The Financial System

CHAPTER 1
The financial system

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1.1 discuss the primary role of the financial system in the economy, and how fund transfers take place
1.2 describe the primary, secondary and money markets, and explain why these markets are so important to
businesses
1.3 explain how financial institutions serve consumers and small businesses that are unable to participate in
the direct financial markets, and describe how companies use the financial system
1.4 discuss the internationalisation of financial markets and the role played by the BIS in ensuring the global
financial markets remain stable
1.5 explain what an efficient capital market is and why market efficiency is important to financial managers.
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Chapter preview
There are three kinds of decisions that financial managers make: capital budgeting decisions, which con-
cern the purchase of capital (non-current) assets; financing decisions, which concern how these assets
will be paid for; and working capital management decisions, which concern day-to-day financial matters
such as having enough cash for payment of bills and invoices. Making sound decisions in any of these
areas requires knowledge of financial markets and the services offered by institutions involved in these
markets.
In making capital budgeting decisions, financial managers should select projects whose cash flows
increase the value of the company. The financial models used to evaluate these projects require an under-
standing of and inputs from financial markets and interest rates. In making financing decisions, financial
managers naturally want to obtain capital at the lowest possible cost, which means that they need to know
how financial markets work and what financing alternatives are available. Finally, working capital man-
agement is concerned with making sure that a company has enough money to pay its bills when they are
due and how it invests its spare cash, if any, to earn a return (e.g. interest).
Clearly, then, financial managers need to have a good knowledge of financial markets and financial
institutions. This chapter provides a quick overview of the financial sector and the services it provides
to businesses. The financial system works properly when consumers receive the highest possible inter-
est rates for their deposits and when only loans with favourable rates of return and good credit stand-
ing are financed. The more efficient and competitive the financial system, the more likely this is to
happen.
We begin the chapter by looking at how the financial system facilitates the transfer of money from
those who have it to those who need it. Then we describe direct financing, through which large companies
finance themselves by issuing debt and equity, and the important role that investment banks play in the
process. Next we explain why smaller companies and consumers must finance themselves indirectly by
borrowing from financial institutions such as commercial banks. We then examine other types of services
that financial institutions provide to large and small businesses, and the internationalisation of financial
markets. Finally, we discuss the concept of efficient capital markets and explain why market efficiency is
important to financial managers.
2 Financial markets, institutions and money

1.1 The financial system
LEARNING OBJECTIVE 1.1 Discuss the primary role of the financial system in the economy, and how fund
transfers take place.
The financial system consists of financial markets and financial institutions. These markets and institutions
provide the structure to the financial system. Financial market is a general term that includes a number of
different types of markets (e.g. money market, capital market) for the creation and exchange of financial
assets, such as loans, bonds and shares. Financial institutions are companies such as commercial banks,
credit unions, insurance companies, superannuation funds and finance companies that provide financial
services to the economy. The distinguishing feature of financial institutions is that they invest their funds
in financial assets, such as business loans, shares and bonds, rather than real assets, such as property,
plant and equipment.
The critical role of the financial system in the economy is to gather money from people and businesses
with surplus funds and channel the gathered money to those who need it. Businesses need money for day-
to-day expenses or to invest in new productive assets to expand their operations. Consumers too, need
money, which they use to purchase things such as houses, cars and boats — or to pay university fees. Some
of the players in the financial system are household names, such as the Commonwealth Bank of Australia
(a commercial bank), Macquarie Bank Limited (a merchant bank), QBE Insurance Group Limited (an
insurance company), AMP Limited (a wealth management/advice business) and the Australian Securities
Exchange (ASX) (a capital market). Others are less well-known but important companies such as the
superannuation company AustralianSuper.
A well-developed financial system is critical for the operation of a complex economy such as that of
Australia. An economy cannot function efficiently without a competitive and sound financial system that
gathers money and channels it into the best investment opportunities. Let’s look at a simple example to
illustrate how the financial system channels money to businesses.
The financial system at work

Suppose you are a university student. Assume at the beginning of the university year, you receive $10 000
from your parents to help pay your expenses for the year, but you need only $5000 for the first semester.
You wisely decide to invest the remaining $5000 for a short time to earn some interest income. After
shopping at several banks near your campus, you decide that the best deal is a $5000 term deposit that
matures in 3 months and pays 5 per cent interest.
The bank pools your money with funds from other term deposits and uses this money to make business
and consumer loans. In this case, assume that the bank makes a loan to the pizza restaurant near campus:
$30 000 for 5 years at a 9 per cent interest rate. The bank decides to make the loan because of the pizza
restaurant’s sound credit rating and because it expects the pizza restaurant to generate enough cash flows
to repay the loan. The pizza restaurant owner wants the money to invest in additional assets to earn
greater returns (net cash inflows) and thereby increase the value of the business. During the same week,
the bank makes loans to other businesses and also rejects a number of loan requests because the potential
borrowers have poor credit ratings or the proposed projects have low rates of return.
From this example, we can draw some important inferences about financial systems.
r If the financial system is competitive, the interest rate the bank pays on term deposits will be at or near
the highest rate that you can earn on a term deposit of similar maturity and risk. At the same time,
the pizza restaurant and other businesses will have borrowed at or near the lowest possible interest
cost, given their risk profiles (i.e. given how risky their businesses are). Competition among banks for
deposits will drive term-deposit interest rates up and loan interest rates down.
r The bank gathers money from you and other consumers in small dollar amounts, aggregates it and then
makes loans in much larger dollar amounts. Saving by consumers in small dollar amounts is the origin
of much of the money that funds large business loans in the economy.
CHAPTER 1 The financial system 3

r An important function of the financial system is to direct money to the best investment opportunities
in the economy. If the financial system works properly, only business projects with high rates of return
and good credit standing are financed. Those with low rates of return or poor credit standing will be
rejected. Thus, financial systems contribute to higher production and efficiency in the overall economy.
r A key role of the financial system is allowing for financial risk to be managed and/or transferred to
other parties. This provides various mechanisms to financial system participants: systems to manage
the risks they are exposed to, including insurance products, securitisation (packaging like assets and
selling them on to a third party) and derivative products (discussed later in this chapter).
r Finally, note that the bank has earned a profit from the deal. The bank has borrowed money at 5 per cent
by selling term deposits to consumers and has lent money to the pizza restaurant and other businesses
at 9 per cent. Thus, the bank’s gross profit is 4 per cent (9 − 5), which is the difference between the
bank’s lending and borrowing (deposit) rates. Banks earn much of their profits from the spread between
the lending and borrowing rates.
How funds flow through the financial system

We have seen how banks, an example of an institution in the financial system, play a critical role in
the economy. The system moves money from lender-savers (whose income exceeds their spending)
to borrower-spenders (whose spending exceeds their income), as shown schematically in figure 1.1.
Lender-savers are also called surplus spending units (SSU) and borrower-spenders are also called deficit
spending units (DSU). The largest lender-savers in the economy are households, but some businesses
and many state and local governments at times have excess funds to lend to those who need money.
The largest borrower-spenders in the economy are generally businesses, followed by the Commonwealth
Government.
FIGURE 1.1 The flow of funds through the financial system
Direct financing
Financial markets
Wholesale markets for the creation

Funds and sale of financial securities, such as shares, Funds
bonds and money market instruments. Large
corporations use the financial markets to sell
securities directly to lenders.
Lender-savers Borrower-spenders
Funds
• Consumers • Consumers
• Businesses • Businesses
• Government • Government
Financial institutions
Institutions, such as commercial banks, that

invest in financial assets and provide financial
services. Financial institutions collect money from
Funds Funds
lender-savers in small amounts, aggregate the
funds, and make loans in larger amounts to
consumers, businesses and government.
Indirect financing

