1B - Overview Of The Australian Financial System

Question 1

What is a Financial System?

Answer 1

The financial institutions, markets and instruments that provide an economy’s financial services.

Question 2

What are Financial Functions?

Answer 2

The Major functions formed performed by the financial system.

Question 3

What are the five financial functions of Australia’s financial system?

Answer 3

1. to arrange the settlement of commercial transactions. 2. to promote the flow of funds.
2. to provide opportunities for participants in the financial system to manage the risks they face.
3. to promote the financial system’s efficient operation and development.
4. to promote the financial system’s stability.

Question 4

What is the settlement function?

Answer 4

The arrangements that can be used to settle commercial transactions. This function is performed by the payments system.

Question 5

What is the flow of funds?

Answer 5

The supply of funds, usually on the basis the users compensate the suppliers for the use of their funds.

Question 6

What is the difference between money and finance?

Answer 6

Money’ is a means of exchange used to settle financial transactions and is therefore part of the financial system’s settlement function. ‘Finance’ usually refers to the flow of funds function where surplus units supply funds to deficit units through the financial system.

Question 7

What is Finance?

Answer 7

The term given to the “funds” that are made available for use under agreed terms and conditions. The principal source of finance is savings from households followed by earnings from firms (the difference between a firm’s revenue and costs).

Question 8

What are Surplus Units and Deficit Units?

Answer 8

We use the terms surplus units and deficit units to represent the flow of funds. Surplus units are
households, firms, governments and other organisations that have funds surplus to their immediate needs. Deficit units, conversely, need additional funds to meet their requirements.

Question 9

What are the two basic ways of arranging the flow of funds?

Answer 9

through transactions in financial markets, and

through transactions with financial institutions.

Question 10

What is direct financing?

Answer 10

The flow of funds arranged by the market process is called direct financing, because deficit units raise funds directly from surplus units, usually through the issue of securities.

Question 11

What is indirect financing?

Answer 11

It is called indirect financing, because the deposit-taking institution acts as an intermediary, borrowing from surplus units to make loans to deficit units. Indirect financing involves two sets of contracts: those the institution has with surplus units (such as its depositors), and those it has with deficit units (its loan contracts).

Question 12

What are the two basic forms finance?

Answer 12

Debt and Equity.

Question 13

What is Debt Financing?

Answer 13

Debt refers to borrowed funds (i.e. a loan). It commits the borrower to make the agreed loan-servicing payments, which comprise interest and the repayment of the loan. Debt is provided as loans by financial institutions (indirect financing) and security markets (direct financing) for either short or long periods.

Question 14

What is Interest?

Answer 14

Interest is the borrowers cost of debt. It compensates the lender for the use of the funds and for the credit risk posed by the borrower. Interest payments may be scheduled during the loan period (such as monthly or quarterly) and/or at the end of the loan. They are based on the agreed interest rate, which may be a fixed rate for the whole period of the loan or a floating rate.

Question 15

What is a secured and unsecured loan?

Answer 15

An unsecured loan is a loan that does not have a charge over the borrower’s assets whereas a secured loan is a loan made on the basis of assets pledged by the borrower.

Question 16

What is Fixed Rate and Floating Rate Interest?

Answer 16

A Fixed rate is an interest rate that applies over the whole period of a loan whereas a Floating rate is an interest rate that can change at agreed periods during the life of a loan.

Question 17

What is Equity Capital?

Answer 17

Equity capital is the funding provided to the business by its owner(s). It is ‘permanent’ capital, because it has no maturity date (unlike debt) and imposes no payment commitments on the business. Equity provides a company with financial strength because it provides the capacity to remain solvent during loss-making Periods.

Question 18

How do Companies Raise Equity Capital?

Answer 18

Equity is raised through the issue of ordinary shares (also known as common stock) and through the retention of earnings.

Question 19

What is Risk Capital?

Answer 19

Equity is often referred to as risk capital, because the returns to its suppliers have the lowest payment
priority, behind the payment priority of debt holders. The returns to equity suppliers are a residual claim on the firm’s earnings and assets, meaning they are met only after all obligations have been paid.

Question 20

What is a Financial Asset?

Answer 20

A financial asset is an intangible asset - its value depends on legal claims or rights to cash flows.Shares in a company represent financial assets. Other names for financial assets are financial instrument, contract, claim or security. Financial assets that are traded in the financial markets are called securities.

Question 21

What are the Four Attributes of Financial Assets?

Answer 21

Return, Risk, Liquidity, and Maturity.

Question 22

What is Return as it pertains to a financial asset?

Answer 22

The financial benefits from the supply and/ or use of funds, such as interest and dividends, an increase (or decrease) in an asset’s market value, whether or not the asset is sold, generating either a cash payment (known as a realised capital gain) or a loss (known as a realised capital loss).

Question 23

What is Risk as it pertains to a financial asset?

Answer 23

Returns on investments are exposed to risk – namely, the possibility that actual returns will be less than expected.

