TOPIC 5: Financial MarketsTypes of financial marketsIntroduction

Financial intermediaries: Firms that receive the accumulated funds of individuals/firms, and then make loans to other individuals who can make use to them

o Channels excess savings (net savers) to those who wish to borrow funds (net borrowers)

Financial Markets: Create products that provide a return for those who have excess funds making these funds available for those who wish to consume or invest

Primary and secondary financial markets Definitions:

o Securities: Any form, of financial instrument, including shares and bonds, that provide the holder of that instrument with a claim over real assets or a future income stream

Derivatives: Price is derived from the underlying assetso Australian Securities Exchange (ASX): Where the purchase and sale

of most shares in public companies occurs, bringing together people wishing to buy and sell shares (transactions)

Primary: Facilitate the creation of securities that can be sold into the economy

Secondary: Involves transactions with financial assets that have already been issued on secondary markets

Primary Financial Transaction: Sale of new shares Secondary Financial Transaction: When an existing shareholder sells their

shares to another shareholder

Market DescriptionShares Where ownership shares in companies are exchanged

BondsBond is lending money to the Govt/company that issued the bond, and in return, the government or company that issued the bond is agreeing to pay your money back, with interest, some point in the future

Derivatives Where people buy and sell financial assets that are based on the value of other financial assets

TOPIC 5: Financial MarketsForeign

ExchangeWhere financial assets defined in one country’s currency are exchanged for assets defined in another country’s currency

Financial Institution Description

Banks

Offers wide range of services Deposits (savings), Advances (loans) Credit cards, stored-value cards, travellers’ cheques Overseas payments and fund collection Provision of safe deposit facilities and financial advice Arranged external fund managers to invest an individual’s

savings

Finance companiesBorrow from the public (issuing debt securities) to obtain fundsReloan funds to households/SMEs at higher rates of interest

Investment banks

Uses surplus funds to borrow from companies (short-term basis)Lends funds to other large companies (expansion) and the government

Credit unions

Non-profit, co-operative organisations (members = particular trade, industry, profession, reside in a particular area)People can deposit or borrow money, with any profits returned to members

Permanent building societies

Accept deposits from the public and provide funds mainly for home loans. They can also offer other personal and business loans, although their interest rate structure is controlled by some degree by state governments

Mortgage originators

Mortgage funds who offer home loans to consumers, e.g. Aussie Home Loans, RAMS (bought by traditional banks after GFC) Offer low interest rates and more flexible repayment

optionsSuperannuation

fundsProvide retirement income for employees and employers by investing the contributions in financial assets

Financial products

Description

Consumer Credit

Credit: Loans to individuals, businesses, govt. for spending on consumption CC: Allows consumers to purchase g/s and repay their borrowings w/interest Issued by banks, credit unions, businesses: MC/Visa +

Woolies/Virgin/JetstarPersonal loans offered by banks and credit unions Interest rate: Personal loans = 10 – 15%, Credit Card = 10 –

20%

Housing loansLong-term loans to purchase property, requires periodic payments w/interest, offered by banks and mortgage originators (Aussie/RAMS).

Business loans Investment in operations, such as with new tech or expanded

TOPIC 5: Financial Marketsoffice space.Rates are typically higher than household lending ratesLarge corporations = 1% more, small businesses = 5% more

Short term money market

Brings together people and businesses with temporary shortages and surpluses of funds (Banks)Debt securities (bank bills/promissory notes) are issued, EXP. Less than one year

Bonds

Longer-term securities for which lenders receive regular fixed payments (coupons) from the issuing institution, receiving the principal value of the debt (face value) at the end of the bond period (date of maturity)

Financial futures and

options

Contracts to trade in financial instruments at a later date for a certain price

Protection against adverse movements (interest rates/share price)

Early agreement of the price for a future transaction Foreign

Exchange

Market for the buying and selling of foreign currencies Individuals: Going on holiday Businesses: Required for overseas transactions

The share market

Definitionso Share: Type of financial asset that provides an individual with

ownership over part of a business or companyo Public company: An entity whose shares are traded freely on the

share market, and are not subject to any restrictions on being transferred to other parties

o Dividends: The profit returns received by the shareholders (owners) of a business

o Capital gains: Profits made by investors who sell their shares or assets at a price above the level that they originally paid for them

o Float: When a company lists itself on the stock exchange and offers its shares to the general public for the first time

o Speculation: Investors buy assets with the intention of re-selling

them for a higher price

Role and Functiono Investors

TOPIC 5: Financial Markets Gain a stake in a company’s profits (dividends awarded on a

per share basis), make capital gains from increase in share prices (↑ company value)

Right to vote for a company’s board of directors Appoint senior managers who decide how to

maximise shareholders’ wealtho Company

Opportunity to raise funds (investment + business growth) Can access equity funds by issuing an approved

prospectus for the release of new shareso Reduces control that existing shareholders have

over the company Effect on the economy

o Indicator of a country’s economic conditions Rising share prices: new and better economic prospects Lower share prices: fewer economic opportunities

o Method of allocating resources to different types of productiono Many share purchases are speculative (re-sold within a short period)

Shareholders ManagementsShare price rises Value of investment

increasesPossible bonuses and increased job security

Share price falls Value of investment decreases

Increased pressureThreat of takeover (insecurity)

Not being bought to gain a long-term income streamo All Ordinaries index: Measures all changes in the ASX (Australian

Securities Exchange)

Domestic and global markets Dramatic increase in the participation of foreign investors in Australian

markets through increased lending and through increased foreign ownership of Australian companies

More opportunities for Australians to lend their surplus funds overseas or to invest in companies overseas

AU financial markets have become much more closely integrated over the past 3 decades

o ICT: ↓ communication cost, ↑ reliability/speed of electronic fund transfers

o Deregulation of financial markets (1980s) Foreign exchange markets: Movements of funds around the world

(investing and borrowing), increased when exchange rate was floated and most exchange controls abolished in 1983

o By April 2015: Daily transactions averaged US%136 billion Global debt markets: Economic development relies on foreign borrowing,

mostly by 4 bankso AU individuals: $1 trillion in loans to foreign entities

TOPIC 5: Financial Marketso AU: $2 trillion in outstanding foreign loans, usually by CBA, ANZ,

NAB, Westpac Benefits

o Access to foreign capital to invest in houses and businesses (would face higher borrowing costs or might not be able to access finance otherwise)

o Opportunity to invest and earn returns from businesses overseas Disadvantage: Instability overseas is easily transmitted to AU, especially

through speculation

Regulation of financial marketsDefinitions

Reserve Bank of Australia: AU’s central bank, in charge of conducting monetary policy and to oversee the stability of the financial system

Australian Prudential Regulation Authority: Govt. body responsible for supervision and regulation of all authorised deposit-taking institutions (ADIs), life/general insurance, and super funds

Australian Securities and Investments Commission: Govt. body responsible for corporate regulation, consumer protection, and oversight of financial service products

Australian Treasury: Advises the Government on financial stability issues, and the legislative and regulatory framework for the financial system

Council of Financial Regulators: Co-ordinating body for financial market regulation that provides for cooperation and collaboration among its members (RBA, APRA, ASIC, Treasury)

Council of Financial Regulators Informal body for financial market regulation that provide for cooperation

and collaboration among RBA, APRA, ASIC, and Treasury, allows sharing of information and advice coordination

o 2008 Global Financial Crisis Produced joint Memorandum of Understanding Interim ban imposed by ASIC on short selling (lifted in 2009)

Individual sells a share they do not own at the time of sale, planning to buy later at a lower price and profit from any decline in its value

Reserve Bank of Australia Conducts monetary policy, aims to achieve 2-3% I.R. while encouraging

economic growth Provides guidelines to foster the stability of individual financial institutions

(enforced by APRA), seeks to maintain long-term stability by avoiding/reducing risk of financial crises

TOPIC 5: Financial Markets Control of note issue: Sole issuing authority of Australian currency (Note

Printing Australia) Regulation of the electronic payments system by ensuring the efficiency

and stability of different payment methods, carried out by Payments Systems Board

Holds exchange settlement accounts (w/other banks) which allow banks to settle debts or by the banks to buy and sell securities from the RBA

Responsibility for holding AU’s reserves of gold/foreign currency dealings,o Provides funds (intl. payments/RB operations), oversees dealers in

Foreign Exchange Provides banking/financial agency services to the Commonwealth/State

govt.o Govt. can lodge excess funds w/RB, and obtain funds through

Treasury bills RB is printing new money that the govt. needs

o Raises short and long term loans (Notes/Bonds) making interest payments, and buying them back on maturity

Publishes regular assessments of the state of the economy and financial markets: Highly respected, significant influence on economic policy-making

Australian Prudential Regulation Authority Encourages institutions to meet their obligation with clients

o ADIs: Deposit-holders can take back their deposit money when they want it

o Insurance companies can meet their policy obligationso Superannuation funds can pay people who withdraw their savingso Requires deposit-taking institutions to maintain a certain level of

funds (risks) Sorting out institutions that experience financial difficulties

(ADIs/Insurance/Super funds)o Ensures that policy/deposit-holders receive as much of their funds

as possibleo APRA has right to intervene (range of investigative powers)

Australian Securities and Investments Commission Monitors, investigates, and acts (individuals’ illegal acts, unethical

investment products)Protect consumers against misleading/deceptive and unconscionable conduct affecting financial products and services

Crucial in lifting standards of corporate behaviour/maintaining confidence in financial markets

o ‘Insider trading’: Company directors use non-public info to buy/sell shares

o Company executives failing to inform the market of price-sensitive information

Has hundreds of investigations underway: Paying fines, frozen assets, jail-time

TOPIC 5: Financial Markets Does not prevent investors from making losses, nor does it prevent

companies from experiencing financial difficultiesAustralian Treasury

Main source of economic policy advice to the government: Budgets, taxes, expenditure, monetary/labour market policy, market regulation

Provides advice on regulations (financial markets, corporate practices, consumer protection)

GFC: Kept Govt up to date on AU/overseas development markets, best approach to minimise the impacts of financial market disturbances

Borrowers Individuals

o Short-term: Purchasing a car, international travel, educational courses, credit cards

o Long-term: Mortgage for family home. Bank can sell it to regain debt if defaulted (Security)

Businesses: Need access to funds (expand production, invest in R&D, other special projects)

o Raising equity (issuing equity) or debt (issuing bonds)o Borrowing from deposit-taking financial institutionso Investment in R/D (↑ production): Selling bonds/borrowing funds

from F.I. Government: Raise the level of

economic activityo Increase spending/tax

cuts to stimulate AU economy

o Funding major infrastructure projects

Factors affecting the demand for fundsLiquidity: The ease with which a financial asset can be transformed into cash so it can be used as a medium of exchange

Motives Transactional: Day-to-day transactions, e.g. Purchases, regular payments

for g/s Precautionary: Numerous unpredictable circumstances, emergencies Speculative: Possibility of making capital gains or losses

Financial innovations Increased use of technology: ATM, EFTPOS, online banking/payment

systems Increased availability of contactless payment systems: ↓ 25%-time vs

CC/DC Digital currencies: Bitcoin, directly exchanged for g/s

TOPIC 5: Financial MarketsLenders

Individualso Lend money to banks in order to get a return on it (interest)o Individuals could also invest in assets (property) or shares (risky!)

Businesses: Possess strong cash flow and good profitso May deposit its funds to get a return on interest

Governmento Revenue exceeds spending: Paying off outstanding debts, maintain

cash flow International: Important source of funds for domestic borrowers

o AU Govt. provided guarantee for all overseas borrowings by AU banks (no risk in lending)

Financial aggregates measured by the Reserve Bank of Australia

Characteristics of moneyo Medium of exchange: Used to exchange G/S, resourceso Measure of value: Used to compare the relative value of G/S,

resourceso Store of value, Measures value of G/S, resources over timeo Deferred payment: System of lending and borrowing

Money Base: Measure the most liquid financial assets M3: RBA’s definition of the money supply Broad Money: Accurate measure of total money supply, but it takes longer

to collect the relevant statistics Credit: Allows payments for purchases to be deferred (no store of value),

not measure of money supply

Interest RatesInterest rates: Cost of borrowing money expressed as a % of total amount borrowed, or the rate of return (yield) on financial assets or financial instruments, such as bonds

Demand for funds curve represents demand for financial assets by borrowers. They borrow more at lower interest rates Downward-sloping (Inverse relationship)

TOPIC 5: Financial Markets Supply of funds curve represents supply of financial assets by lenders.

