1. The Financial System

2. 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

3. Introduction (cont.) Role of markets – 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

4. Introduction (cont.) Financial instrument – 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

5. 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

6. Introduction (cont.)

7. 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

8. 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

9. 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

10. 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

11. 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

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

13. 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

14. Financial Markets Matching principle Primary and secondary market transactions Direct and intermediated financial flow markets Wholesale and retail markets Money markets Capital markets

15. 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

16. 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

17. Primary and secondary market transactions (cont.) Secondary market transaction – 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

18. 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

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

20. 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

21. 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

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

23. 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

24. 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

25. 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

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

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

28. 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

29. 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

30. 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