Preliminary Topic Five Financial Markets

1. Financial markets in Australia

Financial markets are important since they allow borrowers and lenders to interact. They also ensure funds are allocated to their most efficient use.

a. Types of financial markets Primary and secondary markets

Primary Markets The financial markets is the distinction between primary and secondary markets Primary markets are used by business, government and households to raise funds for expenditure on goods and services. The distinguishing characteristic of primary market is that they create new financial securities. SECURITIES: shares, bonds that provide the holder with ownership of the asset and involve direct transactions between investors and companies Examples include the issuing of new shares by a corporation, the sale of the government bonds to finance spending, and borrowing financed by a new mortgage. Secondary Markets The secondary markets deal in the sale of existing financial instruments, that is, those that were created in primary market transactions. For example, the buyer of new shares (primary market transaction) sells the shares to another individual or group of investors (secondary market transaction).

Consumer credit, housing loans, business loans, short term, money market, bond, market, financial futures, foreign exchange

Consumer credit

Credit used by consumers to finance the purchase of various consumer goods and services Long term loans to purchase property, comes with interest rate

Banks, credit unions, credit card companies Banks, mortgage originators Finance companies, banks

Housing loans

Business loans

Allows businesses to begin/expand production of g + s. It can be short, medium or long term. Brings together people + businesses with temporary shortages or surpluses of funds. A bond is a written record of a debt. The borrower sells a bond in return for a loan. The holder of the bond receives interest payments and the final repayment. Bonds can be sold/traded in secondary financial markets. The share market is for the buying and selling of shares, options and rights of publicly listed companies on the Australian Stock Exchange. Shares give their owner a share in the ownership of a company and a right to a dividend and capital gain if the value of the share increases. This is the market for buying and selling of shares or bonds at a later date for a certain price. It allows investors to protect themselves against movements in interest rates or share prices by agreeing on a price at which to sell at a later date.

Short term money market Bond market

Banks

Banks, small companies

Share market

Companies

Financial futures

Banks

Foreign exchange

Market for buying/selling foreign product.

Banks

The share market its role, function and effect on the economy Role
The share market serves the role of being the institutional framework through where investors buy and sell shares that gives their owner a part ownership of the company Investors purchase shares to gain a chance in company profits and make capital gains from increases in share prices Function
Shareholders invest in shares to gain profit and capital gain from an increase in share price. These profits are known as dividends, it is a profit per share, divided amongst the shareholders according to the amount of shares they have. Capital gains is when an investor sells their shares for more than what they were originally sold for

The investor can only loose as much as their initial purchase of the shares

Effects Investment the share market can allow the level of investment to increase. Companies can access funds in order to increase their investment by issuing new shares. Debt Companies can raise new capital by issuing new shares. This will avoid increasing their debt levels Business cycle The business cycle can affect the price of shares and the share market can also affect it. E.g. an expansion phase, means peoples high expectation can result in an increase in the price of shares
Importance of the share market: The share market provides individuals with a source of income and investment through dividends and capital gains. Companies issue shares which provides access to finance for investment and growth.

Domestic and global markets

As a resource rich country Australia depends on foreign sources of capital to finance its development. - Foreign exchange markets: enable the movement of funds around the world - Global debt markets: important for Australias economic development because of the reliance on foreign borrowing

- Equity markets: regulated by national governments so exist within individual countries.

b. Regulation of financial markets the role and functions of current institutions

The key regulating agencies in Australia are the Reserve Bank of Australia (RBA), the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investment Commission (ASIC)

Reserve Bank of Australia Role

The RBA is Australias central bank; it is responsible for monetary policy, payment systems regulation and stability of the financial system. The RBA also contributes to: 1. Stability of Austr.s currency 2. Maintenance of full employment 3. Economic prosperity + welfare of Austr. People Function

Conducts monetary policy on behalf of the government- Monetary policy is action taken by the Reserve Bank to affect the level of interest rates, which in turn affects the level of economic activity. The Reserve bank tries to keep inflation 2-3%, by adjusting the cash rate of interest. Control of note issue: Decides how much money will be printed based on consumer demand (actual production of currency is done by The Mint) Responsible for the payments system: ensuring the stability and efficiency of payment
methods such as credit cards and electronic cash. In other words, it ensures that money owed through these various forms of borrowing will be paid back.

Banker to the banks: RBA acts like a normal bank for all the other banks. Banks hold exchange settlements accounts with the Reserve Bank. The banks use these exchange settlement accounts to pay debts between themselves. Responsibility for holding Austr.s reserve of gold + foreign currency dealings: RBAs reserve provides funds that can be used to make international payments. Banker + source of financial and economic advice to govts: provides banking + financial agent services to the Commonwealth Govt. And also acts as a source of financial + economic advice to the govt.

