Topic 1 Intro to FM_vBB

Introduction to Financial Markets

Topic 1

RMIT University Slide 2Slide 2

Overview of the Course•Basic finance course for 1st year student

•Compulsory for Finance students, elective for other streams, Macro 1 desirable

•5 in-class quizzes (20%)

•Group Assignment: FX trading report (30%)

•Final Exam 50%: Closed Book = no formula sheet

• JPV: Lecture + 3 Tutorials

•Plagiarism punished severely by the University

Overview: Course GuideWeek Lecture Topic Assessment Deadline Activity

1Course overview and Introduction to

Financial Markets Tutorial 1

2 Interest rates Tutorial 2: Interest rates

3 Money Markets Quiz 1 : Interest rates No Tutorial

1h30 Money Markets Practice Dealing Session.

4 Foreign Exchange Part A No Tutorial

1h30 Money Markets Dealing Session.

5 Foreign Exchange Part B + FX Report Quiz 2: Money MarketsNo Tutorial

1h30 FX Practice Dealing Session.

6 Bonds & Debt Markets No Tutorial

1h30 FX Dealing Session.

7Week 7: Personal Learning

(No Lecture & Tutorial)

8Equity Markets +

FX Report Preparation SessionQuiz 3: FX Tutorial 6 questions: Bonds & Debt

9 Derivatives Markets Quiz 4: BondsTutorial 8: Equity

10The changing financial system and Role of

Financial Institutions

FX market report due.

Quiz 5 : Equity

Tutorial 9: Derivatives

11 Recap Tutorial

12 Revision Past Exam Questions

Overview of the Course•Group Assignment (20%): Analyze and trade 2 currency pairs, USD/JPY and VND/USD

•Final Exam 60%: Closed Book = no formula sheet a lot of details to memorize

•Sample Exam Questions: See Blackboard Week 12• (a) Define and explain the structure of interest rates.

• (b) Differentiate between the expectations plus liquidity premium theory and the market segmentation theory.

• (c) Distinguish between debt and equity securities (discuss risk, return, liquidity, time pattern...)

•Student’s challenge is writing in English

Topic 1 - Contents

1. Functions of the financial system

2. Components of the financial system2.1 Economic surplus/deficit units2.2 Financial institutions2.3 Financial assets2.4 Financial markets

3. Direct & Indirect finance

4. Financial & Economic systems

5. Gov’t intervention into financial systems

1. Functions of the financial system

•To facilitate the transfer of funds from surplus economic units to deficit economic units, in primary markets, by the creation of new financial assets

•To facilitate the trade of existing financial assets in secondary financial markets.

2. Components of the financial system

•Surplus economic units (Savers/ Lenders/ Investors)

•Deficit economic units (Borrowers)

•Financial institutions

•Financial assets

•Financial markets

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2.1 Surplus economic units• Individuals, households, companies with more funds than required for immediate expenditure

•Savers

•Potential lenders

• Individuals, households, companies who require additional funds to meet expenditure plans

•Potential borrowers

2.1 Deficit economic units

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The financial markets and flow of funds

2.2 Financial Institutions

Organisations whose core business involves:•Borrowing and lending (financial intermediation)

•Provision of financial services to other organisations or individuals

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2.2 Main types of financial institutions

•Deposit taking financial institutions: attract the savings of depositors through on-demand deposit and term deposit accounts.– e.g. commercial banks, building societies and credit cooperatives (shareholders are usually the members)

•Non Deposit taking financial institutions: may managed funds under contractual arrangements and provide a wide range of financial services. –e.g. Investment banks, general insurance companies and superannuation funds (pension/retirement).

2.3 Financial assets

•Represent a claim or a right that a surplus economic unit holds over a deficit economic unit. They represent an entitlement to future cash flows.

•Represent a financial liability of a deficit economic unit (ie. the party issuing the financial assets).

•A financial instrument is a financial asset whose value is represented in paper (or electronic form) eg. bank loans, shares, bonds, certificates of deposits.

2.3 Attributes of financial assets

•All financial assets have four different attributes which provide the basis for comparison between different types of financial assets.Return or yieldRisk LiquidityTime pattern of return or cash flow

•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 (or variation in expected return)

•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

Types of financial assets

•Assets that are created and exchanged can be divided into the following broad types:

DebtEquityHybridDerivatives

Debt financial assets

•Represent an obligation on the part of the borrower to repay principal and interest. Eg.Bank deposits and loansContractual savings eg. Life insurance savingsDiscount securitiesFixed interest securities

Equity financial assets = shares, stock

•Represent an ownership claim over the profits and assets of a business. Eg.–Ordinary shares in a company

•Financial assets which have features of both debt and equity. Eg.–Preference shares–Convertible notes

Hybrid financial assets

Derivatives

•Financial assets whose value is derived from another financial asset, rate or index. Eg.Forward contractsFuturesOptionsSwaps

2.4 Classification of financial markets

•Primary and Secondary

•Money (<1 year) and Capital (>1 year)

•By type of financial assets traded:Money Market (topic 3) Foreign Exchange (topic 4)Debt-Capital Market (topic 5)Equity Market (topic 6)Derivatives Market (topic 7)

Primary markets: Markets in which financial assets are first created, e.g. Facebook IPO

Markets in which funds flow from surplus economic units to deficit economic units

Markets in which existing financial assets are traded

Deficit economic units do not directly participate in secondary market transactions

Secondary markets

Primary Vs. Secondary

Primary vs. Secondary markets

Examples of Primary market transaction:–The issue of a new financial instrument to raise funds to purchase goods, services or assets byBusinesses

Company shares (IPO) or debenturesGovernments

Treasury notes or bondsIndividuals

Mortgages

Primary vs. Secondary markets

•Secondary market transaction–The buying and selling of existing financial instrumentsNo direct impact on the original issuer of securityTransfer of ownership from one saver to another saver

Provides liquidity which facilitates restructuring of portfolios of security owners

Financial securities

•Financial assets which can be traded in secondary markets - eg. shares and bonds.

•Examples of financial assets which are not financial securities are bank deposits and loans.

•But they can be securitized, i.e. transformed into financial securities that trade like any other: Housing loans in US securitized into CDOs

Money markets•Markets where funds are lent for periods of less than 12 months

•A market in which short-term debt financial assets are created and traded

Capital marketsMarkets where funds are lent for periods of 12 months or more

A market in which long-term debt financial assets are created and traded

By type of financial assets traded

The Foreign Exchange Market

•A market in which foreign currencies are traded

The Equity Market•A market in which equity financial assets are created and traded (eg. shares)

The Derivatives Market

•A market in which derivative financial assets are created and traded (eg. futures, options etc.)

Overviewfinancial system

Components

Nature and classification of

financial markets

Direct and indirect finance

Types of Financial Institution

Relationship between financial markets and the

real economy

The government and financial

markets

How can you raise funds?

3. Direct and indirect finance

Two alternative methods of finance

• Direct finance

• Indirect finance

Direct finance

• Funds are transferred directly from surplus economic units to deficit economic units

• Primary financial assets are issued directly from deficit units to surplus units

• Financial institutions play a role in direct finance by providing financial services, such as financial advice, underwriting, etc., in return for fees and commissions

Indirect finance

• Also known as intermediated finance

• Financial institutions act as intermediaries, borrowing from surplus units and lending to deficit units

• Primary financial assets are issued by deficit units to intermediaries, and secondary financial assets are issued by intermediaries to surplus units

• Financial institutions earn income by way of net interest margin

Advantages of financial intermediation

•Asset value transformation

•Maturity transformation

•Credit risk reduction and diversification

•Liquidity provision

These are very useful for households

• Increased quantity of national savings

Disadvantages of financial intermediation

• Increased cost of funds for borrowers

•Reduced return from lending for savers

Why? Institutions take a net interest margin

•Less likely for secondary financial assets (e.g. bank deposits) to be securitised (i.e. Transformed into financial securities) so that they can be traded in a secondary market. Primary financial assets (e.g. Housing loans can be securitized into CDOs)

Components

financial markets

real economy

markets

Main types of financial institutions

Deposit taking financial institutions: attract the savings of depositors through on-demand deposit and term deposit accounts. e.g. commercial banks, building societies (Housing loans = mortgage) and credit cooperatives (shareholders are the members or customers).

Non Deposit taking financial institutions: may managed funds under contractual arrangements and provide a wide range of financial services. e.g. Investment banks, general insurance companies and superannuation funds (pension / retirement).

Main types of financial institutions

•Commercial banks

•Building societies and credit cooperatives

• Investment banks and Merchant Banks

•Superannuation funds / Managed funds

•Life insurance and general insurance companies

•Finance companies and general financiers

Institutions features

Total Assets (Percentage Share) of Financial Institutions

Institutions features

•Banks continue to dominate the financial system

•Significant changes have occurred in the relative importance of:–Building societies–Money market corporations–Finance companies–Superannuation funds–Public unit trusts

Commercial banks

•Commercial banks are the largest group of financial institutions within a financial system.

•The core business of banks is often described as the gathering of savings (deposits) in order to provide loans for investment.

•They also provide a wide range of off-balance-sheet transactions such a underwriting, issue of derivatives or execute Fx transactions.

Building societies and credit unions

•The majority of building society funds are deposits from customers. Residential housing is the main form of lending. Credit unions funds are sourced primarily from deposits of members.

•A defining characteristic of a credit union is the common bond of association of its members, usually based on employment, industry or community.

Investment banks and merchant banks

•Mainly provide advisory services to support corporate and government clients, e.g.:–advice on mergers and acquisitions, portfolio restructuring, finance and risk management

•May also provide some loans to clients but are more likely to advise on raising funds directly in capital markets.

•They also execute FX transactions

Managed funds•The main types of managed funds are

– cash management trusts, public unit trusts, superannuation (pension) funds, statutory funds of life offices, common funds and friendly societies.

–The large pool of funds is then used to purchase both primary and secondary market securities

•Managed funds may be categorised by their investment risk profile, being capital guaranteed funds, capital stable funds, balanced growth funds, managed or capital growth funds.

Life and general insurance companies

•The liabilities of these institutions are contractual obligations. They provide a contract that require, in return for periodic payments to the institution, the institution to make payments to the contract holders if a specified event occurs, e.g.:– death of the policyholder, fire and theft

•The large pool of funds is then used to purchase both primary and secondary market securities

•Payouts are made for insurance claims and to retirees

Finance companies

•Finance companies make loans, provide lease finance and factoring options to customers in the household and business sectors

•Funds are raised by issuing financial securities, such as commercial papers, medium-term notes and bonds, directly into money markets and capital markets

Components

financial markets

real economy

markets

4. The Financial and Economic systems

•The financial system is a component of the economic system.

•The economic system comprises:Markets for goods & servicesMarkets for resources (land, labour, capital and entrepreneurship)

Financial markets

Economic markets

•Resource markets

•Output markets

(goods & services)

•Financial markets

Circular Flow

Economic objectives

• Economic growth

• Full employment

• Price stability

• External balance

• Efficient allocation of resources

• Equitable distribution of income and wealth

The role of the financial system is to facilitate the performance of the overall economic system.

5. Government policy

• In terms of government regulation, the last 50 years can be divided into the following distinct periods:–Regulation (pre-1980s)–Deregulation (1980s)–Post-deregulation (1990s onward)

Reasons for government intervention

•Macroeconomic objectives:–growth, full employment, price stability, external balance

•Efficient, fair and competitive financial system

•Promotion of financial safety

Methods of government intervention

•Fiscal policy (Government budget and taxes): What is happening to US Government: CLOSED!

•Monetary policy (RBA – central bank of Australia)

•External policy (tariff and cap on fund flows)

•Wages policy (superannuation)

•Direct legislation (corporation law)

•Competition policy (avoid oligopolies and /monopolies)

•Consumer protection (ombudsman, ACCC)

Summary• Surplus & Deficit economic units• Financial institutions• Financial assets• Financial markets

financial system Components

• By asset• Primary vs Secondary

Nature and classification of financial markets

• Advantages• Disadvantages

Direct and indirect

Financial markets and the real economy

The government and financial markets

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