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The Definition and Importance of the Financial System

The phrase "financial system" has a wide range of definitions in the financial literature, with various writers understanding the term in different ways. The financial system may be characterized as a mechanism that allows governments to supply fundamental requirements to its citizens by facilitating the formation and active movement of financial resources (Lenka & Sharma, 2017). The public's interest in the operation of the financial system is growing by the day, as evidenced by historical evidence. Several experts disagree over whether a country's financial system has an influence on its economic growth. The framework related to the monetary decisions in the country sets out principles which are to be followed by different participants of the financial markets (Van der berg, 2016). These frameworks are used by lenders and borrowers which are utilized for conducting borrowing and lending activities inside the economy (Valickova, Havranek and Horvath, 2015). The financial system of a country comprises of various sections and segments including financial markets, institutions and instruments. Each of the segment is discussed below in detail:

  • Financial markets – These are the centers which allows a lender and a borrower to meet and carry out borrowing and lending activities. The components that are traded in the market are bonds, stocks, remote trade and subordinates. The markets are involved in empowering financial instruments like stocks, bonds, debentures, checks and other securities and the prices of the securities are governed by the laws of supply and demand (Madura, 2020). The market can be divided into several segments directed towards each security like stock market, bond market, commodity market, and derivatives market. The primary purpose of this report is to invest the savings of the individuals and the institutions into the markets, increase the wealth of the participants, minimizes transaction costs, to smoothen the assets liquidation process and regulates the commodity prices in the country (Valdex & Molyneux, 2015).
  • Financial Institution – The institutions and the establishment are the only authorities responsible for the monetary and fiscal components of the economy, as well as for regulating foreign commerce and managing money transactions. Banks, agency businesses, sellers, trust groups, and other types of financial institutions all have an influence on the economy. Institutions are significantly reliant on the inhabitants of the economy and financial players for a variety of financial needs (Burton, Nesiba and Brown, 2015). Individuals and institutions rely on financial institutions to carry out transactions and contribute to the economy. Governments control banks and other financial institutions, which must be monitored owing to the potential influence these institutions might have on the economy's growth. Institutional closures may have a considerable influence on the economy's performance. The most important participants are investment banks, insurance firms, non-banking financial institutions, and commercial banks (Fabozzi & Jones, 2019).
  • Financial instruments – These can be defined as financial contracts which are lawfully binding which obligates the party to fulfill the agreement entered into at the time of making the contract. The financial instrument which includes matters related to money are the ones that are required to be fulfilled by the law of the country (Chuen, 2015). There are multiple financial contracts which are explained in detail below:

Derivatives – Derivatives instruments are financial contracts that are used by financial markets participants for the purpose of hedging, speculation and arbitrage. The instruments include options, futures, forwards and other types of instruments which are used by participants for various purposes.

Cash instruments – These are instruments that are traded on the money markets and the price of such instruments are decided upon by the demand and supply in the market.

Because the laws and regulations within a jurisdiction encourage individuals to save through interest rates, the system plays an essential role in influencing economic growth. By making working money available to lenders and borrowers, the financial system increases employment and extends the business environment.

The overall budgetary structure of a country is responsible for the development of the monetary and fiscal policy making framework and assists in the development of financial system around the country. The global financial system has been developed with the help of national banks, multilateral disbursements and institutions associated with the government providing principle, sensibility and stability of the comprehensive market. The event of globalization has been expanding rapidly throughout the years starting from 1970s and the effect of the globalization driven by cash impacted the countries by merging them with countries and resources. After the year 1970, the world saw the beginning of association of several countries by means of flowing of capital streams, capital controls and deregulation of systems related to cash which is private to the individuals of the country. Capital related receptiveness have significant importance and advantages over the conduct of the world, as it has allowed the access of capital markets to various countries developing and developed. It has been established that once a country gains access to the world capital markets by means of globalization, it has resulted in several economic and financial benefits including the development of employment opportunities, development of the middle-class section of the society which holds significant importance for the development of a country and overall upliftment of the society by means of integration and learning. The valuable elements that had an impact on the overall growth of the financial system across the globe are as follows:

  • Stability in the banking system -The stability in the banking system in nations has a greater significance in the expansion of the financial markets as it establishes a relationship of trust and support amongst the participants. The development of banking industry helps in the improvement of capital distribution framework and the promotion of various financial products which are innovative in nature. Additional participation of the general public in the financial and banking system is an important element acting towards the upliftment of the society. The banking system is important in establishing a robust structure of the rules and regulations which prevent unlawful activities within a country.
  • Improvement in the macroeconomic factors – For an efficient structure of finance across the country it is important for a country to regulate the price of goods and services in the nation and imply strict punishments for practices which are unlawful and unethical in nature. Doing so the country can be able to diminish the changes of strategy loopholes to occur in the system and effectively allow the nation to follow well-established and proven macroeconomic theories.
  • Efficient use – If a country has access to global markets of credits it may allow the company to dictate terms or follow a path where it can have the maximum benefits by tweaking the terms and conditions of trades entered into with various counterparties.
  • Investment and growth – If a firm has the ability to grow its capital using the advantages provided by the access to global capital markets may have a significant impact in the private industry of the country. In many of the countries the growth is limited as the compensation offered is critically low. Access to global markets can allow the employers to get their hands-on capital which can be used to employ people with increased wages and compensation. Growth in access of capital allows a country to eventually increase the savings of the general public, raise the investments due to the fall in cost of capital and provide other necessary benefits for the weaker sections of the society.

The Monetary Framework and Its Principles

A term deposit is a type of fixed-term investment in which a person deposits money with a financial institution for a specific amount of time. An individual cannot withdraw funds before that time period, so if funds must be taken well before maturity term, he or she must pay penalties (Asritha, Hemavathi & Sujatha, 2022). The buyer is, for the most part, bound by the financial instrument's fixed term. When the investment reaches maturity, the investor must tell the commercial bank if he or she want to reinvest the proceeds or deposit cash into their account. If the client fails to disclose the commercial bank of the maturity date, the funds will be automatically transferred to a new term deposit with the same term and interest rate. The current rate of interest is paid on each term deposit, that may be lower than the previous rate of interest (Mirea, Florea & Aivaz, 2019). A demand deposit differs from a term deposit in that the investor does not have to wait for the investment to expire before withdrawing the money. The investor has the option to withdraw his or her money at any moment. As a trade-off for the convenience of withdrawing at any time, demand deposits pay lower rates than deposit accounts. The following section highlights the attributes of the instrument:

  • The asset provides security of capital.
  • A stable and consistent source of income in the form of interest payments are provided.
  • The term deposits are flexible in nature in terms of the duration of the investment. The investment can be made for short-term or long-term (Ziegler, 2020).
  • The term-deposits has a feature of rollover which allows an investor to roll over the capital at the time of maturity of the funds.

Equity is the amount of capital that would be left with a company if it sells all the assets of the company and meets all the liabilities of the company with the proceeds. It represents the worth of the company. The formula for equity can be understood by Total assets – Total Liabilities (Bhattacharjee & Singh, 2017). The following are the attributes of the equity which helps us understand the asset class:

  • Transferable – If you buy an equity share of the company, you buy a portion of the company in proportion of the amount of capital paid to buy the share of the company. The right to own the company is transferred to the investor up to the limit allowed by the number of shares purchased. The investor can participate in the decision-making process of the company. The investor can also transfer the ownership right to another party and get the capital invested into it (Edmans, Fang & Lewellen, 2017).
  • Obligation – The shareholder of the company is entitled to enjoy the profits of the firm similarly it will play an active role in withstanding the loss of the company if any.

Derivative instruments can be characterized as instruments which derive their value from an underlying asset and are a basic resource of gathering benefits. The derivatives is a financial contract entered into between two parties which agree upon a certain position in an asset which may yield returns or losses (Chance & Brooks, 2015). The examples of financial derivatives are futures, forwards, options, swaps and others. The purpose of the derivatives are diverse as it can be used arbitragers to exploit riskless profit opportunities, it can be used by hedgers to hedge against an existing position or it can be used by speculators to take bets on the direction of the price of a particular asset or the market as a whole. It is one of the most traded financial instruments in the world and is used by almost every other banks and financial institution for the management of risk (Gupta, 2017).

B) I consider myself to be a moderate risk taker not feeling shy of taking risk and also not overhyping my risk tolerance level. I would not go for asset classes which yields supernormal returns but comes with high risk associated to them. I would like to build an investment portfolio with moderately risky assets and capital growth assets with a time horizon of 10 to 15 years. I have a preference for large cap stocks over small cap and I avoid asset categories like private equity, venture capital and real estate. I do not hesitate from investing in foreign stocks given superior prospects for future. As per the thumb rule, the higher the risk I take the higher the reward I would expect. A portfolio with a moderate return and a safety for capital would satisfy my needs and wants.

C) My portfolio would be consisting of large cap stocks, small cap stocks, treasury bond ETFs and emerging market equites.

