Chapter 1

Structure and Role of the Financial Market

Answers to Think It Over (p.2)

1 As your group does not have enough funds to finance the business, you will need to borrow money from other people. Banks would be unwilling to lend you money since the business is risky and your group has no prior experience in running a successful business. The most available source of financing would be loans from your family members, relatives, friends and teachers. There are two major types of financing: equity financing and debt financing. (You have already learnt about these in NSS BAFS: Business Environment and Introduction to Management, Chapter 7.) Equity financing refers to funds supplied by the owners of a business. Debt financing refers to funds obtained from outsiders, such as banks. For debt financing, interest must be paid to the lender. Therefore, you have to consider whether the business would be able to make enough money to pay the interest and repay the loans. In addition, as the risk of failure is high, you should not borrow large sums of money to finance the business. Most of the funds should be obtained in the form of equity financing. You can raise funds by inviting your family members, relatives, friends and teachers to become co-owners of the stall. This minimises borrowing and saves on interest expense. In addition, you need not repay large loans if the business fails. 3 You can get your friends, relatives and teachers to invest in the business by offering them an attractive return. This would sound more attractive if a limit is put on their losses in case the business fails. In order to make them feel more confident, you should also allow them to have more information about the business, e.g., nature of the business, budget, sales forecast, marketing plan and operational plan.

Check Your Progress

Q1 The banking sector plays an important role in providing financial services in Hong Kong. It acts as a financial intermediary, channelling savings into investment by receiving deposits from the public and then lending the money to borrowers. The major function of retail banking is to provide various financial services for private individuals. Examples of such services include savings deposits, current accounts and loans.

Q2

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Corporate banking helps companies perform needed financial transactions for their daily operations. Commercial lending is the main service offered by corporate banking. Other services include loans, deposit accounts, credit cards, insurance and MPF, corporate Internet banking, and payroll services. Q3 (a) Corporate banking (b) Corporate banking (c) Retail banking (1) life insurance, (2) general insurance, (3) motor insurance and (4) casualty insurance (any three) Pool and transfer risks: The major function of insurance is to pool and transfer risks. The insurance products provided by insurance companies help individuals and business manage risks. This encourages firms to undertake risky but profitable projects. This also enables individuals to receive financial protection for their life and assets at an affordable cost. Provide a source of capital: Insurance companies are one of the biggest investors in the securities markets. After receiving premiums from individuals and firms, insurance companies invest them in the securities market. These premiums thus serve as a source of capital for other companies. Q6 (a) For individuals, securities are important investment vehicles for retirement and savings purposes. They can earn dividends on shares and interests on bonds. They may also earn capital gains by selling the shares and bonds when their prices go up. For firms, the securities sector provides a market for raising funds. To raise capital, they can issue different kinds of securities. Bonds Common stocks Mutual funds Preferred stocks

Q4

Q5

(b)

Q7

(a) (b) (c) (d)

Q8

(1) government authorities, (2) stock exchanges, (3) the public and (4) financial institutions (any three) The success of the primary market depends heavily on the health (i.e., the size and liquidity) of the secondary market. Without a liquid secondary market, it would be difficult to attract investors to buy new issues in the primary market. This is because investors need a platform to
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NSS BAFS: Basics of Personal Financial Management Answers to textbook exercises

trade newly issued securities immediately after the securities are issued in the primary market. Q10 Brokers act as middlemen to help investors buy and sell securities. On the other hand, dealers trade from their own inventory of securities. Q11 A primary market is a market where new securities are issued. It also refers to the system for creating and listing newly issued securities such as stocks or bonds. A secondary market is a market for trading securities that have already been issued. It provides a continuous trading channel for securities owners and new buyers. Q12 The major difference between the money market and the capital market is that the money market is for short-term (normally within one year) borrowing and lending while the capital market is for long-term financing activities. In the money market, most instruments are debt instruments. In the capital market, most securities are equity instruments. Money market instruments: (1) US treasury bills, (2) certificates of deposit, (3) commercial paper, and (4) Exchange Fund Bills. Capital market instruments: (1) bonds, (2) notes, (3) Exchange Fund Notes, (4) stocks, and (5) residential mortgages. Q13 Fixed-income securities (three-year note) and a three-year bank loan. The main reasons for using the note and term loan are: 1 Unless the factory is really large, the amount required is too small to issue common stock or preferred stock. The duration of the project is two years. As it takes one year to make a profit, the company can pay the money back to investors by the third year. Thus, the time frame for the note or loan should be three years.

