PowerPoint Slides to accompany McGrath’s Financial Institutions, Instruments and Markets Fifth Edition by Christopher Viney Designed and Written by Anthony Stanger School of Commerce The Flinders University of South Australia Copyright  2007 McGraw-Hill Australia Pty Ltd Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Chapter 1 A Modern Financial System Websites: www.rba.gov.au www.treasury.gov.au www.bis.org www.ny.frb.org www.asx.com.au www.ft.com/asia/ Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Learning Objectives Explain the functions of a financial system Categorise the main types of financial institutions Describe the main classes of financial instruments issued in a financial system Discuss the flow of funds between savers and borrowers, including primary/secondary markets and direct/intermediated finance Distinguish between various types of financial markets according to function Appreciate the evolving influence of globalisation on financial markets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Chapter Organisation 1.1 Functions of a Financial System 1.2 Financial Institutions 1.3 Financial Instruments 1.4 Financial Markets 1.5 Flow of Funds and Market Relationships 1.6 Summary Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System Money Acts as medium of exchange Allows specialisation in production Solves the divisibility problem, i.e. where medium of exchange does not represent equal value for the parties to the transaction Facilitates saving Represents a store of wealth Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) Role of markets Facilitate exchange of goods and services by Bringing opposite parties together Establishing rates of exchange, i.e. prices Surplus units Savers of funds available for lending Deficit units Borrowers of funds for capital investment and consumption Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) Financial instrument Issued by a party raising funds, acknowledging a financial commitment and entitling holder to specified future cash flows Double coincidence of wants satisfied A transaction between two parties that meets their mutual needs Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) Flow of funds Movement of funds through the financial system between savers and borrowers giving rise to financial instruments Financial system Comprises financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) Attributes of financial assets Return or yield Total financial compensation received from an investment expressed as a percentage of the amount invested Risk Probability that actual return on an investment will vary from the expected return Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) Attributes of financial assets (cont.) Liquidity Ability to sell an asset within reasonable time at current market prices and for reasonable transaction costs Time-pattern of the cash flows When the expected cash flows from a financial asset are to be received by the investor or lender Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) Facilitation of portfolio restructuring The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows Implementation of monetary policy Actions of a central bank taken to influence interest rate levels to achieve certain economic outcomes Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.1 Functions of a Financial System (cont.) An efficient financial system Encourages savings Directs savings to the most efficient users Implements the monetary policy of governments by influencing interest rates Is a combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Chapter Organisation 1.1 Functions of a Financial System 1.2 Financial Institutions 1.3 Financial Instruments 1.4 Financial Markets 1.5 Flow of Funds and Market Relationships 1.6 Summary Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.2 Financial Institutions Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial transactions Institutions may be categorised by differences in the sources and uses of funds Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.2 Financial Institutions (cont.) Categories of financial institutions Depository financial institutions Investment banks and merchant banks (money market corporations) Contractual savings institutions Finance companies Unit trusts Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Categories of financial institutions Depository financial institutions Mainly attract the savings of depositors through on-demand deposit and term deposit accounts, e.g. Commercial banks, building societies and credit cooperatives Mainly provide loans to borrowers in household and business sectors Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Categories of financial institutions (cont.) Investment banks and merchant banks (money market corporations) Mainly provide off-balance-sheet (OBS) advisory services to support corporate and government clients, e.g. Advice on mergers and acquisitions, portfolio restructuring, finance and risk management May also provide some loans to clients but are more likely to advise on raising funds directly in capital markets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Categories of financial institutions (cont.) Contractual savings institutions The liabilities of these institutions are contracts that specify, in return for periodic payments to the institution, the institution will make payments to the contract holders if a specified event occurs, e.g. Life and general insurance companies and superannuation funds The large pool of funds are then used to purchase both primary and secondary market securities Payouts are made for insurance claims and to retirees Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Categories of financial institutions (cont.) Finance companies Funds are raised by issuing financial securities, such as commercial paper, medium-term notes and bonds, directly into money markets and capital markets Funds are used to make loans and provide lease finance to customers in the household and business sectors Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Categories of financial institutions (cont.) Unit trusts Formed under a trust deed and controlled and managed by a trustee Funds raised by selling units to the public. Investors purchase units in the trust Funds are pooled and invested by fund managers in a range of asset classes specified in the trust deed Types of unit trusts include equity, property, fixed interest and mortgage trusts Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.2 Financial Institutions (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Chapter Organisation 1.1 Functions of a Financial System 1.2 Financial Institutions 1.3 Financial Instruments 1.4 Financial Markets 1.5 Flow of Funds and Market Relationships 1.6 Summary Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.3 Financial Instruments Equity Ownership interest in an asset Residual claim on earnings and assets Dividend Liquidation Types Ordinary share Hybrid (or quasi-equity) security