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Introduction to Financial Markets

Topic 1

Overview of the Course


Basic finance course for 1st year student
Compulsory for Finance students, elective for
other streams, Macro 1 desirable
5 in-class quizzes (20%)
Group Assignment: FX trading report (30%)
Final Exam 50%: Closed Book = no formula
sheet
JPV: Lecture + 3 Tutorials
Plagiarism punished severely by the University
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Slide 2

Overview: Course Guide


Week
1

Lecture Topic
Course overview and Introduction to
Interest rates

Money Markets

Foreign Exchange Part A

Foreign Exchange Part B + FX Report

Bonds & Debt Markets

Activity
Tutorial 1

Financial Markets

Tutorial 2: Interest rates


Quiz 1 : Interest rates

No Tutorial
1h30 Money Markets Practice Dealing Session.
No Tutorial
1h30 Money Markets Dealing Session.

Quiz 2: Money Markets

No Tutorial
1h30 FX Practice Dealing Session.
No Tutorial
1h30 FX Dealing Session.

Week 7: Personal Learning

(No Lecture & Tutorial)


Equity Markets +

FX Report Preparation Session

9
10

Assessment Deadline

Quiz 3: FX

Derivatives Markets

Quiz 4: Bonds

The changing financial system and Role of

FX market report due.

Financial Institutions

Quiz 5 : Equity

Tutorial 6 questions: Bonds & Debt


Tutorial 8: Equity
Tutorial 9: Derivatives

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Recap

Tutorial

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Revision

Past Exam Questions

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Slide 3

Overview of the Course


Group Assignment (20%): Analyze and trade 2
currency pairs, USD/JPY and VND/USD
Final Exam 60%: Closed Book = no formula
sheet a lot of details to memorize
Sample Exam Questions: See Blackboard Week 12
(a)

Define and explain the structure of interest rates.

(b) Differentiate between the expectations plus liquidity premium


theory and the market segmentation theory.
(c) Distinguish between debt and equity securities (discuss risk,
return, liquidity, time pattern...)

Students challenge is writing in English


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Slide 4

Topic 1 - Contents
1.

Functions of the financial system

2.

Components of the financial system


2.1
2.2
2.3
2.4

Economic surplus/deficit units


Financial institutions
Financial assets
Financial markets

3.

Direct & Indirect finance

4.

Financial & Economic systems

5.

Govt intervention into financial systems

1. Functions of the financial system


To facilitate the transfer of funds from surplus
economic units to deficit economic units, in
primary markets, by the creation of new financial
assets
To facilitate the trade of existing financial assets
in secondary financial markets.

2. Components of the financial system


Surplus economic units (Savers/ Lenders/
Investors)
Deficit economic units (Borrowers)
Financial institutions
Financial assets
Financial markets

2.1 Surplus economic units


Individuals, households, companies with more
funds than required for immediate expenditure
Savers
Potential lenders

2.1 Deficit economic units


Individuals, households, companies who
require additional funds to meet expenditure
plans
Potential borrowers
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The financial markets and flow of funds

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2.2 Financial Institutions


Organisations whose core business
involves:
Borrowing and lending (financial
intermediation)
Provision of financial services to other
organisations or individuals

2.2 Main types of financial institutions


Deposit taking financial institutions: attract the
savings of depositors through on-demand deposit
and term deposit accounts.
e.g. commercial banks, building societies and credit
cooperatives (shareholders are usually the members)

Non Deposit taking financial institutions: may


managed funds under contractual arrangements
and provide a wide range of financial services.
e.g. Investment banks, general insurance companies
and superannuation funds (pension/retirement).

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2.3

Financial assets

Represent a claim or a right that a surplus


economic unit holds over a deficit economic unit.
They represent an entitlement to future cash
flows.
Represent a financial liability of a deficit
economic unit (ie. the party issuing the financial
assets).
A financial instrument is a financial asset whose
value is represented in paper (or electronic form)
eg. bank loans, shares, bonds, certificates of
deposits.