Q14 Common stock. The reasons are: 1 it is a public company. That means its shares are listed on the stock exchange and the company can issue more shares to raise capital. the amount is large and the project is long-term. The payback period of the project is uncertain. Thus, a bank loan is not possible.
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Q15 The major difference is that trading on a stock exchange involves brokers who charge a commission. On the OTC market, no brokers are involved and no commission is charged. Instead, dealers buy securities from clients and sell them to other clients as holders of securities. They pay a lower price when they buy and charge a higher price when they sell. The difference between the two prices reflects the service charge or profit of the dealer. Q16 Open-end funds are traded on the OTC market. There is no restriction on the number of shares it can issue. Investors buy units of the fund from a mutual fund company and sell (redeem) them to the company through investment companies whenever they choose. Closed-end funds are traded on stock exchanges. The number of shares issued is fixed at its IPO. The mutual fund company is not required to buy back shares of the fund from investors. Q17 Stamp duty, transaction levy, brokerage commission and HKEx trading fee Q18 (1) Stocks, (2) bonds, (3) mutual funds and (4) foreign currencies (any two) Q19 Compared with a single stock, ETFs can provide better risk diversification. ETFs are indextracking funds and are traded like stocks on a stock exchange. They invest in a basket of securities tracking an index. That means the ETF would buy stocks following a well-known index such as the NASDAQ 100 Index or the Hang Seng Index. As a result, the price movements of an ETF would be similar to that of the index. Q20 As of 8 October 2008, there were 42 constituent stocks in the Hang Seng Index and 30 constituent stocks in the Dow Jones Industrial Average. Each represents large companies in their own stock market. Thus, these indices reflect the general price movements of an entire market. Q21 Insurance premiums are the major source of revenue for insurance companies. After receiving premiums from clients, insurance companies then invest them in the financial market to generate additional investment returns. Q22 Securities firms serve as middlemen for investors in securities trading. Because of the large amounts of investments and the frequency of trading that securities firms handle, they are a major player in the financial market.

Q23 (1) The Securities and Futures Commission, (2) the Hong Kong Monetary Authority, (3) the
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Office of the Commissioner of Insurance and (4) the Mandatory Provident Fund Schemes Authority (any three) Q24 Investors buy and sell financial products in the financial market. They always need reliable information and a fair market to make sound investment decisions. Other market participants, such as securities firms and banks, can help investors make wise investment decisions by assessing the risks and returns of different financial products.

Try This Activity

A1 (a) (b) (1) savings deposits, (2) credit card, etc. (1) (2) Without savings deposits, people would find it difficult to hold their money safely and conveniently. They would earn no interest on it. Without credit cards, people could buy things only when they had enough cash. They would have to carry a large amount of money around to shop.

