TOPIC 1: INTRODUCTION TO FINANCIAL MARKETS
TOPIC 1:Introduction to Financial Markets
Aim
The aim of this topic is to provide an introduction to, and
framework for examining, the nature and operation of the financial
system. The two main methods of financing are distinguished along
with the different types of financial assets that are created. In
addition, the relationship between the financial system and the
economic system and the role of government with respect to the
financial system are considered.
Learning objectives
After working through this topic, you should be able to:
1. Describe the main features of the financial system.
2. Distinguish between direct and indirect financing and the
characteristics of each.3. Explain the relationship between the
financial system and the economic system.
4. Outline the main reasons for, and methods of, government
intervention into financial markets.
Objective 1
After working through this section you should be able to
describe the main features of the financial system.
1.1 The financial system
To understand the nature of financial markets it is first
necessary to understand the overall financial system that
comprises, inter alia, financial markets.
The main functions of a nations financial system are to
facilitate the:
transfer of funds from surplus to deficit economic units, in
primary financial markets, by the creation of new financial assets
trade of existing financial assets in secondary financial
markets
A nations financial system comprises surplus economic units
(lenders), deficit economic units (borrowers), financial
institutions, financial markets and financial assets.
1.1.1 Surplus economic units
These are individuals or small groups (eg individual households
or business firms) who have more funds available than they require
for immediate expenditure. That is, they represent savers and
potential lenders of their surplus funds.1.1.2 Deficit economic
units
These are individuals or groups (eg individual households or
business firms) who require additional funds to meet their
expenditure plans. That is, they represent potential borrowers of
funds.
1.1.3 Financial institutions
These are organisations whose core business involves the
borrowing and lending of funds (financial intermediation) and/or
the provision of financial services to other economic units.
1.1.4 Financial assets
Financial assets, also called financial instruments, represent a
claim or right that a surplus economic unit holds over a deficit
economic unit. Issued by the party raising funds, it acknowledges a
financial commitment and entitling the holder to specified future
cash flows. For the party issuing the financial assets, the assets
represent a liability or obligation.
Whenever, funds are lent and borrowed, financial assets are
created. Primary market financial transactions involve an exchange
as funds are exchanged for financial assets. Lenders of funds are
also buyers of financial assets and borrowers of funds are sellers
of financial assets.
All financial assets have four different attributes which can
provide a basis for comparison between different types of financial
assets:
return or yield
risk
liquidity
time pattern of return or cash flow
Note that expected return or yield has a positive relationship
with risk and inverse relationship with liquidity. The higher the
level of risk and the lower the liquidity, the higher the return on
investment required by lenders of funds (surplus economic unites).
Lenders of funds are able to satisfy their own personal preferences
by choosing various combinations of these attributes.
The financial assets that are created and exchanged can be
divided into the following four broad types:
Debt: Debt instruments represent an obligation on the part of
the borrower to repay the principal amount borrowed and interest in
a specified manner over a defined period of time or when a
specified event occurs. Some examples are:
Deposits - eg bank deposits
Contractual savings- eg life insurance, superannuation
Discount securities - eg commercial bills
Fixed interest securities - eg bonds, debentures
Equity: Equity differs from debt in that it represents an
ownership claim over the profits and assets of a business. The main
example is ordinary shares.
Hybrid: Hybrid financial assets comprises securities that
combine features of both debt and equity. Two examples are
preference shares and convertible notes.
Derivatives: Derivative instruments are financial assets whose
value is derived from another type of financial asset. Two examples
are options and futures
Whatever form financial assets take they represent a claim (or
right) which a surplus economic unit holds over a deficit economic
unit. Likewise they also represent an obligation of deficit
economic units.
1.1.5 Financial markets
An economic market comprises a mechanism which brings together,
not necessarily to a single location, sellers and buyers for the
purpose of exchange. Financial markets are where financial assets
are created and/or exchanged. Every nations financial system
comprises a number of different financial markets which can be
classified in different ways for different purposes.
One type of classification is between primary and secondary
financial markets. In the former, new financial assets are created
and traded in exchange for borrowed funds: eg a household (surplus
economic unit) lends funds to a corporation (deficit economic unit)
in exchange for debentures (a financial asset). In the latter,
existing financial assets are traded which results in a change of
ownership but not the lending of funds: eg the holder of debentures
sells his financial asset to another person.
The term financial security is used to describe financial assets
that can be traded in a secondary market.