2.3 Attributes of financial assets


All financial assets have four different attributes
which provide the basis for comparison between
different types of financial assets.
Return or yield
Risk
Liquidity
Time pattern of return or cash flow

2.3 Attributes of financial assets

Return or yield
Total financial compensation received from an
investment expressed as a percentage of the
amount invested

Risk
Probability that actual return on an investment
will vary from the expected return (or variation
in expected return)

2.3 Attributes of financial assets

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

Types of financial assets


Assets that are created and exchanged can be
divided into the following broad types:

Debt
Equity
Hybrid
Derivatives

Debt financial assets


Represent an obligation on the part of the
borrower to repay principal and interest. Eg.
Bank deposits and loans
Contractual savings eg. Life insurance savings
Discount securities
Fixed interest securities

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Equity financial assets = shares, stock


Represent an ownership claim over the profits
and assets of a business. Eg.
Ordinary shares in a company

Hybrid financial assets


Financial assets which have features of both debt
and equity. Eg.
Preference shares
Convertible notes
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Derivatives
Financial assets whose value is derived from
another financial asset, rate or index. Eg.
Forward contracts
Futures
Options
Swaps

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2.4 Classification of financial markets


Primary and Secondary
Money (<1 year) and Capital (>1 year)
By type of financial assets traded:
Money Market (topic 3)
Foreign Exchange (topic 4)
Debt-Capital Market (topic 5)
Equity Market (topic 6)
Derivatives Market (topic 7)

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Primary Vs. Secondary


Primary markets:

Markets in which financial assets are first created,


e.g. Facebook IPO
Markets in which funds flow from surplus
economic units to deficit economic units

Secondary markets

Markets in which existing financial assets are


traded
Deficit economic units do not directly participate
in secondary market transactions

Primary vs. Secondary markets


Examples of Primary market transaction:
The issue of a new financial instrument to raise
funds to purchase goods, services or assets by
Businesses
Company shares (IPO) or debentures
Governments
Treasury notes or bonds
Individuals
Mortgages

Primary vs. Secondary markets


Secondary market transaction
The buying and selling of existing financial
instruments
No direct impact on the original issuer of security
Transfer of ownership from one saver to another
saver
Provides liquidity which facilitates restructuring of
portfolios of security owners

Financial securities
Financial assets which can be traded in
secondary markets - eg. shares and bonds.
Examples of financial assets which are not
financial securities are bank deposits and loans.
But they can be securitized, i.e. transformed into
financial securities that trade like any other:
Housing loans in US securitized into CDOs

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By type of financial assets traded


Money markets
Markets where funds are lent for periods of less
than 12 months
A market in which short-term debt financial
assets are created and traded

Capital markets

Markets where funds are lent for periods of 12


months or more
A market in which long-term debt financial assets
are created and traded

The Foreign Exchange Market


A market in which foreign currencies are traded

The Equity Market


A market in which equity financial assets are
created and traded (eg. shares)

The Derivatives Market


A market in which derivative financial assets are
created and traded (eg. futures, options etc.)
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Overview

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How can you


raise funds?
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3. Direct and indirect finance


Two alternative methods of finance
Direct finance

Indirect finance

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Direct finance

Funds are transferred directly from surplus economic


units to deficit economic units
Primary financial assets are issued directly from deficit
units to surplus units
Financial institutions play a role in direct finance by
providing financial services, such as financial advice,
underwriting, etc., in return for fees and commissions

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Indirect finance

Also known as intermediated finance


Financial institutions act as intermediaries, borrowing from
surplus units and lending to deficit units
Primary financial assets are issued by deficit units to
intermediaries, and secondary financial assets are
issued by intermediaries to surplus units
Financial institutions earn income by way of net interest
margin
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Advantages of financial intermediation


Asset value transformation
Maturity transformation
Credit risk reduction and diversification
Liquidity provision
These are very useful for households
Increased quantity of national savings

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Disadvantages of financial
intermediation
Increased cost of funds for borrowers
Reduced return from lending for savers
Why? Institutions take a net interest margin
Less likely for secondary financial assets (e.g.
bank deposits) to be securitised (i.e. Transformed
into financial securities) so that they can be
traded in a secondary market. Primary financial
assets (e.g. Housing loans can be securitized into
CDOs)
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Overview

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Main types of financial institutions


Deposit taking financial institutions: attract the
savings of depositors through on-demand deposit
and term deposit accounts.
e.g. commercial banks, building societies (Housing
loans = mortgage) and credit cooperatives
(shareholders are the members or customers).

