TOPIC 1: INTRODUCTION TO FINANCIAL MARKETS

TOPIC 1:Introduction to Financial Markets

Aim

The aim of this topic is to provide an introduction to, and framework for examining, the nature and operation of the financial system. The two main methods of financing are distinguished along with the different types of financial assets that are created. In addition, the relationship between the financial system and the economic system and the role of government with respect to the financial system are considered.

Learning objectives

After working through this topic, you should be able to:

1. Describe the main features of the financial system.

2. Distinguish between direct and indirect financing and the characteristics of each.3. Explain the relationship between the financial system and the economic system.

4. Outline the main reasons for, and methods of, government intervention into financial markets.

Objective 1

After working through this section you should be able to describe the main features of the financial system.

1.1 The financial system

To understand the nature of financial markets it is first necessary to understand the overall financial system that comprises, inter alia, financial markets.

The main functions of a nations financial system are to facilitate the:

transfer of funds from surplus to deficit economic units, in primary financial markets, by the creation of new financial assets trade of existing financial assets in secondary financial markets

A nations financial system comprises surplus economic units (lenders), deficit economic units (borrowers), financial institutions, financial markets and financial assets.

1.1.1 Surplus economic units

These are individuals or small groups (eg individual households or business firms) who have more funds available than they require for immediate expenditure. That is, they represent savers and potential lenders of their surplus funds.1.1.2 Deficit economic units

These are individuals or groups (eg individual households or business firms) who require additional funds to meet their expenditure plans. That is, they represent potential borrowers of funds.

1.1.3 Financial institutions

These are organisations whose core business involves the borrowing and lending of funds (financial intermediation) and/or the provision of financial services to other economic units.

1.1.4 Financial assets

Financial assets, also called financial instruments, represent a claim or right that a surplus economic unit holds over a deficit economic unit. Issued by the party raising funds, it acknowledges a financial commitment and entitling the holder to specified future cash flows. For the party issuing the financial assets, the assets represent a liability or obligation.

Whenever, funds are lent and borrowed, financial assets are created. Primary market financial transactions involve an exchange as funds are exchanged for financial assets. Lenders of funds are also buyers of financial assets and borrowers of funds are sellers of financial assets.

All financial assets have four different attributes which can provide a basis for comparison between different types of financial assets:

return or yield

risk

liquidity

time pattern of return or cash flow

Note that expected return or yield has a positive relationship with risk and inverse relationship with liquidity. The higher the level of risk and the lower the liquidity, the higher the return on investment required by lenders of funds (surplus economic unites). Lenders of funds are able to satisfy their own personal preferences by choosing various combinations of these attributes.

The financial assets that are created and exchanged can be divided into the following four broad types:

Debt: Debt instruments represent an obligation on the part of the borrower to repay the principal amount borrowed and interest in a specified manner over a defined period of time or when a specified event occurs. Some examples are:

Deposits - eg bank deposits

Contractual savings- eg life insurance, superannuation

Discount securities - eg commercial bills

Fixed interest securities - eg bonds, debentures

Equity: Equity differs from debt in that it represents an ownership claim over the profits and assets of a business. The main example is ordinary shares.

Hybrid: Hybrid financial assets comprises securities that combine features of both debt and equity. Two examples are preference shares and convertible notes.

Derivatives: Derivative instruments are financial assets whose value is derived from another type of financial asset. Two examples are options and futures

Whatever form financial assets take they represent a claim (or right) which a surplus economic unit holds over a deficit economic unit. Likewise they also represent an obligation of deficit economic units.

1.1.5 Financial markets

An economic market comprises a mechanism which brings together, not necessarily to a single location, sellers and buyers for the purpose of exchange. Financial markets are where financial assets are created and/or exchanged. Every nations financial system comprises a number of different financial markets which can be classified in different ways for different purposes.

One type of classification is between primary and secondary financial markets. In the former, new financial assets are created and traded in exchange for borrowed funds: eg a household (surplus economic unit) lends funds to a corporation (deficit economic unit) in exchange for debentures (a financial asset). In the latter, existing financial assets are traded which results in a change of ownership but not the lending of funds: eg the holder of debentures sells his financial asset to another person.

The term financial security is used to describe financial assets that can be traded in a secondary market.

Another type of classification is between money markets, where funds are lent for a period of less than one year, and capital markets, where funds are lent for one year or longer.

Other types of classification distinguish between financial markets for the different type of financial assets that are traded. This is the basis on which we will be examining different financial markets in Australia. Specifically, we will examine the following separate Australian financial markets in turn:

The Money Market (topic 3) The Debt-Capital Market (topic 4) The Foreign Exchange Market (topic 5)

The Equity Market (topic 6)

The Derivatives Market (topic 7)Objective 2

After working through this section you should be able to distinguish between direct and indirect financing and the characteristics of each.