Australian Prudential Regulation Authority

Role

Responsible for supervision and regulation of all deposit-taking institutions (ADIs), such as banks, insurance companies and superannuation funds and credit unions

They have 2 main regulatory roles: Ensures institutions will be able to meet obligations to paying customers, ie. Be able to pay them back if they take back deposits/savings. Do this by ensuring they maintain certain levels of funds (18%) on hand and manage risks specifically. Provides assistance and recovery to ADIs that experience financial difficulty

Australian Securities and Investments Commission

ASIC supervises company behaviour in terms of information, registration and reporting. It has the power to investigate and act in situation where there have been illegal activities or unethical practices. As a result it is responsible for the behaviour and conduct of companies

Australian Treasury
The treasury has the responsibility for advising the government on financial stability issues and for the legislative and regulatory framework for the financial system. They are the main source of economic policy advice to the government Influence how governments devise budgets, collect taxes, allocate expenditure and implement other policies

Council of Financial Regulators

Its role is to contribute to the efficiency and effectiveness of financial regulation by providing a collaboration among its four members- the RBA, APRA, ASIC and Treasury.

c. Borrowers
Borrowing is good for the economy and generates economic growth, employment, a high standard of living and quality of life.

Individuals
Consumers borrow when their demand for goods and services exceeds their current income. Over 60% of economic growth (GDP) comes from consumers sending. Consumers borrowing inject money into the economy and this stimulates growth. Borrow for housing (mortgage) or consumption

Business
Entrepreneurs and business managers borrow to fund the expansion of their businesses. This will generate profit, employment and economic growth. Business borrow for expansion or investment

Government
The government becomes a borrower of funds when it budgets for a deficit (when its current expenditure is greater than its current revenue)

d. Factors affecting the demand for funds

When individuals have surplus funds, they need to decide what form to hold them in. Do they keep it in the form of money, which is currency and bank deposits, or buy financial assets such as bonds or shares?. Holding currency give no return to the saver while financial assets can yield a return such as interest and dividends.

Transactions and speculative motives Reasons why some people prefer to hold money instead of financial assets:
1. Transactions motive: people have day-to-day transactions to be made to purchase goods and services, this means individuals hold a certain amount of money to make these transactions. 2. Speculative motive: Speculative motive is buying financial assets with the possibility of making a capital gain or loss. E.g investment opportunities The benefits of holding cash funds are that they are available for immediate use and the avoidance of capital losses The costs of holding cash funds are that they can be affected by inflation and the lost possibility of capital gains

Financial innovations Financial innovations: is when innovations in technology such as an increase in ATMs and increased use of credit cars changes the demand patterns for money.

e. Lenders
Individuals, businesses and governments participate in financial markets as lender when they are seeking a return on their wealth.

Individuals
Individuals have a range of options, some invest in assets, while others may invest in shares. They could save up for future needs; in effect, loaning their money to that institution, to get a return on it.

Business
A business with a good cash flow and profits may choose to deposit its funds into a financial institution Banks are the major lenders in Australia and lend to businesses and individuals

Government
Play minimal role as a lender mainly borrowers

International

Australian financial institutions can lend money overseas to borrowers.

Foreign net savers provide potential source of funds.

e. Financial aggregates measured by the Reserve Bank of Australia

The Reserve Bank collects information on the range of financial aggregates in the economy. These aggregates give some indication of the level and growth in the money supply

Currency
The money supply is the amount of money in the economy at a particular time. This generally consists of currency: notes and coins in the public. Plus deposits held by all banks. The Reserve Banks definition of the money supply includes 4 separate monetary aggregates the money base (M1) M3 and broad money. Money supply can be measured with three main indicators called financial aggregates: Money Base= Currency + Bank Deposits with RBA M3= Money Base + Bank Deposits Broad Money= M3 + NBFI Deposits - NBFI Deposits in Banks

Broad money
Broad money includes M3 plus deposits in non-bank financial institutions minus non-bank financial institutions holdings of bank deposits. Advantage: broad money is not greatly affected by financial deregulation, unlike M3. With deregulation, banks became more competitive with the non-bank financial sector, resulting in a large movement of funds from this sector and an increase in M3. Disadvantage: the delay involved in its calculation, which is the ereason for the governments use of M3

Credit
Credit: system that allows payments for purchases to be deferred. Loans to individual, businesses and govt for spending on consumption and investment. * While credit can act as medium of exchange, it does not serve as store of value, so not used as money supply.

f. Interest rates

Interest rates are the cost of borrowing funds and the return for lending. Interest rate differential is the difference between the borrowing rate (return given to those who place funds in financial institutions) and the lending rate (amount charged by financial institutions to those who borrow funds) and is how bank make profit. The nominal interest rate refers to the cost of lending money before adjustment for inflation. The nominal interest rate is measured: Dollars of interest paid Original deposit x 100 1

Real interest rate is the lending interest rate adjusted for inflation. Real interest rate % = nominal interest rate inflation rate

Types of rates in the short term and long term

Short term and long term interest rates are based on the length to maturity of the financial assets or securities. Financial assets of a shorter tem (such as bank bills) have a lower rate of return (interest) as there is less risk involved in terms of maturity and inflation levels. Short term government securities such as Treasury notes attract a short term interest rate as opposed to long term securities, such as Treasury bonds, attract a higher rate, as long term securities are seen as not only being more risky, bur also less liquid and less flexible. Types of interest rates in the short and long term include:

-Lending rates
Lending rates: rate that the bank charges for lending money to a person. Lenders will offer more funds when the interest rates rise as their return is higher.

