Introduction to Direct Financing

Question 1

What is direct financing?

Answer 1

Direct financing raises funds for deficit units through the issuing of securities to investors in the financial markets

Question 2

How do deficit units issue securities?

Answer 2

Deficit units engage firms that assist them to issue securities
these are the investment banks (or securities firms), who charge fees for their services

Question 3

How do surplus units supply funds in direct financing?

Answer 3

Surplus units mostly supply funds to fund managers who invest the pooled funds, and who also charge fees.
Surplus units supply funds by purchasing deficit units’ securities.

Question 4

What is a spread?

Answer 4

A spread exists between the cost of funds for deficit units and the returns to surplus units

Question 5

How do institutions and fund managers make their money with direct financing?

Answer 5

For direct financing
deficit units pay the returns to surplus units plus fees to the institutions that arranged the issue
the returns to surplus units are net of the fees paid to fund managers

Question 6

What is the spread in indirect financing?

Answer 6

For indirect financing, the spread is the difference between the interest paid on loans from a bank and the rate earned by the bank’s depositors and other lenders

Question 7

How does direct financing work?

Answer 7

Direct financing involves:
the arrangements for the issuing of securities – this is their primary market
the subsequent trading of issued securities in the secondary market

Question 8

Which regulator oversees the issuing of securities?

Answer 8

The issuing of securities is subject to ASIC regulations, particularly when they are issued to retail investors
Most markets are wholesale only and are self-regulated by the Australian Financial Markets Association (AFMA)

Question 9

How are Australian government securities issued?

Answer 9

Through a competitive tender.

Question 10

What is the ‘best efforts’ approach to selling securities?

Answer 10

Shares are mainly issued in Australia under contracts known as best efforts, with an investment bank arranging the issue
they prepare a prospectus and market the issue,
earn fees, normally in the form of commission, and
do not guarantee all the securities will be sold – this requires an additional standby underwriting contract

Question 11

What are ratings agencies?

Answer 11

Ratings agencies are firms that are paid to provide an expert opinion about the level of credit risk for a security or financial institution

Question 12

What are rating agencies?

Answer 12

Ratings agencies are firms that are paid to provide an expert opinion about the level of credit risk for a security or financial institution
The ratings agencies are Standard & Poor’s (S&P), Moody’s and Fitch Ratings

Question 13

What do rating agencies do?

Answer 13

The lowest risk securities are given the highest rating, ratings are reviewed and changed if required
Their role is to help overcome information asymmetry
Debt securities usually have to be rated before issue, and the rating influences the demand for the security

Question 14

What is a security registry?

Answer 14

When securities are issued, they and their ownership details are recorded on the security registry
These can be maintained by the market’s clearinghouse or by a separate organisation
Securities and security registers are now electronic, rather than paper-based

Question 15

What are rating agencies?

Answer 15

Rating agencies are firms that are paid to provide an expert opinion about the level of credit risk for a security or financial institution

Question 16

What is a secondary market?

Answer 16

Secondary markets arrange trading in issued securities

Question 17

What must the buyer and the seller agree upon?

Answer 17

1. The security being traded
2. The quantity
3. The price
   Trading is easier and faster for standardised securities - meaning the security has no optional features

Question 18

What comprises a secondary market?

Answer 18

Secondary markets comprise:
1. A trading platform, meaning the facility where trading occurs
2. Trading rules and protocols, such as who can trade and how trades are expressed
3. Clearing and settlement procedures, which organise the exchange of the securities for payment

Question 19

What are the two types of secondary markets?

Answer 19

Secondary markets are either:
Organised by a securities exchange – where trades are arranged through brokers on behalf of their clients
Conducted on an over-the-counter (OTC) basis with trading between dealers
Dealers are financial institutions that trade securities on their own behalf, as well as the individuals who are employed to do the trading

Question 20

What do Brokers do?

Answer 20

Exchanges were developed by share brokers to organise their trading
Brokers do not buy from or sell to their clients, they are agents through whom their clients can access the market
brokers may provide online systems to allow their clients to place orders,
they earn a commission on completed trades, and
they must ensure their clients can pay for the securities they purchase, and that they possess the securities they sell

Question 21

What is an order-driven market?

Answer 21

Trading is on the basis of orders from traders, so they are referred to as ‘order-driven’ markets
An order specifies:
1. A buying or selling intention
2. The security
3. The quantity
4. The price

Question 22

What are over-the-counter markets?

Answer 22

Dealers act as principals meaning they buy and sell on their own behalf
they trade with each other and with wholesale clients
this is now mostly using automated trading systems
they hold an inventory of securities (this is their position), and so are exposed to price risk

Question 23

What is dealer trading?

Answer 23

Dealers earn a trading spread when traders sell to and buy from them, that is, on a ‘round-trip’ transaction
they aim to buy ‘low’ and sell ‘high’
they would like to set a wide spread, but they must compete with other dealers
dealers will also initiate trades with other dealers in order to manage their position
their desired position will have regard to its risk, the requirements of clients and to expected future price movements

Question 24

Who sets the OTC (over the counter) market rules?

Answer 24

For the OTC markets, rules are set by AFMA and include:
- trading hours
- pricing practices
- trading protocols
- transaction sizes

The ASX also has rules regarding trading hours, the securities it trades …

Question 24

Who sets the OTC (over the counter) market rules?

Answer 24

For the OTC markets, rules are set by AFMA and include:
- trading hours
- pricing practices
- trading protocols
- transaction sizes

The ASX also has rules regarding trading hours, the securities it trades …

Question 25

Who provides market informaiton?

Answer 25

Traders have a huge appetite for information relevant to security values
Companies such as Bloomberg and Reuters supply information both real-time and via databases
Listed-companies are required by the ASX to provide price-sensitive information in a timely fashion

Question 26

How do secondary markets assist primary markets?

Answer 26

The secondary market can assist the primary market in two ways:
To provide investors with liquidity
and thus transform the maturity of funds in the market
To perform the ‘price-discovery’ process through which the market judges the value of the traded securities

Question 27

What are indicators of a securities liquidity?

Answer 27

A security’s liquidity is indicated by its:
daily turnover or turnover ratio – higher ratios indicate greater liquidity
bid-ask spread – where liquidity is indicated by narrow spreads
price resilience – liquidity varies inversely with the impact

Question 28

What is price discovery?

Answer 28

Markets generate prices (including market indices), interest rates and exchange rates that may be regarded as ‘fair’ when they are a result of trading by informed traders
the discovery of ‘fair’ prices is most effectively performed by efficient and liquid markets
This information:
allows investors to monitor the value of their investments, and
informs potential issuers of securities of their expected proceeds

Question 29

What is the efficient market hypothesis? (EMH)

Answer 29

The efficient market hypothesis (EMH) states that security markets efficiently use information to generate ‘fair’ prices that move randomly

Question 30

What is random walk?

Answer 30

The movement over time in a security’s price where an increase is equally likely to be followed by a fall as by a further increase

Question 31

What is a price bubble?

Answer 31

Price bubbles are periods where prices exceed fair values and are followed by a sharp correction

Question 32

What are bull and bear markets?

Answer 32

A bull market refers to long periods of generally rising prices and a bear market refers to periods where prices are generally falling

Question 33

What is volatility?

Answer 33

Volatility is the degree of movement in a variable that can be measured by its variance (or standard deviation) around the average value