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1

regulators include

institutions:
-banks
building societs
credit unions
insurance companies
superannuation funds

Instruments
debt
equity
hybrids
derrivatives

Markets
Money
capital
debt (Cd's bond)
equity
foreign exchange
derivates

2

explain financial assets

Financial Assets (e.g. stocks and bonds) are financial “securities”
Historically nothing but sheets of paper
Do not contribute directly to the productive capacity of the economy.
Represent investors’ claims on real assets and incomes generated by real assets.

3

explain real assets

Real assets generate net cash flows within the economy, while financial asset defines the allocations of these cash flows.

Example: You cannot own auto plant or factory (real asset), you can still buy shares in Ford or Toyota (financial assets) and thereby share in the cash flows derived from the production of automobiles.

4

read flow of funds slide

jazzie pp

5

explain the financial system in Australia

The financial functions are performed by financial institutions and markets with oversight from their regulators and the Reserve Bank of Australia.
The flow-of-funds and risk-management functions are performed by both institutions and markets.
The settlement function is performed by institutions only.
Markets and institutions are both complement and compete with each other

6

explain the major tasks served by the financial system

Pooling of Funds
Flow of Funds
Settlement of Transactions
Risk Management
Overcome Information Asymmetry
Overcome Incentive Problems

7

explain surplus units

Surplus units

Economic units that earn more than they spend.

surplus units normally want to supply small amounts for short periods

They require compensation for forgoing the immediate use of the funds and for the risk the funds will not be returned - ‘required rate of return’ on investment, e.g. deposit interest rate.

8

explain deficit units

Economic units that spend more than they earn.

They need to raise funds to ‘meet the end’ at a cost, e.g. loan interest rate.

Usually deficit units are seeking large amounts that will take a long period to repay

9

how to overcome surplus and defecit units

Pooling of funds (typically via banks)

a bank that accepts many small deposits and makes fewer large value loans

a deficit unit, i.e. a company with several investment projects, issues many securities to many investors to raise a very large amount of funds

10

The funds are supplied either:

Directly
Deficit units raise funds directly from surplus units through the issue of securities in the financial markets

Securities, a.k.a. financial assets, are issued by deficit units to raise funds - they specify the promised payments by the deficit unit and can be traded in the financial markets


Indirectly (Intermediated)
Funds are supplied as deposits to financial institutions, which in turn supply funds as loans to deficit units

draw out slide diagram (12)

11

pros of direct finance

Removes cost of financial intermediary
Diversify funding instruments and sources
Raise profile in financial markets

12

cons of direct finance

Documentation, such as prospectus
Matching lender and borrower preferences
Liquidity and marketability of securities
Legal, financial and expert advice
Credit ratings

13

explain indirect finance asset trnasformation and maturity transformation

Asset transformation:
Range of products
Pooling of funds
Maturity transformation:
Liquidity
Maturity
Risk management

14

explain settlement transactions

Financial system provides the arrangements used to settle commercial transactions.
Settlement occurs when a buyer exchanges money for a purchased item.
Money contains cash and deposit, including a range of electronic methods.
All commercial banks in Australia have to hold Exchange Settlement Accounts (ESA) with the Reserve Bank, which are used to manage the settlement between commercial banks.
e.g. If a CBA customer pays $100 to a NAB customer by writing a cheque or doing a transfer via internet banking, the
CBA’s exchange settlement account at the RBA is debited $100, and
the NAB’s exchange settlement account at the RBA is credited $100

15

explain exchange settlement accounts

Exchange Settlement Accounts (ESA)
Its balance fluctuates on a daily basis due to the transactions between commercial banks
Commercial banks must maintain sufficient funds in their ESAs to fund daily transactions with other banks.
pay relatively low interest rates.
commercial banks have little incentive to keep large balances in their ESAs
Commercial banks access the overnight cash market to manage their ESA balances
Overnight cash market facilitates the borrowing and lending for one day
‘borrow today, repay tomorrow’
The interest rate which banks borrow and lend to each other is called the overnight cash rate.

A commercial bank with a surplus ESA balance can
lend the money in the overnight cash market.

A commercial bank with a deficit ESA balance can
borrow funds from the overnight cash market.

