Review Exercise 2

Introduction to Financial Systems

Review Exercise
Topic 2
Introduction to Financial Systems

Review Exercise 2- Introduction to Financial Systems

1. Outline the main functions of financial systems. (10 marks) 2007-1a
2 (a) Discuss the main functions of a financial system and explain why these are2012-1a-ZA
important for an economy. (13 marks)
3 (a) Explain the channels through which funds can flow from lenders/savers to20111a-ZB
spenders/borrowers in a financial system and discuss the relative risks faced by
lenders/savers in relation to the different channels. (15 marks)
4 Explain the essential differences between direct and indirect financing identifying the20101b-ZB
characteristics of the financial instruments used in each type of financing. (7 marks)
5 2(b) Explain the essential differences between direct and indirect financing2013-2b-ZAB
identifying the characteristics of the financial instruments used in each type of
financing. (7 marks)
6 Explain the essential differences between direct and indirect financing identifying the20071a-ZA
characteristics of the financial instruments used in each type of financing. (7 marks)
7 What factors have caused the decline in the share of financial assets held by banks20071b-ZAB
in recent years? What are the main consequences for banks? (15 marks)

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Introduction to Financial Systems

8 Describe the historical evolution of the savings and loan associations 20081b-ZB
in the . (7m)
9 Discuss how, and to what extent, insurance companies and pension 2011-1b-ZB
funds act as financial intermediaries. (10 marks)
10 What are the differences between commercial banks, savings and 20081a-ZAB
loan associations, and credit unions? (9 marks)
11 Explain how long-term mutual funds differ from short-term mutual 20081c-ZB
funds. (4 marks)
12 Explain how securities firms differ from investment banks.(4m 2008-1c-ZA
13 Explain the characteristics of the following types of bonds: 2010-1c-ZA
(i) zero coupon bond (ii) perpetual bond (iii) puttable bond
(iv) convertible bond (v) Eurobond (10 marks)
14 What is the difference between US Government bonds and notes? Why 2007-8d-ZB
do 2-year Treasury bonds typically have lower interest rates than 4-
year Treasury bonds? Why do corporate bonds have higher rates than
government bonds?(8 marks)
15 Explain why corporate bonds generally have higher returns than 2014-8d-ZA
government bonds. (4 marks)

16 Describe the characteristics of common stocks and preferred stocks. 2007-7b-ZB

What are the main differences between common stocks and preferred
stocks? (6 marks)
17 An investor is considering investing in one or more of the following types 2010-1b-ZA
of assets: corporate bonds, preferred stocks or common stocks.
Discuss the relative returns, risks and ownership rights of each of
these asset types. (8 marks)
18 Compare and contrast the characteristics of preferred stock and 2013-2a-ZAB
corporate bonds from the perspective of both an investor and a firm
issuing such financial claims. (8 marks)
19 6. (a) Discuss the empirical evidence on the risk-return relationship for 2014-6a-ZAB
the following US securities: Treasury bills, Treasury bonds, large firm
common stocks and
small firm common stocks. (8 marks)
20 Explain the yield curve for government bonds and discuss the main 2013-7e-ZAB
theories for explaining the shape of the yield curve.(12m
21 7(d) Explain the concept of the yield curve for bonds and distinguish 2015-7a-ZAB
between the main theories of the term structure of interest rates. (12
marks)

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22 What is the difference between primary and secondary markets? What 20082a-ZAB
are the main functions of secondary markets? (6 marks)
23 What is the difference between money markets and capital markets? 20082b-ZAB
(4 marks)
24 Distinguish between money markets and capital markets giving 20101a-ZB
examples of financial instruments traded in each market. (5 marks)
25 Distinguish between money markets and capital markets giving 2013-2c-ZA
examples of financial instruments traded in each market. (5 marks)
26 Compare and contrast the following categories of markets: 2012-1a-ZA
i. Primary and secondary markets
ii. Organised exchanges and Over-the-counter (OTC) markets
iii. Money and capital markets
iv. Order-driven and quote-driven markets (12 marks)

1(a) Outline the main functions of financial systems.

(10 marks) 2007-1a

• refer to page 12 of the subject guide.

• The essential economic function of financial systems is to channel funds from units
who have saved
surplus funds (lender-savers) to units who have a
shortage of funds (borrower-spenders).
• explain the reasons of the importance of this channelling function: a) to facilitate
lending and borrowing &
b) to adjust the composition of the lenders’ portfolios
• the provision of payment mechanisms and thus
the monetary function of a financial system

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 Review Exercise 2
Introduction to Financial Systems

1. (a) Discuss the main functions of a financial system and ZA-2012-1a

explain why these are important for an economy. (13 marks)
• See subject guide pp.16–18.

The main functions of financial systems are to:

• provide the mechanisms by which funds can be transferred from units in surplus to units
with a shortage of funds in order to directly or indirectly facilitate lending and borrowing
• enable wealth holders to adjust the composition of their portfolios provide payment
mechanisms
• provide mechanisms for risk transfer.

• Examiners are looking for a discussion of these functions such that the second part of the
question is answered – the following points are expected in a discussion of why a financial
system is important:
i. mobilise savings
ii. increase funds available to fund capital investments
iii. increase efficiency of economic activity.

