Mock Exam MNA106

1(a). What are the key functions of a financial system?
[8 marks]
The main functions of financial systems are to:
• provide the mechanisms by which funds can be transferred from units in surplus to units with a shortage of funds in order to directly or indirectly facilitate lending and borrowing
• enable wealth holders to adjust the composition of their portfolios
• provide payment mechanisms
• provide mechanisms for risk transfer

1(b) Describe the key functions of financial markets.
[6 marks]
PRICING FUNCTION: financial markets provide both buyers and sellers with “fair” valuation of the asset they are buying/selling
DISCIPLINE FUNCTION: financial markets are regulated – regulation encourages issuers of securities (borrowers) not to engage in activities that the market deems detrimental to the value of their assets

1(c) Describe the problems arising due to information asymmetry.
[12 marks]
Adverse selection is the problem created by asymmetric information before the transaction occurs. It arises when the potential borrowers who are most likely to produce an undesirable (adverse) outcome are the ones who most actively seek out loans. Thus adverse selection increases the probability that bad credit risks will get loans. As a consequence, lenders may decide not to give any loans, even to good credit risks.

Moral hazard is the problem that occurs after the transaction is made. It is the risk (hazard) that the borrower will engage in activities that are undesirable (immoral) for the lender. These activities potentially reduce the probability that the loan will be repaid. Again, the consequence is that lenders may decide not to make any loans. Investors are more likely to behave differently when using borrowed funds rather than when using their own funds.

1(d) Compare and contrast money markets with capital markets
[7 marks]