financial markets - 2500 words

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Introduction to Financial Markets

FINANCIAL MARKETS

Topic 1

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Overview

financial system Components

Nature and classification of financial markets

Direct and indirect finance

Relationship between financial markets and the real economy

The government and financial markets

Types of Financial Institution

What is the financial system?

1. Financial system comprises a range of financial institutions, instruments, markets that facilitate transactions for goods and services and financial transactions

2. The key elements of the Australian financial system are

Financial instruments

Financial markets

Financial institutions

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Functions of the financial system

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

To facilitate the trade of existing financial assets

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Components of the financial system

Surplus economic units

Deficit economic units

Financial institutions

Financial assets

Financial markets

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Components of the financial system

Surplus economic units

Individuals, households and companies with more funds than required for immediate expenditure

 Savers

 Potential lenders

Deficit economic units

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

 Potential borrowers

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Financial Institutions

Organisations whose core business involves:

Borrowing and lending (financial intermediation)

Provision of financial services

Financial assets/financial instruments

Are issued by a deficit economic unit

Acknowledge a financial commitment and entitle the holder to specified future cash flows

Components of the financial system

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Putting it all together…...

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THE FINANCIAL SYSTEM: The financial markets and flow of funds

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Overview

financial system Components

Nature and classification of financial markets

Direct and indirect finance

Relationship between financial markets and the real economy

The government and financial markets

Types of Financial Institution

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Types of financial assets

Debt

Equity

Hybrid

Derivatives

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Types of financial assets

Debt financial assets

Represent an obligation on the part of the borrower to repay principal and interest.

Deposits and loans

Contractual savings

Discount securities

Fixed interest securities

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Types of financial assets

Equity financial assets

Represent an ownership claim over the profits and assets of a business.

Ordinary shares

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Types of financial assets

Hybrid financial assets

Financial assets which have features of both debt and equity.

Preference shares

Convertible notes (bonds)

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Types of financial assets

Derivatives

Financial assets whose value is derived from another financial asset, rate or index.

Forward contracts

Futures

Options

Swaps

When considering investment options...

Attributes of Financial assets

Return vs Risks

Liquidity

Time pattern of the cash flows

Portfolio structuring

Attributes of financial assets

Return vs Risk

Return = The gain or loss of an investment over a specified period, expressed as a percentage increase over the initial investment cost **

** Gains/losses on investments = periodic income received from the security + realized capital gains / losses

Risk = The chance that an investment's actual return will be different than expected.

There is always a trade off between risk and return.

Attributes of financial assets

Liquidity

The degree to which an asset or security can be bought or sold in the market without affecting the asset's price.

 The ability to convert an asset to cash quickly. (also known as "marketability”)

 Particularly critical with a high level of trading activity.

It is safer to invest in liquid assets than illiquid ones because it is easier for you to get your money out of the investment.

Attributes of financial assets

Time pattern of the cash flows

When the specified or expected cash flows related to a financial asset are to be received by an investor.

 When, how much, how often

Attributes of financial assets

Portfolio structuring:

A combination of assets and liabilities to maximize the returns from a set of investment for a given level of risk.

 A good portfolio is not simply a collection of individually good investments.

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By the nature of the assets

Primary markets

Markets in which financial assets are first created

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

Secondary Markets

Markets in which existing financial assets are traded – Financial Securities

Deficit economic units do not directly participate in secondary market transactions

Classification of financial markets

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By the term of the assets

Money markets

Funds are lent for periods of less than 12 months

Capital Markets

Funds are lent for periods of 12 months or more

Classification of financial markets

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Overview

financial system Components

Nature and classification of financial markets

Direct and indirect finance

Relationship between financial markets and the real economy

The government and financial markets

Types of Financial Institution

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How to borrow or invest?

Two alternative methods of finance

Direct finance

Indirect finance

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Direct finance

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

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

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

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Indirect finance

Also known as intermediated finance

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

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

Financial institutions earn income by way of net interest margin

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Advantages of financial intermediation

Asset value transformation

Maturity transformation

Credit risk reduction and diversification

Liquidity provision

These are very useful for households

Increased quantity of national savings

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Disadvantages of financial intermediation

Increased cost of funds for borrowers

Reduced return from lending for savers

Why?

 Institutions take a net interest margin

e.g. Bank Borrows at 5.5% Term deposit/Lends at 8.5% loan >> Profit margin 3%

It is less likely for secondary financial assets to be securitised (i.e. Financial securities)

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Overview

financial system Components

Nature and classification of financial markets

Direct and indirect finance

Relationship between financial markets and the real economy

The government and financial markets

Types of Financial Institution

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Main types of financial institutions

Deposit Taking Financial Institutions: attract the savings of depositors through on-demand deposit and term deposit accounts.

e.g. commercial banks, building societies and credit cooperatives.

Non Deposit Taking Financial Institutions: may manage funds under contractual arrangements and provide a wide range of financial services.

e.g. Investment banks, general insurance companies and superannuation funds.