The arrows in figure 1.1 show that there are two basic mechanisms by which funds flow through the
financial system: (1) funds can flow directly through financial markets (the route at the top of the diagram),
wherein lender-savers invest directly in financial securities; and (2) funds can flow indirectly through
financial institutions (the route at the bottom of the diagram), wherein the financial institutions mediate
between lender-savers and borrower-spenders. In the following sections, we look more closely at the
direct flow of funds and at the financial markets. After that, we discuss financial institutions and the
indirect flow of funds.
Direct financing
In direct transactions, the lender-savers and the borrower-spenders deal ‘directly’ with one another:
borrower-spenders sell securities, such as shares and bonds, to lender-savers in exchange for money.
These securities represent claims on the borrowers’ future income or assets. A number of inter-
changeable terms are used to refer to securities, including financial instruments and financial
claims.
The financial markets where direct transactions take place deal with large sums, with a typical minimum
transaction size of $1 million. For most companies, these markets provide funds at the lowest possible
cost. The major buyers and sellers of securities in the direct financial markets are: commercial banks; other
financial institutions, such as insurance companies and finance companies; large business companies; the
Commonwealth Government; hedge funds; and some wealthy individuals. Even not-so-wealthy people
buy and sell shares in the share market. It is important to note that financial institutions are major buyers
of securities in the direct financial markets. For example, superannuation funds buy large quantities of
corporate bonds and shares for their investment portfolios. In figure 1.1 the arrow leading from financial
institutions to financial markets depicts this flow.
Although individuals participate in direct financial markets, they can also gain access to many of the
financial products produced in these markets through retail channels at investment banks or financial
institutions such as commercial banks (the lower route in figure 1.1). For example, individuals can buy
or sell shares and bonds in small dollar amounts at Macquarie Bank Limited or from the Commonwealth
Bank’s retail brokerage business, Commonwealth Securities Limited (CommSec). We discuss indirect
financing through financial institutions later in this chapter.
A direct financing transaction (without using the market)

Let’s look at a typical direct market transaction. When managers decide to engage in a direct market
transaction, they often have a specific capital project in mind that needs financing, such as building
a new shopping centre. Suppose that the Westfield Group needs $200 million to build a new centre
and decides to fund it by selling long-term bonds with a 15-year maturity. Say that Westfield con-
tacts a superannuation fund, which expresses an interest in buying Westfield’s bonds. The superannu-
ation fund will buy Westfield’s bonds only after determining that the bonds are priced fairly for their
level of risk and the interest rate they carry. Westfield will sell its bonds to the superannuation fund
only after studying the current bond market to be sure the price offered by the superannuation fund is
competitive.
If Westfield and the superannuation fund strike a deal, the flow of funds between them will be as shown
below:
$200 million
Superannuation fund Westfield group
$200 million debt

Assume that Westfield sells its bonds to the superannuation fund for $200 million and gets the use of
the money for 15 years. For Westfield, the bonds are a liability, and it pays the bondholders interest for use
of the money and pays back the $200 million principal on maturity (in 15 years). For the superannuation
fund, the bonds are an asset, which earns interest. The superannuation fund also owns a financial claim
for the $200 million principal.
Direct financing (using the market)

To raise finance, companies can issue their own securities (e.g. bonds and shares) in the financial market,
particularly in the capital market. For example, to raise $200 million Westfield could issue bonds or shares
in the capital market (i.e. through the ASX). To issue securities to the market, a company needs to follow
a rigorous process, including issuing a public document called a prospectus. Typically companies need
help from experts to organise, issue and sell securities in the market.
Investment banks and direct financing

An important player in delivering critical services to companies that sell securities in the direct finan-
cial markets is an investment bank. Investment banks specialise in helping companies sell new debt or
equity, although they also provide other services, such as the broker and dealer services discussed later.
When investment bankers help companies bring new debt or equity securities to market, they perform
two important tasks: origination and underwriting.
Origination
Origination is the process of preparing a security issue for sale. During the origination phase, the invest-
ment banker may help the client company determine the feasibility of the project being funded and the
amount of capital that needs to be raised. Once this is done, the investment banker helps secure a credit
rating if needed, determines the sale date, obtains legal clearances to sell the securities and gets the secu-
rities printed or created. If securities are to be sold in the public markets, the issuer must also lodge a
prospectus with the Australian Securities and Investments Commission (ASIC). Securities sold inprivate
are not required by ASIC to lodge a prospectus.
Underwriting
Underwriting is the process by which the investment banker, the underwriter, guarantees that the company
will raise the funds it expects from its new security issue. In the most common type of underwriting
arrangement, called stand-by underwriting, the investment banker guarantees to the company that the
total funds that the company plans to raise by issuing new securities will be raised. The guarantee of the
total amount of funding is important to the issuing company. It is likely that the company needs a specific
amount of money to pay for a particular project or to fund operations, and receiving anything less than
this amount will pose a serious problem. As you would expect, financial managers almost always prefer
to have their new security issues underwritten on a stand-by basis. Stand-by underwriting is known as
‘firm commitment underwriting’ in the rest of the world.
Under a stand-by underwriting arrangement, the investment banker will purchase any securities that
are not sold from the issue at the offer price. Later, it will resell these shares in the market at the prevail-
ing market price. The underwriter bears the risk that the resale price might be lower than the price the
underwriter paid to the issuing company — this is called price risk. The resale price can be lower if
the investment banker overestimates the value of the shares when determining the initial offer price of
the issue. If this happens, the investment bank suffers a financial loss.
The investment banker’s compensation for underwriting is called the underwriting spread. This
is the difference between the price the investment banker pays for the security and the initial sale
price.

DEMONSTRATION PROBLEM 1.1
Underwriter’s compensation
Problem:
Assume Harvey Norman needs to raise
$500 million for an expansion and decides to issue
long-term bonds. The financial manager hires an
investment bank to help design the bond issue
and to underwrite it. The issue consists of 500 000
bonds with a face value of $1000 each and the
investment banker agrees to underwrite the entire
issue on a stand-by basis, effectively guaranteeing
Harvey Norman a price of $1000 per bond. The
issue raises a total of $520 million at an initial sale
price of $1040 per bond. What is the underwriter’s
total compensation and per-bond compensation?
Approach:
The underwriter’s total compensation is the total underwriting spread, which is the difference between the
total amount raised by selling the bonds in the market and the total amount guaranteed to the company
by the underwriter. The underwriting spread per bond is then calculated by dividing the total underwriting
spread by the number of bonds that are issued.
Solution:
Step 1: Calculate the total underwriting spread:
$520 000 000 − $500 000 000 = $20 000 000
Step 2: Calculate the underwriting spread per bond:
$20 000 000∕500 000 = $40
Note that, because of the guarantee, the issuer gets a cheque from the underwriter for $500 million
regardless of the price at which the bonds are sold.
BEFORE YOU GO ON
1. What essential role does the financial system play in the economy?
2. What are the two basic ways in which funds flow through the financial system from lender-savers to
borrower-spenders?
1.2 Financial markets

LEARNING OBJECTIVE 1.2 Describe the primary, secondary and money markets, and explain why these
markets are so important to businesses.
Financial markets are just like any kind of market you have seen before: people buy and sell, haggle and
argue, win and lose, and, yes, some may become rich playing the financial markets while others may lose
it all. Markets can be informal, like a flea market in your community, or highly organised and structured,
like the gold markets in London or Zurich. The only difference is that in financial markets, people buy
and sell financial instruments, such as stocks, bonds, futures contracts or mortgage-backed securities. In
this section, we turn our attention to several types of financial markets.

