Financial Markets

Topic 1: Introduction to Financial Markets

 Outline
1. Functions of the financial system

2. Components of the financial system

3. Direct & Indirect finance

4. Financial & Economic systems

5. Government intervention into financial systems

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 1. Functions of the financial system
Facilitate: Surplus
$ Funds Deficit
economic
economic
units
units

Creating financial
assets
And
Facilitate the trade of existing financial assets in
secondary financial markets.

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The financial markets and flow of funds
Figure 1.1. Financial Markets and flow of funds relationship

Suppliers of funds Users of funds

 Surplus (saving) units  Deficit units

are are
Lenders: Borrowers:
 Householders  Householders
 Companies  Companies
 Governments  Governments
 Rest of world  Rest of world

Who Who
supply receive
funds funds

and Financial Markets and

Receive financial Issue financial

instruments instruments
2. Components of the financial system
2.1. Financial Institutions

Core
Business

Providing
Borrowing
Financial
& Lending
Services

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 Main types of financial institutions
Deposit Taking Financial Non-Deposit Taking
Institution Financial Institution

Attract the savings of Managed funds & provide

depositors financial services.

E.g. commercial banks, building E.g. Investment banks, general

societies and credit cooperatives insurance companies and
superannuation funds

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 Main types of financial institutions

1. Commercial banks

2. Building societies and credit cooperatives

3. Investment banks and Merchant Banks

4. Superannuation funds / Managed funds

5. Life insurance and general insurance companies

6. Finance companies and general financiers

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Institutions features
Total Assets (Percentage Share) of Financial Institutions
Financial institution 2010 % of assets 2016 % of assets
Reserve Bank 84.5 1.9 133 1.95
Commercial banks 2532 56.4 3983 58.49
Building societies 23.4 0.5 11.9 0.17
Credit unions 48.4 1 39.8 0.58
Money market corporations 62 1.4 65.3 0.96
Finance companies and general
99.6 2.2 129.7 1.90
financiers
Life insurance offices 182 4 241.9 3.55
Superannuation funds 878 19.6 1570.9 23.07
Cash management trusts 35.8 0.8 33.8 0.50
Common funds 6.8 0.2 8.4 0.12
Friendly societies 3.5 0.1 5.3 0.08
Public unit trusts 262 5.8 283.4 4.16
General insurance offices 121 2.7 164.1 2.41
Securitisation vehicles 154 3.4 138.7 2.04
Total 4493 6809.2
2.1.1. Commercial banks
• The largest group of financial institutions within a financial
system.

• Core business: gathering savings (deposits) in order to

provide loans for investment.

• Also provide off-balance-sheet transactions such a

underwriting, issue of derivatives

• Execute Fx transactions.
e.g. Commonwelth Bank

Westpac

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2.1.2. 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 who are usually in the same employment,
industry or community.
e.g. Abacus Australian Mutuals Ltd.

CUA Health Mobile Claiming

Police Credit Banking

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2.1.3. 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

• Execute FX transactions
e.g. Merrill Lynch

Morgan Stanley

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2.1.4. Managed funds
Types Categories
(By Risk Profile)
Cash Management
Trust Capital
Guaranteed
Public Unit Trust
Capital Stable
Superannuation
Balanced
Statutory Fund Growth
Common Fund Managed Or
Capital Growth
Friendly Society

e.g. BlackRock Inc.

State Street Global Advisors (SSGA)
AustralianSuper
2.1.5. Life and general insurance
companies

Client Insurer Insurer Pays

Contract
Makes Invests Insurance
Between
Periodic Clients’ Claims
Client And
Payments To Funds Into (Death, Fire,
Insurer
Insurer Securities Theft, Etc.)

e.g. Westpac
Allianz SE
American International Group Inc.

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2.1.6. 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 directly

into money markets and capital markets
e.g. Esanda Finance Corporation Limited

General Electric

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 2.2. Financial assets

Entitlement to future cash flows

Deficit Surplus
Economic Economic
Unit Loans, shares, Unit
bonds,
deposits certificate

Financial liability
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2.2.a. Attributes of financial assets

• Financial Actual return may vary

Compensation from expected return
• % of investment Return
/ Yield Risk

Time
Liquidity Pattern
of Return
• When cash flows
Ability to sell will be received
asset e.g. Once per month/year

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 2.2.b.Types of financial assets
•Obligation of the borrower to repay principal and
interest
Debt
E.g. Bank deposits, life insurance savings, discount
securities, fixed interest securities

•Ownership or claim over the profits and assets of

Equity a business.
E.g. Ordinary shares
•Have features of both debt and equity.
Hybrid
E.g. Preference shares, convertible notes
•Value is derived from another financial asset, rate
or index.
Derivatives
E.g. Forward contracts, futures, options, swaps

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 2.3. Classification of financial markets
1. Primary and Secondary

2. Money (<1 year) and Capital (>1 year)

3. 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)

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 2.3.1. Primary and Secondary
a) Primary Market

Suppliers of
supply funds Users of Funds
Funds
(Deficit Units)
(Surplus Units)

issue new financial instruments

e.g. Company shares, treasury notes, mortgages
use funds to
acquire goods,
services or assets

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 b) Secondary Market

Surplus Entity 1
Holders Of
Previously Issued
sell marketable
Financial Surplus Entity 2
securities to
Instruments

Surplus Entity n

and receive market value

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 Primary vs Secondary markets
Secondary market transaction:

• No direct impact on the original issuer of security

• Transfer of ownership from one saver to another saver

• Provides liquidity which facilitates restructuring of

portfolios of security owners

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 2.3.2. Money vs Capital markets
 Money markets

Funds lent for less

Short-term debt than 12 months

 Capital markets

Long-
Funds lent for more than 12 months
term debt

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2.3.3. By type of financial assets traded
• funds are lent for • funds are lent for • equity financial
periods of less than periods of 12 assets are created
12 months months or more and traded
• short-term debt • long-term debt • e.g. shares
financial assets are financial assets are
created and traded created and traded

Money Debt-Capital Equity

market market market

• foreign currencies • derivative financial

are traded assets are created
• Part of Money and traded
market • e.g. futures, options
etc.

Foreign Derivatives
Exchange market

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How can you raise funds?

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3. Direct and indirect finance
Two alternative methods of finance:
1. Direct finance

Suppliers of funds $ fund Users of funds

(surplus units) (deficit units)
Commission/fees

Broker and dealers

Financial instruments
(shares, bonds, etc)
 Direct and indirect finance (cont)
2. Indirect finance

Suppliers of $ funds $ funds Users of funds

funds (surplus Intermediaries
(deficit units)
units)
Net Interest
Margin
(NIM)
Financial instruments Financial instruments

E.g. Borrow Lend

Bank 5% p.a 8% p.a

NIM 3% p.a

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 Advantages of financial intermediation

Asset Value Transformation

Maturity Transformation

Credit Risk Reduction And Diversification

Liquidity Provision

Increased Quantity Of National Savings

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 Disadvantages of financial intermediation

Increased Cost Of Funds For Borrowers

Reduced Return From Lending For Savers

Less Likely For Secondary Financial Assets

To Be Securitised

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4. The Financial and Economic systems
• Resource markets Economic resources (land, labour, capital, enterprise)
• Output markets
Payments for resources
(goods & services)

• Financial markets Households Firms

Payments for goods
and services

Goods and services

Financial
Saving Investment
Sector
 4.1 Economic objectives

1. Economic growth
2. Full employment
3. Price stability
4. External balance
5. Efficient allocation of resources
6. Equitable distribution of income and wealth

The role of the financial system is to facilitate the

performance of the overall economic system.

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 5. Government policy
In terms of government regulation, the last 50 years can
be divided into the following distinct periods:

o Regulation (pre-1980s)

o Deregulation (1980s)

o Post-deregulation (1990s onward)

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 Reasons for government intervention

Macroeconomic objectives:
Growth, full employment, price stability, external balance

Efficient, fair and competitive financial system

Promotion of financial safety

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Methods of government intervention
• Fiscal policy (Government budget and taxes):
• 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 (ACCC)

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Summary
 Financial system Components
1. Surplus & Deficit economic units
2. Financial institutions
3. Financial assets
4. Financial markets

 Nature and classification of financial markets

1. Primary vs Secondary
2. Money vs Capital
3. By asset

 Direct and indirect finance

1. Advantages
2. Disadvantages

 Financial markets and the real economy

 The government and financial markets