Chapter 1: Financial Institutions and Markets PDF

financial system are complex sophisticated and dynamic These are components to the system working together to perform the basic function of channelling funds from surplus to deficit, entities. In exchanging for a variety of types of promise of future payments Imagine a economy without an financial...

financial system are complex sophisticated and dynamic These are components to the system working together to perform the basic function of channelling funds from surplus to deficit, entities. In exchanging for a variety of types of promise of future payments Imagine a economy without an financial system, they will have some entities, individual firms. Government that have desirable. Real investment opportunities, example purchasing an factory, Public transport infrastructure, for instance purchasing an factory. But those entitles could not proceed with their investment plans without saving from their own current income. Their income along with there consumption plan limits their ability to devote resources to a new investment project. Meanwhile other economic entities with high current incomes desiring to save for the future could only do. So by accepting to them. These are these opportunities might be so limited by them ending up storing good or real assets. That generate no return. May even involve storage costs. We call then the first set of entities. Those with consumption and real investment expenditure plans, that exceed their income deficit entities. The second entities that exceed their planned expenditure Surplus entities. A financial system make the combined surplus funds of the surplus. Entities available to be used by the deficit, Therefore that the surplus entities do not have to invest in the unfavourable reals investment opportunities that happen to be available to them. And deficit entities are able to invest in some of the favourable opportunities that are available to them. As an result society is able to build those real assets house factories infrastructure that will produce the goods and services likely to be most valued in the future. Regardless od which entity has the surplus funds and deficit or which have the access to the best investment opportunity. This channelling of fund from surplus to deficit entities is achieved by allowing surplus funds to be exchanged for promise of there future payments. The contract that record the promise is an financial instrument. The instrument would be classified as a debt and equity or derivative instrument. The expectations of future cash flow both inflows and outflows arising from such contractual arrangements. Our financial assets and liabilities many entities, both receive and make numerous promise of there future payment. That is they will acquire numerous financial assets, Together with there real assets, the set of financial assets, acquired and issued is the entities portfolio. Entities includes individual perusing their objective of maximising, their utility and firms pursuing, the air objective of maximising, their share hold as wealth And only care about there own attributes that the portfolio of there own. Attribute of an portfolio: 1. How much is expected to be received and when 2. The possibility that what ends up ultimately being received is different from what is expected 3. How easily value might be exchanged for something else 4. Whether and how the payments will be spread over a number of future period. The attributes are referred to as: Return risk Liquidity Timing of Cash flow Financial system observes the entity's structuring and restructuring of its portfolio. An efficient financial system allows individuals to more easily vary their inter-temporal pattern of consumption meaning that they don’t have to consume their income in a period which they can receive it. This mean they can instead have smoother consumption over their lifetime. The facility of facilitating of portfolio is structuring and restructuring also allows for the matching of investment and funding need meaning that there entities can make the kind of promise they most easily keep and be efficient for there financial system. This will encourage savings and ensures that savings flow to the (ex ante) most efficient users. Meaning that those projects with the best prospects will receive funding, An efficient financial system will accumulates and disseminates financial and economic information which is rapidly absorbed and resurfaced in assets prices and will allow the allow the central bank tp implement monetary policy. Financial institution include: 1. Deposit-takers 2. Investment banks 3. Contractual savings institution 4. Financial companies 5. Units trust These facilitates the transaction actions that permit the flow of the funds from the surplus and deficit. Some of these institution act as intermediaries and transform assets issued by deficit entities which may have undesirable attributes into assets which are desirable by surplus entities. For example the bank promise the deposit access to their funds on demand The result is the deficit entities entity has made a promise they easily keep while the surplus the surplus entity obtains as an assets. Financial markets which allow for the direct flows of the funds surplus to deficient entity. For example equity market can be obtain as funds to finance an new factory directly from surplus entities by promising to share future profit in the form of dividends. 