FINS1612

CAPITAL MARKETS AND INSTITUTIONS

WEEK1
Introduction to Financial System

Introduction to FINS1612
Refer to unit outline

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
Distinguish between various types of financial markets
according to function
Discuss the flow of funds between savers and borrowers,
including primary/secondary markets and
direct/intermediated finance

What is finance?

Then, what is money?

Money

Acts as medium of exchange

Represents a store of wealth
Facilitates saving
Solves the divisibility problem,

5 Sector Economy
HOUSEHOLD
Sector

FIRMS
Sector

FINANCIAL
Sector

GOVERNMENT
Sector

OVERSEAS
Sector

Flow of Funds
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

Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6

Functions of a Financial System

Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary

What is financial System?

The financial system is part of a countrys

economic system
A financial system comprises a range of financial
institutions, financial instruments and financial
markets which interact to facilitate the flow of
funds
Financial institutions permit the flow of funds
between borrowers and lenders by facilitating
financial transactions

The main functions of financial system

Provide investment products for surplus

economic units shares, bank deposits

Provide alternative funding sources for
deficit economic units bank loans
Provide risk management products and
services insurance products

The main functions of financial system

Main function is to facilitate the flow of funds
Primary Financial Market -facilitate the transfer of funds

from surplus to deficit economic units by the creation of

new financial assets
Secondary Market facilitates the transfer of funds by
arranging trades in existing financial assets
Efficient financial system should ensure that savings will
be directed to the most efficient users of those funds
Overseeing the financial system is the Central bank and
the prudential supervisor

Functions of a Financial System (cont.)

1. Financial Institutions
Financial institutions are classified into five

categories based on the differences between

the institutions sources and uses of funds
1.Depository financial institutions
2.Investment banks and merchant banks
3.Contractual savings institutions
4.Finance companies
5.Unit trust

Depository financial institutions

Commercial banks
obtains a large proportion of their funds from

deposits lodged by savers.

A principal business of these institutions is the
provision of loans to borrowers in the
household and business sectors
E.g.

Investment banks and merchant banks

Major function is to provide off-balance sheet

advisory services to support their corporate and

government clients
Off balance sheet business includes advising clients
on mergers and acquisitions, portfolio restructuring,
and risk management.
These institutions may provide some loans to clients
but are more likely to advise and assist a client to
raise funds directly in the capital markets.

Contractual savings institutions

Financial institutions such as life insurance offices,

general insurers and superannuation funds

Their liabilities are mainly contracts which specify that,
in return for periodic payments to the institution, the
institution will make specified payouts to the holder of
the contract if and when the event specified in the
contract occurs.
The periodic cash receipts received by these institution
provide them with a large pool of funds that they invest.

Finance companies
These institutions raise funds by issuing financial

securities such as commercial paper, medium

term notes and bonds in the money markets and
the capital markets
They use those funds to make loans and provide
lease finance to their customers in the household
sector and the business sector

Unit trusts
A unit trust is formed under a trust deed and is

controlled and managed by a trustee or responsible

entity
Unit trusts attract funds by inviting the public to
purchase units in a trust. The funds obtained from the
sale of units are pooled and then invested by funds
managers in asset classes specified in the trust deed.
There is a wide range of unit trusts, including equity
trusts, property trusts, fixed interest trusts and mortgage
trust.

1.2

Financial Institutions (cont.)

Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6

Functions of a Financial System

Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary

Financial Assets
A financial asset is defined as entitlement to

future cashflows
A financial instrument is the more general
term used in the markets to describe financial
assets and other instruments where there is no
organised secondary market where that
instrument can be traded
A financial security is a financial asset that can
be traded in secondary market.

Financial Assets
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

Financial Assets
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

Financial Assets
The financial system (financial

institutions, instruments and markets)

provides the potential suppliers of
funds with the combinations of risk,
return, liquidity and cash-flow patterns
that best suit each savers particular
needs

2. Financial Instruments
A financial instrument represents an

entitlement to the holder to a specified set of

future cash flows.
Equity
Debt
Derivatives
Hybrid

Equity
Equity can be described as an ownership

interest in an asset
Types
Ordinary share
Hybrid (or quasi-equity) security
Preference shares
Convertible notes

Debt
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

Debt Finance
Short-term debt is a financing arrangement for a

period of less than one year with various

characteristics to suit borrowers particular needs
Timing of repayment, risk, interest rate structures
(variable or fixed) and the source of funds
Long term debt has a maturity of more than one

year

Derivatives
Derivative instruments are different from equity and debt in

that they do not provide actual funds for a borrower, but

rather facilitate the management of certain related risks.
Used mainly to manage price risk exposure and to

speculate
4 different types of derivative instrument

A futures contract
A forward contract
An option contract
A swap contract

HYBRID
A hybrid security incorporates the

characteristics of both debt and equity

E.g. preference share

Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6

Functions of a Financial System

Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary

3. Financial Markets
Matching principle
Primary and secondary market transactions
Direct and intermediated financial flow

markets
Wholesale and retail markets
Money markets
Capital markets

Financial Markets
Financial market within the economic system is

vital for the country

Financial markets are characterised by
Lending and borrowing of funds
Creation and trading of financial assets
financial market is distinguished from other

economic markets such as the market for final

goods real assets
The markets are categorised according to the types
of transactions that occur

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
lack of adherence to this principle accentuated

effects of frozen money markets with the subprime market collapse

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

Direct and intermediated finance (cont.)

1
37

Primary and secondary market transactions (cont.)

Secondary market transaction

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

Direct Finance and Intermediated Finance

The issue of new financial instruments generates a flow of funds

through the primary markets from the provider of funds to the

user of those funds.
This flow can occur in two ways
Direct relationship from the provider of funds to the user of funds
Indirect relationship from the provider of funds to the user of funds
i,e, financial intermediary is involved

Direct and intermediated financial flow markets

Direct financial flow markets - Users of funds obtain finance

directly from savers

The contractual agreement is between the provider of funds
and the user of funds
Direct finance is generally available only to corporations and
government authorities that have established a good credit
rating (investment-grade credit rating)

Direct finance cont

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

Direct and intermediated financial flow markets (cont.)

Direct and intermediated financial flow markets (cont.)

Intermediated financial 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

Direct and intermediated financial flow markets (cont.)

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
Savers 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,
expertise and business volume

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

Wholesale and retail markets (cont.)

1
47

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

Money markets (cont.)

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

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
Financial markets may be classified according to

Primary and secondary transactions

Direct and intermediated flows
Wholesale and retail markets
Money markets and capital markets