FINS1612 Study Notes - StudentVIP · FINS1612 Study Notes | Daniel Quinn age 9 Providers of funds...

FINS1612 STUDY NOTES

DANIEL QUINN

FINS1612 Study Notes | Daniel Quinn

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Table of Contents

TABLE OF CONTENTS ..........................................................................................................................1

CHAPTER 01: FINANCIAL SYSTEM INTRODUCTION ...............................................................................8

FUNCTIONS OF A FINANCIAL SYSTEM ................................................................................................................. 8

CATEGORIES THE MAIN TYPES OF FINANCIAL INSTITUTIONS .................................................................................... 9

MAIN CLASSES OF FINANCIAL INSTRUMENTS .................................................................................................... 10

FLOW OF FUNDS .......................................................................................................................................... 11

Benefits ................................................................................................................................................ 12

Disadvantages ..................................................................................................................................... 12

Benefits ................................................................................................................................................ 13

TYPES OF FINANCIAL MARKETS BASED ON FUNCTION ......................................................................................... 14

Central bank ......................................................................................................................................... 15

Inter-bank market ................................................................................................................................ 15

Bills Market .......................................................................................................................................... 15

Commercial Paper Market ................................................................................................................... 15

Negotiable Certificates of Deposit ....................................................................................................... 15

Equity market ....................................................................................................................................... 16

Corporate debt market ........................................................................................................................ 16

Government debt market .................................................................................................................... 16

FUNCTIONS AND ACTIVITIES ........................................................................................................................... 17

SOURCES OF FUNDS ..................................................................................................................................... 17

Bonds ................................................................................................................................................... 18

Foreign Currency Liabilities .................................................................................................................. 19

Loan Capital and Shareholders’ Equity ................................................................................................ 19

USES OF FUNDS ........................................................................................................................................... 19

NATURE AND IMPORTANCE OF OFF-BALANCE-SHEET BUSINESS ........................................................................... 21

REGULATION AND PRUDENTIAL SUPERVISION OF BANKS ..................................................................................... 22

BACKGROUND TO CAPITAL ADEQUACY STANDARDS ........................................................................................... 23

Functions of Capital: ............................................................................................................................ 23

Tier 1 Capital (core capital) - EQUITY ................................................................................................... 23

Tier 2 Capital - LIABILITY ...................................................................................................................... 23

Main Elements ..................................................................................................................................... 24

Capital Adequacy Standard ................................................................................................................. 24

BASEL II STRUCTURAL FRAMEWORK ................................................................................................................ 24


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Credit Risk ............................................................................................................................................ 25

Operational Risk ................................................................................................................................... 26

Market Risk .......................................................................................................................................... 27

LIQUIDITY MANAGEMENT AND OTHER SUPERVISORY CONTROLS ......................................................................... 28

CHAPTER 04: THE SHARE MARKET AND THE CORPORATION .............................................................. 29

NATURE OF A CORPORATION ......................................................................................................................... 29

THE STOCK EXCHANGE .................................................................................................................................. 30

Primary Market Role ............................................................................................................................ 31

Secondary Market Role ........................................................................................................................ 31

Exchange Traded Funds (ETF) .............................................................................................................. 32

Contracts for Difference ....................................................................................................................... 32

Real Estate Investment Trusts (REIT) ................................................................................................... 33

Infrastructure funds ............................................................................................................................. 33

Options ................................................................................................................................................. 33

Warrants .............................................................................................................................................. 33

Futures Contracts ................................................................................................................................. 34

Trading and Settlement Role ............................................................................................................... 34

Information Role .................................................................................................................................. 34

Regulatory Role .................................................................................................................................... 35

THE PRIVATE EQUITY MARKET ....................................................................................................................... 35

CHAPTER 05: CORPORATIONS ISSUING EQUITY IN THE SHARE MARKET ............................................. 37

INVESTMENT DECISIONS ................................................................................................................................ 37

NPV ...................................................................................................................................................... 37

IRR ........................................................................................................................................................ 37

FINANCING DECISIONS .................................................................................................................................. 38

Business Risk ........................................................................................................................................ 38

Financial Risk ....................................................................................................................................... 38

