6/13/2018

MoneyandCapitalMarketsTrimester1

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TableofContents

Topic1FinancialSystemOverview...................................................................................7WhatisaFinancialSystem?.......................................................................................................7Financialmarketsandflowoffundsrelationship........................................................................8

AuthorisedDepositoryInstitutions(ADI)......................................................................................9ContractualSavingsInstitutions....................................................................................................9FinanceCompanies........................................................................................................................9Investmentbanks&merchantbanks............................................................................................9Unittrusts&Managedfunds......................................................................................................10AssetsofFinancialInstitutions(%oftotalassets).......................................................................10Regulatoryenvironment–legislation&prudentialsupervision.................................................10

AustraliaFinancialSystem........................................................................................................11FinancialInstruments...............................................................................................................11

1.Equity.......................................................................................................................................112.Debt.........................................................................................................................................113.Hybrids.....................................................................................................................................114.Derivatives...............................................................................................................................11

FinancialMarkets.....................................................................................................................12Matchingprinciple.......................................................................................................................12Directandintermediatedmarkets..............................................................................................12CategorisingFinancialMarkets....................................................................................................14

Flowoffundsandmarketrelationships....................................................................................16Sectorialflowoffunds.................................................................................................................16

Summary..................................................................................................................................16

Week2Topic2FinancialInstitutions–CommercialBanks..............................................17WhatareCommercialBanks?...................................................................................................18Whyarebanksimportant?.......................................................................................................18WhatdoBanksdo?..................................................................................................................18

Assetmanagement(−1980s).......................................................................................................18Liabilitymanagement(1980s−)...................................................................................................19

Wheredobanksgettheirfundsfrom?.....................................................................................19Currentdeposits..........................................................................................................................19Callordemanddeposits..............................................................................................................19Termdeposits..............................................................................................................................19Negotiablecertificatesofdeposit(CDs)......................................................................................19Billacceptanceliabilities..............................................................................................................19Debtliabilities..............................................................................................................................20Foreigncurrencyliabilities...........................................................................................................20Loancapitalandshareholders’equity.........................................................................................20

Whatdobanksusethesefundsfor?.........................................................................................20Usesoffunds...............................................................................................................................20Personalandhousingfinance......................................................................................................20Commerciallending.....................................................................................................................20Lendingtogovernment...............................................................................................................21

WhyOff-balance-sheetBusiness?.............................................................................................21Directcreditsubstitutes..............................................................................................................21Tradeandperformance-relateditems........................................................................................22Commitments..............................................................................................................................22Foreignexchange,interestrate-andothermarketrate-relatedcontracts................................22

RegulationandPrudentialSupervision.....................................................................................22

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Reasonsforregulationofbanks..................................................................................................22Prudentialsupervision.................................................................................................................22

Australianregulatorystructure................................................................................................22Functionsofcapital.....................................................................................................................23

BaselAccord.............................................................................................................................23WhataretheCapitalAdequacyStandards?..............................................................................23

BASELIII.......................................................................................................................................23Increasedcapitalrequirements...................................................................................................23

BaselIIIstructuralframework..................................................................................................24Pillar2-Supervisoryreview........................................................................................................27Pillar3-Marketdiscipline...........................................................................................................27LiquidityManagementStrategy..................................................................................................27Liquiditycontrolsforbanks.........................................................................................................28

TopicSummary........................................................................................................................28

Week3Topic3Non-BankingSector:Non-BankFinancialInstitutions............................29NBFIscanbedifferentiatedbytheirsourceanduseoffunds,OBSbusinessandregulation......29

NatureofNBFIs...........................................................................................................................29InvestmentandMerchantBanks.................................................................................................30OffBalanceSheetBusiness:........................................................................................................30LifeInsuranceOffices..................................................................................................................31GeneralInsurancePolicies...........................................................................................................33SuperannuationFunds.................................................................................................................35HedgeFunds................................................................................................................................36FinanceCompaniesandGeneralFinanciers................................................................................36BuildingSocieties.........................................................................................................................36CreditUnions...............................................................................................................................37

