Financial Markets, Institutions and Money

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Questions and Problems: 1.1 Explain the key roles of the financial system. Why is it so important to the broader economy to have an efficient and effective financial system? The role of the financial system is to gather money from the suppliers of funds (SSUs) and transfer it to the demanders of funds (DSUs) in the most efficient manner possible. When the financial system is efficient and effective, the greater the results in regards to the ability of businesspeople to invest in their firms, and the flow of individual preferences for current spending and saving. 1.4 Compare and contrast debt and equity as a source of funds for financial claims. Financial claims: written promises to pay a specific sum of money (the principal) plus interest for the privilege of borrowing money over a period of time. Financial claims are issued by DSUs (liabilities) and purchased by SSUs (assets). Debt Funds: Equity Funds: Funds supplied in the form of a loan.  Classified into short-term or long-term facilities  Short-term = money  Long-term = capital  Suppliers of loans or debt funds face credit risk  Credit risk: the risk the borrower won’t pay back loan Funds supplied in the form of the acquisition of an ownership share of a business.  Longer-term  Referred to as capital investment  Equity investors face investment risks, but are compensated with dividend payments and capital growth (increase in ownership shares over time)  Investment risk: the possibility that the investor’s return will not be realised 1.5 What are some problems with direct financing that make indirect financing more attractive? Direct financing: financing in which DSUs issue financial claims on themselves and sell them for money directly to SSUs. The SSU’s claim is against the DSU, not a financial intermediary. Some problems with direct financing include the denominations of the

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