Pokhara University BBA Financial Institutions and Markets Notes: Chapter 1 The Role of Financial Institutions and Markets

1. What is financial system? The system that allows the transfer of funds between savers and users is called financial system. 2. What is financial market? A place where borrowers and lenders of funds are brought together is called financial market. 3. Define financial institution. A financial institution is a company engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investment and currency exchange. 4. Some people have money some people need money. Explain how the financial system links these people together. It consists of complex, closely related services, markets and institutions intended to provide on efficient and regular linkage between investor and depositor. 5. What role does financial system play in economic growth? The economic system plays a vital role in the economic growth of a country. It encourages both savings and investment and creates link between savers and investors and also facilitates the expansion of financial market. 6. Does the financial system promote economic growth? Yes, the financial system promotes economic growth via increasing capital accumulation efficiency together and improving marginal productivity consequential from it. 7. Define financial system. Explain briefly the function of financial system. Financial system is defined as the system that allows the transfer of funds between savers and users. THE FUNCTION OF FINANCIAL SYSTEM ARE EXPLAINED BELOW a. Pooling of funds In a financial system, the savings of people are transferred from households to business organizations. With these production increases and better goods are manufactured, which increases the standard living of people. b. Capital formation Business requires finance. These are made available through banks, households, and different financial institutions. They mobilize savings which leads to capital formation. c. Facilities payment The financial system offers convenient modes of payment for goods and services. New methods of payment like credit cards, debit cards, cheques etc. facilitates quick and easy transactions. d. Provide liquidity In financial system, liquidity means the ability to convert into cash. The financial market provides the investors the opportunity to liquidate their investment which are in instruments like shares, debentures, bonds, etc. e. Short- and long-term needs The financial market takes into account the various needs of different individuals and organizations. These facilitates optimum use of finances for productive purpose. f. Risk Function The risk function uses much of the same data as finance, but uses it differently. Specifically, risk inputs data into models to predict future outcomes based on correlations, analytics and assumptions with a higher reporting frequency and velocity. g. Better decision Decision making is crucial decision made by the financial manager relating to the financing -mix of an organization. It is concern with the borrowing and allocation of funds required for the investment decision. 8. In what a way financial institution helps in channelizing the savings for best uses? Explain. Financial institution is the particular types of intermediary who stands between the borrower and the lender. The way financial institutions help in channelizing the savings for best users are explained below a. Safety It is risky to keep your money in cash. It could be easily got lost, stolen, or even destroyed in an unexpected event such as a housefire. By keeping your money in a financial institution, you will have the peace of mind knowing your funds are always safe. b. Convenience By using financial institutions, you don’t have to carry large amount of cash, but you can conveniently get cash when you want it at bank branches, ATMS, grocery stores and many others convenient locations even when you travel away from home. c. Saves money Many people who don’t have a bank account use cheque cashing store instead. Most of these stores change very high fees. You can usually save a lot by using a bank. d. Financial future By working with a bank, you will have financial professionals you can take to and work with. The knowledgeable advice of bankers can be valuable resources to help you and your family to build a better financial future. 9. Explain briefly the economic function and finance function of financial markets. Financial markets is defined as the place where borrowers and lender of funds are brought together. The two main functions of financial markets are: A. Economic Functions B. Finance Functions A. Economic Functions Financial market performs an economic function because financial market is backbone of the economy. The way how financial market performs the economic functions is highlighted as follows a. Funds transformation Financial market is an important component of the financial system as it facilitates the transfer of real economic sources from the lenders to borrowers. Lenders are those who have saved some part of their income in anticipation of the needs of the funds for future consumptions. b. Investing in productive assets Financial market helps to investors in choosing the investment alternatives or portfolio of securities in generating the income. This requires wise investment in diverting the funds into income generating assets. c. Capital formations The important function of financial market is to help in the capital formation to the economy by encouraging investment in infrastructures like hydro-electric