Chapter 01 - A Modern Financial System An Overview

Chapter 1
The Financial System
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger
Learning Objectives
Explain the functions of a financial system Describe the main classes of financial
instruments issued in a financial system Distinguish between various types of financial markets according to function Discuss the flow of funds between savers and borrowers, including direct and intermediated finance
Learning Objectives (cont.)

Appreciate the influence of globalization on
financial markets Categorize the main types of financial institutions Understand the impact of a financial crisis on a financial system and a real economy
Chapter Organization
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalization Financial Institutions Summary
1.1 Introduction
Money
Medium of exchange Allows specialization in production Solves the divisibility problem, i.e. where medium of exchange does not represent equal value for the parties to the transaction Facilitates saving Store of wealth Any commodity that is widely accepted in exchange transactions
1.1 Introduction (cont.)

Role of markets Facilitate exchange by

Bringing opposite parties together Establishing rates of exchange, i.e. prices
Surplus units Savers of funds available for lending Deficit units Borrowers of funds for capital investment and consumption

Financial instrument Issued by a party raising funds, acknowledging a financial commitment and entitling holder to specified future cash flows Flow of funds Movement of funds through the financial system between savers and borrowers giving rise to financial instruments

Financial system Financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions Overcomes difficulty of

Double coincidence of wants

Transaction between two parties meets their mutual needs
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments andWillis Financial Accounting by Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger Slides prepared by Kaye Watson
Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalisation Financial Institutions Summary
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1.2 Functions of the Financial System

Attributes of financial assets Return or yield

Total financial compensation received from an investment expressed as a percentage of the amount invested Probability that actual return on an investment will vary from the expected return
Risk

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1.2 Functions of the Financial System (cont.)

Liquidity Ability to sell an asset within reasonable time at current market prices and for reasonable transaction costs Time-pattern of the cash flows When the expected cash flows from a financial asset are to be received by the investor or lender
12

The financial system facilitates portfolio
restructuring
The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows
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An efficient financial system Encourages savings Savings flow to the most efficient users Implements the monetary policy of governments by influencing interest rates The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows
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1.3 Financial Instruments

Equity Ownership interest in an asset Residual claim on earnings and assets

Dividend Liquidation Ordinary share Preference shares or Equity Hybrid (or quasi-equity) security
Preference shares Convertible notes
Types

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1.3 Financial Instruments (cont.)

Debt Contractual claim to

Periodic interest payments Repayment of principal
Ranks ahead of equity Can be secured or unsecured
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Derivatives A synthetic security providing specific future rights that derives its price from a

Physical market commodity

Gold and oil
Financial security
Interest rate-sensitive debt instruments, currencies and equities
Used mainly to manage price risk exposure, and to speculate
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Four basic derivative contracts Futures Contract Forward Contract Option Contract Swap Contract
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1.4 Financial Markets

Matching principle Primary and secondary market transactions Direct and intermediated financial flow
markets Wholesale and retail markets Money markets Capital markets
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Matching principle
Short-term assets should be funded with
short-term liabilities
Inventory funded by overdraft
Longer-term assets should be funded with
equity or longer-term liabilities

Equipment funded by debentures
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Primary and secondary market transactions

Primary market transaction The issue of a new financial instrument to raise funds to purchase goods, services or assets by

Businesses
Company shares or debentures
Governments
Treasury notes or bonds
Individuals
Mortgage
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Primary and secondary market transactions (cont.)

Secondary market transaction The buying and selling of existing financial instruments

No direct impact on original issuer of security Transfer of ownership from one saver to another saver Provides liquidity which facilitates restructuring of portfolios of security owners
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Direct and intermediated financial flow markets

Direct flow markets Users of funds obtain finance directly from savers

Advantages
Avoids costs of intermediation Increases range of securities and markets
Disadvantages
Matching of preferences Liquidity and marketability of a security Search and transaction costs Assessment of risk, especially default risk
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Direct and intermediated financial flow markets (cont.)
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Intermediated flow markets A financing arrangement involving two separate contractual agreements whereby saver provides funds to intermediary, and the intermediary provides funding to the ultimate user of funds
Advantages

Asset transformation Maturity transformation
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Advantages (cont.)

Credit risk diversification and transformation Liquidity transformation Economies of scale
Sectorial flow of funds The flow of funds between business, financial institutions, government and household sectors and the rest of the world Influenced by fiscal and monetary policy
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Wholesale and retail markets

Wholesale markets Direct financial flow transactions between institutional investors and borrowers

Involves large transactions
Retail markets Transactions conducted primarily with financial intermediaries by the household and smallmedium business sectors

Involves smaller transactions
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Money markets
Wholesale markets in which short-term
securities are issued and traded

Securities highly liquid

Term to maturity of one year or less Highly standardised form Deep secondary market
No specific infrastructure or trading place Enable participants to manage liquidity
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Money markets (cont.)

