Specifics of Financial Intermediation - Coursework Example

?Finance Questions Question When we talk about capital markets, the firms and individuals present there usually borrow on a long-term basis. This means that there are either people who want to spend more than they presently earn (deficit units) or those who spend lesser than their current income, namely surplus units. Hence, there has to be some sort of connection or link between these individuals or firms in order to achieve their goals and make sure money is utilized in the most effective way possible. Defined simply, ‘financial intermediation is a process which involves surplus units depositing funds with financial institutions who then lend to deficit units.’ (Gwilym, 2011) There is a clear difference between banks that operate as financial intermediaries and non-bank institutions that also operate as financial intermediaries. The latter performs the process of lending after purchasing securities from the market instead of directly giving out loans. These include insurance companies, investment trusts, pension funds, mutual funds and so on. The major outcome of financial intermediaries is to ensure that at all times there is a steady flow of funds, including cash, which moves smoothly from the surplus units to the deficit units. This in turn will result in regular investments to boast the economy and help support the growth of activities in the market in general. By doing so the ideal funds will be utilized in the best way, which otherwise would have generated only a marginal interest. Financial intermediaries who match the lender with the borrower help both by reducing their transaction costs. They also provide in-depth information to their clients to provide them with the best available source of investing their money. Information costs are substantially costs are reduced for both parties, namely the lender and the borrower, since they don’t have to spend resources from their own end to dig out extensive information. Hence, it is not surprising to know that in United States alone roughly 24.4% of firm investment was financed through bank loans that were taken from 1970 – 1985. (Gorton & Winton, 2002) This proves that bank loans (financial intermediaries) are the primary source of external financing globally no matter whether it is a developing or a developed country. Therefore, one can state that ‘financial intermediation is the root institution in the savings-investment process’. (Gorton & Winton, 2002) An outcome of this is that a large number of individuals and firms come together to make this happen, so that in case if one party fails to give a loan, another is available to support that. The huge pool ensures a constant availability of both capital and expertise which is available for all. The whole process can be summed up as ‘a value-creating economic process.’ (Scholtens & Wensveen, 2003) It can be concluded that financial intermediaries are not only providing a place for investors to borrow from, rather their role is more diverse and comprehensive. They are constantly and actively working to offer products that an individual investor can barely provide to a saver. This is the advantage of ‘cover for risk’, the basic reason behind why every saver will trust in a financial intermediary. Question 2 Stock markets all around the globe are the ideal modes of generating funds for businesses or companies that want to fulfill their capital requirements. It provides a very comprehensive way for investors to choose from a variety of stocks that best suit their needs (mainly risk and return). Any investor can select his own set of stocks of as many companies as he like and create a portfolio to reduce his risk in the market. One of the major roles of stock markets in the financial system is to provide the feature of liquidity. This means that an investor can at any given time trade his security for cash when the market is operating. (Rohit, 2008) The incentive offered by this feature makes it a very promising driver of growth in an economy. The amount of trade or activity going on in a stock market gives a clear indication of the functioning of that economy. If a stock market is experiencing constant downward decline then it will mean some negative factors or news in the economy is breaking the investors’ confidence and hence affecting the market adversely. As mentioned earlier, stock markets allow companies to acquire cash through IPO (initial public offering) and further issuance of shares, to fund their expansion projects or meet certain debt requirements. It is very essential to link the stock markets with financial development and economic growth. There are several instances when a strong stock market performance is backed by a growing economy. (Arestis, 2001) Stock markets have complimented the banking systems in providing five mainstream financial functions namely, ‘information production and capital allocation, corporate governance, risk management, savings mobilization and the exchange of goods and services.’ (Sharma & Roca, 2011) They act as intermediaries between investors and companies by helping transactions carry out smoothly. Information is made available to the public to help them make better informed decisions and spur economic growth in the economy. Markets all around the globe ‘play a significant role in diversifying risks associated with individual projects, firms, industries, regions and even countries.’ (Sharma & Roca, 2011) The overall role of stock markets in the financial system is hence to provide a firm base for investment, remove any inefficiency that might have been created by lax banking system and encourage economic participation in the financial system of the economy. In the past decade or so, the role of stock markets has increased substantially. However, after the financial crisis of 2008, the stock markets have suffered to restore back to their normal states and with the Greek debt crisis looming around the corner, it is highly uncertain how the stock markets will perform in the near future. Question 4 A derivative is ‘a contractual relationship established by two (or more) parties where payment is based on (or “derived” from) some agreed-upon benchmark.’ (Rutledge & Bertram, 1995) The concept underlying a derivative product is an agreement that is reached between parties, and as the number of terms and agreements change, this result in numerous types of derivative products. Therefore, there is no set or pre-determined list of derivative products. Derivatives have the ability to shift the risk from one party to another, and are often extensively used to reduce exposure to changes in interest rates, stock indexes or exchange rates. (Rutledge & Bertram, 1995) For instance, if a Japanese company expects to receive payments for a truckload of goods in US dollars, it can certainly enter into a highly beneficial derivative contract with another willing party. This will involve the reduction of risk in case the exchange rate of US dollars with the Japanese Yen turns out to be more unfavorable at the time the actual transaction and payment takes place in the future. To explain the effect created, it should be understood that the other party is obliged under the duly signed derivative contract to fully pay the company the agreed amount based on the exchange rate that was prevailing at the time the contract was signed. Firms occasionally use derivatives for hedging purposes, which as mentioned above is the reduction in the amount of risk an individual’s portfolio is exposed to. (Stulz, 2005) The reason for forming derivatives is for firms and individuals to achieve benefits and payoffs that otherwise would have been impossible to achieve without derivatives. Derivatives allow investors to efficiently trade on the information available that otherwise is highly expensive to use. According to a survey by Gordon Bodnar, Gregory Hayt, Richard Marston and Charles Smithson, 28 percent of the firms were actively using derivatives to minimize the volatility present in their earnings. (Stulz, 2005) This suggests that it can be used as a tool for all firms to protect themselves from the risk present in their daily operations or revenue streams. It is very essential that each party in a derivative contract assess the various risks before engaging in such a contract. Common financial derivatives include forward contracts, financial futures, options and swaps. The list is nonetheless expanding all the time as more ways are being made available to transfer risk to other entities. A forward contract is ‘when two parties engage in a transaction of an item (such as shares, debt instruments) at a future point in time (maturity date) at a specified price (forward price).’ (Fofana, 2010) A forward contract is flexible and hence can be used in a variety of circumstances. On the other hand, a swap can be classified as a ‘contract in which two parties agree to exchange a set of payments at specified intervals over a specified period of time.’ (Fofana, 2010) In developing countries where volatility is very high, derivatives can act as a hedging instrument or to secure the value of assets in the future by providing an agreed amount set right now in the contract. A very useful way to hedge against inflation is to have a derivative instrument to protect against the deterioration in the value of assets. Bibliography Arestis, P., 2001. Financial Development and Economic growth: the role of stock markets. Journal of Money, Credit and Banking, 33(1), pp. 16-41. Fofana, I. K., 2010. FINANCIAL DERIVATIVES AND DEVELOPMENT IN DEVELOPING COUNTRIES. [Online] Available at: http://www.guineepourtous.org/fddd.pdf [Accessed 9 May 2012]. Gorton, G. & Winton, A., 2002. Financial Intermediation, Pennsylvania: The Wharton School. Gwilym, O. a., 2011. Financial Intermediation, London: University of London. Rohit, T., 2008. Ezine articles-Significance of Stock Market in the Financial System. [Online] Available at: http://ezinearticles.com/?Significance-of-Stock-Market-in-the-Financial-System&id=1463972 [Accessed 9 May 2012]. Rutledge, G. P. & Bertram, R., 1995. A Brief Guide to Financial Derivatives. [Online] Available at: http://www.psc.state.pa.us/corpfinance/derivatives.html [Accessed 9 May 2012]. Scholtens, B. & Wensveen, D. v., 2003. The Theory of Financial Intermediation: An Essay On What It Does (Not) Explain, Vienna: SUERF. Sharma, P. & Roca, E., 2011. Re–Designing Financial Systems: A Review of the Role of Stock Markets in Developing Economies, Brisbane: Department of Accounting, Finance and Economics, Griffith University. Stulz, R. M., 2005. Demystifying Financial Derivatives, Ohio: Ohio State University. Read More