  • Large-cap stocks: Out of the total earnings of $10 million, I would be investing 40 percent of the capital into Large Cap stocks: 40% of 10,000,000 = $4,000,000.

Company

Price per share

Dividend Yield

Investment amount

No of shares purchased

JP Morgan Chase

$121.83

3.29%

40% of $4,000,000 = $1,600,000

1,600,000/121.83 = 13133 shares

Wallmart Inc

$153.83

1.46%

40% of $4,000,000 = $1,600,000

1,600,000/153.83 = 10,401 shares

Microsoft

$283.16

0.88%

20% of $4,000,000 = $800,000

800,000/283.16 = 2825 shares

  • Small-cap stock – 20 percent of the total winning amount of $10 million would be invested in small cap stocks: 20% of 10,000,000 = $2,000,000

Company

Price per share

Investment amount

No of shares purchased

Titan Machinery Inc

$24.49

40% of 2,000,000 = $800,000

800,000/24.49 = 32,666 shares

Original Materials Inc

$6.54

40% of 2,000,000 = $800,000

800,000/6.54 = 122,324 shares

BlueLinx Holdings Inc

$68.50

20% of 2,000,000 = $400,000

400,000/68.50 = 5839 shares

  • Emerging Market equities – 20% of the total income from lottery would be invested in high quality and large cap stocks of emerging markets: 20% of $10,000,000 = $2,000,000.

Company

Price per share

Investment amount

No of shares purchased

Teck Resources ltd Class B

$39.68

40% of 2,000,000 = $800,000

800,000/39.68 = 20,161 shares

Telefonica Brasil SA

$4.82

40% of 2,000,000 = $800,000

800,000/4.82 = 165,975 shares

Gold Field ADR

$13.58

20% of 2,000,000 = $400,000

400,000/13.58 = 29,455 shares

  • Treasury bonds ETF – 20% of the remaining capital would be invested in Exchange Traded Funds that have exposure to the treasury bonds of United States. A capital of $2,000,000 would be invested into SPDR Barclays 1-3 Month T-Bill ETF which seeks to track the Barclays Capital US 1-3-month Treasury Bill index. The weighted average maturity of the fund is 1.08 months and the expense ratio of the fund is equal to 0.14 percent. The NAV of the fund is equal to $91.43 and a total of 21,874 units of the fund could be bought using the capital (2,000,000/91.43).

References

Asritha, M., Hemavathi, D., & Sujatha, G. (2022). Analysis to Increase the Term Deposits in the Banking Sector Using Decision Tree. In Mobile Computing and Sustainable Informatics (pp. 795-804). Springer, Singapore.

Bhattacharjee, J., & Singh, R. (2017). Awareness about equity investment among retail investors: A kaleidoscopic view. Qualitative Research in Financial Markets.

Burton, M., Nesiba, R. F., & Brown, B. (2015). An introduction to financial markets and institutions. Routledge.

Chance, D. M., & Brooks, R. (2015). Introduction to derivatives and risk management. Cengage Learning.

Chuen, D. L. K. (Ed.). (2015). Handbook of digital currency: Bitcoin, innovation, financial instruments, and big data. Academic Press.

Edmans, A., Fang, V. W., & Lewellen, K. A. (2017). Equity vesting and investment. The Review of Financial Studies, 30(7), 2229-2271.

Fabozzi, F. J., & Jones, F. J. (2019). Foundations of Global Financial Markets and Institutions. MIT Press.

Gupta, S. L. (2017). Financial Derivatives: Theory, concepts and problems. PHI Learning Pvt. Ltd.

Lenka, S.K. & Sharma, R., 2017. Does financial inclusion spur economic growth in India?. The Journal of Developing Areas, 51(3), pp.215-228.

Madura, J. (2020). Financial markets & institutions. Cengage learning.

Mirea, M., Florea, I. M., & Aivaz, K. A. (2019). The Impact of the Interest Rate and the Income of the Households on the Dynamics of Bank Deposits. Ovidius University Annals, Economic ences Series, 19.

Valdez, S., & Molyneux, P. (2015). An introduction to global financial markets. Macmillan International Higher Education.

Valickova, P., Havranek, T. and Horvath, R., (2015). Financial development and economic growth: A meta?analysis. Journal of Economic Surveys, 29(3), pp.506-526.

Van den Berg, H., (2016). Economic growth and development. World Scientific Publishing Company.

Ziegler, L. (2020) Money, Sight and Term Deposits A New Monetarist Approach.

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