Lecture Notes Lectures 1 6 Financial Institutions and Markets 7th Edition

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Lecture notes, lectures 1 - 6 - financial institutions and

markets 7th edition
Finance 1 (University of Melbourne)
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Finance 1: Notes
By Himal Pillay
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CONTENTS
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Part I – The Financial System

Note: This course is concerned with the overall study of the financial system.
Objectives:
 Main functions performed by the
financial system
 Describe and evaluate debt and
equity finance
 Describe the structure of
Australia’s financial institutions
and markets and their regulations
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1.1 Functions of the financial system:

- Settle commercial transactions (domestic + international)
o Facilitates the conduct of commercial transactions through settlement
- hrrange flow of funds (financing)

o The supply of funds for a period usually on the basis the users compensate
the suppliers for use of their funds
- Transfer and manage risk

o Provide instruments for managing risk
- Overcoming information asymmetry

o Generate info to assist decision making
- Deal with incentive problems in contracting

o Monitor bad behavior
 Moral Hazard: h situation where a contracting partner has an
incentive not to behave responsibly
- Pooling of funds (Requires supervision)

o hn arrangement that consolidates small amounts of funds to satisfy the
demand for large amounts
1.2 Introduction to the financial system
1.2.1 Fundamental Principles:

1. Returns are positively related with risk
a. Reflected in the risk/return function
b. Generally expected return on equity will be greater for riskier returns
2. Time Value of Money
a. The idea that money in the present is worth more in the future because of it’s
potential earning capacity
i. $10 today can be worth $10+ in the future through some sort of
investment
3. Rule of One Price
a. The principle that a financial instrument should have one price where it can
be traded in different markets
b. Simplified: The price of a given security, commodity or asset will have the
same price when exchange rates are taken into consideration
i. The law exists due to arbitrage opportunities. If the price of a financial
instrument is different in two markets, then an arbitrageur will
purchase the asset in the cheaper market and sell it for a higher price.
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1.2.2 Participants in the financial system:

Surplus units: These people supply funds. E.g. lenders, investors, shareholders
Deficit units: The uses of these funds. They use someone else’s money. E.g. Burrowers,
credit card users, companies/issuers.
Figure 1.2.3
Both people and companies/corporations can be surplus and deficit units simultaneously.
Figure 1.2.4
Intermediaries:
Intermediation is the flow of funds through institutions which are performed by hDIs (e.g.
banks) Intermediaries connect surplus and deficit units through contracts.
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1.2.5 Basic Forms of finance

1. Debt
a. Borrowed funds that have not yet been paid back
2. Equity
a. The funds that owners have invested in their business or their assets
Debt funds are usually provided on the basis of loan contracts (or other securities) that set
out the timing of the repayment by deficit units, the security being provided (if any) by
deficit units and the amount of interest to be paid.
Equity funds are provided on the basis that surplus units share in the earnings of the
business that are usually paid as dividends on a six-monthly basis. The risks are greater for
equity since payments to debt holders have priority over payments to equity holders, both
while the business is solvent and when assets are distributed in the event of bankruptcy.
Hence a business can expect to pay a lower interest rate for debt than the rate of return
expected by suppliers of equity.
1.2.6 Risk
1. Credit risk
Possibility that borrower will not meet scheduled payments  default on loan
obligations.
2. Market risk
Possibility of unexpected movement in the market – interest rates, E/X rates
3. Operational risk
Failure of process or controls
4. Shocks
5. hvoidance (opportunity cost return foregone by passing up best choice)
6. hcceptance management
h lender can reduce credit risk by reuiring a mortgage over property (-ve gearing)
7. Transfer – Insurance
Payout to cover loss
8. Default risk – borrowers do not make loan repayments as agreed
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Risk and Return
‘Deficit units pay a return to compensate surplus units for:’
- Deferring their use of funds; and
- The risk they face

o Risk/return function (below)
Figure 1.2.7
1.2.8 Financial Contracts
Security
a. Financial contract that can be traded in a financial market
a. Commodity – gold
b. Hard asset – property
c. Financial asset – shares
Transaction
a. hrrangement between a buyer and a seller to exchange an asset for payment
Settlement of transactions
Settlement is reached when value (=purchasing power) and title transfer

Transaction and settlement can be different e.g. payment by check
1.2.9 Markets
� Primary Market
o Issues new securities
� Secondary Market
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o Facilitates subsequent trading of existing securities

Note: Investors are more likely to buy new securities if they can be subsequently sold in
liquid (active) secondary markets.
1.2.9.1 Problems in Markets
1. hgency problems
a. hrise when an agent (acting on behalf of principal) acts in her own interests
rather than those of the principal(s).
2. Moral Hazard
a. hrises when a contract changes incentives so one party may not act
responsibly
i. E.g. insurance, bank loan approvals
3. Information asymmetry
a. Parties do not have equal access to information
i. E.g. Borrower knows more about capacity to repay and intended use
of the burrowed funds than the lender
ii. Can result in adverse selection when one party contracts on the wrong
basis
b. To reduce risk:
i. hpply credit standards
ii. Provide investors with relevant information
iii. Rely on Market forces
1.3 Australia’s Financial System

hPRh (hustralian hSIC (hustralian hDI (huthorized RBh (The Reserve Bank
Prudential Regulation Securities and Deposit taking of hustralia)
huthority) Investment institutions)
Commissions)
Main function is Main responsibility is hDIs are the The RBh’s main
prudential (Showing to enforce company main arrangers responsibilities are to
forethought) and financial services if indirect implement monetary
supervision. law to protect financing policy, oversee the
consumers of through a stability of the
financial services, process known financial system,
investors and as regulate the payments
creditors. intermediation. system, issue notes
and act as the
Banks, credit Commonwealth
unions and Government’s banker.
building
societies that
are authorized
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by the hPRh.
Part II: Financial Mathematics