Summary..................................................................................................................................37

Week4:Interestratedetermination:LiquidityPreferenceandLoanableFunds(SandDforBonds)theories...............................................................................................................37

RBAMonetaryPolicyObjectives..............................................................................................38Themacroeconomiccontextofinterestratedetermination.....................................................38WhyDoesaCentralBank(likeRBAinAustralia)RaiseInterestRates?.....................................39InterestRates:TheMacroeconomicContext............................................................................39Economicindicators.................................................................................................................39DeterminantsofAsset(money,bond,ordinarysharesetc.)Demand.......................................40TheoryofInterestRateDetermination:LiquidityPreferenceFramework(JohnMaynardKeynes)................................................................................................................................................41PriceofBondisinverselyrelatedwithinterestrate:How???...................................................42LiquidityPreferenceTheory:MdCurve....................................................................................43EffectontheEquilibriumInterestRateduetochangesinIncomeandPrices(bothincreasing) 44MoneyandInterestRatesrelationshipinpractice....................................................................44EvolutionofInterestrate:Liquidityeffectlargerthanothereffects.........................................45EvolutionofInterestrate:Liquidityeffectsmallerthanothereffectsandslowadjustmentofexpectedinflation....................................................................................................................46Liquiditypreferencetheoryvs.Loanablefundstheoryfordeterminationofinterestrate........46MarketEquilibrium..................................................................................................................47Nominalinterestratevs.realinterestrate...............................................................................47ShiftsintheBondSupplyCurve................................................................................................49Factorsthatshiftthesupplycurveforbonds............................................................................50APPLICATIONSOFTHELOANABLEFUNDSTHEORY:BusinessCycleExpansion.........................51

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LoanableFundsTheoryfromtheperspectiveofloanmarket...................................................51LoanableFundsTerminology....................................................................................................52Loanmarketapproachtoi/rdetermination.............................................................................52cDemandforLoanableFunds...................................................................................................52DemandforLoanableFunds.....................................................................................................53Supplyofloanablefunds..........................................................................................................53Supplyofloanablefunds..........................................................................................................53LoanableFundsEquilibrium.....................................................................................................54EquilibriumintheLFmarket....................................................................................................54Summary..................................................................................................................................54

Week5Topic5TermandRiskStructuresofInterestRates..............................................54TermStructureandRiskStructuresofInterestRates................................................................55DifferencebetweenInterestRate,ExpectedReturnandYieldonBond....................................55BondYield(YTM)......................................................................................................................55BondYieldsvInterestRateonaBond......................................................................................55WhatistheYieldCurve?..........................................................................................................56

NormalYieldCurve:.....................................................................................................................56Negative(downward)slopingyieldcurve...................................................................................56FlatYieldCurve............................................................................................................................57TheHumpedYieldCurve.............................................................................................................57

YieldCurve...............................................................................................................................58Theexpectationtheory...............................................................................................................58SegmentedMarketsTheory........................................................................................................59LiquidityPremiumTheory...........................................................................................................61

RiskStructureofInterestRates................................................................................................62IncreaseinDefaultRiskonCorporateBonds..............................................................................63AnalysisoftheDiagram:IncreaseinDefaultRiskonCorporateBonds......................................63

RiskStructureofInterestRates................................................................................................63Riskpremiumeffectonyieldcurves............................................................................................63CapitalmarketYieldsandSpreads-NonGovernmentInstruments............................................64

Yieldcurvesforborrowerswithdifferentriskprofiles..............................................................64Summary..................................................................................................................................64

Week6Topic6................................................................................................................65LearningObjectives..................................................................................................................65Readings..................................................................................................................................65FinancialManagement.............................................................................................................65TheFinancingDecision.............................................................................................................65

Businessrisk................................................................................................................................65Financialrisk................................................................................................................................66

InitialPublicOffering................................................................................................................66Underwriters...............................................................................................................................67ProspectuslodgedwithASIC.......................................................................................................67Out-clause....................................................................................................................................67Publiclylistedcorporation...........................................................................................................67Ordinaryshares:limitedliabilitycompanies...............................................................................67Instalmentreceipt.......................................................................................................................67

ListingaBusinessonaStockExchange.....................................................................................67Equity-fundingforListedCompanies........................................................................................68

Additionalordinaryshares..........................................................................................................68Preferenceshares........................................................................................................................69

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Quasi-equity................................................................................................................................69Taxation...................................................................................................................................70

Capitalgainstaxonsharespurchase...........................................................................................71PricingofShares.......................................................................................................................71

Cum-dividendandex-dividend....................................................................................................72Bonusshareissues.......................................................................................................................74Sharesplits..................................................................................................................................74Pro-ratarightsissue.....................................................................................................................75

Summary..................................................................................................................................75

Week7GovernmentDebt,MonetaryPolicyandthePaymentsSystem..........................77CommonwealthGovernmentBorrowing..................................................................................77

WhyDoGovernmentsNeedtoBorrow?.....................................................................................77StateGovernmentSecurities....................................................................................................82MonetaryPolicy.......................................................................................................................83

ThePaymentsSystem..................................................................................................................83Summary..................................................................................................................................85

Week8Topic8................................................................................................................86Short-termDebt.......................................................................................................................86BankOverdrafts.......................................................................................................................86CommercialBills.......................................................................................................................87Calculatingprice—yieldknown................................................................................................88DiscountSecurities-CalculatingPrice......................................................................................88Calculatingyield.......................................................................................................................89Calculatingprice:Discountrateknown.....................................................................................90Calculatingdiscountrate..........................................................................................................90PromissoryNotes(P-notes)......................................................................................................90NegotiableCertificatesofDeposit(CDs)...................................................................................90Medium-to-Longer-TermFinance.............................................................................................91TermLoans...............................................................................................................................91

Loancovenants............................................................................................................................91Positivecovenant........................................................................................................................91Negativecovenant.......................................................................................................................91

Calculatingtheloaninstalment—ordinaryannuity..................................................................92MortgageFinance....................................................................................................................92

Calculation-MortgageLoanInstalment(endofperiod)............................................................92Calculation-MortgageLoanInstalment(beginningofperiod)...................................................93

CorporateBonds......................................................................................................................93DebenturesandUnsecuredNotes..............................................................................................93

Debentures..............................................................................................................................93UnsecuredNotes:higherlevelofriskattached........................................................................93

Issuingdebenturesandnotes......................................................................................................94Subordinateddebt:Morerelatedtoequity..............................................................................94CalculatingthePriceofaBond(debentureandunsecurednote)..............................................94BondCalculationBetweenInterestPayments..........................................................................95Summary..................................................................................................................................97

Week9Topic9–TheForeignExchangeMarkets.............................................................98Exchangerateregimes.............................................................................................................98FXMarketParticipants.............................................................................................................98

FXdealersandbrokers................................................................................................................98Centralbanks...............................................................................................................................98

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Firmsconductinginternationaltradetransactions.....................................................................99Investorsandborrowersintheinternationalcapitalmarkets....................................................99Speculativetransactions..............................................................................................................99Arbitragetransactions...............................................................................................................100

OperationofF/XMarket........................................................................................................100SpotandForwardTransactions..............................................................................................100

SpotMarketQuotations............................................................................................................101ForwardMarketQuotations......................................................................................................103

EuropeanMonetaryUnionandFXMarkets............................................................................104Summary................................................................................................................................105

Week10AnIntroductiontoRiskManagementandDerivativesChapter13...................106UnderstandingRisk................................................................................................................106

OperationalRisk........................................................................................................................106FinancialRisks............................................................................................................................106

TheRiskManagementProcess...............................................................................................107FuturesContract....................................................................................................................108

