Chap 1

Chapter 1
The Financial System
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PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney
Slides prepared by Anthony Stanger
Learning Objectives
Explain the functions of a financial system
Describe the main classes of financial
instruments issued in a financial system

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

Learning Objectives (cont.)

Appreciate the influence of
globalization on financial markets

Categorize the main types of financial
institutions
Understand the impact of a financial
crisis on a financial system and a real
economy

Chapter Organization
1.1
1.2
1.3
1.4
1.5
1.6
1.7
Introduction
Functions of the Financial System
Financial Instruments
Financial Markets
Impact of Globalization
Financial Institutions
Summary

Whatifmarketsandcurrencydidnotexist
Doublecoincidenceofwants
Exchangerates
Divisibilityproblem
Perishableproducts
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Markets 4/e by Christopher Viney
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1.1 Introduction
Money
Medium of exchange
Allows specialization in production
Solves the divisibility problem, i.e. where medium
of exchange does not represent equal value for
the parties to the transaction
Facilitates saving
Store of wealth
Any commodity that is widely accepted in exchange

transactions

1.1 Introduction (cont.)

Role of markets
Facilitate exchange by
Bringing opposite parties together

Establishing rates of exchange, i.e. prices
Surplus units
Savers of funds available for lending
Deficit units
Borrowers of funds for capital investment

and consumption


Financial instrument
Issued by a party raising funds,
acknowledging a financial commitment
and entitling holder to specified future
cash flows
Flow of funds
Movement of funds through the financial
system between savers and borrowers
giving rise to financial instruments

Financial system
Financial institutions, instruments and
markets facilitating transactions for goods
and services and financial transactions
Overcomes difficulty of
Double coincidence of wants

Transaction between two parties meets their
mutual needs
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10
Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6
1.7
Introduction
Financial Markets
Impact of Globalisation
Summary
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1.2 Functions of the

Financial System
Attributes of financial assets
Return or yield
Total financial compensation received from an

investment expressed as a percentage of the
amount invested
Risk
Probability that actual return on an investment

will vary from the expected return
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Financial System (cont.)
Liquidity
Ability to sell an asset within reasonable
time at current market prices and for
reasonable transaction costs
Time-pattern of the cash flows
When the expected cash flows from a
financial asset are to be received by the
investor or lender
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The financial system facilitates
portfolio restructuring
The combination of assets and liabilities

comprising the desired attributes of
return, risk, liquidity and timing of cash
flows

14

An efficient financial system
Encourages savings
Savings flow to the most efficient users
Implements the monetary policy of
governments by influencing interest rates
The combination of assets and liabilities
comprising the desired attributes of
return, risk, liquidity and timing of cash
flows

15
1.1
1.2
1.3
1.4
1.5
1.6
1.7
Introduction
Financial Markets
Summary

16
1.3 Financial Instruments

Equity
Ownership interest in an asset
Residual claim on earnings and assets
Dividend
Liquidation
Types
Ordinary share
Preference shares or Equity Hybrid (or quasiequity) security
Preference shares
Convertible notes

17

(cont.)
Debt
Contractual claim to
Periodic interest payments

Repayment of principal
Ranks ahead of equity

Can be secured or unsecured
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(cont.)
Derivatives
A synthetic security providing specific
future rights that derives its price from a
Physical market commodity

Gold and oil
Used mainly to manage price risk

exposure, and to speculate
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(cont.)
Four basic derivative contracts
Futures Contract
Forward Contract
Option Contract
Swap Contract
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1.1
1.2
1.3
1.4
1.5
1.6
1.7
Introduction
Financial Markets
Summary
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1.4 Financial Markets

Matching principle
Primary and secondary market
transactions
Direct and intermediated financial flow
markets
Wholesale and retail markets
Money markets
Capital markets
22
Matching principle
Short-term assets should be funded
with short-term liabilities
Inventory funded by overdraft
Longer-term assets should be funded
with equity or longer-term liabilities
Equipment funded by debentures

23
Primary and secondary

market transactions
Primary market transaction
The issue of a new financial instrument to
raise funds to purchase goods, services or
assets by
Businesses
Company shares or debentures
Governments
Treasury notes or bonds
Individuals
Mortgage
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Primary and secondary

market transactions (cont.)
Secondary market transaction
The buying and selling of existing financial
instruments
No direct impact on original issuer of security