Objectives:
 Explain how simple interest is
calculated and used in security
markets
 Calculate sesurity prises and
investment yields with simple
interest
 Explain how sompound interest
is calculated and used in security
markets
 Calculate sesurity prises and
investment yields with
compound interest
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2.1 Time Value of Money
- Present Value (P)

o the starting amount invested
o or burrowed
o or value today of future payments
- Future Value (F)

o The terminal value of a loan or investment (such as the face value of a
security, or the accumulated value or series of payments)
F=P+ I
2.2 Simple Interest
F=P(1+ r × ( d
di )
)
Where:
- F security’s face (or future) value
- P principle amount (starting amount)
- r interest rate expressed as a simple interest yield (p.a.)
- d number of days to maturity
- diy days in year
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Key Ideas:
- Increases linearly
2.2.3 Simple Interest example
$1000 invested at 6% pa for 2 months (60 days)
( (
F=1000 1+ 0.06 ×
60
365 )) ¿ $ 1009.86
2.3 Compound Interest

( )
tk
r
F=P 1+
k
Where:
- F future sum
- P principle value
- r nominal interest rate pa
- k compound freq. pa. (compounding monthly: k=12, quarterly: k=4)
- t is the time of the deposit in years
Key Ideas:
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- Grows exponentially with time
- ‘interest-on-interest’
2.3.1 CI example
2.4 Effective Interest Rate
( )
r effective =
F 1t
P
−1
where:
- F future value
- P principle value
- t time in years
Key Ideas:
- The compounding effect is greater the shorter the compound period (i.e. larger k)
2.4.1 EFR example
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2.5 Money Market Securities
- Bills of exchange, promissory notes and treasury notes
- Payment at maturity is set at a round number
- Use simple interest to calculate prices and yields
h money market security is a loan agreement.
- Between a borrower and the lender (the buyer)
- Borrower sells the security (receives cash: equal to P)
- Lender buys security: pays cash equal to P
- ht maturity borrower repays F
2.5.1 Example
Say you wanted to borrow $700 for 5 years, but you didn’t want to pay back annual interest
payments until year 5, when the initial $700 is due.
What could you do?
- You could increase the value of the debt to include the interest payments, but only
receive $700 in return for the note:
Option 1 – Debt with periodic interest payments
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- You borrow $700 at 7.4% interest for 5 years.
- hfter one year you pay $700 times 0.74 = $51.80 to buyer
- The lender lends you back the $51.80
- Repeat every year
- 5
hfter 5 years the lender receives 700 × ( 1.074 ) =1000
Option 2 – Debt with interest included in value of debt.
- You borrow $700
- You issue a 5-year note worth $1000

o That is, you issue a note with a FACE VALUE of $1000 and a MATURITY of 5-
years.
- There are no annual transfers of interest payments, but everyone gets the same in
the end!
2.5.2 Discount securities

Single payment (F: face value) for interest and borrowed funds
F(face value) = P(issue price) + I (interest)
t t
F = P(1+r) or P = F/(1+r)
5
P = 1000/(1.074) = 700
Note: Money market securities have terms less than 1 year and use simple interest
discounting.
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2.6 Yield to Maturity

If the lender in the previous example held the debt until the end of the 5-year period (until
maturity) how would the lender calculate the effective yield?
( )1000 15
700
−1=0.074=7.4 %
How about the simple yield?
(1000
700 )
−1 =0.4286=42.86 % Annually :
0.4286
5
=0.0857=8.57 %
2.7 Holding Period Yield (HPY)

If the security is sold before maturity, actual yield (investor’s HPY) will differ from yield to
maturity – depending on the selling price (Psell)
Investment yield:
HPY ∨r= ( F∨P sell

P buy )
−1 ×
diy
d
- If the security is held to maturity, F would be used in the numerator
- If the security is sold before maturity, Psell would be used in the numerator
2.7.1 HPY Example
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2.8 Annuities
- h series of equal payments (R) made at equal time intervals e.g. monthly, half-yearly
2.8.1 The Present Value of an Annuity:
P=R × PVAF
where:
- P present value
- R regular payment value
- PVAF present value annuity factor
−k× t
PVAF ( Present Value Annuity Factor )=

1− 1+
r
k ( ) where:
r
k
- r interest rate pa
- k frequency of payment (k=12 if monthly; k=4 if quarterly)
- t time in years
2.8.2 Present Value of an Annuity Example
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2.8.3 The Future Value of an Annuity:
F=R× FVAF
Where:
- F Future value
- R regular payment value
- FVAF future value annuity factor
( )
tk
r
1+ −1
k
r
FVAF=
k
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2.8.4 Future Value of an Annuity Example:
2.8.5 – PVAF derivation
2.9 Coupon Bonds

h fixed-interest security that makes regular (e.g. half yearly or monthly) payments for a fixed
period and repays the face value of the security at maturity. It is also known as ‘bearer
bonds’.
2.9.1 CB examples
h 4- year bond with

a face value of $100
makes half-yearly
coupon payments at
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the rate of 10% pa. How much is this bond worth today if the required yield (annual
nominal) is 11% pa?
Price = PV(a) + PV(b) = $31.67 + $65.16 = $96.80
TOGETHER:
2.9.2 Change in interest rates & Coupon Bonds
- Suppose you just paid $100 for a bond paying 10% interest pa
- One minute later the interest rates change to 11% by the RBh
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- If you want to sell your bond, will you get your $100 back?
o Who would buy your bond getting 10%, when they could get 11%
o What would you have to do to be able to sell?
- How does the value of bonds change with interest rates?
- Prices of fixed interest securities and their yields move in opposites directions
- Interest rate changes bring capital gain or loss.
2.9.3 Interest rates and Zero Coupon bonds
- You purchase a zero-coupon bond (money market security) with a face value of $500,
payable in 7 years with 5% interest. With 7 years still remaining, rates decrease to
3%.
- How much was the present value at purchase
- What is the current value of the bond?
- What is the loss/gain?

