1: Overview of Financial Systems

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Questions and Answers

What is the purpose of financial markets, financial institutions, and money?

They affect everyday life and the flow of funds throughout the economy, affecting business profits, the production of goods and services, and even the economic well-being of countries.

The primary function of financial intermediaries is to bridge the gap between individuals who need funding and those who have surplus funds.

True (A)

What are the six main components of a financial system?

  • Savings, investing, lending, borrowing, insurance, and retirement planning
  • Loans, stocks, bonds, mutual funds, insurance companies, and investment banks
  • Banking, non-banking institutions, intermediaries, non-intermediaries, money markets, and equity markets
  • Money, financial instruments, financial institutions, financial markets, government regulatory agencies, and central banks (correct)

How does a financial system contribute to economic growth and development?

<p>A developed and efficient financial system is highly beneficial for economic growth and development as it performs several crucial functions, such as mobilizing and allocating resources, reducing transaction costs, and facilitating risk management.</p> Signup and view all the answers

Describe the key functions of financial markets.

<p>Financial markets act as a link between savers and investors, facilitating the allocation of resources from those who have a surplus of funds to those who need them.</p> Signup and view all the answers

Which of the following is NOT a key function of financial markets?

<p>To ensure the stability of government currencies (C)</p> Signup and view all the answers

Explain the difference between primary and secondary capital markets.

<p>The primary market is where new securities are first issued to investors, while the secondary market is where existing securities are traded among investors.</p> Signup and view all the answers

What are three important functions that secondary markets serve?

<p>Facilitate the transfer of risk, create a wealth effect, and enhance liquidity (B)</p> Signup and view all the answers

What is the role of government regulatory agencies in the financial system?

<p>They are responsible for making sure that the elements of the financial system operate in a safe and reliable manner.</p> Signup and view all the answers

What is the role of central banks in the financial system?

<p>Central banks monitor and stabilize the economy.</p> Signup and view all the answers

Which of the following describes the process of financial deepening?

<p>The increase in liquid financial assets as a percentage of GDP (B)</p> Signup and view all the answers

Which of the following describes the process of financial broadening?

<p>The increase in the number of individuals and households participating in the financial system (A)</p> Signup and view all the answers

Financial markets are essential for producing an efficient allocation of capital.

<p>True (A)</p> Signup and view all the answers

What is the difference between direct and indirect finance?

<p>In direct finance, borrowers borrow funds directly from lenders in the financial markets, while in indirect finance, financial intermediaries, such as banks, intervene in the process.</p> Signup and view all the answers

What are the two key categories by which financial markets are defined?

<p>Financial markets are defined by the maturity of the securities traded: money markets for short-term instruments and capital markets for long-term instruments.</p> Signup and view all the answers

What is the primary function of the money market?

<p>To provide a balancing mechanism to even out the demand for and supply of short-term funds.</p> Signup and view all the answers

What is the primary function of the capital market?

<p>To facilitate economic growth through the issue of primary and secondary securities and the transaction of outstanding securities, which facilitates liquidity.</p> Signup and view all the answers

Which of the following is NOT a characteristic of money market instruments?

<p>High risk (D)</p> Signup and view all the answers

Which of the following is NOT a characteristic of capital market instruments?

<p>Typically issued at a premium to their face value (A)</p> Signup and view all the answers

Which of the following is NOT a type of capital market instrument?

<p>Treasury Bills (C)</p> Signup and view all the answers

The primary market for securities is typically well-known to the public.

<p>False (B)</p> Signup and view all the answers

What is the primary function of an investment bank?

<p>Investment banks help corporations issue securities by underwriting them, guaranteeing a price, and selling them to the public.</p> Signup and view all the answers

What are the three main functions of financial instruments?

<p>Financial instruments serve as a means of payment, a store of value, and a mechanism for transferring risk.</p> Signup and view all the answers

What are some of the key characteristics of financial instruments?

<p>Key characteristics of financial instruments include liquidity, transaction costs, risk of default, maturity, tax status, volatility, and rate of return.</p> Signup and view all the answers

Treasury Bills are typically issued by the central bank to finance short-term financial requirements.

<p>True (A)</p> Signup and view all the answers

What are the main advantages of Treasury Bills?

<p>Treasury Bills are highly liquid, negotiable, offer a risk-free investment, provide a reasonable yield, and are eligible for inclusion in securities for SLR.</p> Signup and view all the answers

Who are eligible to bid and purchase Treasury Bills?

<p>Banks, financial institutions, corporate bodies, mutual funds, foreign institutional investors, state governments, provident funds, primary dealers, and foreign banks (C)</p> Signup and view all the answers

Treasury Bills are always issued at a premium to their face value.

<p>False (B)</p> Signup and view all the answers

Which type of auction is used for Treasury Bills when all bids equal to or above the cut-off price are accepted and the bidders pay a uniform price as decided by the central bank?

<p>Dutch auction (D)</p> Signup and view all the answers

Retail investors are only allowed to participate in non-competitive bids for dated Government of India securities and Treasury Bills.

