The Financial System

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					The Financial System
         Introduction

   Money
    –   Medium of exchange
    –   Allows specialisation in production
    –   Solves the divisibility problem, i.e. where medium
        of exchange does not represent equal value for
        the parties to the transaction
    –   Facilitates saving
    –   Store of wealth
Introduction (cont.)

   Role of markets
    –   Facilitate exchange by
            Bringing opposite parties together
            Establishing rates of exchange, i.e. prices
   Surplus units
    –   Savers of funds available for lending
   Deficit units
    –   Borrowers of funds for capital investment and
        consumption
Introduction (cont.)

   Financial instrument
    –   Issued by a party raising funds, acknowledging a
        financial commitment and entitling holder to
        specified future cash flows
   Flow of funds
    –   Movement of funds through the financial system
        between savers and borrowers giving rise to
        financial instruments
Introduction (cont.)

   Financial system
    –   Financial institutions, instruments and markets
        facilitating transactions for goods and services
        and financial transactions
    –   Overcomes difficulty of
            Double coincidence of wants
              –   Transaction between two parties meets their mutual
                  needs
Introduction (cont.)
         Functions of the
         Financial System

   Attributes of financial assets
    –   Return or yield
            Total financial compensation received from an
             investment expressed as a percentage of the amount
             invested
    –   Risk
            Probability that actual return on an investment will vary
             from the expected return
         Functions of the
         Financial System (cont.)

   Liquidity
    –   Ability to sell an asset within reasonable time at
        current market prices and for reasonable
        transaction costs


   Time-pattern of the cash flows
    –   When the expected cash flows from a financial
        asset are to be received by the investor or lender
         Functions of the
         Financial System (cont.)

   The financial system facilitates portfolio
    restructuring
    –   The combination of assets and liabilities
        comprising the desired attributes of return, risk,
        liquidity and timing of cash flows
         Functions of the
         Financial System (cont.)

   An efficient financial system
    –   Encourages savings
    –   Savings flow to the most efficient users
    –   Implements the monetary policy of governments
        by influencing interest rates
    –   The combination of assets and liabilities
        comprising the desired attributes of return, risk,
        liquidity and timing of cash flows
Financial Instruments

   Equity
    –   Ownership interest in an asset
    –   Residual claim on earnings and assets
            Dividend
            Liquidation
    –   Types
            Ordinary share
            Hybrid (or quasi-equity) security
               –   Preference shares
               –   Convertible notes
         Financial Instruments
         (cont.)

   Debt
    –   Contractual claim to
            Periodic interest payments
            Repayment of principal
    –   Ranks ahead of equity
    –   Can be secured or unsecured
         Financial Instruments
         (cont.)

   Derivatives
    –   A synthetic security providing specific future rights
        that derives its price from a
            Physical market commodity
               –   Gold and oil
            Financial security
               –   Interest rate-sensitive debt instruments, currencies and
                   equities
    –   Used mainly to manage price risk exposure, and
        to speculate
Financial Markets

   Matching principle
   Primary and secondary market transactions
   Direct and intermediated financial flow
    markets
   Wholesale and retail markets
   Money markets
   Capital markets
Matching principle

   Short-term assets should be funded with
    short-term liabilities
    –   Inventory funded by overdraft


   Longer-term assets should be funded with
    equity or longer-term liabilities
    –   Equipment funded by debentures
Primary and secondary market
transactions

   Primary market transaction
    –   The issue of a new financial instrument to raise
        funds to purchase goods, services or assets by
            Businesses
               –   Company shares or debentures
            Governments
               –   Treasury notes or bonds
            Individuals
               –   Mortgage
Primary and secondary market
transactions (cont.)

   Secondary market transaction
    –   The buying and selling of existing financial
        instruments
            No direct impact on original issuer of security
            Transfer of ownership from one saver to another saver
            Provides liquidity which facilitates restructuring of
             portfolios of security owners
Direct and intermediated financial
flow markets

   Direct flow markets
    –   Users of funds obtain finance directly from savers
            Advantages
              –   Avoids costs of intermediation
              –   Increases range of securities and markets
            Disadvantages
              –   Matching of preferences
              –   Liquidity and marketability of a security
              –   Search and transaction costs
              –   Assessment of risk, especially default risk
Direct and intermediated
financial flow markets (cont.)
Direct and intermediated financial
flow markets (cont.)

   Intermediated flow markets
    –   A financing arrangement involving two separate
        contractual agreements whereby saver provides
        funds to intermediary, and the intermediary
        provides funding to the ultimate user of funds

    –   Advantages
            Asset transformation
            Maturity transformation
Direct and intermediated financial
flow markets (cont.)

    –   Advantages (cont.)
            Credit risk diversification and transformation
            Liquidity transformation
            Economies of scale


   Sectorial flow of funds
    –   The flow of funds between business, financial
        institutions, government and household sectors
        and the rest of the world
    –   Influenced by fiscal and monetary policy
Direct and intermediated
financial flow markets (cont.)
Wholesale and retail markets

   Wholesale markets
    –   Direct financial flow transactions between
        institutional investors and borrowers
            Involves large transactions


   Retail markets
    –   Transactions conducted primarily with financial
        intermediaries by the household and small-
        medium business sectors
            Involves smaller transactions
Money markets

   Wholesale markets in which short-term
    securities are issued and traded
    –   Securities highly liquid
            Term to maturity of one year or less
            Highly standardised form
            Deep secondary market
    –   No specific infrastructure or trading place
    –   Enable participants to manage liquidity
Money markets (cont.)

   Money market securities
    –   Cash deposits (11 a.m. and 24-hour call)
    –   Commercial bills
    –   Treasury notes
    –   Government bonds
    –   Promissory notes
    –   Intercompany loans
    –   Interbank loans
Money markets (cont.)

   Money market participants
    –   Reserve Bank
            Financial system liquidity
            Implementation of monetary policy
    –   Banks
    –   Finance companies
    –   Funds managers
    –   Building societies
    –   Credit unions
    –   Companies
Money markets (cont.)

   Money market sub-markets
    –   Intercompany market
    –   Interbank market
    –   Bills market
    –   Commercial paper market
    –   Negotiable certificates of deposit (CDs) market
Capital markets

   Markets in which longer-term securities are
    issued and traded
    –   Equity markets
    –   Corporate debt markets
    –   Government debt markets
    –   Foreign exchange markets
    –   Derivatives markets
   Term to maturity of more than one year
Financial Institutions

   Financial institutions permit the flow of funds
    between borrowers and lenders by facilitating
    financial transactions

   Institutions may be categorised by
    differences in the sources and uses of funds
         Financial Institutions
         (cont.)

   Categories of financial institutions
    –   Depository financial institutions
    –   Investment banks and merchant banks (money
        market corporations)
    –   Contractual savings institutions
    –   Finance companies
    –   Unit trusts

				
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posted:11/27/2010
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