1. (a) Explain the channels through which funds can flow from lenders/savers to
spenders/borrowers in a financial system and
discuss the relative risks faced by lenders/savers in relation to the different
channels. (15 marks) 20111a

• Funds can flow (i) directly through financial markets with borrowers issuing debt or
equity claims.
• The risks faced by lender/savers are essentially credit risk and liquidity risk.
These risks need to be explained.
• Liquidity risk mitigated if claims held are marketable.
• Funds can also flow through intermediaries such as banks. Intermediaries issue
claims that have low risk/high liquidity (e.g. bank deposits) but hold longer-term
higher-risk claims. Answers need to explain why banks are able to do this (i.e. how
they can perform asset transformation).
• Thus from the point of view of lender/savers the credit risk and liquidity risk are
higher for direct lending than for indirect lending.

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Introduction to Financial Systems

1(b) Explain the essential differences between direct and indirect financing
identifying the characteristics of the financial instruments used in each type of
financing. (7 marks) 2010-1b
• refer to pp.14–15 of the subject guide, and to pp.18–19 (sixth edition) of Mishkin and
Eakins Financial markets and institutions.
• In direct financing lenders lend directly to borrowers by buying the claims issued by
borrowers in financial markets. These claims include equity claims and long-& short-
term debt claims. However the majority of claims will be long term and relatively high
risk.
• In indirect financing lenders lend to a financial institution such as a bank. The bank
then on-lends the funds it collects to borrowers. Where a bank is the institution then the
claims issued by banks (held by lenders) will generally be short term and low risk
(deposits) but the claims held by banks will be longer term and higher risk (bank
loans).

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2(b) Explain the essential differences between direct and indirect financing
identifying the characteristics of the financial instruments used in each type of
financing. (7 marks) 2013-2b-ZAB

• See the subject guide, Chapter 2, section headed `The structure of financial systems'.
Approaching the question
• A diagram is useful in illustrating the differences between direct and indirect
(intermediated) finance - see the one in Chapter 2 of the subject guide:
The essential differences include:
• Direct financing mainly takes place through securities (equity, bond) markets.
• Indirect financing takes place through intermediaries (banks, investment
intermediaries).
• Where this takes place through banks, the securities used are non-tradable (deposits,
loans).
• Most financing is indirect.
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ZA-2007-1a
1(a) Outline the structure of a developed financial system. (10 marks)

• refer to page 13 of the subject guide. A good way to tackle this question would be to
critically analyse the entities that compose a financial system. 2 marks were awarded
for emphasising the need to interpret the structure of a financial system in terms of its
entities, and for stating what these are. In particular, the Examiners would here be
expecting a balanced, essay-format discussion of the three entities that compose the
system:
• financial markets (2 marks)
• securities (3 marks)
• financial intermediaries (3 marks).

1(b) What factors have caused the decline in the share of financial assets held by
banks in recent years? What are the main consequences for banks? (15 marks)
ZA-2007-1b
• refer to page 60 of the subject guide. The Examiners would expect students to begin with a
clear definition of disintermediation as the process of lenders and borrowers bypassing the
banking system and lending/borrowing directly (2 marks awarded for this).
• Then students should go on to discuss this in more detail to show that they understand the
definition and have not simply learnt it from a book. The Examiners would award marks for
students who constructed clear paragraphs which made the following points:
– Lenders look for higher-yielding assets and take their deposits out of banks (2 marks).
– Borrowers issue securities directly into markets (2 marks) due to lower cost (1 mark) and
development of credit rating agencies (1 mark).
– Development of securitisation allows other types of intermediaries to originate loans and
then bundle them to enable securities to be issued. This lowers the advantages banks have
in the loan markets (2 marks). (1 mark also awarded for the definition of securitisation).
• A good answer would then go on to discuss the consequences for banks which include the
growth in off-balance sheet activities – often facilitating direct capital raising by firms (2 marks)
and expansion into new riskier areas of business (2 marks).

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Introduction to Financial Systems

20081b
1 (b) Describe the historical
evolution of the
savings & loan associations in the United States. (7 marks)
• refer to pp.14−15 of the subject guide.
• In the 1950s and 1960s, S&Ls grew much more rapidly than commercial banks. However, between
1979 and 1982 the change in the monetary policy of the Fed determined a dramatic surge in
interest rates (increase).
• the effects for S&Ls of the increase in the short-term rates:
a) S&Ls had negative interest spreads (interest income - interest expense) in funding the fixed-
rate long-term residential mortgages
b) S&Ls had to pay more competitive interest rates on savings deposits
• the actions taken to overcome the effects of rising rates and disintermediation − in the
early 1980s the Congress passed acts allowing S&Ls to expand the deposit-taking (i.e. to
offer checking account) and asset-investment powers (i.e. to make consumer and commercial
loans).
• the consequences of the new business model of S&Ls. For many S&Ls the new powers created
safer & more diversified institutions. But, for a small – but significant – group of S&Ls, they
created an opportunity to take more risk in the attempt to improve profitability. As a result a
large number of S&Ls failed at the end of the 1980s and a new legislation – the FIRREA29of
1989 – was adopted.