1.1 Theory and fact about finance 1. Risk and reward 2. Supply and demand 3. No arbitrage 4. The time value of money Supply and demand Supply and demand mean when the a supply of an particular feature goes up the demand will remain the same or it will fall. The price must and vice versa, this is important of supply and demand because it a fundamental determinants of the market price for everything. No Arbitrage This mean when a trader cannot buy an finance instrument in one market with a lower price, No Arbitrage mean help people understand that prices are just statement and must be consistent with each other prices. The time value of money The meaning of this mean that when you put your money in a deposit it will cumulate interest meaning Which there is a risk free investment but the issue is in society that people are not willing to wait due to waiting for there money. When transaction take place a transaction take over therefore it will be processed and will be claimed as future of the cash flow meaning it will be the creation of the finance asset on the balance sheet. The financial asset are the representation on what is borrowed. 1.2 The financial system and financial institution The financial system has a variety of the financial institution. The financial system that interact to the market and facilitate the flow of funds through the financial system. The decision to save up on surplus unit help in income in the future for future of level of income. Surplus entity are use to get there wealth up and improve overall of there wealth. The explanation of a saver there is a high rate of return. But there are other factors that would affect that rate of return such as in the following: Return or Yield Risk Liquidity Time-pattern of cash flows Risk relates to when there an opportunity of there investment going down such as example the tenant payment or the possibility of the property might be burning down. Liquidity mean when there another access of funds in order to meet there day to day expenses. Time pattern mean when there is a when there a expected flow of cash flow from shares and this depends on the profitability and there dividend policy of that cooperation but typically is twice a year by share holders. Risk averse mean these people are only taking low risk instrument meaning they will for financial instrument that a have low rate of return. Financial system are a range of financial instrument and institution that are been overseen by central banks and supervised by prudential authority regulator. Financial instrument Is when a party issue a raised of funds by be acknowledge by the financial committee in order for the holder to have entitlement of a future of an specific of cash flow. Flow of fund Is the movement of funds through the financial system Surplus Unit Is a saver or an fund that are available for lending or investing Rate of return Is what they gained by from investing in saving and is been shown in expressed terms Return or Yield Is what they gain from there investment, this usually by interest and is expressed as a percentage Time pattern of cash flow, this mean the frequency of parodic of cash flow which is related to there financial instrument. Asset Portfolio Is a combined with asset, return, risk, liquidity and timing of cash flow. Portfolio and structuring Is the buying and selling of asset of liability in order to meet the current saving and instruments and there funding needs Monetary policy: Relates to the action of the central bank and this influences the interest rate in order to achieve the economic outcomes; primary inflation. Inflation: Is the increase of good and services due to the consumer price index GDP Financial institution based on differences on the institution resources and uses of funds 1. Depository Financial institution is when people put large amount funds in a term deposit and they give out loan this usually for people in the house hold and business sector 2. Investment Banks these banks are for people who give financial and advise to corporation and high income owner. They help with restructuring and portfolios. 3. Contractual Saving institutions Are institution that provide contract with parodic payment to an specific institution for example to there workforce they work in, they provide a large amount of cash receipt that  receive by there institution and they get claim on there insurance policy or payment to there superannuation fund Example are life insurance and superannuation. 4. Finance Companies and general financers They issue fund of financial instruments such as commercial papers and medium terms notes and bonds in the money market and capital market. The purpose of these funds is to provide lease finance to their customer and there household and business sector. 5. Unit trust are controlled and managed by trustee or responsible entity. The process where there a pool of fund and then it invested by fund managers in asset in a specified trust deed. Trust funds are usually use to be investments such as loans and household sector and business sector. Securitisation: are non liquid asset in order the trustee to make new securities meaning there is new cash flow from the original securities and they are used to repay the new securities. 1.3 Financial instruments Equity: Is the sum of financial interest and investor to have as an asset therefore having ownership position. For example paying for a deposit from your own funds and borrowing the remainer from a bank. Ordinary stock or common stock Ordinary share don't have an maturity date and share on the stock exchange Dividends Is the part of the business/cooperation profit that are been distributed to the shareholders Hybrid security: That has the characteristic of the debt and equity in an security example ordinary shares. Liquidation: The legal process of winding up shares in the affairs of the company of financial distress. 