chapter 01 - a modern financial system an overview
TRANSCRIPT
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger1
Chapter 1
The Financial System
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger2
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger3
Learning Objectives (cont.)
• Appreciate the influence of globalization on financial markets
• Categorize the main types of financial institutions
• Understand the impact of a financial crisis on a financial system and a real economy
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger4
Chapter Organization1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalization1.6 Financial Institutions1.7 Summary
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger5
1.1 Introduction• Money
– Medium of exchange– Allows specialization 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
“Any commodity that is widely accepted in exchange transactions”
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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1.1 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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger7
1.1 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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger8
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger9
1.1 Introduction (cont.)
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger10
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Chapter Organisation1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger11
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger12
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Chapter Organisation1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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1.3 Financial Instruments• Equity
– Ownership interest in an asset– Residual claim on earnings and assets
Dividend Liquidation
– Types Ordinary share Preference shares or Equity Hybrid (or quasi-
equity) security• Preference shares• Convertible notes
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
1.3 Financial Instruments (cont.)
• Debt– Contractual claim to
Periodic interest payments Repayment of principal
– Ranks ahead of equity– Can be secured or unsecured
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger19
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
1.3 Financial Instruments (cont.)
• Four basic derivative contracts– Futures Contract– Forward Contract– Option Contract– Swap Contract
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Chapter Organisation1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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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 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger26
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Direct and intermediated financial flow markets (cont.)
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger28
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Direct and intermediated financial flow markets (cont.)
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger31
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Money markets (cont.)• Money market sub-markets
– Intercompany market– Interbank market– Bills market– Commercial paper market– Negotiable certificates of deposit (CDs)
market
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger36
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Chapter Organisation1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger37
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger38
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Chapter Organisation1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger39
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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1.6 Financial Institutions (cont.)
• Assets of financial institutions
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson
Chapter Organisation1.1 Introduction1.2 Functions of the Financial System1.3 Financial Instruments1.4 Financial Markets1.5 Impact of Globalisation1.6 Financial Institutions1.7 Summary
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger48
Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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
Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
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Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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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