Types of financial markets
We have seen that direct and indirect flows of funds occur in financial markets. However, as already
mentioned, financial market is a very general term; in fact, it is a broad concept that covers all forms of
markets that deal with short-term and long-term funds. When the focus is on short-term funds, such a
market is called a money market. In contrast, when the focus is on the long-term funds, such a market is
called a capital market. The same institution may be involved in both the money market and the capital
market. A complex industrial economy such as ours includes many different types of financial markets and
institutions involved in direct and indirect financing. Next, we examine some widely used classifications
of financial markets. Note that these classifications overlap to a large extent.
Primary and secondary markets

A primary market is any market where companies initially sell new security issues (debt or equity).
Suppose Wesfarmers Limited needs to raise $100 million for a business expansion and decides to raise the
money through the sale of ordinary shares. The company will sell the new equity issue (ordinary shares)
in the primary market for corporate shares — probably with the help of an underwriter, as discussed
in the previous section. When such issues are open to the public, they are called initial public offerings
(IPOs). The primary market may be a wholesale market where the sales take place outside the public
view.
A secondary market is any market where owners of securities (i.e. those who have already bought
the securities) can sell them to other investors. Securities already issued (i.e. outstanding securities) are
bought and sold in the secondary market. When securities are bought and sold in the secondary market,
the original issuers (i.e. the companies that issued these securities in the primary market) do not receive
any money. Conceptually, secondary markets are like used-car markets in that they allow the current
owners of the cars to sell second-hand cars. Car manufacturing companies do not receive any money from
transactions in the used-car market. Secondary markets for securities are important because they enable
investors to buy and sell securities (e.g. shares, bonds) as frequently as they want. As you might expect,
investors are willing to pay higher prices for securities that have active secondary markets, compared
to similar securities which do not have active secondary markets. Secondary markets are important to
companies as well, because investors are willing to pay higher prices for securities in primary markets
if the securities have active secondary markets. Thus, companies whose securities have active secondary
markets enjoy lower funding costs (i.e. they raise funds at a lower cost) than similar companies whose
securities do not have active secondary markets.
An important characteristic of a security to investors is its marketability. Marketability is the ease
with which a security can be sold and converted into cash. A security’s marketability depends on whether
buyers for the security are readily available, and also on the costs of trading and searching for infor-
mation, so-called transaction costs. The lower the transaction costs, the greater a security’s marketabil-
ity. Because secondary markets make it easier to trade securities, their existence increases a security’s
marketability.
A concept closely related to marketability is liquidity. Liquidity is the ability to convert an asset into
cash quickly without loss of value. In common use, the terms marketability and liquidity are often used
interchangeably, but they are different. Liquidity implies that when the security is sold, its value will be
preserved; marketability does not carry this implication.
Two types of market specialists facilitate transactions in secondary markets. Brokers are market spe-
cialists who bring buyers and sellers together for a sale to take place. They execute the transaction for
their clients (the buyers and the sellers) and charge a fee from both buyers and sellers for their services.
They bear no risk of ownership of the securities during the transactions; their only service is that of
‘matchmaker’. In Australia, CommSec is a well-known broker.
Dealers, in contrast, ‘make markets’ for securities and do bear risk. They make a market for a security
by buying and selling from an inventory of securities they own. Dealers make their profit, just as retail

merchants do, by selling securities at a price above what they paid for them. The risk that dealers bear is
price risk, which is the risk that they will sell a security for less than they paid for it.
Exchanges and over-the-counter markets

Financial markets can be classified as either organised markets (more commonly called exchanges) or
over-the-counter (OTC) markets. Traditional exchanges, such as the ASX, provide a platform and facilities
for members to buy and sell securities or other assets (such as commodities) under a specific set of rules
and regulations. All members of the ASX are brokers. Only members can use the exchange to facilitate
their clients’ transactions (buying and selling of securities).
Securities not listed on an exchange are bought and sold in OTC markets. These differ from organised
exchanges in that the ‘market’ has no central trading location. Instead, investors can execute OTC
transactions by visiting or telephoning an OTC dealer or by using a computer-based electronic trading
system linked to the OTC dealer. Traditionally, shares traded over the counter have been those of
small and relatively unknown companies, most of which would not qualify to be listed on a major
exchange.
Money and capital markets

Money markets are where short-term debt instruments, those which have maturities of less than 1 year,
are sold. Money markets are wholesale markets in which the minimum transaction is $1 million and
transactions of $100 million are not uncommon. Money market instruments are lower in risk than other
securities because of their high liquidity and low default risk. In fact, the term ‘money’ market is used
because these instruments are close substitutes for cash. The most important and largest money markets
are in New York, London and Tokyo. Figure 1.2 lists the most common money market instruments and
the dollar amounts outstanding.
FIGURE 1.2 Selected money market and capital market instruments, June 2016 ($billions)1
Money market instruments

Treasury notes $ 23.8
Bank certificates of deposit, bank bills and commercial paper 263.5
Capital market instruments
Treasury bonds $ 641.0
State government bonds 8.0
Corporate bonds 512.1
Corporate bonds issued offshore 553.8
Corporate equity (at market value) 1619.7
Eurobonds 50.8
Residential mortgage securities 114.1
The figure shows the size of the Australian market for some of the most important money and capital market instruments.
Compared with money market instruments, capital market instruments have longer maturities and higher default risk.
Large companies use money markets to adjust their liquidity positions. Liquidity, as mentioned, is the
ability to convert an asset into cash quickly without loss of value. Liquidity problems arise because cash
receipts and expenditures of companies are rarely perfectly synchronised. For example, expenditures may
have to be paid before a company can collect money from its customers. To manage a temporary cash
shortfall, a company can raise cash overnight by selling money market instruments from its portfolio.
In contrast, if a company has a temporary cash surplus, it can invest such money in short-term money
market instruments without keeping the surplus money idle.
Capital markets are markets where intermediate-term and long-term debt and corporate shares are
traded. In these markets, companies raise funds to finance capital assets, such as property, plant and

equipment. The ASX as well as the New York, London and Tokyo stock exchanges are capital markets.
Figure 1.2 lists the major Australian capital market instruments and the dollar amounts outstanding. Com-
pared with money market instruments, capital market instruments carry more default risk and have longer
maturities.
Public and private markets

Public markets are organised financial markets where members of the general public buy and sell secu-
rities through their stockbrokers. The ASX, for example, is a public market. ASIC regulates public
securities markets in Australia. This body is responsible for overseeing the securities industry and regulat-
ing all primary and secondary markets in which securities are traded. Most companies want access to the
public markets, because they can sell their securities at competitive prices and raise funds at the lowest
possible cost. The downside for companies selling in the public markets is that they have to comply with
the various ASIC regulations. The cost of such compliance can be significant.
In contrast to public markets, the private market involves direct transactions between two parties. Trans-
actions in a private market are often called private placements. In a private market, a company contacts
investors directly and negotiates a deal to sell them all or part of a security issue. Larger companies may
be equipped to handle these transactions themselves. Smaller companies are more likely to use the ser-
vices of an investment bank, which will help locate investors, help negotiate the deal and handle the legal
aspects of the transaction. Major advantages of a private placement are the speed at which funds can be
raised and low transaction costs. Downsides are that privately placed equity dilutes the value of shares
owned by existing shareholders because private placements are normally placed at a discount to the cur-
rent market price of the security; further, the dollar amounts that can be raised from private placements
tend to be smaller.
Futures and options markets

Markets also exist for trading in futures and options. Perhaps the best-known futures markets are the New
York Board of Trade and the Chicago Board of Trade. In Australia, the ASX conducts the markets for
futures and options, following the merger with the Sydney Futures Exchange in 2008. These securities
are listed on the ASX 24 market and traded on ASX Trade24,2 the ASX’s proprietary trading platform.
Futures and options are often called derivative securities because they derive their value from some
underlying asset. Futures contracts are contracts for the future delivery of such assets as securities, foreign
currencies, interest cash flows or commodities. Companies use these contracts to reduce (hedge) risk
exposure caused by fluctuations in things such as foreign exchange rates or commodity prices. We discuss
this use of futures contracts further in the chapter on financial markets.
Options contracts call for one party (the option writer) to perform a specific act if called upon to do
so by the option buyer or owner. Options contracts, like futures contracts, can be used to hedge risk in
situations where a company faces risk from price fluctuations. Options are also discussed in more detail
in the chapter on financial markets.
Foreign exchange markets

Foreign currencies are bought and sold in the foreign exchange markets. Foreign currencies such as
the US dollar, the UK pound, the yen and the euro are traded against the Australian dollar or against
other foreign currencies. They are traded either for spot or forward delivery over the counter at large
commercial banks or investment banking firms. Futures contracts for foreign currencies are traded on
organised exchanges such as the ASX, New Zealand Futures and Options Exchange (NZFOX) and Hong
Kong Stock Exchange (HKE). There are three important reasons for the development of foreign exchange
(FX) markets. First, they provide a mechanism for transferring purchasing power from one currency to
another. Second, FX markets provide a means for passing the risk associated with changes in exchange

rates to professional risk-takers. Third, FX markets facilitate the provision of credit internationally. FX
markets are discussed further in the chapter on financial markets.
BEFORE YOU GO ON
1. What is the difference between primary and secondary markets?

2. How and why do large companies use money markets?
3. What are capital markets and why are they important to companies?
1.3 Financial institutions

LEARNING OBJECTIVE 1.3 Explain how financial institutions serve consumers and small businesses that
are unable to participate in the direct financial markets, and describe how companies use the financial system.
As mentioned earlier, many companies are too small to sell their debt or equity directly to investors. They
have neither the expert knowledge nor the reputation and money to transact in wholesale markets. When
these companies need funds for capital investments or liquidity adjustments, their only choice may be
to borrow in the indirect market from financial institutions. These financial institutions act as intermedi-
aries, converting financial instruments with one set of characteristics into instruments with another set of
characteristics. This process is called financial intermediation. The hallmark of indirect financing is that
a financial institution — an intermediary — stands between the lender-saver and the borrower-spender.
This route is shown at the bottom of figure 1.1.
Indirect market transactions

We worked through an example of indirect financing at the beginning of the chapter. In that scenario, a
university student had $5000 to invest for 3 months. A bank sold the student a 3-month term deposit for
$5000, pooled this $5000 with the proceeds from other term deposits and used the money to make small-
business loans, one of which was a $30 000 loan to our pizza restaurant owner. Following is a schematic
diagram of that transaction:
Pizza restaurant’s
Sells term deposits
loan Commercial
Investors and
Pizza restaurant bank
depositors
$30 000 (intermediary) Cash
The banks raise money by selling financial instruments, such as cheque accounts, savings accounts,
term deposits and various securities, and then use the money to make loans to businesses or consumers.
On a smaller scale, both superannuation funds and insurance companies provide a significant portion
of the long-term financing in the Australian economy through the indirect finance market. Superannuation
funds collect individuals’ contributions and then invest into the money market and the long-term equity
and bond market. Insurance companies also invest into debt and equity securities using the funds that
they receive when they sell insurance policies to individuals and businesses. The schematic diagram for
intermediation by an insurance company is as follows:
Issues debt or equity Sells policies

Insurance
Investors and
Company company
policyholders
Cash (intermediary) Cash
Note an important difference between the indirect and direct financial markets. In the direct mar-
ket, as securities flow between lender-savers and borrower-spenders, the form of the securities remains

unchanged. In the indirect market, however, as securities flow between lender-savers and borrower-
spenders, they are repackaged and their form is changed. In the example above, money from the sale
of insurance policies becomes investments in debt or equity. By repackaging securities, financial inter-
mediaries tailor-make a wide range of financial products and services that meet the needs of consumers,
small businesses and large companies. Their products and services are particularly important for smaller
businesses that do not have access to direct financial markets. The benefits of financial intermediation
include the following.
r Denomination divisibility: financial intermediaries are able to produce a wide range of denominations
from $1 to many millions by pooling the funds of many individuals and investing them in direct secu-
rities of varying sizes.
r Currency transformation: financial intermediaries help finance the global expansion of Australian com-
panies by buying financial claims denominated in one currency and selling financial claims denomi-
nated in other currencies.
r Maturity flexibility: financial intermediaries are able to create securities with a wide range of maturities
from 1 day to more than 30 years.
r Credit risk diversification: by purchasing a wide variety of securities, financial intermediaries are able
to spread risk.
r Liquidity: most commodities produced by intermediaries are highly liquid, so they are able to be con-
verted into money quickly with minimal transaction cost.
Somewhat surprisingly, the indirect markets are a much larger and more important source of financing
to businesses than the more newsworthy direct financial markets, such as share markets. This is true not
only in Australia, but in all countries.
Financial institutions and their services

We have briefly discussed the role of financial institutions as intermediaries in the indirect financial mar-
ket. Next, we look at various types of financial institutions and the services they provide to small busi-
nesses as well as large companies. We discuss only financial institutions that provide a significant amount
of services to businesses.
Commercial banks
Commercial banks are the most prominent and largest financial intermediaries in the economy, and offer
the widest range of financial services to businesses. Nearly every business, small or large, has a significant
relationship with a commercial bank — usually a cheque or transaction account and also some type of
credit or loan arrangement. For businesses, the most common type of bank loan is a line of credit (often
called an overdraft), which works much like a credit card. A line of credit is a commitment by a bank to
lend a company an amount up to a predetermined limit, which can be used as needed. Banks also make
term loans, which are fixed-rate loans with a typical maturity of 1 year to 10 years. In addition, banks do
a significant amount of equipment lease financing. A lease is a contract that gives a business the right to
use an asset, such as a truck or a photocopier, for a period of time in exchange for payments.
Life and general insurance companies

Two types of insurance companies are important in the financial markets: (1) life insurance companies;
and (2) general insurance companies, which sell protection against loss of property from fire, theft, acci-
dents and other predictable causes. The cash flows for both types of companies are fairly predictable.
As a result, they are able to provide funding to companies through the purchase of shares and bonds in
the direct finance markets, as well as funding for private companies through private placement financing.
Businesses of all sizes often purchase life insurance programs as part of their employee benefit packages,
and purchase general insurance policies to protect physical assets such as cars, truck fleets, equipment
and entire plants.

Superannuation funds
Superannuation is Australia’s retirement savings scheme whereby employers are required to contribute
9.5 per cent of an employee’s salary to a complying superannuation fund. Superannuation funds then
invest these contributions in financial market securities on behalf of the employees. Superannuation funds
receive contributions during an employee’s working years and then provide a lump sum payment and/or
monthly cash payments (a pension or an annuity) to the employee on retirement. Because of the pre-
dictability of these cash flows, superannuation fund managers invest in money market securities and cap-
ital market securities (bonds and shares) and also participate in the private placement market.
Investment funds
Investment funds, such as retail funds, sell shares to investors and use the funds to purchase a wide variety
of direct and indirect financial instruments. As a result, they are an important source of business funding.
For example, retail funds may focus on purchasing: (1) equity or debt securities; (2) securities of small or
medium-sized companies; (3) securities of companies in a particular industry, such as energy, computer
or information technology; or (4) foreign investments.
Finance companies
Finance companies, such as Esanda Limited, obtain the majority of their funds by selling short-term debt,
called commercial paper, to investors in direct credit markets. These funds are used to make a variety
of short-term and intermediate-term loans and leases to individuals and to small and large businesses.
The loans are often secured by accounts receivable or inventory. Finance companies are typically more
willing than commercial banks to make loans and leases to companies with higher levels of default risk.
Financial planning practices
Financial planning practices,3 such as AMP Limited, are run by qualified investment professionals who
assist individuals and corporations to meet their long-term financial goals by analysing each client’s

financial status and setting a program to achieve their goals. Financial planners specialise in wealth man-
agement, tax planning, asset allocation, risk management, retirement and estate planning services.
Risks faced by financial institutions

