Topic 1 - Financial System Overview Flashcards
financial system
organized structure that facilitates the flow of funds.
The financial system comprises of
Financial institutions
Financial markets
Financial instruments
Flow of funds from
surplus units (savers) to deficit units (borrowers).
Financial Institutions and markets facilitate
flow of funds resulting in financial transactions
Financial instruments are created to
recognise financial transactions
Savers reason for investing:
to trade off current consumption for a larger future consumption.
Invest savings to improve their overall wealth.
The financial asset has 4 main attributes
Return or Yield
Risk
Liquidity
Time pattern of cashflows
There are five broad categories of financial institutions based on how they source and use their funds:
Depository financial institutions Contractual savings institutions Investment Banks Finance companies and general financiers Unit Trusts
Financial instruments
legal documents issued by parties raising funds, acknowledging a financial commitment and entitling the holder to specified future cash flows.
Three broad categories for financial instruments
Equity
Debt
Derivatives
Equity
The sum of the financial interest an investor has in an asset; an ownership allocation
2 types of equity
Ordinary Shares
Hybrid Securities
ordinary shares
represents an ownership positions
shareholders are entitled to share in the profits of the business in the form of dividend payments.
Hybrid Security
incorporates characteristics of both debt and equity
Example: an instrument issued which makes periodic interest payments, but offers a future ownership entitlement (e.g. convertible notes and preference shares).
Debt
Contractual claim against an issuer and require the borrower to make specific payments such as coupon or interest payments and the repayment of principal amount at the end of the maturity period.
Ranks ahead of equity
Features of Debt
can be short term or medium to long term.
secured or unsecured.
negotiable debt instrument (ownership transferable) or non-negotiable (e.g. term loan obtained from a bank).
Derivatives
Derivative security is a financial instrument whose value depends (derives from) on another (fundamental) security such as stocks/bonds or commodity.
Primary use of Derivatives
Primarily used not to raise funds but to manage risk.
Types of Derivatives Contracts
Futures contract
Forwards contract
Option contract
Swap contract
matching principles
Short-term assets financed by short-term liabilities
Medium-to-long-term assets financed with equity and/or medium-to-long-term liabilities.
Categorization of financial markets based on the type of transactions that occur within each market:
Primary and secondary markets
Direct and intermediated markets
Money and capital markets
Wholesale and retail markets
Primary Market Transactions
Markets where new instruments are sold and the money raised goes directly to the issuing entity.
eg - bonds, preferred stocks, common stocks
Secondary Market Transactions
Provides liquidity
Without a proper secondary market primary market issuers would have to provide a much higher return to compensate investors for the substantial liquidity risk.
A deep and liquid secondary market strengthens the primary market.
Direct Finance
Funding obtained direct from the money and capital markets;
Contractual agreement is between the provider of funds and the user of funds. use of agents
Funds are not provided by the financial institutions.
Agents
through which the instructions of providers and users of the funds are carried out.
Do not provide finance, but receives a fee or commission for arranging transaction between two parties.
Advantages of Direct Finance
Removes cost of intermediary
allows the borrower to diversify funding
Greater flexibility in types of funding instruments used for different financing needs
Enhance international profile by carrying out transactions in international financial markets
Disadvantages of Direct Finance
Matching preferneces of lenders and borrowers
Liquidity and marketability of securities
Search and transaction costs
Difficult to assess risk, especially default risk
Intermediated Finance
Supplier of funds (investor) contracts with a financial intermediary such as a bank (e.g. term deposit);
User of funds (borrower) also contracts with the intermediary (e.g. housing loan)
Claims of each party are with the intermediary; i.e. the investor has no claim against the borrower
Benefits of Intermediation
Asset transformation Maturity transformation Credit risk diversification Liquidity transformation Economies of Scale/Distribution of costs:
Asset Transformation
Ability to prove a range of products that meet customers portfolio preferences
Maturity Transformation
Products offerred with a range of terms to maturity
Liquidity Management
Banks actively manage their sources of funds (liabilities )in order to meet future loan demands (assets)
Credit Risk Diversification
A savers credit risk is limited to the intermediary, the intermediary is exposed to the credit risk of the borrower
Economies of Scale
Financial and operational beenfits gained from organisational size, expertise and volume of business.
