Financial Markets and Institutions Chapter 1 Quiz

Lectures in Financial Markets and Institutions

• Course offered by Dr. Wessam Mohsen Abdel Aziz
• Academic year: 2024-2025
• Business Administration Section

Chapter 1: Introduction to Financial Markets and Institutions

• Objectives: Students will be able to understand the financial system concept, determine the functions of the financial system, identify major players, differentiate between financial markets and institutions, and understand risks faced by financial institutions.

• Financial System: An intermediary facilitating funds flow from surplus to deficit parties. Scarcity of economic resources drives economic system development.

• Functions of Financial Systems:

  • Efficient/effective distribution of economic resources to achieve economic growth
  • Achieving higher returns on investment (ROI) for investors

• Basic Players: Individuals, corporations, government, central bank, financial markets and institutions (the cornerstone of the financial system).

The Basic Players

• Individuals: Act as suppliers or borrowers of funds.
• Corporations: Act as suppliers or borrowers of funds.
• Government: Can act as a supplier or borrower of funds. Sets rules and regulations for financial system activities.
• Central Bank: Represents the regulatory authority for national monetary policy. Controls money supply, stabilizes currency valuation, influences interest rates, and acts as a lender of last resort to commercial banks.
• Financial Markets and Institutions: Vital for funds flow and risk management (cornerstone of the financial system).

Financial Markets

• Definition: Markets where financial assets are traded.

• Role: Provide a platform for buyers and sellers of financial assets (buy and sell).

• Assets: Intangible assets representing claims to future income (dividends, capital gains, interest payments, principal).

  • Examples: Bank loans, Government bonds, Corporate bonds, Municipal bonds, Foreign bonds, Common stocks, Preferred stocks and Foreign Stocks

• Functions:

  • Determine financial asset prices
  • Provide liquidity (ease of converting to cash)
  • Reduce transaction costs

• Classification: Debt vs. equity markets, Primary vs. secondary markets, Money vs. capital markets, Foreign exchange markets.

1- Debt Market Vs Equity Market

• Debt Market: Where debt/loan instruments are traded and bought/sold. Bonds (issued by governments and corporations) are common instruments and offer fixed periodic payments (interest).
• Equity Market (Stock Market): Often termed as the stock market for its association with common and preferred stocks, that provide variable returns linked to corporate income streams.

2- Primary Vs Secondary Markets

• Primary Market: Where newly issued securities are sold to initial investors.
• Secondary Market: Where existing securities are traded among investors. U.S. primary markets rely on investment bankers.
• Example of secondary markets (as presented in the context): NYSE, AMEX, EGX

3- Money Market Vs Capital Market

• Money Market is for short-term debt instruments. (NCDs, T-Bills – Over The Counter Market (OTC) , Direct exchange between buyer and seller).
• Capital Market is for long-term debt and equity instruments (bonds and stocks). Interest rate changes affect capital market instruments more than short term.

4- Foreign Exchange Markets

• Definition: Markets for exchanging one currency for another ("FX" or "Forex"). Currencies are traded in pairs.
• Structure: Over-the-counter market, crucial for global trade.
• Participants: Central banks, commercial banks and forex dealers.
• Foreign Exchange Rate Risk: Risk in investment due to currency value fluctuations. Currency value tied to free versus fixed float systems.
• Spot FX Transactions: Immediate currency exchange at current rates.
• Forward FX Transactions: Currency exchange at a future date and predetermined rate.

Financial Institutions

• Role: Channels for funds moving from surplus to shortage entities. Funds movers, bridging borrowers and investors.
• Types:
  • Commercial banks
  • Thrifts (savings associations, credit unions)
  • Finance companies
  • Insurance companies
  • Securities firms
  • Mutual funds
  • Pension funds

Risks Faced by Financial Institutions

• Types: Interest rate risk, foreign exchange risk, market risk, credit risk, off-balance sheet risk, technology risk, operational risk, country/sovereign risk, insolvency risk, liquidity risk
• Interest rate risk: Risk due to changes in interest rates affecting asset values/earnings. Increased interest rates impact profitability (higher funding costs limit borrowing and hurt profits). Decrease will encourage borrowing.
• Foreign exchange risk: Risk from fluctuations in currency exchange rates. Impacting assets/liabilities for businesses operating internationally
• Market risk: Risk from unpredictability of equity, commodity, and interest rate markets. Fluctuations on commodities influence investment returns negatively.
• Credit risk: Risks of loan defaults impacting income/profitability for lenders. Loan portfolio diversification/credit history checks limit credit risk.
• Off-balance sheet risk: Risk associated with contingent assets/liabilities not shown on balance sheet. Securitized loans excluded to be considered assets of the bank may affect profitability.
• Technology risk: Risks associated with technological investments not meeting the expected benefits.
• Operational risk: Losses through human error, process failures, or systemic interruptions.
• Country/sovereign risk: Risk of payment problems due to political/economic instability in foreign countries.
• Insolvency risk: Risk of being unable to meet financial obligations.
• Liquidity risk: Risk of being unable to convert assets into cash quickly enough to meet liabilities.