Financial institutions, in providing financial intermediation services to consumers and businesses, must
transact in the financial markets. They intermediate between savers, or surplus spending units (SSUs),
and borrowers, or deficit spending units (DSUs), in the hope of earning a profit by acquiring funds at
interest rates that are lower than those they charge when they sell their financial products. But there is
no free lunch here. The differences in the characteristics of the financial claims that financial institutions
buy and sell expose them to a variety of risks in the financial markets. The global financial crisis (GFC)
in 2007–09 testifies to the importance of successfully managing these risks: the plethora of institutions
that either failed or survived only due to significant government bailouts demonstrate this. Managing
the risks does not mean eliminating them: there is a trade-off between risk and higher profits. Managers
who take too few risks sleep well at night, but eat poorly. Their slumber reaps a reward of declining
earnings and stock prices that their shareholders will not tolerate for long. On the other hand, excessive
risk-taking — betting the bank and losing — is also bad news. It will place you in the ranks of the
unemployed with an armada of expensive lawyers defending you.
In their search for higher long-term earnings and stock values, financial institutions must manage and
balance five basic risks: credit, interest rate, liquidity, foreign exchange and political risk. Each of these
risks is related to the characteristics of the financial claim (e.g. term to maturity) or to the issuer (e.g.
default risk). Each must be managed carefully to balance the trade-off between future profitability and
potential failure. For now, this section summarises nine risks and briefly discusses how they affect the
management of financial institutions in order to provide a frame of reference for other topics in the
chapters.
Credit risk
When a financial institution makes a loan or invests in a bond or other debt security, the institution bears
credit risk (or default risk) because it is accepting the possibility that the borrower will fail to make either
interest or principal payments in the amount and at the time promised. To manage the credit risk of loans
or investments in debt securities, financial institutions should diversify their portfolios, conduct careful
credit analysis of potential borrowers to measure default risk exposure, and monitor borrowers over the
life of the loan or investment to detect any critical changes in financial health, which is just another way
of expressing the borrowers’ ability to repay the loans.
Interest rate risk
Interest rate risk is the risk of fluctuations in a security’s price or reinvestment income caused by changes
in market interest rates. In other words, a change in interest rates will alter forecast cash flows and affect
the value of interest rate–sensitive assets and liabilities. For example, if a bank issues fixed-rate loans and
then interest rates go up, the value of the loans will decline because the bank could have been receiving
higher returns from other loans and the cost of replacing the issued funds will be higher. The concept of
interest rate risk is applicable not only to loans but also to a financial institution’s balance sheet. Financial
institutions are exposed to interest rate risk whenever they plan to borrow or lend at a variable rate. Interest
rate risk may affect a significant proportion of a financial institution’s assets and liabilities, making it a
serious issue.
Liquidity risk
Liquidity risk is the risk that a financial institution will be unable to generate sufficient cash inflow
to meet required cash outflows. Liquidity is critical to financial institutions: banks and other authorised
deposit-taking institutions (ADIs) need liquidity to meet deposit withdrawals and to pay off other liabili-
ties as they come due; superannuation funds need liquidity to meet contractual superannuation payments;

and life insurance companies need liquidity to pay death benefits. Liquidity also means that an institution
need not pass up a profitable loan or investment opportunity because of a lack of cash. If a financial
institution is unable to meet its short-term obligations because of inadequate liquidity, the firm will fail
even though over the long run it is profitable.
Foreign exchange risk
Foreign exchange risk is the fluctuation in the earnings or value of a financial institution that arises
from changes in exchange rates. Many financial institutions deal in foreign currencies either on their
own account or for their customers. Also, financial institutions invest in the direct credit markets of other
countries and sell indirect financial claims overseas. Because of changing international economic con-
ditions and the relative supply and demand of local and foreign currencies, the rates at which foreign
currencies are converted into Australian dollars change. These changes can cause gains or losses in the
currency positions of financial institutions and the Australian-dollar values of non-Australian financial
investments.
Political risk
Political risk is the risk of fluctuation in the value of a financial institution resulting from the actions
of Australian or foreign governments. Domestically, if the government changes the regulations faced by
financial institutions, their earnings or values are affected. Internationally, the concerns are much more
dramatic, especially when institutions consider lending in developing countries without stable govern-
ments or well-developed legal systems. Governments can repudiate (i.e. cancel) foreign debt obligations.
Repudiations are rare, but less rare are debt reschedulings, in which foreign governments declare a
moratorium on debt payments and then attempt to renegotiate more favourable terms with the foreign
lenders. In either case, the lending institution is left ‘holding the bag’. To grow and be successful in the
international arena, managers of financial institutions must understand how to measure and manage these
risks.
Reputational risk
Reputational risk is defined as the potential for negative publicity regarding an institution’s business
practices to cause a decline in the customer base, costly litigation or revenue reduction. This is irrespective
of whether the publicity is accurate or not.4 It is no secret that financial institutions, banks inparticular,
are not the classroom favourite when it comes to public reputation. This has been exacerbated as their
profits have grown, fees have increased and perceptions of customer service have declined. To top it off,
the huge bonuses and corporate salaries paid by many of these institutions are regarded as excessive by
many. The GFC, which the populist view suggests was caused by greed within the sector, is another thorn
in the sector’s side in this regard.
Environmental risk
Environmental risk issues, such as climate change and environmental litigation, are increasingly being
recognised as key risk factors for financial institutions and their clients. Climate change is seen as one of
the most significant challenges to face business, government and the community in the foreseeable future.5
While the financial sector is a comparatively low emissions sector, it is accepted that the financial sector
will be critical to climate change response due to its role as a provider of capital. In addition, the effects
of climate change (extreme weather patterns, sea level rises and atmospheric changes) on asset values,
business performance and risk will have a material impact on the performance of credit, investment and
insurance portfolios. This will also lead to significant regulatory risk as governments move to respond to
climate change and other environmental concerns.
Operational risk
Financial institutions are often large and complex businesses with billions of dollars in assets and lia-
bilities. They are usually highly geared (i.e. they have a lot of debt in comparison to their assets) and

have investments in risky assets (loans) funded predominantly by short-term liabilities (deposits). This
complexity and scale create a risk of loss due to the failure or inadequacy of internal systems, people
and processes that should ensure the effective and efficient operation of a financial institution. This is
referred to as operational risk, which is therefore significant in these businesses and needs to be actively
managed and monitored. Indeed, these risks have become increasingly of interest to regulators in recent
decades, and the international capital accords require management of these risks.
Contagion risk
Failure of a financial institution can have significant economic and social consequences. These conse-
quences can reach far beyond the failed institution, given the interdependence between institutions and
the impact that a failure can have on market confidence. The risk of financial difficulties in one organisa-
tion spreading to others due to the complex interrelationships between institutions and the nature of the
exchange settlement systems is referred to as contagion risk. Contagion can destabilise the entire sector,
as was seen in the GFC when the US$600 billion-plus collapse of US investment bank Lehman Brothers
triggered a collapse in an already nervous market. A month later the market closed at a six-year low and
financial institutions around the globe were in chaos, with government bailout and guarantee packages
stepping in to keep the global system alive, albeit only just. Indeed, the competitive landscape changed
in financial services as a result of the GFC.
Companies and the financial system

We began this chapter by saying that financial managers need to understand the financial system in order
to make sound decisions. We now follow up on that statement by briefly describing how companies oper-
ate within the financial system. The interaction between the financial system and a large public company
is shown in figure 1.3. The arrows show the major cash flows for a company over a typical operating
cycle. These cash flows relate to some of the key decisions that the financial manager must make. As
you know, these decisions involve three major areas: capital budgeting, financing and working capital
management.
Let’s work through an example using figure 1.3 to illustrate how businesses use the financial system.
Suppose you are the chief financial officer (CFO) of a new high-tech company with business ties to
Telstra. The new venture has a well-thought-out business plan, owns some valuable technology and has
one manufacturing facility. The company is large enough to have access to public markets. The com-
pany plans to use its core technology to develop and sell a number of new products that the marketing
department believes will generate a strong market demand.
To start the new company, management’s first task is to sell equity and debt to finance the expansion of
the company. Assume 70 per cent of the long-term funds will come from an initial public offering (IPO)
of ordinary shares. An IPO is a company’s first offering of its shares to the public. For example,
management hires Macquarie Bank Limited as its investment bank to underwrite the new securi-
ties. After the deal is underwritten, the new venture receives the proceeds from the share sale, less
Macquarie’s fees (see arrow E in figure 1.3). The financial markets chapter contains a discussion of the
IPO process.
In addition to the equity financing, 30 per cent of the company’s long-term funds will come from the
sale of long-term debt through a private placement deal with a large superannuation fund (see arrow B).
Management has decided to use a private placement because the lender is willing to commit to lend-
ing the company additional money in the future if the company meets certain performance goals. Since
management has ambitious growth plans, locking in a future source of funds is important.
Once the long-term funds from the debt and equity sales are in hand, they are deposited in the com-
pany’s cheque account at a commercial bank. Management then decides to lease an existing manufac-
turing facility and equipment to manufacture the new high-technology products; the cash outflow is
represented by arrow A.

