financial sytem

8/12/2019 Financial Sytem

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PART 1F I N A N C I A LI N S T I T U T I O N S

C H A P T E R 1

A modern financial system: An overviewC H A P T E R 2

Commercial banksC H A P T E R 3

Non-bank financial institutions

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Much of what you will learn from this text is international in nature, but it will be

necessary at times to focus on the financial system of a particular nation-state. It is not

possible to look at the variations that occur in the financial systems of all nation-states.

Therefore, when necessary, reference will be made to the Australian financial system as it

has a modern, efficient and stable financial system that operates effectively within the global

financial system.Think of a financial system as being a number of financial institutions and markets

through which funds move between lenders and borrowers. The institutions and markets that

facilitate this flow of funds develop the financial instruments and techniques that encourage

savings and investment. The financial system also provides the framework through which

central banks and prudential regulators influence the operations of participants in the

financial system. Most importantly, a central bank, through its monetary policy initiatives,

affects the level of interest rates, economic activity and business performance.

A financial system is essential in facilitating economic growth and future productive

capacity in a country. The provision of finance to business allows economic growth to occur,

which should lead to increased productivity, increased employment and a higher standard of

living. A modern, sound and efficient financial system encourages the accumulation of savings

that are then available for investment in productive capital within an economy.

Chapter 1 presents an overview of a modern financial system and provides a context

for the more detailed studies that occur throughout the textbook. It introduces the main

categories of financial institutions, discusses the functions of financial markets and provides

an overview of the types of instruments that are created within the markets. At the end of

Chapter 1, three extended learning sections are provided: Globalisation of the financial

markets, The impact of the Asian financial crisis on the financial system and The global

sub-prime credit crisis.

Chapter 2 provides a detailed analysis of the roles and functions of the commercial banks.

Commercial banks are the largest financial institutions providing savings, lending and a wide

range of other financial services for their customers. The assets, liabilities and off-balance-

sheet business of commercial banks are analysed in detail. At the end of the chapter threeextended learning sections are provided: Business continuity risk management, Authorised

deposit-taking institutionsbanks operating in Australia and Registered banks operating in

New Zealand.

Chapter 3 extends the discussion of financial institutions further and looks at the

operations and significance of other types of financial institutions. In particular the chapter

considers investment banks, merchant banks, managed funds, superannuation funds, cash

management trusts, public unit trusts, life insurance offices, general insurance offices, hedge

funds, finance companies, general financiers, building societies, credit unions and export

finance corporations. At the end of the chapter an extended learning section is provided:

Project finance and structured finance.




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L E A R N I N G O B J E C T I V E S

The relevant section of the chapter is provided in brackets beside the learningobjective.

This chapter will assist you to:1. explain the functions of a modern financial system (1.1)

2. categorise the main types of financial institutions, being depository financial institutions,

investment banks and merchant banks, contractual savings institutions, finance companies and

unit trusts (1.2)

3. define the main classes of financial instruments that are issued into the financial system, that is,

equity, debt, hybrids and derivatives (1.3)

4. discuss the nature of the flow of funds between savers and borrowers, including primary

markets, secondary markets, direct finance and intermediated finance (1.4)

5. distinguish between various financial market structures, including wholesale markets and retail

markets, and money markets and capital markets (1.4)

6. analyse the flow of funds through the financial system and the economy (1.5)

Extended learning

7. appreciate the importance of globalisation of the international financial markets

(Extended learning A)

8. understand the effects and consequences of a financial crisis on a financial system and a real

economy (Extended learning B and Extended learning C)

Once you understand these learning objectives you will be ready to complete the

end-of-chapter review questions.

A MODERNFINANCIAL SYSTEM:

AN OVERVIEW

C H A P T E R 1




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5

INTRODUCTIONThe development of financial markets has made the exchange of value forgoods and services much easier. The introduction of money into the exchange processincreases the speed and efficiency with which transactions take place. The use of monetary value

also makes it easier to save surplus funds. In order to receive a return on these accumulated

savings, they are usually lent to individuals, businesses and governments to finance investment

in capital projects and/or for consumption spending.

The effective flow of funds between savers and borrowers requires the existence of a modern and

efficient financial system, comprising specialist financial institutions, instruments and markets. To

ensure the soundness and stability of a financial system, nation-states establish legislation and

regulatory authorities responsible for the prudential supervision of the financial system.

However, before progressing further, we should consider the evolution of markets. Markets

facilitate the exchange of things of value. These are often categorised as real assets, such as

a house or a car, and financial assets, such as a loan to buy a house or a car. Although such

transactions can take place without a formal marketplace, non-market exchanges can be very

time consuming and difficult to carry out.

Imagine how difficult it would be to have to own a cow in order to obtain milk, or to have todrive to a farm every morning to obtain milk. Consider the whole range of goods and services

that are consumed and used every day. Without markets, people could spend their whole time

seeking out those things they require but do not produce themselves. It would be necessary to

find someone who had produced a surplus of what we wanted and who, in turn, wanted what we

had produced in surplus amounts. The development of village and regional marketplaces helped

to overcome the problem. Markets brought people together and enabled the double coincidence of

wantsthat is necessary before an exchange can take place.

The role of a marketplace extends beyond bringing people together who wish to exchange

one good or service for another. Having located the right person in the marketplace, the next

problem is the need to establish the rate of exchange (the price) at which the trade will take place.

This may cause a divisibility problem. What if a bag of potatoes that you want to obtain from a

trader is worth one-half of the left rump of a cow? It is simply not possible to take a small piece of

the cow and directly exchange it for the bag of potatoes. One way around this problem is for the

owner of the cow to specialiseto set up a butcher shop and then hope that people will offer a

range of products and services for parts of the butchered cow.

The evolution of financial markets solved the problem. Money, as a medium of exchange,

allowed markets in goods and services to become much more efficient. No longer was it necessary

to barter to exchange goods and services. Money can be defined as any commodity that is widely

accepted in a country as a medium of exchange.

The history of money is interesting. For example, when Australia was first settled by Europeans,

rum and tobacco were accepted as mediums of exchange. These days money may be notes and

coins issued by a nation-state as legal tender, a financial instrument such as a cheque or digital

money in the form of a credit card transaction or electronic funds transfer.The introduction of money has made it much easier for individuals to save their surplus

earnings. Saving may be defined as deferring consumption into the future. Therefore, another

attribute of money is that it can be used as a store of value. The funds saved by surplus units

those savers with current excess fundscan be put to use by those whose current demand for

goods and services is greater than their current available funds. Such users of funds are called

borrowers or deficit units.




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P A R T 1 F I N A N C I A L I N S T I T U T I O N S

Just as the exchange of goods and services can be carried out more efficiently through

organised markets, so too can the exchange of money or value between surplus units and deficit

units. Financial institutions and markets facilitate financial transactions between the providers

of funds and the users of funds.

When a financial transaction takes place it establishes a claim to future cash flows. This is

recorded by the creation of a financial asset on the balance sheet of the saver. The financial assetis represented by a financial instrument that states how much has been borrowed, and when and

how much is to be repaid by the borrower. For example, if you invested money in a term deposit

with a bank, the bank would issue a term deposit receipt to you. This is a financial instrument.

The receipt would specify how much you had invested, the rate of interest to be paid, when interest

payments are due, and when the amount invested had to be repaid by the bank. The interest

payments and principal repayment are claims to future cash flows.