1. (a) What are the differences between commercial banks,

savings & loan associations, credit unions? (9 marks)
• the need to consider all these financial institutions as depository institutions
(intermediaries with a significant proportion of their funds derived from customer
deposits).
• Commercial banks – they accept deposits (liabilities) to make loans (assets) and to buy
government securities. Describe the possible types of deposits and loans.
• Savings and loan associations (S&Ls) – historically they have concentrated mostly on
residential mortgages by acquiring funds primarily through savings deposits. To
overcome the effects of rising rates & disintermediation, in the early 1980s S&Ls
expanded their deposit-taking (i.e. to offer checking accounts) and asset-investment
powers (i.e. to make consumer & commercial loans).
• Credit unions – they are non-profit institutions mutually organised and owned by their
members, who have to belong to a particular group. Their primary objective is to satisfy
the depository & lending needs of their members: the members’ deposits are used to
provide loans to other members, and earnings from these loans are used to pay higher
31
rates to member depositors.

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Introduction to Financial Systems

• refer to pp.14–15 of the subject guide. 20081a-ZAB

• A good way to tackle this question would be to critically analyse depository

institutions. One mark was awarded for the emphasis on the need to consider all
these financial institutions as depository institutions (intermediaries with a significant
proportion of their funds derived from customer deposits).
• The Examiners would then be expecting a balanced, essay-format discussion of these
three financial institutions (examiners consider excellent candidates as those who are
able to describe these institutions by using the appropriate technical terms):
commercial bank, SLA, credit unions.
• An outstanding answer would finally discuss the relative market share of these
institutions in the USA. Up to 2 marks were awarded for this.

20081a
1. (a) What are the differences between commercial banks,
savings & loan associations, credit unions? (9 marks)
• the need to consider all these financial institutions as depository institutions
(intermediaries with a significant proportion of their funds derived from customer
deposits).
• Commercial banks – they accept deposits (liabilities) to make loans (assets) and to buy
government securities. Describe the possible types of deposits and loans.
• Savings and loan associations (S&Ls) – historically they have concentrated mostly on
residential mortgages by acquiring funds primarily through savings deposits. To
overcome the effects of rising rates & disintermediation, in the early 1980s S&Ls
expanded their deposit-taking (i.e. to offer checking accounts) and asset-investment
powers (i.e. to make consumer & commercial loans).
• Credit unions – they are non-profit institutions mutually organised and owned by their
members, who have to belong to a particular group. Their primary objective is to satisfy
the depository & lending needs of their members: the members’ deposits are used to
provide loans to other members, and earnings from these loans are used to pay higher
35
rates to member depositors.

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Introduction to Financial Systems

ZA-2008-1b
1(b) Describe the historical evolution of the
savings and loan associations in the United States. (7 marks)
• refer to pp.14−15 of the subject guide.
• This part of the question requires candidates to focus on one of the depository institutions
analysed in part a): S&Ls. The Examiners would award marks for candidates who
constructed clear paragraphs which made the following points:
• In the 1950s and 1960s, S&Ls grew much more rapidly than commercial banks (1 mark).
However, between 1979 and 1982 the change in the monetary policy of the Fed determined
a dramatic surge in interest rates (1 mark).
• A good answer would then go on to discuss the effects for S&Ls of the increase in the short-
term rates:
a) S&Ls had negative interest spreads (interest income minus interest expense) in funding
the fixed-rate long-term residential mortgages (1 mark).
b) S&Ls had to pay more competitive interest rates on savings deposits (1 mark).

• A good answer would then go on to discuss the effects for S&Ls of the increase in the short-term
rates: ZA-2008-1b
a) S&Ls had negative interest spreads (interest income minus interest expense) in funding the
fixed-rate long-term residential mortgages (1 mark).
b) S&Ls had to pay more competitive interest rates on savings deposits (1 mark).
• A very good answer would discuss the actions taken to overcome the effects of rising rates and
disintermediation − in the early 1980s the Congress passed acts allowing S&Ls to expand the
deposit-taking (i.e. to offer checking account) and asset-investment powers (i.e. to make
consumer and commercial loans) (1 mark).
• An outstanding answer would finally discuss the consequences of the new business model of
S&Ls. For many S&Ls the new powers created safer and more diversified institutions. But, for a
small – but significant – group of S&Ls, they created an opportunity to take more risk in the
attempt to improve profitability. As a result a large number of S&Ls failed at the end of the 1980s
and a new legislation – the FIRREA of 1989 – was adopted. (Up to 2 marks were awarded for
the discussion of these consequences).

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Introduction to Financial Systems

1(b) Discuss how, and to what extent, insurance companies and pension funds act as
financial intermediaries. (10 marks) 20111a
• Not directly covered in the subject guide but implicit in the discussion of financial
intermediaries and pension funds/insurance companies – see pp.20–21 of the subject
guide.
• Financial intermediation is the process whereby an intermediary obtains funds from
saver/lenders and on-lends these funds to spender/borrowers.
• Insurance companies and pension funds are intermediaries to the extent that they take
in funds from saver/lenders in the form of insurance premiums and pension
contributions and then invest those funds in claims issued by spender/borrowers (e.g.
equity and corporate bond claims).
• There is less of a maturity transformation process taking place compared with the
involvement of banks as the liabilities and assets tend to be both long term for pension
funds and life insurance companies. However, there is a definite channelling of funds
from savers to borrowers and a transformation of risk as the pension fund/insurance
company is able to pool and diversify risks on its assets thus lowering risk across its
liabilities.

