Australian Financial Markets Chapter 8 PDF

Chapter 8 Objectives  Define financial markets.  Explain the role of financial markets in a developed economy.  Describe financial intermediaries in a developed financial market.  Discuss movement of funds to finance business activities.  Describe the various component market groups that mak...

Chapter 8 Objectives  Define financial markets.  Explain the role of financial markets in a developed economy.  Describe financial intermediaries in a developed financial market.  Discuss movement of funds to finance business activities.  Describe the various component market groups that make up the overall Australian financial markets.  Outline the main pattern of fund flows underlying the financing of businesses in Australia. 1 What are financial markets?  A complex of institutions, procedures and arrangements that facilitate a transfer of funds from one entity in the economy to another.  A typical transaction in the financial market involves one party, the investor, transferring funds to another party, the net user of funds, and in exchange receiving a financial asset that entitles the investor to receive some cash flows in the future.  ‘Financial markets’ is a general term that describes many sub- markets, for example the debt market, where firms and individuals borrow and lend money, and the share market, or stock market, where firms and individuals buy and sell company shares. 2 Three players in the financial markets Within the financial markets, there are three principal sets of players that interact: Borrowers (individuals and businesses) Savers (mostly individuals) Financial intermediaries (e.g. commercial banks)  an institution that assists the transfer of savings from economic units with excess savings to those with a shortage of savings. That is, it acts as an intermediary between saver and borrower. 3 Role of Financial Markets Net savers of funds Surplus savings Suppliers of funds FINANCIAL INTERMEDIARY Facilitation Net users of funds Shortage of savings Demanders of funds 4 Why would the economy suffer without a developed financial market system? The answer is simple. The wealth of the economy would be less without the financial markets. The rate of capital formation would not be as high if financial markets did not exist. See Example 8.1 in the textbook which clearly illustrates this point. Types of assets Real assets Tangible assets such as houses, equipment, inventory. Financial assets Represent claims for future payments (e.g. shares, debentures, bills, notes) Owners anticipate earning a future rate of return 5 Development of a financial market system: Figure 8.1 Stage 1 Real assets = net worth Stage 2 Cash + Real assets = net worth Cash + Real assets + other financial assets Stage 3 = financial liabilities + net worth Stage 4 The addition of loan brokers, security underwriters, and secondary markets Stage 5 The addition of financial intermediaries 6 Financial Intermediaries  Financial intermediaries share a common characteristic: they offer their own financial claims, called indirect securities, to economic units with excess savings. When financial intermediaries sell financial claims, they are effectively borrowing money, as they receive money from investors in exchange for a promise to pay them back in the future with some interest payments.  The proceeds from selling their indirect securities are then used to purchase the financial claims of—or invest in—other economic units. These latter claims can be called direct securities.  Thus, a bank might sell fixed term deposits (their indirect security) and purchase the debentures (direct securities) of some major companies.  Indirect securities are characterised by small denominations, large volumes and short maturity, whereas direct securities are in larger denominations and smaller volumes and are of longer maturity. 7 Financial intermediaries  Financial intermediaries facilitate the movement of money from savers to borrowers:  commercial banks  non-bank authorised deposit-taking institutions  investment banks  insurance companies  superannuation funds  investment companies  private equity firms 8 Commercial Banks  Commercial banks Commercial banks are authorised by the Australian Prudential Regulation Authority (APRA) to take deposits from the public.  They collect the savings of individuals as well as businesses and then lend those pooled savings to other individuals and businesses. They earn money by charging a rate of interest to borrowers that exceeds the rate they pay to savers.  Examples: The Big 4 - ANZ, CBA, NAB and WESTPAC. 9 Non-bank Authorised Deposit-Taking Institutions  Building societies and credit unions are mutual organisations owned by their members, taking deposits and providing mortgage loans and personal loans.  They are collectively referred to as Approved Deposit-Taking Institutions (ADIs). They are authorised by APRA to accept retail deposits..  These institutions are unlisted not-for-profit organisations and profits generated are used to improve the services provided to their members in the form of lower fees, cheaper loans and/or higher interest rates on members’ savings.  Since the deregulation of the financial system in Australia in 1983, the building societies sector has contracted significantly due to their inability to compete with commercial banks. Credit unions, on the other hand, appear to have a stronger presence in the Australian financial landscape.  