Buyers of financial instruments are lenders that have excess funds today and want to invest

and transfer that purchasing power to the future. The sellers of the instruments are those deficit

units that are short of funds today, but expect to have a surplus amount in the future which will

enable the repayment of the current borrowing.

A principal role of financial institutions and markets is to bring together providers of funds

(savers) with users of funds. The flow of funds and the relationship between savers and users

of funds, and the place of the financial markets in the flow, are shown in Figure 1.1. Once it is

understood why financial markets have evolved, it is possible to consider the major functions

served by a modern financial system.

FIGURE 1.1 FINANCIAL MARKETS AND FLOW OF FUNDS RELATIONSHIP

REFLECTION POINTS

A financial system encourages savings, provides funds for investment and facilitates

transactions for goods and services.

Economic and financial transactions are valued in money terms. Money is a universally

acceptable medium of exchange and a store of value.

A financial instrument establishes an entitlement to future cash flowsfor example, the receipt

of interest and return of principal on a bank term deposit.

6

are are

and and

Suppliers of funds: surplus (savings) units

Users of funds: deficit units

Lenders: householders companies governments

rest of world

Borrowers: householders companies governments

rest of world

Financial markets

whosupplyfunds

whoreceivefunds

receive financial

instruments

issue financial

instruments




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7C H A P T E R 1 A M O D E R N F I N A N C I A L S Y S T E M : A N O V E R V I E W

1.1 Functions of a financial systemA financial system comprises a range of financial institutions, financial instruments and

financial markets which interact to facilitate the flow of funds through the financial system.

Overseeing the financial system, and sometimes taking a direct role, is the central bank and the

prudential supervisor.

The decision to save allows surplus units to transfer some of todays income to the future

when it can be used for consumption. Therefore, savings allow consumption in the future to be

independent of future levels of earned income. Surplus entities invest their savings through the

purchase of financial instruments which are expected to improve their overall wealth.

The expectation of the saver is to earn a positive rate of return. However, there are other factors

that savers should consider, otherwise all savers would only purchase financial instruments that

offered the highest rate of return. Providers of funds should consider their own particular needs

when they purchase or invest in assets. This will affect the expected rate of return. It is useful to

think of an asset, whether it is a real asset such as an investment property or a financial asset such

as a bank term deposit, as being a package of four main attributes:

return or yield

risk liquidity

time-pattern of cash flows

With a real asset such as an investment in a residential unit, return is the regular rental or

lease payments received, plus any increase in the value of the property over time (capital gain).

Risk relates to uncertainty and probabilities such as the failure of the tenant to make rental

payments or the possibility that the property may be burnt down. The liquidity of the residential

unit is the ease with which it can be sold. Finally, the time-pattern of the cash flows will vary

depending on the frequency of the rental payments, the cost of maintenance and the payment of

other expenses such as insurance and rates.

In the case of a financial asset, such as the purchase of shares in a corporation, return consists

of the dividends received and the capital gains or losses made through movements in the share

price on the stock exchange. Note that a dividend is the portion of corporation profits periodically

paid to the shareholder; a stock exchange is where corporation shares are bought and sold. Risk

is measured by the variability of the expected returns and, in the extreme, the possibility that

the corporation may fail. The liquidity of the shares relates to the ease with which they can be

sold on the stock exchange at the current market price. Finally, the time-pattern of the cash flows

expected from the shares depends on the profitability and dividend policy of the corporation.

Typically, a profitable corporation will pay dividends to shareholders twice a year.

It is reasonable to assume that the average person likes return and liquidity, dislikes risk

and prefers reliable cash flows. Fortunately, the preferences of savers with regard to these four

attributes are not identical. If they were, all savers would seek to place all of their savings with

very few borrowers. Since preferences are not identical, financial institutions and markets provide

an enormous range of investment opportunities that have different levels of return, risk, liquidityand timing of cash flows.

Individuals and businesses may be categorised as being risk averse, risk neutral or risk takers.

Risk takers will accept more risk but will do so only if they are compensated by the expectation

of receiving a higher return. On the other hand, those that are risk averse will accept a lower

rate of return in order to reduce their exposure to risk. Furthermore, savers will accept various

FINANCIAL SYST

Comprises a r

financial instit

instruments a

markets; over

by central ban

supervised byprudential reg

FINANCIAL INSTR

Issued by a pa

raising funds,

acknowledgin

financial comm

and entitling th

holder to spec

future cash flo

FLOW OF FUNDS

Movement of f

through a fina

system

SURPLUS UNITS

Savers or prov

of funds; funds

available for le

or investment

RATE OF RETURN

The financial

benefit gained

from investme

savings; expre

percentage ter

RETURN OR YIEL

The total finan

benefit receive

(interest and c

gain) from an

investment; ex

as a percentag

RISK

The possibility

probability tha

actual outcom

will vary from

expected outc

uncertainty

LIQUIDITY

Attributeabi

convert an ass

into cash quic

at current mar

price

TIME-PATTERN O

FLOWS

The frequency

periodic cash

(interest and p

associated wit

financial instru




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8 P A R T 1 F I N A N C I A L I N S T I T U T I O N S

levels of liquidity or different timings of cash flows associated with financial instruments.

Participants in the financial markets are therefore able to alter the composition of their financial

asset portfolio by changing their preferences in relation to the four attributes of return (yield),

risk, liquidity and the timing of cash flows. An asset portfolio is the list of assets held by a saver.

A major function of the financial system is to facil itate portfolio structuring and restruc-

turing through the buying and selling of a wide range of financial instruments. Financialinstitutions and markets provide the potential suppliers of funds with the combinations of

risk, return, liquidity and cash-flow patterns that best suit each savers particular portfolio

needs.

To support decisions taken by both the providers of funds and the users of funds, the financial

system is also a provider of financial and economic information to market participants. Information

affects price and investment decisions; therefore the provision of timely and accurate information

is essential for an efficient financial system.

If a financial system is successful in creating a range of financial instruments that possess

different combinations of the four attributes valued by savers, this will encourage an increased

flow of savings. By encouraging savings, the financial system is important to economic growth

as the savings are available for investment capital which can be used for the improvement of the

productive capacity of an economy.

Not only can it be expected that a well-functioning financial system will increase the flow of

savings, but it can also be argued that an efficient financial system should ensure that savings are

more likely to be directed to the most efficient users of those funds. This outcome further enhances

the rate of economic growth. Since typical savers will seek to maximise their return, subject to

their preferred level of risk, liquidity and the time-pattern of cash flows, they should be expected

to invest their funds with users that show a high probability of meeting those expectations, for

example by investing in corporations that use funds to produce goods and services that are in

demand in the marketplace.

Another important function of a financial system is its role in implementing monetary policy.

Monetary policy relates to the actions of a central bank that are taken to influence the level of

interest rates in the financial system. The current monetary policy stance of central banks indeveloped countries is to maintain the level of inflation within a specified level. Inflation is the

increase in the price for goods and services within an economy. By targeting the level of inflation,

a central bank seeks to achieve a range of economic objectives such as increased employment and

the stability of the exchange rate of the currency.

REFLECTION POINTS

A financial system comprises financial institutions, financial instruments and financial markets.

Overseeing a financial system are the central bank and prudential supervisor.

A financial asset incorporates four main attributes: return, risk, liquidity and time-pattern of

cash flows.