Another type of classification is between money markets, where
funds are lent for a period of less than one year, and capital
markets, where funds are lent for one year or longer.
Other types of classification distinguish between financial
markets for the different type of financial assets that are traded.
This is the basis on which we will be examining different financial
markets in Australia. Specifically, we will examine the following
separate Australian financial markets in turn:
The Money Market (topic 3) The Debt-Capital Market (topic 4) The
Foreign Exchange Market (topic 5)
The Equity Market (topic 6)
The Derivatives Market (topic 7)Objective 2
After working through this section you should be able to
distinguish between direct and indirect financing and the
characteristics of each.
1.2 Direct and indirect finance
The flow of funds in primary financial markets can either be
direct from lender to borrower or indirectly through a financial
intermediary. The alternative methods of financing are illustrated
in the diagram below;
1.2.1 Direct finance
With direct finance the surplus economic units who are the
ultimate lenders provide funds directly to the deficit economic
units who are the ultimate borrowers. In exchange for the funds,
the deficit economic units issue financial assets that are primary
securities held by the surplus economic units and represent a
direct claim over the ultimate borrower.
In direct finance financial institutions frequently provide
financial services to the parties, particularly the borrowers.
These services include financial advice, financial management and
security documentation, marketing, sales negotiation, provision and
arrangement of underwriting facilities. In providing such services
financial institutions are paid commission or fees.
1.2.2 Indirect finance
Indirect financing is also known as intermediated financing
because it involves financial institutions performing the role of
financial intermediary. With indirect financing, the surplus
economic units, the ultimate savers, lend their funds initially to
a financial institution who then lends the funds to the deficit
economic units who are the ultimate borrowers.
The financial institution acts as a financial intermediary and
performs the role of both borrower and lender. This is the basis of
the legal relationship that financial intermediaries have with
surplus and deficit economic units. In performing this role
financial intermediaries earn income in the form of a net interest
margin and fees. The net interest margin represents the difference
between the average cost (interest paid) of funds and average
return (interest earned) from lending.
In indirect financing, deficit economic units issue primary
securities which are held by financial intermediaries who issue
secondary securities to surplus economic units. Surplus economic
units do not have a direct claim on deficit economic units.
You should not become confused between primary and secondary
financial markets and primary and secondary financial assets
(securities). The terms primary and secondary are used in different
contexts for each of the above which are not related. Primary and
secondary securities are both created in primary financial markets
and can be traded in secondary financial markets.
1.2.3 Advantages of financial intermediation
In carrying out the role of intermediation financial
institutions provide a number of benefits to borrowers, lenders and
the economy as a whole. The main advantages of financial
intermediation are:
Asset value transformation: financial intermediaries are able to
create secondary securities that differ in value from the primary
securities that are issued by deficit economic units. In this way
they can tap small individual savings and pool them together for
the purpose of making larger loans. Maturity transformation:
financial intermediaries are able to borrow for different time
periods than for what they lend. In doing this they are able to
match the maturity preferences of borrowers and lenders. As a
general rule, lenders require greater liquidity than borrowers are
prepared to provide. Credit risk reduction and diversification:
financial intermediaries are able to reduce the risk of lending to
borrowers who are unable to meet their loan commitments as a result
of their expertise and knowledge. In addition, as a result of their
size and diversification of loans, they are able to spread a small
percentage of bad loans across their total loan portfolio.
Liquidity provision: Ability to convert financial assets into cash.
Financial intermediaries, due to their size and specialisation in
borrowing and lending are able to provide their customers with a
high degree of liquidity eg. cheques, ATM, EFTPOS facilities.
Increased quantity of national savings: As a result of the above
advantages the existence of indirect financing will tap a greater
quantity of national savings and hence increase the supply of funds
available to finance real investment and promote economic
growth.
1.2.4 Disadvantages of financial intermediationThere is no doubt
that financial intermediation provides a number of advantages.
However, it does not come without cost as both borrowers and
lenders must pay for the benefits they receive. This generally
means: Increased cost of funds for borrowers Reduced return from
lending for savers.
In addition to this, there is a further disadvantage in that, as
a general rule: It is less likely for secondary financial assets to
be securitised ( ie financial securities) in that they can be
traded in a secondary market.Over recent years there has been
increased reliance by large borrowers on direct rather than
indirect (intermediated) finance. Hence the term disintermediation
is used to describe this process.
