Lecture

1 - The Financial System

Monday, 31 July 2017 9:47 am

Finance is about how individuals, companies and governments raise money and
invest it to maximise wealth
It could incorporate
• Corporate finance
• Asset-pricing
• Financial markets (including banking and fund management)
• Behavioural finance

Economic Data
Type of data
- Type of data (employment, GDP (growth), inflation, industrial Production;
commodity prices; exchange rates; national debt)
- Data sources (e.g. RBA - interest rates, ABS - growth)
- Consistency in basis; frequency; efficacy

Money and Currency

• Money and currency can be used interchangeably
• Money is a store of value (something that maintains its intrinsic value)

Gold standard - currency backed by gold (We abandoned this system)

Fiat currency (Trust currency)

Price and value

We estimate asset values in the face of uncertainty by discounting cash flows
"Price is what you pay, value is what you get"

The Financial System provides a market place for money, enabling transfer of
purchasing power between;
• Market participants
• Present and future time
Households are the biggest lenders/savers

Direct financing - primarily achieved through wholesale markets (investment

banks) by selling shares, bonds and money market instruments. Large corporations
use the financial markets to sell securities directly to lenders

Wholesale markets (Minimum transaction of $1 million)

Main participants --> Financial institutions such as superannuation funds, mutual
funds, insurance companies
It is important that large creditworthy companies are best placed to access direct
financing

Indirect financing - Examples would include

• Commercial banks
○ The big 4
§ CBA, ANZ, NAB, WBC
• Insurance companies
○ Allianz, AAMI, NRMA
• Superannuation funds
○ State super, uni super, industry super funds
• Investment funds
○ Hedge funds (Pool capital of investors into asset portfolios of wide
ranging properties)
§ E.g black rock and quantum
• Finance companies
○ Esanda and capital finance fund businesses that commercial banks
deem too high of a credit risk
 ranging properties)
§ E.g black rock and quantum
• Finance companies
○ Esanda and capital finance fund businesses that commercial banks
deem too high of a credit risk

Part 2 of lecture - Determinants of Real interest rates

The real rate of interest
• Inflation adjusted rate. Rate after removing the effect of inflation. The
nominal rate of interest is the unadjusted version.
• The real rate of interest is the rate at which inflation in not taken into
account (general increase in the level of prices)

Determinants of interest rate levels

1. DEMAND : Return on investment - When company returns (Productive
assets) exceeds the weighted average cost of funding (debt and equity), value
is added to the company
2. SUPPLY : Time preference? Individuals often express a positive time
preference, hence they'd prefer consumption of goods now rather than later.
At low rates of interest offered on saving products (saving investments),
individuals are offered low incentives to delay consumption, ie. Saving.
With the fisher equation, it is clear to see that the real rate of interest in influenced
by fluctuations in inflation.
With the fisher equation, it is clear to see that the real rate of interest in influenced
by fluctuations in inflation.
Levels of inflation tend to increase during economic expansion, while decreasing
during economic contraction