Assessment
MCQ
1 2 3 4 5 6 7 8 9 10 11 12 13 14 B C C B C B A B B B D B D A

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Short Questions
15 Money market Certificates of deposit: Certificates of deposit (CDs) which are generally issued by commercial banks are a kind of time deposit. Holders usually enjoy higher interest rates than time deposit holders. They can withdraw the deposits together with the interest on maturity dates. Commercial paper: Commercial paper is a debt obligation issued by large banks and wellknown corporations. It is not backed by collateral and is a short-term instrument. Commercial paper is normally regarded as a safe investment product. Exchange Fund Bills: They are short-term debts issued by the HKMA. Exchange Fund Bills are fully backed by foreign currency reserves. (Any two of the above) Capital market Fixed-income securities: Fixed-income securities are debt instruments. They are interestbearing securities which pay a fixed percentage of return. Provided that the issuer of the fixedincome securities does not go bankrupt and investors hold the securities to maturity, the return on these securities is guaranteed. Examples of fixed-income securities are bonds, notes and Exchange Fund Notes. Equity securities: Equity securities refer to securities that entitle holders to part of the ownership of listed companies (i.e., stocks). Investors may earn dividends and capital gains when stock prices increase. However, they may suffer a loss if the price drops. Examples of equity securities are common stocks and preferred stocks. 16 Similarities: 1 Both open-end and closed-end funds provide risk diversification for small investors who cannot afford to buy a large number of individual stocks. 2 Both open-end and closed-end funds provide professional wealth management for small investors who cannot afford to engage these services directly. Difference: Open-end funds are traded on the OTC market. There is no restriction on the number of shares it can issue. Investors buy units of the fund from a mutual fund company and sell (redeem) them to the company through investment companies whenever they choose. Closed-end funds are traded on stock exchanges. The number of shares issued is fixed at its IPO. The mutual
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fund company is not required to buy back shares of the fund from investors. 17 Mutual funds operate by pooling funds from investors and investing the money in different securities. They are managed by professional fund managers based on certain pre-determined investment objectives. Mutual funds act as an important investment vehicle for small investors who cannot afford to buy a large number of individual stocks. They help small investors achieve long-term investment goals such as preparing for retirement. Through mutual funds, small investors can invest in various securities and achieve risk diversification with a relatively low investment amount. 18 After receiving premiums from individuals and firms, insurance companies invest them in the securities market to generate additional investment returns. These premiums serve as a source of capital for other companies. Insurance companies are big investors in the securities market because premiums from individuals collectively add up to a huge amount. In addition, insurance premiums are a very stable source of cash inflows. They serve as a major source of capital for long-term investment in the securities market. 1 Common stocks: Also known as ordinary shares. These are shares which have voting rights at annual general meetings and potential dividend payments. Preferred stocks: Also known as preference shares. These are shares without voting rights. They have a priority over common stocks in dividend payment. Bonds: Also known as debentures. These are long-term debts (normally 10 years or longer) issued by governments and companies. The bond-issuing institution has to pay back the principal to the bondholder on the maturity date. Notes: Medium-term debts (normally one to nine years) issued by governments and companies. Mutual funds: Also known as unit trusts. These are pools of money managed by professional fund managers which have certain investment objectives. Futures: These are standardised forward contracts that demand delivery of an asset at a specific date and price. Options: These are a right to buy or sell a certain asset at a specific date and price.

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Equity warrants: These offer holders the right to buy certain common stocks at a predetermined price (i.e., exercise price) on or before a given date.

(Any five of the above) 20 The success of the primary market depends heavily on the health (i.e., the size and liquidity) of the secondary market. Without a liquid secondary market, it would be difficult to attract investors to buy new issues in the primary market. This is because investors need a platform to trade newly issued securities immediately after the securities are issued in the primary market. Newly issued securities in the primary market form the basis of the secondary market. Without securities issued in the primary market, there would be no securities to trade in the secondary market. The over-the-counter (OTC) market is a network of buyers and sellers organised for the purpose of securities trading. Transactions in the OTC market are made directly between two parties through electronic systems.

21

Essay Questions
22 Companies can raise capital on the stock exchange. They may apply for a listing on the stock exchange. If their applications are approved, they may issue shares to raise capital. Individuals can trade stocks on the stock exchange. They can earn dividends and capital gains when stock prices increase. This allows them to accumulate wealth for long-term goals (e.g., buying a flat, retirement). 23 Listed companies Through IPOs and debt issues, listed companies can raise capital for their operations in the financial market. These capital market securities are ideal for investors looking for long-term investments for retirement purposes. While some listed firms buy securities as well, most supply securities in the financial market. Insurance companies Insurance companies play important roles in the financial services industry, particularly in financial planning. They help individuals and firms manage risks and in return receive premiums. After receiving premiums from clients, the insurance companies then invest them in the financial market to generate additional investment returns.