projects such as Butwal Power, Chilime Hydro Power, and other potential projects of greater national importance. d. Value of assets Financial markets perform a very significant economic functions in helping to enhance the value of assets for the investors in general and economic particularly. e. Confidence of investors Financial market has already recorded a favourable growth in generating the confidence of the investors as investors could materialize higher return and value from engagement in financial market. B. Finance Functions Financial market also performs an important finance function. It is because financial market is a place the manufactures the funds for economic development. Some of the important finance functions are stated below a. Providing funds Financial market has made it possible to channel funds or makes funds available to the borrowers to carry out their plans and activities of business and industry they undertake. Borrowers could obtain the funds at reasonable costs without any inconvenience. b. Adequate earnings Financial market is also an important place providing opportunities to multiply earnings. It is because it provides the lenders of the funds with sufficient earning assets to increase their wealth than before. c. Wealth-maximization Financial market helps in the wealth maximization of the shareholders. While performing a finance function, financial market in Nepal has been successful enough to enable the borrowers to have funds. d. Maintaining track record of performance Financial market cannot function efficiently if a track record of performance is not showing favourable trend. In the financial market, the joint venture banks in Nepal have recorded tremendous growth with multiple assets and earnings to extend that investors have greater demand even by paying higher price for the shares of such companies. e. Ensuring return to shareholders Financial market basically aims to generate return to the shareholders as they are the backbone of the capital market. Their expectations should be fulfilled otherwise they may lose confidence on the functioning of the capital market. 10. Explain the functions of financial institutions. The functions of financial institutions are explained below a. Perform Direct Financing Direct financing is the easiest way to make a direct flow of funds or transfer funds from surplus spending units to deficit spending units. Deficit saving units issue financial claims on them and sell them for money to surplus spending units. b. Perform Indirect Financing Indirect financing involves indirect flow of funds through the involvement of the financial intermediaries. It is also known as intermediation financing that emerged due to inefficiencies found in direct financing. c. Perform Denomination Divisibility Function Denomination divisibility pools the savings of many small investors and invested these funds in securities of various sizes. It helps small savers to invest their funds in a situation when they have no sufficient funds to employ in large denomination transactions. d. Perform Maturity Flexibility Function Maturity flexibility function involves buying direct securities issued by deficit spending units and issue indirect securities with precise maturities desired by the surplus spending units. e. Perform Risk Diversification Function Risk diversification function is to spread risks by purchasing wide variety of securities. It can minimize fluctuations in the principal value of the portfolios if the securities purchased are perfectly correlated with each other. f. Perform Liquidity Function Liquidity function provides the consumers access to sufficient liquidity at minimal transactions costs since for most consumer the timing of the income and expenses rarely coincide. g. Perform Various Benefit Functions Benefit functions transfers claims in such a way as to make them attractive to both surplus spending units and deficit saving unit with economics of scale as they handle a large number of transactions by spending out their costs. 11. Distinguish betweenMoney market and capital market a. Money market and capital market b. Primary market and secondary market a. Money market and capital market Money Market Capital Market Short term securities are made. Long term securities are created and traded. It is less risky. It is risky compared to money market. It helps in meeting short term credit requirements of the companies. It helps in meeting long term credit requirements of the companies. Its time horizon is less than one year. Its time horizon is more than one year. It is directly and closely linked with central bank of country. There is no direct linked with central bank of country. b. Primary market and secondary market Primary Market Secondary Market It is the market where securities are issued for the first time. It is the market where securities are already issued. Undertaken for expansionary plans or for promotes to off load their stakes. It provides a ready market for trading the securities between investors. It is fixed by the investment banks at time of issue, after sufficient discussion with the management. Price depends on demandand supply forces or the security in the market. Company is directly involved and thus sells the shares and the investors buy. Investors buy and sell the shares among themselves. There is no direct involvement of the company. It is usually not placed in any specific geographical locations. It does not have any physical existence. It has physical existence usually through stock exchange.