
22. Financial institutions are supervised by the RBA.
ANS: F
The Australian Prudential Regulation Authority (APRA) supervises financial institutions.
PTS: 1
REF: p 17 (1.4 The financial regulators)
23. Leveraged investments always produce better returns than unlevered investments.
ANS: F
Leverage (debt financing) increases the risk of an investment—both potential profits and losses are
increased.
PTS: 1
REF: p 12–13 (1.2.1(c) Debt versus equity)
24. Monetary policy is one tool used by the RBA to enhance financial system stability.
ANS: T
By controlling inflation the RBA creates an environment conducive to economic growth and helps to
avoid asset-price ‘bubbles’. The RBA’s regulation of the payment system and monitoring of
economic and financial data also contribute to financial system stability.
PTS: 1
REF: p 18 (1.4.1 Financial system stability)
25. APRA enforces company and financial services laws to protect consumers, investors and creditors.
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ANS: F
This function is performed by the Australian Securities and Investments Commission (ASIC).
PTS: 1
REF: p 17 (1.4 The financial regulators)
26. A firm does not have to repay its equity funds and is not obliged to pay dividends. Therefore equity
is a cheaper source of funds than debt.
ANS: F
Suppliers of equity financing face greater risks than suppliers of debt financing because they have
only a residual claim in the firm’s earnings. Therefore equity holders require higher rates of return.
PTS: 1
REF: p 12 (1.2.1(c) Debt versus equity)
27. The Australian payments system is overseen by the RBA.
ANS: T
A safe and efficient payments system is essential to financial system stability.
PTS: 1
REF: p 17 (1.4 The financial regulators)
MULTIPLE CHOICE
1. The study of ‘the financial system’ is best described as:
A. financial decision-making under uncertainty
B. financial decision-making that allocates resources over time
C. financial decision-making by firms
D. the set of financial institutions, markets and securities that manage financial contracting and
the exchange of financial assets and risks.
E. All of the above.
ANS: D
PTS: 1
REF: p 2 (Introduction)
2. The improvement of the provision of financial services over time is known as:
A. financial innovation
B. coincidence of wants
C. deregulation
D. financial conglomerates
E. the global financial system.
ANS: A
PTS: 1
REF: p 2 (Introduction)
3. According to Merton (1995) financial systems perform six functions. The function performed by the
payment system is:
A. to provide the means for the settlement of commercial transactions
B. to arrange the flow of funds from surplus to deficit units
C. to provide ways for participants in the financial system to transfer and manage risk
D. to generate information that assists decision-making
E. to provide ways of dealing with the incentive problems that arise in financial contracting.
ANS: A
PTS: 1
REF: p 3 (1.1.1 The settlement function)
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4. According to Merton (1995) financial systems perform six functions. The function performed by the
financing system is:
A. to provide the means for the settlement of commercial transactions
B. to arrange the flow of funds from surplus to deficit units
C. to provide ways for participants in the financial system to transfer and manage risk
D. to generate information that assists decision making
E. to provide ways of dealing with the incentive problems that arise in financial contracting.
ANS: B
5.
REF: p 3–4 (1.1.2 The flow of funds function)
According to Merton (1995) financial systems perform six functions. The function that employs the
use of derivatives is:
A. to provide the means for the settlement of commercial transactions
B. to arrange the flow of funds from surplus to deficit units
C. to provide ways for participants in the financial system to transfer and manage risk
D. to generate information that assists decision making
E. to provide ways of dealing with the incentive problems that arise in financial contracting.
ANS: C
6.
PTS: 1
PTS: 1
REF: p 5–6 (1.1.3 The risk-transfer function)
‘Means of exchange’ refers to:
A. the arrangements that can be used to settle commercial transactions
B. cash
C. the instruments that can be used to settle transactions
D. the supply of funds from surplus units for use by deficit units.
E. None of the above.
ANS: C
PTS: 1
REF: p 3 (1.1.1 The settlement function)
7. Direct financing is a situation where:
A. deficit units raise funds from surplus units
B. surplus units raise funds from deficit units
C. deficit units raise funds from financial intermediaries
D. financial intermediaries obtain funds from surplus units.
E. None of the above.
ANS: A
PTS: 1
REF: p 4 (1.1.2 The flow of funds function)
