PowerPoint Slides to accompany Financial Institutions, Instruments and Markets Fourth Edition by...

PowerPoint Slides to accompany

Financial Institutions, Instruments and Markets

Fourth Edition by Christopher Viney

Designed and Written by Anthony Stanger

School of CommerceThe Flinders University of South Australia

Chapter 1

The Financial System

Learning Objectives

• Explain the functions of a financial system• Describe the main classes of financial instruments issued in a

financial system• Distinguish between various types of financial markets according

to function• Discuss the flow of funds between savers and borrowers,

including direct and intermediated finance

Learning Objectives (cont.)

• Appreciate the influence of globalisation on financial markets• Categorise the main types of financial institutions• Understand the impact of a financial crisis on a financial system

and a real economy

Chapter Organisation

1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary

1.1Introduction

• Money• Medium of exchange• Allows specialisation in production• Solves the divisibility problem, i.e. where medium of exchange does not

represent equal value for the parties to the transaction• Facilitates saving• Store of wealth

1.1 Introduction (cont.)

• Role of markets• Facilitate exchange by

• Bringing opposite parties together• Establishing rates of exchange, i.e. prices

• Surplus units• Savers of funds available for lending

• Deficit units• Borrowers of funds for capital investment and consumption

1.1 Introduction (cont.)

• Financial instrument• Issued by a party raising funds, acknowledging a financial commitment and

entitling holder to specified future cash flows

• Flow of funds• Movement of funds through the financial system between savers and

borrowers giving rise to financial instruments

1.1 Introduction (cont.)

• Financial system• Financial institutions, instruments and markets facilitating transactions for

goods and services and financial transactions• Overcomes difficulty of

• Double coincidence of wants• Transaction between two parties meets their mutual needs

1.1 Introduction (cont.)

Chapter Organisation

1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary

1.2 Functions of the Financial System

• Attributes of financial assets• Return or yield

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

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

1.2 Functions of the Financial System (cont.)

• Liquidity• Ability to sell an asset within reasonable time at current market prices and

for reasonable transaction costs

• Time-pattern of the cash flows• When the expected cash flows from a financial asset are to be received by

the investor or lender

1.2 Functions of the Financial System (cont.)

• The financial system facilitates portfolio restructuring• The combination of assets and liabilities comprising the desired attributes of

return, risk, liquidity and timing of cash flows

1.2 Functions of the Financial System (cont.)

• An efficient financial system• Encourages savings• Savings flow to the most efficient users• Implements the monetary policy of governments by influencing interest

rates• The combination of assets and liabilities comprising the desired attributes of

return, risk, liquidity and timing of cash flows

Chapter Organisation

1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary

1.3 Financial Instruments

• Equity• Ownership interest in an asset• Residual claim on earnings and assets

• Dividend• Liquidation

• Types• Ordinary share• Hybrid (or quasi-equity) security

• Preference shares• Convertible notes

1.3 Financial Instruments (cont.)

• Debt• Contractual claim to

• Periodic interest payments• Repayment of principal

• Ranks ahead of equity• Can be secured or unsecured

1.3 Financial Instruments (cont.)

• Derivatives• A synthetic security providing specific future rights that derives its price from

a• Physical market commodity

• Gold and oil• Financial security

• Interest rate-sensitive debt instruments, currencies and equities

• Used mainly to manage price risk exposure, and to speculate

1.3 Financial Instruments (cont.)

• Four basic derivative contracts• Futures (Chapter 18)• Forward (Chapter 18)• Option contract (Chapter 19)• Swap (Chapter 20)

Chapter Organisation

1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary

1.4 Financial Markets

• Matching principle• Primary and secondary market transactions• Direct and intermediated financial flow markets• Wholesale and retail markets• Money markets• Capital markets

Matching principle

• Short-term assets should be funded with short-term liabilities• Inventory funded by overdraft

• Longer-term assets should be funded with equity or longer-term liabilities• Equipment funded by debentures

Primary and secondary market transactions

• Primary market transaction• The issue of a new financial instrument to raise funds to purchase goods,

services or assets by• Businesses

• Company shares or debentures• Governments

• Treasury notes or bonds• Individuals

• Mortgage

Primary and secondary market transactions (cont.)