Objective 3After working through this section you should be able
to outline the main institutional and regulatory features of the
Australian financial system
1.3.1 Nature and role of financial institutionsA financial
institution is a business organisation whose core business is
financial intermediation and/or the provision of financial services
to other sectors of the economy.
In indirect financing, a financial institution performs the
function of financial intermediation by borrowing from surplus
units and lending to deficit units. Revenue is generated by net
interest margin and fees. In direct financing, a financial
institution provides financial services by performing the function
of broker, agent, financial advisor, etc. Revenue is generated by
fees and commission.
Although there is a great deal of overlap between the services
offered by different financial institutions, it is common practice
to categorise non-bank financial institutions on the basis of how
they raise the majority of their funds. We can identify two main
types of institutions:
Deposit taking financial institutions: They attract the savings
of depositors through on-demand deposit and term deposit accounts.
They provide loans to borrowers in household and business sectors.
e.g. commercial banks, building societies and credit cooperatives.
Non Deposit taking financial institutions: They generally do not
provide laons or take deposits but they may managed funds under
contractual arrangement (superannuation) and provide a wide range
of financial services. e.g. Investment banks, general insurance
companies and superannuation funds.
1.3.2 Current Institutional features
The Australian financial system comprises a range of different
types of financial institutions providing financial intermediation
or other financial services.
Total Assets (Percentage Share) of Financial Institutions
From this table a number of observations can be made concerning
the institutional structure of the Australian financial system.
These include:
The dominant role of banks with the commercial banks, as a
group, comprising more than 50% of the total assets of all
financial systems. During the period of regulation banks share of
financial assets fell however, following deregulation it did
increase.
Both building societies and credit unions are very small in
terms of percentage share of financial assets. However, there are a
large number of individual institutions with approximately 30
building societies and 320 credit unions. The decline in percentage
share of financial assets owned by building societies has been
particularly due to the conversion of a number of building
societies into banks.
Life offices and superannuation funds, as a group, have
experience a significant increase in the share of financial assets
they control. The percentage share of life offices has declined in
recent years while superannuation funds have represented one of the
fastest growing sectors of the financial system. This is
particularly due to government wages and taxation policy.
Other form of managed funds, particularly public unit trusts,
have also grown significantly as retail investors have turned
toward equity and other types of managed investments and away from
traditional forms of investment such as bank deposits.
Mortgage originators and securitisation vehicles have only
become recognised as a type of financial institution in recent
years. Officially, the Reserve Bank did not collect statistics on
them until December 1996. Mortgage originators have experienced
considerable recent growth in the 90s but shrank following the
Global Financial Crisis. Mortgage originators make housing loans
and then sell these loans to securitisation vehicles set up as
separate entities by financial institutions. Funds are raised
through the issue of mortgage backed securities by the
securitisation vehicles.
1.3.3.1 Commercial banks
Commercial banks are the largest group of financial institutions
within a financial system and therefore they are very important in
facilitating the flow of funds between savers and borrowers. The
core business of banks is often described as the gathering of
savings (deposits) in order to provide loans for investment.
The traditional image of banks as passive receivers of deposits
through which they fund their various loans and other investments
has changed since deregulation (for deregulation see topic 8). For
example, banks provide a wide range of off-balance-sheet
transactions such a underwriting where for instance the bank will
commit to purchase unsold share after the share were issued to the
market. The bank can also act as guarantor on some financial
products such as money market bills (bank bills).
A wide range of non-bank financial institutions has evolved
within the financial system in response to changing market
regulation and to meet particular needs of market participants.
1.3.3.2 Building societies and credit unions
The majority of building society funds are deposits from
customers. Residential housing is the main form of lending. Credit
unions funds are sourced primarily from deposits of members.
Housing loans, personal loans and credit card finance is available
to their members. A defining characteristic of a credit union is
the common bond of association of its members, usually based on
employment, industry or community.
1.3.3.3 Investment banks and merchant banks
Investment banks and merchant banks play an extremely important
role in the provision of innovative products and advisory services
to their corporations, high-net-worth individuals and
government.
Investment and merchant banks raise funds in the capital
markets, but are less inclined to provide intermediated finance for
their clients; rather, they advise their clients and assist them in
obtaining funds direct from the domestic and international money
markets and capital markets.
Investment banks specialise in the provision of
off-balance-sheet products and advisory services, including
operating as foreign exchange dealers, advising clients on how to
raise funds in the capital markets, mergers and acquisitions,
acting as underwriters and assisting clients with the placement of
new equity and debt issues, advising clients on balance-sheet
restructuring, evaluating and advising on corporate mergers and
acquisitions, advising clients on project finance and, providing
risk management services.
