MAF702

FINANCIAL MARKETS

SCHOOL OF ACCOUNTING, ECONOMICS

AND FINANCE
DEAKIN UNIVERSITY
MICHAEL D’ROSARIO
 Email: michaeld@deakin.edu.au
 Direct line: 9244 6231

 Background: Corporate recovery, financial consultancy

and international development.

 Teaching responsibilities: Ethics, Business Finance,

Financial markets theory

 Research interests: development economics, race and

identity studies and Diaspora communities, game
theoretic frameworks in political philosophy, M&A
Theory/Governance
REQUIRED TEXT

VINEY, C., 2003, FINANCIAL

INSTITUTIONS, INSTRUMENTS
AND MARKETS, FIFTH
EDITION, MCGRAW HILL,
SYDNEY
TOPIC 1

OVERVIEW OF A
MODERN FINANCIAL SYSTEM
SEMINAR OUTCOMES
 To have gained a broad understanding of
modern financial systems
 To have a rudimentary understanding of the
various financial assets
 To appreciate the level of integration that
exists between financial systems
FINANCIAL SYSTEM
A financial system comprises three
principal elements which facilitate the
flow of funds:
 financial institutions

 financial markets

 financial instruments
FINANCIAL SYSTEM
 A financial system facilitates financial
transactions through the creation, sale and
transfer of financial assets
FINANCIAL ASSETS
 Currency or a financial instrument which
represents a claim to future cash flows.
Examples include:
 shares issued by a company

 government treasury bonds

 bank term deposits

ATTRIBUTES OF A FINANCIAL ASSET
 return or yield
 risk

 liquidity

 time pattern of cash-flows

FUNCTIONS OF A FINANCIAL SYSTEM
 facilitates the efficient conduct of
transactions for goods and services
 facilitates the flow of funds between lenders
and borrowers
 allows the management of portfolios of
assets and liabilities
 encourages economic development
FINANCIAL SYSTEM
 the financial system allows both lenders and
borrowers to trade-off between the different
attributes to achieve their desired portfolio
structure needs
 Financial System
Regulators and Supervisors

Institutions Instruments Markets

Banks Debt Money

Building societies Equity Capital
Credit unions Hybrids Equity
Insurance offices Derivatives Foreign
Superannuation funds exchange
Merchant banks Derivatives
Investment banks
Finance companies
Unit trusts
FINANCIAL INSTRUMENTS
 1. Equity
 shares issued by a company which represent
an ownership position for the shareholder
 shareholder has an entitlement to receive a
share of any distribution of profits of the
company - dividends
FINANCIAL INSTRUMENTS
 2. Debt
 debt instruments are contractual claims to
periodic cash flows in the form of interest
payments and principal repayments
 may be issued with a fixed or floating
interest rate, or at a discount; secured or
unsecured; short to longer-term
FINANCIAL INSTRUMENTS
 3. Hybrids
 combine the elements or characteristics of
both debt and equity
 example - an instrument issued which makes
periodic interest payments, but offers a
future ownership entitlement (example:
convertible notes)
FINANCIAL INSTRUMENTS
 4. Derivatives
 a product whose pricing is derived from an
existing product (e.g. gold)
 not instruments issued for raising funds

 a tool for managing risk (e.g. the risk that the

price of gold may change in the future)
 types: futures, options, swaps, forwards
FINANCIAL MARKETS
 1. Matching principle
 short-term assets should be funded with
short-term liabilities
 medium-to-longer-term assets should be
funded with equity and/or medium-to-longer-
term liabilities
 seeking to match the cash-flows on both
sides of the balance sheet
FINANCIAL MARKETS
 2. Primary and secondary markets
 primary markets involve the issue of new
financial instruments (e.g. IPO)
 secondary markets trade existing
instruments (securities). No new funds are
raised by the original issuer
 deep and liquid secondary markets
strengthen the primary markets
FINANCIAL MARKETS
 3. Direct and intermediated markets
 government, business and individuals access
finance to meet funding needs
 access to funding may be categorised as:
 directfinance, or
 intermediated finance
FINANCIAL MARKETS
 3.1 Direct markets
 supplier of funds contracts directly with the
user of funds
 creates an entitlement to dividends and
capital gains (losses) on shares; or interest
receipts and principal repayment on debt
 direct finance issues include shares, discount
securities, bonds and government securities
DIRECT FINANCIAL FLOWS