-Borrowing rates
Borrowing rates: rate of interest paid by banks to accept deposits (savings). Individuals borrow more funds when interest rates are lower as the costs are lower. Difference between these rates is called interest rate differential.
The lending rate the borrowing rate = the interest rate differential

Role of the Reserve Bank of Australia in determining the cash rate

The official cash rate is the Reserve banks main instrument of monetary policy. Exchange settlement funds Banks keep a certain proportion of their total funds with the Reserve banks in the form of exchange settlement funds, which are used by banks to settle payments with other banks. The demand for cash is determined by the reserves of cash in the exchange settlement accounts of the banks with the Reserve banks. The supply of cash in this market is determined by the Reserve bank, which has monopoly control over the supply of cash. Market operations by the Reserve Bank Market operations involve the purchase or sales of second hand government securities in the cash market for the purpose of influencing the cash rate and, as a result, all interest rates. If supply of funds in the short-term cash market increases, the cash rate, which is the price for borrowing, falls. If the supply of funds decreases then the cash rate increases. The Reserve Bank can, as a result, directly control the supply of funds by selling or buying these securities within the cash market. Monetary Policy The Reserve Banks monetary policy can be either used to lift the level of economic activity or lower it. A tightening of monetary policy involves raising interest rate sin order to contract the economy, while a loosening of monetary policy involves a lowering of interest rates to expand the economy. Loosening of monetary policy Reserve Bank purchases second hand government securities Amount of borrowable funds to increase to a point of surplus Downward pressure on cash rate Downward pressure on market interest rates as banks need to maintain margins Investment and consumption spending increases Level of economic activity increases Key terms Short-term money market: The sector of the financial market that caters for the borrowing and lending of money for short periods Money market: The trade in short-term loans between banks and other financial institutions Cash rate: A benchmark rate for bank lending, usually set by a country's central bank. Tightening monetary policy Reserve Bank sells second hand government securities Amount of borrowable funds decrease to the point of a shortage Upward pressure on cash rate Upward pressure on market interest rates as banks need to maintain margins Investment and consumption spending decreases Level of economic activity decreases

As without any other market, when the supply of funds held in the short-term money market is too high, the price of borrowing this money, the cash rate of interest, falls. Whereas, when the supply of funds in the settlements market decreases, the cash rate will rise. The role of the Reserve Bank of Australia in determining the cash rate: If the RBA wants to reduce the cash rate, it will buy securities from commercial banks and in exchange deposit additional funds in their exchange settlement accounts. This may either be a purchase of securities, or repurchase agreements for securities where the seller agrees to buy the security back at a later date. This would result in downward pressure of the overnight cash rate as there is an increase in the supply of settlement funds.

When the RBA sells securities to a bank they subtract from the total exchange settlement balances. Thus decreasing the supply of settlement funds which puts upward pressure on the overnight cash rate. By selling government securities, the reserve bank creates a shortage or surplus of funds in the short term money market, thus affecting the cash rate of interest. Increasing the cash rate means that it becomes more expensive for financial institutions to obtain funds in the short-term money market. Similarly a reduction in the cash rate lowers the cost of borrowing for banks in the short term money market and financial institutions then pass this cost saving on their customers in the form of lower lending interest rates If interest rates fall, this encourages consumption and investment spending, which increases the level of economic activity. If interest rates rise, this deters consumption and investment in spending, and reduces the overall level of economic activity. RBA influence on interest rates to affect the level of economic activity is known as monetary policy.

loosening of monetary policy

decreases

cash rate

to maintain margin, banks drecrease market interest rates

economic activity increases

RBA buys securities

excess of borrowable funds

consumer and business pay less on exisiting debt, new borrowers find it easier

increase in consumption and investment spending

Influence of the cash rate on interest rates.

Any changes in the cash rate will flow on to other interest rates in the money market, such as commercial bills, government bonds and interest rates that banks pay to depositors and charge borrowers.

Lowering the cash rate Cheaper cost of borrowing in the cash market Banks lower borrowing and lending rates to customers Competition takes place in the whole financial system, causing a lower term structure of interest rates

Increasing the cash rate Increased cost of borrowing in the money market Bank pass on higher costs of cash through an increase in borrowing and lending rates Competition in the financial system between institutions will cause a higher term structure in interest rates