500 500
PV ( purchase )= 7
=355.34 PV ( after )= 7
=406.55
1.05 1.03
51.21
Gain=406.55−355.34=51.21 → =14.41 %
355.34
2.10 Reducible Loans

A=R × PVAF
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Where:
- A principle borrowed
- R Repayment (Face value)
- PVAF Present Value Annuity Factor

Key Ideas:
- Usually A is known and R must be found
2.10.1 RL example
Say you borrow $200,000 to purchase a house

at 7.2% pa compounding monthly, and agree
to make monthly repayments for 20 years.
Find the monthly repayment.
hfter 5 years, you win the lottery. How much

do you owe?
Present value of the remaining repayments:
2.11 Perpetuities
- Perpetuity is an annuity that does not terminate
- It is described as a constant cash flow
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2.11.1 Perpetuity Derivation
Part III – The Payments System

Objectives:
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 Overview of Australia’s Payment

System
 Wholesale and Retail payment
systems
 Describe netting of payments by
banks and real-time gross
settlement
 Name and describe several
different types of payment
orders
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3.1 Overview of the Australian Payments System
- Trading allocates resources and distributes goods and services

o Requiring efficient and reliable means of exchange
 Precious metals
 Legal tender (notes and coins)
 Payment orders (Cheques and cards)
- h transaction is settled when an item is exchanged for agreed value on agreed date
- Payment orders are instructions that can be used to settle transactions

o They facilitate payments by transferring funds between accounts with hDIs
 E.g. Internet banking transfers
 From the drawer’s (party that instructs payment to be made) to the
depositor’s account
Clearing
- The process by which institutions agree to the terms of the transaction
- Managed by the hustralian Payments Clearing hssociation

o (Everything between the transaction and settlement)
Settlement
- The exchange of value that completes a transaction

o The actual payment of amounts between hDIs
o hDIs hold funds with the RBh for this purpose
 Funds are held in exchange settlement accounts (ESAs)
 These balanaces in the EShs belong to the account holders and are
known as ES funds.
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Figure 3.1.1
Categories of Payment Orders

Wholesale
- Generally large-value
- Particularly those that originate in the financial markets
- Large corporate payments
- Uses real-time gross settlement (RTGS)

Retail
- Settles retail payment orders which uses deferred net settlement (DNS) (Process of
settling 9am the next business day)
- Generally small-value payments
- Individuals and small businesses
- Cash, cheques, cards, internet
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3.2 The Retail Payment System

Retail payment orders must be:
 huthorised by drawer using:
o PIN (personal Identification number)
o Or signature
 Usually are direct entries (auto debit charges/credit to an account)
o Debit, credit cards and cheques
 Cleared and settled through DNS system
3.2.1 DNS (Deferred Net Settlement)
 Settlement between hDis is on a deferred net basis
3.2.1.1 DNS e.g. from Financial institutions and markets 7th edition, Ben
Hunt, Chris Terry
Two banks hlpha and Beta. Suppose you bank with hlpha and a supermarket banks with
Beta and that today you paid your $70 supermarket bill with a retail payment order. The
settlement of the payment order requires hlpha to pay $70 to Beta to fund the $70 deposit
in the supermarket’s account. Suppose also that a depositor with beta pays her $60 gas bill
and the gas company banks with hlpha. This requires Beta to pass $60 to hlpha so that it can
fund the deposit in the gas. If settled separately, $130 in two payments would be required.
But under a DNS process, the $70 transfer from hlpha to Beta is offset by the $60 from Beta
to hlpha. Consequently only $10 would be paid tomorrow morning by hlpha to Beta ($70
offset by $60)
3.2.2 Payment Orders
Cheque
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- h cheque is a dated, paper-based instruction to the drawer’s hDI to pay the stated
party the stated sum
Direct Entry
-Pre-authorised and verified orders that are processed electronically which is more
efficient than cheques
o hll organisations to:
 Make payments ot large groups
 These are direct credits
 Such as employee remuneration, social security payments by
the RBh
 Receive payments from large groups
 Known as direct debits
 Such as loan repayments to hDIs
Payment cards
- Debit card
o Issued by hDIs to depositors to enable them to access their funds
- Credit card
o Issued by credit card companies (VISh). The credit card companies pay for
purchases and then the owner repays the accumulated amount.
- Charge
cards
o Full amount is repaid each moth. No DNS, because the charge card company
gets instruction, not the merchant’s bank.
3.2.3 Clearing Systems
- Separate systems for cheques (hustralian paper clearing system), direct entry (bulk
electronic clearing system) and hTM/EFTPOS transactions (consumer electronic
clearing system)
- Common objectives:
o Simplify payments through the calculations of net amounts
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o Rapid processing
 Quick debit of payer’s account
 Credit payee when funds are cleared or transferred
 Encourage interchange arrangements (e.g. facilities allow any hTM
and EFTPOS terminal to be used by all holders of debit and credit
cards that are issued by hDIs)
3.2.4 Retail Payment System trends
- Technology
o Electronic payments are much cheaper for hDIs to process
 Particularly direct payments, debit cards, telephone and internet
banking
 While electronic presentation has reduced the cost of cheques, their
processing remains much more expensive than electronic payments
- Fees: for payment services that more closely reflect the cost
o People pay lowest cost methods
o Fees for processing cheques are about double that of electronic payments
- Convenience with electronic payments
3.3 The Wholesale Payment System
- Since 1998 the WPS has used real-time gross settlement (RTGS)
o Real-time (course of the day)
 By transfer of exchange settlement (ES) funds
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 hs distinct from ‘deferred’ settlement

o Gross: Ech payment is settled in full (as distinct from “net” settlement)
3.3.1 Intra-day liquidity Management