8. In a developed financial system, financing is provided by:
A. derivative and securities markets
B. securities markets and financial intermediaries
C. governments and financial intermediaries
D. derivative markets and financial intermediaries
E. derivative markets, securities markets and financial intermediaries.
ANS: B
PTS: 1
REF: p 4 (1.1.2 The flow of funds function)
9. In reference to the flow of funds from surplus to deficit units, deficit units generally prefer:
A. high cost of funds
B. low risk
C. large amounts
D. flexible and short contracts
E. more stringent loan conditions.
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ANS: C
PTS: 1
REF: p 5 (1.1.2 The flow of funds function)
10. In reference to the flow of funds from surplus to deficit units, surplus units generally prefer:
A. high returns
B. high risk
C. large amounts
D. inflexible and long contracts
E. illiquidity.
ANS: A
PTS: 1
REF: p 5 (1.1.2 The flow of funds function)
11. Which of the following is not an example of market risk?
A. A share investor whose portfolio has been devastated by a stock-market crash.
B. A loan on which the borrower is unable to make scheduled repayments.
C. A borrower who finds that interest rates are higher than expected.
D. An importer that has to cope with an unexpected depreciating exchange rate.
E. A fund manager intending to sell at a future date that may face falling share prices.
ANS: B
PTS: 1
REF: p 5 (1.1.3 The risk-transfer function)
12. Which of the following situations illustrates the problem of asymmetric information?
A. A loan applicant who neglects to mention the impending insolvency of their employer.
B. A government guarantee to bail out financial institutions in distress.
C. Company managers receiving large bonuses despite low profitability.
D. Brokers giving their clients buy recommendations on shares they are themselves selling.
E. An investment bank that encourages an issuer to set a low issue price.
ANS: A
PTS: 1
REF: p 6 (1.1.4 Overcoming information asymmetry)
13. A situation where a contract distorts incentives to behave appropriately is known as:
A. information asymmetry
B. coincidence of wants
C. pooling of funds
D. moral hazard.
E. None of the above.
ANS: D
14.
PTS: 1
REF: p 6 (1.1.5 Overcoming incentive problems)
An arrangement that consolidates small amounts of funds to satisfy the demand for large amounts is
known as:
A. financial innovation
B. leverage
C. retail banking
D. coincidence of wants
E. pooling of funds.
ANS: E
PTS: 1
REF: p 7 (1.1.6 Pooling of funds)
15. Identify the correct statement about Australia’s financial system.
A. The main source of funds is household savings.
B. Savings can be in the form of deposits and/or investments.
C. The use of debt by households has increased significantly since deregulation.
D. In general, companies use more debt relative to equity than households.
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E. All of the above.
ANS: E
PTS: 1
REF: p 8 (1.2 An introduction to finance)
16. Of the following, which is not a feature of debt?
A. Interest payments.
B. Maturity date.
C. Dividends.
D. Security arrangements.
E. Risk premiums.
ANS: C
17.
REF: p 8–9 (1.2.1(a) Debt finance)
Credit risk is best defined as:
A. the possibility that loan payments will not be made when they are due
B. the component of an interest rate that compensates for borrower’s risk
C. the component of a return that compensates for risk
D. the interest rate paid by a default-free borrower.
E. None of the above.
ANS: A
18.
PTS: 1
PTS: 1
REF: p 9 (1.2.1(a) Debt finance)
Depending upon the circumstances, equity can also be referred to as:
A. ordinary shares
B. common stock
C. risk capital
D. shareholders’ funds.
E. All of the above.
ANS: E
PTS: 1
REF: p 10 (1.2.1(b) Equity finance)
19. The risk borrowers face of not being able to maintain the level of their debt is known as:
A. credit risk
B. funding risk
C. default risk
D. capital risk
E. market risk.
ANS: B
PTS: 1
REF: p 13 (1.2.1(c) Debt versus equity)
20. Which of the following was not a feature of the GFC?
A. Incentive problems.
B. Information asymmetries.
C. A credit crunch.
D. Payment system collapse.
E. A crisis of confidence.
ANS: D
PTS: 1
REF: p 13–14 (Lessons from the GFC 1.1)
21. The ‘big four’ (Westpac, Commonwealth bank, NAB and ANZ) are best described as:
A. retail banks
B. financial conglomerates
C. wholesale banks
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D. investment banks
E. superannuation schemes.
ANS: B
system)
PTS: 1
REF: p16 (1.3 The structure of Australia’s financial
22. Which of the following types of institutions accept deposits from, make loans to and provide
payment services for Australian households?