1.3.3.4 Managed funds
The main types of managed funds are cash management trusts,
public unit trusts, superannuation funds (pension funds), statutory
funds of life offices, common funds and friendly societies. Managed
funds may be categorised by their investment risk profile, being
capital guaranteed funds, capital stable funds, balanced growth
funds, managed or capital growth funds.
Managed funds are a significant and growing sector of the
financial markets due, in part, to deregulation, ageing
populations, a more affluent population and more highly educated
investors. In Australia, employers must contribute the equivalent
of 9 per cent of an employees wage into a superannuation account in
the name of the employee. The superannuation funds receive
concessional taxation treatment.
1.3.3.5 Life insurance offices and general insurance offices
Life insurance offices are contractual savings institutions.
They generate funds primarily from the receipt of premiums paid for
insurance policies written. Life insurance offices are also major
providers of superannuation savings products.
Whole-of-life insurance policies include an insurance risk
component and an investment component. The policy will accumulate a
surrender value over time. A term-life policy provides life
insurance cover for a specified period. If the policyholder dies
during that period, an amount is paid to the named beneficiary.
Related insurance policies include total and permanent
disablement insurance, trauma insurance, income protection
insurance and business overheads insurance. General insurance
policies include house and contents insurance. Motor vehicle
insurance includes comprehensive, third party fire and theft, third
party only and compulsory third party insurance.
1.3.3.6 Finance companies and general financiers
Finance companies derive the largest proportion of their funding
from the sale of debentures (Debt). They provide loans to
individuals and businesses, including lease finance, floor plan
financing and factoring. Deregulation of commercial banks has
resulted in a significant decline in finance companies. Many
finance companies are now operated by manufacturers, such as car
companies, to finance sales of their product.
i.e. AGC, CBFC and ESANDAObjective 4After working through this
section you should be able to explain the relationship between the
financial system and the economic system.
1.4 The financial and economic systems
In the study of economics, it is normal to treat the financial
system as a component part of the larger economic system. The
economic system is seen as comprising, inter alia, real output
markets (for goods and services), resource markets and financial
markets.
The role of the financial system is to facilitate the operation
of the overall economic system and in particular the output markets
for goods and services. 1.4.1 The economic system
A nations economic system is concerned with the production and
distribution of goods and services. In performing this function, a
nations economic performance is normally assessed in terms of the
following economic objectives: economic growth
full employment
price stability
external balance
efficient allocation of resources
equitable distribution of income and wealth
1.4.2 The financial system and economic objectives
A nations financial system will affect its performance with
respect to each of the economic objectives listed above.
1.4.2.1 Economic growth
Historically, there is a well established relationship between
the development of a nations financial system and economic
development. The establishment of a well developed financial system
is seen as a necessary prerequisite for a country to raise
sufficient funds, to finance the necessary infrastructure projects
required for sustained economic development.
For developed economies, the cost and availability of funds,
determined in the financial system, are significant determinants of
aggregate demand, particularly private investment demand. The level
and rate of growth of aggregate demand, in turn, has a major impact
on a nations economic growth rate.
1.4.2.2 Full employment
The demand for resources, including labour, is derived from the
demand for final goods and services. Thus, the level of employment
in the economy is directly related to aggregate demand and the rate
of economic growth. As the cost and availability of funds is a
significant determinant of aggregate demand, it is also a
significant determinant of the level of employment.
1.4.2.3 Price stability
The rate of inflation is also significantly determined by the
growth of aggregate demand. Consequently, the cost and availability
of funds in the financial system will have some bearing on whether
a nation is experiencing inflation or relative price stability.
A nations monetary policy normally involves Central Bank
intervention into the financial system in pursuit of macroeconomic
objectives, particularly price stability. In Australia, at the
present time, the Reserve Bank of Australia has set an inflation
target of 2 - 3% per annum for determining the conduct of monetary
policy.
1.4.2.4 External balance
External balance refers to a desirable position in terms of a
nations international transactions, as reflected in that countrys
balance of payments, and exchange rate value of its currency. Both
the balance of payments and the exchange rate will be significantly
affected by the financial system.
The cost and availability of funds will affect the level and
rate of change of the export and import of goods and services. In
addition, borrowing from overseas (capital inlow) and overseas
investment of funds (capital outflow) are directly affected by
conditions in financial markets both domestically and globally.