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Main types of financial institutions

Commercial banks

Building societies and credit cooperatives

Investment banks and Merchant Banks

Managed funds

Life insurance offices and general insurance offices

Finance companies and general financiers

Institution features

Total Assets (Percentage Share) of Financial Institutions

Main Types of Financial Institutions as at June 2017
Type of institution	Main supervisor/ regulator	Number of institutions	Total assets ($b)	Percentage share
Banks	APRA	83	4,187.30	59.01%
Building societies	APRA	4	13	0.18%
Credit unions	APRA	54	37.6	0.53%
Non-ADI Financial Institutions				0.00%
Money market corporations (broker-dealers)	ASIC	9[4]	31.3	0.44%
Finance companies	ASIC	112[4]	140.6	1.98%
Securitisers		–	125.3	1.77%
Insurers and Funds Managers				0.00%
Life insurance companies	APRA	29	173	2.44%
General insurance companies	APRA	104	170.4	2.40%
Health insurance companies	APRA	37	13.8	0.19%
Superannuation and approved deposit funds	APRA	2,338	1,865.10	26.28%
Public unit trusts	ASIC	–	290.2	4.09%
Cash management trusts	ASIC	–	34	0.48%
Common funds	State and territory authorities	–	9.3	0.13%
Friendly societies	APRA	12	5.5	0.08%
Source: http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn3

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Main types of financial institutions

Commercial banks

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

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

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

Main types of financial institutions

Managed Funds

Attract the savings from individual investors and invest in both money and capital market.

Funds normally managed by professional investment managers with extensive investment knowledge and skills.

Managers seek to maximise the return on investment portfolios at given level of risk.

Provide access to wholesale markets (not an intermediary).

Investors in the fund obtain a right to the assets of the fund or the income derived from those assets.

George Soros and the Quantum Fund

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Main types of financial institutions

Managed Funds (cont’d)

The main types of managed funds are

cash management trusts, public unit trusts, superannuation funds (also a contractual institution), statutory funds of life offices, common funds and friendly societies.

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

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

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Main types of financial institutions

Life and general insurance

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

life and general insurance companies

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

Payouts are made for insurance claims and to retirees

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Main types of financial institutions

Building societies and credit unions

Authorised deposit-taking institutions that primarily give loans for housing finance.

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

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

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Main types of financial institutions

Investment banks and merchant banks (MM Corp)

Mainly provide off-balance-sheet (OBS) advisory services to support corporate and government clients, e.g.:

advice on mergers and acquisitions, portfolio restructuring, finance and risk management

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

They also execute FX transactions

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Main types of financial institutions

Finance companies

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

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

Main types of financial institutions

Finance companies

Finance companies with bank background

AGC---Westpac

Esanda---ANZ

CBFC---CBA

Finance companies with corporation background

GE Money--- General Electric Company

Ford Credit --- Ford Motor

Overview

financial system Components

Nature and classification of financial markets

Direct and indirect finance

Relationship between financial markets and the real economy

The government and financial markets

Types of Financial Institution

Economic markets

Resource markets

Output markets

(goods & services)

Financial markets

Circular Flow

Transmission of economic policies

How does the financial system impact on macroeconomic economic objectives?

Economic growth

Full employment

Price stability

External balance

Efficient allocation of resources

Equitable distribution of income and wealth

Impact of the financial system

Economic growth

to raise sufficient funds to finance necessary infrastructure projects for sustained economic development, a well-developed financial system is necessary.

Impact of the financial system

Full employment

Level of employment is directly related to aggregate demand and economic growth.

Cost and availability of funds is a strong determinant of aggregate demand, and therefore level of employment.

Impact of the financial system

Price stability

Rate of inflation is significantly determined by aggregate demand

Hence, cost and availability of funds (which is a strong determinant of aggregate demand) will also impact on inflation.

Impact of the financial system

External Balance

reflected in a country’s balance of payment (BOP) and exchange rate (ER) value of its currency

External balance: refers to the situation when the current account is neither to positive nor too negative.

A large current account deficit can make foreigners think that an economy can not repay its debts and therefore make them stop lending, causing a financial crisis.

A large current account surplus can cause protectionist or other political pressure by foreign governments (e.g., pressure on Japan in the 1980s and China in the 2000s).

Impact of the financial system

External Balance (cont’d)

BOP & ER are affected by the financial sys:

 conditions in financial markets (domestic and global) affect cost and availability of funds

 availability of funds affects imports and exports AND capital inflows and outflows

 international transactions determine Ss and Dd of a currency, the value of the currency will be affected

In Singapore, the monetary policy is directed at stabilizing the exchange rate.

Impact of the financial system

Efficient allocation of resources

Non-market factors affect market competition

Efficient allocation requires that financial markets direct funds to the highest yielding form of expenditure

Efficient allocation of resources is best achieved by competitive markets and least amount of government intervention

Impact of the financial system

Equitable distribution of income and wealth

Non-market factors (such as government intervention) that affect cost and flow of funds will cause inequitable distribution of wealth

For example, ceilings on particular interest rates means some will benefit and others disadvantaged.

Government policy

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

Regulation (pre-1980s)

Deregulation (1980s)

Post-deregulation (1990s onward)

Reasons for government intervention

Macroeconomic objectives:

growth, full employment, price stability, external balance

Efficient, fair and competitive financial system

Promotion of financial safety

Methods of government intervention

Fiscal policy (budget and taxes)

Monetary policy (RBA)

External policy (tariff and cap on fund flows)

Wages policy (superannuation)

Direct legislation (corporation law)

Competition policy (avoid oligo/monopolies)

Consumer protection (ombudsman, ACCC)

Overview

financial system Components

Nature and classification of financial markets

Direct and indirect finance

Relationship between financial markets and the real economy

The government and financial markets

Types of Financial Institution