1.3.2 Debt Debt Instrument Is the specific condition and terms of an loan agreement such as return, timing of cash flows, maturity date and the debt must be repaid Secured debt Its an financial instrument that help the provider if the borrower they can have one of the loaner asset in order to cover there default. Negotiable debt instrument A debt instrument that can be sold through the financial market Derivative instrument: Is synthetic security that derives it price from the physical market for security mainly being used to mainly handle any risk exposure. For example a borrower might be concerned that the interest rate on existing debt funding may rise in the futures. The use of derivative instrument is to locked in that rate for there investment, The four basic types of derivative contracts: Future forwards, option and swap: 1.Futures contract: These are for buy and sell and they hold a specific amount of commodity or financial instrument at a price that determines the today for delivery or payment of a futures date. They are standardised in contracts that are traded through the financial. 2.Foward contract: they are more flexible and negotiable over the counter with investment bank or commercial banks. Forward foreign exchange rate when they apply currency rate that will apply to an specific date. 3.An option contract: Is when the buyer given the option to have an designated asset to an specific date or an specific period during the life of the contract at a specific price. 4.A swap contract is when two parties have an agreement to swap for future cash flow; and interest rate swap and currency swap. Currency swap is for is denominate in a foreign currency and fixes the exchange rate at which the initial and final principle amounts are swapped. Ongoing interest payment are also swapped at the same interest rate 1.4.1 Matching principle Matching Principle: Is when the principle have to match with there asset and liabilities such as short term asset must match with short term liabilities and vice versa with long-term asset. Overdraft facility: Is an fluctuating credit facility provided by the bank to allow business to open account with an operating account to go debt up to an agreed limit. Bonds: A long-term debt instrument that been issued by there directly into the capital market and that is payed by there bondholder periodic interest coupons and the principle is repaid at there maturity. Primary Market Transaction: Is when the businesses, governments and individual issue financial instrument in the money market and capital market and this scenario they called the issuer Money: A commodity that the universally use for medium of exchange. Secondary market transaction Is the market of buying existing financial securities; therefore the transfer of the new ownership to new funds raised by there issuer. Securities The asset that are traded in a formal secondary market example stock exchange  Direct financing Funding obtained directly from the money market and capital market Broker: Agent that carries instruction from the client Dealer: Makes a market for there security by quoting both buy and sell prices Credit Rating: Is Assessment by the credit rating agency of there credit therefore accessing them if they are worthy to have financial obligation toward the contract. The Benefit and disadvantages of direct finance: The Main advantages of direct finance: -It removes the cost of financial intermediaries. This mean if the borrower is able to maintain a loan from financial institution the borrower will pay the profit margin to the intermediaries. -it allow borrower to have a diversify funding sources that are accessing both from the domestic and international market money and capital market. There are some disadvantages: -Problem matching the preferences of lenders and the borrower for example lender may have certain amount of funds available for investment but the borrower may not have sufficient for the needs of the borrower. There fore meaning need additional funding from other supplier. -The search of transactional cost associated with the direct finance instrument maybe the concern, because not all financial intermediaries don't have a second market. -Default risk this mean the borrower may not have the commitment of loan repayment when they are due. Intermediate finance Is the process of an financial transaction with financial intermediaries example with bank deposit and bank loan, they provide deficit unit and acquires the ownership of the financial instrument that is created of the transaction and gives benefit such as receipt of interest payments and risk associated with. Benefit of financial intermediation: The benefit of financial intermediation are they are suitable to risk averse lender and they are tend to have a lower rate of return meaning they will not get much return on interest with there payment and they can be able to turn to short-term deposit fund into longer term of funds. Intermediaries can perform a wide range of function that are important to the saver and the borrower these are: Asset transformation Maturity transformation Credit risk diversification and transformation Liquidity transformation Economic of scale Asset Transformation: Asset transformation, gives the ability of financial intermediaries to provide an wide range of product that meet the customer needs and portfolio reference. Maturity transformation: Financial intermediaries provide an transformation of an wide range product that offer an wide range of terms of maturity. For example maturity transformation function of intermediaries. The deposit they receive are generally quite short term in nature less then 5 year. Yet a large bank with maturity of 30 years. Banks have mismatch between the teams to maturity of large proportion of their sources meaning their loan liability. Liability management: Is when the bank are trying to meet there future asset/demand by managing there liability. Credit risk transformation: this mean there is a risk to saver of there credit to the intermediaries because the intermediaries is expose to the credit risk of there ultimate borrower. The advantage of the intermediaries they can accesses the risk of the potential borrower by seeing there credit score. Liquid transformation: Is the measurement of the saver to convert there financial instrument to cash. Economic to scale: This mean the financial and operational benefit of gaining form a large organisational size of expertise and volume of a business. 1.4.4 Wholesale and retail market Wholesale Market: Is the transaction of direct between institutional investors and borrowers. Retail Market: Is the financial transaction of intermediaries mainly from individual and small to medium-sized businesses. Money Market: Wholesales market are which in short-term securities are issued and traded. Institutional Investors: Is the participants of the wholesales market example fund manager and insurance office banks. These are the market participants shown above Central bank: System liquidity and monetary Central Bank use the money market to carry out transaction that will be consistent or change the amount of liquidity that is available within the financial system. The amount of changes of daily liquidity is being influence of the government budget of surpluses or deficit. Interbank Market: are lending and borrowing of the funds of the very short term of fund by the bank operating in the payment system they facilitate the management of the short-term liquidity need of the commercial bank. And the important role of interbank market is lending if surplus exchange of the settlement account funds. Discount securities:  Is an short-term of securities that issue face value of payable of maturity that they do not pay interest and sold in today of a discount to the face value. Bill Market: Is the active of money that is issue to the market and they are the trading of bill exchange. Commercial Paper: Also known are promissory notes meaning they issued into money market by corporation who have good credit rating. Negotiable Certificate of deposit: They are discount security that they are issued by the bank they are important because they are an source of liquidity of funding and they give banks the flexibility of managing of the short-term Maturity structure of their balance sheet. 1.4.6 Capital Market Is a market that they are for longer term funding, this include such as equity, corporate debt and government debt and is supported by the foreign exchange of the derivative markets. Equity Markets: They are for to facilitate the issue of the financial securities that represent of the ownership and there interest in the asset example the stock market. They are able to: Finance the physical infrastructure such as building and equipment Provide creditor confidence in dealing with the firm Corporate debt market: They facilitates the issue of the trading of debt and securities by the corporation such as discount securities and bonds. Medium to longer term debt instrument include such as : Term loans: Provided by the commercial and investment banks Commercial property: provided by a register mortgage over the asset of the borrower Debenture: Are the corporate bonds of where the security is given to the form of a change to the borrower Unsecured notes: a corporate bond with no security included Subordinate debt: where the claim are debt holder and subordinate against there debt lenders Lease arrangement: Are the least of certain period payment in the return of the borrowing of an asset. Securitisation are the sales of an existing of an asset such as mortgage loans to generate new funds. Euromarkets instrument: Financial transaction that are been operated by the foreign country in a currency other than the currency of that country. Government debt: Are the process of borrowing of the short-term liquidity or longer-term budget of capital expenditure (t-notes, treasury bonds) Treasury notes: is the discount security that has the maturity up to six months. Crowding Out: Is when the government that borrows the reduce net amount of fund available for other in the financial system. Foreign Exchange market: Where the market facilitate of buying and the selling of the foreign currencies. Derivative markets: A market that has synthetic risk of the management products such as futures, forwards option and swaps. They help borrowers that help them manage risk associated with capital-market transaction. Principle risk include interest rate and exchange rate risk. 1.5 Flows of fund. Market relationship The function of funds is the financial system is to facilitate the flow of funds between supplier of funds and user of the funds. Deficit units: Is the term of the borrower or the user of the funds. Sectorial flows of the funds: Is the flow of funds that have the surplus and deficit sectors in the economy such as the business, financial government, household and rest of the world sector. The domestic economy are divided into four section which are: Business corporations Financial corporation Government Household sector Fiscal Policy: Is the management of the annual revenues and the expenditure of an government Compulsory Superannuation: Employer must contribute to an minimum specified amounts into an retirement saving for employee In Australia. World Bank: An monetary fund for the world bank as an organisation of 189 member countries tasked with the reducing poverty of developing countries. IMF international Monetary Fund: Is an organisation of 189 countries, that is created in 1945 to foster financial stability such as trade and the economic growth.