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Chapter 10 Financial Markets in Australia

Financial markets perform the essential economic function of channelling fund from those economics units with a surplus of funds to lend, to those economic units who have a shortage of funds and wish to borrow.

Types and role of financial markets

Direct and indirect finance The flow of funds in the economy can follow either a direct finance approach, or an indirect finance approach, through financial institutions which act as financial intermediaries. The rationale for financial intermediaries is given by the presence of substantial information and transaction costs in the economy. For lenders, the process of identifying the credit risk attributes of potential borrowers is costly, which is best served by financial institution that processes the necessary expertise.

Primary, secondary and derivatives markets Primary market Where financial securities such as debt, shares, bonds and options are issued for the first time for capital raising purposes. The primary market allows companies and governments to issue bonds or debentures in the fixed interest market, and shares and options in the equities market. An example of this is the ASX Australian securities Exchange. Secondary market It involves transactions with financial assets that have already been insured on a primary market sometime in the past. Companies whose securities are traded on this market do not receive any money from these transactions.

The Superannuation Industry Superannuation is the compulsory payment by employers of 9% of the gross income of employees into a nominated superannuation fund to build retirement savings for employees. The Australian Prudential Regulation Authority (APRA) regulates most superannuation funds and total superannuation assets. Domestic and Global financial markets Australians financial markets and financial system are linked with global financial markets through the offshore borrowing of all financial intermediaries (AFIs) which amounted $344.8b in October 2010 Australian banks, RFCs and large public companies issue debt and bond instruments in international credit markets to raise additional funds for lending and also have strong linkage with international investor including hedge funds in equity and foreign exchange markets.

The role and function of the share market

The Australian Securities Exchange Limited (ASX) is a company with oversees the operation of the share market. 1. It provides a link between listed public companies needing equity funds or equity capital to expand their operation, and people with funds to invest who are seeking capital gains and dividend cost. 2. It provides markets place for the trading shares and other listed securities at the current market price determined by the forces of demand and supply in the market. The operation of ITS ITS is a computerised trading system based on a modern Windows product, that allows brokers to view prices and the volumes of equities and other securities traded. Members of the public do not have direct access to ITS, but can place an order on ITS by telephoning their broker or placing an order on line. Supervision of the share market ASX markets supervision oversees compliance with the ASXs operating Rules such as Listing Rules, Market Rules, Clearing Rules and settlement rules by: Co operating with other regulatory bodies such as ASIC (Australian securities investment commission) and the ACCC (Australian consumer competition corporation)

The CHESS and DCS systems for Settlement The system used for settling equities is known as the Clearing House Electronic Sub-Register System (CHESS) and is operated by a subsidiary of the ASX on behalf of listed public companies. The impact of the ASX on the economy Bull markets When the stock market is doing well Bear markets When the stock market is doing badly Regulation of the Australian Financial system The reserve bank of Australia, Australias central bank, has responsibility for the conduct of monetary policy and the maintenance of financial system stability, including stability of the payment system. The RBA remains the only agency which is able to provide emergency liquidity support to intermediaries in the event of any threats to the stability of the financial system. The payments system board has the tasks of controlling risk, and promoting efficiency and competition in the payments system. A single prudential supervisor known as the Australian Prudential Regulation Authority (APRA) was established in 1998 to take over responsibility form the RBA for the supervision

of all deposit taking institutions (DTIs) such as banks and non bank financial intermediaries (NBFIs) including life and general insurance companies and superannuation funds.

The structure of the Australian Financial System

The Australia Securities and Investment Commission (ASIC) has responsibility for market integrity, consumer protection and dispute resolution across the entire financial system including investment, futures, insurance and superannuation products. The Australian Treasury has responsibility for advising the Australian government on financial stability issues and for the legislation and regulatory framework that underpins the financial system.

Financial System stability Creating an environment of low and stable inflation conducive to sustainable economic growth. This is done through the conduct of the monetary policy and meeting the inflation target of 2% to 3% over the economic cycle. Monitoring the health of the financial system through assessment of financial and economic data such as credit growth, inflation and asset prices Ensuring that the payments system is safe and robust through the regulatory powers of the Payment System Board of the RBA

The RBA can use (in extreme cases) its own balance sheet to provide emergency liquidity support to a financial institution whose lack of liquidity may threaten financial system stability. Participating in the Financial Stability Board of the Bank for international Settlements (BIS) to develop new procedures for preventing global financial instability.

