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Week 1
1/5 Functions of a Financial System:
Composition of financial institutions, instruments and markets
facilitating transactions for goods and services and financial
Side note - Money (5 - Extra special savings divides wealth)

Medium of Exchange, Specialisation of production,

Solves divisibility problem, Facilitates saving,
Represents store of wealth

Role of markets and the Financial System

Facilitate exchange of goods and services by;

o Bringing opposite parties together

Double coincidence of wants satisfied

>>> Transaction between two parties that meets mutual needs

o Establishing rates of exchange

Facilitation of portfolio restructuring;

o Combination of assets and liabilities comprising the desired attributes
of return (yield, ROR), risk, liquidity and timing of cash flows.

Helps Implementation of monetary policy (influencing interest rates)

Provision of Investment products, risk management products, alternative

funding sources.

Facilitating the movement of money From surplus holders to deficit


Note: Surplus units (savers of funds for lending) and deficit

units (borrowers of funds for capital investment and

Efficient Financial System

o Encourages savings & Directs savings to most efficient users,
Facilitates the CF to the most efficient users (not needy, that
is welfare)

o Implements monetary policy of governments by influencing interest

o Is a combination of assets and liabilities comprising the desired
attributes of yield, risk, liquidity, CF timing.

3/5 Tools Of a financial System - Financial

Financial Instruments - definition

Issued by a party raising funds, acknowledging a financial commitment

and entitling the holder to specified future cash flows
o Lenders/Savers (surplus units) supply funds and receive financial
o Users / borrowers (deficit units) receive funds and issue
financial instruments

Financial Instruments - attributes:

-Total financial compensation received from an investment, expressed as a
percentage of the amount invested

-Probability that the actual return on an investment will vary from the
expected return

-Ability to sell an asset within a reasonable time at current market prices
and for reasonable transaction costs

Time-pattern of cash flows

-When the expected cash flows from a financial asset are to be received by
the investor or lender

Financial Instruments THREE TYPES

Ownership interest (and voting rights) in an asset that gives residual claim on
earnings and assets
>> Dividend, liquidation etc

Ordinary Shares
Hybrid securities (preference shares, convertible notes)
Debt (Ranks ahead of equity)
Contractual claim to periodic interest payments and repayment of a principal

Short term (money market instrument) / Medium to long term (capital


Secured / unsecured

Negotiable (ownership transferable commercial bills and promissory

notes) / non-negotiable ( term loan obtained from bank)
o Bonds Corporate
o Bonds Government [T = treasury];

T-bills (< 1 year)

T-notes ( 1 to 10 year) >>> < 6 month in Australia (not

since 2003 )
T-bond (10 to 30 year) >>> < up to ten years

Synthetic security providing specific future rights that derives price from
either a physical market commodity (gold, oil etc) or a financial
security (interest-rate-sensitive debt instruments, currencies and equities)
NO actual money to firm
o Four types:

Futures contract

Forward contract

Option contract (call / put)

Swap Contract

o Used
to manage
price riskvs
and to speculate.
Asset is entitlement to future CF,
Instrument is type of asset represented by paper/electronic paper
Security is a type of asset with a well-developed secondary market

2/5 Financial Institutions:

>>>Permit the flow of funds between borrowers and lenders by facilitating
financial transactions
>>> Categorised (5) by differences in sources and use of funds

Depository Financial Institutions

o Savings of depositors through on-demand deposit and term deposit
o Provide loans mainly to borrowers in household and business sectors,
>>> Makes money via the rates charged on these loans.
>>> Commercial banks, building societies and credit cooperatives

Investment banks and merchant banks

o Provide OBS (off-balance-sheet) advisory services to support
corporate and government clients
o May provide some loans to clients but more likely to advise clients on
how to raise funds in capital markets themselves.
>>> Makes money via large fees for advice (large portion goes to
>>> Advice on M&A, portfolio restructuring, finance and risk

Contractual savings institutions

o Institutions that have liabilities in the form of an exchange for
periodic payments to the institution that entails making payments to
the contract holders if a specified event occurs
o Large pool of funds used to purchase primary and secondary market
>>> Makes money via premiums and statistical odds of people not
>>> Life and general insurance companies and superannuation

Finance Companies
o Funds raised by issuing financial securities directly into money
markets and capital markets. (Do not receive deposits)
o Funds used to make loans and provide lease finance to customers in
the household and business sectors
>>> Makes money via borrowing from market at low rate and
lending at higher rate.

Unit Trusts

o Formed under a trust deed and controlled and managed by a trustee

by raising funds from selling units to the public. (Investors
purchase units in the trust)
o Funds are pooled and fund managers invest by classes specified in
>>> Makes money via taking a cut of money made through investing
>>> Types include equity, property, fixed interest and mortgage trusts.

4/5 Financial Markets:

No actual exchange of real goods market decides prices

Matching Principal
o Short-term assets should be funded with short term (money
market) liabilities
>>> Seasonal inventory needs funded by overdraft
o Hence longer term assets funded with equity or capital market
>>> Equipment funded by debentures
WHEN NOT ADHERED TO accentuates effects of frozen money
markets with the sup-prime market collapse

Primary vs. Secondary Market Transactions

o Primary is issue of NEW financial instruments to raise funds
>>> Businesses use shares or debentures, governments use treasury
notes or bonds, individuals use mortgages

Funds are obtained by the issuer

o Secondary is the trading of existing financial securities

No impact on original issuer

Transfer of ownership between savers

Provides liquidity which facilitates restructuring of portfolios of

security owners.

Wholesale and Retail Markets

o Wholesale markets:
-Direct financial flow transactions between institutional investors and
(Larger Transactions)

o Retail Markets:
-Transactions conducted primarily with financial intermediaries by the
household and small-to-medium-sized business sectors.
(Smaller transactions)

Money Markets vs. Capital Markets

o Money Markets are where short-term, one year or less, securities
are issued (primary market) and traded (secondary markets).

Securities are highly liquid

Highly standardised

Have a deep secondary market

>>Submarkets exist for central bank, inter-bank, bills,
commercial paper and negotiable CDs (certificate of deposit)

Have no specific infrastructure or trading place.

o Capital Markets are where longer term securities are issued and
traded with original maturity times in excess of one year.
>>>Equity, corporate debt, government debt markets
(Also incorporates FOREX and derivatives markets)

Direct and Intermediated Finance

o Direct: Users of funds obtain finance through primary market via
direct relationship with providers (savers)

- Avoids costs of intermediation
-Increase access to diverse range of markets
-Greater Flexibility in range of securities to issue for different
financing needs

- Matching of preferences
- Liquidity and marketability of a security
- Search and transaction costs
- Assessment of risk (especially default risk)

o Intermediated Finance: Financing arrangement involving two separate

contractual agreements the saver provides funds to an intermediary
which then provides funding to the end user of the funds.

-Asset transformation
-Maturity transformation
-Credit risk diversification and transformation (access to
wholesale market)
(Savers credit risk limited to intermediary, which is chosen to
have expertise and information)
-Liquidity transformation
(convert financial assets to cash)
-Economies of scale
(Financial and operational benefits of organisational size and
business volume)