You are on page 1of 13

FINS1612 A MODERN FINANCIAL SYSTEM: AN OVERVIEW

Introduction
Role of Money
o
o
o

Resolves divisibility problem


Medium of exchange: commodity widely accepted in a country
Store of value: saving surplus earnings, and deferring consumption into
future
Users of funds: borrowers/deficit units
Providers of funds: savers/surplus units

Financial transaction establishes claim to future flows creation of financial


asset on balance sheet of saver
Financial asset represented by financial instrument (how much borrowed,
when and how much is repaid by borrower)
Example: term deposit is a financial instrument
When saver acquires ownership claim on deficit entity
o Financial instrument is equity

Buyers of financial instruments are lenders that have excess funds today
o Invest and transfer purchasing power to future
Sellers of financial instruments are those deficit units short of funds
o Expect surplus amount in future to repay current borrowing

Functions of a Financial System


Financial system consists of financial institution, financial instruments and
financial markets, overseen by central bank and prudential supervisor

Facilitates flow of funds

Main Attributes of Asset:

Return or yield
Risk (measured by the variability of expected returns)
Liquidity (ease at which it can be sold)
Time-Pattern of Cash Flows

Types of Risk Adversity:

Risk averse: accept lower rate of return to reduce risk exposure


Risk takers: accept more risk only if compensated with expectation of
higher return

Major Functions of Financial System:


o
o

Facilitates portfolio structuring/restructuring


Encourages increased flow of savings (and allocates savings to most
efficient users of funds)
Both due to the range of financial instruments available
Improves productive capacity and economic growth
Provides financial and economic information to market participants
Needs to be timely and accurate
Rapidly absorbs and reflects new information into price of financial
instruments
Implementing monetary policy maintaining level of inflation within
specified level

Financial Institutions
1. Depository Financial Institutions

Large proportion of funds from deposits by savers


Provision of loans to borrowers in household and business sectors

Examples: commercial banks (dominate share of assets), building societies and


credit cooperatives
2. Investment banks and Merchant banks

Do not have a depositor base


Provision of advisory services to clients
Advising on mergers and acquisitions, portfolio restructuring and
financial risk management
Advises and assists clients in raising funds directly from capital markets

3. Contractual Savings Institutions

Liabilities are contracts - in return for periodic payments made to institution,


specified payouts made to holder on occurrence of specified events
Periodic cash receipts provide institutions with large pool of funds that are
then invested

Examples: life insurance offices, general insurers and superannuation funds


4. Finance companies and general financiers

Raises funds directly from money markets and capital markets


Issues debt financial instruments e.g. commercial paper, medium-term
notes and bonds
Funds used make loans- provides lease finance to household and business
sector

5. Unit Trusts

Formed under trust deed


Controlled and managed by trustee/responsible entity
As the public purchases units in trust, funds are obtained, pooled and
invested by fund managers in asset classes specified

Examples: equity trusts, property trusts, fixed-interest trusts and mortgage trusts
Financial Instruments
o
o

Legal document that defines contractual arrangement between user and


provider of funds
Acknowledges financial commitment entitlement to future cash flows
Financial asset for provider of funds

1. Equity
o
o

Ownership interest in an asset


Typically, ownership of shares issued by corporation
Ordinary share/common stock (primary)
No maturity date
o Continues for life of corporation
o Yet, can be sold to other investors at current market price
Ordinary shareholder is entitled share in profits of business
o Portion of profits received as dividends
Increase in shares results in capital gain
Failure of company results in residual value of assets
o Only after claims of all other creditors and security holders have
been paid
Owners have right to vote at general meetings e.g. elections of board
of directors

Hybrid security
o
o

Characteristics of both equity and debt


Example: preference share

Preference shares

Holders are entitled to receive a specified fixed dividend for


defined period
o Similar to fixed-interest payments of debt instruments

Dividend must be paid before any dividend is made to ordinary


shareholders
Rank ahead of ordinary shareholders in claim on assets of
corporation (if company placed in liquidation or is failing)

