FINS1612 CAPITAL MARKETS AND INSTITUTIONS

WEEK1Introduction to Financial System

Introduction to FINS1612 Refer to unit outline…

Learning Objectives Explain the functions of a financial system Categorise the main types of financial institutions 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 primary/secondary markets and direct/intermediated finance

What is finance?

Then, what is money? Money

– Acts as medium of exchange

– Represents a store of wealth

– Facilitates saving

– Solves the divisibility problem,

HOUSEHOLDSector

FIRMSSector

FINANCIALSector

GOVERNMENTSector

OVERSEASSector

5 Sector Economy

Flow of Funds Sectorial flow of funds

– The flow of funds between business, financial institutions, government and household sectors and the rest of the world

– Net borrowing and net lending of these sectors of an economy vary between countries

– Influenced by• The impact of fiscal and monetary policy on savings and investment

decisions

• Policy decisions like compulsory superannuation

Chapter Organisation

1.1 Functions of a Financial System1.2 Financial Institutions1.3 Financial Instruments1.4 Financial Markets1.5 Flow of Funds and Market Relationships1.6 Summary

What is financial System?

The financial system is part of a country’s economic system

A financial system comprises a range of financial institutions, financial instruments and financial markets which interact to facilitate the flow of funds

Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial transactions

The main functions of financial system

Provide investment products for surplus economic units – shares, bank deposits

Provide alternative funding sources for deficit economic units – bank loans

Provide risk management products and services – insurance products

The main functions of financial systemMain function is to facilitate the flow of fundsPrimary Financial Market -facilitate the transfer of funds from surplus to deficit economic units by the creation of new financial assets

Secondary Market – facilitates the transfer of funds by arranging trades in existing financial assets

Efficient financial system should ensure that savings will be directed to the most efficient users of those funds

Overseeing the financial system is the Central bank and the prudential supervisor

Functions of a Financial System (cont.)

1. Financial InstitutionsFinancial institutions are classified into five categories based on the differences between the institutions’ sources and uses of funds1.Depository financial institutions

2.Investment banks and merchant banks

3.Contractual savings institutions

4.Finance companies

5.Unit trust

Depository financial institutionsCommercial banksobtains a large proportion of their funds from deposits lodged by savers.

A principal business of these institutions is the provision of loans to borrowers in the household and business sectors

E.g.

Investment banks and merchant banksMajor function is to provide off-balance sheet advisory services to support their corporate and government clients

Off balance sheet business includes advising clients on mergers and acquisitions, portfolio restructuring, and risk management.

These institutions may provide some loans to clients but are more likely to advise and assist a client to raise funds directly in the capital markets.

Contractual savings institutionsFinancial institutions such as life insurance offices, general insurers and superannuation funds

Their liabilities are mainly contracts which specify that, in return for periodic payments to the institution, the institution will make specified payouts to the holder of the contract if and when the event specified in the contract occurs.

The periodic cash receipts received by these institution provide them with a large pool of funds that they invest.

Finance companiesThese institutions raise funds by issuing financial securities such as commercial paper, medium term notes and bonds in the money markets and the capital markets

They use those funds to make loans and provide lease finance to their customers in the household sector and the business sector

Unit trustsA unit trust is formed under a trust deed and is controlled and managed by a trustee or responsible entity

Unit trusts attract funds by inviting the public to purchase units in a trust. The funds obtained from the sale of units are pooled and then invested by funds managers in asset classes specified in the trust deed.

There is a wide range of unit trusts, including equity trusts, property trusts, fixed interest trusts and mortgage trust.

1.2 Financial Institutions (cont.)

Chapter Organisation

1.1 Functions of a Financial System1.2 Financial Institutions1.3 Financial Instruments1.4 Financial Markets1.5 Flow of Funds and Market

Relationships1.6 Summary

Financial Assets A financial asset is defined as entitlement to

future cashflows A financial instrument is the more general

term used in the markets to describe financial assets and other instruments where there is no organised secondary market where that instrument can be traded

A financial security is a financial asset that can be traded in secondary market.

Financial AssetsAttributes 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

Financial AssetsAttributes of financial assets (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

Financial AssetsThe financial system (financial

institutions, instruments and markets) provides the potential suppliers of funds with the combinations of risk, return, liquidity and cash-flow patterns that best suit each saver’s particular needs

2. Financial InstrumentsA financial instrument represents an entitlement to the holder to a specified set of future cash flows.

EquityDebtDerivativesHybrid

EquityEquity can be described as an ownership interest in an asset

Types• Ordinary share

• Hybrid (or quasi-equity) security

–Preference shares

–Convertible notes

Debt Debt

– Contractual claim to:• periodic interest payments• repayment of principal

– Ranks ahead of equity – Can be:

• short-term (money market instrument) or medium- to long-term (capital market instrument)

• secured or unsecured• negotiable (ownership transferable, e.g. commercial bills and

promissory notes) or non-negotiable (e.g. term loan obtained from a bank

Debt FinanceShort-term debt is a financing arrangement for a period of less than one year with various characteristics to suit borrowers’ particular needs–Timing of repayment, risk, interest rate structures (variable or fixed) and the source of funds

Long term debt has a maturity of more than one year

DerivativesDerivative instruments are different from equity and debt

in that they do not provide actual funds for a borrower, but rather facilitate the management of certain related risks.

Used mainly to manage price risk exposure and to speculate

4 different types of derivative instrument–A futures contract

–A forward contract

–An option contract

–A swap contract

HYBRIDA hybrid security incorporates the

characteristics of both debt and equityE.g. preference share

Chapter Organisation

1.1 Functions of a Financial System1.2 Financial Institutions1.3 Financial Instruments1.4 Financial Markets1.5 Flow of Funds and Market

Relationships1.6 Summary

3. Financial Markets Matching principle Primary and secondary market transactions Direct and intermediated financial flow

markets Wholesale and retail markets Money markets Capital markets

Financial Markets Financial market within the economic system is vital

for the country Financial markets are characterised by

– Lending and borrowing of funds

– Creation and trading of financial assets financial market is distinguished from other

economic markets such as the market for final goods – real assets

The markets are categorised according to the types of transactions that occur

Matching principle Short-term assets should be funded with short-

term (money market) liabilities, e.g.– Seasonal inventory needs funded by overdraft

Longer-term assets should be funded with equity or longer-term (capital market) liabilities, e.g.– Equipment funded by debentures lack of adherence to this principle accentuated

effects of frozen money markets with the ‘sub-prime’ market collapse

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

– Funds are obtained by the issuer

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Direct and intermediated finance (cont.)

Primary and secondary market transactions (cont.) Secondary market transaction

– The buying and selling of existing financial securities

• No new funds raised and thus no direct impact on original issuer of security

• Transfer of ownership from one saver to another saver

• Provides liquidity, which facilitates the restructuring of portfolios of security owners

Direct Finance and Intermediated Finance

The issue of new financial instruments generates a flow of funds through the primary markets from the provider of funds to the user of those funds.

This flow can occur in two ways– Direct relationship from the provider of funds to the user of funds

– Indirect relationship from the provider of funds to the user of funds i,e, financial intermediary is involved

Direct and intermediated financial flow markets Direct financial flow markets - Users of funds obtain finance

directly from savers The contractual agreement is between the provider of funds

and the user of funds Direct finance is generally available only to corporations and

government authorities that have established a good credit rating (investment-grade credit rating)

Direct finance con’t

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

Direct and intermediated financial flow markets (cont.)

Intermediated financial 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

Direct and intermediated financial flow markets (cont.)

Direct and intermediated financial flow markets (cont.)

Advantages– Asset transformation

• Borrowers and savers are offered a range of products

– Maturity transformation

• Borrowers and savers are offered products with a range of terms to maturity

– Credit risk diversification and transformation

• Saver’s credit risk limited to the intermediary

– Liquidity transformation

• Ability to convert financial assets into cash

– Economies of scale

• Financial and operational benefits of organisational size, expertise and business volume

Direct and intermediated financial flow markets (cont.)

Wholesale and retail markets Wholesale markets

– Direct financial flow transactions between institutional investors and borrowers

• Involves larger transactions

Retail markets– Transactions conducted primarily with financial

intermediaries by the household and small- to medium-sized business sectors

• Involves smaller transactions

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Wholesale and retail markets (cont.)

Money markets Wholesale markets in which short-term securities

are issued (primary market transaction) and traded (secondary market transaction)– 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

Money markets (cont.)

Capital markets Markets in which longer-term securities are issued and

traded with original term-to-maturity in excess of one year– Equity markets

– Corporate debt markets

– Government debt markets Also incorporate use of foreign exchange markets and

derivatives markets Participants include individuals, business, government

and overseas sectors

1.6 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 Financial markets may be classified according to

– Primary and secondary transactions

– Direct and intermediated flows

– Wholesale and retail markets

– Money markets and capital markets