Examples; Building societies(e.g. Newcastle Permanent Building Society) and Credit unions (e.g. Police Credit Union and Defence Force Credit Union) 10  Investment Banks  Investment banks are specialised financial intermediaries that help companies and government raise money and provide advisory services to client firms.  Their major source of revenue is fees for the financial services rendered. The main advisory services that investment banks provide include advice on equity and debt, mergers and acquisitions, and corporate restructurings.  Examples: Bank of America Merrill Lynch Australia and Macquarie Group. 11 Insurance Companies  Insurance companies sell insurance to individuals and businesses to protect their investments.  They collect premiums and hold the premiums in reserve until there is an insured loss, then pay out claims to the holders of the insurance contracts. These reserves are deployed in various types of investments including loans to individuals and businesses, company shares and various governmental securities.  Examples: GIO and AAMI 12  Superannuation Funds  Superannuation is designed to provide funds for retirement through government taxation incentives and compulsory contributions by employers on behalf of their employees.By law, most Australian employers have an obligation to contribute at least 9% of their employees’ incomes to their superannuation funds. This compulsory contribution is referred to as the superannuation guarantee (SG).  Employees can also choose to make additional contributions to their superannuation funds. Investments in superannuation are long term as individuals do not have access to the money until they reach a certain age, known as the preservation age. https://www.ato.gov.au/Super/Self-managed-super-funds/Paying-benefits/Preservation- of-super/  Due to the regular contributions, superannuation funds have a large amount of money invested in the bond and share markets, both domestically and internationally.  An exception exists for individuals who have a defined benefit fund, the payout of which is determined by a fixed formula and does not depend on market performance.  Examples: AMP and UniSuper 13 Investment Companies  Investment companies are financial institutions that pool the savings of individuals and invest the money, purely for investment purposes, in the securities issued by other companies.  Perhaps the most widely known type of investment company is a managed fund, a special type of intermediary through which individuals can invest in virtually all of the securities offered in the financial markets such as cash, debt securities, domestic and international shares, and property.  When individuals invest in a managed fund, they receive shares (or ‘units’) in a fund that is professionally managed according to a stated investment objective or goal—for example, investing only in international stocks. Shares in the managed fund grant ownership claim to a proportion of the managed fund’s portfolio.  Example : BT and Colonial 14 Investment Companies: Managed Funds  Managed funds can either be listed or unlisted.  Investments in unlisted managed funds are made by buying ‘units’ in the fund at their net asset value (NAV).  Unlisted managed funds can be ‘open’ or ‘closed’. Additional units in an open fund can be created and issued based on demand, whereas the number of units in a closed fund is fixed. 15  Investment Companies: Managed Funds  Managed funds that are listed on the stock exchange are referred to as exchange-traded products (ETPs) and are generally closed funds. A significant component of these ETPS are referred to as exchange-traded funds (ETFs).  Most ETFs tracks an index, such as the S&P/ASX 200.  Managed funds and ETFs provide a cost-effective way to diversify and reduce risk. For example, by buying a mutual fund or ETF that invests in S&P/ASX 200, you are indirectly purchased a portfolio that tracks 200 shares with just one transaction. 16 Investment Companies: Hedge Funds  Hedge funds are similar to managed funds but are less regulated and take more risk.  They also tend to more actively influence the managers of the corporations that they invest in. Because of the higher risk, hedge funds are open to a limited range of wealthy investors or institutions.  Management fees are typically higher than other managed funds with most funds including an incentive fee (typically 20% of profits) based on the fund’s overall performance. 17  Private Equity Firms  Private equity firms are financial intermediaries that invest in equities which are not traded on the public capital markets (private companies).  Two types of private equity firms dominate this group: Venture Capital (VC) firms and Business Angels (see chapter 3 for more details).  For example, in Australia, the initial financing of Seek and Cochlear grew out of venture capital funding. 18  Movement of funds  In a developed financial market system funds are transferred to businesses in need of cash in three ways:  direct transfer of funds,  indirect transfer using commercial banks, and  indirect transfer using other financial intermediaries. 19 Direct Transfer of Funds In a direct transfer of funds, firms seeking cash sell their securities, for example shares or bonds, directly to investors who are willing to purchase them in the hope of earning a reasonable rate of return. 20 Indirect transfer of funds 21 Components of Australian Financial Markets Generally speaking, financial markets can be grouped along three main dimensions:  By the type of financial asset being traded. This includes the stock market, the debt market, the foreign-exchange market and the derivative market.  By the maturity of the financial asset.  Capital market which encompasses transactions in long-term financial assets.  Money market captures transactions in short-term financial assets.  By the way in which financial assets are created.  Initial Public Offerings and Private Placements  Primary and Secondary markets. 22 The Stock Market  A stock market is a public market in which company shares are traded. Traditionally, the stock markets are classified as either organised security exchanges or the over-the-counter markets.  Organised security exchanges are organisations that provide for the buying and selling of securities, and allow all participants to buy or sell at publicly advertised prices. Trading can be either floor trading or electronic trading system.  The over-the-counter markets A network of dealers who trade securities directly between the two parties to the transaction without the intervention of an exchange.  There are two major types of equity securities traded in the stock market: ordinary shares, which is more widely traded, and preference shares (hybrid security). 23 The Bond Market  Firms borrow money by selling debt securities in the debt market. If the debt must be repaid in less than a year, these securities are typically called notes.  If the debt has a maturity of longer than one year, then the debt security is called a bond. The vast majority of these bonds pay a fixed interest rate, which means that the interest the owner of the bond receives never changes over its lifetime. 24 Foreign-exchange Markets  The foreign exchange market provides a mechanism for the transfer of purchasing power from one currency to another by facilitating the exchange of currencies.  This market is not a physical entity but is an international network of licensed foreign-exchange dealers and customers who transact with each other via electronic connections.  Retail and wholesale segments of the FOREX or FX market.  Very efficient markets.  Major types of transactions:  Spot transactions: the current or going price (spot price) of the currencies. In practice, settlement of the transaction occurs two working days after the transaction is agreed.  Forward transactions: settlement of the transaction occurs in more than two working days in the future. 25 Derivatives Markets  Derivatives are financial instruments that are derived from, or based on, the value of an underlying asset. They are often used to manage risk  Examples of derivatives: Futures, options, & swaps  Derivatives may be traded through an organised exchange or over-the-counter (OTC) 26 Derivatives Markets (cont) Futures markets  Futures markets are where futures contracts are traded.  A futures contract is a legally binding agreement to buy or sell the underlying financial instrument or commodity at a:  specific quantity  specific quality  deliverable at an agreed location  deliverable at an agreed future time  at an agreed price  Upon maturity, these contracts end up as a cash settlement. 27 Derivatives Markets (cont’d) Options markets ▪ An options contract is an agreement that gives the holder the right (but not the obligation) to buy or sell the specified commodity or financial instrument on or before a specified date  Call option: the right to buy an asset  Put option: the right to sell an asset  There is a large variety of options-type products 28 Money and Capital Markets  Money markets  Markets in short-term financial instruments.  By convention: terms less than one year.  Treasury notes, certificates of deposit, commercial bills and promissory notes.  Capital markets  Markets in L0ng-term debt and equity securities.  By convention: terms greater than one year  Loan notes, debentures, shares, leases and convertible securities. 29 Public offerings and Private Placements  When a company decides to raise external capital, the funds can be obtained by making a public offering or a private placement of the company’s securities.  Public offerings  New securities offered to the public.  Securities issued through a stockbroking firm or a syndicate of firms.  The company selling its securities does not meet the ultimate purchasers of the securities in the public offering. The public market is an impersonal market.  Examples: shares, bonds  Private placements  New securities only offered to a limited number of investors.  Usually offered to majority owner.  The private placement market is a more personal market than its public counterpart.  Examples: shares, bonds 30 Primary and Secondary Markets  Primary markets  Selling of new securities.  New funds are raised by businesses.  This type of transaction increases the total number of financial assets in the economy.  Secondary markets  Reselling of existing securities.  Adds marketability and liquidity to primary markets.  Essential for the primary markets to exist.  The sale of these securities does not affect the total number of financial assets that exist in the economy.  Both the money market and the capital market, described previously, have primary-market and secondary-market aspects. 31 The Australian Securities Exchange  In July 2006, the ASX and SFE merged Australian Australian Sydney Stock Securities Futures Exchange Exchange Exchange 32 The Australian Securities Exchange (cont’d)  Major primary and secondary equity market.  Secondary market for debentures, notes and governmental bonds.  Publicly listed company.  ASX listing rules.  Aim: To provide an efficient, honest, competitive and informed market for trading. 33 Share price quotes 34 Pattern of fund flows in Australia’s financial markets 35