Question 24

What is Liquidity as it pertains to a financial asset?

Answer 24

Liquidity is the access suppliers of funds have to their funds (The realisation of the cash value of an asset).

Question 25

What is Maturity as it pertains to a financial asset?

Answer 25

Most assets have a maturity date after which these assets ‘expire’. The maturity date gives us their term to maturity – the period from now to the date of maturity.

Question 26

What is an Expected Return?

Answer 26

Return is the expected reward for investing in an asset. The return is really an expected return. Owning an asset means claims to its future cash flows. Most assets do not offer guaranteed returns. Also, The minimum return a supplier of funds requires when supplying funds for a particular purpose.

Question 27

What is Liquidity Risk?

Answer 27

Risk also applies to expected liquidity, through the risk that the seller will receive less than expected when liquidating an asset.

Question 28

What is Market Risk?

Answer 28

Market risk, is posed by the variability of returns given that market values move in unexpected ways. Returns that are consistent over time display a low level of risk, whereas returns that are more volatile pose greater risk.

Question 29

What is the Risk Return Relationship?

Answer 29

The relationship between returns and their risk is based on the belief that rational investors are risk-averse, meaning they need to be compensated with the prospect of higher returns to accept greater risk. The risk and return relationship implies that expected returns can be divided into two components: the risk-free rate and a risk premium, which is the extra rate of return to compensate for risk.

Question 30

What is the Risk free rate and risk premium?

Answer 30

The Risk-free rate is the rate of return (such as an interest rate) on an asset that is not subject to any variation. The Risk premium is the component of an interest rate (or return on an asset) that compensates the supplier of funds for risks faced.The Total Risk is…
r = r risk-free rate + r risk premium

Question 31

What are four contractual preferences that cause a mismatch between surplus and deficit units?

Answer 31

1. Amount of funds. (Size Mismatch)
2. Length of Contract (Maturity Mismatch)
3. Risk exposure
4. Return on/Cost of funds

Question 32

How is “Size” mismatch resolved within the financial system?

Answer 32

Through the pooling of funds and the issuing of securities. Pooling of funds helps contribute to the efficiency function of Australia’s financial system.

Question 33

What is the Primary Market?

Answer 33

The primary market is where securities are created. It’s in this market that firms sell (float) new stocks and bonds to the public for the first time. An initial public offering, or IPO, is an example of a primary market.

Question 34

What is the Secondary Market?

Answer 34

Transactions that occur on the secondary market are termed secondary simply because they are one step removed from the transaction that originally created the securities in question.

Question 35

In Australia how are government securities issued?

Answer 35

In Australia, government securities are issued through a competitive tender process conducted by the relevant government department. A tender process relies on bids from security dealers, and so the interest rate at which the securities are issued is determined by the market for these securities.

Question 36

In Australia who normally issues shares?

Answer 36

Shares are issued mainly by specialist financial institutions (such as investment banks) on behalf of deficit units on a best-efforts basis, meaning these institutions earn commissions and fees provided they successfully issue the securities.

Question 37

What is a “best effort basis”?

Answer 37

The method of arranging the issue of securities where the arranger is paid only where the securities are sold .

Question 38

What is a “commission”?

Answer 38

A fee for successfully completing a transaction for a client, such as selling securities.

Question 39

What is a “best effort basis” as it pertains to the issuing of securities?

Answer 39

The method of arranging the issue of securities where the arranger is paid only where the securities are sold .

Question 40

What is commission?

Answer 40

A fee for successfully completing a transaction for a client, such as selling securities.

Question 41

What drives the level of fees when issuing securities??

Answer 41

The type of securities involved. Shares are the most expensive, due to greater documentation and a more intensive marketing effort. Short-dated securities and government bonds are the least expensive, because they are issued to institutional investors on a regular basis and use standardised documentation. The fee depends also on the method used to issue securities. A best-efforts contract is usually cheaper than underwriting.

Question 42

What is “underwriting” as it pertains to the issuing of securities?

Answer 42

Arranging the issue of securities in such a way that guarantees they are issued.

Question 43

What is “Standby underwriting” as it pertains to the issuing of securities?

Answer 43

An arrangement whereby an investment bank agrees to buy the securities it is unable to sell under its best-efforts agreement.

Question 44

What are Ratings Agencies?

Answer 44

Firms that are paid to provide an expert opinion about the expected performance of securities and financial institutions.

Question 45

Who are the 3 major international rating agencies?

Answer 45

Moody’s, Standard & Poor’s (or S&P) and Fitch Ratings.

Question 46

What are credit ratings?

Answer 46

Scales that represent opinions about the risk that the security’s payments will not be made as scheduled; Securities with the lowest risk of default are assigned the highest rating. Ratings play an important role within primary markets for debt securities, because these securities are rated prior to being issued and the rating influences demand for them.

Question 47

What are the three components of secondary markets?

Answer 47

1. a trading platform
2. trading rules and protocols
3. clearing and settlement procedures.

