Week 1 – Introduction to Financial Systems
Explain the functions of a financial system
- Financial System – consists of financial institutions, financial instruments and financial markets that facilitate the flow of funds through the system
- Money
o Medium of exchange, saving, store of wealth, allows specialisation in production - Role of Markets
o Facilitate exchange of g/s by bringing parties together and establishing rates of exchange - Surplus Units Æ Savings available for lending
- Deficit Units Æ Borrowings for capital investment/consumption - Financial Instruments
o Issued by party raising funds
o Acknowledges financial commitment and entitling holder to FCF
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- Double Coincidence of Wants Satisfied – transaction that meets needs of both parties - Flow of Funds – flow of funds through FS that gives rise to instruments
- Attributes of Financial Assets
o Return on Yield – Total compensation received (%)
o Liquidity – Ability to sell an asset within a reasonable time at a current price for a reasonable transaction cost
o Risk – Probability actual return doesn’t equal expected return
o Pattern of Cash Flows – When expected CF to be received by lender/borrower
- Portfolio Restructuring – combination of desired Assets/liabilities that provide the desired risk, return, liquidity, pattern of CF
- Implementation of Monetary Policy
o Inflationary objectives is the main target o CB influences cash rate to achieve objectives - An efficient Financial System:
o Encourages savings
o Directs savings to the most efficient users of it (low hanging fruit…) o Implement Monetary Policy of governments
o Is a combination of a/l comprising the desired attributes of financial assets
Categorise the main types of financial institutions
- Fin Institutions = depositary fin institutions, investment banks, merchant banks, contractual savings institutions, finance companies, unit trusts)
- Permit Flow of Funds by facilitating financial tranasctions - Categories of Fin Institutions
o Depositary
Attract savings (TD) and savings accounts
Loans to borrowers (biz/hh sector) o Inv and Merchant Banks
Provide OBS advisory services to support corporate/gov clients
Advise on raising funds in K markets
o Contractual Savings Institutions (Insurance companies etc.)
Receive periodic payments in return for a payout if a specified event occurs
Invest the pools of funds o Finance Companies
Funds are raised through issuing financial securities
Funds used to make loans/lease finance to hh/biz sector o Unit Trusts
Formed under trust deed
Managed by trustee
Units are sold to the public to raise funds
Describe the main classes of financial instruments issued in a financial system - Equity
o Interest in Asset (Ownership)
o Residual claim on earnings/assets (Dividend/liquidation) o Ordinary or Hybrid/Preference
- Debt
o Contractual claim to period interest payment + principle o Ranked above equity
o Variations – st/lt, secured/unsecured, negotiable/non-negotiable - Derivatives
o Synthetic security that provides future rights
o Derives price from an underlying commodity or fin instrument o Hedge/speculate
o Futures, forwards, options, swaps
Discuss the flow of funds between savers and borrowers, and through the financial system and economy
- Matching Principle
o ST Assets should be funded with ST Liabilities (Money Market) o LT Assets should be funded with LT Liabilities (K Market) - Primary and Secondary Market Transactions
o Primary – Issue of new financial instruments to raise funds o Secondary – Buying/selling of existing financial instruments
Transfer of ownership
Provides liquidity Æ Makes primary market financing cheaper (lower risk)