16

explain risk management

Risk is the possibility that returns on investment may deviate from expectation.
E.g. borrower may default and fail to repay the principal.
Risk transfer contracts, arranged through trading in derivatives, provide ways to manage risk exposures.
E.g. a company is going to borrow in 6 months (not now) and concerned about increase in interest rate.

Forward rate agreement (FRA)
Interest rate futures
Interest rate option (more costly)

E.g. a farmer will harvest the wheat in 3 months and export to Japan (priced in JP¥). What risks will he/she face?
Drop in wheat price – hedge with futures contract
Foreign exchange (FX) risk – hedge with forward FX contract, or currency futures

17

explain overcoming information assymetry

Overcoming information asymmetry
Information asymmetry arises when one party to a potential contract has an information advantage over the other party.
E.g. borrower knows more about their capacity to repay the loan than the lender does.

18

explain overcoming incentive problems

Financial contracting is influenced by the incentives faced by the parties involved.
Incentives may motivate bad behaviours, i.e. selling defective products to clients for bonus

‘Moral hazard’: situations where one party to a transaction has an incentive (perhaps supported by an information advantage) to act in his or her own interests at the expense of the other party to whom they may owe a duty of care.

19

define financial markets

the markets in which financial assets are bought and sold.

20

Financial markets can be classified in according to different criteria

Maturity:
Money vs. Capital Market

New vs Outstanding security:
Primary vs. Secondary

Asset class:
Equity, Bond, FX, Derivatives

Organisation of transactions:
Exchange traded vsOver the counter (OTC)

21

explain money markets

short-term financial instruments

By convention: terms no longer than one year

e.g. Treasury notes, certificates of deposit, commercial bills, promissory notes

22

explain capital markets

long-term financial instruments

By convention: terms greater than one year
Long-term debt and equity markets

e.g. Government bonds, debentures, shares, leases, convertibles

23

explain the exchange traded market

Exchange traded market are more regulated trading mechanism.
Securities are traded through an organised exchange such as a stock exchange
Brokers carry out clients’ instructions to buy or sell nominated securities.
Trading is more transparent and governed by certain rules.
Prices are available to all market participants.

24

explain the over the counter market

Over-the-counter (OTC) market is less regulated trading mechanism facilitated by dealer(s).
Not an organised exchange: fewer regulations, more flexible, but less transparent
Financial institutions (dealers) quote private prices to clients and other dealers.
Dealers’ prices can be negotiated through phone and electronic media.

25

explain the primary market

financial assets are issued (sold) to investors
New financial assets are created with the help of investment banks.
Initial Public Offerings (IPOs): debt/equity/other financial assets
Investors exchange their funds for financial assets issued by corporations

26

explain the secondary market

where existing (issued) financial assets are traded
Investors trade the ownerships of existing financial assets with the help of brokers.
No new financial assets are created.
Corporations do not raise any new funds for the investors.
Provides marketability and liquidity to primary markets

27

explain the derivatives market

Derivatives are financial securities that provide payoffs determined by the prices of other financial assets.
Options, Futures, Forwards and Swaps
OTC market: Forwards, Swaps and Options
Exchange traded market: Futures and Options

28

define banks

authorised deposit-taking institutions (ADIs) whether or not the ADI calls itself a bank

Most accept deposits, make loans and provide payment services for:
households, small businesses and organisations (retail customers) and/or
large companies and organisations (wholesale customers)
Australia’s four major banks provide both retail and wholesale banking services

29

The main investing institutions in Australia are:

Private equity firms
Managed funds (superannuation funds)
Hedge funds
life insurance companies
general insurance companies
Private Equity firms
Invest in private companies (not traded on the stock market)

Private equities are considered to be long-term and high risk investments, partly because it is difficult to offload the shares of these companies they invest

30

explain managed funds

Pool money from many investors and invest in a wide range of financial assets.
Financial assets are selected and managed by a professional fund managers.
Superannuation funds
Accept contributions from 1) employers (on behalf of employees); 2) fund members
Manage investments to provide retirement income benefits.
Popular asset classes: equity, debt securities, real estate (trust) and cash