Deck 1: Overview of the Financial System

Question 1

Debt is often referred to as 'risk capital' because debt holders only have a residual claim on the firm's earnings.

Answer 1

False

Question 2

The risk that the value of bonds falls because of an unexpected increase in interest rates is known as default risk.

Answer 2

False

Question 3

According to Merton (1995), financial systems perform three functions.These are the settlement function, the flow of funds function and the risk-transfer function.

Answer 3

False

Question 4

Moral hazard problems arise in the financial system because people are fundamentally dishonest.

Question 5

Securities are financial contracts that are used by deficit units to raise funds and by surplus units for investment.

Question 6

Australia went through a process of increasing regulations on the financial system in the 1980s.

Question 7

The size of risk premiums will change over time.

Question 8

Derivative contracts can be used to both increase and decrease exposure to risk.

Question 9

The risk associated with an unsecured loan is greater than the risk associated with an otherwise identical secured loan.

Question 10

The pooling of funds is required because surplus units typically prefer short-term contracts for small amounts whereas deficit units commonly require large amounts for long periods.

Question 11

Risk-averse investors will always choose low risk and return investments.

Question 12

Firms and the government are the largest sources of finance in the Australian financial system.

Question 13

The term 'flow of funds' refers to the exchange of value required to settle commercial transactions.

Question 14

Equity is considered riskier than debt because the returns to its suppliers are non-enforceable.

Question 15

The flow of funds is arranged directly when funds are deposited with banks, and indirectly when funds are invested in securities.

Question 16

Information asymmetry arises where a contract distorts incentives to behave appropriately.

Question 17

The returns earned from supplying funds include interest, dividends and the potential for capital gains.

Question 18

A financial crisis can be triggered when people lose 'trust' or confidence that their financial dealings will be honoured.

Question 19

Leveraged investments always produce better returns than unlevered investments.

Question 20

Transactions are settled by the exchange of money from the buyer to the seller.

Question 21

'Sub-prime' lending refers to loans where the borrower does not meet the normal loan requirements, such as having the capacity to make repayments.

Question 22

The GFC saw the mortgage-backed securities market collapse because of the loss of investor confidence.

Question 23

The money market trades discount securities.

Question 24

Monetary policy is one tool used by the RBA to enhance financial system stability.

Question 25

The improvement in 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.

Question 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.

Question 27

The Australian payments system is overseen by the RBA.

Question 28

Financial institutions are supervised by the RBA.

Question 29

ADIs are institutions that are authorised to provide traditional banking services.

Question 30

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 these.

Question 31

Australia has four financial markets that perform the flow-of-funds function - the money market, the bond market, the share market and the foreign exchange market.

Question 32

Bailouts of loss-making financial institutions pose incentive problems and moral hazards.

Question 33

Investors in mortgage-backed securities used to finance sub-prime loans were well aware of the risks involved.

Question 34

The Reserve Bank of Australia (RBA)controls Australia's financial system.

Question 35

The sub-prime crisis became a financial crisis because of the collapse of the payment system.

Question 36

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 promote the pooling of funds
E)to provide ways of dealing with the incentive problems that arise in financial contracting.

Question 37

Choose the best definition of 'money' from the following:

A)the arrangements that can be used to settle commercial transactions
B)cash
C)the instruments that can be used as a means of exchange
D)the supply of funds from surplus units for use by deficit units.
E)None of these.

Question 38

Superannuation funds provide indirect financing because they collect contributions from workers and arrange the investment of these funds.

Question 39

According to Merton (1995), financial systems perform six functions.The flow-of-funds function is:

A)to provide the means for the settlement of commercial transactions
B)the exchange of funds for a period requiring the user to compensate the supplier for the use of their funds
C)to provide ways for participants in the financial system to transfer and manage risk
D)to overcome information asymmetry
E)to provide ways of dealing with the incentive problems that arise in financial contracting.

Question 40

APRA enforces company and financial services laws to protect consumers, investors and creditors.

Question 41

Which of the following is NOT an advantage for a firm of using equity rather than debt financing?

A)Lower cost.
B)Lower risk of insolvency.
C)Lower funding risks.
D)No legal liability to pay dividends.
E)No requirement to repay capital.

Question 42

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.

Question 43

According to Merton (1995), financial systems perform six functions.The function that employs the use of derivatives is:

A)the settlement function
B)the flow of funds function
C)the risk-transfer function
D)to resolve incentive problem
E)to promote the pooling of funds.

Question 44

The expected return on an investment:

A)will be negatively related to the risk of the investment
B)will increase when risk-free rate increases, all else being equal
C)is the difference between r _risk-free and r _{risk premium}
D)Includes interest and dividends, but not capital gains or losses.
E)All of these.

Question 45

Of the following, which is NOT a feature of debt?

A)Interest payments.
B)Maturity date.
C)Dividends.
D)Security arrangements.
E)Risk premiums.

Question 46

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 these.