2. Debt
o
o
o
o

Contractual claim against issuer


Requires borrower to make specified payments e.g. periodic interest
payments and principal repayments
Loan must be repaid
Claim ahead of equity holders to income stream by borrower and assets
of borrower (if borrower defaults on loan repayments)

Examples: debentures, unsecured notes, term loans, commercial bills, promissory


notes, overdrafts and mortgage loans

Debentures and unsecured notes: longer-term in capital markets


Commercial bills and promissory notes: short-term in money
markets
Term loans, mortgage loans and overdrafts: provided by financial
institutions

Examples of government debt instruments: Treasury bonds and Treasury notes


Categories of debt:
1. Secured and Unsecured:

Secured debt

Specifies assets of borrower/third party as security or collateral


Lender is entitled to take possession of assets to recover amount
owing (if borrower defaults on loan)
Unsecured debt

Any others not made on secured basis

2. Negotiable and Non-Negotiable: (based on transferability of ownership of


instrument)

Negotiable debt instruments

Easily be sold and transferred from one owner to another

Example: commercial bills sold in money markets

Non-negotiable instruments:

Cannot be transferred from one party to another

Example: term loan


3. Derivatives
o

Contracts that manage exposure to identified risk for both equity and
debt
Related to both commodities (e.g. gold and oil) and financial
instruments (e.g. interest-rate sensitive debt currencies, equity)
Do not provide actual funds for issuer funds need to be raised in either
equity or debt markets

Types of Derivative Contracts:


1. Futures Contract:

Contract to buy/sell a specified amount of commodity or financial


instrument at price determined today for payment/delivery in
future
Standardised contracts traded through futures exchange
2. Forward Contract:

Similar to futures contract


More flexible
Negotiated over counter with commercial bank or investment bank

Examples:

Forward foreign exchange contract: establishes foreign currency


exchange rate applied at specified date
Forward rate agreement: secures interest rate today that will apply at
specified date

3. Option Contract:

Provides buyer the right to buy/sell (not obligation) asset at specified


date or within specified period at predetermined price
Premium is paid (as buyer is not obligated to proceed with contract)

4. Swap Contract:

Examples:

Arrangement to exchange specified future cash flows

Interest rate swap: exchange of future interest payments based on


notional principal amount
Currency swap: denominated in foreign currency and fixes exchange rate at
which initial and final principal amounts are swapped

Financial Markets
Matching Principle: short-term assets should be funded with short-term liabilities,
longer-term assets funded with equity and long-term liabilities
1. Primary Market Transaction

Businesses, governments and individuals issue financial instruments in


money markets and capital markets
Creates a new financial instrument

Example:
o
o
o

Corporation issues additional ordinary shares to raise equity funding


Government sells new long-term bonds
Individuals borrowing from bank to finance house purchase

2. Secondary Market Transaction

Transactions with existing financial instruments


Instruments traded were initially created in primary market transactions
No direct impact on amount of funding raised to initial issuer no extra funds
received
Transfer of ownership between parties

Example: If holder of shares sells the shares


Significance of Secondary Markets

Resolves savers preferences for liquidity and aversion to risk


Without active secondary market, purchasers of instruments would
hold these instruments until they mature
This is a greater problem with equity no maturity date
Provides deep and liquid markets where instruments can be sold or bought
Many buyers and sellers
Economic growth is reliant on this
Allows corporations and government to raise new funding
Increases capital and productive investment
Indirectly encourages both savings and investment
Enhances marketability and liquidity of primary-issue instruments
more attractive to savers

Market Terminology

1. Financial Asset: entitlement to future cash flows (both examples are


financial assets)

Financial Instrument: instruments with no organised secondary


market where that instrument can be traded

Example: bank term deposit

Security: financial asset that can be traded in an organised active


secondary market e.g. stock exchange or futures exchange

Example: ordinary share in publicly listed company


Types of Finances
1. Direct Finance
Contractual agreement between the provider of funds and user of funds
Funds are not provided by financial institution
Can involve agents or brokers