The wide range of financial products available in a financial system facilitates portfolio

structuring.

A financial system provides economic and financial information to the markets; that information

should be timely and accurate.

ASSET PORTFOLIO

A combination

of assets, each

comprising attributes

of return, risk,

liquidity and timingof cash flows

PORTFOLIO

STRUCTURING

The buying and

selling of assets

and liabilities to

best meet current

savings, investment

and funding needs

MONETARY POLICY

Actions of a central

bank that influence

the level of interest

rates in order to

achieve economic

outcomes; primary

target is inflation

INFLATION

An increase in

prices of goods and

services over time;

measured by the

consumer price

index (CPI)




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An efficient financial system rapidly absorbs and reflects new information into the price of

financial instruments.

A financial system encourages savings and allocates those savings to the most efficient users of

funds.

The central bank uses the financial system to implement monetary policy in order to target the

level of inflation and achieve certain economic objectives.

1.2 Financial institutionsMost of you have carried out transactions with one or more financial institutions. For example,

you may have opened a deposit account with your local bank, applied for a loan from that

bank or obtained a credit card facility. Also, you may have entered into an insurance contract

for motor vehicle insurance, medical insurance, travel insurance or life insurance with an

insurance office.

There is a very wide range of financial institutions operating in the financial system. While

some institutions offer similar products and service, typically institutions tend to specialise in

areas where they have greater expertise. We will discuss the different types of institutions in detailin Chapters 2 and 3. In this chapter we simply classify financial institutions into five categories

based on the differences between the institutions sources of funds and uses of funds.

1. Depository financial institutions obtain a large proportion of their funds from deposits

lodged by savers. Examples include deposits placed in demand deposit accounts or term

deposit accounts with commercial banks, building societies and credit cooperatives. A

principal business of these institutions is the provision of loans to borrowers in the household

and business sectors.

2. Investment banks and merchant banks generally focus on the provision of advisory services

for their corporate and government clients. This includes advising clients on mergers and

acquisitions, portfolio restructuring and financial risk management. These institutions may

provide some loans to clients but are more likely to advise and assist a client to raise fundsdirectly from the capital markets.

3. Contractual savings institutions are 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 made to the institution, the institution will

make specified payouts to the holder of the contract if and when an event specified in the

contract occurs. The periodic cash receipts received by these institutions provide them with a

large pool of funds that they invest. Payouts made by these institutions include payments for

claims made on an insurance policy, or payment to a superannuation fund member on their

retirement from the workforce.

4. Finance companies raise funds by issuing financial instruments such as commercial paper,

medium-term notes and bonds in the money markets and the capital markets. They use thosefunds to make loans and provide lease finance to their customers in the household sector and

the business sector.

5. Unit trusts are formed under a trust deed and are 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

DEPOSITORY FIN

INSTITUTIONS

Accept depos

and provide lo

to customers

commercial b

credit unions

INVESTMENT BA

Institutions th

specialise in

providing adv

services to cl

(e.g. mergers

acquisitions)

CONTRACTUAL INSTITUTIONS

Offer financia

contracts suc

as insurance

superannuat

large investo

FINANCE COMPA

Borrow funds

from markets

to provide loa

lease finance

customers

UNIT TRUSTS

Investors buy

units issued b

trust; pooled

invested (e.g.

trusts and pr

trusts)




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in asset classes specified in the trust deed. Trusts generally specialise in certain categories

of investments, including equity trusts, property trusts, fixed-interest trusts and mortgage

trusts.

TABLE 1.1 ASSETS OF FINANCIAL INSTITUTIONS, AUSTRALIA ($ BILLIONS)

Financial institution 1990 % total assets 2008 % total assets

Reserve Bank 24.9 3.4 93.7 2.2

Commercial banks 325.8 43.8 2239.5 52.0

Building societies 22.9 3.1 21.7 0.5

Credit unions 8.7 1.2 41.6 1.0

Money-market corporations 53.6 7.2 113.5 2.6

Finance companies and general financiers 55.5 7.5 130.7 3.0

Life insurance offices 85.3 11.5 184.8 4.3

Superannuation funds 80.8 10.8 752.2 17.5

Cash management trusts 4.7 0.6 46.2 1.1

Common funds 7.0 0.9 11.6 0.3

Friendly societies 8.1 1.1 4.1 0.1

Public unit trusts 27.7 3.7 272.1 6.3

General insurance offices 32.5 4.4 130.0 3.0

Securitisation vehicles 5.7 0.8 263.9 6.1

Total 743.2 4305.6

SOURCE: RESERVEBANKOFAUSTRALIA, RBA BULLETIN, VARIOUSISSUES.

Table 1.1 shows the total assets of the various Australian financial institutions in June 1990

and 2008. The Australian financial system has rapidly evolved over this period in response tosignificant changes that have occurred, including regulatory change, internationalisation of the

financial markets and the application of technology to the development of new financial products

and information systems. As can be seen, there has been an enormous growth in assets held

within the financial system. This is not restricted to the Australian market, as international

markets have also shown considerable growth. Some generalisations that emerge from

Table 1.1 include:

Total assets of the financial institutions increased nearly sixfold over the period, to $4305.6

billion.

Commercial banks account for the largest share of the assets of financial institutions, at

52.0 per cent. However, this figure does not fully represent the ful l extent of commercial banks

influence, as these institutions also participate in a range of activities that are not recorded

directly on the banks balance sheets (e.g. their managed funds activities).

The importance of building societies significantly declined as changes in regulation allowed

most of the larger societies to become commercial banks.

The percentage share of financial assets of investment banks and merchant banks (officially

known as money-market corporations) declined. This reflects the change in focus of their




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business activities. Much of their business is based on the provision of off-balance-sheet

advisory services to their corporate and government clients.

Finance companies contracted as the impact of financial deregulation, greater competition

and the absorption of some finance companies into their parent bank took effect.

The percentage of life insurance offices share of total assets declined over the period.

However, this was offset by significant increases in their managed funds business, particularly

superannuation products.

The percentage share of superannuation assets increased to 17.5 per cent. Factors

influencing this growth were an ageing population saving for retirement, the introduction of

compulsory superannuation and the introduction of taxation incentives for superannuation

savings.

Another growth area was in managed funds, specifically in unit trusts. This sector of the

market increased tenfold over the period and expectations are that it will continue to show

strong growth. Managed funds provide investors with the opportunity to use the specialist

skills of funds managers, particularly in investment categories which are more difficult for

the individual investor to access, for example the international equity markets.

Securitisation vehicles showed enormous relative growth up until mid-2007. The ensuing

severe tightening of the availability of credit in the capital markets resulting, in part, from

problems with securitised assets that were backed by sub-prime mortgage assets, has

seen new securitisation issues subsequently almost disappear. Once the sub-prime

problems have been largely resolved it is to be expected that this sector of the market will

grow again. Securitisation is discussed in the extended learning section at the end of

Chapter 10, but can be briefly described as a process whereby an organisation, such as a

bank, sells existing balance-sheet assets, for example housing loans, thereby generating new

cash flows.

REFLECTION POINTSFinancial institutions may be classified into five categories based on their sources of funds and

uses of funds.

Depository financial institutions, such as commercial banks, gather savings from depositors and

provide loans to customers. (Commercial banks also provide a wide range of other financial

services.)