Debt to Equity Ratio ............................................................................................................................. 39

The Appropriate D/E Ratio................................................................................................................................................. 39

INITIAL PUBLIC OFFERING .............................................................................................................................. 39

Ordinary Shares: Limited Liability Companies ..................................................................................... 40

Ordinary Shares: No Liability Company ............................................................................................... 40

LISTING A BUSINESS ON A STOCK EXCHANGE .................................................................................................... 40

EQUITY-FUNDING ALTERNATIVES FOR LISTED COMPANIES .................................................................................. 41

Rights Issue or Share Purchase Plan .................................................................................................... 41

Placements ........................................................................................................................................... 41

Takeover Issues .................................................................................................................................... 42


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Dividend Reinvestment Schemes ......................................................................................................... 42

Preference Shares ................................................................................................................................ 42

Convertible Notes and Other Quasi-Equity .......................................................................................... 43

Convertible Notes .............................................................................................................................................................. 43

Company-issued Options ................................................................................................................................................... 44

Company-issued Equity Warrants ..................................................................................................................................... 44

CHAPTER 06: INVESTORS IN THE MARKET ......................................................................................... 45

PRICING OF SHARES ...................................................................................................................................... 45

Price Estimation ................................................................................................................................... 45

Cum-dividend and Ex-dividend ............................................................................................................ 46

Bonus Share Issues ............................................................................................................................... 46

Share Splits........................................................................................................................................... 46

Pro-rata Rights Issue ............................................................................................................................ 47

SHARE-MARKET INVESTMENT ......................................................................................................................... 47

Unsystematic Risks .............................................................................................................................. 48

Systematic Risks ................................................................................................................................... 48

Active Investment ................................................................................................................................ 48

Passive Investment .............................................................................................................................. 49

BUYING AND SELLING OF SHARES .................................................................................................................... 49

Direct Investment ................................................................................................................................. 49

Indirect Investment .............................................................................................................................. 49

TAXATION ................................................................................................................................................... 49

FINANCIAL PERFORMANCE INDICATORS ........................................................................................................... 50

Capital Structure .................................................................................................................................. 51

Liquidity ............................................................................................................................................... 51

Debt Servicing (Solvency) ..................................................................................................................... 52

Profitability .......................................................................................................................................... 52

Share Price ........................................................................................................................................... 52

STOCK MARKET INDICES AND PUBLISHED SHARE INFORMATION .......................................................................... 53

Performance Benchmark Index ............................................................................................................ 53

Tradeable Benchmark Index ................................................................................................................ 53

Market Indicator Index ........................................................................................................................ 53

CHAPTER 09: SHORT-TERM DEBT ...................................................................................................... 54

TRADE CREDIT ............................................................................................................................................. 54

BANK OVERDRAFTS ...................................................................................................................................... 55

COMMERCIAL BILLS ...................................................................................................................................... 55

Parties Involved (for bank accepted bills) ............................................................................................ 55


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Establishing Bill Financing Facility ....................................................................................................... 56

CALCULATIONS: DISCOUNT SECURITIES ............................................................................................................ 57

Calculating PRICE (yield known) or Calculating FACE VALUE (issue price & yield known) .................. 57

Calculating Yield .................................................................................................................................. 58

Discount Rate ....................................................................................................................................... 59

PROMISSORY NOTES ..................................................................................................................................... 60

Issue Programs ..................................................................................................................................... 60

Underwritten Issues ............................................................................................................................. 61

Non-underwritten Issues ...................................................................................................................... 61

NEGOTIABLE CERTIFICATES OF DEPOSIT (CD) ................................................................................................... 61

INVENTORY FINANCE, ACCOUNTS RECEIVABLE FINANCING AND FACTORING........................................................... 62

Inventory Finance................................................................................................................................. 62

Accounts Receivable Finance ............................................................................................................... 62

Factoring ............................................................................................................................................................................ 62

CHAPTER 10: MEDIUM- TO LONG-TERM DEBT................................................................................... 63

TERM LOANS OR FULLY DRAWN ADVANCES [INTERMEDIATED FINANCE] ............................................................... 63

Structure Types .................................................................................................................................... 63

Loan Covenants .................................................................................................................................... 64

Calculating Loan Installment – Ordinary Annuity ................................................................................ 65

Annuity Due ......................................................................................................................................... 65

MORTGAGE FINANCE [INTERMEDIATED FINANCE] ............................................................................................. 65

Securitisation and Mortgage Finance .................................................................................................. 66

BOND MARKET: DEBENTURES, UNSECURED NOTES AND SUBORDINATED DEBT [DIRECT FINANCE] ............................ 66

Debentures and Unsecured Notes ....................................................................................................... 67

Issuing Debentures and Notes ........................................................................................................................................... 68

Subordinated Debt ............................................................................................................................... 68

CALCULATIONS: FIXED-INTEREST SECURITIES .................................................................................................... 68

Price of a Fixed Interest bond at Coupon Date .................................................................................... 68

Price of Fixed Interest Bond between Coupon Dates ........................................................................... 69

LEASING ..................................................................................................................................................... 70

Types of Leases .................................................................................................................................... 70

Operating Lease ................................................................................................................................................................. 70

Finance Lease .................................................................................................................................................................... 70

Sale and Lease-back ........................................................................................................................................................... 71

Cross-border Lease ............................................................................................................................................................ 71

Lease Structures ................................................................................................................................... 71

Direct Finance Lease .......................................................................................................................................................... 71

Leveraged Finance Lease ................................................................................................................................................... 71

CHAPTER 15: THE STRUCTURE AND OPERATION OF THE FX MARKET ................................................ 72


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FX MARKET PARTICIPANTS ............................................................................................................................ 72

FX Dealers ............................................................................................................................................ 72

FX Brokers ............................................................................................................................................ 72

Central Banks ....................................................................................................................................... 73

Firms Conducting International Trade Transactions............................................................................ 73

Investors and Borrowers in the International Money & Capital Markets ............................................ 73

Speculative Transactions ..................................................................................................................... 73

Arbitrage Transactions ........................................................................................................................ 74

OPERATION OF THE FX MARKET ..................................................................................................................... 74

SPOT AND FORWARD TRANSACTIONS .............................................................................................................. 74

SPOT MARKET QUOTATIONS .......................................................................................................................... 75

Asking for a Quotation ......................................................................................................................... 75

Two-way Quotations............................................................................................................................ 75

Transposing Spot Quotations .............................................................................................................. 76

Calculating Cross Rates ........................................................................................................................ 76

FORWARD MARKET QUOTATIONS .................................................................................................................. 76

Real World Complications .................................................................................................................... 78

EUROPEAN MONETARY UNION AND FX MARKETS .............................................................................................. 79

CHAPTER 16: FACTORS THAT INFLUENCE THE EXCHANGE RATE ......................................................... 80

FX MARKETS AND AN EQUILIBRIUM EXCHANGE RATE ........................................................................................ 80

FACTORS THAT INFLUENCE EXCHANGE RATE MOVEMENTS ................................................................................... 81

Relative Inflation Rates ........................................................................................................................ 81

Relative National Income Growth Rates .............................................................................................. 81

Relative Interest Rates ......................................................................................................................... 82

Expectations of Future Interest Rates ............................................................................................................................... 82

Reason for Change in Nominal Interest Rate ..................................................................................................................... 82

Exchange Rate Expectations ................................................................................................................ 83

Government or Central Bank Intervention ........................................................................................... 83

International Trade Flows .................................................................................................................................................. 83

Foreign Investment Flows .................................................................................................................................................. 84

Direct Market Intervention ................................................................................................................................................ 84

MEASURING EXCHANGE RATE SENSITIVITY TO CHANGES IN ECONOMIC VARIABLES ................................................. 84

CHAPTER 13: INTRODUCTION TO INTEREST RATE DETERMINATION AND FORECASTING ..................... 85

Economic Indicators ............................................................................................................................. 86

LOANABLE FUNDS APPROACH (LF) TO INTEREST RATE DETERMINATION ............................................................... 87

Demand for Loanable funds................................................................................................................. 87

Supply of Loanable Funds .................................................................................................................... 87

EQUILIBRIUM IN THE LOANABLE FUNDS MARKET ............................................................................................... 88


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Expected Increase in Economic Activity ............................................................................................... 89

Inflationary Expectations ..................................................................................................................... 89

The Fisher Effect ................................................................................................................................................................ 89

A Non-Fisher Outcome ...................................................................................................................................................... 90

TERM STRUCTURE OF INTEREST RATES ............................................................................................................. 90

The Expectations Theory ...................................................................................................................... 90

Assumptions ...................................................................................................................................................................... 91

Segmented Markets Theory ................................................................................................................. 91

Expectations Approach VS Segmented Markets Approach ................................................................. 92

Liquidity Premiums Theory .................................................................................................................. 92

RISK STRUCTURE OF INTEREST RATES............................................................................................................... 94

CHAPTER 19: FUTURES CONTRACTS AND FORWARD RATE AGREEMENTS .......................................... 95

HEDGING USING FUTURES CONTRACTS............................................................................................................ 95

MAIN FEATURES OF A FUTURES TRANSACTION.................................................................................................. 95

Orders and Agreement to Trade .......................................................................................................... 96

Margin Requirements .......................................................................................................................... 96

Closing out of a Contract ..................................................................................................................... 96

Contract Delivery ................................................................................................................................. 96

FUTURES MARKET INSTRUMENTS ................................................................................................................... 97

FUTURES MARKET PARTICIPANTS.................................................................................................................... 97

Hedgers ................................................................................................................................................ 97

Speculators .......................................................................................................................................... 98

Traders ................................................................................................................................................. 98

Arbitragers ........................................................................................................................................... 98

HEDGING: RISK MANAGEMENT USING FUTURES ............................................................................................... 98

Borrowing Hedge ................................................................................................................................. 99

Investment Hedge on Yield ................................................................................................................ 100

Share Portfolio Hedge ........................................................................................................................ 100

Hedging a Foreign Currency Transaction ........................................................................................... 101

RISKS IN USING FUTURES MARKETS FOR HEDGING .......................................................................................... 101

Standard Contract Size....................................................................................................................... 101

Margin Payments ............................................................................................................................... 102

Basis Risk ............................................................................................................................................ 102

Cross-Commodity Hedging ................................................................................................................ 102

FORWARD RATE AGREEMENTS (FRA) ........................................................................................................... 102

Advantages of FRAs ........................................................................................................................... 104

Disadvantages of FRAs ...................................................................................................................... 104

CHAPTER 20: OPTIONS ................................................................................................................... 105


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NATURE OF OPTIONS .................................................................................................................................. 105

OPTION PROFIT AND LOSS PAYOFF PROFILES .................................................................................................. 105

Call Option Profit and Loss Payoff Profiles......................................................................................... 105

Put Option Profit and Loss Payoff Profiles ......................................................................................... 106

Covered and Naked Options .............................................................................................................. 106

ORGANISATION OF THE MARKET .................................................................................................................. 107

International Options Market ............................................................................................................ 107

Australian Options Markets ............................................................................................................... 107

Options on Futures Contracts .......................................................................................................................................... 107

Share Options .................................................................................................................................................................. 108

Low-Exercise Price Options (LEPOs)................................................................................................................................. 108

Warrants .......................................................................................................................................................................... 108

Over-the-counter Markets............................................................................................................................................... 109

FACTORS AFFECTING AN OPTION CONTRACT PREMIUM .................................................................................... 109

Intrinsic Value .................................................................................................................................... 109

Time Value ......................................................................................................................................... 110

Price Volatility .................................................................................................................................... 110

Interest Rates ..................................................................................................................................... 110

Call Option ....................................................................................................................................................................... 110

Put Option ....................................................................................................................................................................... 110

OPTIONS RISK MANAGEMENT STRATEGIES ..................................................................................................... 111

Single Option Strategies..................................................................................................................... 111

Long Asset and Bearish about Future Asset Price ............................................................................................................ 111

Short Asset and Bullish about the Future Asset Price ...................................................................................................... 112

Combined Options Strategies ............................................................................................................ 112

Expectation of Increased Price Volatility with No Trend ................................................................................................. 112

Expectation of Increased Price Volatility without Trend, but with Stagnation ................................................................ 113

Expectation of Asset Price Stability ................................................................................................................................. 113


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Chapter 01: Financial

System Introduction Finance is the science of funds management, or the allocation of assets and liabilities over time

under conditions of certainty and uncertainty

Money:

o Acts as a medium of exchange

o Represents a store of wealth

o Facilitates saving

o Solves the divisibility problem

Sectorial Flow of Funds The domestic economy can be divided into:

o Business corporations

o Financial corporations

o Government

o Household sector

o Add: rest of the world a source of surplus funds flowing into a nation-state plus an

outward investment destination for surplus funds within an economy

Business sector will on average be deficit sector

o Most businesses need to borrow to fund business activities

Financial sector tends to be deficit also, as they fund the growth in balance sheets by borrowing

in capital markets

Government fluctuates between deficit and surplus depending on budget policy objectives

Household sector typically a surplus sector. In particular, accumulated savings of an ageing

population should ensure this sector remains in surplus

Rest of the world is likened to a balancing item

Functions of a Financial System

A financial system comprises a range of financial institutions, instruments and markets which

interact to facilitate the flow of funds through the financial system

o Overseeing the financial system is the central bank and the prudential supervisor

Surplus entities invest their savings through the purchase of financial instruments which are

expected to improve their overall wealth


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Providers of funds need to consider their own needs when choosing a combination of four

attributes in an asset:

o Return or yield: total financial benefit gained (interest + capital gain) from an

investment

o Risk: uncertainty and probabilities in outcomes

o Liquidity: Ease with which an asset can be turned to cash for expenditure

o Time-pattern of cash flows: frequency of periodic cash flows associated

Function 1: To facilitate portfolio structuring through buying and selling of a wide range of

financial instruments provide potential suppliers of funds with their desired combination of

risk, return, liquidity and time patter of cash flows

Function 2: Provide information to market participants accurately and punctually affects

price and investment decisions efficient financial system

Function 3: Increase flow of savings savings used for capital investment improve

productive capacity of economy economic growth

Function 4: Ensure savings are directed to most efficient users of those funds savers should

be expected to invest funds with users that are likely to meet their expectations (preferred

combination of the four attributes of an asset)

Function 5: Implement monetary policy influence level of interest rates in financial system to

maintain level of inflation within a specific level achieve range of economic objectives such as

increase employment rates and exchange rate stability

Categories the main types of financial institutions

Depository financial intuitions: accept deposits and provide loans to customers (banks, credit

unions)

Investment bank and merchant banks: assists individuals, corporations, and governments in

raising capital by underwriting and/or acting as the client's agent in the issuance of securities,

provide advice on mergers, acquisitions, portfolio restructuring and financial risk management

o Mostly off balance sheet business

Contractual savings institutions: in return for periodic payments made to them, the institution

will make specified payout to holder of contract if an event specified occurs (life insurance,

superannuation funds, general insurers etc)

o Periodic payments large fund pool for them to invest

Finance companies and general financiers: raise funds by issuing financial instruments such as

commercial paper, medium-term notes and bonds to provide loans and lease finance to

customers

Unit trusts: public purchase units in a trust funds pooled and invested by fund managers in

asset classes specified in trust deed (equity trusts, property trusts etc)

http://en.wikipedia.org/wiki/Underwriting

http://en.wikipedia.org/wiki/Securities


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Main Classes of Financial Instruments

Equity Sum of the financial interest an investor has in an asset – an ownership position

Ordinary shares have no maturity date continue until corporation ceases to exist

o Can be sold to other investors

o Increase in value of share capital gain

o Entitled to residual value of assets of corporation in chance of failure but only after all

other creditors and security holders

o Owners of ordinary shares have right to vote at general meetings in particular for

election of members of the board of directors

Hybrid security has characteristics of both debt and equity (e.g. preference shares)

o Specified dividend for a defined period

o Rank ahead of ordinary shareholders in their claim of residual assets in case of

liquidation

Debt Specific conditions of a loan agreement and debt must be repaid with specific payments such as

periodic interest payments and principal repayments over a defined period (e.g. debentures,

unsecured notes, term loans, commercial bills, promissory notes, overdrafts, mortgage loans)