Individual debt Instruments The main forms of borrowing by individuals in the debt market include mortgage loans for housing, personal loans, loan for home additions and renovations, overdraft and credit cards.

Business Debt Instruments Overdraft loan Small and large business loans are usually secured by a businesss assets or the owners personal assets. Small businesses usually secured by mortgage on real assets Debentures and notes are major debt instruments of larger companies which are issued in financial markets, guaranteeing a fixed rate of interest. Debentures are secured by a companys assets, but notes are unsecured and riskier, therefore earns a higher interest rate Commercial bills and promissory notes are short-term financial instruments which are issued by companies to raise finance. Commercial bills are usually bought by banks at a discounted price, enabling the borrower to receive the funds sought, but the bank makes a profit when the bill matures and the funds have to be repaid. Promissory notes are issued by the borrower directly in the market but are not underwritten by banks. Interest rate on promissory notes are higher because of a higher risk. (Not written by banks). Leasing loans are another form of debt finance where a business will enter into a lease agreement in purchasing a new item of capital or transport equipment. Bill of exchange is where one party called the drawer (borrower), draws a bill on another party called the drawee (the lender). Certificates of deposit are debt instruments sold by banks to depositors. (Depositors agree to lend money to bank for a certain period of time, in return, bank gives them a predetermined interest rate, and if the money is withdrawn before it matures, customer is charged a penalty) Corporate bonds: Corporate bond issues trade at a discount similar to semi government securities, reflecting their lower credit backing, and the less liquid market in which they are traded. Convertible bonds: These are hybrid securities which are issued as debt, but contain an option that allows them to be converted to equity (i.e. shares) at some stage in the future. (Just means securities which can be changed into shares)

Government Debt Instruments Treasury notes and bonds are short-term discount securities with maturities of 5 weeks, 13 weeks and 26 weeks. They are the main short-term debt instruments of Commonwealth government and are used for liquidity management by RBA in the cash market. Commonwealth government and semi government bonds (3,4,and 10 years maturity): Commonwealth dominate the Australian fixed interest market. Commonwealth bonds 45% Semi gov 43% Coporate bonds 12% Commonwealth and state government bonds Commonwealth government bonds are the benchmark for yields in the bond market, given their superior credit standing relative to state government and privately issued bonds. Semi government bonds are issued in substantial amounts in additional to commonwealth government bonds.

Borrowers in the equity market

Futures and Derivative Products Futures Contracts A futures contract is an agreement to buy or sell a certain commodity or interest rate at same data in the future, for a predetermined price. Options an option is the right, but not obligation to buy or sell a commodity, share or debt security at some future data (expiration date) at a particular price (strike price) Interest Rate Swaps An interest rate swap allows one party to exchange a stream of floating rate payments for fixed rate payments or vice versa.

Factors affecting the demand and supply of funds Demand for fund
The transitionary motive for demanding funds, was a result of individuals desire to by goods and services. The precautionary motive for demanding funds, comes from desire of individuals to have funds set aside for unforeseen events such as accidents. The speculative motive for holding money balance is for individuals to take advantage of investment opportunities which might lead to real return

The demand for duns is influenced by many factors such as the rate of economic growth, changes in real incomes, investment expectations, asset prices and the rate of interest. The supply of funds depends on factors such as the household saving ratio, (i.e. savings as a proportion of household disposable income), the growth of the money supply, corporate profitability, government fiscal balances, and access to funds in world financial markets. Financial innovations

The Australian financial system was deregulated in 1983, with RBA controls over bank lending and interest rates abolished; the exchange rate floated; and 16 foreign banks were granted licences to compete in the domestic financial market. The major recent financial innovation has been the global spread of electronic banking and commerce due to improvement in information and telecommunications technology.

Lenders in the Australian financial system

In2011, banks accounted for 58.9% of the total Australian financial systems assets, with the NBFIs (building societies, credit unions and finance companies) share at 6.4%, and funds managers and insurers accounted for a 34.7% share.