A. Retail banks.
B. Wholesale banks.
C. Investment banks.
D. Insurance companies.
E. Funds managers.
ANS: A
system)
PTS: 1
REF: p 15 (1.3 The structure of Australia’s financial
23. Indirect financing services and payment services are provided to large companies by:
A. retail banks
B. wholesale banks
C. investment banks
D. insurance companies
E. funds managers.
ANS: B
system)
PTS: 1
REF: p 15 (1.3 The structure of Australia’s financial
24. Which of the following types of institutions is best described as providing investment management
services?
A. Retail banks.
B. Wholesale banks.
C. Investment banks.
D. Insurance companies.
E. Fund managers.
ANS: E
system)
PTS: 1
REF: p 15 (1.3 The structure of Australia’s financial
25. In which of the following markets may securities be ‘rolled over’ in order to extend the period of
financing?
A. Money market.
B. Bond market.
C. Share market.
D. Derivative markets.
E. A and B.
ANS: E
system)
PTS: 1
REF: p 16 (1.3 The structure of Australia’s financial
26. The financial authority that has responsibility for the protection of consumers, investors and
creditors in Australia is:
A. the Reserve Bank of Australia
B. the Australian Prudential Regulation Authority
C. the Australian Securities and Investments Commission
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D. the Australian Treasury
E. the Council of Financial Regulators.
ANS: C
PTS: 1
REF: p 17 (1.4 The financial regulators)
27. The financial authority that has responsibility for the stability of the financial system in Australia is:
A. the Reserve Bank of Australia
B. the Australian Prudential Regulation Authority
C. the Australian Securities and Investments Commission
D. the Australian Treasury
E. the Council of Financial Regulators.
ANS: A
PTS: 1
REF: p 17 (1.4 The financial regulators)
SHORT ANSWER
1. Carefully describe the two general methods for arranging the flow of funds, and the roles of financial
institutions in each process.
ANS:
Intermediation is the flow of funds through financial institutions. We refer to these as authorised
deposit-taking institutions (ADIs). An ADI raises funds from depositors and makes loans to deficit
units. These activities are reflected on the ADI’s balance sheet, where the deposits are liabilities and
the loans are assets.
Financing is also arranged in the financial markets (that is, the money, bond and share markets)
when deficit units sell securities to investors. Examples of securities are discount securities, bonds
and shares. Issuers use the services of specialist financial institutions, known as investment banks, to
arrange the issue of securities.
PTS: 1
financial system)
REF: p 4, 15 (1.1.2 The flow of funds; 1.3 The structure of Australia’s
2. Explain how maturity and size mismatches arise in the flow of funds.
ANS:
The preferences of surplus and deficit units are very different. Typically, deficit units will require
funds for long periods of time whereas surplus units value liquidity, which means they want access
to their funds at short notice. This represents a maturity mismatch. A size mismatch occurs because
deficit units will often require large amounts (to buy a house, for example) but surplus units are
individually only able to supply smaller amounts. Intermediaries and markets that arrange the flow
of funds have developed mechanisms to help address these mismatches, such as the pooling of funds.
PTS: 1
REF: p 4–5, 7 (1.1.2 The flow of funds function; 1.1.6 Pooling of funds)
3. What types of payments do investors receive from investments in debt and equity securities? What
determines the size of these payments?
ANS:
Debt-holders receive interest payments, as well as the return of principal. Interest payments depend
upon the interest rate, which in turn depends on the market interest rate and the degree of credit risk.
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Equity-holders receive dividend payments. The amount of dividends paid (in the medium to long
term), depends on the level of company profits.
PTS: 1
REF: p 8–11 (1.2.1 The two basic forms of finance)
4. Define market risk, default risk and credit risk.
ANS:
Market risk is the chance of loss resulting from an adverse change in a market variable—share
prices, interest rates or exchange rates. Movements in these variables are random and at times
volatile.
Default risk is the chance of loss resulting from financial obligations being met. Credit risk is a type
of default risk. It is the possibility that borrowers will not make their loan payments (of interest
and/or principal) when due.
PTS: 1
REF: p 5, 9 (1.1.3 The risk-transfer function; 1.2.1(a) Debt finance)
5. Define leverage and briefly explain the risks posed by it.
ANS:
Leverage refers to the use of debt financing and can be measured by the ratio of an investment’s
assets to its equity capital. The risks faced by a firm taking on greater levels of debt include:
i.
Leverage magnifies the impact of poor returns.
ii.
Funding risks exist when debt needs to be rolled-over (to extend its term) but circumstances
(such as the GFC) make this difficult.
iii.
When loans are secured, there is the risk of forced asset sales by lenders if the borrower
defaults on loan payments.
iv.