20081c
1 (c) Explain how long-term mutual funds differ from
short-term mutual funds. (4 marks)
• refer to p.16 of the subject guide.
• definition of these two types of investment intermediaries, focusing on the
Differences between the two:
1) Long-term funds comprise
bond funds (funds that contain fixed income debt securities),
equity funds (funds that contain stock securities) and
hybrid funds (funds that contain both debt & stock securities)
2) Short-term fund are represented by money market mutual funds, funds that contain various
mixes of money market securities and partially allow shareholders to write cheques against the
value of their holdings. An outstanding answer would emphasis that the presence of deposit-type
accounts makes money market mutual funds to some extent similar to depositary institutions.

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1(c) Explain how securities firms differ from investment banks.(4 marks)
• refer to pp.16−17 of the subject guide. ZA-2008-1c

• The Examiners would expect candidates to begin with a clear definition of these two types
of investment intermediaries, focusing on the differences between the two:
– Investment banks assist corporations or governments in the issue of new debt or equity
securities. Investment banking includes the origination, underwriting and placement of
securities in primary financial markets (primary and secondary markets are discussed
next). It also includes corporate finance activities (such as advising on mergers and
acquisitions) (1 mark).
– Securities firms assist in the trading of existing securities in the secondary markets.
There are two main categories of securities firms: brokers (agents of investors who
match buyers with sellers of securities), and dealers (agents who link buyers and sellers
by buying and selling securities) (1 mark).
• Up to 2 marks were awarded for the explanation of the types of securities firms and investment
banks and for providing the names of the major US players for each type.

(c) Explain the characteristics of the following types of bonds: ZA-2010-1c

(i) zero coupon bond
(ii) perpetual bond
(iii) puttable bond
(iv) convertible bond
(v) Eurobond (10 marks)
refer to pp.25–26 of the subject guide, and to pp.245– 47 (sixth edition) of Mishkin and Eakins Financial
markets and institutions.
This is a straightforward question requiring a brief statement of the characteristics of the five different
types of bond.
i. Zero coupon bond – a bond that pays no coupon. There is one payment of par value at maturity.
ii. Perpetual bond – bonds with an infinite life. Therefore valued as perpetuities as they pay a fixed
interest payment forever.
iii. Puttable bond – a bond with an embedded option to repay early. In this case the option lies with the
investor
iv. Convertible bonds are debt instruments that can be converted into equity instruments under certain
conditions.
v. Eurobonds are bonds denominated in one country but sold or traded in another country (e.g. a
sterling denominated bond issued in New York).

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Introduction to Financial Systems

56 Nature Of Financial Instruments

2 types of financial instruments:
(A) ________ instruments (e.g. Shares) or (B) ________ instruments (e.g. Bonds)
(A) Equity instruments –(e.g. shares = stocks)

The _____ may pay to equity holder (= shareholders = _____) dividend semiannually.

Shares do not have maturity date.
• Equity holders have ___________ right & ownership right ,
• they are __________ claimants after paying to all the debtholders

B. Debt instruments - Bonds

B____ (<1 yr) N____ (1~ 10 yr), B____ (10 ~20 yrs)
The borrower (i.e. bond ______) pay to the lenders (i.e. bondholders = ________)
(i) coupon ________ (annually or ____________) until the maturity date &
(ii) pay back the principal = p___ value(= f_____ value= $1000) at the maturity date
56

Bond issuer (= borrower)

G_________ bond UK government bond: G____
(risk free/ low risk Germany government bonds: B____
low coupon interest) US government bond:
T________ B___ (maturity <1 yr)
(= zero coupon bond = deep discount bond)
Treasury Notes (1-____ yrs), Treasury Bonds (10-___ yrs)
M________ bond Issue by ______ government or state or province to finance
(with default) public interest projects.
secured on their own revenues
lower interest rates than not guaranteed by central government.
Treasury bonds interest income is fully or partially tax exempted
C________ bonds Issue by private l_____ company as long term financing
(low risk, low return) but bondholders have ______ claims on the issuer’s assets.
higher than T--bill Bond’s risk depends on the issuer’s business activity
Semi-annual coupon int e.g. c_______ bond, r____________ bond, c________ bond 59

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Introduction to Financial Systems

Types of Bond
C_________ Bonds The issuer pay the coupon interest to the bondholders
regularly (annually or semiannually) until maturity.
Z C Bonds The issuer DOES NOT pay the coupon interest to the
(= deep d_______ bond) bondholder, rather it is sold at deep discount.
e.g. Treasury Bill (maturity < 1 year)
Perpetual bonds The issuer pay the coupons interest forever.
(= consols)
F_________ rate bonds The coupon rates vary over the life of bond.
The floating coupon rate is a premium over market interest
rate (e.g LIBOR or US T-bill rate) and
is reset on a pre-specified basis.
I______________ bonds Bond’s coupons & principal grow together with index
(e.g.stock market index, consumer price index-inflation.
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Types of Bond
F_____bond bonds issued in foreign country (using ________ currency)
E.g. a Russian firm sells in UK (in Sterling)
B_________ bonds- Sterling denominated foreign bonds.
E_____bonds bonds denominated in country A’s currency but sold in country B.
(E.g. E_________ bond denominated in Sterling but sold outside the UK).
Coupons on Eurobonds are paid on an annual basis.
London is one of the major Eurobond markets.

