Question

Problem 2. (A) What is a financial system? Frame your answer in both structural (institutional) and functional perspectives (15 marks) (B) What is the relationship between spot and forward rates? What rates are used to compute the present value of cash flows? How can the 'normal' shape of the yield curve be incorporated into the calculation of NPV? (10 points)

Answer 1

A) A financial system is one wherein investors can park their money in instruments such as bonds or equity and at the same time entrepreneur or businesses needing the money to grow the economy can have access to capital through this system. In a financial system, there are number of financial intermediaries such as banks or other financial companies which help connect the investors to the businesses and thus promote smooth flow of capital in the system. In doing so, they are able to earn a margin on the capital and hence sustain their own businesses. The overall system is then governed by goverment or the central bank to ensure that it is a fair system and no violation of regulations happen and also frauds are prevented.

Thus a financial system would be comprised of lenders, investors, who would be looking at avenues to invest their money, financial intermediaries such as banks and the businesses & entrepreneurs who would need the money to grow their businesses. And also there would be institutions such as the stock market, regulatory bodies such as stock market regulators and the central bank, the bank regulator whose job is to ensure fair and equitable system.

B)

Forward rates are derived from spot rates. For example, if S1 and S2 are spot rates for maturity term 1 & 2 respectively. Then forward rate for year 1 to 2 is given by:

f(1,2) = (1+S2)^2/(1+S1) - 1

The prevailing market interest rates are used to compute the present value of cash flows. Based on the yield curve we have different yields for bonds of different duration. And using this we can discount the cash flows occurring in that particular year using the yield for that year (calculated from the yield curve) to compute the present value of cash flows.