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Applied Foundations of Finance (FINM7006)

Tutorial 1 Solutions

Question One

What is the primary role of financial markets?

The primary role of financial markets is to bring together lenders and borrowers. 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).

Question Two

What are the three principal sets of players that interact in the financial markets?

Borrowers need money to help finance some specific purpose—a student loan to help pay for university fees, a car loan, or a mortgage for a house. Savers have money that they don’t need for consumption today, so they set this money aside to use in the future. Financial intermediaries bring the two together, channelling the savers’ ‘extra’ money to the borrowers for their immediate use. If the borrowers and savers could get together themselves somehow, they could ‘cut out the middleman’ and save the intermediation costs.  

This might sound good—but is it feasible? Financial intermediaries specialise in evaluating the creditworthiness of borrowers, so they help ensure that savers’ money is channelled to borrowers who will repay. They also enable the efficient aggregation of small amounts of individual savings into blocks of loanable funds large enough to be useful to borrowers.

Question Three

What is a financial intermediary? List and describe the principal types of financial intermediaries in the Australian financial markets.

A financial intermediary is a firm that collects money from savers, bundles it into attractive sizes with attractive terms, and lends it to borrowers. The principal types of financial intermediaries in Australia are commercial banks, non-bank financial intermediaries and investment companies.

Commercial banks are depository institutions that take deposits and make loans (such as mortgage loans or car loans). Commercial banks are an integral part of our national payment system. Their importance to the functioning of our economy has led to their being heavily regulated and subject to extensive oversight by the Reserve Bank of Australia (RBA) and the Australian Prudential Regulation Authority (APRA).

In addition to commercial banks, non-bank financial intermediaries are highly specialised financial intermediaries that also provide financial services to consumers and businesses.

Building societies and credit unions are mutual organisations owned by their members. They provide similar financial services to banks, taking deposits and providing mortgage loans and personal loans. Banks, building societies and credit unions are collectively referred to Authorised Deposit-taking Institutions (ADIs).

Money market corporations tend to operate in wholesale—rather than retail— markets, providing services to businesses and government agencies. They provide a range of financial services, including deposits, loans and advisory services to client firms when they enter into major transactions such as buying or merging with other firms.  

Finance companies provide loans to householders and small businesses. Money market corporations and finance companies are collectively referred to as Registered Financial Corporations (RFCs).

Insurance companies (including general insurance and life insurance companies) are by definition in the business of selling insurance to individuals and businesses to protect their investments. This means they collect premiums, hold the premiums in reserves until there is an insured loss, and then pay out claims to the holders of the insurance contracts. Note that in the course of collecting and holding premiums, the insurance companies build up huge pools of reserves to pay these claims. These reserves are then used in various types of investments, including loans to individuals and businesses.

Superannuation is designed to provide funds for retirement. Successive Australian governments have taken steps to encourage Australians to save for their retirement, in order to reduce the threat to the sustainability of the aged pension posed by our ageing population. As a result of these developments, the assets controlled by superannuation funds have grown enormously. There is now almost $2 trillion in superannuation funds, and this money all needs to be invested in debt, equity and property in order to yield a satisfactory return.

Investment companies are financial institutions that pool the savings of individuals and invest the money, purely for investment purposes, in the securities issued by other companies.

A managed fund is a special type of intermediary through which individuals can invest in virtually all of the securities offered in the financial markets. Managed funds typically focus on a particular type of investment, such as cash, debt securities, domestic and international shares, and property. When individuals invest in a manage fund, they receive shares (or ‘units’) in a fund that is professionally managed according to a stated investment objective or goal—for example, investing only in international stocks. Shares in the managed fund grant ownership claim to a proportion of the managed fund’s portfolio.

Unlisted managed funds can be ‘open’ or ‘closed’. Additional units in an open fund can be created and issued based on demand, whereas the number of units in a closed fund is fixed. Managed funds that are listed on the stock exchange are referred to as exchange-traded products (ETPs), and are generally closed funds. A significant component of these ETPs are referred to as exchange-traded funds (ETFs), which seek to track an index, such as the S&P/ASX 200, and generally have relatively low expenses.

A hedge fund is very much like a managed fund, but hedge funds are less regulated and tend to take more risk. They also tend to more actively influence the managers of the corporations that they invest in.

A private equity firm is a financial intermediary that invests in equities that are not traded on the public capital markets. Two types of private equity firms dominate this group: venture capital (VC) firms and leveraged buyout (LBO) firms. Venture capital firms raise money from investors (wealthy people and other financial institutions), which they then use to provide financing for private start-up companies when they are first founded.

The second major category of private equity firms is the leveraged buyout fund. These funds acquire established firms that typically have not been performing very well, with the objective of making them profitable again and then selling them. LBO funds have been the subject of a number of films, including Barbarians at the Gate, Other People’s Money and Wall Street.

Question Four

Describe the flow of funds within the financial system.

Lenders loan funds that are excess to their consumption 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 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:

Question Five

Describe the difference between the primary and the secondary market.

The primary market is the market for newly issued securities. In this market, the issuer (e.g. a corporation) creates a new financial asset and sells it to an investor. It does this to raise money to finance a new project. The asset it creates can be either a debt security (like a bond), or an equity security (like a new share). Every asset must trade in the primary market once (and only once), because every asset must be ‘born’. The primary market transaction is the only point at which the issuer receives cash for the security.  

The secondary market is the market for investor-to-investor trading. The markets that we hear about every day—the Australian Securities Exchange (ASX) and New York Stock Exchange (NYSE or ‘Wall Street’)—are secondary markets. Secondary markets allow investors to trade out of securities that they have purchased (or to buy new ones); that is, they provide liquidity. Investors are more willing to buy securities in the first place if they know they can sell them easily. Thus, securities are more attractive to investors—and therefore are less costly to issuers—if they are backed by a large, liquid secondary market.

Assets may trade many times in the secondary market (think of the number of times a BHP share could change hands on the ASX), or they may never trade there at all (for example, a bond may be held to maturity by its initial investor).

Question Six

Discuss the main differences between money markets and capital markets. Describe these markets and name some instruments that are traded on these markets.

The term money markets encompasses all markets where instruments that mature in 1 year or less are traded. These include Treasury Notes and Bank Accepted Bills that have maturities of less than year. Conversely, the term capital markets is used to describe all 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 Seven

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.

Question Eight

To what amount will the following investments accumulate?

a) $5000 invested for 10 years at 10% compounded annually;

b) $8000 invested for 7 years at 8% compounded annually;

c) $775 invested for 12 years at 12% compounded annually; and,

d) $21000 invested for 5 years at 5% compounded annually.

Question Nine

If you deposit $10000 today into an account earning an 11% annual rate of return, in the third year how much interest would be earned? How much of the total is simple interest and how much results from compounding of interest?

The simple interest each year is $1100, so the additional interest resulting from the compounding of interest is equal to $1355.31 – $1100 = $255.51.

Question Ten

What is the present value of the following future amounts?

a) $800 to be received 10 years from now discounted to the present at 10%;

b) $300 to be received five years from now discounted to the present at 5%;

c) $1000 to be received eight years from now discounted to the present at 3%; and,

d) $1000 to be received eight years from now discounted to the present at 20%.