Provider User
of Funds of Funds

Broker
FINANCIAL MARKETS
 3.1 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
 legal, financial and expert advice
 credit ratings
FINANCIAL MARKETS
 3.2 Intermediated markets
 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
INTERMEDIATED FINANCIAL FLOWS

Provider
of Funds

Intermediary

User
of Funds
ADVANTAGES OF INTERMEDIATION
 Asset transformation:
 range of products

 pooling of funds

 Maturity transformation:
 liquidity

 maturity

 risk management
ADVANTAGES OF INTERMEDIATION
 Credit risk diversification:
 assessing credit risk

 diversified portfolio of loans

 Provision of liquidity:
 cash flows

 risk return trade-off

ADVANTAGES OF INTERMEDIATION
 Distribution of costs:
 infrastructure and technology based
distribution systems (branches; ATMs)
 expertise (financial, legal, economic)

 standardised documentation
FINANCIAL MARKETS
 4. Wholesale markets and retail markets
 wholesale markets - transactions by
institutional investors and borrowers.
Typically in the millions of dollars
 retail markets - generally transactions of
household and small business sectors, using
financial institutions
FINANCIAL MARKETS
 5. Money markets
 wholesale markets in funds with less than 1
year to maturity
 deep secondary markets

 (e.g. bills of exchange market)

 enable participants to manage liquidity
FINANCIAL MARKETS
 5. Money markets
 Participants include commercial banks,
investment banks, merchant banks, finance
companies, insurance offices, funds
managers, large corporations, central banks
FINANCIAL MARKETS
 5. Money markets
 sub-markets include:

 central bank – managing financial system

liquidity and monetary policy
 inter-bank market

 bills market

 commercial paper market

 certificate of deposit market

FINANCIAL MARKETS
 6. Capital Markets
 capital market instruments provide medium-
to-longer-term funding
 encompass both the international and
domestic markets
FINANCIAL MARKETS
 6. Capital Markets
 sub-markets include:

 equity market

 corporate debt market

 government debt market

 supported by:
 foreign exchange market

 derivatives market
GLOBALISATION OF THE FINANCIAL
MARKETS
 the integration of financial institutions,
instruments and markets into an
international financial system
 changing needs of market participants

 use of technology and communication

systems
 removal of most regulations restricting the
flow of capital between countries
 active foreign exchange markets
FINANCIAL INSTITUTIONS
 in a modern financial system, different types
of institutions provide a wide range of
balance sheet and off-balance sheet products
and services
 institutions are classified by their sources
(liabilities) and uses (assets) of funds
 products and services provided vary between
institutions depending on regulation, markets
and competition
 the following five classifications are used
FINANCIAL INSTITUTIONS
 1. Depository financial institutions
 attract savings from depositors and investors
to provide loan facilities to borrowers
 includes - banks; building societies; credit
unions
FINANCIAL INSTITUTIONS
 2. Contractual savings institutions
 liabilities (source of funds) are contracts that
generate periodic cash flows, such as
insurance contract instalments or
superannuation savings
 accumulated funds are used to purchase
both real and financial assets
 includes - insurance offices and
superannuation funds
FINANCIAL INSTITUTIONS
 3. Finance companies
 liabilities (funds) generated from the issue of
financial securities direct into the money
markets and capital markets
 assets (use of funds) are mainly loans to
retail customers (individuals and small
business)
FINANCIAL INSTITUTIONS
 4. Investment banks and merchant banks
 (money market corporations)

 generally raise short-term funds in the

wholesale money markets
 provide short-to-medium-term loans to
corporate clients
 specialise in off-balance sheet financial
services to corporate clients and government
FINANCIAL INSTITUTIONS
 5. Unit trusts and managed funds
 investors purchase units in a trust

 trustee (using funds managers) invests

accumulated funds in a specified range of
investment types
 include - cash management trusts; equity
trusts; property trusts; mortgage trusts