FIGURE 1.3 Cash flows between a company and the financial system
The financial
The company Transactions system
Management
invests in assets: Private Debt
Lease B placement of debt markets
manufacturing
A facility and
• Current assets
equipment
Sale of Money
C
• Productive assets commercial paper markets
Plant
Equipment
Buildings Bank loans and Financial
Technology D
lines of credit intermediaries
Patents
Equity
E Sale of shares
markets
G
Cash
inflows
from
operations
Cash reinvested Cash

H F
in business dividend
To begin manufacturing, the company needs to raise short-term funds for the working capital and does
this by: (1) selling commercial paper in the money markets (arrow C); and (2) obtaining a line of credit
from a bank (arrow D). As the company becomes operational, it generates cash inflows from its earning
assets (arrow G). Some of this cash inflow is reinvested in the company (arrow H) and the remainder is
used to pay a cash dividend to shareholders (arrow F).
BEFORE YOU GO ON
1. What is financial intermediation and why is it important?

2. What are some services that commercial banks provide to businesses?
3. What are some of the risks faced by the financial system and the institutions that comprise it?
1.4 International financial markets

LEARNING OBJECTIVE 1.4 Discuss the internationalisation of financial markets and the role played by the
BIS in ensuring the global financial markets remain stable.
Financial markets can be classified as either domestic or international. The most important international
financial markets for Australian firms are the short-term US market and eurocurrency market, and the
long-term eurobond market. In these markets, domestic and overseas firms can borrow or lend large
amounts of Australian dollars that have been deposited in overseas banks. These markets are closely
linked to the Australian money and capital markets. Large financial institutions, business firms and

institutional investors, both in Australia and overseas, conduct daily transactions between the Australian
domestic markets and the international markets.
Internationalisation of financial markets

It is generally accepted that a strong financial system is a key ingredient of economic prosperity. Domestic
financial markets are, however, part of a global financial system, intermediating borrowing and lending
between the local nation and the rest of the world. This has been necessitated by expanding international
trade and production, and the development of multinational corporations. The rapid development of tech-
nology and communication systems has made this growth possible. This places emphasis on multilateral
cooperation between nations and their central banks to ensure that the global financial system and domes-
tic systems are stable. The Bank for International Settlements (BIS) has become pivotal in encouraging
this cooperation.
International organisations
In addition to the domestic financial institutions discussed, important international organisations play a
significant role in the global financial markets. Examples of these are as follows.
r The Bank for International Settlements (BIS): the BIS has a mandate to encourage international mon-
etary and financial cooperation. It also operates as a banker for the central banks of countries around
the world. Furthermore, the BIS plays an important role in helping to maintain the stability of the
global financial system.
r The World Bank: the World Bank6 is not a bank per se, but an agency of the United Nations that
aims to reduce poverty and improve living standards in developing nations. It has 189 member nations
(including Australia and New Zealand), which jointly finance and allocate its resources. The ‘Bank’
side of the World Bank commonly refers to the International Bank for Reconstruction and Development
and the International Development Association, which are divisions of the World Bank Group. They
provide low-interest and no-interest credit and grants to developing countries. With lending averaging
almost US$57 billion per year over the 2012–16 period, the World Bank plays a major role in the
global community.
r The International Monetary Fund (IMF): the IMF was also established under the United Nations and
has 188 member nations. The role of the IMF is contained in its articles of agreement:7
To promote international monetary cooperation through a permanent institution which provides the
machinery for consultation and collaboration on international monetary problems.
To facilitate the expansion and balanced growth of international trade, and to contribute thereby to
the promotion and maintenance of high levels of employment and real income and to the development of
the productive resources of all members as primary objectives of economic policy.
To promote exchange stability, to maintain orderly exchange arrangements among members, and to
avoid competitive exchange depreciation.
To assist in the establishment of a multilateral system of payments in respect of current transactions
between members and in the elimination of foreign exchange restrictions which hamper the growth of
world trade.
To give confidence to members by making the general resources of the Fund temporarily available to
them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their
balance of payments without resorting to measures destructive of national or international prosperity.
In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the
international balances of payments of members.
r The Asian Development Bank (ADB): this is a multilateral development bank that aims to reduce
poverty and improve living conditions and quality of life in the Asia–Pacific region. The ADB has
48 regional members and 19 non-regional members. Australia has been a member of the ADB since
1966 and has contributed 5.80 per cent of the contributed capital.8

International assets of Australian institutions
In the Australian financial system, Australian banks have accumulated significant offshore assets and
liabilities. As of June 2016, Australian banks had international assets of US$295 billion and interna-
tional liabilities of US$615.1 billion, the majority of which are denominated in US$.9 In comparison
with those for other countries that report to the BIS, these figures are not large as a percentage of GDP,
and Australia’s reliance on international funding is more apparent when the net liability position of
Australian banks is considered. Therefore, it is necessary in any study of financial markets and insti-
tutions to consider aspects of the international financial system and the importance of globalisation.
BEFORE YOU GO ON
1. What are two of the most important international financial markets for Australian firms?
2. Which international organisations play a significant role in ensuring the stability of the global
financial markets?
1.5 Capital market efficiency

LEARNING OBJECTIVE 1.5 Explain what an efficient capital market is and why market efficiency is
important to financial managers.
Security markets, such as the bond and share markets, help bring buyers and sellers of securities together.
They reduce the cost of buying and selling securities by providing a physical location or computer trading
system where investors can trade securities. The supply and demand for securities are better reflected
in organised markets because much of the total supply and demand for securities flows through these

centralised locations or trading systems. Any price that balances the overall supply and demand for a
security is a market equilibrium price.
Ideally, economists would like financial markets to price securities at their true (intrinsic) value. A
security’s true value is the present value of the cash flows that an investor who owns that security can
expect to receive in the future. This present value, in turn, reflects all available information about the
size, timing and riskiness of the cash flows at the time the price was set. As new information becomes
available, investors adjust their cash flow estimates through buying and selling, and the price of a security
adjusts to reflect this information.
Markets such as those just described are called efficient capital markets. More formally, in an efficient
capital market security prices fully reflect the knowledge and expectations of all investors at a particular
point in time. If markets are efficient, investors and financial managers have no reason to believe securities
are not priced at or near their true value. The more efficient a security market, the more likely securities
are to be priced at or near their true value.
The overall efficiency of a capital market depends on its operational efficiency and its informational
efficiency. Market operational efficiency focuses on bringing buyers and sellers together at the lowest
possible cost. The costs of bringing buyers and sellers together are called transaction costs and include
such things as broker commissions and other fees and expenses. The lower these costs, the more oper-
ationally efficient markets are. Why is operational efficiency important? If transaction costs are high,
market prices will be more volatile, fewer financial transactions will take place and prices will not reflect
the knowledge and expectations of investors as accurately.
Markets exhibit market informational efficiency if market prices reflect all relevant information about
securities at a particular point in time. As suggested above, informational efficiency is influenced by
operational efficiency, but it also depends on the availability of information, and the ability of investors
to buy and sell securities based on that information. In an informationally efficient market, prices adjust
quickly to new information as it becomes available. Prices adjust quickly because many security analysts
and investors are gathering and trading on information about securities in a quest to make a profit. Note
that competition among investors is an important driver of informational efficiency.
Efficient market hypotheses

