FINM1001: Foundations of Finance

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Tutorial 1 Solutions Question One What are the primary roles of financial markets? The primary roles of financial markets are:

To bring together lenders and borrowers (via the money and capital markets). In doing this, the financial markets assist in transferring funds between people who have more than they wish to consume now (lenders) and those who have less than they wish to consume or invest now (borrowers);

To facilitate the transference of risk (via the derivatives market); and, To facilitate international trade (via the foreign exchange market).

Question Two Describe the flow of funds within the financial system. Lenders loan funds that are excess to their consumption requirements to other market participants, namely borrowers. In exchange for doing this, they receive a positive rate of return on funds lent from the people they lend them to. Borrowers borrow funds that are required to meet their current consumption and / or investment requirements. In exchange for borrowing these funds, borrowers pay a positive rate of return on borrowed funds to the people they borrowed from. Diagrammatically, we can depict the flow of funds as follows:

Source: Based on a diagram from Viney, C., McGraths Financial Institutions, Instruments and Markets, 5th Edition.

Lenders: Have surplus of funds and are suppliers of funds

Borrowers: Have deficit of funds and are demanders of funds

Examples of Lenders: Individuals (foreign and domestic) Companies (foreign and domestic) Governments (foreign and domestic)

Examples of Borrowers: Individuals (foreign and domestic) Companies (foreign and domestic) Governments (foreign and domestic)

Financial Markets

Give $ Receive $ Issue financial

instruments Receive financial

instruments

FINM1001: Foundations of Finance

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Question Three What is the difference between a primary market and a secondary market? Primary markets are those in which newly issued instruments are traded. Conversely, the trading of existing instruments is executed in the secondary market. It is important to note that primary market transactions raise funds for the issuer, whereas secondary market transactions simply represent a transferring of ownership from one holder to another. Therefore, the latter do not raise any additional funds for entity that originally issued the instrument. Question Four Discuss the main differences between money markets and capital markets. The term money markets encompasses all markets where instruments that mature in 1 year or less are traded. Conversely, the term capital markets is used to describe all markets where instruments maturing in more than 1 year are traded. Question Five Name and describe the markets that are collectively referred to as capital markets. As discussed in Question four, capital markets are all financial markets where instruments maturing in more than 1 year are traded. More specifically, capital markets encompass all markets that that trade in medium-to-long term debt instruments, including corporate and government debt, and equity, including ordinary and preference shares. Question Six What is the intercompany market? Is it regarded as a money market or a capital market? The intercompany involves direct lending between companies. The supply of funds in the intercompany market comes from companies that have cash flows surplus to their current requirements. The demand for funds comes from companies who do not have cash flows sufficient to meet their current obligations. Given the nature of trading within the market, it is regarded as an example of a money market.

FINM1001: Foundations of Finance

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Question Seven What does the term professionalism mean to you, and why is it important? I. PROFESSIONALISM

A. Knowledge of the Law. Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, Members and Candidates must comply with the more strict law, rule, or regulation. Members and Candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations.

B. Independence and Objectivity. Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or anothers independence and objectivity.

C. Misrepresentation. Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

D. Misconduct. Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence. Textbook Questions 3-2 (p.22) Which are the three major groups of players that interact in the financial markets? Briefly describe them. Borrowers: Those who need money to finance their purchases, including

businesses and individuals. Lenders or investors: Those who have money to invest; principally individuals

who save money for a variety of reasons, and also firms with excess cash. Financial intermediaries: Financial institutions and markets that help bring

borrowers and lenders together. 3-3 (p.22) Define in a technical sense what is meant by a financial intermediary. Give an example. A financial intermediary is a key player that helps bring borrowers and lenders together. Examples of financial intermediaries include: commercial banks (in Australia: NAB, Commonwealth Bank, etc); credit unions; investment banks, etc.