45.a: Functions of the financial system
The key functions of financial markets are:
1. Allow people to a) to save money, b) borrow money, c) raise equity, d) manage risk, e) exchange assets for immediate or future use, and f) trade on information/analysis.
2. Aggregate the total demand (i.e. borrowing) and supply (i.e. savings) of money and determine the appropriate rate of return (i.e. interest rate).
3. Ensure the best use of capital.
Six key uses of financial markets explained:
a) Savings: Savings represent the corpus of money that an individual sets aside for future use. She may choose to park this money in stocks, mutual funds, bonds, certificates of deposits, real estate etc. Ideally, the saver would want a rate of return that compensated her for the inflation, risk of failure of investment and the opportunity cost of use of money.
b) Borrowing: Individuals, companies, and governments borrow money to fund education/purchase house, capital expenditure and spend on social schemes respectively. Riskier projects generally have higher borrowing costs but borrowers can use collateral i.e. pledge assets which the lender can use (i.e. sell) to recover money in case of default.
c) Raising equity: Companies also raise money by selling part ownership to investors. Equity stake sold to investors doesn’t necessarily require scheduled payments like in the case of loans, but equity stake also represents a stake in future profits.
d) Risk management: Companies try to shield their profitability from volatility in prices of commodities, currency values, borrowing rates etc.
For e.g. A farmer worried about the price of his produce (sugarcane) as harvesting approaches can enter into a forward binding contract with a customer (sugar producing company) who may be worried about the possible rise in the price of same produce at a mutually beneficial price.
Commodity exchanges, investment banks, insurance firms generally provide a platform for such contracts.
e) Exchanging assets: Based on their judgment and necessity, individuals and companies can trade one asset for another through financial markets. For e.g. an individual in Eurozone worried about euro stability may trade his Euros for gold or for US dollar (both are considered safe options in times of uncertainty).
f) Utilizing information or analysis: people can use their knowledge and judgment to enhance their returns and capitalize on potential market inefficiencies.
Information-motivated traders trade to profit from the information. They believe that the information allows them to predict the future prices. They expect a higher return as compared to the pure investors because they expect an additional return on the information as well.
The distinction between pure investors and information-motivated traders depends on their motives for trades and not on the risks taken by them and their respective holding periods. Investors trade to move wealth from the present to the futures whereas information-motivated traders trade to profit from their information about the futures prices. However, these two categories are not mutually exclusive as some investors also analyze information and expect an additional return for that.
Return determination
Financial markets act as an aggregator where the demand of money meets supply and an appropriate rate of return for the lender (cost of borrowing for the borrower) is set. Higher the rate of return, lower will be the borrowing and vice versa. Equilibrium interest rate is the rate at which the amounts which borrowers want to borrow matches the rate at which savers want to lend.
Allocation of capital
Investors consider risk-reward scenarios for all available investment options and allocate accordingly. In a liquid and well-functioning financial market, this leads to efficient use of capital.
Check your concepts:
(45.1) Which of the following is least likely to be a key function of a financial market?
(a) To help in increasing the risk exposure
(b) To decrease the income inequality
(c) To determine the interest rate for mortgage borrowings
(45.2) What is the most likely impact of an increase in the number of borrowers in comparison to the number of lenders on the interest rates? Assume that each borrower and lender would borrow and lend an equal amount of money.
(a) Increase in interest rates
(b) No change in interest rates
(c) Decrease in interest rates
(45.3) Which of the following statements is least accurate?
(a) The interest rate decreases with increase in the collateral amount and increase in the total savings
(b) An investment is an equity always provides higher return than an investment in debt because equity has a higher risk than debt
(c) An increase in allocation towards debt is most likely to decrease the interest rates
(45.4) Sarah invests in a hedge fund to expect higher returns. She also understands the higher risk associated with investing in the hedge fund. Sarah is most likely to be classified as a(n):
(a) Investor
(b) Hedger
(c) Information-motivated trader
Solutions:
(45.1) Correct Answer is B: The financial markets help in increasing or decreasing the risk exposure (risk management). The markets also help in determining the interest rates for various kind of loans including mortgage loan by primarily matching the demand and supply. Decreasing the income inequality is not a function of the financial markets.
(45.2) Correct Answer is A: When the number of borrowers increases, they will compete for the funds and that would most likely lead to an increase in the interest rates.
(45.3) Correct Answer is B: An increase in collateral makes the investment less risky and that leads to a decrease in the interest rates. The increase in savings will also lead to a decrease in interest rates due to increase in the total lending amount. An increase in allocation towards debt will lead to a decrease in the interest rate as more people are willing to lend their money to the debt borrowers. An investment in equity does not necessarily provide a higher return than an investment in debt. The required return on equity is most likely to be higher than the required return on debt due to a higher amount of risk. But the actual realized return can be anything.
(45.4) Correct Answer is C: Sarah is an investor. She is simply investing in risky assets consistent with her level of risk taking ability. She is not hedging any existent risk by investing in hedge fund and also, she is not acting on any information to earn superior returns.
Exam Alert: Read the questions carefully and look for what is being asked in the question. If the question is looking too simple to answer then recheck it once more for confirmation.