Investment banks and merchant banks do not have a depositor base; they specialise in the

provision of advisory services to clients (e.g. merger and acquisition advice).

Contractual savings institutions, such as insurance offices and superannuation funds,

gather savings from the sale of insurance contracts and from superannuation contributions

respectively, and make payouts on the occurrence of specified events (e.g. a car accident or

retirement from the workforce).

Finance companies raise funds directly from the money markets and capital markets and

provide loans and lease finance to customers.

Unit trusts sell units in a trust and invest those funds in assets specified in the trust deed; for

example, an equity trust would invest in certain types of shares.




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1.3 Financial instrumentsWhen a user of funds obtains finance from the provider of funds, the user must prepare a

legal document that clearly defines the contractual arrangement. This document is known as a

financial instrument and acknowledges a financial commitment and represents an entitlement to

future cash flows. The financial instrument becomes a financial asset on the balance sheet of the

provider of funds. If the financial asset represents debt that will be repaid then it also appears as

a liability on the balance sheet of the borrower; however, if it represents equity it will appear as

part of shareholder funds.

For example, if a bank customer deposits funds in a term deposit, the bank will acknowledge

this deposit and issue a receipt that will specify the amount of funds provided, the maturity

date when the funds will be repaid, the rate of interest to be paid and the timing of interest

payments. The terms and conditions specified in a financial security can vary significantly.

For example, a loan agreement may include an interest rate that is fixed for the term of the loan,

while another loan may have a variable rate of interest that can change on certain dates. One

loan may require monthly payments of interest and principal, while another loan may require

half-yearly interest payments with principal only repaid at maturity. Savers, as the providers of

funds, will purchase financial assets that have attributes of risk, return, liquidity and cash flowsthat meet their particular needs. In the financial markets, the saver is said to buy the paper of

the issuer.

Financial instruments may be divided into three broad categories: equity (including

hybrid instruments), debt and derivatives. These three categories reflect the nature and main

characteristics of financial instruments.

1 .3 . 1 EQU ITY

Equity can take a number of forms. For example, if you buy a new car by paying a deposit

from your own funds and borrowing the remainder from a bank, your equity in the car is

the amount of the deposit paid. As you progressively repay the loan to the bank, your level

of equity in the car will increase. Equity can therefore be described as an ownership interest

in an asset.

Within the context of the discussions in this text, equity in a business corporation is represented

through the ownership of shares issued by a corporation. The principal form of equity issued by a

corporation is an ordinary share or common stock. As we will discuss in detail in Part 2, larger

corporations list their shares on the stock exchange. Ordinary shares have no maturity date; they

continue for the life of the corporation. However, as the shares are listed on the stock exchange

they may be sold to other investors at the current market price.

An ordinary shareholder is entitled to share in the profits of the business. Shareholders

generally receive a portion of the profits of the company in the form of dividend payments. (This

is discussed in Part 2.) The value of a corporations shares may increase over time, representing a

capital gain. In the event of the failure of a corporation, however, shareholders are entitled to the

residual value of the assets of the corporation (if any remain), but only after the claims of all othercreditors and security holders have been paid.

The owners of ordinary shares have the right to vote at general meetings, in particular for the

election of members of the board of directors of the company.

Another form of equity is known as a hybrid security. A hybrid security may be described

as having the characteristics of both equity and debt (see below). Preference shares are an

EQUITY

The sum of the

financial interest an

investor has in an

asset; an ownership

position

ORDINARY SHARE ORCOMMON STOCK

The principal form

of equity issued by a

corporation; bestows

certain rights to the

shareholder

DIVIDEND

That part of a

corporations profit

that is distributed to

shareholders

HYBRID SECURITYA financial

instrument that

incorporates the

characteristics of

both debt and equity

(e.g. preference

shares)




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example of hybrid securities. Preference shares, while being a form of equity finance, have many

characteristics in common with debt instruments. For example, the holders are entitled to receive a

specified fixed dividend for a defined period, similar to a fixed-interest payment. The fixed dividend

must be paid before any dividend is made to ordinary shareholders. Preference shareholders also

rank ahead of ordinary shareholders in their claim on the assets of the corporation should the

company be wound up or placed into liquidation.The issue of hybrid securities, or quasi-equity instruments, has become an increasingly

important means by which corporations raise additional equity funding. These instruments are

discussed in detail in Chapter 5.

The equity markets are discussed in much more detail in Part 2.

1 .3 .2 DEBT

A debt is a loan that must be repaid. Debt instruments represent a contractual claim against an

issuer, and require the borrower to make specified payments, such as periodic interest payments

and principal repayments over a defined period.

The types of debt instruments issued by a corporation include debentures, unsecured notes,

term loans, commercial bills, promissory notes, overdrafts and mortgage loans. These types of

debt instruments are discussed in detail in Part 3 of the text. However, when we discuss the

financial markets later in this chapter, we will introduce the money markets and the capital

markets. Debentures and unsecured notes are longer-term debt instruments issued into the

capital markets, while commercial bills and promissory notes are short-term instruments issued

into the money markets. Term loans, mortgage loans and overdrafts are generally provided by

financial institutions.

Government debt instruments are Treasury bonds and Treasury notes (T-notes); these are

examined in Part 4.

Debt instruments entitle the holder to a claim (ahead of equity holders) to the income stream

produced by the borrower and to the assets of the borrower if the borrower defaults on loan

repayments. Debt can be divided into two sub-categories on the basis of the nature of the loan

contract: secured debt and unsecured debt. A secured debt contract will specify the assets of theborrower, or a third party, that are pledged as security or collateral. If the borrower defaults on

the loan the lender is entitled to take possession of those assets to recover the amount owing. In

other cases a loan may be made on an unsecured basis.

Another subdivision of debt is based on the transferability of ownership of the instrument.

Negotiable debt instruments are those that can easily be sold and transferred from one owner

to another. Commercial bills are an example of negotiable debt instruments that can be sold

in the money markets (Chapter 9). Non-negotiable instruments are instruments that cannot be

transferred from one party to another. A term loan obtained through a bank is generally non-

negotiable.

Corporate debt is discussed in Part 3 and government debt in Part 4.

1 .3 .3 DERIVATIVESA third class of instrument has become significant in the financial markets: the derivative

instrument.

Derivatives contracts are primarily used to manage an exposure to an identified risk. For

example, a borrower might be concerned that interest rates on existing debt funding may rise

in the future. The borrower can accept this forecast risk, or seek to reduce that risk exposure by

LIQUIDATIONThe legal pro

of winding up

affairs of a co

in financial di

DEBT INSTRUM

Specify condi

a loan agreem

issuer/borrow

amount, retu

timing of cash

maturity date

must be repa

SECURED DEBT

A debt instru

that provideslender with a

over specified

if the borrowe

defaults

NEGOTIABLE DE

INSTRUMENT

A debt instru

that can be so

the original le

through a fina

market

DERIVATIVE INSA synthetic se

that derives it

from a physic

market comm

or security; m

used to mana

exposures




14/45


locking in an interest rate today. One way the borrower can lock in an interest rate is through the

use of derivative contracts.

