Assignment BUS 422
- Explain the statement, “A financial claim is someone’s asset and someone else’s liability”?
There exist two sides of perception of a financial claim or of a debt, which is the natural outcome of the fact that a debt is always a relationship between two counterparts. Whereas the issuers of a debt consider their debt as a liability, the creditors consider it an asset. Accordingly, financial claims are registered in a balance sheet, which is a financial statement that summarizes the liabilities and assets in a defined point of time and which thus mirror different perceptions of a debtor or of a creditor.
- Explain concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial systems?
Financial intermediation is the process that permits transformation of liabilities or assets to different types of liabilities or assets. Financial intermediaries channel surplus savings from individuals or companies to borrowers that need capital in order to carry out specific activities. Financial intermediation thus permits transformation of maturity of short-term liabilities to long term assets, convenience denomination and transformation of risk. The intermediation enhances the efficiency of the financial system through economies of scale and scope and allocation of available capital to areas of opportunity where the capital can put to use.
- Why is denomination divisibility an important intermediation service to the typical household?
The denomination divisibility is crucial for households as typical households on recurrent basis do not have enough liquid capital that would permit them to link their capital needs to capital markets that are trading high lump sums of capital with higher efficiency. Therefore, financial intermediaries, between other functions, also facilitate investment by households by offering financial claims with smaller denominations. Without such function, households would have to wait to accumulate large lump sums of capital before being able to invest and that would lead to high opportunity cost.
- Why are economies of scale important to the viability and profitability of financial intermediaries?
Economies of scale provide financial intermediaries a cost advantage in permitting reduction of average transaction costs. As financial services can be standardized as well as automated on large scales due to size of financial intermediaries that provide them, the average costs per transaction can be substantially lower. The economies of scale thus permit substantial savings for every intermediary, making financial system more efficient as a whole.
- Explain the differences between the money markets and the capital markets. Which market would General Motors use to finance a new vehicle assembly plant? Why?
Money markets are markets specialized on transactions with liquid, short-term capital with maturity of one year or less. Money markets include short-term loans, bills of exchange and acceptances, while liquidity is the major purpose of money markets. Covering of operating expenses or working capital belong to major reasons why companies invest funds in money markets. Capital markets on the other hand are markets that permit access to capital for long-term capital purposes, including stocks and bonds. Capital markets are also classified as primary markets for securities that are placed for the first time - or secondary markets, for already issued securities that are traded among traders. GM would seek to finance its new production plant through issuance of bonds or stocks in capital markets that permit long term repayment of financial claims. Investors would thus finance the new plant through purchase of the securities issued by GM as a long-term investment purpose. GM would be very probably unable to repay financial claims from the profits generated by the new plant in a time of less than one year and therefore capital markets are the only option for major investments.
- What is the prime rate? Why do some banks make loans below the prime rate?
The term of prime rate is applied in many financial systems in order to describe the interest rate that commercial banks charge the best customers. The prime rate is to a great extent influenced by the overnight interest rates on capital that banking institutions charge in mutual lending operations.
- What do we mean by “off-balance-sheet” activities? If these things are not on the balance sheet, are they important? What are some off-balance-sheet activities?
Off-balance-sheet activities describe financial transactions that are not recorded in the balance sheet of companies due to specific accounting classification methods. Some notorious off-balance-sheet activities are operating leases, joint venture financing or development partnerships. The mentioned activities can be crucial for the health of the company even if they are not recorded in the financial statements. The Enron bankruptcy was partially caused by issues caused by activities of off-balance-sheet entities that were set up by the mother holding.