Bond is in d_______ if the borrower is unable to repay

the coupon interest or/and principal at specified dates.
Bond has a h______ coupon interest rate (i.e. default risk premium)
if has higher possibility of default (i.e. lower credit rating)
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Q: What is the difference between US Government bonds and notes? 20078d

20078d

Why do 2-yr Treasury bonds have lower interest rates than 4-yr Treasury bonds?
Why do corporate bonds have higher rates than government bonds? (8 marks)

8(d) US Government notes have an original maturity of one to ten years, while bonds have
an original maturity of ten to twenty years. Both government notes and bonds are free
of default risk.
• maturity influences the interest rate. Bonds with identical risk may
• have different interest rates because of the difference in the time remaining to maturity.
A yield curve plots the interest rates of bonds with different maturity but the same risk. It
describes the term structure for a particular type of bond. The yield curve can be
upward (the long-term rates are above the short-term rates); flat (short and long-term
interest rates are the same); and inverted (long-term interest rates are below short-term
interest rates).
• The degree of risk of corporate bonds, which depends on the default risk of the
company, is higher than for government and municipal bonds. This determines the
presence of higher interest rates.
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8(d) Explain why corporate bonds generally have higher returns than
government bonds. (4 marks)
2014-8d-ZA
See subject guide, Chapter 8, section headed ‘Valuation of financial assets’.
Approaching the question
Both have certainty of cash flows so lower risk than common stocks.
However, there is a greater risk of default from corporate bonds.
Governments can generally always increase taxes to raise funds to service bonds so
defaults are rare.
Higher risk (for corporate bonds) requires greater compensation for investors in the form of
higher returns.

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Introduction to Financial Systems

Term Structure of Interest Rates (3 Theories)

an investor who invests will receive the same return from either
E____________ (a) £1,000 in either a 2-year bond, or
theory (b) a 1-year bond subsequently reinvesting the proceeds from the 1st year into
another 1-year bond
The long-term rate is a geometric average of today’s
short-term rate and expected short-term rates in the
future. Requires there is an implicit relationship between
current bond yields and forward rates.
Forward rate of interest = interest rate payable
on funds beginning at some future date. (1 + R)2 = (1 + r1) x (1 + r2)
L______________ Investors /lenders prefer to hold assets which can be converted into ________ quickly.
Investors demand a liquidity premium for holding long term debt.
theory
Borrowers prefer to borrow for a longer period at a rate which is certain now.
Borrowers will be willing to pay a liquidity premium. A higher rate of interest on a longer-
term debt. Yield curve normally is ___________sloping
Combine the expectations & liquidity preference in reality
A downward sloping yield curve occur when expectations of an interest rate fall are
sufficient to offset the liquidity premium.
S______________ bond market is actually made up of a number of separate markets distinguished by time to
maturity, each with their own supply & demand
theory
Different classes of investors and issuers will have a strong preference for73certain
segments of the yield curve. Yield curve may move up, or d_______, over its entire range.

Yield Curve
= factors that influence the shape of the yield curve
Expectations of future interest rates determine the shape of the yield curve
U________ sloping current long rate (after 3 years) > current short rate
yield curve short-term rates are expected to rise in the future.
(normal)
D________ sloping Current long rate < current short rate
yield curve short-term rates are expected to decline in the future

F________ sloping If no change is expected in short rates

yield curve current long rate = current short rate

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7(e) Explain the yield curve for government bonds and discuss the main theories for
explaining the shape of the yield curve. (12 marks) 2013-7e-ZAB

• See the subject guide, Chapter 2, section on `The term structure of interest rates'.
Approaching the question
• The term to maturity influences the interest rate. Bonds with identical risk may have
• different yields (interest rates) because of the difference in the time remaining to
maturity.
• A yield curve plots the yields (interest rates) of bonds with different maturity but the
same risk. The yield curve can be: upward (the long-term rates are above the short-
term rates); at (short- and long-term interest rates are the same); and inverted (long-
term interest rates are below short-term interest rates).
• There are a number of theories that attempt to explain the shape of the yield curve.

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Expectations theory 2013-7e-ZAB

• The expectations theory of the term structure of interest rates states that in equilibrium,
the long-term rate is a geometric average of today's short-term rate and expected short-
term rates in the future.
• In this theory, if the current long rate is higher than the current short rate, short-term
rates must be expected to rise in the future. Conversely, if the current long rate is lower
than the current short rate then short-term rates are expected to decline in the future: in
this instance, we will observe a downward-sloping yield curve. Finally, if no change is
expected in short rates, then the current long rate will equal the current short rate, and
we will observe a at yield curve. Hence, the shape of the yield curve will be determined
by expectations of future interest rates.

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Introduction to Financial Systems

Liquidity premium theory 2013-7e-ZAB

• Liquidity premium theory asserts that, in a world of uncertainty, investors and lenders
will want to hold assets that can be converted into cash quickly. Therefore they will
demand a liquidity premium for holding long-term debt. Conversely, the same dislike for
uncertainty causes borrowers (for example, firms and governments) to prefer to borrow
for a longer period at a rate which is certain now | therefore they will be willing to pay
a liquidity premium and, therefore, a higher rate of interest on their longer-term debt.
• This implies that the yield curve will normally be upward sloping, in the absence of any
other influences. In reality, we need to consider the combined effect of expectations
together with liquidity preference. A downward sloping yield curve will occur when
expectations of an interest rate fall are sufficient to offset the liquidity premium.

