CHAPTER ONE

AN OVERVIEW OF FINANCIAL SYSTEM

A financial system is a system that allows the transfer of money between savers and borrowers.
The Role/Functions of the Financial System in an Economy
 Saving Role/Function
 Liquidity Role/ Function
 Wealth Role/Function
 Credit Role/Function
 Payments Role/ Function
 Risk Role/Function
 Pooling Resources and Subdividing Shares
 Providing Information
 Policy Role/Function
Goals of a financial system
 Facilitate the flow of funds
 Share risks
 Generate liquidity

The three types of markets functioning with in the economic system

 Input/Factor Markets,
 Output/Product Markets, and
 Financial Markets
Classifications of financial market
 Money Markets
 Capital Markets
 Forex Markets
 Credit Market - financial market where borrowers and lenders come together to
obtain and extend credit.
FINANCIAL INTERMEDIARIES are financial institutions that facilitate the flow of
funds from those who have excess funds (savers) to those who need funds
(borrowers/surplus unit) by accepting deposits from savers and making loans to
borrowers. By
Financial regulators are governmental or non-governmental entities responsible for overseeing
and regulating financial markets, institutions, and participants to ensure stability, integrity, and
fair practices within the financial system. Financial regulation aims to protect investors, maintain
financial stability, prevent financial crimes, and promote market transparency and efficiency
The three major economic functions financial markets
 Price discovery
 Liquidity
 Reduced transaction costs
The four characteristics of money
 Medium of exchange
 Unit of account - standard numerical unit of measurement
 Store of value
 Standard of deferred payment
Types of Money
 Commodity money
 Representative money
 Credit money
 Fiat money

CHAPTER TWO
FINANCIAL ASSETS, FINANCIAL TRANSACTION AND FINANCIAL
INTERMEDIATION

Assets are classified as –

 Financial assets/instruments and
 Physical assets
Characteristics / properties of Financial Assets
 Moneyness
 Divisibility& denomination
 Reversibility
 Term to maturity
 Liquidity
 Convertibility
 Complexity
 Store value

Financial assets can also be classified as

A
 Debt securities and
 Equity securities.

B
 Negotiable Instruments
Negotiable instruments are securities that can be easily transferred from one holder to
another. Their claims are paid to the bearer of the instrument.
Negotiable instruments include instruments like bonds, checks, stock, Treasury bill, et
 Non-negotiable Instruments
Non-negotiable instruments are securities that cannot legally be transferred from one
party to another party.
They include instruments like: Saving accounts, Bill of lading (proof of purchase), Air
way bill, Letter of credit, etc.
C
 Money Market Instruments
 Treasury-Bills (T-Bills)
 Commercial paper
 Certificate of deposit
 Repurchase agreement
 Bankers’ Acceptance
 Federal Funds
 Capital market instruments
 Common stocks
 Preferred stocks
o Redeemable and irredeemable
o Convertible and nonconvertible
o Cumulative and noncumulative
o Participating and nonparticipating
 Bonds
o Convertible Bonds
o Income bonds
o Term bond
o Serial bonds
o Callable /Redeemable Bonds
o Puttable /Put Bond Bonds
o Zero Coupon Bonds
o Secured and Unsecured Bonds

FINANCIAL TRANSACTIONS
 Direct Finance - rowers and lenders meet each other and exchange funds in return for
financial assets
 Semi Direct Finance - market specialists (security brokers and dealers) exist whose
essential function is to bring the SSU and the SDU together, thereby reducing
information costs.
 Indirect Finance/Financial Intermediation -the financial intermediaries obtain the
funds from the SSUs and offer their own securities to the SSUs, then provide the funds to
the DSUs and accept the securities issued by DSUs as financial claims on the DSUs.

FIM CHAPTER 2

1. What is the primary function of a financial system in an economy?

- A) Allocating resources efficiently
- B) Generating profits for investors
- C) Regulating financial institutions
- D) Facilitating government spending

Explanation: A) Allocating resources efficiently. The financial system facilitates the transfer of
funds between savers and borrowers, allowing for the efficient allocation of resources in the
economy.

