Week 4: Financial Markets and Institutions Flashcards
What is the financial system?
The financial institutions, markets and instruments that provide an economy’s financial services.
The financial system allows both lenders and borrowers to trade-off between the different attributes to achieve their desired portfolio structure needs.
What do the regulators and supervisors in the financial system look over?
Institutions - banks, building societies, credit unions etc.
Instruments - debt, equity, hybrids, derivatives
Markets - money, capital, equity, foreign exchange, derivatives
What are real assets?
The wealth of a society is determined by the productive capacity of its economy - the goods and services its members can create.
This capacity is a function of the real assets of the economy:
•tangible assets - land, buildings, machines; and
•intangible assets – knowledge, intellectual property
•that can be used to produce goods and services.
What are financial assets?
Financial Assets (e.g. stocks and bonds) are financial “securities” •historically no more than sheets of paper •do not contribute directly to the productive capacity of the economy.
Financial assets are the means that investors hold their claims on real assets.
•claims to the income generated by real assets.
Difference between financial and real assets.
Real assets generate net cash flows within the economy, financial assets define the allocations of the cash flows.
Investors buy financial assets (e.g. shares and bonds) which are “issued” by companies:
– the firms then use the money they receive from investors to pay for real assets (e.g. plant, equipment, technology or inventory),
– the real assets are used to generate cash flows (or income in the economy),
– the cash flows are distributed back to investors in the form of returns.
Eg. You cannot own a car plant or factory (real asset), you can still buy shares in Ford or Toyota (financial assets) and thereby share in the cash flows derived from the production of cars.
What are financial markets?
The markets in which financial assets are bought and sold.
The financial market can be classified according to:
. Maturity (money vs capital market)
. Market (primary vs secondary)
. Asset class (T notes, CDs equity, bond)
. Organisation of transactions (exchange traded vs over the counter)
Maturity: money market V capital market.
Money markets:
Markets short-term financial instruments
– by convention: terms less than one year
e.g. Treasury notes, certificates of deposit, commercial bills, promissory notes
Capital markets:
Markets in long-term financial instruments
– by convention: terms greater than one year
– long-term debt and equity markets
e.g. Government bonds, debentures, shares, leases, convertibles
Organisations of transaction: over the counter (OTC) V exchange traded market.
Exchanges: more formal trading mechanism.
Securities are traded through an organised exchange such as a stock exchange, where brokers carry out clients’ instructions to buy or sell nominated securities.
- Trading is governed by certain rules.
- Prices are available to all market participants.
- More transparency
Over-the-counter (OTC): an informal market where trading is facilitated by dealer(s).
Not an organised exchange:
- less transparency
- fewer regulations.
What do OTC markets consist of?
OTC markets consist of financial institutions (dealers) who trade with clients and other institutions.
Dealers quote private prices to customers and other dealers.
–Prices can be negotiated through phone and electronic media.
Market: primary V secondary market.
Primary markets:
Financial assets are first sold by their originators (issuers) to investors.
– Transaction is between the deficit units (who need the funds) and surplus units (who have excess funds to invest).
– New financial assets are provided to investors.
– Called Initial Public Offerings (IPOs).
– Usually priced conservatively because:
• Issuer is new to the market (higher risk)
• Want to start off on a positive note
Secondary markets:
Where existing (issued) securities are traded.
– Does not raise any new funds for the issuer (the company).
. only result a change of ownership
. adds marketability and liquidity to primary markets
. reduces risk on primary issues
Asset class: Equity, bond and currency market.
Equity market:
•Market where equities are traded
•usually through an organized exchanged
Bond market: •Market where bonds are traded •mostly OTC . Government securities . Non government securities
Currency market:
Transfer of purchasing power from one currency to another
•Networks of licensed foreign-exchange dealers
•Very efficient markets
•Major types of transactions
. Spot
. Forward
Equity Vs debt.
Equity: eg. Share
. Owner
. Unlimited life
. Expect annual dividend and capital gain (not guaranteed)
Debt: eg. Bond
. Lender
. Limited life
. Guaranteed interest payment
Flow of funds function.
The supply of funds for a period usually on the basis that the users compensate the supplier for the use of their funds.
- Funds are supplied by SURPLUS UNITS mostly as bank deposits and superannuation contributions they require compensation for forgoing the immediate use of the funds and for the risk the funds will not be returned (‘return’ on investment, interest rate).
- The DEFICIT UNITS that require funds include households (for housing loans), businesses and the government.
The flow of funds: direct finance considerations.
Benefits:
•removes cost of financial intermediary
•diversify funding instruments and sources
•raise profile in financial markets
Disadvantages:
•documentation; prospectus
•matching lender and borrower preferences
•liquidity and marketability of securities
The flow of funds: intermediated finance considerations.
Asset transformation:
•range of products
•pooling of funds
Maturity transformation:
•liquidity
•maturity
•risk management
Financial assets - derivatives.
Financial securities that provide payoffs that are determined by the prices of other assets, such as the price of a bond or equity.
Examples of derivative securities:
. options
. futures contracts.
You buy derivatives to minimise risk. Derivatives are a contract to buy or sell an asset in advance (to stay away from price fluctuation).
The structure of Australia’s financial system.
- The financial functions are performed by financial institutions and markets with oversight from their regulators and the RBA
- The flow-of-funds and risk-management functions are performed by both institutions and markets
- The settlement function is performed by institutions only
- Markets and institutions both complement and compete with each other
What are banks?
Banks are defined as authorised deposit taking institutions (ADIs) whether or not the ADI calls itself a bank.
Most accept deposits, make loans and provide payment services for:
. Households, small businesses and organisations (retail customers) and/or
. Large companies and organisations (wholesale customers)
Australia’s four major banks provide both retail and wholesale banking services.
Other financial intermediaries.
Money market corporations
Includes investment banks which operate primarily in wholesale market:
- borrow from and lend to large corporations, corporate advisory activities.
Finance companies
•Main service includes providing loans to small and medium-sized businesses.
•Raises funds from wholesale markets and retail investors, using debentures and unsecured notes.
Superannuation funds.
Superannuation funds accept contributions from
•employers
•fund members (employees, self-employed and retirees)
Superannuation funds manage investments to provide retirement income benefits. Assets are generally managed by professional fund managers who invest in a range of: . equities . property . debt securities . deposits
What are managed funds?
Pool money from different investors and invest in a wide range of financial assets.
Assets are selected and managed by a professional management company.