Money market securities Cash deposits (11 a.m. and 24-hour call) Commercial bills Treasury notes Government bonds Promissory notes Intercompany loans Interbank loans
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Money market participants Reserve Bank

Financial system liquidity Implementation of monetary policy
Banks Finance companies Funds managers Building societies Credit unions Companies
33

Money market sub-markets Intercompany market Interbank market Bills market Commercial paper market Negotiable certificates of deposit (CDs) market
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Capital markets
Markets in which longer-term securities are
issued and traded

Equity markets Corporate debt markets Government debt markets Foreign exchange markets Derivatives markets
Term to maturity of more than one year
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1.5 Impact of Globalisation

Globalisation of financial markets Refers to the interdependence of national financial systems Global standardisation of financial instruments Facilitates the movement of funds between savers and borrowers in different countries
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1.6 Financial Institutions

Financial institutions permit the flow of
funds between borrowers and lenders by facilitating financial transactions

Institutions may be categorised by
differences in the sources and uses of funds
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1.6 Financial Institutions (cont.)

Categories of financial institutions Depository financial institutions Investment banks and merchant banks (money market corporations) Contractual savings institutions Finance companies Unit trusts
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Categories of financial institutions

Depository financial institutions Attract savings from depositors and investors to provide loan facilities to borrowers Commercial banks Building societies Credit unions
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Categories of financial institutions (cont.)

Investment banks and merchant banks (money market corporations)
Mainly provide off-balance-sheet (OBS)
transactions to corporations and government Advice on mergers and acquisitions, portfolio restructuring, finance and risk management Provide some funding
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Contractual savings institutions The liabilities of these institutions are contracts that specify, in return for periodic payments to the institution, the institution will make payments to the contract holders if a specified event occurs Funds are then used to purchase both primary and secondary market securities
Life and general insurance companies Superannuation funds
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Finance companies
Funds are raised by issuing financial
securities direct into money markets and capital markets

Funds are used to make loans to ultimate
borrowers
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Categories of financial institutions (cont)

Unit trusts Investors purchase units in the trust Trust manager invests funds in a range of investments specified by trust deed Types of unit trusts
Cash management trusts Equity trusts Property trusts Mortgage trusts
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1.6 Financial Institutions (cont.)

Assets of financial institutions
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1.7 Summary
The financial system is composed of
financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions
Financial instruments may be equity, debt
or hybrid
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1.7 Summary (cont.)

Financial markets may be classified
according to
Primary and secondary transactions Direct and intermediated flows Wholesale and retail markets Money markets and capital markets Financial institutions
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Chapter 1

The Financial System

Learning Objectives (cont.)

1.1 Introduction (cont.)

Bringing opposite parties together Establishing rates of exchange, i.e. prices

1.1 Introduction (cont.)

1.1 Introduction (cont.)

Double coincidence of wants

1.1 Introduction (cont.)

1.2 Functions of the Financial System

1.2 Functions of the Financial System (cont.)

1.2 Functions of the Financial System (cont.)

1.2 Functions of the Financial System (cont.)

1.3 Financial Instruments

1.3 Financial Instruments (cont.)

Periodic interest payments Repayment of principal

Ranks ahead of equity Can be secured or unsecured

1.3 Financial Instruments (cont.)

Physical market commodity

Used mainly to manage price risk exposure, and to speculate

1.3 Financial Instruments (cont.)

1.4 Financial Markets

markets Wholesale and retail markets Money markets Capital markets

Longer-term assets should be funded with

equity or longer-term liabilities

Primary and secondary market transactions

Primary and secondary market transactions (cont.)

Direct and intermediated financial flow markets

Direct and intermediated financial flow markets (cont.)

Direct and intermediated financial flow markets (cont.)

Asset transformation Maturity transformation

Direct and intermediated financial flow markets (cont.)

Credit risk diversification and transformation Liquidity transformation Economies of scale

Direct and intermediated financial flow markets (cont.)

Wholesale and retail markets

Involves large transactions

Involves smaller transactions

securities are issued and traded

No specific infrastructure or trading place Enable participants to manage liquidity

Money markets (cont.)

Money markets (cont.)

Financial system liquidity Implementation of monetary policy

Money markets (cont.)

issued and traded

Term to maturity of more than one year

1.5 Impact of Globalisation

1.6 Financial Institutions

funds between borrowers and lenders by facilitating financial transactions

differences in the sources and uses of funds

1.6 Financial Institutions (cont.)

Categories of financial institutions

Categories of financial institutions (cont.)

Categories of financial institutions (cont.)

Categories of financial institutions (cont.)

securities direct into money markets and capital markets

Categories of financial institutions (cont)

1.6 Financial Institutions (cont.)

1.7 Summary (cont.)

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