week 4 Flashcards
(37 cards)
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
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.
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.
read flow of funds slide
jazzie pp
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
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
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.
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
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
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)
pros of direct finance
Removes cost of financial intermediary
Diversify funding instruments and sources
Raise profile in financial markets
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
explain indirect finance asset trnasformation and maturity transformation
Asset transformation: Range of products Pooling of funds Maturity transformation: Liquidity Maturity Risk management
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
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.
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
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.
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.
define financial markets
the markets in which financial assets are bought and sold.
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)
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
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
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.
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.