2. Which of the following is not a function of money?

- A) Medium of exchange
- B) Unit of account
- C) Store of wealth
- D) Redistribution of income
Explanation: D) Redistribution of income. Money primarily serves as a medium of exchange,
unit of account, and store of wealth, but it does not directly involve the redistribution of income.

3. Which type of financial market deals with short-term, highly liquid instruments?
- A) Money market
- B) Capital market
- C) Forex market
- D) Credit market

Explanation: A) Money market. The money market deals with short-term, highly liquid
instruments such as treasury bills, commercial paper, and certificates of deposit.

4. What is the main goal of financial intermediaries in the financial system?

- A) Maximizing shareholder profits
- B) Facilitating government spending
- C) Reducing transaction costs
- D) Providing insurance services

Explanation: C) Reducing transaction costs. Financial intermediaries aim to reduce transaction

costs by efficiently matching lenders with borrowers and providing favorable terms for both
parties.

5. Which of the following is not a characteristic of commodity money?

- A) Backed by a physical commodity
- B) Limited supply
- C) Fungible
- D) Unlimited creation by central banks
Explanation: D) Unlimited creation by central banks. Commodity money is backed by a physical
commodity like gold or silver and has a limited supply determined by the availability of the
commodity.

6. What role does the financial system play in managing risk?

- A) Eliminating all forms of risk
- B) Providing insurance against all losses
- C) Offering ways to manage uncertainty
- D) Guaranteeing returns on investments

Explanation: C) Offering ways to manage uncertainty. The financial system provides various
instruments and markets for managing risk, such as insurance policies and derivative products.

7. Which financial market is designed to finance long-term investments?

- A) Money market
- B) Capital market
- C) Forex market
- D) Credit market

Explanation: B) Capital market. The capital market is designed to facilitate the buying and
selling of long-term securities such as stocks and bonds, which are used to finance long-term
investments.

8. What is the main purpose of a unit of account in the monetary system?

- A) Facilitating transactions
- B) Storing wealth
- C) Measuring the value of goods and services
- D) Reducing inflation
Explanation: C) Measuring the value of goods and services. A unit of account provides a
standard numerical unit of measurement for determining the relative worth of goods and services
in the economy.

9. Which financial market deals with the exchange of different currencies?

- A) Money market
- B) Capital market
- C) Forex market
- D) Credit market

Explanation: C) Forex market. The foreign exchange (forex) market deals with the exchange of
different currencies and determines exchange rates between them.

10. What is the primary function of a financial regulator?

- A) Maximizing profits for financial institutions
- B) Ensuring fair and transparent financial markets
- C) Guaranteeing returns on investments
- D) Facilitating government spending

Explanation: B) Ensuring fair and transparent financial markets. Financial regulators oversee
financial institutions and markets to ensure fair practices, transparency, and stability in the
financial system.

11. Which of the following is not a primary goal of a financial system?

- A) Facilitating the flow of funds
- B) Sharing risks among economic agents
- C) Maximizing shareholder profits
- D) Generating liquidity
Explanation: C) Maximizing shareholder profits. While financial systems aim to facilitate the
flow of funds, share risks, and generate liquidity, maximizing shareholder profits is not their
primary goal but rather a byproduct of efficient operations.

13. Which of the following is a characteristic of fiat money?

- A) Backed by a physical commodity
- B) Limited supply
- C) Redeemable for a fixed quantity of gold
- D) Value determined by government decree

Explanation: D) Value determined by government decree. Fiat money has value because the
government decrees it to be legal tender and accepts it for all debts, public and private, within the
country.

14. What is the main function of financial markets in an economy?

- A) Providing insurance services
- B) Reducing transaction costs
- C) Allocating resources efficiently
- D) Facilitating government spending

Explanation: C) Allocating resources efficiently. Financial markets facilitate the allocation of

resources by matching savers with borrowers and determining the prices of financial instruments.

15. Which type of market determines the interest rates and security prices in an economy?
- A) Money market
- B) Capital market
- C) Forex market
- D) Credit market

Explanation: B) Capital market. The capital market sets interest rates and security prices for
long-term investments, including stocks and bonds.
16. What is the primary function of financial intermediaries in the financial system?
- A) Maximizing shareholder profits
- B) Reducing transaction costs
- C) Facilitating government spending
- D) Providing insurance services

Explanation: B) Reducing transaction costs. Financial intermediaries aim to reduce transaction

costs by efficiently matching lenders with borrowers and providing favorable terms for both
parties.

17. Which financial market deals with short-term, highly liquid instruments?
- A) Money market
- B) Capital market
- C) Forex market
- D) Credit market

Explanation: A) Money market. The money market deals with short-term, highly liquid
instruments such as treasury bills, commercial paper, and certificates of deposit.

18. What role does the financial system play in managing risk?
- A) Eliminating all forms of risk
- B) Providing insurance against all losses
- C) Offering ways to manage uncertainty
- D) Guaranteeing returns on investments

Explanation: C) Offering ways to manage uncertainty. The financial system provides various
instruments and markets for managing risk, such as insurance policies and derivative products.

19. Which financial market is designed to finance long-term investments?

- A) Money market
- B) Capital market
- C) Forex market
- D) Credit market

Explanation: B) Capital market. The capital market is designed to facilitate the buying and
selling of long-term securities such as stocks and bonds, which are used to finance long-term
investments.
22. What is the primary function of a financial regulator?
- A) Maximizing profits for financial institutions
- B) Ensuring fair and transparent financial markets
- C) Guaranteeing returns on investments
- D) Facilitating government spending

Explanation: B) Ensuring fair and transparent financial markets. Financial regulators oversee
financial institutions and markets to ensure fair practices, transparency, and stability in the
financial system.

24. What is the primary function of money as a medium of exchange?

- A) Storing wealth
- B) Measuring the value of goods and services
- C) Facilitating transactions
- D) Reducing inflation

Explanation: C) Facilitating transactions. Money serves as a medium of exchange by enabling

the easy exchange of goods and services without the need for bartering.

25. Which of the following is a characteristic of fiat money?

- A) Backed by a physical commodity
- B) Limited supply
- C) Redeemable for a fixed quantity of gold
- D) Value determined by government decree
Explanation: D) Value determined by government decree. Fiat money has value because the
government decrees it to be legal tender and accepts it for all debts, public and private, within the
country.

26. What role does the financial system play in managing risk?
- A) Eliminating all forms of risk
- B) Providing insurance against all losses
- C) Offering ways to manage uncertainty
- D) Guaranteeing returns on investments

Explanation: C) Offering ways to manage uncertainty. The financial system provides various
instruments and markets for managing risk, such as insurance policies and derivative products.

28. What is the main function of a financial regulator?

- A) Maximizing profits for financial institutions
- B) Ensuring fair and transparent financial markets
- C) Guaranteeing returns on investments
- D) Facilitating government spending

Explanation: B) Ensuring fair and transparent financial markets. Financial regulators oversee
financial institutions and markets to ensure fair practices, transparency, and stability in the
financial system.

29. Which of the following is not a characteristic of commodity money?

- A) Backed by a physical commodity
- B) Limited supply
- C) Fungible
- D) Unlimited creation by central banks
Explanation: D) Unlimited creation by central banks. Commodity money is backed by a physical
commodity like gold or silver and has a limited supply determined by the availability of the
commodity.

30. What is the primary function of financial markets in an economy?

- A) Providing insurance services
- B) Reducing transaction costs
- C) Allocating resources efficiently
- D) Facilitating government spending

Explanation: C) Allocating resources efficiently. Financial markets facilitate the allocation of

resources by matching savers with borrowers and determining the prices of financial instruments.

These questions cover various aspects of financial systems, money, financial markets, and
regulatory frameworks, providing a comprehensive understanding of the subject matter.

FIM CHAPER 2

1. Which of the following is NOT a characteristic of financial assets?

a) Moneyness
b) Depreciation
c) Convertibility
d) Liquidity
Correct Answer: b) Depreciation
Explanation: Financial assets do not depreciate physically like tangible assets. Their value may
fluctuate but they do not wear out over time.

2. Equity securities represent:

a) Ownership in a business firm
b) Debt obligations
c) Short-term loans
d) Physical assets
Correct Answer: a) Ownership in a business firm
Explanation: Equity securities confer ownership rights in a business firm and are entitled to share
in the profits and assets of the company.

3. Which financial asset typically has the shortest term to maturity?

a) Bonds
b) Treasury bills
c) Stocks
d) Preferred shares
Correct Answer: b) Treasury bills
Explanation: Treasury bills usually have very short terms to maturity, often ranging from a few
days to a year.

4. Negotiable instruments include:

a) Savings accounts
b) Warehouse receipts
c) Certificate of deposits
d) Bankers' acceptances
Correct Answer: d) Bankers' acceptances
Explanation: Negotiable instruments are securities that can be easily transferred, such as bonds,
checks, stocks, and bankers' acceptances.

5. Which money market instrument is often regarded as the least risky?

a) Commercial paper
b) Certificate of deposit
c) Treasury bills
d) Repurchase agreements
Correct Answer: c) Treasury bills
Explanation: Treasury bills are backed by the government and are considered to be among the
safest investments, hence they are often regarded as the least risky.
6. What is the primary function of financial assets?
a) Generate profits for businesses
b) Transfer funds between parties
c) Provide continuous services
d) Ensure physical maintenance of assets
Correct Answer: b) Transfer funds between parties
Explanation: Financial assets facilitate the transfer of funds from surplus units to deficit units in
an economy.

7. What is the main difference between debt securities and equity securities?
a) Debt securities represent ownership, while equity securities represent debt obligations.
b) Debt securities pay periodic interest and principal, while equity securities do not.
c) Equity securities have a fixed term to maturity, while debt securities do not.
d) Debt securities are highly marketable compared to equity securities.
Correct Answer: b) Debt securities pay periodic interest and principal, while equity securities do
not.
Explanation: Debt securities involve regular interest payments and repayment of principal, while
equity securities represent ownership without any obligation for regular payments.

8. Which financial asset is considered a derivative instrument?

a) Treasury bills
b) Corporate bonds
c) Options
d) Common stock
Correct Answer: c) Options
Explanation: Options derive their value from underlying assets such as stocks, bonds, or
commodities, making them derivative instruments.

9. Marketable assets are characterized by:

a) Difficulty in transferring ownership
b) Low liquidity
c) Easy transferability
d) High depreciation rates
Correct Answer: c) Easy transferability
Explanation: Marketable assets are easily transferable from one person to another without much
difficulty.

11. What is the main characteristic of negotiable instruments?

a) They cannot be transferred between parties
b) Their claims are paid to the bearer of the instrument
c) They have fixed interest rates
d) They cannot be traded in the secondary market
Correct Answer: b) Their claims are paid to the bearer of the instrument**
Explanation: Negotiable instruments are securities whose claims are paid to the bearer of the
instrument, making them easily transferable.

12. Treasury bills typically have a term to maturity of:

a) 5 years
b) 10 years
c) 1 year or less
d) 30 days
Correct Answer: c) 1 year or less
Explanation: Treasury bills usually have very short terms to maturity, often less than a year.

13. Certificate of deposit (CD) is a type of:

a) Equity security
b) Derivative instrument
c) Debt security
d) Money market instrument
Correct Answer: c) Debt security
Explanation: Certificate of deposit represents a time deposit and is considered a debt security.

14. Which money market instrument typically has the highest liquidity?
a) Treasury bills
b) Commercial paper
c) Certificate of deposit
d) Federal funds
Correct Answer: d) Federal funds
Explanation: Federal funds are overnight borrowings by banks to maintain their reserves and
are highly liquid.

15. Bankers' acceptances are primarily used to:

a) Facilitate commercial trade transactions
b) Provide long-term financing
c) Hedge against interest rate risk
d) Invest in real estate
Correct Answer: a) Facilitate commercial trade transactions
Explanation: Bankers' acceptances are used to facilitate international trade transactions by
providing a guarantee of payment.

16. Which of the following is NOT a characteristic of negotiable instruments?

a) Easily transferable
b) Payable to the bearer
c) Fixed interest rates
d) Can be traded in the secondary market
Correct Answer: c) Fixed interest rates
Explanation: Negotiable instruments may have variable interest rates and are not necessarily
fixed.

1. What are Treasury Notes and Bonds?

A. Short-term debt instruments
B. Medium-term debt instruments
C. Long-term debt instruments
D. Equity instruments

Answer: C. Long-term debt instruments

Explanation: Treasury Notes and Bonds are long-term debt instruments issued by the U.S.
Treasury.

2. Which type of bond allows the bondholder to exchange it for shares of the issuing
corporation's stock?
A. Municipal bond
B. Convertible bond
C. Corporate bond
D. Foreign bond

Answer: B. Convertible bond

Explanation: Convertible bonds allow bondholders to convert their bonds into shares of the
issuing corporation's stock at a predetermined ratio.

3. What is a characteristic of common stock?

A. Guaranteed dividends
B. Priority in bankruptcy
C. Limited liability for shareholders
D. Fixed maturity date

Answer: C. Limited liability for shareholders

Explanation: Common stockholders have limited liability, meaning they are not personally
liable for the debts of the corporation.

5. What is the main function of financial systems?

A. Generate profits for financial institutions
B. Facilitate the transfer of funds from savers to borrowers
C. Ensure government control over monetary policy
D. Guarantee returns for investors

Answer: B. Facilitate the transfer of funds from savers to borrowers

Explanation: The main function of financial systems is to move funds from savers to
borrowers.

6. What is a drawback of direct finance?

A. Low information costs
B. Minimal involvement of third parties
C. Limited options for borrowers and lenders
D. High liquidity of financial assets

Answer: C. Limited options for borrowers and lenders

Explanation: Direct finance requires borrowers and lenders to find each other directly, limiting
their options.

7. What is the role of brokers in semi-direct finance?

A. Provide information about securities
B. Buy and sell securities from their inventory
C. Act as matchmakers between buyers and sellers
D. Offer securities directly to ultimate investors

Answer: C. Act as matchmakers between buyers and sellers

Explanation: Brokers bring buyers and sellers together but do not buy or sell securities from
their inventory.

8. Indirect finance involves the use of:

A. Financial intermediaries
B. Direct credit markets
C. Secondary securities
D. Primary securities

Answer: A. Financial intermediaries

Explanation: Indirect finance relies on financial intermediaries to channel funds from savers to
borrowers.

10. What is a characteristic of depository institutions?

A. They primarily issue life insurance policies
B. They are not subject to government regulations
C. They accept deposits from the public
D. They do not provide loans to borrowers

Answer: C. They accept deposits from the public

Explanation: Depository institutions accept deposits from the public and provide loans to
borrowers.

11. What is the main advantage of convertible bonds?

A. They offer high fixed interest rates
B. They provide priority in bankruptcy proceedings
C. They allow bondholders to convert into equity shares
D. They have a shorter maturity period

Answer: C. They allow bondholders to convert into equity shares

Explanation: Convertible bonds give bondholders the option to convert their bonds into equity
shares.

12. Which type of preference shares are presumed to be cumulative unless stated otherwise?
A. Redeemable preference shares
B. Irredeemable preference shares
C. Cumulative preference shares
D. Non-cumulative preference shares

Answer: C. Cumulative preference shares

Explanation: Cumulative preference shares accumulate unpaid dividends for future payment.

14. What is the primary function of dealers in semi-direct finance?

A. Offer securities directly to investors
B. Act as intermediaries between buyers and sellers
C. Provide loans to corporations
D. Purchase securities for their own inventory

Answer: D. Purchase securities for their own inventory

Explanation: Dealers purchase securities for their own inventory and make a market for them
by offering to buy and sell at specific prices.