Non Deposit taking financial institutions: may


managed funds under contractual arrangements
and provide a wide range of financial services.
e.g. Investment banks, general insurance companies
and superannuation funds (pension / retirement).
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Main types of financial institutions


Commercial banks
Building societies and credit cooperatives
Investment banks and Merchant Banks
Superannuation funds / Managed funds
Life insurance and general insurance companies
Finance companies and general financiers

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Institutions features
Total Assets (Percentage Share) of Financial Institutions

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Institutions features
Banks continue to dominate the financial system
Significant changes have occurred in the relative
importance of:
Building societies
Money market corporations
Finance companies
Superannuation funds
Public unit trusts

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Commercial banks
Commercial banks are the largest group of
financial institutions within a financial system.
The core business of banks is often described as
the gathering of savings (deposits) in order to
provide loans for investment.
They also provide a wide range of off-balancesheet transactions such a underwriting, issue of
derivatives or execute Fx transactions.

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Building societies and credit unions


The majority of building society funds are deposits
from customers. Residential housing is the main
form of lending. Credit unions funds are sourced
primarily from deposits of members.
A defining characteristic of a credit union is the
common bond of association of its members,
usually based on employment, industry or
community.

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Investment banks and merchant banks


Mainly provide advisory services to support
corporate and government clients, e.g.:
advice on mergers and acquisitions, portfolio
restructuring, finance and risk management
May also provide some loans to clients but are
more likely to advise on raising funds directly in
capital markets.
They also execute FX transactions

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Managed funds
The main types of managed funds are
cash management trusts, public unit trusts,
superannuation (pension) funds, statutory funds of life
offices, common funds and friendly societies.
The large pool of funds is then used to purchase both
primary and secondary market securities

Managed funds may be categorised by their


investment risk profile, being capital guaranteed
funds, capital stable funds, balanced growth funds,
managed or capital growth funds.

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Life and general insurance companies


The liabilities of these institutions are contractual
obligations. They provide a contract that require, in
return for periodic payments to the institution, the
institution to make payments to the contract
holders if a specified event occurs, e.g.:
death of the policyholder, fire and theft
The large pool of funds is then used to purchase
both primary and secondary market securities
Payouts are made for insurance claims and to
retirees

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Finance companies
Finance companies make loans, provide lease
finance and factoring options to customers in the
household and business sectors
Funds are raised by issuing financial securities,
such as commercial papers, medium-term notes
and bonds, directly into money markets and
capital markets

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Overview

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4. The Financial and Economic systems


The financial system is a component of the
economic system.
The economic system comprises:
Markets for goods & services
Markets for resources (land, labour, capital and
entrepreneurship)
Financial markets

Economic markets

Circular Flow

Resource markets

Output markets
(goods & services)

Financial markets
Source: "Interactive Economics 2000" is copyright Michael Jarrett 2000

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Economic objectives
Economic growth
Full employment
Price stability
External balance
Efficient allocation of resources
Equitable distribution of income and wealth
The role of the financial system is to facilitate the
performance of the overall economic system.

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5. Government policy
In terms of government regulation, the last 50
years can be divided into the following distinct
periods:
Regulation (pre-1980s)
Deregulation (1980s)
Post-deregulation (1990s onward)

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Reasons for government intervention


Macroeconomic objectives:
growth, full employment, price stability, external balance

Efficient, fair and competitive financial system


Promotion of financial safety

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Methods of government intervention


Fiscal policy (Government budget and taxes):
What is happening to US Government: CLOSED!
Monetary policy (RBA central bank of Australia)
External policy (tariff and cap on fund flows)
Wages policy (superannuation)
Direct legislation (corporation law)
Competition policy (avoid oligopolies and
/monopolies)
Consumer protection (ombudsman, ACCC)
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