The Financial System

Introduction

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

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

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

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

Introduction (cont.)

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

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

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

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

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

Financial Instruments (cont.)

Debt– Contractual claim to

Periodic interest payments Repayment of principal

– Ranks ahead of equity– Can be secured or unsecured

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

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

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

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