Question 47

Which of the following categories 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.

Question 48

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)Governments are a source of savings when they have budget surpluses.
D)Firms are a source of savings when they retain earnings.
E)All of these.

Question 49

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 in the money market 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.

Question 50

When lenders/investors become very confident, the risk-return function will:

A)shift upwards
B)shift downwards
C)be relatively steep
D)be relatively flat.
E)None of these.

Question 51

In the Australian 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.

Question 52

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
D)the Australian Treasury
E)the Council of Financial Regulators.

Question 53

Which of the following categories of institutions accept deposits from, make loans to and provide payment services for Australian households?

A)ADIs.
B)Wholesale banks.
C)Investment banks.
D)Insurance companies.
E)Fund managers.

Question 54

The 'big four' (Westpac, Commonwealth bank, NAB and ANZ)are BEST described as:

A)retail banks
B)financial conglomerates
C)wholesale banks
D)investment banks
E)superannuation schemes.

Question 55

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.

Question 56

Debt financing can be raised by firms in the __________________________markets.

A)money and share
B)bond and FX
C)share and derivative
D)money and bond
E)share and FX

Question 57

Our study of information asymmetry revealed:

A)It is where one party to a potential contract has an information advantage over the other party.
B)The markets assume professional traders are well informed.
C)Retail investors must be supplied with relevant information to enable a well-informed decision.
D)It can result in contracts that are not mutually beneficial at the expense of the less informed party.
E)All of these.

Question 58

The textbook's coverage of leverage explained its use will:

A)increase the expected return on equity but not the risk of these returns
B)reduce the risk but not the expected return on equity
C)increase the return on equity as long as the return on assets is less than the cost of debt
D)reduce the risk of bankruptcy.
E)None of these.

Question 59

A situation where a contract distorts incentives to behave responsibly is known as:

A)information asymmetry
B)coincidence of wants
C)pooling of funds
D)moral hazard.
E)None of these.

Question 60

In reference to the flow of funds from surplus to deficit units, deficit units generally prefer:

A)high interest rates
B)small amounts
C)contracts with long periods
D)All of these.
E)None of these.

Question 61

Identify the six functions performed by the financial system.

Question 62

Which institutions took advantage of information asymmetry in the sale of sub-prime loans to investors in mortgage-backed securities?

A)The ratings agencies.
B)The Wall Street investment banks.
C)The Federal Reserve.
D)AIG (America's largest insurer).
E)None of these.

Question 63

How do the Australian financial markets address the problem of asymmetric information?

Question 64

The securitisation of 'sub-prime' loans meant they were sold to investors in:

A)mortgage-backed securities
B)mortgage-related securities
C)the share market
D)credit-default swaps
E)the money market.

Question 65

Why are financial systems susceptible to crisis?

Question 66

The GFC:

A)prompted a 'flight to quality' that pushed up the interest rate on government securities
B)caused a sharp contraction in lending that prevented many firms from being able to refinance their maturing debt
C)prompted the US government to 'bail-out' financial institutions, including Lehman Brothers
D)reinforced the view that markets are 'self-correcting'
E)lead to widespread failures of financial institutions in Australia.

Question 67

Which contracts can be used to manage financial risks?

Question 68

Explain the difference between direct and indirect financing.

Question 69

What are securities?

Question 70

Provide a summary of the main features of debt.

Question 71

The boom in 'sub-prime' lending (which was the source of the GFC)was motivated by the:

A)desire to help low-income minority groups
B)belief that the repayment capacity of borrowers had been misrepresented
C)desire for high risk and return investments
D)belief that housing prices would always rise
E)provision of subsidies by the US government.

Question 72

Discuss the relative risks of debt and equity from the perspective of
(i)an investor supplying funds to a firm, and (ii)the firm itself.

Question 73

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.

Question 74

Explain the principal source of funds to the Australian financial system and the returns to investors from supplying funds.

Question 75

Define leverage and briefly explain the risks posed by it.

Question 76

Explain why equity is a more expensive source of funds for a firm.

Question 77

Describe the rights of shareholders in a large company.

Question 78

Mortgage-related securities:

A)are securities whose value depends on the value of mortgage-backed securities
B)came to be known as 'toxic securities'
C)were erroneously rated as being safe ('AAA')by the ratings agencies
D)magnified the impact of defaulting sub-prime loans throughout the US financial system.
E)All of these.

Question 79

Explain the term 'financial innovation'.

Question 80

Tom and Ben both intend to invest $50,000 (that they have each received from an inheritance)in Macquarie Group shares that are currently trading at $50 per share.Tom prefers an unlevered investment, whereas Ben decides to borrow a further $50,000 at 10% pa so that he can initially purchase $100,000 in shares.Compare the potential returns and risks for a one year investment (ignoring transaction costs and taxes)for two investors assuming firstly, the share price increases from $50 to $60, and secondly, the share price falls from $50 to $40.