FINS1612 Study Notes - StudentVIP · FINS1612 Study Notes | Daniel Quinn age 9 Providers of funds...
Transcript of FINS1612 Study Notes - StudentVIP · FINS1612 Study Notes | Daniel Quinn age 9 Providers of funds...
FINS1612 STUDY NOTES
DANIEL QUINN
FINS1612 Study Notes | Daniel Quinn
Pa
ge1
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge2
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge3
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge4
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge5
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge6
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge7
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge8
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge9
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)
FINS1612 Study Notes | Daniel Quinn
Pa
ge10
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge11
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge12
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge13
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge14
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge15
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
FINS1612 Study Notes | Daniel Quinn
Pa
ge16
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