Chapter 8

 

The capital market
 

Solutions to questions

 
1.    Direct finance occurs when a surplus unit (supplier of funds) lends directly to a deficit unit (demander of funds). Intermediated finance occurs when a financial intermediary interposes itself between the surplus and deficit units. Typically, companies with large funding requirements and high credit ratings can access direct funding at a competitive cost, while other borrowers tend to rely on financial intermediaries, which are able to achieve a matching of the different size, maturity and risk preferences of deficit and surplus units. Financial intermediaries can generate economies of scale and benefits from the pooling of risks, in both their loan portfolios and their mix of liabilities.
2.    Secondary markets generate liquidity. Without this liquidity many investors would not participate in the primary market, since they require the flexibility to redeploy their funds.
3.    An exchange-traded market involves an organised exchange, such as a stock exchange or futures exchange, where securities are traded by members of the exchange (brokers) who act on behalf of clients. An over-the-counter market does not have an organised exchange, and the market consists of financial institutions (dealers) who trade as principals with clients and with each other. It follows that exchange-traded markets involve greater regulation and transparency (for example, prices are published on websites and in newspapers), while over-the-counter markets provide greater flexibility to ‘tailor’ the terms of contracts to suit the needs of clients.
4.    Financial institutions providing funds to companies may be divided into three categories: financial agency institutions, financial intermediaries and investing institutions.
·           A financial agency institution arranges or facilitates the direct transfer of funds from investors to companies. Financial agency institutions include stockbrokers and investment banks.
·           A financial intermediary, such as a bank, provides funds as a principal—that is, a company that borrows funds from a bank has an obligation to repay the bank, but it has no obligation to the bank’s depositors.
·           Investing institutions include superannuation funds, life insurance companies and unit trusts.
       This range of institutions is necessary to ensure that all companies are able to tap into the capital market.
5.    Major points are as follows:
       (a)   Stockbrokers. They are important in advising companies on the terms of new security issues, underwriting new issues and in raising funds by selling securities to their clients.
       (b)   Investment banks. Financial intermediation and corporate lending have become relatively minor activities for investment banks in Australia. However, investment banks have an important role in assisting companies to raise finance through activities such as providing advice, and underwriting issues of securities.
       (c)   Banks.They are the most important lenders to the corporate sector in Australia. In answering the question, students should emphasise the wide range of banks’ lending activities,competition between the banks, and competition between banks and other financial institutions.
       (d)   Finance companies. Providing finance to businesses is a major activity for most finance companies. The major forms of lending to companies are by way of instalment credit, lease financing, inventory financing and debtor finance. Many finance companies specialise in a particular segment such as motor vehicle finance.
       (e)   Superannuation funds. These funds are major providers of long-term debt and equity to Australian companies. They provide funds to companies by purchasing shares and marketable debt securities, and by providing loans. Their growth is underwritten by compulsory superannuation.
6.    As explained in the chapter, investment banks and larger stockbrokers provide a complete range of specialised financial services to companies. Important services provided by investment banks include acting as an adviser to companies on matters related to fundraising, and underwriting issues of securities.