Public financial markets are efficient in part because regulators such as ASIC require issuers of publicly
traded securities to disclose a great deal of information about those securities to investors. Investors are
constantly evaluating the prospects for these securities and acting on the conclusions from their analyses
by trading them. If the price of a security is out of line with what investors think it should be, then they will
buy or sell that security, so causing its price to adjust to reflect their assessment of its value. The ability
of investors to easily observe transaction prices and trade volumes, and to inexpensively trade securities
in public markets contributes to the efficiency of this process. This buying and selling by investors is the
mechanism through which prices adjust to reflect the market’s consensus. The theory about how well this
mechanism works is known as the efficient market hypothesis.
Strong-form efficiency
The market for a security is perfectly informationally efficient if the security’s price always reflects all
available information. The idea that all information about a security is reflected in its price is known as the
strong form of the efficient market hypothesis. Few people really believe that the market prices of public
securities reflect all available information, however. It is widely accepted that insiders have information
that is not reflected in the security prices. Thus, the concept of strong-form market efficiency represents
the ideal case, rather than the real world.
If a security market were strong-form efficient, then it would not be possible to earn abnormally high
returns (returns greater than those justified by the risks) by trading on private information — information
unavailable to other investors — because there would be no such information. In addition, since all

available information would already be reflected in security prices, the price of a share of a particular
security would change only when new information about its prospects became available.
Semistrong-form efficiency
A weaker form of the efficient market hypothesis, known as the semistrong form, holds only that all
public information — information available to all investors — is reflected in security prices. Investors
who have private information are able to profit by trading on this information before it becomes public.
As a result of this trading, prices adjust to reflect the private information. For example, suppose that con-
versations with the customers of a company indicate to an investor that the company’s sales, and therefore
its cash flows, are increasing more rapidly than other investors expect. To profit from this information,
the investor buys some of the company’s shares. By buying the shares, the investor helps drive up the
price to the point where it accurately reflects the higher level of cash flows.
The concept of semistrong-form efficiency is a reasonable representation of the public share markets
in developed countries, such as Australia. In a market characterised by this sort of efficiency, as soon as
information becomes public it is quickly reflected in share prices through trading activity. Studies of the
speed at which new information is reflected in share prices indicate that, by the time you read a hot tip
in The Australian Financial Review or a business magazine, it is too late to benefit by trading on it.
Weak-form efficiency
The weakest form of the efficient market hypothesis is known, aptly enough, as the weak form. This
hypothesis holds that all information contained in past prices of a security is reflected in current prices,
but there is both public and private information that is not. In a weak-form efficient market, it would not
be possible to earn abnormally high returns by looking for patterns in security prices, but it would be
possible to do so by trading on public or private information.
An important conclusion from efficient market theory is that, at any point in time, all securities of the
same risk class should be priced to offer the same expected return. The more efficient the market, the
more likely this is to happen. Since both the bond and share markets are relatively efficient, this means
that securities of similar risk will offer the same expected return. This conclusion is important because it
provides the basis for identifying the proper discount rate to use in applying the bond and share valuation
models developed in this chapter.
BEFORE YOU GO ON
1. How is information about a company’s prospects reflected in its share price?

2. What is strong-form market efficiency? Semistrong-form market efficiency? Weak-form market
efficiency?

SUMMARY
1.1 Discuss the primary role of the financial system in the economy, and how fund transfers
take place.
The primary role of the financial system is to gather money from people and businesses with surplus
funds (lender-savers) and channel the money to businesses and consumers who need to borrow money
(borrower-spenders). If the financial system works properly, only creditworthy investment projects with
high rates of return (higher than the cost of capital) are financed and all other projects are rejected.
Money flows through the financial system in two basic ways: (1) directly, through financial markets; and
(2) indirectly, through financial institutions.
1.2 Describe the primary, secondary and money markets, and explain why these markets are so
important to businesses.
Primary markets are markets in which new securities are sold for the first time. Secondary markets pro-
vide the aftermarket for securities previously issued. Not all securities have secondary markets. Secondary
markets are important because they enable investors to convert securities easily to cash. Companies whose
securities are traded in secondary markets are able to issue new securities at a lower cost than they oth-
erwise could because investors are willing to pay a premium price for securities that have secondary
markets.
Large companies use money markets to adjust their liquidity because cash inflows and outflows are
rarely perfectly synchronised. Thus, on the one hand, if cash expenditures exceed cash receipts, a com-
pany can borrow short term in the money markets or, if the company holds a portfolio of money market
instruments, it can sell some of these securities for cash. On the other hand, if cash receipts exceed
expenditures, the company can temporarily invest the funds in short-term money market instruments.
Businesses are willing to invest large amounts of idle cash in money market instruments because of their
high liquidity and their low default risk.
1.3 Explain how financial institutions serve consumers and small businesses that are unable to
participate in the direct financial markets, and describe how companies use the financial system.
One problem with direct financing is that it takes place in a wholesale market. Most small businesses
and consumers do not have the expert skills or the money to transact in this market. In contrast, a large
portion of the indirect market focuses on providing financial services to consumers and small businesses.
For example, commercial banks collect money from consumers in small dollar amounts by selling them
cheque accounts, savings accounts and term deposits. They then aggregate the funds and make loans in
larger amounts to consumers and businesses. The financial services bought and sold by financial institu-
tions are tailor-made to fit the needs of the market they serve. Figure 1.3 illustrates how companies use
the financial system.
1.4 Discuss the internationalisation of financial markets and the role played by the BIS in ensuring
the global financial markets remain stable.
Domestic financial markets are part of a global financial system, intermediating borrowing and lending
between the local nation and the rest of the world. This has been necessitated by expanding interna-
tional trade and production, and the development of multinational corporations. The rapid development
of technology and communication systems has made this growth possible. This places emphasis on multi-
lateral cooperation between nations and their central banks to ensure that the global financial system and
domestic systems are stable. The BIS has become pivotal in encouraging this cooperation.
1.5 Explain what an efficient capital market is and why market efficiency is important to financial
managers.
An efficient capital market is a market where security prices reflect the knowledge and expectations of all
investors. Public markets, for example, are more efficient than private markets because issuers of public
securities are required to disclose a great deal of information about these securities to investors, while
investors are constantly evaluating the prospects for these securities and acting on the conclusions from

their analyses by trading them. Market efficiency is important to investors because it assures them that
the securities they buy are priced close to their true value.
KEY TERMS
brokers Market specialists who bring buyers and sellers together, usually for a commission.
contagion risk Risk of the effects of financial difficulties in one organisation spreading to others
because of the complex interrelationships between institutions and the nature of the exchange
settlement systems.
credit risk Risk that the borrower will fail to make either interest or principal payments in the amount
and at the time promised.
dealers Market specialists who ‘make markets’ for securities by buying and selling from their own
inventories of securities.
efficient capital market Market where prices reflect the knowledge and expectations of all investors.
efficient market hypothesis Theory concerning the extent to which information is reflected in security
prices and how information is incorporated into security prices.
environmental risk Actual or potential threat of adverse impacts on value from changes in the
environment and/or organisational effects on the environment.
eurocurrency market Market for short-term borrowing or lending of large amounts of any currency
held in a time deposit account outside its country of origin.
financial intermediation Conversion of financial instruments with one set of characteristics into
financial instruments with another set of characteristics.
foreign exchange markets Markets in which foreign currencies are bought and sold.
foreign exchange risk Fluctuation in the earnings or value of a financial institution that arises from
changes in exchange rates.
initial public offering (IPO) Primary offering of a company that has never before offered a particular
type of security to the public, meaning the security is not currently trading in the secondary market;
an unseasoned offering.
interest rate risk Risk that changes in interest rates will cause an asset’s price and realised yield to
differ from the purchase price and initially expected yield.
investment banks A bank that specialises in helping businesses and governments sell their new
security issues in the primary markets to finance capital expenditures, and makes secondary markets
for the securities as brokers and dealers.
liquidity The ability to convert an asset into cash quickly without loss of value.
liquidity risk Risk that a financial institution will be unable to generate sufficient cash inflow to meet
required cash outflows.
market informational efficiency Degree to which current market prices reflect relevant information
and, therefore, the true value of the security.
market operational efficiency Degree to which the transaction costs of bringing buyers and sellers
together are minimised.
marketability The ease with which a financial claim can be resold. The greater the marketability of a
financial security, the lower is its interest rate.
money markets Markets where short-term financial instruments are traded.
operational risk The risk of loss from the execution of a company’s business, in particular inadequate
or failed internal processes, people and systems, or from external events.
political risk Country or sovereign risk that can result in financial claims of foreigners being repudiated
or becoming unenforceable because of a change of government or in government policy in a country.
primary market A financial market in which new security issues are sold by companies directly to
initial investors.

