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Chapter 1

The Financial System

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger

Learning Objectives
Explain the functions of a financial system Describe the main classes of financial

instruments issued in a financial system Distinguish between various types of financial markets according to function Discuss the flow of funds between savers and borrowers, including direct and intermediated finance

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger

Learning Objectives (cont.)


Appreciate the influence of globalization on

financial markets Categorize the main types of financial institutions Understand the impact of a financial crisis on a financial system and a real economy

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger

Chapter Organization
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalization Financial Institutions Summary

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger

1.1 Introduction
Money
Medium of exchange Allows specialization in production Solves the divisibility problem, i.e. where medium of exchange does not represent equal value for the parties to the transaction Facilitates saving Store of wealth Any commodity that is widely accepted in exchange transactions

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1.1 Introduction (cont.)


Role of markets Facilitate exchange by
 

Bringing opposite parties together Establishing rates of exchange, i.e. prices

Surplus units Savers of funds available for lending Deficit units Borrowers of funds for capital investment and consumption

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1.1 Introduction (cont.)


Financial instrument Issued by a party raising funds, acknowledging a financial commitment and entitling holder to specified future cash flows Flow of funds Movement of funds through the financial system between savers and borrowers giving rise to financial instruments

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger

1.1 Introduction (cont.)


Financial system Financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions Overcomes difficulty of


Double coincidence of wants


Transaction between two parties meets their mutual needs

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1.1 Introduction (cont.)

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger

Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalisation Financial Institutions Summary

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1.2 Functions of the Financial System


Attributes of financial assets Return or yield


Total financial compensation received from an investment expressed as a percentage of the amount invested Probability that actual return on an investment will vary from the expected return

Risk


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1.2 Functions of the Financial System (cont.)


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

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1.2 Functions of the Financial System (cont.)


The financial system facilitates portfolio

restructuring
The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows

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1.2 Functions of the Financial System (cont.)


An efficient financial system Encourages savings Savings flow to the most efficient users Implements the monetary policy of governments by influencing interest rates The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger

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Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalisation Financial Institutions Summary

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1.3 Financial Instruments


Equity Ownership interest in an asset Residual claim on earnings and assets
 

Dividend Liquidation Ordinary share Preference shares or Equity Hybrid (or quasi-equity) security
Preference shares Convertible notes

Types
 

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1.3 Financial Instruments (cont.)


Debt Contractual claim to
 

Periodic interest payments Repayment of principal

Ranks ahead of equity Can be secured or unsecured

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1.3 Financial Instruments (cont.)


Derivatives A synthetic security providing specific future rights that derives its price from a


Physical market commodity


Gold and oil

Financial security
Interest rate-sensitive debt instruments, currencies and equities

Used mainly to manage price risk exposure, and to speculate

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1.3 Financial Instruments (cont.)


Four basic derivative contracts Futures Contract Forward Contract Option Contract Swap Contract

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Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalisation Financial Institutions Summary

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1.4 Financial Markets


Matching principle Primary and secondary market transactions Direct and intermediated financial flow

markets Wholesale and retail markets Money markets Capital markets

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Matching principle
Short-term assets should be funded with

short-term liabilities
Inventory funded by overdraft

Longer-term assets should be funded with

equity or longer-term liabilities


Equipment funded by debentures

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Primary and secondary market transactions


Primary market transaction The issue of a new financial instrument to raise funds to purchase goods, services or assets by


Businesses
Company shares or debentures

Governments
Treasury notes or bonds

Individuals
Mortgage

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Primary and secondary market transactions (cont.)


Secondary market transaction The buying and selling of existing financial instruments
 

No direct impact on original issuer of security Transfer of ownership from one saver to another saver Provides liquidity which facilitates restructuring of portfolios of security owners

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Direct and intermediated financial flow markets


Direct flow markets Users of funds obtain finance directly from savers


Advantages
Avoids costs of intermediation Increases range of securities and markets

Disadvantages
Matching of preferences Liquidity and marketability of a security Search and transaction costs Assessment of risk, especially default risk

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Direct and intermediated financial flow markets (cont.)

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Direct and intermediated financial flow markets (cont.)


Intermediated flow markets A financing arrangement involving two separate contractual agreements whereby saver provides funds to intermediary, and the intermediary provides funding to the ultimate user of funds
Advantages
 

Asset transformation Maturity transformation

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Direct and intermediated financial flow markets (cont.)


Advantages (cont.)
  

Credit risk diversification and transformation Liquidity transformation Economies of scale

Sectorial flow of funds The flow of funds between business, financial institutions, government and household sectors and the rest of the world Influenced by fiscal and monetary policy
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Direct and intermediated financial flow markets (cont.)

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Wholesale and retail markets


Wholesale markets Direct financial flow transactions between institutional investors and borrowers


Involves large transactions

Retail markets Transactions conducted primarily with financial intermediaries by the household and smallmedium business sectors


Involves smaller transactions

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Money markets
Wholesale markets in which short-term

securities are issued and traded


Securities highly liquid
  

Term to maturity of one year or less Highly standardised form Deep secondary market

No specific infrastructure or trading place Enable participants to manage liquidity

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Money markets (cont.)


Money market securities Cash deposits (11 a.m. and 24-hour call) Commercial bills Treasury notes Government bonds Promissory notes Intercompany loans Interbank loans

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Money markets (cont.)


Money market participants Reserve Bank
 

Financial system liquidity Implementation of monetary policy

Banks Finance companies Funds managers Building societies Credit unions Companies
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Money markets (cont.)


Money market sub-markets Intercompany market Interbank market Bills market Commercial paper market Negotiable certificates of deposit (CDs) market

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Capital markets
Markets in which longer-term securities are

issued and traded


Equity markets Corporate debt markets Government debt markets Foreign exchange markets Derivatives markets

Term to maturity of more than one year

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Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalisation Financial Institutions Summary

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1.5 Impact of Globalisation


Globalisation of financial markets Refers to the interdependence of national financial systems Global standardisation of financial instruments Facilitates the movement of funds between savers and borrowers in different countries

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Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalisation Financial Institutions Summary

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1.6 Financial Institutions


Financial institutions permit the flow of

funds between borrowers and lenders by facilitating financial transactions


Institutions may be categorised by

differences in the sources and uses of funds

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1.6 Financial Institutions (cont.)


Categories of financial institutions Depository financial institutions Investment banks and merchant banks (money market corporations) Contractual savings institutions Finance companies Unit trusts

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Categories of financial institutions


Depository financial institutions Attract savings from depositors and investors to provide loan facilities to borrowers Commercial banks Building societies Credit unions

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Categories of financial institutions (cont.)


Investment banks and merchant banks (money market corporations)
Mainly provide off-balance-sheet (OBS)

transactions to corporations and government Advice on mergers and acquisitions, portfolio restructuring, finance and risk management Provide some funding
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Categories of financial institutions (cont.)


Contractual savings institutions The liabilities of these institutions are contracts that specify, in return for periodic payments to the institution, the institution will make payments to the contract holders if a specified event occurs Funds are then used to purchase both primary and secondary market securities
Life and general insurance companies Superannuation funds
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Categories of financial institutions (cont.)


Finance companies
Funds are raised by issuing financial

securities direct into money markets and capital markets


Funds are used to make loans to ultimate

borrowers

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Categories of financial institutions (cont)


Unit trusts Investors purchase units in the trust Trust manager invests funds in a range of investments specified by trust deed Types of unit trusts
Cash management trusts Equity trusts Property trusts Mortgage trusts
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1.6 Financial Institutions (cont.)


Assets of financial institutions

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Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction Functions of the Financial System Financial Instruments Financial Markets Impact of Globalisation Financial Institutions Summary

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1.7 Summary
The financial system is composed of

financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions
Financial instruments may be equity, debt

or hybrid

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1.7 Summary (cont.)


Financial markets may be classified

according to
Primary and secondary transactions Direct and intermediated flows Wholesale and retail markets Money markets and capital markets Financial institutions

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