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Pension fund companies The assets of pension plans that are pooled in pension funds will then be invested in the financial market to generate additional funds. Financial institutions that manage pension funds are, therefore, major players in the financial market. Pension funds are an important source of capital for the financial market. Banks Commercial banks provide banking services for the general public. Private banks help wealthy people and organisations invest their money. Investment banks focus on corporate business such as raising capital for firms. All types of banks serve as middlemen between borrowers and lenders of capital in the financial market. Securities firms Securities firms serve as middlemen for investors in securities trading. Sometimes, they also use their own money to trade securities for profit. Because of the large amounts of investments and high frequency of trading handled by securities firms, they are a major player in the financial market. Regulators Regulators are responsible for regulating financial institutions and market participants and protecting the interests of investors. Investors Investors trade financial products and create a demand for and supply of securities in the financial market. (Any three of the above) 24 Role of banking sector The banking sector plays an important role in providing financial services in Hong Kong. It acts as a financial intermediary, channelling savings into investment by receiving deposits from the public and then lending the money to borrowers. Role of insurance sector 1 The major function of insurance is to pool and transfer risks. Insurance products provided by insurance companies help individuals and businesses manage risks. This encourages firms to undertake risky but profitable business projects. This also enables individuals to receive financial protection for their life and assets at an affordable cost. 2 Insurance companies are one of the biggest investors in the securities market. After
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receiving premiums from individuals, insurance companies invest them in the securities market. Premiums therefore serve as a long-term source of capital. Role of securities sector 1 Securities are important investment vehicles for retirement and savings purposes. For example, people can earn dividends on shares and interest on bonds. They may also earn capital gains by selling shares and bonds when their prices go up. 2 The securities sector provides a market for raising funds. To raise capital, companies may issue different kinds of securities while the government and public corporations issue bonds.

In conclusion, our economy will suffer without these financial sectors. They help allocate capital among different participants. They serve as middlemen in matching suppliers and borrowers of funds. Without these sectors, individuals would not be able to hold their money in a safe and convenient way. They could not earn interest on their savings. Firms would find it difficult to raise funds for expansion. They would be unwilling to bear risks because of a lack of protection. The operation of business sectors and the development of our economy would be seriously hampered. 25 1 Fixed-income securities are debt instruments. They are interest-bearing securities with a fixed percentage of return. Provided that the issuer of the fixed-income securities does not go bankrupt and the investors hold the securities to maturity, the return on those securities is guaranteed. Equity securities refer to securities that entitle holders to part of the ownership of listed companies (i.e., stocks). Investors may earn dividends and capital gains when stock prices increase. However, they may suffer a loss if the price drops. Mutual funds operate by pooling funds from investors and investing the money in different securities. They are managed by professional fund managers based on certain pre-determined investment objectives. Through mutual funds, investors can invest in various securities and achieve risk diversification with a relatively low investment amount.

26

The advantages of using debentures over shares are: 1 2 As interest on debentures is fixed, companies can predict the cost of raising capital.. By issuing debentures to raise capital, companies can retain decision-making power. This
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is because bondholders are only creditors of the companies. Shareholders are owners of the companies and companies must obtain approval from shareholders for important decisions. 3 Management can avoid losing control of the company. If companies issue shares and most of the shares fall into the hands of other companies (i.e., the majority shareholders), the majority shareholders could take control of the companies (Students may refer to Chapter 3 of Business Environment and Introduction to Management).

Case Analysis
27 (b) Martin can vote for or against important decisions made by SJM Holdings. He also has the right to receive dividends if declared. He should pay: 3 lots 1,000 shares $4 = $12,000 The securities sector allows SJM Holdings to raise capital by issuing shares. SJM Holdings can then use the capital raised for business development. On the other hand, SJM Holdings investors can earn dividends and capital gains by selling the shares when the stock price goes up. They can save for retirement and accumulate wealth through trading securities. Tom should use equity financing by issuing common stocks. The reasons are: (1) the company can issue shares to raise a huge amount of capital with riskier projects. (2) the amount is so big and the project is long-term without a clear timetable as to when there would be a profit. Thus, a bank loan (i.e., debt financing) is not possible. Step 1 Step 2 Step 3 Step 4 Step 5 Investment banks will identify suitable firms for listing Various professionals will then evaluate the listing candidate The listing candidate needs to obtain approval from government authorities The listing candidate also needs to obtain approval from the stock exchange The listing candidate becomes a listed company and needs to distribute new shares

(c) (d)

28

(a)

(b)

(c)

Advantages of using bonds: Refer to question 26. Disadvantages of using bonds: The company needs to pay interest to bondholders whether or not it makes a profit.

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