Thus, both current and capital account transactions of a nations
balance of payments will be significantly determined by domestic
and international financial market conditions.
As international transactions determine the demand and supply
for a nations currency, financial market conditions will also have
a significant affect on the foreign exchange value of that nations
currency.
1.4.2.5 Efficient allocation of resources
An efficient allocation of resources is where a nations limited
resources are allocated to produce that output mix of particular
goods and services that maximises the satisfaction of society. This
is best achieved by competitive markets where the allocation of
resources is determined by demand and supply for individual goods
and services.
Any non-market distortions that influence the levels of demand
or supply will reduce the efficient allocation of resources.
Non-market distortions can result from factors in resource markets,
finance markets or in the markets for goods and services
themselves.
The efficient allocation of resources requires that factors in
finance markets do not distort the pattern of demand for individual
goods and services from that which would otherwise take place.
Allocative efficiency requires that the financial system directs
funds to the highest yielding forms of expenditure. This is best
achieved by competitive financial markets with a minimum of
government intervention and controls.
1.4.2.6 Equitable distribution of income and wealth
Non-market distortions that affect the cost and flow of funds
not only reduce allocative efficiency but have effects that are not
spread evenly over the community. For example, ceilings on
particular interest rates means some groups receive benefits, or an
effective subsidy, while other groups are required to pay higher
cost for funds than would otherwise be the case. As a result, the
distribution of income between different groups in the community is
affected.
At different times, governments have intervened into finance
markets for the main purpose of altering the distribution of income
to one that it views as more socially desirable or equitable.
Objective 5After working through this section you should be able
to outline the main reasons for, and methods of, government
intervention into finance markets.
1.5 The government and finance markets
Over the past fifty years, the Australian government and
government bodies, such as the Central Bank, have significantly
altered both the extent, and methods, of intervention into
financial markets. Similar changes have been experienced in
financial markets around the world.
In general terms, we can divide the past 50 years into the
following three periods:
Regulation (pre 1980s): During this period the Australian
financial system was characterised by an extensive array of direct
controls, particularly over banks. Deregulation (1980s): During the
first half of this decade the direct controls and other types of
government regulation were progressively removed and the financial
system took on the features of a competitive market.
Post-deregulation (1990s): During the first half of this decade,
the role of government changed again with a strengthening of
government intervention. However, this was different in nature from
the regulations that existed in the pre-1980 period.These three
periods are outlined in more detail in the next objective.
1.5.1 Reasons for government intervention
All government policy actions are aimed at the achievement of
particular objectives. In particular, the following objectives have
been important reasons for government intervention into finance
markets:
Macroeconomic objectives of economic growth, full employment,
price stability and external balance. The previous section outlines
how the financial system can affect a nations performance with
respect to these objectives and they have always been a major
rationale for government intervention. An efficient, fair and
competitive financial system.
The promotion of financial safety.
1.5.2 Methods of government intervention
There are numerous ways in which government actions can affect
conditions in finance markets either directly or indirectly. This
includes the main arms of economic policy as well as direct
legislation. The main methods are:
Fiscal policy
the financing of a budget deficit or disposal of a budget
surplus
individual outlay and revenue items.
Monetary policy
open market operations
reserve asset requirements.
External policy
exchange rate policy
actions affecting exports and imports
capital inflow/outflow controls.
Wages policy eg superannuation requirements.
Competition policy
eg attitude of the Australian Consumer and Competition
Commission towards bank mergers.
Consumer protection - voluntary and legislative.
Direct legislation - eg aspects of corporations law,
superannuation legislation.
TOPIC 1: Summary
In this introduction to finance markets the emphasis has been on
the nature and characteristics of the financial system and its
relationship to the larger financial system.
The financial system comprises both primary and secondary
markets, each of which performs a different role. The primary
markets are concerned with mobilising the savings of surplus
economic units and transferring the surplus funds, either by means
of direct or indirect finance, to deficit economic units in
exchange for newly created financial assets. The secondary markets
are concerned with the trade of existing financial assets.
There are many different financial assets that are created and
traded in financial markets. Financial assets can be classified as
debt, equity, hybrid or derivatives and can be distinguished from
each other on the basis of return, risk, liquidity and time pattern
of return..
Conditions in finance markets will have a significant influence
on the overall economic system and the achievement of economic
objectives have always been main reasons for explaining government
intervention into finance markets.
1762012 Topic 1 Introduction to Financial Markets