Week 1. Introduction to financial markets, institutions and money

Week 1. Introduction to financial markets, institutions and money

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Unformatted text preview: 1302AFE Money, 1302AFE Banking and Finance Professor Andrew Worthington Monday 28 July 2008 Course objectives Course objectives Upon successful completion of this course, students will be able to: Define a financial market, and distinguish between the various types and roles of the financial markets; Discuss the importance of financial regulation and explain the supervision framework and methodology; Explain the objectives and importance of monetary policy and the role of centrals banking Explain the economic function of money and capital markets and identify and describe various market instruments; Understand important issues involved in international markets; Describe the roles, functions and operations of banks and non­bank financial institutions; Describe the roles, functions, operations and regulation of funds management, superannuation, insurance, investment banking and venture capital; Convenors Convenors Text Text Kidwell, D.S., Brimble, M.A., Beal, D. and D. Willis, 2006, ‘Financial Markets, Institutions and Money’, (1st Edition), John Wiley and Sons, Brisbane. Content Content Assessment Assessment Week 1. Introduction to financial Week 1. Introduction to financial markets, institutions and money 1302AFE Money, Banking and Finance Professor Andrew Worthington Monday 28 July 2008 Objectives Objectives The objective of this lecture is to help you: Explain the role of the financial system and why it is important. Explain the function of direct and indirect financial markets. Describe the different types of financial institutions. Describe the various types of financial markets. Explain the economic function of money and capital markets. Identify the risks that financial institutions face and describe how these risks are managed. Function of financial markets Function of financial markets Financial markets perform the essential economic function of channelling funds from economic entities with surplus funds to those with a shortage of funds. We refer to those who have saved funds (that is, their income is greater than their expenditure) and who are lending as a ‘surplus spending unit’ (SSU) or ‘lender­saver’. Principal SSUs are households, but also governments, businesses, and foreign governments, businesses and households. We refer to those who need funds (that is, their income is less than their expenditure) and who are borrowing as a ‘deficit spending unit’ (DSU) or ‘borrower­spender’. Principal DSUs are businesses and governments, but also households and foreigners. We can see the net borrowing and lending position of these units in Australia from the National Accounts. Australian flow of funds, sectoral balances: net Australian flow of funds, sectoral balances: net borrowing (­), net lending (+) ($ bil.) ABS Cat. 5232.0General Year end Non­financial Financial Households Rest of world Jun­1990 Jun­1991 Jun­1992 Jun­1993 Jun­1994 Jun­1995 Jun­1996 Jun­1997 Jun­1998 Jun­1999 Jun­2000 Jun­2001 Jun­2002 Jun­2003 Jun­2004 Jun­2005 Jun­2006 Jun­2007 corporations ­24.8 ­19.8 ­3.8 ­1.2 2.3 ­7.6 ­15.4 ­18.3 ­18.7 ­26.6 ­28.5 ­14.4 ­5.6 ­17.7 ­17.9 ­31.5 ­46.3 ­53.3 corporations 4.6 7.1 1.4 3.9 ­0.2 3.3 2.6 3.8 4.9 2.4 4.5 10.7 8.3 16.7 20.9 20.6 19.9 24.7 government ­4.8 ­12.1 ­21.9 ­24.8 ­20.0 ­21.1 ­14.4 ­6.3 2.4 7.7 15.9 ­2.4 2.6 11.7 10.2 12.3 19.6 10.9 5.6 7.8 5.4 3.8 2.8 ­2.3 6.9 5.0 ­9.6 ­14.9 ­21.7 ­9.6 ­22.7 ­47.7 ­57.8 ­55.3 ­45.7 ­39.3 20.8 15.4 11.2 14.4 15.6 27.7 20.3 15.8 21.1 31.4 29.9 15.8 17.4 37.1 44.7 53.9 52.4 56.6 We can see that households have been net borrowers since 1998. This is a result of households borrowing for owner­occupier and investor mortgages, credit cards and margin accounts. Household debt is now at record levels. Government has been a net lender mostly since 1998. This is because most governments (state and federal) have run surpluses or balanced budgets. Non­financial corporations rely on positive funds flow to finance investment projects. The rest of the world finances most of Australia’s borrowing as Australia is an attractive option for lending to and generally lacks the domestic capital necessary to finance large resource and other projects. Some observations on the flow of Some observations on the flow of funds Direct finance Direct finance There are two routes by which funds are channelled from SSUs (lenders­savers) to DSUs (borrowers­ spenders). Direct finance is where funds are directly obtained by DSU from SSU by selling securities (or financial instruments or assets) (like an IOU) in financial markets. Here there is a direct ‘asset­liability’ relationship between the SSU and the DSU. Financial institutions (FI) have a role by providing broking advice, financial planning, funds management, security documentation and underwriting in return for commission or fees. Direct flow of funds Direct flow of funds SSU 1. Households 2. Businesses 3. Government 4. Foreigners DSU 1. Businesses 2. Government 3. Households 4. Foreigners Funds Assets Examples of direct finance Examples of direct finance A company (DSU) floats on a stock market through an initial public offering by issuing shares (securities) in exchange for capital (funds) taken up by SSUs (households, financial corporations). A company (DSU) raises funds in the money market by issuing commercial paper or bills purchased by financial corporations (SSU). The government (DSU) raises funds for infrastructure by issuing government bonds purchased by financial corporations, households and the rest of the world (SSU). A bank (DSU) raises funds to lend to households or businesses by selling negotiable certificates of deposit (NCDs) to superannuation funds (SSUs). Indirect finance Indirect finance Indirect or intermediated finance involves financial institutions performing the role of a financial intermediary. There is no direct claim existing between the SSU and DSU, only via the financial intermediary. The DSU issues primary securities to the FI that then issues secondary securities to the SSU. In performing this role FIs earn income in the form of interest rate spread and fees. Indirect flow of funds Indirect flow of funds Asset SSU Funds DSU Financial intermediary Funds Asset Types of Intermediaries Types of Intermediaries Australian financial intermediaries include: Banks, building societies and credit unions Foreign bank representatives General and life insurers Friendly societies Money market corporations, finance companies and securitisers Approved trustees Superannuation entities. Examples of indirect finance Examples of indirect finance Households (SSU) save money in deposit accounts with their bank. The banks pool these funds and lend to businesses and other households (DSU). Households (SSU) invest money in their superannuation fund for retirement. The fund may place these with venture capital and private equity funds. Financing processes Financing processes Direct financing Arranged by financial service providers, issuing securities in the market in return for underwriting fees and fee income. Investors Depositors Other surplus units Indirect financing Users of funds, such as borrowers Deposit-taking institutions acquire funds as deposits and make Loans for interest rate spreads and fees. Intermediation increases the costs of funds for DSUs and lowers the return for SSUs. Ability to access a variety of different funding markets for diversification. In some cases it may provide more flexible funding arrangements. Problem of matching the preferences of borrowers and lenders. The liquidity and marketability of the assets created may be a problem. Search and transaction costs may be substantial in accessing direct funds. Problem with assessing the credit/default risk of DSUs, especially in other institutional settings. May be difficult to arrange very large sources of funds for Benefits & costs of direct finance Benefits & costs of direct finance Benefits & costs of indirect finance Benefits & costs of indirect finance Asset value transformation means that FIs can aggregate the collective value of individual SSUs to satisfy the large value requirements of DSUs. Maturity transformation means that FI can change the maturity attributes of funds to meet the requirements of DSUs who prefer longer maturities. Credit risk reduction is possible where the FI can assess requests for funds more accurately and diversify these risks across a larger portfolio of assets. Overcoming information asymmetry is an important function because (the larger) DSUs are frequently in possession of more accurate and complete information than the (smaller) SSUs. Provision of liquidity to SSUs is achieved because FI can offer a range of assets and funds that may not be achievable in direct finance. Technological gains are possible because FI access to computing technology is generally better than that of SSUs. Is it this simple? Is it this simple? At first impression indirect finance appears to offer sizeable advantages over direct finance. However, in recent decades several processes have emerged that are associated with a relative decline in the role of intermediated finance. We call this process disintermediation. One important change is securitisation. This is a process whereby financial assets created by a FI are converted into a form (a financial security) that allows transfer in a secondary market. A key role in the US sub­prime crisis was played by securitised mortgage assets. This has meant that FI have disengaged themselves from traditional intermediation and make more active use of financial markets. Securitisation also means that some of benefits of intermediated finance are now available in direct markets. Some of the key issues are the growth of managed funds and the range of financial securities available. This means that financial markets are more important than ever before. Direct and indirect flow of funds Direct and indirect flow of funds Asset SSUs (Lenders-Savers) Funds DSUs (Borrowers-Spenders) Financial intermediary Funds Assets Assets Funds Funds Asset Financial markets Assets Funds Structure of financial markets Structure of financial markets An economic market is a mechanism that brings together, not necessarily in a single location, sellers and buyers for the purposes of exchange. Financial markets are where financial assets are created and/or exchanged. The financial system comprises a number of different financial markets that can be classified in a number of ways for several purposes. We have already introduced the role of financial intermediaries. These will be developed in Weeks 9, 10 and 11. Let us look at how we can categorise these financial markets. Debt and equity markets Debt and equity markets The most common method of raising finance is through the issuance of a debt instrument, such as a bond or mortgage. These instruments normally encompass a contractual arrangement relating to maturity, interest payments and the dates these should be paid. We normally define these as short­term if the maturity is less than 1 year, long­term if longer than 10 years, and medium or intermediate term if between these periods. An alternative technique is the issuance of equity. This is a claim upon the net income and assets of a business. We will cover debt in Weeks 4 and 5 and equity in Week 6. Primary and secondary markets Primary and secondary markets A primary market is where new issues of a security, whether debt or equity, are sold to initial buyers. A secondary market is a financial market where securities that have previously been issued can be resold. Primary markets are used by the issuing party to raise funds. The secondary market does not provide new funds. Secondary markets do, however, serve two important functions. The ability to sell these securities in a secondary market means they are more liquid. The increased liquidity of a secondary market makes it easier for these instruments to be sold in the primary market. The pricing established in the secondary market will determine the price at which issuers can sell at in the primary market. Because conditions in the secondary market are most relevant to the issuance of securities, it is these markets upon which we will focus in this course. Exchanges and OTC markets Exchanges and OTC markets A central exchange, not necessarily physical, where buyers and sellers gather to transact are known as exchanges. Most share markets in the world are examples of exchanges, i.e. ASX, NYSE. An alternative method of organising a secondary market is to have dealers at different locations ready to buy and sell ‘over­the­counter’ (OTC) to anyone willing to pay the price. The US government bond market is an example of an OTC market. We will look at the operation of exchanges throughout the course. Retail and wholesale markets Retail and wholesale markets In retail markets small value transactions are conducted, normally between individuals, households and small businesses. Household investments in bank deposits, managed funds and shares are examples of retail financial transactions, as are housing and small commercial loans. In wholesale markets, large value transactions are conducted, typically by large corporations, governments and financial institutions. We comment on the distinction between wholesale and retail markets throughout most of the course. Money and capital markets Money and capital markets The money market is a financial market in which only short­ term debt instruments are traded. The capital market is where debt and equity instruments with maturities longer than one year are traded. Generally money markets are more liquid and have smaller fluctuations in prices than capital markets. This makes them attractive for corporations and banks to use for temporary cash surpluses. Financial intermediaries such as insurance companies and superannuation funds tend to favour capital markets. This division will receive attention in most weeks. Other markets Other markets Derivative markets are made up of instruments whose price is determined by a price, rate or index established in a secondary market. In terms of financial securities both debt and equity derivatives are examined. We will leave our study of derivative markets for future courses. Foreign exchange is an important aspect of the international flow of funds. We will examine this in Week 8. For next week For next week Read and take notes on Ch. 1 in the text. Complete Q&P 1.4, 1.7, 1.13, 1.14 and 1.15 in the text. These will be discussed in tutorials in Week 3. Start reading Ch. 2 if you have time. ...
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