There is a wide range of derivatives contracts for the management of risk exposures related to

commodities (such as gold and oil) and financial instruments (such as interest-rate-sensitive debt,

currencies and equities). Therefore, financial derivatives may be used to manage risk exposures

related to both equity and debt.There are four basic types of derivatives contracts: futures, forwards, options and swaps:

1.A futures contract is a contract to buy (or sell) a specified amount of a commodity or financial

instrument at a price determined today for delivery or payment at a future date. Futures

contracts are standardised contracts that are traded through a futures exchange. Futures

contracts are discussed in Chapters 18 and 19.

2.A forward contract is similar to a futures contract but is typically more flexible and is

negotiated over the counter with a commercial bank or investment bank. Aforward foreign

exchange contractestablishes a foreign currency exchange rate that will apply at a specified

date. Aforward rate agreement is used to lock in an interest rate today that will apply at a

specified date. Forward contracts are discussed in Chapters 17, 18 and 19.

3.An option contract gives the buyer of the option the rightbut not an obligationto buy (orsell) the designated asset at a specified date or within a specified period during the life of the

contract, at a predetermined price. The fact that the buyer is not obliged to proceed with the

contract is valuable, and therefore the buyer must pay a premium to the writer of the option.

Option contracts are discussed in Chapters 18 and 20.

4.A swap contract is an arrangement to exchange specified future cash flows. With an interest

rate swapthere is an exchange (swap) of future interest payments based on a notional principal

amount. A currency swapis denominated in a foreign currency and fixes the exchange rate

at which the initial and final principal amounts are swapped. Ongoing interest payments

are also swapped at the same exchange rate. Swap contracts are discussed in Chapters 18

and 21.

Derivative instruments are different from equity and debt in that they do not provide actualfunds for the issuer. Funds need to be raised in either the equity or debt markets. Risks associated

with equity or debt issues may be managed using derivative contracts. For example, an investor

might be concerned that the value of shares held in an investment portfolio might fall. The investor

might enter into a derivative contract that gives the investor the option to sell shares at a specified

date at a price that is agreed today. If the share price does fall, the investor will exercise the option

and sell at the agreed higher price.

REFLECTION POINTS

The principal form of equity issued by a publicly listed corporation is the ordinary share or

common stock.

Ordinary shares entitle the shareholder to share in the profits of the company, either through

the receipt of dividends or through capital gains, and provide certain voting rights.

A hybrid security, such as a preference share, incorporates the characteristics of both debt and

equity.

FUTURES CONTRACT

An exchange-traded

agreement to buy

or sell a specific

commodity or

financial instrument

at a specific price

at a predetermined

future date

FORWARD CONTRACT

An over-the-counter

agreement that locks

in a price (interest

rate or exchange

rate) that will apply at

a future date

OPTION CONTRACT

The right, but not the

obligation, to buy or

sell a commodity

or security at a

predetermined

exercise price; the

option buyer pays

a premium to the

option writer

SWAP CONTRACT

An agreement

between two parties

to swap future cash

flows; interest rate

swaps and currency

swaps




15/45


The basic characteristic of debt is that is must be repaid. The debt holder is entitled to receive

cash flows specified in the debt instrument (e.g. interest payments and principal repayment).

Debt may be secured or unsecured.

A derivative contract is designed to facilitate the management of risk (e.g. interest rate risk).

Types of derivative products are futures, forwards, options and swaps.

1.4 Financial marketsWe now introduce the third component of a financial system, being the financial markets. You

gained a basic understanding of the financial institutions and instruments earlier in the chapter;

now, once you understand the structure of the financial markets, you should have a good grasp of

the integrated functions of the markets and the importance of the financial system to economic

growth within a country. In this chapter we begin by categorising the markets according to the

types of transactions that occur within each market. Later in the textbook we will discuss in

detail the institutions and instruments that prevail in each of the financial markets. This section

considers:

the matching principle

primary and secondary markets

direct and intermediated financial flow markets

wholesale and retail markets

money markets

capital markets

1 .4 . 1 MATCHING PR INC IPLE

The matching principle is one of the fundamental reasons for the existence of a wide range of

financial instruments and markets. The principle contends that short-term assets such as working

capital and inventories should be funded with short-term liabilities. For example, if a company is

purchasing stock (asset) that will remain in the company for just a short period of time before the

product is sold, the company should need only a short-term loan (liability) to fund the purchase

of the stock. An example of a short-term loan that can be used for this purpose is an overdraft

facility (see Chapter 9).

The matching principle goes on to state that longer-term assets should be funded with equity

and long-term liabilities. For example, a company may purchase a new factory and manufacturing

equipment, and it is expected that these assets will generate income for the next 10 years.

To fund the purchase, the company should issue equity and/or long-term debt such as bonds (see

Chapter 10).

The money markets and capital markets trade short-term and long-term financial instruments

respectively, and therefore allow borrowers to apply the matching principle in relation to funding.

A borrower is able to match the cash flows associated with a source of funds (liabilities) closelywith the cash flows generated from the use of funds over the life of a particular asset.

While the matching principle may be regarded as a fundamental principal of finance, it

is interesting to note how often this principal is disregarded. For example, from mid-2007,

short-term finance available through the money markets virtually ceased as a result of uncertainty

in relation to risk deriving from the so-called sub-prime market collapse. Quite a number of

MATCHING PRIN

Short-term as

should be fun

with short-te

liabilities; lon

term assets

should be funwith longer-te

liabilities and

OVERDRAFT FAC

A fluctuating

facility provid

a bank; allow

business ope

account to go

into debit up t

agreed limit

BONDS

Debt securitieissued by a b

to raise long-

funds; requir

periodic inter

payments an

principal repa

maturity




16/45


financial institutions had been funding longer-term instruments with short-term finance in the

money markets. When this source of finance was suddenly no longer available the institutions

experienced a significant liquidity problem and some institutions failed or were taken over. They

forgot the fundamentals!

1 .4 .2 PR IMARY AND SECONDARY MARKET TRANSACT IONS

The concept of primary markets and secondary markets is quite simple, but their role in ensuring

the efficiency of the financial markets is very important indeed.

A primary market transaction occurs when businesses, governments and individuals

issue financial instruments in the money markets and capital markets. For example, when

a corporation issues additional ordinary shares to raise equity funding for a proposed

investment project, it is conducting a primary market transaction in the capital markets.

Similarly, if the government sells new long-term bonds in order to finance spending on capital

works, health or education, this is a primary market transaction. Individuals who borrow

money from a bank to finance the purchase of a house are also participating in a primary

market transaction. The distinguishing characteristic of a primary market transaction is that

it creates a new financial instrument. Primary market flows and relationships are il lustrated

in Figure 1.2.

FIGURE 1.2 PRIMARY MARKET TRANSACTIONS

In contrast, secondary market transactions involve transactions with existing financial

instruments. Instruments traded in the secondary markets are those that were initially created

in primary market transactions. For example, consider an investor who buys shares (equity)

issued by a corporation. These primary market flows are shown in Figure 1.2. If the holder of

those shares now decides to sell them, the sale of the shares is regarded as a secondary market

transaction. Figure 1.3 illustrates the flows involved in secondary market transactions.

FIGURE 1.3 SECONDARY MARKET TRANSACTIONS

PRIMARY MARKET

TRANSACTION

The issue of a new

financial instrument;

funds are obtained

by the issuer

MONEY

A commodity that is

universally accepted

as a medium of

exchange

SECONDARY MARKET

TRANSACTION

The buying and

selling of existing

financial securities;

transfer of

ownership, no new

funds raised by

issuer

Issue 'new' financial instruments(debt or equity) to the suppliers of funds

Use funds to acquiregoods, services

or assets

Suppliers of funds(surplus units)

Users of funds(deficit units)

supply funds

Surplus entity 1

Surplus entity 2

Surplus entity n

sell marketable

securities to

Holders of previouslyissued financial

instruments

and receive market value




17/45


Secondary market transactions have no direct impact on the amount of funding raised or

available to the company that was the initial issuer of a financial instrument; that is, the company

receives no extra funds from the secondary market transaction. A secondary market transaction

is simply a transfer of ownership from one party to another party.

However, the existence of well-developed secondary markets has important impacts on the

marketability of new primary market financial instruments or securities.Secondary market transactions help overcome two potential obstacles that may stand in the

way of savers providing funds for the financing of long-term capital investment. These are the

savers preferences for liquidity and their aversion to risk. Without an active secondary market,

purchasers of new-issue instruments would be required to hold those long-term instruments

until they mature. In the case of equity, the problem would be even greater as there is generally

no maturity date. A deep and liquid secondary market solves this problem by providing markets

where these instruments can be bought and sold. A deep and liquid secondary market is one

where there are many buyers and sellers in the market.

Economic growth (and the benefits, such as increased employment, that flow to the community

from that growth) is critically reliant on the existence of strong primary markets. Primary market

transactions allow corporations and government to raise new funding that leads to increased

capital and productive investment. Secondary markets, while not directly involved in the process

of channelling funds from savers to users of funds, encourage both savings and investment

because they enhance the marketability and liquidity of primary-issue instruments, thus making

them more attractive to savers.

It will be useful to introduce and explain some market terminology at this stage. A financial

asset has already been defined as an entitlement to future cash flows. A financial instrument is

the more general term used in the markets to describe instruments where there is no organised

secondary market where that instrument can be traded. The market also describes a number of

financial instruments as securities. A security is the term used to describe a financial asset that

can be traded in an organised secondary market such as a stock exchange or a futures exchange.

An example of a financial instrument is a bank term deposit, and an example of a security is an

ordinary share in a publicly listed company. Both are financial assets.

1 .4 .3 D IRECT F INANCE AND INTERMEDIATED F INANCE

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:

The funds may flow through a direct relationship from the provider of funds to the user of

funds.

The flow of funds may occur through a financial intermediary such as a bank.

Within the financial markets each form of financial flow is an important source of finance.

DIRECT FINANCE

When funds are raised in the primary markets using direct finance, the contractual agreementis between the provider of funds and the user of funds. The funds are not provided by a financial

institution. The relationships that exist between savers and the users of funds in the provision of

direct finance are shown in Figure 1.4.

The brokers and dealers included in Figure 1.4 may act as agents through which the

instructions of the providers of funds and users of the funds are carried out. The broker does

SECURITIES

Financial ass

that are trade

formal secon

market (e.g. sexchange)

DIRECT FINANC

Funding obta

direct from th

money markecapital marke

BROKER

An agent who

out the instru

of a client




18/45


not provide the finance, but receives a fee or commission for arranging the transaction between

the two parties. The broker has no rights to the benefits that may flow from the purchase of the

security. It is not necessary for a broker or dealerto be involved at all in the transaction.

An investor seeking to purchase shares in a company will generally arrange the transaction

through a stockbroker. The stockbroker acts only as an agent to the transaction and, on behalf of

a client, facilitates the direct purchase or sale of shares by accessing the electronic share trading

systems of the stock exchange.

Examples of direct financing include share issues, corporate bonds and government securities.

These securities are discussed further in various chapters of the text.

THE BENEFITS AND DISADVANTAGES OF DIRECT FINANCE

Direct finance is generally available only to corporations and government authorities that have

established a good credit rating. A credit rating is an assessment of the creditworthiness of an

issuer of paper. As the contractual relationship in direct finance is directly between the provider

of funds and the issuer of paper, the risk that the issuer may default is an important consideration.

Therefore, borrowers that do not have an established good credit rating generally are not able to

borrow direct. The credit rating process is discussed in Chapter 11.

The main advantages of direct finance are as follows:

It removes the cost of a financial intermediary. If a borrower obtains a loan from a financial

institution, the borrower will pay a profit margin to the intermediary. Should a corporation orgovernment authority have an investment-grade credit rating (e.g. Standard & Poors BBB and

above), it may well be able to raise funds directly from the domestic or international markets

at a lower total cost than borrowing through a bank.

It allows a borrower to diversify funding sources by accessing both the domestic and

international money and capital markets. This reduces the risk of exposure to a single funding

source or market. Economic and financial conditions change from time to time, and a user

of funds may suddenly find that a traditional source of funds is no longer willing to provide

further funding. For example, this situation was evident in Thailand and Indonesia as a result

of the Asian financial crisis of 199798, and was repeated in Argentina after the collapse of

the countrys financial and economic systems in 2002. From mid-2007, as a result of large

increases in default rates associated with so-called sub-prime market securities, raisingfunds in the global money markets and capital markets became very difficult.

It enables greater flexibility in the types of funding instruments used to meet different

financing needs. More sophisticated funding strategies may be used to raise funds. For

example, a corporation may obtain a US dollar (USD) loan in the international capital

markets and then use USD export income to repay the loan.

FIGURE 1.4 DIRECT FINANCIAL FLOWS

Financial instruments



provide funds

Brokers anddealers

DEALER

Makes a market in a

security by quoting

both buy (bid) and

sell (offer) prices

CREDIT RATING

The assessment

by a credit rating

agency of the

creditworthiness

of an obligor to a

financial obligation




19/45


An organisation may enhance its international profile by carrying out transactions in the

international financial markets. An increased profile in the financial markets may be beneficial

in establishing a reputation in the markets for the firms goods and services.

There are some disadvantages that may, at times, be associated with direct financing. These

include:

There can be a problem of matching the preferences of lenders and borrowers. For example,

a lender may have a certain amount of funds available for investment, but this amount may

not be sufficient for the needs of the borrower, who would then need to seek out and enter into

funding arrangements with additional suppliers of funds. There may also be a mismatch in

the maturity structure of the funding as the borrower may need to borrow for a longer period

than the risk-averse investor is willing to lend.

The liquidity and marketability of a direct finance instrument may be of concern. How easy is

it for the holder of an instrument issued by direct finance to sell at a later date? Is there a deep

and liquid secondary market in that instrument? Not all financial instruments have an active

secondary market through which they may be sold.

The search and transaction costs associated with a direct issue can be quite high. These

might include advisory fees, the cost of preparing a prospectus, legal fees, taxation advice,

accounting advice and specific expert advice (such as a geologists report). On very large direct

finance transactions the fees and costs may run into the millions of dollars.

It can be difficult to assess the level of risk of investment in a direct issue, particularly

default risk. Accounting and reporting standards may vary between nation-states, and

information about an issuer may be limited to the prospectus and the issuers credit rating.

INTERMEDIATED FINANCE

The critical difference between direct and intermediated finance is to be found in the relation-

ships that exist between the saver, the intermediary and the user of funds. With intermediated

finance, as illustrated in Figure 1.5, the intermediary has an active role in the relationship. The

intermediary, in providing finance to deficit units, acquires the ownership of the financial instru-

ment that is created as part of the transaction. It also obtains the rights to the benefits and risks

associated with the ownership of that asset. The benefits include the receipt of interest payments

and the repayment of principal. On the other hand, a significant risk accepted by the intermediary

is default or credit riskthat is, the risk that the borrower may not make all loan repayments.