Secured debt specifies assets of the borrower pledged as collateral

Negotiable debt instruments can be sold from one owner to another (e.g. commercial bills

while term loans from banks are non-negotiable)

Derivatives Manage an exposure to an identified risk (e.g. locking in interest rates)

Futures contract: a contract to buy or sell a specific commodity or financial instrument at a

specific price at a predetermined future date

o Standardised contracts traded through a futures exchange

Forward contract: more flexible than futures and is negotiated over the counter with a

commercial bank or investment bank

Option contract: gives the buyer of the option the right, but not obligation, to buy or sell the

designated asset at a specific date or within a specified period during the life of the contract at a

predetermined price

o Buyer must pay a premium for the lack of obligation

Swap contract: an agreement between two parties to exchange sequences of cash flows for a

set period of time


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Flow of Funds

Matching Principle Short term assets such as working capital and inventories should be funded with short-term

liabilities such as overdraft

Longer term assets should be funded with equity and long-term liabilities

o e.g. a factory expected to generate income for next 10 years, should be funded with

bonds or equity

Primary Market Transaction When businesses, governments and individuals issue financial instruments into money markets

and capital markets to create new financial instrument

o e.g. borrowing from bank to buy new house, issuing long term bonds to finance capital

works or education spending

Allows corporations and governments to raise new funding increased capital and productive

investment economic growth and benefits such as increased employment

Secondary Market Transaction Buying and selling of existing financial securities transfer of ownerships and no new funds

raised by issuer

Savers with preferences of high liquidity and low risk aversion would never invest in long term

instruments if there were no secondary markets as they would need to hold long term

instruments until they mature (equity has no maturity date) and hold them regardless of risk

levels

Encourage saving and investment because enhance marketability and liquidity of primary issue

instruments thus making them more attractive

A security is a financial asset that can be traded in an organized secondary market (ordinary

shares)

Financial instrument cannot be traded at a secondary market (e.g. term deposit)

Direct Finance The contractual agreement is between the provider of funds and the user of funds

The funds are not provided by a financial institution


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Brokers and dealers carries out instructions of providers and users of funds

They arrange the transaction but have no right to the benefits that flow from the purchase of

the security

Not necessary for a broker to be involved at all

Benefits

Removes cost of financial intermediary, who collects a profit margin from borrower

Allows borrower to diversify funding sources by accessing both domestic and international

money and capital markets

o Reduces risk specific to a single source of funding

Greater flexibility in types of funding instruments used to meet financing needs

Enhance international profile by carrying out transactions in international financial markets

which may establish a reputation in markets for the firm’s goods and services

Disadvantages

Problem of matching preferences lenders and borrowers

o Mismatch in how much money is available/required, maturity structures

Liquidity and marketability of a direct finance instrument

o Not all direct financial instruments have a secondary market through which they are

sold

High search and transaction costs

o Advisory fees, preparing prospectus, legal fees, tax advice, accounting advice, specific

expert advice (e.g. geologist)

Difficult to assess level of risk such as default risk

Intermediated Finance Intermediary obtains funding from surplus units issues financial instrument to savers (e.g.

term deposit)

Intermediary provides loan for deficit units acquires ownership of separate financial

instrument obtains rights to benefits (interest payments and repayment of principal) and

risks (credit or default risk) with ownership


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o Saver has no claim on income or assets of ultimate borrower

o If the borrowers fails to repay loan, the bank must still repay money to depositor

Benefits

Asset transformation:

o Ability to provide a range of products that meet customer’s portfolio preferences

o They can profitably receive small amounts from many savers, pool them into larger

amounts and make them available as loans to borrowers

o Without intermediaries, savers may earn too little from saving and too costly to borrow

for deficit units

o Intermediaries provide a large range of deposit products (demand deposit accounts,

current accounts, cash management trusts) and loan products (overdraft, term loans,

mortgage loans, credit card)

Maturity transformation: offer products with range of terms to maturity

o Savers generally want high liquidity and borrowers want longer-term commitment in

funds they borrow

o Financial intermediaries can allow short term deposits yet provide long-term loans

because:

Deposit withdraws are generally matched by new deposits

Efficient liability management. If liabilities begin to begin to decline below

necessary funding for assets, then bank may:

Adjust interest rates to attract new deposits

Issue further securities (liabilities) to raise additional funds

Credit risk transformation: limiting the saver’s credit risk exposure to the intermediary. Only the

intermediary is exposed to credit risk of ultimate borrower

o Intermediaries specialize in making loans develop expertise in assessing risk of

potential borrowers through technical skills, system monitoring and required

information prior to dealings

Liquidity transformation: ability to convert financial assets into cash into cash at a value close to

market price of the financial instrument

o Savers generally want to maximize liquidity in their investments, as there are times

when expenditure exceeds income and vice versa. This volatility is overcome by keeping

some assets in very liquid form


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o Conversion to cash requires transaction costs which can be high

o However, a financial intermediary can lower transaction fees by spreading fixed costs

across a large number of transactions

o Banks often offer highly liquid accounts which ultimate users of funds would be highly

unlikely to agree to

o Further liquidity ATMs and EFTPOS systems

Economies of scale: financial and operational benefits from sheer size and volume of business

transacted resources to develop cost-efficient distribution systems, extensive branch

networks technology-based distribution systems (ATMs)

o Also have cost advantage through effective knowledge management and the

accumulation of financial, economic and legal expertise use standardized

documentation which already comply with legal requirements

o Reduction in search costs for savers and borrwoers as they do not need to investigate

creditworthiness of the ultimate borrower

o These savings due to efficiency are usually passed on in forms of reduced interest

margins and fees

Types of Financial Markets based on Function

Wholesale Markets o Direct financial transactions between merchant banks and other financial institutions such as

insurance offices, investment banks, fund managers, credit unions, government authorities and

large corporations

o Wholesale investors are able to accumulate large quantities of surplus funds with their strong

credit rating use market power and investment skills to obtain higher returns than retail

market

Retail Markets Typical mass-market banking in which individual customers use local branches of larger

commercial banks or similar financial intermediaries

Participants are price takers and have no market power in changing rate of interest

Money Markets Wholesale markets in which short-term securities (less than 12 months to maturity) are issued

and traded

Attractive for short-term financing arrangements for institutional investors:

o Highly liquid

o Standardized

o Well-developed secondary markets


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E.g. A retail store has surplus funds but will need funds in a few days to purchase more stock

purchase short-term security easily sell in a few days when cash is needed

o Borrowing from money market likely to be cheaper than bank for short term loans

No specific trading location

Central bank

Central banks use money markets to carry out transactions to control the amount of liquidity

available within the financial system

Central bank implements monetary policy (keeping inflation within a desired range over time)

by targeting cash rate and hence central bank carries out money market transactions so that

cash rate remains at target level

Inter-bank market

Facilitates the management of the short-term liquidity needs of commercial banks through the

payments system

Bills Market

Short term discount securities issued with a face value payable at maturity

Does not pay interest

Sold at a discount to face value

Holders obtain their return on investment from difference between price they pay and price

they sell it, or face value if held to maturity

Commercial Paper Market

AKA promissory notes

Only able to be issued by corporations with good credit rating as it is unsecured

Negotiable Certificates of Deposit

Short-term discount securities issued by banks (e.g. bills)

Capital Markets Channel savings to finance longer-term investment plans of businesses, individuals and

governments (financial instruments with original term to maturity > 1 year)

Provide long-term necessary funds for productive investment important for economic

growth

Incorporates use of:

o Foreign exchange market

Markets that facilitate the buying and selling of foreign currencies necessary for

conduct of international capital-market transactions

Risk is that exchange rate between currencies will change


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o Derivatives market

Provides a range of risk management products to manage risks associated with

capital market transactions

Equity market

Issuance of financial securities that represent an ownership interest in an asset (e.g. stock

market)

Shareholder has entitlement to dividend payments or capital gains (losses) in value of the

shareholding

Corporate debt market

Financial commitment that typically requires periodic interest payments to be made during the

term of debt arrangement and repayment of principal (amount borrowed, either periodically or

lump sum at maturity)

Government debt market

Government borrowing for short-term liquidity needs or longer-term budget capital

expenditures (T-notes, treasury bonds)

Increased government borrowing will crowd out or reduce amount of funds

available to corporate borrowers

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