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Market segmentation 2013-7e-ZAB

• As well as the investors' expectations with respect to future interest rates and their
preferences for liquidity, another theory, the market segmentation theory, suggests that
the bond market is actually made up of a number of separate markets distinguished by
time to maturity, each with their own supply and demand conditions. Dierent classes of
investors and issuers will have a strong preference for certain segments of the yield
curve and, therefore, the curve will not necessarily move up, or down, over its entire
range.

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 Review Exercise 2
Introduction to Financial Systems

7(d) Explain the concept of the yield curve for bonds and distinguish between the
main theories of the term structure of interest rates. (12 marks)
2015-7a-ZAB
[See subject guide, Chapter 2, pp.30–31. ]
Bonds with identical risk may have different yields (interest rates) because of the difference in
the time remaining to maturity. A yield curve plots the yields (interest rates) of bonds with
different maturity but the same risk. Usually the yield curve is constructed from government
securities. These are often referred to as the benchmark yield curve, as they are the basis for
evaluating other yields of similar maturity bonds. The yield curve can be: upward (the long-term
rates are above the short-term rates); flat (short- and long-term interest rates are the same);
and inverted (long-term interest rates are below short-term interest rates).
There are a number of theories that attempt to explain the shape of the yield curve:
i. expectations theory
ii. liquidity preference theory
iii. market segmentation theory.
Each of these needs to be explained highlighting how they explain the different shapes of the
yield curve. Better answers will aim to identify which theory provides the best explanation of
why we commonly observe an upward sloping yield curve.

Common Stocks vs Preferred Stocks vs Bonds

Common Stocks
(= o shares)
O_______ (equity)
With v______ right
High risk, high return
Capital gain (Selling- cost)
Preferred Stocks
(= p__________ shares)
Creditor (equity but with
limited ownership rights)
___ voting right
Lower risk, lower return
Bond
(bill, notes, debenture)
Creditor (debt)
___ voting right
Low risk, low return
(investor- for diversification)

Dividend (option) Preference dividend (must C_______ i_______ (must)

but accumulative)
annually, semi-annually annually, semi-annually annually, semi-annually
R_________ claims Claims after bondholder Priority claims

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20077b
Q:Describe the characteristics of common stocks and preferred stocks.
What are the main differences between common stocks and preferred stocks? (6 marks)
Ans: 7(b) refer to page 22 of the subject guide.
• Common stocks represent ownership interests in the firm. Common stockholders
receive dividends (when distributed), take capital gains (or losses) when the stock price
on the market increases (or decreases) and have the right to vote.
• Preferred stocks are equity claims with limited ownership rights in comparison to
common stocks. They differ from common stocks in several ways:
a) Preferred stocks distribute a fixed constant dividend, which makes them more
similar to bonds than to common stocks.
b) The price of preferred stocks is relatively stable, as the dividend is a constant
amount.
c) Preferred stocks do not usually attribute voting rights.
d) Preferred stockholders have a residual claim on assets and income left over after
creditors have been satisfied, but they have priority over common stockholders.

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1(b) An investor is considering investing in one or more of the following types of assets:
corporate bonds, preferred stocks or common stocks.
Discuss the relative returns, risks and ownership rights of each of these asset types. (8
marks) ZA-2010-1b

• refer to pp.27–28 of the subject guide, and to pp.244–50 and pp.259–61 (sixth edition)
of Mishkin and Eakins Financial markets and institutions.
• There is no single way to answer this question. One approach would be to begin by
identifying that all these securities are long term and issued by companies. The
characteristics stated in the question could then be assessed for each of the securities
individually.
• Common stocks are an equity claim (and hence give ownership rights) have an infinite
life, pay uncertain dividends as income and generally give voting rights to the investor.
They are generally considered to be very risky securities and therefore pay investors a
higher return as compensation for bearing this risk.

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Introduction to Financial Systems

• Preferred stocks are equity claims, generally with an infinite life, but they pay a fixed
constant dividend (although this is not guaranteed). They generally do not give voting
rights. In terms of ownership rights they rank above common stockholders in terms of
having a residual claim on assets and income. They are considered to be less risky
than common stocks and therefore generally pay investors a lower return.
• Corporate bonds are debt claims paying a contractual fixed interest payment ZA-2010-1b to
investors. They generally have a finite life. They have no voting rights. They rank above
equity claims in the event of bankruptcy of the firm. A good answer would explain how
the risk of default of a corporate bond relates to the creditworthiness of the issuer as
captured in the issuer’s credit rating. So a large well-run company would have a good
credit rating and therefore pay a lower return on its corporate bonds than a less-well-run
company with a poorer credit rating.
• A satisfactory answer would simply identify the characteristics for the three securities.
Better answers would compare the three securities, from the viewpoint of an investor,
on the basis of these characteristics.

2(a) Compare and contrast the characteristics of preferred stock and corporate bonds
from the perspective of both an investor and a firm issuing such financial claims. (8 marks)
2013-2a-ZAB
• See the subject guide Chapter 2, sections headed `Bonds, notes and bills' and
`Common and preferred stock'.
Approaching the question
Common stock:
• Issuer perspective - Low risk, high cost.
• Investor perspective - High risk, high return.
Corporate bonds:
• Issuer perspective- high risk, low cost.
• Investor perspective - low risk (though depends on credit rating of issuer), low return
(relative to risk of common stock).
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6. (a) Discuss the empirical evidence on the risk-return relationship for the following US
securities: Treasury bills, Treasury bonds, 2014-6a-ZAB
large firm common stocks and small firm common stocks. (8 marks)
See subject guide, Chapter 8, section headed ‘Empirical evidence on risk, return and their
relationship’.
Approaching the question
The first point to explain is why there is a positive relationship between risk and ex-post
return – as an investor requires more compensation for bearing risk as risk increases.
Treasury bills have the lowest risk (short maturity plus low risk of default) and hence lowest
return.
Treasury bonds have the next highest level of risk (longer maturity and therefore price risk
but low default risk).
For large firm common stocks the risk is higher but return is higher. Small firm common
stocks have the highest risk (volatility) but the highest return

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Primary market vs Secondary markets

Financial market consists of (i) primary market and (ii) secondary markets
P_______________ market S___________ markets
For n_______ issued financial securities For resale of issued financial securities
facilitate new financing Facilitate most of the securities trading
Make financial securities more liquid.
Issuer sell the securities Investors sell the securities
e.g. IPO, Right issue

Functions of Financial Markets

 make financial securities more l_________ (i.e. more marketable)
investor prefer more liquid (secondary) market,
easier for the firm to sell the securities in the primary market.
b) they set the price of the securities the firm sells in the primary market.
i.e. securities’ prices issues on the primary markets is partly determined by the
securities’ price traded in the secondary market.

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Introduction to Financial Systems

2008-2a
Q: What is the difference between primary and secondary markets?
What are the main functions of secondary markets? (6 marks)
• refer to p.23 of the subject guide.
• definition of primary and secondary markets. A primary market is a financial market in
which new issues of financial securities (both bonds and stocks) are sold to initial
buyers. A secondary market is one in which securities that have been previously issued
can be resold.
• Primary markets facilitate corporations to acquire new financing, but most of the trading
takes place in the secondary markets. Secondary markets make financial securities
more liquid.
• the improvement in liquidity makes securities more desirable to investors, and thus
easier for the firm to sell them in the primary market. Moreover, secondary markets set
the price of the securities the firm sells in the primary market.

107

1. (a) Distinguish between primary and secondary capital markets.

Discuss the relationship between a primary & secondary capital market. (7 marks)
• refer to p.29 of the subject guide, and to pp.20–21 (sixth edition) of Mishkin and Eakins
Financial markets and institutions. ZA-2010-1a
• A good answer to part (a) would begin by briefly explaining what capital markets are. They
are markets where long-term finance, both debt and equity, is raised. Candidates can then
go on to explain the difference between primary and secondary capital markets. Primary
markets are where new issues of long-term debt and equity securities issued are (i.e. where
new capital is raised). Secondary markets are where the securities issued in the primary
market are subsequently traded. A very good answer would point out that most transactions
occur in the secondary market although the primary market is key to the process of
transferring finds from surplus to deficit units.
• In relation to the second part of the question the secondary markets play an important role
in relation to the primary markets in two respects:
– they provide liquidity making the primary issues more attractive to investors.
– the price determined by trading in the secondary market sets the price for new issues
into the primary market.

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Introduction to Financial Systems

Exchange Market Vs Over-the-counter (OTC)

Financial securities may be traded in the Exchange market or Over-the-counter (OTC)

E market O (OTC)
With central location for securities trading no central location for securities trading
(i.e. buying or selling) Securities are traded by dealers at different
locations.
e.g. NYSE (recently acquired the e.g. US government bond market
LSE & American Stock Exchange (AMEX) e.g. NASDAQ (2nd largest US market)
competitive as dealers use technology to link
prices. Significant in the USA with strict listing
requirement

2(c) Distinguish between exchange traded and over-the-counter markets giving

examples of financial instruments traded in each market. (5 marks)
ZB2013-2c

• See the subject guide, Chapter 2, section on `Exchange and OTC markets'.
Approaching the question
• In exchanges, buyers and sellers (through their brokers) transact in one central location
to conduct trades. Examples are the New York Stock Exchange (NYSE) and the
London Stock Exchange (LSE). Stocks and some derivatives are traded on exchanges.
• In over-the-counter markets, dealers at dierent locations have an inventory of securities,
and are ready to buy and sell these securities `over-the-counter' to anyone willing to
accept their price. Examples of OTC markets are: the US government bond market and
the NASDAQ (National Association of Securities Dealers Automated Quotation System)
stock exchange. Derivatives are mainly traded OTC.

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Introduction to Financial Systems

Money Markets vs Capital Markets

Different types of financial markets, e.g. money market, capital markets, forex market etc.

M_________ Markets C___________ Markets

where s_______-term securities (maturity <1 year) where l_____-term securities (maturity > 1 year)
are issued & traded are issued & traded
For wholesale markets (large size transactions) - provide longer-term (more stable) sources
e.g. treasury bills or certificates of deposit of finance for borrowers
(CD) e.g. government / corporate bonds
equity (infinite life)
Securities are often held by Securities are often held by
firms & financial institutions to manage their financial intermediaries
short-term liquidity needs (e.g. mutual funds, pension funds &
(i.e. to earn interest on temporary surplus insurance companies)
funds).

2008-2b
Q: What is the difference between money markets and capital markets? (4 marks)

• refer to p.24 of the subject guide.

