Examine the role of the financial system in the economy and the rationale for financial intermediation

Posted: June 6th, 2021

Assignment Fin 402. Assignment Purposes/Learning Outcomes:
1. Examine the role of the financial system in the economy and the rationale for financial intermediation.
2. Demonstrate an awareness of the variety of financial instruments.

Assignment questions: Total grade – 10 points

1. All over the world, the financial system is among the most heavily regulated sectors. By giving reasons, explain in detail why such regulations are needed for this sector. (2 points)

2. What is the distinction between the nominal interest rate and the real interest rate? Which is a better indicator of incentives to borrow and lend? What is the real interest rate if the nominal interest rate is 8% and the expected inflation rate is 10% over the course of a year? (2 points)

3. Suppose an economy is passing through the expansionary phase of the business cycle. Using supply demand model of bonds, graphically examine.
• Impact on shift of demand and supply curves of the bonds
• Impact on price of bonds and expected interest rates.
• Based on your finding advice an investor, in such an economic condition, whether to invest in long-term bonds or short-term bonds and why? (4 points)
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4. What are the factors an average investor must consider when facing a choice of whether to buy and hold an asset or whether to buy one asset rather than another. Also explain how changes in these factors influence quantity demanded of an asset. (2 points)

All over the world, the financial system is among the most heavily regulated sectors. There are several key reasons for such stringent regulations. Primarily, financial markets are prone to systemic risks and market failures due to asymmetric information, moral hazard, and adverse selection (Acharya et al., 2016). Left unregulated, these imperfections can destabilize the entire financial system and cause severe economic damage. Regulations aim to promote financial stability, protect consumers, and maintain integrity and fairness in the sector (Llewellyn, 2022). Some specific regulations control capital adequacy, liquidity risk, activities of financial institutions, governance, transparency, and consumer protection (KPMG, 2022). Overall, oversight helps curb excessive risk-taking, prevents crises, and safeguards public trust in the financial system.
The nominal interest rate refers to the stated annual interest rate without adjusting for inflation, while the real interest rate is the nominal interest rate minus the inflation rate (Mishkin, 2016). The real interest rate is a better indicator of incentives to borrow and lend because it represents the actual purchasing power received for postponing consumption (Bernanke, 2016). For example, if the nominal rate is 8% and inflation is 10%, the realanke, 2016). For example, if the nominal rate is 8% and inflation is 10%, the real rate would be -2%. In this case, even though borrowers are paying 8% nominally, inflation erodes the value of money over time so lenders are effectively paying borrowers to take loans. Therefore, the real rate captures the true cost of borrowing and opportunity cost of lending more accurately.
During an economic expansion, the demand for bonds typically decreases while the supply increases (Mishkin, 2016). This can be shown graphically with a leftward shift in the demand curve for bonds (D1 to D2) and a rightward shift in the supply curve (S1 to S2). The resulting equilibrium would be a lower bond price (P2) and higher interest rates (I2) compared to previous levels (P1, I1). Given these shifts, an investor would be better off investing in short-term bonds rather than long-term bonds during an expansion. Short-term bonds are less sensitive to interest rate changes. Since expansion often leads to higher rates, the prices of long-term bonds with fixed coupons would fall more than short-term bonds as rates rise.
Key factors an average investor should consider when choosing between holding an asset or choosing one asset over another include the assets’ expected returns, risks, liquidity, and tax implications (Bodie et al., 2014). Higher expected returns, lower risks, easier liquidation of the asset, and more favorable tax treatment make an asset more attractive to hold. Changes in these characteristics influence the quantity demanded. For example, an increase in expected returns of an asset leads to increased demand as the asset becomes more valuable. Likewise, a rise in perceived risk of an asset would decrease demand. Understanding how different assets fare regarding these factors helps investors make optimal choices.
References:
Acharya, V., Engle, R., & Pierret, D. (2014). Testing macroprudential stress tests: The risk of regulatory risk weights. Journal of Monetary Economics, 65, 36-53.