The size and flow of payments through the RTGS system places considerable intra-day
liquidity pressure on institutions.
This can be solved by:
- Requiring banks to hold far greater amouts in their ESh; sufficient to cover all their
payments and not to rely on funds before payment
- RBh
o Queuing arrangements
 Help banks with their payment flow  instructions are placed in a
queue and are tested for settlement and offsetting payments between
banks
o Intra-day repurchase agreements
 Repos that provide banks with additional funds for part of the day 
the RBh purchases government securities from an hDI on the basis
they will be repurchased at the same price later that day.
3.3.2 Managing ES funds
- Settlement risk
o Possibility that hDI is unable to meet its payment system obligations  could
cause other hDIs to default.
- Contagion risk is the risk that the payment system collapses as a result of default by
hDIs in general
3.3.3 Liquidity Risk Management
hDIs manage their own settlement (or liquidity) risk by:
- Holding sufficient ES funds to settle their expected settlement obligations

o hccounts must be in credit
o Earn interest at the cash rate less 25 basis points
- hDIs hold most of their reserve funds as

o Deposits with other hDIs, and
o Securities that are traded in the money market, and can be used in
repurchase agreements
o These assets can be quickly converted in ES funds if required, but usually earn
a higher yield than ES funds.
- Each hDI needs to determine the amount of funds it needs in order to settle
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o Net retail insturctions at 9am the next day  hDIs will ensure they have
sufficient funds at the close of business
o Wholesale instructions throughout the day
- To enure they have sufficient ES funds hDIs will

o Ue the overnight market ot trade money-market securities
 Buy to reduce ES balances vice versa
o Use allowances within the RTGS
o Trade with the RBh to acquire overnight funds – rarely used, because interest
rates are high
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Part IV – Deposit Taking

Institutions
Objectives:
 ADIs
 Role of Deposit taking institutions
 Describe and analyse deposits
and other fund raising by ADIs
 Describe and analyse lending and
the uses of funds by ADIs
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4.1 ADIs
hll hDIs are supervised by the hPRh (hustralian Prudential Regulation huthority.
Some forms hDIs include:
- Banks
- Building Societies
- Credit Unions
Registered financial corporations
- Not directly supervised by the hPRh
- Money Market corporations (PhRT 4) aka merchant banks
- Finance companies (more risk, higher cost)

Roles of ADIs
The traditional role of hDIs is to accept deposits in order to fund loans. Which is a process
known as intermediation. Intermediation is defined in the book, Financial Institutions and
Markets as: ‘Contracting with surplus units to rais funds and contracting with deficit units to
supply funds.’
In effect, hDIs transform:
- Many small deposit balances into fewer larger loans
- Short-term deposits into long-term loans (assistance with direct financing)
- The risk accepted by depositors from that faced by hDIs on their loans (risk-
management)
Major players:
- hNZ, CBh, NhB, Westpac
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- These institutions generally have separate divisions for retail and wholesale
(corporate) customers
- Wholesale banking is also known as investment banking
The bank as a business:
4.2 Source of Bank Funding
- Domestic deposits
- Short-term securities issued in wholesale doemsitc and overseas financial markets
- Long-term seceurities (bonds) issued domestically and in overseas capital markets
- Equity
- Securitization
ADIs offer depositors:
- h safe place for funds (regulated by hPRh)
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- Interest
- The capacity to accept both small and large deposits
- Liquidity
4.2.1 Current Deposits
- Deposits in accounts that provide a cheque facility – cheques remain an important

payment method for business
- They are liquid. hll deposits ca be withdrawn by the depositor but this has been
accompanied by the introduction of fees
- These are transaction accounts where funds are used within a short period, and
replenished through a regular income flow.
4.2.2 Savings deposits
- Interest paying transaction accounts

o Without cheque facility
o But with access to hTMs and EFTPOS
- Traditionally these were passbook accounts now mostly statement accounts.

o Current, term and savings accounts are mainly used by retail depositors
4.2.3 Term Deposits
- Funds placed in an account for an agree period on which a fixed amount of interest is
paid
o Terms are from 1 month to 5 years
o Can be viewed as a retail, capital-guaranteed investment
- Interest rates depend mainly upon the amount deposited, and to a lesser extent, the
term
4.2.4 Negotiable certificates of deposits (CD)
Large value, fixed term deposits
- Minimum amounts of around $50,000 - $100,000
- Have liquidity because they can be traded in the money market
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- Take a form of promissory notes (hn unsecured short-term security that has a fixed
term with an agreed interest rate that can be traded in the money market) issued by
the hDI to the depositor
- Most terms are less than one year but some can extend to 5
4.2.5 Issueing
hDIs Issue:
- Money Market securities: Commercial paper (and CDs)
- Bond market securities: medium-term notes.
- Most securities: borrowing is arranged offshore using commercial paper, medium-

term notes and bonds
- Debt issues, especially in overseas markets, serve to diversify the hDIs soruce pf
funds.
o Giving hDIs longer term fund access
o Foreign debt poses E/X rate risk which requires risk management
4.3 Uses of funds
4.3.2 Securities
- Cash – to satisfy withdrawals at banks and hTMs
- Liquid assets such as ES funds, securities held under repos, and payments due from
other hDIs
- Repo: form of short term burrowing for dealers in government securities. The dealer
sells the government securities to investors, usually on the
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- Trading securities and investment securities

short/long/government/nongovernment/domestic and foreign securities
- These securities earn a lower return than loans
- Loans and advances where interest rates should reflect
- Others, inc. bill acceptances

4.3.3 Role of ADIs
Flow of Funds
- hDis accept deposits and make loans
- Thus transforming the different preferences of surplus and deficit units in relation to
o Size (many small deposits into fewer, larger, loans)
o Maturity (short-term deposits into long-term loans)
o Risk (depositors face credit risk of the hDI rather than that of borrrowers)
- Payment services: Deposits with hDIs are used to settle payments
- hDIs operate on the basis of public trust

o Hence the need for prudential supervision by hPRh
hDIs finance through:
- Indirect financing
o Deposits and loans – mostly conducted by hDIs
o Lending institutions provide indirect financing
- Direct Financing
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o The issue of securities – mostly organized by registered financial corporations

(RFCs_ that is, money market corporations (merchant banks) and finance
companies
4.3.4 ADI Housing Loans
- Non hDI lenders (loan organisations e.g. Rams) raise funds through the issue of
securities
- Loans are generally secured, typically by mortgage

o Lender takes assets if borrower defaults
o hsset usually is insured
- Benefits of mortgage
o Reduces credit risk for the hDI
o Reduces losses in the case of default
o Helps lenders deal with information asymmetry
o Lowers the interest rate on loans
- EXhMPLE:
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4.3.5 Other Loans to Households
- Secured personal loans

o Terms up to 10 years
o Fixed interest rate
o Used to purchase durable assets, such as new cars or boats, which are subject
to a mortgage
- Unsecured personal loans

o Credit cards
 These, and unsecured loans have the highest interest rates, because
they also have the highest rates of default
o Personal overdrafts
 Revolving source of finance, generally accessed through a cheque
account
 Usually secured by a mortage over residential property
 Floating interest rate
o Student loans
4.3.6 Loans to businesses
- Small to medium businesses

o Standardized loan application process and interest rate
o Usually secured by mortgages over property
o Some may be able to issue commercial bills
- Large non-financial and financial corporations
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o Customized loan products

o Interest rate depends upon the risk of the burrower
o The hDI may assist the raising of funds through the issue of securities
4.3.7 Wholesale Lending to Corporations
- Most commonly as
o Term laons: laons, up to 10 years, on a fixed or floating rate basis
o Through the issue of short or longer term securities
o Revolving credit facilities: access to short-term funds, similar to an overdraft
o Standby facilities: where the corporation may need to borrow, conditional
upon agreed circumstances
- Where the loan is large, it may be syndicated
- Interest rates established case-by-case

o Having regard to the risk of the loan
o In relation to the insitutions’s prime or reference rate( lender’s point of view:
guaranteed rate of borrowing (Investopedia))
o hDIs may also impose loan covenants (What the buyer can and cannot do)
(Investopedia)
4.4 Securitization
Securitization is the process of assigning the cash flows from illiquid assets to securities. I.e.
securities that are secured by mortgages over specified assets.
- Establishes a ‘special purpose vehicle’ SPV

o hsset-backed, or mortgage-backed, securities
o SPV earns fees (a legal entity that is responsible for the issue of securities
used to acquire assets) (Financial institutions and markets, 140)
- Use these funds to purchase assets (loans) from the bank => reduces the assets on
the bank’s balance sheet
- Financial manager
o Receives and administer repayments by borrowers
o Make payments to investors in the securities
o Financial manager earns fees
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4.4.1 Mortgage Origination
Mortgage originators are non-bank lenders who arrange loans that are funded through the
issue of securities.
4.5 Risks Faced by ADIs
- hDIs are inherently risky – they use borrowed funds to finance loans
- Bank management transforms an inherently risky business into a safe haven for
depositor’s funds
- hDIs that operate in hustralia are generally highly rated, suggesting they are
successful at transforming risk
- hll hustralian hDIs are within the investment grade range, of BBB – hhh
Liquidity and Funding risk
- hrises from maturity mismatch

o Long term assets such as housing loans
o Financed with short-term liabilities such as deposits
- Liquidity Risk is the possibility an hDI cannot meet its financial obligations as they fall
due, including depositors’ requests to withdraw funds
- hDIs manage this through:

o Holding cash, exchange settlement funds, repurchase agreements, deposits
with other hDIs, money market securities and government securities
o Borrow from other hDIs and RBh
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- Funding Risk
o hDI cannot maintain sufficient funds to roll-over its liabilities
- Managed by:
o Diversifying sources of funds
o Holding securities
o Securitizing some assets
o Raising funds from the money market
o Issuing long-term securities
Credit Risk
- Risk a borrow defaults on scheduled loan payments

o hDI would classify loan as impaired asset (for 90 days overdue loans)
- Main risk hDIs face, though levels of default prove very low b/c
o Economy strength
o Use of housing property as a security
o Prudent lending practices and careful management
 Diversifying lending across sectors
 Reducing exposures through securitization
 Development of credit derivatives
Principles of Bank Lending
- Overcome asymmetric information between prospective borrowers and bankers –

sophisticated credit approvals
- Diversify loan portfolio

o Geography, industry, time
o hvoid ‘concentration risk’
- Match Interest rate to risk
- Monitor exposures
- httract large number of depositors

o Liquidity/funding risk
o hvoid concentration
Market and Interest Rate Risk
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- hDIs face risk on securities and foreign exchange they hold form adverse moves in
the market
- Interest rate risk arises in the banking book

o Fixed rate loan with funds borrowed at a floating rate, or vice versa
o hn hDI borrows and lends on the same basis, but the timing of the changes in
interest rates is not matched
Operating Risk
- Loss from inadequate or failed internal processes, people and systems or external
events.
o Rogue traders
o Poor strategic decisions
o Industrial action by employees
o Computer fraud or systems failures
o External shocks, such as terrorism or earthquakes
Summary of Risks
Type Problem Solution
Liquidity Can’t meet customers’ Hold liquid assets and
demands for withdrawals borrow from hDIs and RBh
Funding Can’t maintain sufficient securitization, diversifying
funds to cover its loans sources of funds and issuing
long-term securities
Credit Borrow defaulting Requiring loan security,
prudent lending practices,
securitization and CDs
Market Chance of loss arising from Hedging positions with
movements in market derivatives
variables
Interest-rate Borrows on a different Interest-rate derivatives
basis(i.e. fixed or floating) to
which it lends, or where the
timing of the changes in
rates does not match
Operating Loss resulting from
inadequate or failed internal
processes, people and
systems or external events
4.6 APRA’s regulatory framework
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- Philosophy: ‘prime responsibility for the prudential management of a bank’s business

lies with the bank itself’
- General supervisory approach:

o Identify and assess weaknesses
o Consultation
o On-site visits
o Invervention and enforcement where necessary
- Within guidelines of the “Basel Committee”

o Major instrument is a minimum level of bank ‘capital’
o ‘capital’ ~ shareholders’ funds
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Part V – Markets
Objectives:
- Functions of Financial markets

- Primary markets and the issue of
securities
- Define the role of rating agencies
in markets
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5.1 Functions
- hrrange the flow of funds

o ‘Direct financing’
o Funds are raised through the sale of securities to investors
- Perform price discovery, in both

o Spot markets – settlement of trades occur in normal period
o Derivative market (promise of purchase)
- Transfer and manage risk

o Through derivative markets
- Provide ways of dealing with information asymmetry

o E.g. investors require reliable information upon which to base their
investment decisions
5.1.1 Direct vs. Indirect
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- Direct financing raises funds in wholesale amounts only
- The issue of securities requires a substantial effort that is only economical for arge
amounts
- Large amounts of money because DF is costly
5.1.3 Underwriting
- Issuing securities is known as underwriting
- It is arranged by investment banks for fees
- The main suppliers of underwriting (and secondary market dealer and broker
services) in hustralia are
o The big 4
o Macquarie Bank
o Leading international investment banks
o Certain money market corporations
5.2 Primary Market Process
- The issuing occer in the primary market
- The aim of issuing securities is to raise funds for the issuer at an accpetabl eprice or
interest rate
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- The issuer generally engages the services of an investment bank to act as the
arranger, or manager
o For large issues there could be a lead manager an a number o fco-managers
o The manager’s tasks include
 hdvising on the type of securities and its features
 The location and timing of the issue
 Whether there should be standby underwriting
 Preparation of legal documents
 Marketing to investors thorugh a ‘road show’
 Registering the securities for trading
- IPO – initial public offering

o Taking a portion of your company and selling some of it
5.2.1 Contractual Arrangements for Issuing securities
- The contract enetered between issuer and the investment bank can be:
- Best efforts/best endeavors

o Usual arrangement in hustralia
o The investment bank is paid a fee for attempting to sell the securities
o The issuer is exposed to the risk that the required funds are not raised – risk
can be transferred to the investment bank through a standby underwriting
agreement (for a further fee)
- Bought deal
o Where the investment bank agrees to buy all the securities and then attempts
to sell them for a higher price
o The underwriter accepts the risk of not being able to sell all the new
securities – though this risk is reduced through ‘book-building’
o This has been the usual practice in the USh
5.2.2 Selling practices
- hs well as determining whether to use a best efforts or bought deal contract, a

procedure for selling the securities must also be agreed
- Auctions and tenders
- Open outcry
o Bidding is conducted in a trading room
o Historically, this was the mechanism for share trading
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- Tender
o h sealed-bid process where potential buyers are invited to submit bids (price
and quantity) and the issue manager chooses the most favourable
o Used for the issue of government securities
o Relatively inexpensive
- Public offer
o Securities are sold by announcing their price and seeking applications from
the public
o Relatively inexpensive
o However, having a fixed price can be problematic should new information
change the fair price of securities through the issue process
o In some cases, the price is not determined until the closing date of the issue
- Bookbuilding
o Now the principal method for conducting issues of shares
o hn investment bank
 Establishes an initial price range
 Gathers information from institutional investors and uses this
information to determine the offer price
 hllocates shares to bidders at their discretion
o Hybrid offerings
 Some combination of methods
5.2.3 Ratings Agencies
- Investors generally require debt securities to be ‘rated’

o Function is performed independently by ratings agencies
o Cost is paid by issuer
- Ratings agencies publish informed opinions about the ability of debt issuers to meet
their repayment obligations.
o This information is relevant to investors in both the primary and secondary
markets
- Ratings
o hssist the flow-of-funds
o Contribute to the measurement of risk premiums
- Standard and Poor’s and Moody’s are the dominant international ratings agencies
- Publish informed assessments (using a standard scale) about the financial standing of
securities and institutions
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- Best S&P rating is hhh: borrower’s capacity to meet scheduled payments appears
extrememly strong
o Investment grade is BBB or higher
o Junk rating is BB or lower (D is in default)
- Securities are rated according to standard scales

o The better the rating the lower the risk and the interest rate paid by the
issuer
o Ratings can be adjusted over time to reflect changes in the issuer’s financial
circumstances
5.3 Secondary Markets
- Involves trading between investors in issued securities
- Does not raise funds for issuers

5h liquid and efficient secondary market greatly assists the operations of the primary
market
- 3 main functions:
o Provide investors with liquidity – transforms the maturity of funds
o Identify the price of securities. This is known as price discovery
o Identify investors who are interested in securities – who could be approached
to supply funds in the primary market
5.3.1 Liquidity and Maturity Transformation
- The secondary market performs a maturity transformation
- Companies can issue long term securities to short term investors because the
investors can trade
- The security market enhances a security value by providing liquidity
- Investors are more likely to buy securities in the primary market if they can be traded
in the secondary market
5.3.2 Investors for Primary Markets
- Identifies potential investors in new securities and thus assists the primary markets
by:
o Reducing search costs and
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o Creating access to large-scale fundraising opportunities

5.3.3 Price discovery and Its Use
- Provide the market’s valuation of a company’s shares
- Value is reflected int eh company’s market capitalization, equal to the share price
times the number of shares
- This is useful to:

o Issuers of new securities
o Current investors
- Debt markets
- Discover (or identify) the current interest
- Rate (or yield) for funds

o Reflect
 General level of interest rates
 The security’s credit risk (and liquidity risk) premium
o Useful in pricing new loans
Part B:
Learning Objectives:
- Describe price discovery in secondary markets
- Explain the process of shoting a stock/security
- Describe the trading process and dealer markets
- Name and define some market abuses
5.4 Price Discovery
- Markets “uncover” prices

o If a stock price is too low, investors buy until the price rises
o If a stock price is too high, investors sell until the price falls
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- What happens if you know the price is too high but you don’t own shares so you
can’t sell?
o Is your information valuable If you cannot sell?
5.5 Financial Positions
Long Position:
- Holding an investment that increases in value as the value of a firm, security or other
asset increases in value
o You want the value of the security or asset to go UP
Short Position:
- Holding an investment that increases in value as the firm, security or other asset
decreases in value
o You want the value of the secruiyt or asset to go DOWN
Making money if you think the stock will go down in value:
- Short the stock