FeaturesofFuturesContracts...................................................................................................108ForwardContracts.....................................................................................................................109OptionContracts.......................................................................................................................110SwapContracts..........................................................................................................................114

Summary................................................................................................................................116

Shortanswerquestions.................................................................................................117

Sampleexam.................................................................................................................117

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Topic1FinancialSystemOverviewTopicsCovered1.FinancialSystemOverview(CustomTextCh1)2.FinancialInstitutions:CommercialBanks(CustomTextCh2)3.NonBankFinancialinstitutions:investmentbanks,insuranceoffices,superannuationfunds,unittrusts(CustomTextCh3)4.Interestratedetermination:LiquiditypreferenceandLoanablefundstheories(CustomTextCh11;Mishkin,11thednChapter5)5.Risk,termstructuretheoriesofinterestratesandforecastinginterestrates(CustomTextCh11;Mishkin,11thednChapter6)NOTE:ReadingsfromMishkin,Chs5&6areavailableonCloudDeakin6.Capitalmarkets:CorporationsandinvestorsinSharemarket(CustomTextChs5&6)7.Governmentdebt,MonetarypolicyandPaymentsystem(CustomTextCh10)8.Moneyandcapitalmarkets:short-termandlonger-termdebtfinancing(CustomTextChs8&9)9.Foreignexchangemarkets(CustomTextCh12)10.Introductiontoriskmanagementandderivatives(CustomTextCh13)11.RevisionLectureReadings:MAF202CustomTextbook,chapter1WhatisaFinancialSystem?

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Financialmarketsandflowoffundsrelationship

FinancialAssetsAre…

• Currency• Financialinstruments,whichrepresentsaclaimtofuturecashflows

Forexample:a. Ordinarysharesissuedbyacompanyb. Govt.treasurybondsc. Banktermdeposits

FinancialSystem-WhatElse?

TypeofFinancialinstitutions

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AuthorisedDepositoryInstitutions(ADI)ADI:AttractsavingsfromdepositorsandinvestorstoprovideloanfacilitiestoborrowersAsatSept2017(RBABulletin)Banks–54.8%oftotalfinancialsystemassets(was58.78%in2016,upfrom52%in2008)Why??Non-bankdepositoryinstitutionsBuildingSocieties–0.18%CreditUnions–0.54%ContractualSavingsInstitutionsLiabilities(sourceoffunds)arecontractsthatgenerateperiodiccashflowssuchasinsurancecontractinstalmentssuperannuationsavingsAccumulatedfundsareusedtopurchasebothrealandfinancialassetsSuperannuation:fastestgrowingsector1990madeup10.8%oftotalassets2017makesup28.0%AsofSeptember2016superannuationsectorhad$2.5trillionfundsundermanagement(source:ASFA)FinanceCompanies

n Liabilities(funds)n Generatedfromtheissueoffinancialsecuritiesdirectintothemoney

marketsandcapitalmarkets–1.9%ofFSassetsn Assets(useoffunds)

n Mainlyloanstoretailcustomers(individualsandsmallbusiness)Investmentbanks&merchantbanksAlsoknownasmoneymarketcorporations-0.5%

• Generallyraiseshort-termfundsinthewholesalemoneymarkets• Provideshort-to-medium-termloanstocorporateclients• Specialiseinoff-balancesheetfinancialservicestocorporateclientsand

government

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Unittrusts&Managedfunds• Investorspurchaseunitsinatrust-4.8%• Trustee(usingfundsmanagers)investsaccumulatedfundsinaspecifiedrangeof

investmenttypes:Example:

• Cashmanagementtrusts• Equitytrusts• Mortgagetrusts

AssetsofFinancialInstitutions(%oftotalassets)

Regulatoryenvironment–legislation&prudentialsupervision4Componentsofregulatoryframework

• ReserveBankofAustralia(RBA)• AustralianPrudentialRegulationAuthority(APRA)• AustralianSecuritiesandInvestmentsCommission(ASIC)• AustralianCompetitionandConsumerCommission(ACCC)