private information Information that is not available to all investors.
private placements Sales of securities directly to an investor, such as an insurance company.
public information Information that is available to all investors.
public markets Financial markets where securities listed on an exchange are sold.
reputational risk Potential that negative publicity will cause a decline in the customer base, costly
litigation or revenue reduction.
secondary market A financial market in which the owners of outstanding (already existing) securities
sell them to other investors.
semistrong form (Of the efficient market hypothesis) theory that security prices reflect all public
information but not all private information.
stand-by underwriting An underwriting agreement in which the underwriter guarantees the full
amount of funds to be raised through a securities issue.
strong form (Of the efficient market hypothesis) theory that security prices reflect all available
information.
true (intrinsic) value For a security, value of the cash flows that an investor who owns that security
can expect to receive in the future.
weak form (Of the efficient market hypothesis) theory that security prices reflect all information in
past prices, but do not reflect all private or all public information.
QUESTIONS AND PROBLEMS

BASIC | MODER ATE | CHALLENGING
1.1 Financial system

What is the role of the financial system, and what are the two major components of the financial
system?
What does a competitive financial system imply about interest rates?
What is the difference between saver-lenders and borrower-spenders, and who are the major repre-
sentatives of each group?
List the two ways in which a transfer of funds takes place in an economy. What is the main differ-
ence between these two?
Suppose you own a security that you know can be easily sold in the secondary market, but the
security will sell at a lower price than you paid for it. What would this mean for the security’s
marketability and liquidity?
Why are direct financial markets also called wholesale markets?

Tinker Pty Ltd is a $300 million company, as measured by asset value, and Horst Pty Ltd is a
$35 million company. Both are privately held companies. Explain which company is more likely to
go public and list on the ASX, and why.
1.8 Primary markets
What is a primary market? What does IPO stand for?
1.9 Primary markets
Identify whether the following transactions are primary market or secondary market transactions.
(a) Jim Hendry bought 300 shares of AGL Energy through his share broker.
(b) Candy How bought $5000 of AGL Energy bonds from the company.

(c) Hathaway Insurance Company bought 500 000 shares of AGL Energy when the company issued
new shares.
1.10 Investment banking
What does it mean to ‘underwrite’ a new security issue? What compensation does an investment
banker get from underwriting a security issue?
1.11 Investment banking
Cranbourne Ltd is issuing 10 000 bonds, and its investment banker has guaranteed a price of
$985 per bond. The investment banker sells the entire issue to investors for $10 150 000.
(a) What is the underwriting spread for this issue?
(b) What is the percentage underwriting cost?
(c) How much did Cranbourne raise?
What are some of the ways in which a financial institution or intermediary can raise money?
How do financial institutions act as ‘intermediaries’ to provide services to small businesses?
Which financial institution is usually most important to businesses?
What is the main difference between money markets and capital markets?
1.16 Money markets
What are Australian government Treasury notes?
1.17 Money markets
Besides Treasury notes, what are other money market instruments?
1.18 Money markets
What is the primary role of money markets? How do money markets work?
1.19 Capital markets
How do capital market instruments differ from money market instruments?
What are the major differences between public and private markets?
1.21 Financial instruments
Explain the two risk-hedging instruments discussed in the chapter.
1.22 Market efficiency
Define operational efficiency.
What will happen to market prices if transaction costs are high?
What costs are associated with a markets operational efficiency?
Why is it important to the broader economy to have an efficient and effective financial system?
ENDNOTES
1. Reserve Bank of Australia (RBA) 2016, Tables F7, D4.
2. www.asx.com.au/services/trading-services.htm.
3. Source: www.investopedia.com/terms/f/financialplanner.asp.
4. Federal Reserve of Chicago n.d., www.chicagofed.org/banking_information/legal_reputational_risk.cfm, accessed 1
September 2009.
5. IPCC 2007, ‘Climate change 2007: The physical science basis’. Contribution of Working Group 1 to the Fourth Assessment
Report of the Intergovernmental Panel on Climate Change [Solomon, S, Qin, D & Manning, M (eds)].
6. www.worldbank.org/en/about/annual-report/wbg-summary-results.
7. International Monetary Fund n.d., ‘Articles of agreement of the International Monetary Fund’, Article I — Purposes.

8. www.adb.org.
9. Bank of International Settlements (BIS) 2016, Locational banking statistics for Australia, table A5, www.bis.org/statistics/
bankstats.htm?m=6%7C31%7C69.
ACKNOWLEDGEMENTS
Photo: © Bianda Ahmad Hisham / Shutterstock.com
Photo: © TK Kurikawa / Shutterstock.com
Photo: © Jean-Philippe Menard / Shutterstock.com
Photo: © hywards / Shutterstock.com
Extract: © International Monetary Fund, n.d., ‘Articles of agreement of the International Monetary
Fund’, Article I — Purposes.

The Financial System - Chapter 1

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CHAPTER 1

After studying this chapter, you should be able to:

2 Financial markets, institutions and money

The ﬁnancial system at work

CHAPTER 1 The financial system 3

How funds ﬂow through the ﬁnancial system

FIGURE 1.1 The flow of funds through the financial system

Wholesale markets for the creation

Institutions, such as commercial banks, that

4 Financial markets, institutions and money

A direct ﬁnancing transaction (without using the market)

CHAPTER 1 The financial system 5

Direct ﬁnancing (using the market)

Investment banks and direct ﬁnancing

6 Financial markets, institutions and money

1.2 Financial markets

CHAPTER 1 The financial system 7

Primary and secondary markets

8 Financial markets, institutions and money

Exchanges and over-the-counter markets

Money and capital markets

Money market instruments

CHAPTER 1 The financial system 9

Public and private markets

Futures and options markets

Foreign exchange markets

10 Financial markets, institutions and money

1. What is the difference between primary and secondary markets?

1.3 Financial institutions

Indirect market transactions

Issues debt or equity Sells policies

CHAPTER 1 The financial system 11

Financial institutions and their services

Life and general insurance companies

12 Financial markets, institutions and money

CHAPTER 1 The financial system 13

Risks faced by ﬁnancial institutions

14 Financial markets, institutions and money

CHAPTER 1 The financial system 15

Companies and the ﬁnancial system

16 Financial markets, institutions and money

Cash reinvested Cash

1. What is financial intermediation and why is it important?

1.4 International financial markets

CHAPTER 1 The financial system 17

Internationalisation of ﬁnancial markets

18 Financial markets, institutions and money

1.5 Capital market efficiency

CHAPTER 1 The financial system 19

Efﬁcient market hypotheses

20 Financial markets, institutions and money

1. How is information about a company’s prospects reflected in its share price?

CHAPTER 1 The financial system 21

22 Financial markets, institutions and money

CHAPTER 1 The financial system 23

QUESTIONS AND PROBLEMS

1.1 Financial system

Why are direct financial markets also called wholesale markets?

24 Financial markets, institutions and money

CHAPTER 1 The financial system 25

26 Financial markets, institutions and money

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