• Secondary market transaction• The buying and selling of existing financial instruments

• No direct impact on original issuer of security• Transfer of ownership from one saver to another saver • Provides liquidity which facilitates restructuring of portfolios of security owners

Direct and intermediated financial flow markets

• Direct flow markets• Users of funds obtain finance directly from savers

• Advantages• Avoids costs of intermediation• Increases range of securities and markets

• Disadvantages• Matching of preferences• Liquidity and marketability of a security• Search and transaction costs• Assessment of risk, especially default risk

Direct and intermediated financial flow markets (cont.)

Direct and intermediated financial flow markets (cont.)

• Intermediated flow markets• A financing arrangement involving two separate contractual agreements

whereby saver provides funds to intermediary, and the intermediary provides funding to the ultimate user of funds

• Advantages• Asset transformation• Maturity transformation

Direct and intermediated financial flow markets (cont.)

• Advantages (cont.)• Credit risk diversification and transformation• Liquidity transformation• Economies of scale

• Sectorial flow of funds• The flow of funds between business, financial institutions, government and

household sectors and the rest of the world• Influenced by fiscal and monetary policy

Direct and intermediated financial flow markets (cont.)

Wholesale and retail markets

• Wholesale markets• Direct financial flow transactions between institutional investors and

borrowers• Involves large transactions

• Retail markets• Transactions conducted primarily with financial intermediaries by the

household and small- medium business sectors• Involves smaller transactions

Money markets

• Wholesale markets in which short-term securities are issued and traded• Securities highly liquid

• 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 markets (cont.)

• Money market securities• Cash deposits (11 a.m. and 24-hour call)• Commercial bills• Treasury notes• Government bonds• Promissory notes• Intercompany loans• Interbank loans

Money markets (cont.)

• Money market participants• Reserve Bank

• Financial system liquidity• Implementation of monetary policy

• Banks• Finance companies• Funds managers• Building societies• Credit unions• Companies

Money markets (cont.)

• Money market sub-markets• Intercompany market• Interbank market• Bills market• Commercial paper market• Negotiable certificates of deposit (CDs) market

Capital markets

• Markets in which longer-term securities are issued and traded• Equity markets• Corporate debt markets• Government debt markets• Foreign exchange markets• Derivatives markets

• Term to maturity of more than one year

Chapter Organisation

1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary

1.5 Impact of Globalisation

• Globalisation of financial markets• Refers to the interdependence of national financial systems• Global standardisation of financial instruments• Facilitates the movement of funds between savers and borrowers in

different countries

Chapter Organisation

1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary

1.6 Financial Institutions

• Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial transactions

• Institutions may be categorised by differences in the sources and uses of funds

1.6 Financial Institutions (cont.)

• Categories of financial institutions• Depository financial institutions• Investment banks and merchant banks (money market corporations)• Contractual savings institutions• Finance companies• Unit trusts

Categories of financial institutions

Depository financial institutions• Attract savings from depositors and investors to provide loan

facilities to borrowers•Commercial banks •Building societies•Credit unions

Categories of financial institutions (cont.)

Investment banks and merchant banks(money market corporations)

• Mainly provide off-balance-sheet (OBS) transactions to corporations and government•Advice on mergers and acquisitions, portfolio

restructuring, finance and risk management• Provide some funding

Categories of financial institutions (cont.)

Contractual savings institutions• The liabilities of these institutions are contracts that specify, in

return for periodic payments to the institution, the institution will make payments to the contract holders if a specified event occurs• Funds are then used to purchase both primary and secondary

market securities• Life and general insurance companies• Superannuation funds

Categories of financial institutions (cont.)

Finance companies

• Funds are raised by issuing financial securities direct into money markets and capital markets

• Funds are used to make loans to ultimate borrowers

Categories of financial institutions (cont)

Unit trusts• Investors purchase units in the trust• Trust manager invests funds in a range of investments specified by

trust deed• Types of unit trusts

• Cash management trusts• Equity trusts• Property trusts• Mortgage trusts

1.6 Financial Institutions (cont.)• Assets of financial institutions

Chapter Organisation

1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary

1.7 Summary

• The financial system is composed of financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions

• Financial instruments may be equity, debt or hybrid

1.7 Summary (cont.)

• Financial markets may be classified according to• Primary and secondary transactions• Direct and intermediated flows• Wholesale and retail markets• Money markets and capital markets• Financial institutions