1. PowerPoint Slides to accompany Financial Institutions, Instruments and Markets Fourth Edition by Christopher Viney
Designed and Written by Anthony Stanger School of Commerce The Flinders University of South Australia

2. Chapter 1
The Financial System

3. Learning Objectives Explain the functions of a financial system
Describe the main classes of financial instruments issued in a financial system
Distinguish between various types of financial markets according to function
Discuss the flow of funds between savers and borrowers, including direct and intermediated finance

4. Learning Objectives (cont.)
Appreciate the influence of globalisation on financial markets
Categorise the main types of financial institutions
Understand the impact of a financial crisis on a financial system and a real economy

5. Chapter Organisation
1.1 Introduction 1.2 Functions of the Financial System 1.3 Financial Instruments 1.4 Financial Markets 1.5 Impact of Globalisation 1.6 Financial Institutions 1.7 Summary

6. 1.1 Introduction Money 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
Store of wealth

7. 1.1 Introduction (cont.) Role of markets Surplus units Deficit units
Facilitate exchange 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

8. 1.1 Introduction (cont.) Financial instrument Flow of funds
Issued by a party raising funds, acknowledging a financial commitment and entitling holder to specified future cash flows
Flow of funds
Movement of funds through the financial system between savers and borrowers giving rise to financial instruments

9. 1.1 Introduction (cont.) Financial system
Financial institutions, instruments and markets facilitating transactions for goods and services and financial transactions
Overcomes difficulty of
Double coincidence of wants
Transaction between two parties meets their mutual needs

10. 1.1 Introduction (cont.)

11. Chapter Organisation
1.1 Introduction 1.2 Functions of the Financial System 1.3 Financial Instruments 1.4 Financial Markets 1.5 Impact of Globalisation 1.6 Financial Institutions 1.7 Summary

12. 1.2 Functions of the Financial System
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

13. 1.2 Functions of the Financial System (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

14. 1.2 Functions of the Financial System (cont.)
The financial system facilitates portfolio restructuring
The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows

15. 1.2 Functions of the Financial System (cont.)
An efficient financial system
Encourages savings
Savings flow to the most efficient users
Implements the monetary policy of governments by influencing interest rates
The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows

16. Chapter Organisation
1.1 Introduction 1.2 Functions of the Financial System 1.3 Financial Instruments 1.4 Financial Markets 1.5 Impact of Globalisation 1.6 Financial Institutions 1.7 Summary

17. 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

18. 1.3 Financial Instruments (cont.)
Debt
Contractual claim to
Periodic interest payments
Repayment of principal
Ranks ahead of equity
Can be secured or unsecured

19. 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

20. 1.3 Financial Instruments (cont.)
Four basic derivative contracts
Futures (Chapter 18)
Forward (Chapter 18)
Option contract (Chapter 19)
Swap (Chapter 20)

21. Chapter Organisation 1.1 Introduction
1.2 Functions of the Financial System
1.3 Financial Instruments
1.4 Financial Markets
1.5 Impact of Globalisation
1.6 Financial Institutions
1.7 Summary

22. 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

23. Matching principle
Short-term assets should be funded with short-term liabilities
Inventory funded by overdraft
Longer-term assets should be funded with equity or longer-term liabilities
Equipment funded by debentures

24. 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

25. Primary and secondary market transactions (cont.)
The buying and selling of existing financial instruments
No direct impact on original issuer of security
Transfer of ownership from one saver to another saver
Provides liquidity which facilitates restructuring of portfolios of security owners

26. Direct and intermediated financial flow markets
Direct 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

27. Direct and intermediated financial flow markets (cont.)

28. Direct and intermediated financial flow markets (cont.)
Intermediated flow markets
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
Advantages
Asset transformation
Maturity transformation

29. Direct and intermediated financial flow markets (cont.)
Advantages (cont.)
Credit risk diversification and transformation
Liquidity transformation
Economies of scale
Sectorial flow of funds
The flow of funds between business, financial institutions, government and household sectors and the rest of the world
Influenced by fiscal and monetary policy

30. Direct and intermediated financial flow markets (cont.)

31. Wholesale and retail markets
Wholesale markets
Direct financial flow transactions between institutional investors and borrowers
Involves large transactions
Retail markets
Transactions conducted primarily with financial intermediaries by the household and small- medium business sectors
Involves smaller transactions

32. Money markets
Wholesale markets in which short-term securities are issued and traded
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

33. Money markets (cont.) Money market securities
Cash deposits (11 a.m. and 24-hour call)
Commercial bills
Treasury notes
Government bonds
Promissory notes
Intercompany loans
Interbank loans

34. Money markets (cont.) Money market participants Reserve Bank Banks
Financial system liquidity
Implementation of monetary policy
Banks
Finance companies
Funds managers
Building societies
Credit unions
Companies

35. Money markets (cont.) Money market sub-markets Intercompany market
Interbank market
Bills market
Commercial paper market
Negotiable certificates of deposit (CDs) market

36. Capital markets
Markets in which longer-term securities are issued and traded
Equity markets
Corporate debt markets
Government debt markets
Foreign exchange markets
Derivatives markets
Term to maturity of more than one year

37. Chapter Organisation
1.1 Introduction 1.2 Functions of the Financial System 1.3 Financial Instruments 1.4 Financial Markets 1.5 Impact of Globalisation 1.6 Financial Institutions 1.7 Summary

38. 1.5 Impact of Globalisation
Globalisation of financial markets
Refers to the interdependence of national financial systems
Global standardisation of financial instruments
Facilitates the movement of funds between savers and borrowers in different countries

39. Chapter Organisation
1.1 Introduction 1.2 Functions of the Financial System 1.3 Financial Instruments 1.4 Financial Markets 1.5 Impact of Globalisation 1.6 Financial Institutions 1.7 Summary

40. 1.6 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

41. 1.6 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

42. Categories of financial institutions
Depository financial institutions
Attract savings from depositors and investors to provide loan facilities to borrowers
Commercial banks
Building societies
Credit unions

43. Categories of financial institutions (cont.)
Investment banks and merchant banks
(money market corporations)
Mainly provide off-balance-sheet (OBS) transactions to corporations and government
Advice on mergers and acquisitions, portfolio restructuring, finance and risk management
Provide some funding

44. 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
Funds are then used to purchase both primary and secondary market securities
Life and general insurance companies
Superannuation funds

45. Categories of financial institutions (cont.)
Finance companies
Funds are raised by issuing financial securities direct into money markets and capital markets
Funds are used to make loans to ultimate borrowers

46. Categories of financial institutions (cont)
Unit trusts
Investors purchase units in the trust
Trust manager invests funds in a range of investments specified by trust deed
Types of unit trusts
Cash management trusts
Equity trusts
Property trusts
Mortgage trusts

47. 1.6 Financial Institutions (cont.)
Assets of financial institutions

48. Chapter Organisation
1.1 Introduction 1.2 Functions of the Financial System 1.3 Financial Instruments 1.4 Financial Markets 1.5 Impact of Globalisation 1.6 Financial Institutions 1.7 Summary

49. 1.7 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

50. 1.7 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