• Illustrate the difference between two types of markets: money markets and capital
markers.
• identify clearly the parameter according to which the distinction can be made − the
maturity of the securities traded.
• characteristics of money and capital markets:
– Money markets are financial markets where only short-term debt instruments
(maturity of less than one year) are traded. Money markets are mainly wholesale
markets (large size transactions) where firms and financial institutions manage their
short-term liquidity needs.
– Capital markets are markets in which long-term securities are traded. Candidates
were also expected to list the types of long term instruments. Capital markets
securities are often held by financial intermediaries, such as mutual funds, pension
funds and insurance companies. 122

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Introduction to Financial Systems

2(b) What is the difference between money markets and capital markets? (4m)
• refer to p.24 of the subject guide. 2008-2b-ZAB
• In a similar way to part (a), part (b) requires candidates to illustrate the difference between
two types of markets: money markets and capital markers.
• The Examiners would expect outstanding answers to identify clearly the parameter according
to which the distinction can be made − the maturity of the securities traded. (1 mark was
awarded for a correct identification of this parameter).
• Candidates should then go on to discuss in detail the characteristics of money and capital
markets:
– Money markets are financial markets where only short-term debt instruments (maturity of
less than one year) are traded. Money markets are mainly wholesale markets (large size
transactions) where firms and financial institutions manage their short-term liquidity needs
(1.5 marks were awarded).
– Capital markets are markets in which long-term securities are traded. Candidates were
also expected to list the types of longterm instruments. Capital markets securities are
often held by financial intermediaries, such as mutual funds, pension funds and insurance
companies (1.5 marks were awarded).

2010-1a
Q: Distinguish between money markets and capital markets
giving examples of financial instruments traded in each market. (5 marks)

• refer to p.30 of the subject guide

• Money markets are markets where debt securities with an original maturity of less than
one year are traded. They are mainly wholesale markets where firms and financial
institutions manage their shortterm finance needs. Examples include the markets for
treasury bills or certificates of deposit.
• Capital markets are markets where long-term securities are issued and traded. These
provide longer-term (more stable) sources of finance for borrowers. Examples include
markets for equity instruments, government bonds and corporate bonds.

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Introduction to Financial Systems

2(c) Distinguish between money markets and capital markets giving examples of
financial instruments traded in each market. (5 marks) ZA2013-2c

• See the subject guide, Chapter 2, section headed `Structure of financial markets'.
Approaching the question
• The distinction between these two kinds of markets is essentially made based on the
maturity of the instrument.
Money markets:
• where short-term debt instruments (maturity of less than one year) are traded mainly
wholesale markets (large transactions)
• where firms and financial institutions manage their short-term liquidity needs.
Capital markets:
• markets in which long-term securities are traded include equity instruments (infinite
life), government bonds and corporate bonds securities are often held by financial
intermediaries, such as mutual funds, pension funds and insurance companies.
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1(b) Compare and contrast the following categories of markets:

ZA-2012-1a
i. Primary and secondary markets
ii. Organised exchanges and Over-the-counter (OTC) markets
iii. Money and capital markets
iv. Order-driven and quote-driven markets (12 marks)
i. Primary and secondary markets
• Primary market is where capital is raised. Secondary market is where securities
created in the primary market are subsequently traded – provides liquidity allowing it
the primary market to operate more efficiently. (3 marks)

ii. Organised markets and OTC markets

• Organised exchanges – more rules governing trading. In exchanges, buyers and
sellers (through their brokers) transact in one central location to conduct trades.
• OTC – fewer rules. dealers at different locations have an inventory of securities, and
are ready to buy and sell these securities ‘over-thecounter’ to anyone willing to
accept their price. Dealers are typically banks. (3 marks)

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Introduction to Financial Systems

iii. Money and capital markets

• Money markets are financial markets where only short-term debt instruments (maturity of
less than one year) are traded. Money markets are mainly wholesale markets (large
transactions) where firms and financial institutions manage their short-term liquidity needs
(i.e. to earn interest on their temporary surplus funds).
• Capital markets are markets in which long-term securities are traded.
• These long-term instruments include equity instruments (infinite life), government bonds and
corporate bonds (original maturity of 1 year or greater). (3 marks)

iv. Order-driven and quote driven markets

• Quote-driven dealer markets, a dealer or market-maker is on one side of every trade. (Note
that dealers are also known as market makers, as they quote prices and stand ready to buy
and sell at these quotes, so that they provide liquidity).
• Order-driven markets are where buyers and sellers trade directly without any intermediation.
Most order-driven markets are auction markets. Most trading takes place through electronic
order matching.(3 marks)

Brokered Markets vs Quote-driven Dealer Markets vs Order-driven Markets &

B_________ markets Quote-driven D_______ markets Order-driven markets
brokers match the b____ & s______. a dealer (= market-maker) buyers & sellers trade directly
is on one side of every trade. without any intermediation.
brokers find liquidity but dealer quotes prices & ready to Trading rules formalise the
buy & sell at these quotes process where
do not provide liquidity dealer provide liquidity.
brokers do not hold securities Dealers hold security, buyers seek the lowest prices&
as they do not trade themselves. which fluctuates as they trade. sellers seek the highest prices
(p______ d________process).
important for large blocks of stocks & Dealer profit from Mostly auction markets.
bonds charging a bid-ask spread &
from speculating.

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