FIGURE 1.5 INTERMEDIATED FINANCIAL FLOWS

In order to be able to provide loans to its customers, an intermediary obtains its funding

from savers. Savers receive financial instruments issued by the intermediary, such as a term

deposit receipt issued by a bank. A contractual agreement then exists between the saver and the

Financial instrumentFinancial instrument



funds fundsIntermediaries

DEFAULT RISK

The risk that

borrower ma

not meet fina

commitments

as loan repay

when they ar

INTERMEDIATED

Financial tran

conducted wi

financial

intermediary

bank deposits

and bank loan

separate con

agreements




20/45


intermediary in relation to the term deposit. The intermediary creates a separate contractual

agreement with the borrower (the ultimate user of funds). The saver has no claim on the income

or assets of the ultimate borrower. Those entitlements reside with the bank as the intermediary.

The saver only has a claim for the payment of interest and the return of principal at maturity

from the bank. On the other hand, under a separate loan contract, the intermediary relies on the

borrower for repayment of the loan. Failure of the bank to recover the funds from the borrowerdoes not change the contractual relationship the bank has with its depositor.

THE BENEFITS OF FINANCIAL INTERMEDIATION

Very often the portfolio preferences of savers and borrowers differ. For example, a risk-averse

lender may be prepared to receive a lower rate of return in exchange for maintaining funds

at call. On the other hand, a borrower may be prepared to pay a higher rate of return, but

may want to have the funds available for a number of years. It is likely that many savers and

borrowers would find it difficult to meet their investment and funding needs if only direct finance

was possible.

An intermediary is able to resolve this problem and satisfy the preferences of both parties,

and at the same time make a profit. An intermediary is able to transform short-term depositfunds into longer-term loan funds. An essential economic role of an intermediary is to resolve the

conflicting preferences of surplus units and deficit units, and thus encourage both savings and

productive capital investment.

In carrying out the role of offering instruments with varying financial attributes (risk, return,

liquidity, timing of cash flows), intermediaries perform a range of functions that are important to

both savers and borrowers. These are:

asset transformation

maturity transformation

credit risk diversification and transformation

liquidity transformation

economies of scale

Asset transformation

Financial intermediaries engage in asset transformation by offering their customers a wide

range of financial products on both sides of the balance sheet, including deposit, investment and

loan products.

Without intermediation, surplus units that could generate only small levels of savings would

not have any incentive to save; and users of funds, such as individuals and small businesses,

would find the cost of obtaining loans too great to be worthwhile. Intermediaries specialise in the

gathering of savings and can achieve economies of scale in their operations. They can profitably

receive small amounts from many savers, pool them into larger amounts and make them available

as loans to borrowers.Financial intermediaries provide a range of deposit products which meet the varying

preferences and need of their customers. These include demand deposit accounts, current

accounts, term deposits and cash management trusts. At the same time, financial intermediaries

provide a range of loan products, including overdraft facilities, term loans, mortgage loans and

credit card facilities.

ASSET

TRANSFORMATION

The ability of financial

intermediaries to

provide a range of

products that meet

customers portfolio

preferences




21/45


22/45


The time involved in carrying out a transaction may also be an important component of the total

transaction cost.

Many intermediaries provide highly liquid accounts in which individuals may store some of

their wealth. For example, a demand (at-call) account with a bank represents complete liquidity.

The depositor has the right to withdraw funds without notice. There is zero risk that the value of

the asset, when it is converted into cash, will be less than the value of the deposit in the demandaccount. In addition, the transaction costs associated with converting the credit balance into cash

are limited to transaction fees imposed by the bank. Intermediaries such as commercial banks

can offer highly liquid assets to savers, which the ultimate users of funds would be most unlikely

to be able to do.

Banks have further extended liquidity arrangements by adopting systems such as electronic

networks: automatic teller machines (ATMs) and electronic funds transfer at point of sale (EFTPOS)

arrangements.

Economies of scale

Financial intermediaries gain considerable economies of scale due to their size and the volume

of business transacted, and therefore have the resources to develop cost-efficient distributionsystems. Banks maintain extensive branch networks as their primary distribution mechanism.

At the same time they also provide extensive technology-based distribution systems such as

ATMs, EFTPOS, telephone banking and Internet banking.

The cost of the sophisticated computer and communication systems required to support such

distribution networks is spread over the millions of transactions processed.

Intermediaries also obtain cost advantages through effective knowledge management and

the accumulation of financial, economic and legal expertise. For example, a bank will typically

use standardised documentation for its deposit and lending products. The bank knows that these

documents will comply with regulatory and legal requirements. Other cost advantages include a

reduction in search costs for both savers and borrowers; that is, savers do not need to investigate

the creditworthiness of the ultimate borrower; the intermediary will have that data available

before making a loan decision.

In a competitive market, financial intermediaries should pass on efficiency gains in the form

of reduced interest margins and fees.

1 .4 .4 WHOLESALE AND RETA IL MARKETS

Direct financial transactions between institutional investors and borrowers are described as

wholesale market transactions. Institutional investors include commercial banks, insurance

offices, superannuation funds, investment banks, merchant banks, funds managers, finance

companies, building societies, credit unions, government authorities and large corporations.

Transactions conducted in the wholesale markets typically range from the tens of thousands

of dollars to the millions of dollars. For example, a portfolio manager may purchase a $50 000

wholesale managed fund for a client while a financial institution might sell $10 million worth ofcommercial bills into the money market.

The cost of wholesale funds is determined by a range of factors, such as the level of liquidity

(surplus funds) within the financial system, future interest rate expectations and the maturity

structure of investment opportunities. For example, large amounts of short-term funds are

invested overnight in the money markets. Generally, wholesale investors are able to accumulate

ECONOMIES OF SCALE

Financial andoperational benefits

gained from

organisational

size, expertise and

volume of business

WHOLESALE MARKET

Direct financial flow

transactions between

institutional investors

and borrowers




23/45


large quantities of surplus funds and use their market power and investment skills to obtain

higher returns than would normally be available in the retail market. At the same time, wholesale

market borrowers are able to use their good credit standing in the markets to obtain access to

those funds.

The retail market, on the other hand, comprises transactions primarily of individuals

and small to medium-sized businesses. Transactions are principally conducted with financialintermediaries. Market participants are price takers; that is, the financial intermediary is able to

set both deposit and lending rates of interest. Retail market participants are not totally excluded

from the wholesale markets. They are able to gain indirect access to the wholesale markets

through managed investment products such as cash management accounts and unit trusts. These

are discussed in Chapter 3.

1 .4 .5 MONEY MARKETS

The financial markets may be categorised according to the characteristics of the financial

instruments that are traded in the markets. Within the debt and equity markets, the two main

market classifications are the money markets and the capital markets. The money markets and

the capital markets include a number of submarkets (see below). Other markets, such as the

foreign exchange market and the derivatives market, also form part of the financial system.

Money market transactions involve wholesale short-term-to-maturity securities of less than

12 months. As discussed below, medium- to long-term-to-maturity transactions are referred to as

capital-market transactions. Figure 1.6 depicts the structure of the money markets and the capital

markets. You will note that each market incorporates primary and secondary markets within

both the domestic and the international markets.

