the financial system. introduction money medium of exchange allows specialisation in production ...
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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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