They supply more at higher interest rates Upward-sloping (Direct Relationship)

Equilibrium: Quantity of funds supplied by lenders = quantity of funds demanded by borrowersReality: Interest rates not determined by normal interaction, but indirectly set by RBA. The supply of funds (savings) tends to be unresponsive to changes in the interest rate (i.e. very inelastic)Lending Rates

Financial institutions earn money by lending funds (savings deposits) to other borrowers

o Borrowing rate: Rate of interest paid to those who deposito Lending rate: Rate of interest that customers who borrow have to

pay backo Interest rate differential/margin: Lending rate > Borrowing rate

Profit Short-term securities: Loans w/maturity of less than a year

o Commonwealth Govt = Treasury Notes (13 or 26 weeks)o Less risky, more liquid (easier to turn into cash) = Lower interest

rate Long-term securities: Loans w/maturity of more than a year

o Commonwealth Govt = Treasury Bonds (5, 7, or 10 years) or Mortgages (25 years)

o Riskier, less liquid (harder to turn into cash) = Higher interest rate

Factors influencing interest rates

D capital goods: ↑ Demand for investment = ↑ Demand for borrowing = ↑ Interest Rates

Level of savings: ↑ levels of savings = ↑ supply of loanable funds = ↓ Interest Rates

Liquid funds: ↑ Demand for investment = ↑ Demand for borrowing = ↑ Interest Rates

Inflationary expectations: Govt budget: ↑ Spending = Budget deficit = Borrower in financial markets

= ↑ Interest Rates Intl interest rates: ↑ intl. rate = ↑ returns = ↓ supply of loanable funds =

↑ Interest Rates RBA buying/selling securities: Affects supply of funds in short-term money

market in order to set the cash rate (influences the interest rates on short-term loans and longer-term loans)

Domestic market operations

Actions by Reserve Bank in the short-term money market to buy/sell securities, either outright or through repurchase agreements in order to influence the cash rate and general level of interest rates

TOPIC 5: Financial MarketsCash rate: Interest rate paid on overnight loans in the short term money market

Exchange Settlement Accounts: Banks and some NBFIs hold a certain proportion of their funds with the RBA to settle payments with other banks

o ANZ costumer uses cheque to buy g/s from NAB business, Funds from ANZ NAB

o No net impact on money supply (one bank gains funds, another loses funds). Some banks borrow from banks w/surplus funds in order to settle their daily transactions

Short term money market: Where banks borrow/lend money for their ES accounts

Expansionary monetary policy: Buys securities, deposit funds (bank buys back at later date)

o ↑ supply of funds = ↓ cash rate (price of borrowing) o Lowers cost of borrowing for banks Lower lending interest rates

for customerso Encourages consumption + investment spending Higher level of

economic activity Contractionary monetary policy: Sells securities, withdraws funds

o ↓ supply of funds = ↑ overnight cash rate of interesto Increases cost of borrowing for banks Lower lending interest

rates for customerso Deters consumption + investment spending Lower level of

economic activity

RBA sells securities

Shortage of borrowable funds

↑ Cash rate

↑ market interest rates (banks maintain profit margins)

Consumers/Businesses pay more on existing debts, New borrowers

find it harder to borrow funds

↓ Consumption and investment spending

↓ Economic Activity

RBA buys securities

Excess of borrowable funds

↓ Cash rate

↓ market interest rates (banks maintain profit margins)

Consumers/Businesses pay less on existing debts, New borrowers

find it easier to borrow funds

↑ Consumption and investment spending

↑ Economic activity