Study Unit 1
The role and structure of the SA Financial System
Page 1 of 94
FORMAT OF THE EXAMINATION
Long questions:
Choose 2 of three 2 x 25 = 50
Study Units 1 and 2
Study Units 2 and 3
Study Units 1, 4 and 5
Multiple choice 25 x 2 25 x 2 = 50
The left hand paragraph reference is to the Study Guide.
The second paragraph reference is to the textbook; Page references are listed with chapter heading.
“Sentences in italics and quotes under paragraph headings reflect stated study guide requirements.”
References (AR) refer to the Tutor.
,Study Unit 1
The role and structure of the SA Financial System
Page 2 of 94
1.1 1.1 Definition of the Financial System SG p11 VZ p1
A set of conventions surrounding the lending and borrowing of funds by
nonfinancial units, and the intermediation of this function by financial
institutions
- to facilitate the transfer of funds;
- to create additional money when required and
- to create markets in debt instruments so that the price and allocation of
funds are determined efficiently
1.2 Six elements characterise the financial system VZ p3
1. Lenders and borrowers (Surplus and deficit units)
2. Financial intermediaries
3. Financial instruments
4. The creation of money
5. Financial markets
6. The price of money, interest rate
Ultimate lenders and ultimate borrowers comprise the same
four categories:
1. Households
Individuals / families / charitable, religious and non profit making
bodies, unincorporated business e.g. farmers, retailers,
partnerships, since the transactions of these businesses cannot be
separated from those of their owners
2. Firms
Corporate sector comprising all companies not classified as
financial institutions; business enterprises engaged in the
production and distribution of goods and services
3. Government
Central, provincial, local government
4. Foreign Sector
All organizations, persons and assets resident in the rest of the
world.
Direct financing takes place where no intermediary is involved in a
financial transaction, however a broker may be involved, e.g. an
underwriting house in selling corporate bonds to raise cash, is a facilitator
not an intermediary
Indirect financing takes place where an intermediary matches a
borrower with a lender, thus satisfying both parties. His fee is the
difference or margin between the two.
Direct securities are financial instruments sold for the first time
Secondary securities are those which have been sold at least once and
are re-sold
Primary securities represent a financial transaction/obligation
between an intermediary and a borrower
Indirect securities represent a financial transaction/obligation
between a lender and an intermediary
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The role and structure of the SA Financial System
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Direct financing is when a deficit economic unit (borrower) issues
financial instruments and sells these to the surplus units in the economy
Indirect financing is when an intermediary concludes a transaction
between a borrower and a lender
NonReversible instruments must be held until their expiry date and
may not be re-sold, like Insurance policies, mortgage bonds
Reversible or Negotiable instruments may be sold as required, e.g.
shares
A Treasury Bill is a short-term paper with a term of 3 months
The Treasury (Government) may use this instrument to raise short-term
money to relieve cashflow shortfalls caused by the fact that its expenses
are monthly but its income is annual or twice annually, or monthly in the
case of VAT (but not enough to cover the salary bill). Treasury bills are
marketable.
A spot transaction is one which will be fully executed (i.e. bought and
paid for) within four days.
Over-the-counter (OTC) transactions are informal.
The JSE is primarily a secondary market since most shares traded are
being traded not for the first time.
SARB debentures are money market instruments in that they enable
the control of the money supply. However, the way the money supply is
controlled nowadays is through the interest rate, which is raised when
there is too much liquidity, in order to curb credit and spending, and
dropped when spending is to be encouraged, by making it cheaper to
borrow.
1.2 9.6 Financial investment is investment in financial instruments in either
primary or secondary markets.
Real investment is investment in capital goods, machinery, plant, etc.
The return is the earnings on financial investment:
This can be either
(a) income yield: the income component of the return, normally a
payment of cash. This cash is either an interest payment or a
dividend payment.
(b) capital gain: This is the difference between the price when
bought and the price realized when sold. Capital gain or loss is
generally caused by an interest rate change in the market.
Proper measurement of return on an investment should
include both the yield and the capital gain (or loss).
9.6 NonDiversifiable and diversifiable risk of investments:
SG p15 VZ p219-220
NonDiversifiable:
i. Interest rate risk: changes in market interest rates, e.g. inverse
relationship between interest rates and bond rates
ii. Inflation risk: influences interest rates
, Study Unit 1
The role and structure of the SA Financial System
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iii. Bull-Bear market risk: market forces
iv. Country or Political risk:
International, e.g. Zimbabwe
Domestic, changes in legislation, taxes, fiscal policy
v. Industry risk: e.g. the clothing industry in Cape Town when
Chinese imports have prevailed at much lower prices
Diversifiable:
i. Management risk: the harm managers can cause, risk
aversion, risk seeking
ii. Default risk: changes in creditworthiness of a firm in which
you may have invested
iii. Liquidity risk: e.g. price discounting or heavy commissions
to promote aggressive selling
iv. Callability risk: e.g. where bonds are called in due to drop in
interest rate
v. Convertibility risk: e.g. where the investment may be
changed from that which is in the investor’s best interest
1.3 9.5 Financing a deficit SG p15 VZ p215-217
a. Loan from bank
b. Loan from micro lender
c. Funds from investor
Debt financing
Equity financing
Important to find the balance of the above which results in the lowest cost
of capital, or weighted average cost of capital WACC.
Example of WACC calculations SG p216:
Debt finance 10%: After-tax cost if 9.94%
Equity finance 90%: Required rate of return on equity is 16%
10% x 9.94 = 0,994
90% x 16% return = 14.400
Total = 15,395
The lower the required rate of return, the higher should be the value of
the firm.
A firm may need to raise money from time to time for such items
as
- replacement of assets (plant, machinery, etc.)
- expansion in the form of growth or acquisition
- renewal of assets
- R&D of new products
Debt financing can be in the form of mortgage bonds, bonds,
debentures.
The amount of debt finance borrowed is called the principal. This must
be paid back to the lenders and the debt must be serviced through
regular interest payments.