<p>True (A)</p> Signup and view all the answers

What is the purpose of cash management bills?

<p>Cash management bills are short-term instruments, similar to T-bills, but issued for maturities less than 91 days.</p> Signup and view all the answers

What is the primary function of the call money market?

<p>The call money market is a market for very short-term funds, typically repayable on demand with a maturity period varying between one day to 14 days.</p> Signup and view all the answers

What are the key characteristics of call money in the call money market?

<p>Call money is unsecured, highly risky, and volatile.</p> Signup and view all the answers

Who are allowed to participate in the call money market?

<p>Scheduled commercial banks, cooperative banks, and primary dealers are allowed to both lend and borrow in the call money market.</p> Signup and view all the answers

What is the role of a primary dealer in the Indian money market?

<p>Primary dealers are authorized to purchase government securities directly from the central bank and resell them in the securities market.</p> Signup and view all the answers

What is the purpose of collateralized borrowing and lending obligations (CBLOs)?

<p>CBLOs provide liquidity to entities that are restricted from accessing the call money market due to certain restrictions.</p> Signup and view all the answers

Who are eligible for CBLO memberships?

<p>Nationalized banks, private banks, foreign banks, cooperative banks, financial institutions, insurance companies, mutual funds, primary dealers, and bank cum primary dealers (D)</p> Signup and view all the answers

What are commercial papers?

<p>Commercial papers are unsecured, negotiable, and transferable promissory notes with a fixed maturity period, typically issued by creditworthy companies and financial institutions.</p> Signup and view all the answers

Commercial papers are typically issued at par with their face value.

<p>False (B)</p> Signup and view all the answers

What is a commercial bill?

<p>A commercial bill is a short-term, negotiable, self-liquidating instrument used to finance trade transactions.</p> Signup and view all the answers

What are the two types of commercial bills based on payment terms?

<p>Commercial bills are either demand bills, payable on demand, or usance bills, payable at a future date.</p> Signup and view all the answers

What is a certificate of deposit?

<p>A certificate of deposit is a debt instrument issued by a bank to depositors that pays annual interest and at maturity pays back the original purchase price.</p> Signup and view all the answers

Certificates of deposit are typically issued at a premium to their face value.

<p>False (B)</p> Signup and view all the answers

When do banks typically issue certificates of deposit?

<p>Banks often issue certificates of deposit during periods of tight liquidity when deposit rates are low, but credit rates are high.</p> Signup and view all the answers

The total value of stocks traded in India exceeded 72.81 percent of its GDP in 2020.

<p>True (A)</p> Signup and view all the answers

What is the primary purpose of mortgages?

<p>Mortgages are loans to households or firms to purchase housing, land, or other real structures.</p> Signup and view all the answers

What is the primary purpose of mortgage-backed securities?

<p>Mortgage-backed securities bundle individual mortgages, whose interest and principal payments are collectively paid to the holder of the security.</p> Signup and view all the answers

What is the primary purpose of corporate bonds?

<p>Corporate bonds are long-term debt instruments issued by corporations to raise capital.</p> Signup and view all the answers

What is a government security?

<p>A government security acknowledges the government's debt obligation and is a tradable instrument issued by the central or state government.</p> Signup and view all the answers

Government securities are typically issued with short-term maturities.

<p>False (B)</p> Signup and view all the answers

What is the difference between government treasury bills and government bonds?

<p>Treasury bills are short-term debt instruments issued by the central bank to finance short-term financial requirements, while government bonds are long-term debt instruments issued by the central or state government to finance long-term projects and initiatives.</p> Signup and view all the answers

What are the two main types of government bonds based on their coupon rates?

<p>Government bonds can be either fixed rate bonds, with a coupon rate that remains constant throughout the life of the bond, or floating rate bonds, where the coupon rate is adjusted at regular intervals during the life of the bond.</p> Signup and view all the answers

What are zero coupon bonds?

<p>Zero coupon bonds are bonds with no coupon payments, issued at a discount to their face value and redeemed at par upon maturity.</p> Signup and view all the answers

What is the primary purpose of capital indexed bonds?

<p>Capital indexed bonds protect investors by linking the principal amount to an accepted index of inflation, safeguarding investors against inflation-related losses.</p> Signup and view all the answers

What are the two main types of inflation indexed bonds based on the index used for inflation protection?

<p>Inflation indexed bonds can be linked to either the Wholesale Price Index or the Consumer Price Index, offering investors various choices based on their investment goals and risk appetite.</p> Signup and view all the answers

What are bonds with call and put options?

<p>Bonds with call and put options provide either the issuer or the investor with the right to buy back or sell the bond at a predetermined price during the currency of the bond.</p> Signup and view all the answers

What are special securities issued by the government?

<p>Special securities are issued by the government to entities like oil marketing companies, fertilizer companies, and the food corporation of India as compensation for subsidies or other specific needs.</p> Signup and view all the answers

What are government bank recapitalisation bonds?

<p>These securities were issued by the government to specific public sector banks in 2018 to provide financial support and are not eligible for investment in pursuance of statutory provisions.</p> Signup and view all the answers

What are STRIPS?

<p>STRIPS are created by separating the cash flows associated with a regular government security into separate securities, representing future interest and principal payments.</p> Signup and view all the answers

What are sovereign gold bonds?

<p>Sovereign gold bonds are unique securities issued by the government, linked to the price of gold, and are budgeted in lieu of market borrowing.</p> Signup and view all the answers

Sovereign gold bonds are taxable upon maturity.

<p>False (B)</p> Signup and view all the answers

What are state and local government bonds?

<p>These bonds are long-term debt instruments issued by state and local governments to finance infrastructure projects, such as schools, roads, and other public works.</p> Signup and view all the answers

Interest income from state and local government bonds in the United States is exempt from federal and state taxes.

<p>True (A)</p> Signup and view all the answers

What is the name of the market in India where bonds issued by state governments are raised?

<p>State Development Loans (SDLs) are the market in India where bonds issued by state governments are raised.</p> Signup and view all the answers

Flashcards

Financial Markets

Platforms where funds are transferred between those with surplus and shortage of funds. Examples include bond and stock markets.

Financial System

A network of financial markets and institutions that facilitates the flow of funds from savers to borrowers.

Financial Institutions

Organizations like banks, insurance companies, and mutual funds that facilitate financial transactions.

Economic Efficiency

The ability to allocate resources effectively to maximize production and benefits.

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Financial Instruments

Contracts that represent rights and obligations, involving money. Examples include stocks and bonds.

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Economic Growth

A sustained increase in the production of goods and services in an economy.

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Rate Cut (RBI)

A decision by the Reserve Bank of India to lower interest rates.

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Transaction Costs

Expenses incurred in exchanging goods or services.

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Project Monitoring

Tracking the progress and performance of a project.

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Payment and Settlement

The process of exchanging money for goods/services or transferring funds.

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Risk Allocation

Distributing risk effectively across various investments/activities.

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Information Asymmetry

When one party in a transaction has more information than the other.

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Portfolio Adjustment

Changing investments in a portfolio to meet specific needs or goals.

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Financial Deepening

Increase in financial assets as a percentage of GDP.

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Financial Broadening

Increase in participants and instruments in the financial system.

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Savers

Individuals or entities with surplus funds to invest.

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Investors

Individuals or entities seeking to invest available funds.

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Bond Market

Market for buying and selling bonds.

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Stock Market

Market for buying and selling stocks.

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Foreign Exchange

Market for trading currencies.

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Automobile Loan

Loan for purchasing an automobile.

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House Affordability

Measure of how easy or difficult it is to purchase a home.

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Corporate Performance

Measures of success of a corporation.

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Bankruptcy

Legal process where a company is declared unable to pay its debts.

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Takeover

Acquisition of one company by another.

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Study Notes

Overview of Financial Systems

  • Financial systems are crucial for economic efficiency, channeling funds from those without productive use to those who do.
  • Well-functioning financial markets are key indicators of economic growth and stability.
  • Financial markets and institutions significantly impact personal wealth, business behavior, and overall economic cycles.
  • Financial systems facilitate efficient allocation of capital, reduce transaction costs, and improve payment mechanisms.
  • Financial institutions mobilize savings for investment and provide various financial services.
  • They include banks, insurance companies, and mutual funds.
  • Understanding the functions of financial systems is essential for understanding economic issues and impacts on business and personal finance.

Functions of Financial Systems

  • Financial systems act as a link between savers and investors.
  • They help to allocate resources efficiently.
  • They monitor project performance.
  • They ensure efficient payment systems.
  • They effectively manage risk allocation.
  • Financial systems help to disseminate price-related information to assist investors.
  • Financial systems facilitate portfolio adjustment.
  • They help in financial deepening and broadening.

Components of a Financial System

  • Financial markets, financial institutions, government regulatory agencies, money, financial instruments and central banks.
  • Money is used for transactions and wealth storage.
  • Financial instruments transfer resources from savers to investors.
  • Financial institutions offer numerous services including access to financial markets and assessing creditworthiness.
  • Government regulatory agencies ensure the safety and smooth operation of the financial system.

Financial Markets

  • Markets where financial instruments are traded.
  • They facilitate the flow of funds from surplus to deficit entities.
  • They include money markets (short term) and capital markets (longer term).
  • Money markets facilitate short-term debt transactions.
  • Capital markets facilitate debt and equity instruments trade.
  • Secondary markets allow existing securities to be traded.

Financial Institutions

  • Institutions that act as intermediaries in financial markets.
  • They mobilize savings (collect funds), make loans (lend funds), and offer various financial services.
  • Depository institutions, contractual savings institutions, and investment banks.
  • They play a vital role in the efficient functioning of the overall financial system.

Financial Instruments

  • Documents or contracts representing value or obligations.
  • They include bonds, stocks, mortgages, insurance policies, and many others.
  • They serve as means of payment.
  • They hold value during specific timeframes.
  • They facilitate risk transfer.

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