Transfer of ownership from one saver to
another saver
Provides liquidity which facilitates restructuring
of portfolios of security owners
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Direct and intermediated

financial flow markets
Direct flow markets
Users of funds obtain finance directly from
savers
Advantages
Avoids costs of intermediation
Increases range of securities and markets
Disadvantages
Matching of preferences
Liquidity and marketability of a security
Search and transaction costs
Assessment of risk, especially default risk
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financial flow markets (cont.)
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Intermediated flow markets
A financing arrangement involving two
separate contractual agreements whereby
saver provides funds to intermediary, and
the intermediary provides funding to the
ultimate user of funds
Advantages
Asset transformation
Maturity transformation
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Advantages (cont.)
Credit risk diversification and transformation

Liquidity transformation
Economies of scale
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Wholesale markets
Direct financial flow transactions between
institutional investors and borrowers
Involves large transactions
Retail markets
Transactions conducted primarily with
financial intermediaries by the household
and small- medium business sectors
Involves smaller transactions
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Money markets
Wholesale markets in which short-
term securities are issued and traded
Securities highly liquid
Term to maturity of one year or less

Highly standardised form
Deep secondary market
No specific infrastructure or trading place

Enable participants to manage liquidity
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Money markets (cont.)

Money market securities
Cash deposits (11 a.m. and 24-hour call)
Commercial bills
Treasury notes
Government bonds
Promissory notes
Intercompany loans
Interbank loans
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Money market participants
Reserve Bank
Financial system liquidity

Implementation of monetary policy
Banks
Finance companies
Funds managers
Building societies
Credit unions
Companies
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Money market sub-markets
Intercompany market
Interbank market
Bills market
Commercial paper market
Negotiable certificates of deposit (CDs)
market
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Capital markets
Markets in which longer-term
securities are issued and traded
Equity markets
Corporate debt markets
Government debt markets
Foreign exchange markets
Derivatives markets
Term to maturity of more than one
year
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1.1
1.2
1.3
1.4
1.5
1.6
1.7
Introduction
Financial Markets
Summary
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1.5 Impact of Globalisation

Globalisation of financial markets
Refers to the interdependence of national
financial systems
Global standardisation of financial
instruments
Facilitates the movement of funds
between savers and borrowers in different
countries
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1.7 Summary (cont.)

Financial markets may be classified
according to
Primary and secondary transactions

Direct and intermediated flows
Money markets and capital markets
Financial institutions
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Chapter 1

The Financial System

Copyright 2003 McGraw-Hill Australia Pty Ltd

instruments issued in a financial system

Copyright 2003 McGraw-Hill Australia Pty Ltd

Learning Objectives (cont.)

globalization on financial markets

Copyright 2003 McGraw-Hill Australia Pty Ltd

Copyright 2003 McGraw-Hill Australia Pty Ltd

Any commodity that is widely accepted in exchange

Copyright 2003 McGraw-Hill Australia Pty Ltd

1.1 Introduction (cont.)

Bringing opposite parties together

Borrowers of funds for capital investment

Copyright 2003 McGraw-Hill Australia Pty Ltd

1.1 Introduction (cont.)

1.1 Introduction (cont.)

Double coincidence of wants

1.1 Introduction (cont.)

Copyright 2003 McGraw-Hill Australia Pty Ltd

1.2 Functions of the

Total financial compensation received from an

Probability that actual return on an investment

1.2 Functions of the

1.2 Functions of the

The combination of assets and liabilities

Copyright 2003 McGraw-Hill Australia Pty Ltd

1.2 Functions of the

Copyright 2003 McGraw-Hill Australia Pty Ltd

Copyright 2003 McGraw-Hill Australia Pty Ltd

1.3 Financial Instruments

Copyright 2003 McGraw-Hill Australia Pty Ltd

1.3 Financial Instruments

Periodic interest payments

Ranks ahead of equity

1.3 Financial Instruments

Physical market commodity

Used mainly to manage price risk

1.3 Financial Instruments

1.4 Financial Markets

with short-term liabilities

Inventory funded by overdraft

Longer-term assets should be funded

with equity or longer-term liabilities

Equipment funded by debentures

Copyright 2003 McGraw-Hill Australia Pty Ltd

Primary and secondary

Primary and secondary

No direct impact on original issuer of security

Direct and intermediated

Direct and intermediated

Direct and intermediated

Direct and intermediated

Credit risk diversification and transformation

Direct and intermediated

Wholesale and retail markets

Involves large transactions

Involves smaller transactions

term securities are issued and traded

Securities highly liquid

Term to maturity of one year or less

No specific infrastructure or trading place

Money markets (cont.)

Money markets (cont.)