Question

a. What are the three main components of a financial system, providing an example of each component?

b. Describe two different ways that savings are ultimately transferred to deficit units in need of funds. Identify 3 advantages of each type of way of transferring funds

c. Briefly explain the following key types of risks in the market

Answer 1

A) The three key components of financial system are: Financial Institution: Financial Institutions basically consist of banking as well as non-banking institution which participates in the activity of buying and selling of financial product and services in the market. Example Bank of America, Goldman Sachs, JP Morgan. Financial Market: Financial Market is a place where buying and selling activity occurs. The market can be divided into short term or money market or long term which is also called capital market. Example NYSE, NASDAQ Financial regulator: Financial regulator plays a key role in sustainable development of the market and creating faith in the system. Regulator makes sure that the system is not being manipulated for gain of selected Individual but it's a fair place. Example Securities and exchange commission, Federal reserve. B) The two main ways in which deficit are transferred to place in need of funds are through Intermediary and direct financing. Intermediary plays a key role in transferring of funds from savers to Investors like banks. The benefit associated are: • Intermediary play a key role in assessing the risk of the investment before financing it. • They take the task of finding the most optimal asset allocation in which maximum return can be achieved. Intermediary works by pooing assets from large number of investors, hence the cost is reduced significantly. Direct financing is another way in which funds can be transferred from savers to Investors. The benefits associated are: • • • With direct financing the Intermediary cost is saved. With direct financing the investor is able to directly assess the borrower. Direct financing process is also faster than the intermediary based.

C) There are basically two types of risk in the market. Systematic risk and Unsystematic risk. Systematic risk is the risk that cannot be reduced by diversifying your portfolio. Systematic risk are basically the macroeconomic factors. The two main sources of systematic risks are: • • Inflation: Inflation is a major source of risk for all kinds of securities because inflation reduces the real return of any security. Political instability, war: Political instability is something that is common to all the security and also situations like Internal conflicts, civil war. These factors disturb the economic environment of a country where economic development can take place Unsystematic risk is also known as the security specific risk which can be reduced by diversifying the portfolio. Two main sources of unsystematic risks are: Business specific risk: The business specific risk can be because of many factors like there is a shift in management happening of any company, company is losing market share, some of the product of the company is facing issue with regulator and had to be recalled back from the market. Financial risk: Financial risk here with reference to specific company means that the company is either too much leveraged or not leveraged at all. The cost of capital is not at the leverage level where it should be the lowest cost of overall capital. Too much leverage can create high risk of bankruptcy and too little can reduce the overall return on capital.