Question 48

What are the two main types of trading institutions?

Answer 48

securities exchanges and over-the-counter (OTC) markets.

Question 49

What is a securities exchange?

Answer 49

An organisation that arranges trading in securities.

Question 50

What is an OTC Market?

Answer 50

Over-the-counter, (OTC) markets are Wholesale financial markets where trades are between traders and/or dealers rather than on an exchange.

Question 51

What is an Exchange organised Market?

Answer 51

Exchanges were developed by share brokers to organise their trading. The exchange provides the trading facilities, sets the trading rules and organises the settlement of trades.

Question 52

What are Brokers?

Answer 52

Financial firms that provide transaction services as agents for traders in a market. They earn income (usually in the form of a commission) when they arrange a trade. They pay a fee for using the exchange’s trading and settlement services.

Question 53

What are Dealers?

Answer 53

Financial firms that trade securities on their own behalf through their buy-and-sell quotes.

Question 54

What is Transparency as it pertains to an exchanged-organised market?

Answer 54

The provision of accurate real-time information about a market’s trading, and an electronic record of all trades.
providing market regulators with information to review trades and enable price indices to use real-time prices. This should contribute to investor confidence in the market’s fairness. Trading transparency is important for the ‘price-discovery’ role of markets.

Question 55

What are order driven markets?

Answer 55

Markets in which trading is conducted by the orders placed in the market.

Question 56

What is a limit price?

Answer 56

The upper price on a buy order in a market and the minimum price on a sell order.

Question 57

What is an at-market order?

Answer 57

An order to buy or sell securities at the best available price.

Question 58

What are quote driven markets?

Answer 58

Markets where dealers are required to make bids and offer quotes (known as two-way quotes) when called by another dealer; they must trade if one of the quotes is accepted.

Question 59

What is a two-way quote?

Answer 59

The system that requires dealers to provide both a bid quote and an offer quote when contacted by another dealer.

Question 60

What is a bid and an offer?

Answer 60

A Bid is Jargon for the quote to buy a security

and an Offer is Jargon for the quote to sell a security; also referred to as ‘ask’.

Question 61

What are Market Makers?

Answer 61

Market makers are Dealers who continuously buy and sell at their bid and offer quotes.

Question 62

What is Transaction immediacy?

Answer 62

A service provided by dealers given they must trade when their bid or offer quote is accepted.

Question 63

What is a Position?

Answer 63

The number of assets or contracts held by a trader.

Question 64

What is a Trading Spread?

Answer 64

The spread between a dealer’s bid and offer quotes. Dealers earn a trading spread (as opposed to a broker’s commission) when traders sell to and buy from them. This is known as a round-trip transaction.

Question 65

What is Price Risk?

Answer 65

Price risk is the risk posed to holders of securities from the random movement in the security’s price.

Question 66

What is a round-trip transaction?

Answer 66

Trades at a dealer’s bid and offer quotes that enable the dealer to earn its spread.

Question 67

What are the two main ways secondary markets assist primary markets?

Answer 67

1. Providing liquidity for investors; this transforms the maturity of the funds supplied to the market
2. Performing the ‘price-discovery’ process, through which the market judges the value of the traded securities.

Question 68

What is maturity transformation?

Answer 68

When a secondary market endows a security with liquidity.

Question 69

How can we tell if a market is liquid?

Answer 69

1. By examining the market’s daily turnover – Expressing the value as a turnover ratio shows the proportion of issued securities that were traded. Both measures can be for the market and for a specific security to indicate its liquidity.
2. By examining the width of the market’s bid–ask spread (or the spread for a security). The narrower the spread, the more liquid the market.
3. Price resilience This refers to the impact a trade will have on the market price. A price is resilient when a normal-sized transaction can be accommodated with little or no reaction in the market price.

Question 70

What is Market Liquidity?

Answer 70

The capacity of a market to allow investors to trade their securities at current values.

Question 71

What is Daily Turnover?

Answer 71

The value and number of securities traded each business day.

Question 72

What is the Bid–ask spread?

Answer 72

The difference between a dealer’s (or a market’s) buying and selling prices.

Question 73

What is the Turnover Ratio?

Answer 73

The ratio of the daily turnover of a security to the total amount of that security

Question 74

What is Price resilience?

Answer 74

The capacity of a security’s market price to resist change due to buying or selling transactions.

Question 75

What is Market Depth?

Answer 75

The volume of buy and sell orders in a market at (or near to) current market values.

Question 76

What is the Bid–offer bounce?

Answer 76

The variation in price caused when seller-initiated trades are followed with buyer-initiated trades.

Question 77

What is the Money Market?

Answer 77

The money market is part of the fixed-income market that specializes in short-term debt securities that mature in less than one year. Most money market investments often mature in three months or less. Because of their quick maturity dates, these are considered cash investments.

Question 78

What is a Capital Market?

Answer 78

A Financial market in which long-term debt or equity-backed securities are bought and sold. Capital markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments.