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Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney

Slides prepared by Anthony Stanger1

Chapter 1

The Financial System



Learning Objectives

• Explain the functions of a financial system

• Describe the main classes of financial instruments issued in a financial system

• Distinguish between various types of financial markets according to function

• Discuss the flow of funds between savers and borrowers, including direct and intermediated finance



Learning Objectives (cont.)

• Appreciate the influence of globalization on financial markets

• Categorize the main types of financial institutions

• Understand the impact of a financial crisis on a financial system and a real economy



Chapter Organization1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalization1.6 Financial Institutions1.7 Summary



1.1 Introduction• Money

– Medium of exchange– Allows specialization 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

“Any commodity that is widely accepted in exchange transactions”



1.1 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



1.1 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



Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis

Slides prepared by Kaye Watson

1.1 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



1.1 Introduction (cont.)





Chapter Organisation1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary





1.2 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





1.2 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




• 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




• 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



1.3 Financial Instruments• Equity

– Ownership interest in an asset– Residual claim on earnings and assets

Dividend Liquidation

– Types Ordinary share Preference shares or Equity Hybrid (or quasi-

equity) security• Preference shares• Convertible notes





1.3 Financial Instruments (cont.)

• Debt– Contractual claim to

Periodic interest payments Repayment of principal

– Ranks ahead of equity– Can be secured or unsecured






• 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






• Four basic derivative contracts– Futures Contract– Forward Contract– Option Contract– Swap Contract



1.4 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






– 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





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





1.5 Impact of Globalisation• Globalisation of financial markets

– Refers to the interdependence of national financial systems

– Global standardisation of financial instruments

– Facilitates the movement of funds between savers and borrowers in different countries





1.6 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





1.6 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





Categories of financial institutions

Depository financial institutions• Attract savings from depositors and

investors to provide loan facilities to borrowers– Commercial banks – Building societies– Credit unions





Categories of financial institutions (cont.)Investment banks and merchant banks(money market corporations)

• Mainly provide off-balance-sheet (OBS) transactions to corporations and government– Advice on mergers and acquisitions,

portfolio restructuring, finance and risk management

• Provide some funding





Categories of financial institutions (cont.)Contractual savings institutions• The liabilities of these institutions are

contracts that specify, in return for periodic payments to the institution, the institution will make payments to the contract holders if a specified event occurs

• Funds are then used to purchase both primary and secondary market securities– Life and general insurance companies– Superannuation funds





Categories of financial institutions (cont.)Finance companies

• Funds are raised by issuing financial securities direct into money markets and capital markets

• Funds are used to make loans to ultimate borrowers





Categories of financial institutions (cont)Unit trusts• Investors purchase units in the trust• Trust manager invests funds in a range

of investments specified by trust deed• Types of unit trusts

– Cash management trusts– Equity trusts– Property trusts– Mortgage trusts





1.6 Financial Institutions (cont.)

• Assets of financial institutions





1.7 Summary• The financial system is composed of

financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions

• Financial instruments may be equity, debt or hybrid





1.7 Summary (cont.)• Financial markets may be classified

according to– Primary and secondary transactions– Direct and intermediated flows– Wholesale and retail markets– Money markets and capital markets– Financial institutions

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