Wholesale Markets
Direct financial flow transactions between institutional investors and borrowers;
Involves larger transactions;
Institutional investors include:
Commercial banks; Insurance offices; Superannuation funds; Investment banks; Fund managers; Finance companies.
Retail markets
Transactions conducted primarily with financial intermediaries by the household and small- to medium-sized business sectors;
Involves smaller transactions.
Money Markets
wholesale markets in which short-term securities (less than 12 months) are issued (primary market)and traded (secondary market).
Bring together institutional investors that have surplus funds and those with a short-term shortage of funds.
Characteristics of Money Markets
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 Market Participants
Central Bank Commercial Banks Superannuation Funds Investment banks Finance Companies Insurance Offices Funds managers Building Societies Cash Management Trusts Corporations
Types of Money Market Instruments
Exchange Settlement Accounts Treasury Notes Commercial Bills Promissory Notes Deposits Negotiable Certificates of Deposits Inter-bank loans Repurchase Agreements
Capital Markets
Markets in which longer term securities are issued and traded with original term-to-maturity in excess of one year.
Encompass both the domestic and international markets.
Examples of Capital Markets
Equity market Corporate debt market Government debt market Foreign exchange market Derivatives market:
The principal function of a financial system
is to facilitate the efficient flow of fund between deficit (users)and surplus (suppliers) units contributing to economic growth.
Domestic economy can be divided into 4 sectors
business corporations
financial sectors
government sector
household sector
and the rest of the world.
Depository Financial Institutions
Accept Deposits and provide loans to customers
eg - commercial banks
Investment Banks
Specialist providers of financial and advisory services to corporatationsm high net worth inviduals and government
Contractual savings institutions
Offer financial contacts such as insurance and supperannuation
large investors
Finance Companies and general financiers
Borrow funds directly from markets to provide loans and lease finance to customers
Unit Trusts
Investors buy units issued by the trust; pooled funds invested
eg - property and equity trusts
Secured Debt
A debt instrument that provides the lender with a claim over specified assets if borrower defaults
Negotiable Debt Instruments
A debt instrument can be sold by the orginal lender through a financial market
Futures Contract
Exchange traded agreement to buy or sell a specific commodity or financial instrument at a specific price at a predetermined future date
Forward Contract
OTC agreement that locks in a price (IR or ER) that will apply at a future date
Option Contract
The right, but not an obligation to buy or sell a commodity or security at a predetermined exercise price the option buyer pays a premium to the option writer
Swap Contract
An agreement between two parties to swap future cash flows (IR or Currency Swaps)
What are the differences between primary market and secondary market financial
transactions?
• Primary market transactions relate to the creation of a new financial asset—for example,
a company issues new shares or the government issues Treasury bonds; new funds being
raised.
• Secondary market transactions relate to the sale and transfer of existing financial assets;
for example, a shareholder sells their shares to another investor and receives value—
transfer of ownership; no new funds raised.
Why is the existence of well-developed secondary markets important to the functioning of
the primary markets within the financial system?
• Investors will purchase primary market securities if they know that there is a deep and
liquid secondary market in which they are able to sell the securities at a later date, if
necessary.
• Secondary market transactions provide price discovery in that the securities will be sold at
the current market value.
financial assets
represents an entitlement to future cash flows.
financial instruments
financial asset whose value is represented in paper or electronic form;
for example, Treasury bond, term deposit.
securities
financial asset where there is a formal secondary market where the asset may be bought or sold;
for example, shares, money market securities such as bills
of exchange and commercial paper.