Preference shares Convertible notes Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.3 Financial Instruments (cont.) Debt Contractual claim to Periodic interest payments Repayment of principal Ranks ahead of equity Can be Short-term (money market instrument), or medium- to long-term (capital market instrument) Secured or unsecured Negotiable (ownership transferable, e.g. commercial bills and promissory notes) or non-negotiable (e.g. term loan obtained from a bank) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.3 Financial Instruments (cont.) Derivatives A synthetic security providing specific future rights that derives its price from A physical market commodity Gold and oil Financial security Interest rate-sensitive debt instruments, currencies and equities Used mainly to manage price risk exposure and to speculate Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.3 Financial Instruments (cont.) Four basic derivative contracts Futures contract (Chapter 18) Forward contract (Chapters 17 & 18) Option contract (Chapter 19) Swap contract (Chapter 20) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Chapter Organisation 1.1 Functions of a Financial System 1.2 Financial Institutions 1.3 Financial Instruments 1.4 Financial Markets 1.5 Flow of Funds and Market Relationships 1.6 Summary Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.4 Financial Markets Matching principle Primary and secondary market transactions Direct and intermediated financial flow markets Wholesale and retail markets Money markets Capital markets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Matching principle Short-term assets should be funded with short-term (money market) liabilities, e.g. Seasonal inventory needs funded by overdraft Longer-term assets should be funded with equity or longer-term (capital market) liabilities, e.g. Equipment funded by debentures Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Primary and secondary market transactions Primary market transaction The issue of a new financial instrument to raise funds to purchase goods, services or assets by Businesses Company shares or debentures Governments Treasury notes or bonds Individuals Mortgage Funds are obtained by the issuer Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Primary and secondary market transactions (cont.) The buying and selling of existing financial securities No new funds raised and thus no direct impact on original issuer of security Transfer of ownership from one saver to another saver Provides liquidity, which facilitates the restructuring of portfolios of security owners Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Direct and intermediated financial flow markets Direct financial flow markets Users of funds obtain finance directly from savers Advantages Avoids costs of intermediation Increases range of securities and markets Disadvantages Matching of preferences Liquidity and marketability of a security Search and transaction costs Assessment of risk, especially default risk Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Direct and intermediated financial flow markets (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Direct and intermediated financial flow markets (cont.) A financing arrangement involving two separate contractual agreements whereby saver provides funds to intermediary and the intermediary provides funding to the ultimate user of funds Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Direct and intermediated financial flow markets (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Direct and intermediated financial flow markets (cont.) Advantages Asset transformation Borrowers and savers are offered a range of products Maturity transformation Borrowers and savers are offered products with a range of terms to maturity Credit risk diversification and transformation Saver’s credit risk limited to the intermediary Liquidity transformation Ability to convert financial assets into cash Economies of scale Financial and operational benefits of organisational size and business volume Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Wholesale and retail markets Wholesale markets Direct financial flow transactions between institutional investors and borrowers Involves larger transactions Retail markets Transactions conducted primarily with financial intermediaries by the household and small- to medium-sized business sectors Involves smaller transactions Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Money markets Wholesale markets in which short-term securities are issued (primary market transaction) and traded (secondary market transaction) Securities highly liquid Term to maturity of one year or less Highly standardised form Deep secondary market No specific infrastructure or trading place Enable participants to manage liquidity Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Money markets (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Money markets (cont.) Money market submarkets exist for Central bank: system liquidity and monetary policy Inter-bank market Bills market Commercial paper market Negotiable certificates of deposit (CDs) market Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Capital markets Markets in which longer-term securities are issued and traded with original term-to-maturity in excess of one year Equity markets Corporate debt markets Government debt markets Also incorporate use of foreign exchange markets and derivatives markets Participants include individuals, business, government and overseas sectors Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Chapter Organisation 1.1 Functions of a Financial System 1.2 Financial Institutions 1.3 Financial Instruments 1.4 Financial Markets 1.5 Flow of Funds and Market Relationships 1.6 Summary Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.5 Flow of Funds and Market Relationships Sectorial flow of funds The flow of funds between business, financial institutions, government and household sectors and the rest of the world Net borrowing and net lending of these sectors of an economy vary between countries Influenced by The impact of fiscal and monetary policy on savings and investment decisions Policy decisions like compulsory superannuation Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

Chapter Organisation 1.1 Functions of a Financial System 1.2 Financial Institutions 1.3 Financial Instruments 1.4 Financial Markets 1.5 Flow of Funds and Market Relationships 1.6 Summary Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.6 Summary The financial system is composed of financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions Financial instruments may be equity, debt or hybrid Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger

1.6 Summary (cont.) Financial markets may be classified according to Primary and secondary transactions Direct and intermediated flows Wholesale and retail markets Money markets and capital markets Financial institutions Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger