cima c04 2013 class chapter 10 domestic institutions and markets
DESCRIPTION
It's Chartered Institute of Management Accountants Course: C-04 Fundamentals of Business Economics ,Class LSBF Manchester ,Q's By Teacher Micheal Mubaiwa.TRANSCRIPT
www.studyinteract ive.org 108
Chapter 10
Financial systems 2 domestic institutions
and markets
CHAPTER 10 DOMESTIC INSTITUTIONS AND MARKETS
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CHAPTER CONTENTS
LEARNING OUTCOMES ------------------------------------------------- 110
COMMERCIAL BANKS AND CREDIT CREATION ---------------------- 111
FINANCIAL INSTRUMENTS -------------------------------------------- 114
ROLE OF CENTRAL BANKS --------------------------------------------- 117
FINANCIAL MARKETS -------------------------------------------------- 118
THE GLOBAL BANKING CRISIS ---------------------------------------- 119
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LEARNING OUTCOMES
(a) Explain the role of commercial banks in the process of credit creation and in
determining the structure of interest rates.
(b) Explain the role and in prudential
regulation.
(c) Explain the origins of the 2008 banking crisis and credit crunch.
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COMMERCIAL BANKS AND CREDIT CREATION
Commercial banks perform a number of functions including: a store of wealth,
provision of loan finance, acting as financial intermediaries as well as the
provision of foreign currency.
However, above all else, commercial banks have three different and potentially
conflicting aims.
Aims
Profitability
Security Liquidity
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Credit creation
The bank multiplier is the name given to banks ability to create credit and hence
money, by maintaining their cash reserves at less than 100% of the value of their
deposits.
commercial bank on the other hand will look to make a profit by lending cash and
charging interest.
The cash ratio describes the percentage of cash that a bank holds in reserve in
order to honor on demand withdrawals!
EXERCISE 1
In the following illustration we shall assume that there is only one bank in the
banking system and that all money lent by the bank is re-deposited by secondary
customers. The bank wishes to maintain a 25% cash ratio.
Complete the following table:
Deposit Cumulative
Deposits
Cash Reserve
Ratio (25%)
Cumulative
Loans
Incremental
Loan
$1,000 $1,000 $250 $750 $750
$750
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Formulae to calculate credit creation:
Note: exam questions may well ask for either the total money supply following an
initial injection, or alternatively for just the increase. If asked to calculate the
increase then remember to deduct the initial deposit.
EXERCISE 2
If all the commercial banks in a national economy operated on a cash reserve ratio
of 20%, how much cash would have to be deposited with the banks for the money
supply to increase by $300 million?
A $60 million
B $75 million
C $225 million
D $240 million
EXERCISE 3
A banking system in a small country consists of just four banks. Each bank has
decided to maintain a minimum cash ratio of 10%. Each bank now receives
additional cash deposits of $1 million. There will now be a further increase in total
bank deposits up to a maximum of:
A $400,000
B $4 million
C $35 million
D $40 million
Deposits = Initial cash deposit
Cash ratio
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FINANCIAL INSTRUMENTS
Financial instruments are tradable assets, the following table provides an overview
as to the various types of instruments that exist.
Asset Class Securities Other Cash Derivatives
Debt < 1 Year Treasury Bills /
Commercial paper
Deposits Forward
agreements
Debt > 1 Year Treasury Bonds Loans Bond futures
Equity Shares N/A Share futures
Foreign
Exchange
N/A Spot forex Currency futures
Treasury bills
Treasury bills (T-Bills) are short term debt obligations backed by the US
government. Their key characteristics include:
o Maturity < 1 year
o Issued at a discount from their par value
o The par value is re-paid at maturity
Yield calculations -
Discount yield
Investment yield
Key
F = face value
P = purchase price
M = maturity of bill in days
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Treasury bonds
Treasury bonds (T-Bonds) are marketable, fixed interest, US government debt
security with a maturity of more than 10 years. Their key characteristics include:
o Maturity > 1 year
o Set yield, known as the coupon rate
o Face value redeemed at maturity
Despite a fixed rate of interest, the market value of a bond is subject to change
over time, for two reasons:
i) Perceived risk
ii) Interest rate fluctuation
Yield calculation -
x 100
Note: yields for bonds are inversely related to bond prices, that is to say as
the price of a bond falls, the yield % will rise.
Ordinary shares
The yield derived on ordinary shares (equities) may be determined as at a
particular point in time based on the following formulae:
Dividend Yield =
However, assessing the long term rate of return is problematic. Firstly, ordinary
shares do not have a set maturity date. Secondly, the dividend paid out varies over
time. Assuming a constant growth rate for dividends, it is possible to approximate
the overall return on equities in the long run.
Ke =
Where Ke = rate of return on equity P = share price
D = dividend paid G = dividend growth rate
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Nominal and real rates of interest
The real value of income from investments is eroded by inflation. The rate of return
after inflation has been deducted is called the real rate of interest.
The real rate of interest may be calculated as follows:
= 1 + real rate
Risk and return on financial instruments
Low risk High risk
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ROLE OF CENTRAL BANKS
A central bank is a bank which acts on behalf of the government. The central bank
for the UK is the Bank of England. The Bank of England is a nationalised
corporation.
Monetary stability
Lender of last resort
Holds forex
Adviser to govt
Banker to govt' & central banks
Issuing new notes
Financial stability
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FINANCIAL MARKETS
Financial markets comprise:
a) Money markets which trade short term instruments.
b) Stock markets which trade in long term instruments such as bonds and
shares.
Money markets
Money markets are essentially short term debt markets, with loans being made for
a specified period at a specified rate of interest. The money market may be sub-
divided as follows:
Capital markets
Stock markets enable the trade in company equities. Significant markets include
the New York Stock Exchange and the London Stock Exchange.
A stock exchange is an organised capital market. Within a functioning economy,
stock exchanges:
1. Enable firms to raise long term capital.
2. Publicises the prices of quoted shares.
3. Enforces rules of conduct, providing investor confidence.
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THE GLOBAL BANKING CRISIS
In many respects the global economy is still reeling from the effects of the 2007-
2010 financial crisis, which started as a result of the collapse of Lehman Brothers.
Causes of the 2007-2010 financial crisis
a) The US Property boom of 1997 2006
b) The sub-prime mortgage crisis
c) Low market interest rates
d) Poor regulation of the financial sector
e) Excessively complex financial assets
f) Greed and poor governance
Consequences of the 2007 2010 financial crisis
a) Collapse of the property sector
b) Credit squeeze
c) Government intervention
d) More regulation of banks and financial institutions
e) Austerity budgets
f) Concern over structural deficits