The money markets bring together institutional investors that have a surplus of funds and

those with a short-term shortage of funds. The money markets are attractive to institutional

RETAIL MARKET

Financialtransactions

conducted

with financial

intermediarie

mainly by ind

and small to

medium-size

businesses

MONEY MARKET

Wholesale m

in which shor

securities areand traded

INSTITUTIONAL

INVESTORS

Participants i

the wholesale

markets (e.g.

managers, in

offices, banks

Money markets

Financial markets

Capital markets

Primary capital

markets(new shares and long-

term debt issues)

Secondary capital

markets(trading in existing

securities)

Primary money

markets(maturities to one year)

Domesticshort-term

money markets

Domesticcapital markets

International

capital markets

Internationalshort-term

money markets

Secondary money

markets(residual maturities

to one year)

FIGURE 1.6 STRUCTURE OF THE MONEY AND CAPITAL MARKETS




24/45


investors for short-term financing arrangements as the markets are (normally) highly liquid

and the securities issued in the market are standardised and have well-developed secondary

markets. At the time of writing, the money markets around the world were experiencing a credit

crisis. As mentioned previously, this essentially stems from the so-called sub-prime crisis and

concerns that some participants in the money markets may default on their financial obligations.

It is to be expected that once the credit crisis has been resolved, liquidity in the money marketswill return.

As mentioned, the money markets allow institutional investors, such as commercial banks,

insurance offices, superannuation funds, investment banks, merchant banks, funds managers,

finance companies, other finance institutions, government authorities and large corporations to

manage their short-term financing needs. For example, a large retail sales store may accumulate

surplus funds from sales. In order to gain a return the store needs to invest the surplus funds.

However, the store may need to use the funds in a few days to buy more stock. The store knows

that it is able to purchase short-term securities in the money markets today that can easily be sold

again in a few days when the cash is needed.

From the point of view of borrowers, one of the principal functions of the money markets is

to enable them to bridge the mismatch between their cash expenditures and their cash receipts.

A large corporation may need to raise short-term funds to cover its forecast working-capital

requirements over the next three months. The corporation could borrow the funds from a bank,

but it may also find that it is able to borrow at a lower yield by issuing short-term securities

directly into the money markets. The securities issued may be repaid as the company generates

income from its products or services.

The money markets have no specific trading location. Money market transactions are

conducted from the business offices of the market participants using computer networks. The

money markets operate both as primary markets in which new securities are issued and as

secondary markets in which existing securities are bought and sold. The major money-market

participants and securities issued and traded are listed in Figure 1.7.

FIGURE 1.7 MONEY-MARKET PARTICIPANTS AND INSTRUMENTS

Market participants

Central bank

Commercial banks

Superannuation funds

Investment banks and merchant banks

Finance companies

Insurance offices

Funds managers (including unit trusts)

Building societies and credit unions

Cash management trusts

Corporations

Money-market instruments

Exchange settlement account funds

Treasury notes

Government bonds (less than 12 months

to maturity)

Commercial bills

Promissory notes (commercial paper)

Deposits (11 am and 24-hour call)

Negotiable certificates of deposit

Inter-bank loans

Repurchase agreements (repos)




25/45


MONEY-MARKET SUBMARKETS

As indicated in Figure 1.7, the money markets comprise a number of submarkets, including:

central bank: system liquidity and monetary policy

inter-bank market

bills market commercial paper market

negotiable certificates of deposit market

Central bank: system liquidity and monetary policy

Central banks use the money markets to carry out transactions that will maintain, or change, the

amount of liquidity that is available within the financial system. The amount of daily liquidity in

the financial system is affected mainly by government budget surpluses or deficits, official foreign

exchange transactions and net sales of government securities. The amount of liquidity in the

financial system directly impacts on interest rates in the market. The central bank implements

its monetary policy by targeting the cash rate, hence the central bank carries out money market

transactions so that the cash rate remains at its target level.For example, in Australia the central bank is the Reserve Bank of Australia. The Reserve

Bank deals regularly, usually daily, in the money markets for the purpose of managing the supply

of liquid funds (cash) available to the financial system. The Reserve Bank deals in (buys and

sells) Commonwealth government securities (CGS) and certain other specified securities of up to

one year to maturity, and in repurchase agreements (repos). The Reserve Bank conducts these

market operations with members of the Reserve Bank Information and Transfer System (RITS),

principally commercial banks and other institutions that participate in the wholesale market for

CGS. RITS is an electronic settlement system.

Furthermore, the Reserve Bank is responsible for the implementation of monetary policy.

Briefly, the main monetary policy objective is to maintain an economic environment whereby

inflation remains within a desired range of 2 per cent to 3 per cent over time. To achieve this,

the Reserve Bank seeks to influence the level of interest rates by targeting the cash rate in themoney markets. As at December 2008 the target cash rate was 4.25 per cent. In an efficient

market, it is expected that if the cash rate changes then this will flow through over time to changes

in other interest rates. Changes in interest rates will then impact on economic activity and the

level of inflation.

System liquidity and monetary policy issues are discussed in Chapter 12.

Inter-bank market

The inter-bank market facilitates the management of the short-term liquidity needs of the

commercial banks.

Banks carry out transactions on behalf of their customers and also on their own behalf.

Settlement of transactions between the banks occurs through the payments system. In orderto effect settlement, each member of the payments system is required to maintain an exchange

settlement account with the central bank.

An important role of the inter-bank market is the lending of surplus exchange settlement

account funds. These cleared settlement funds are known as same-day funds and are required

by the banks to maintain their exchange settlement accounts in credit. The introduction of

INTER-BANK MA

The lending a

borrowing of

short term fu

banks operatthe payments




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real-time gross settlement for the clearance of large-value transactions has increased the profile

of the inter-bank market. The operation of the payments system is discussed in Chapter 12.

Bills market

Bills of exchange are short-term discount securities. A discount security is issued today with

a face value that is payable at the maturity date. A discount security does not pay interest, but

is sold to investors at a price less than the face value. Therefore, the holders of these securities

obtain their return on investment from the difference between the price that they pay for the

security and the price for which they sell it, or the face value if held to maturity. For example, if a

borrower issues a bill with a face value of $1 million, payable in 90 days, and sells the bill today

for $980 000, then the return to the investor will be $2000 if the bill is held to the maturity date.

The issuer of the bill has effectively borrowed $980 000 for 90 days at a cost of $2000.

The commercial bills market is the largest component of the money markets, and involves the

trading of bank bills and non-bank bills. There is an active secondary market in commercial bills.

This allows market participants to manage their maturity preferences. For example, an investor

can buy a 90-day bill but sell it after seven days. The same bill might be sold several times during

its short 90-day life.Commercial bills are discussed in Chapter 9.

Commercial paper market

Another important segment of the money markets is the issue and trading of promissory notes. It

is a market convention to refer to promissory notes as commercial paper.

A promissory note is a discount security (similar to a commercial bill). It is issued with a face

value that is payable at maturity. As the promissory note does not pay interest, it is sold today for

less than the face value. Refer to the example given in the bills market (above).

The strength of this market tends to fluctuate with the overall performance of the economy.

As promissory notes are often issued on an unsecured basis, only corporations with a good credit

rating are able to issue into the

financial sytem

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