Does not provide the finance


Receives fee or commission for arranging transaction
No rights to benefits flowing from purchase of security

Example: investor arranges share purchase transaction through stockbroker (acts as


agent to transaction)
Available only to corporations and government authorities with good
credit rating (assessment of creditworthiness of issuer)
Borrowers without established good credit rating cannot borrow
direct
Examples of direct financing: share issues, corporate bonds and government
securities
Advantages:

Removes cost of financial intermediary


No profit margin to intermediary
Raise funds directly from markets at lower total cost
Allows borrower to diversify funding sources
Can access both domestic and international money and capital
markets
Reduces risk of exposure to single funding source of market

Greater flexibility in types of funding instruments to meet different


financing needs
Increase international profile of organisation through transactions in
international financial markets beneficial for firms goods and services

Disadvantages:

Problem matching preferences of borrowers and lenders


Fund amount and maturity structure
Liquidity and marketability of direct finance instrument
Not all financial instruments have active secondary market where
it can be sold
Search and transaction costs are high e.g. advisory fees, prospectus
preparation cost, legal fees, taxation advice, accounting advice, specific
expert advice
Difficult to assess level of risk of investment (especially default risk)

2. Intermediated Finance

Active role in relationship


Acquires ownership of financial instruments created
Obtains rights to benefits and risks associated with
ownership

Examples of Benefits: receipt of interest payments, repayment of principal)


Examples of Risks: default/credit risk - borrower may not make all repayments

Intermediary obtains funding from savers (who receive financial


instruments issued e.g. term deposit receipt) contractual agreement

Separate contractual agreement created for borrower (ultimate


user of funds)
Relies on borrower for repayment of loan
Saver has no claim on income or assets of ultimate borrower
entitlements reside with intermediary
Only claims are payment of interest and return of principal at
maturity
When intermediary fails to recover funds from borrower, it does
not alter contractual relationship with saver

Advantages:

Satisfy preferences of surplus and deficit units


Transforms short-term deposit funds into longer-term loan
funds

Encourages savings and productive capital investment


Provides range of financial attributes otherwise not available

Functions of Intermediaries:
1. Asset Transformation

Offers wide range of financial products


Receive small amounts from many savers, pool them into larger amounts and
make them available as loans to borrowers

Examples of Deposit Products: demand deposit accounts, current accounts, term


deposits, cash management trusts
Examples of Loan Products: overdraft facilities, term loans, mortgage loans, credit
card facilities
2. Maturity Transformation

Savers prefer liquidity, borrowers prefer longer-term commitment in funds


borrowed
Manage deposits to satisfy both preferences

Reasons of capability:
o
o
o

Unlikely savers will withdraw deposits at same time


Deposit withdrawals matched with new deposits
Liability management
If deposits (liabilities) decline under level necessary to fund loan
portfolio (assets)
Interest rates offered is adjusted to attract additional deposits
Securities (liabilities) issued directly into money or capital markets to
raise funds

3. Credit Risk Diversification and Transformation

Credit risk of saver is limited to risk of intermediary defaulting


Intermediary is exposed to credit risk of borrower separate contractual
agreements

Reasons of capability:
o
o

Specialise in making loans expertise in assessing borrowers risks


Information acquired from previous dealings with borrowers

4. Liquidity Transformation

Savers prefer more liquidity manages timing problem if expenditure


exceeds income
Measure of Liquidity Transformation:
o Ability to convert financial assets into cash (close to current
market price of financial instrument)
o Relates to transaction costs associated with acquiring and disposing
financial asset quite high
Capability to lower transaction fees spreads fixed costs over number of
transactions
Provides highly liquid assets to savers (unlikely provided by ultimate users
of funds)