• E x a m p le :
• S te p 1 : B o r r o w th e s to c k .
– 1 ,0 0 0 s h a r e s .
• S te p 2 : S E L L th e s to c k a t a “ h ig h ” p r ic e o f $ 2 0 .
– Y o u r e c e iv e c a s h o f $ 2 0 X 1 ,0 0 0 s h a r e s = $ 2 0 ,0 0 0
• S te p 3 : W a it fo r th e p r ic e to d r o p a n d B U Y th e s to c k a t a “ lo w
p r ic e ” o f $ 1 5 . B u y b a c k th e 1 ,0 0 0 s h a r e s .
– $ 1 5 X 1 ,0 0 0 = $ 1 5 ,0 0 0 .
– Y o u n o w h a v e 1 ,0 0 0 s h a r e s a n d $ 5 ,0 0 0 .
• S te p 4 : R e p a y th e le n d e r o f s to c k w ith th e s to c k .
– G iv e b a c k th e 1 ,0 0 0 s h a r e s y o u b o r r o w e d .
• S te p 5 : K e e p th e c a s h !
– T h e $ 5 ,0 0 0 is y o u r p r o fit!
5.6 Exchange-traded Markets
- Run by brokers or agents
- Both retail and wholesale investors can participate
- Can be physical or virtual
- The exchanges:
o Enforce trading rules
o Provide trading and settlement systems
- The hSX
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o Operates a market for shares and related derivative contracts
- Function is to ensure trading is fair and efficient

o Exchanges require that brokers conduct (or be responsible for) trading in the
market
o This reduces default risk within the markets
o Brokers are agents who earn commission
- Historically used open-outcry trading but no wuse automated trading systems (hTS)
o Where traders can view orders to buy and sell
o Trading is now ‘location-less’
5.6.1 The Trading Process
- The trading process at the hSX is order-driven, i.e. based on orders to buy and sell
- Orders can be:

o Limit orders
 Which specific the quantity and price at which the client is willing to
trade
o Market Orders
 h quantity traded at the best price available
B id s ( b u y s ) A s k s ( s e lls )
Q u a n tity P r is e Q u a n tity P r is e
500 $ 1 0 .2 0 300 $ 1 0 .2 5
200 $ 1 0 .1 0 1000 $ 1 0 .3 5
2000 $ 1 0 .0 0 15000 $ 1 0 .8 0
1000 $ 9 .9 5
E xa
m p le s :
A ma rk e t b u y o r d e r fo r 3 0 0 à a tr a d e o f 3 0 0 a t $ 1 0 .2 5
A ma r k e t s e ll o r d e r f o r 5 0 0 à a t r a d e o f 5 0 0 a t $ 1 0 .2 0
A ma r k e t s e ll o r d e r f o r 6 0 0 à a t r a d e o f 5 0 0 a t $ 1 0 .2 0 &
100 a t $ 1 0 .1 0
A lim it s e ll o r d e r f o r 6 0 0 a t $ 1 0 . 1 0 à a tra d e o f 5 0 0 a t $ 1 0 .2 0 &
a tra d e o f 1 0 0 a t $ 1 0 .1 0
5.6.2 Dealer Markets
- h dealer is a financial institution that buys and sells securities

o Trade with each other and with wholesale clients by telephone
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o Dealers are principals (not agents) because they buy and sell the security
- Dealers operate in OTC markets: Money, bond and FX markets

o They must trade when a quote is accepted and thus provide traders with
immediacy
- Dealer markets are quote-driven
- Dealers are requied to quote bid (buying) and offer (Selling) prices:
o Consequently, a dealer acts as a market maker
o Provides two-way quotes when called by another dealer, or a one-way quote
when the caller is a wholesale client
o They must trade when a quote is accepted and thus provide traders with
immediacy
- Dealers buy and sell securities and thus must hold an inventory of them
o Size of inventory is known as the dealer’s position
o Increase or decrease to capture expected future price movements
- Dealers face price risk on their inventory

o Hence, volumes in quote-driven markets tend to exceed those in order-driven
markets (“hot potato”)
- Dealers are “hit” when someone accepts their bid or offer price
EXhMPLE: E x a m p le : C a l c u l a t e t h e d e a l e r ’ s s p r e a d g i v e n a
r o u n d tr ip o n a p a r c e l o f 9 0 - d a y s e c u r itie s w ith a
fa c e v a lu e o f $ 2 0 m il a n d a q u o te o f 6 .1 5 –
6 .1 2 %
20 000 000
P buy = = $ 1 9 ,7 0 1,2 4 2 .8 0
1 + 0 . 0 6 1 5 ( 39 60 5 )
a spread of
20 000 000 $ 1 ,4 3 5 .6 8
P sel l = = $ 1 9 ,7 0 2 ,6 7 8 .4 8
1 + 0 . 0 6 1 2 ( 39 60 5 )
- Dealer spreads will

depend upon:
o The Volume of trading
 Markets with substantial turnover allow dealers to set narrow spreads
o The size of the transaction
 Spreads will be wider if the transaction is abnormally large
 Because the dealer is exposed to greater risks when left with too
much or too little inventory
o The risk of adverse selection
 When a counterparty is better informed about factors that will
influence future prices
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5.7 Efficient Market Hypothesis
- The EMH argues that security prices in active secondary markets:

o hre ‘fair’ – meaning they incorporate all available information and thus are
consistent with securities’ expected returns
o Will change in response to new information which arrives randomly, and
therefore changes in prices will also be random.
- Many groups of investors do not subscribe to the EMH, because they believe that
markets provide opportunities for excess returns.
5.7.1 Forms of market efficiency
so
w e a k fo rm e ffic ie n c y c h a r t is t s ,
so as a group,
f undam ent al p ric e s re fle c t a ll in fo rm a tio n
c o n ta in e d in h isto ric a l p ric e s s h o u ld n o t
a n a ly s t s , a s a a c h ie ve
g r o u p , s h o u ld abnorm al
n o t a c h ie v e s e m i-s tro n g fo rm e ffic ie n c y re turns
abnorm al p ric e s re fle c t a ll p u b lic in fo rm a tio n
re turns
s tro n g fo rm e ffic ie n c y
p ric e s re fle c t a ll in fo rm a tio n (p u b lic a n d p riv a te )
N o p r o f it f r o m
m o n o p o ly in f o r m a t io n 49
5.7.2 Random Walk
- Current prices reflect all information conveyed by past prices
- Only new information will change prices
- If markets are weak-form efficient, prices should follow a random walk
- Seems generally true of security prices

o Future prices cannot be consistently predicted
o Risk-averse traders frequently hedge their exposures to market risk
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- If markets are semi-strong form efficient, traders should not be able to identify
investment strategies that deliver risk-adjusted excess returns
o That is, it should not be possible to consistently identify underpriced or
overpriced securities
- While many studies reveal evidence of market efficiency, others have revealed
anomalies
o Where excess returns have been found, these include:
 Firm size – where small firms outperform
 Time patterns- such as the January effect
 Events – such as securities being included inan important index
- Regardless of how a market is set up, if it is to retian the confidence of traders it

needs to prevent market abuses
- Four main categories of market abuses:

o Touting information
o Manipulating prices
o Manipulating volumes
o Insider trading
 Classic insider trading
 h director other company insider buys (sells) knowing that the
company will soon release good (bad) news
 Front-running
 h broker or dealer, knowingly trades in advance of a client’s
trade. Example: buying shares today because the broker knows
the client will be placing a large buy order tomorrow
 Scalping
 Trading prior to the release of a research report
 Piggy-backing
 h broker copies the actions of a client
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Part VI – The Money Market

Objectives:
- Money Market Role

- Reference Rate
- Money Market Securities
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6. Role of the Market

- The money market is a wholesale market for short-term securities
- It provides
- hn alternative flow-of-funds process for wholesale borrowers and investors
- The banking system with a soruce of liquidity
- The reference rate for short term funds
- The RBh with a means of conducting monetary policy
6.0.1 Flow of Funds
- For wholesale, low risk, borrowers the money market providing access to short term
funds
- Can be rolled over to provide financing for 2-3 years
- Cheaper than borrowing from an hDI, therefore places competitive pressure
on hDI lending rates
- For investors, market provides:
- Wholesale investors with low-risk returns
- hn asset class for fund managers to offer clients a low-risk product with ready
access to cash
- hDIs face liquidity risk from long-term assets and short-term liabilities
- Money market provides liquidity;
- hDIs can:
 Quickly sell holdings of money-market securities
 Readily borrow from the market by issuing CDs
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6.1 Reference Rates

- Money market performs price discovery function for short-term funds
- The cost of short-term wholesale funds on given day
- For very low-risk borrowers
- In hustralia, reference rates are for bank accepted bill of various terms and are
calculated by:
- The hustralian Financial Markets hssociation (hFMh) the “bank-bill reference
rate” (BBR)
- Reuters: the “bank bill swap rate” (BBSW)
- From a survey conducted at 10am each day
- Internationally, the best known rate is the LIBOR London inter-bank offer rate
6.3 Money-market Securities

- Five types:
- Certificates of deposits
- Commercial paper
- Treasury notes
- Commercial bills
- Repurchase agreements
- Short term, issuing <1
- Securities pay their face value at maturity
- Investors earn a return by purchasing them at a discount to their face value
Promissory notes (P Notes)
- Money market securities (price, term, value)

- Issuer promises to pay face value
- Term usually a few months
- Face value is calculated by adding the agree amount of interest to the amount of
deposit
Money market secu
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Lecture notes, lectures 1 - 6 - financial institutions and

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Part I – The Financial System

1.1 Functions of the financial system:

- hrrange flow of funds (financing)

- Transfer and manage risk

- Overcoming information asymmetry

- Deal with incentive problems in contracting

- Pooling of funds (Requires supervision)

1.2 Introduction to the financial system

1.2.1 Fundamental Principles:

1.2.2 Participants in the financial system:

1.2.5 Basic Forms of finance

Risk and Return

‘Deficit units pay a return to compensate surplus units for:’

- Deferring their use of funds; and

- The risk they face

1.2.8 Financial Contracts

Settlement is reached when value (=purchasing power) and title transfer

o Facilitates subsequent trading of existing securities

1.2.9.1 Problems in Markets

1.3 Australia’s Financial System

Part II: Financial Mathematics

2.1 Time Value of Money

- Present Value (P)

- Future Value (F)

2.2 Simple Interest

- F security’s face (or future) value

- P principle amount (starting amount)

- r interest rate expressed as a simple interest yield (p.a.)

- d number of days to maturity

- diy days in year

2.2.3 Simple Interest example

$1000 invested at 6% pa for 2 months (60 days)

2.3 Compound Interest

- r nominal interest rate pa

- k compound freq. pa. (compounding monthly: k=12, quarterly: k=4)

- t is the time of the deposit in years

- Grows exponentially with time

2.4 Effective Interest Rate

2.5 Money Market Securities

- Bills of exchange, promissory notes and treasury notes

- Payment at maturity is set at a round number

- Use simple interest to calculate prices and yields

h money market security is a loan agreement.

- Between a borrower and the lender (the buyer)

- Borrower sells the security (receives cash: equal to P)

- Lender buys security: pays cash equal to P

- ht maturity borrower repays F

- You borrow $700 at 7.4% interest for 5 years.

- The lender lends you back the $51.80

- Repeat every year

Option 2 – Debt with interest included in value of debt.

- You borrow $700

- You issue a 5-year note worth $1000

2.5.2 Discount securities

2.6 Yield to Maturity

How about the simple yield?

2.7 Holding Period Yield (HPY)

HPY ∨r= ( F∨P sell

- If the security is held to maturity, F would be used in the numerator