The risk that forced asset sales will fail to achieve fair values.
PTS: 1
REF: p 12–13 (1.2.1(c) Debt versus equity)
6. Briefly distinguish between information asymmetry and moral hazard.
ANS:
Information asymmetry is a situation where one party to a potential contract is better informed than
the other party. Moral hazard is a situation where a contract distorts incentives to behave
appropriately. Information asymmetry refers to a situation occurring prior to a contract being entered
into whereas moral hazard refers to a situation occurring once a contract has already been formed.
PTS: 1
REF: p 6 (1.1.4 Overcoming information asymmetry; 1.1.5 Overcoming
incentive problems)
7. Explain the difference between direct financing and indirect financing.
ANS:
Direct financing occurs where deficit units raise funds directly from surplus units, usually through
the issue of securities. On the other hand, indirect financing occurs where deposit-taking institutions
act as the intermediary between surplus and deficit units. In this situation surplus units lend/invest
funds with the intermediary and deficit units borrow funds from the intermediary. As a result,
surplus and deficit units deal with each other in an indirect manner.
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PTS: 1
REF: p 4 (1.1.2 The flow of funds function)
8. Briefly describe the four main types of contractual preference for deficit units.
ANS:
First, deficit units prefer a cost of funds that is as low as possible. This is consistent with profit
maximising behaviour.
Second, deficit units prefer contracts that are long in length and inflexible.
Third, deficit units prefer to take on more risk, i.e. they are risk-takers.
Fourth, deficit units generally prefer to deal in large amounts of funds.
PTS: 1
REF: p 5 (1.1.2 The flow of funds function)
9. Briefly outline the main functions of the RBA.
ANS:
The RBA is responsible for the implementation of monetary policy, the stability of the financial
system, the regulation of the payment system, the issue of currency and acts as a banker for the
Commonwealth Government.
PTS: 1
REF: p 17 (1.4 The financial regulators)
10. Define financial system stability and briefly explain how the RBA attempts to contribute to it.
ANS:
Financial system stability is defined as ‘the absence of financial crises within, such as distress in
financial institutions or disturbances in financial markets that are sufficiently severe to threaten the
health of the economy’. The RBA contributes to system stability in three ways:
i.
By using monetary policy to contain inflation including asset value inflation.
ii.
By ensuring the payments system is safe and efficient.
iii.
By monitoring domestic and international financial and economic data.
PTS: 1
REF: p 18 (1.4.1 Financial system stability)
11. The GFC is sometimes referred to as a ‘crisis of confidence’. Explain the role of confidence leading
up to and during the crisis.
ANS:
In the period prior to the crisis, lenders were over-confident about the ability of some borrowers to
repay loans and so were prepared to lend to risky borrowers at credit-risk premiums that were too
small. Some lenders sought higher returns by using derivatives whilst underestimating the risks
involved.
The onset of the crisis saw lenders rapidly lose confidence that borrowers would make their
repayments. Many of these loans were funded in the security markets and the value of these
securities fell by large amounts as investors fled the market. Institutions became reluctant to lend to
each other, with concerns about exposure to losses. Overall, the loss of confidence lead to steep
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increases in risk premiums or the cessation of lending altogether.
PTS: 1
REF: p 13–14 (Lessons from the GFC 1.1)
ESSAY
1. Explain the six functions performed by the financial system. Carefully distinguish between the
settlement of transactions and the flow of funds.
ANS:
Essay answers will need to be individually marked.
PTS: 1
REF: p 2–6
2. Explain the two main forms of finance (debt and equity).
ANS:
Essay answers will need to be individually marked.
PTS: 1
REF: p 8–13 (1.2.1 The two basic forms of finance)
3. Explain the risk transfer function, carefully mentioning two of the main categories of risk.
ANS:
Essay answers will need to be individually marked.
PTS: 1
REF: p 5–6 (1.1.3 The risk-transfer function)
4. Outline the differences between debt and equity as forms of finance.
ANS:
Essay answers will need to be individually marked.
PTS: 1
REF: p 8–13 (1.2.1 The two basic forms of finance)
5. Provide a brief overview of the GFC.
ANS:
Essay answers will need to be individually marked.
PTS: 1
REF: p 13–14 (Lessons from the GFC 1.1)
6. Describe the institutions and markets within Australia’s financial system.
ANS:
Essay answers will need to be individually marked.
PTS: 1
REF: p 14–17 (1.3 The structure of Australia’s financial system)
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