Example: For demand account: (complete liquidity)


o
o
o

Depositor has right to withdraw funds without notice


Zero risk value of converted asset will be less than deposit value
Transaction costs limited to transaction fees

5. Economies of Scale
Capable due to size and volume of business transacted
o Resources to develop cost-efficient distribution systems
Cost advantages include:
o Effective knowledge management
o Accumulation of financial, economic, legal expertise
o Reduction in search costs for savers and borrowers
Example: standardised documentation used for deposit and lending products
Types of Markets
1. Wholesale Markets

Direct financial transactions between institutional investors and


borrowers

Examples of Institutional Investors: commercial banks, insurance offices,


superannuation funds

Wholesale investors are able to accumulate large quantities of surplus


funds and obtain higher returns than available in retail market
Wholesale borrowers can use good credit standing to access funds

2. Retail Markets

Transactions primarily of individuals and small to medium-sized


businesses conducted with financial intermediaries
Market participants are price takers
o Deposit and lending interest rates are set by financial intermediary

Participants can gain access to wholesale markets through investment


products
Examples: cash management accounts and unit trusts

3. Money Markets

Transactions involve wholesale short-term-to-maturity securities of less


than 12 months
Incorporates both primary and secondary markets
Attractive to institutional investors who have surplus of funds and shortterm shortage of funds
For investors with short-term finance:
o Markets are highly liquid
o Securities issued are standardised with well-developed secondary
markets
Manage their short-term financing needs

Example: store can invest surplus funds by purchasing short-term securities,


knowing it can be easily sold again in few days when cash needed

For borrowers, it resolves mismatch between cash expenditures and


cash receipts
o Can borrow at lower yield (by issuing short-term securities directly)
than from bank
No specific trading location

Types of Money Markets


1. Central Bank
Transactions maintain or change amount of liquidity available in financial
system
o Directly impacts interest rates
Implements monetary policy by targeting cash rate
2. Inter-Bank Market
Management of short-term liquidity needs of commercial banks
Lending of surplus exchange settlement account funds (settlement of
transactions)
3. Bills Market
Bills of exchange are short-term discount securities
Active secondary market in commercial bills (commercial bills market is
largest)
o Manages maturity preferences
Discount securities:

o
o
o

Does not pay interest


Sold to investors at price less than face value
Holders obtain return from difference between price paid and price
sold/face value if held to maturity

4. Commercial Paper Market


Issue and trading of promissory notes (commercial paper)
Promissory notes are discount securities
Issued typically on unsecured basis issued by corporations only with
good credit rating
5. Negotiable Certificates of Deposit Market
Short-term discount securities issued by banks
Source of liquidity funding for banks manage short-term maturity
structure
4. Capital Markets

Transactions involve medium- to long-term-to-maturity transactions


term of maturity greater than one year

Types of Capital Markets


1. Equity Market
Provider of equity finance obtains ownership interest in asset
Equity finances physical infrastructure, provides creditor confidence,
availability of funds to absorb abnormal losses, improve liquidity of
business
2. Corporate Debt Market
Examples: term loans, debentures, unsecured notes, subordinated debt, lease
arrangements, securitization (sale of existing assets e.g. mortgage loans to
generate new funds)
3. Government Debt Market
If short-term funding need, short-term securities are issued
If government increases market borrowing, this crowds out corporate
borrowers (reduces available funds)
Treasury notes: discount securities in money market with maturities up
to 6 months
o For short-term financing
Treasury bonds: fixed interest securities (up to 10 years maturity)
o Raises longer-term funds
4. Foreign Exchange Market

International capital markets have financial instruments denominated in


foreign currency
Facilitates buying and selling of foreign currencies necessary
Foreign exchange risk: risk exchange rate between currencies changes

5. Derivatives Market
Provides risk management products available to borrowers to manage
risks in capital market transactions
Risks include interest rate risk, foreign exchange risk and price risk
Business sector generally is deficit sector and household sector is a surplus
sector (net saver of funds)