1.2 Direct and indirect finance

The flow of funds in primary financial markets can either be direct from lender to borrower or indirectly through a financial intermediary. The alternative methods of financing are illustrated in the diagram below;

1.2.1 Direct finance

With direct finance the surplus economic units who are the ultimate lenders provide funds directly to the deficit economic units who are the ultimate borrowers. In exchange for the funds, the deficit economic units issue financial assets that are primary securities held by the surplus economic units and represent a direct claim over the ultimate borrower.

In direct finance financial institutions frequently provide financial services to the parties, particularly the borrowers. These services include financial advice, financial management and security documentation, marketing, sales negotiation, provision and arrangement of underwriting facilities. In providing such services financial institutions are paid commission or fees.

1.2.2 Indirect finance

Indirect financing is also known as intermediated financing because it involves financial institutions performing the role of financial intermediary. With indirect financing, the surplus economic units, the ultimate savers, lend their funds initially to a financial institution who then lends the funds to the deficit economic units who are the ultimate borrowers.

The financial institution acts as a financial intermediary and performs the role of both borrower and lender. This is the basis of the legal relationship that financial intermediaries have with surplus and deficit economic units. In performing this role financial intermediaries earn income in the form of a net interest margin and fees. The net interest margin represents the difference between the average cost (interest paid) of funds and average return (interest earned) from lending.

In indirect financing, deficit economic units issue primary securities which are held by financial intermediaries who issue secondary securities to surplus economic units. Surplus economic units do not have a direct claim on deficit economic units.

You should not become confused between primary and secondary financial markets and primary and secondary financial assets (securities). The terms primary and secondary are used in different contexts for each of the above which are not related. Primary and secondary securities are both created in primary financial markets and can be traded in secondary financial markets.

1.2.3 Advantages of financial intermediation

In carrying out the role of intermediation financial institutions provide a number of benefits to borrowers, lenders and the economy as a whole. The main advantages of financial intermediation are:

Asset value transformation: financial intermediaries are able to create secondary securities that differ in value from the primary securities that are issued by deficit economic units. In this way they can tap small individual savings and pool them together for the purpose of making larger loans. Maturity transformation: financial intermediaries are able to borrow for different time periods than for what they lend. In doing this they are able to match the maturity preferences of borrowers and lenders. As a general rule, lenders require greater liquidity than borrowers are prepared to provide. Credit risk reduction and diversification: financial intermediaries are able to reduce the risk of lending to borrowers who are unable to meet their loan commitments as a result of their expertise and knowledge. In addition, as a result of their size and diversification of loans, they are able to spread a small percentage of bad loans across their total loan portfolio. Liquidity provision: Ability to convert financial assets into cash. Financial intermediaries, due to their size and specialisation in borrowing and lending are able to provide their customers with a high degree of liquidity eg. cheques, ATM, EFTPOS facilities. Increased quantity of national savings: As a result of the above advantages the existence of indirect financing will tap a greater quantity of national savings and hence increase the supply of funds available to finance real investment and promote economic growth.

1.2.4 Disadvantages of financial intermediationThere is no doubt that financial intermediation provides a number of advantages. However, it does not come without cost as both borrowers and lenders must pay for the benefits they receive. This generally means: Increased cost of funds for borrowers Reduced return from lending for savers.

In addition to this, there is a further disadvantage in that, as a general rule: It is less likely for secondary financial assets to be securitised ( ie financial securities) in that they can be traded in a secondary market.Over recent years there has been increased reliance by large borrowers on direct rather than indirect (intermediated) finance. Hence the term disintermediation is used to describe this process.

Objective 3After working through this section you should be able to outline the main institutional and regulatory features of the Australian financial system

1.3.1 Nature and role of financial institutionsA financial institution is a business organisation whose core business is financial intermediation and/or the provision of financial services to other sectors of the economy.

In indirect financing, a financial institution performs the function of financial intermediation by borrowing from surplus units and lending to deficit units. Revenue is generated by net interest margin and fees. In direct financing, a financial institution provides financial services by performing the function of broker, agent, financial advisor, etc. Revenue is generated by fees and commission.

Although there is a great deal of overlap between the services offered by different financial institutions, it is common practice to categorise non-bank financial institutions on the basis of how they raise the majority of their funds. We can identify two main types of institutions:

Deposit taking financial institutions: They attract the savings of depositors through on-demand deposit and term deposit accounts. They provide loans to borrowers in household and business sectors. e.g. commercial banks, building societies and credit cooperatives. Non Deposit taking financial institutions: They generally do not provide laons or take deposits but they may managed funds under contractual arrangement (superannuation) and provide a wide range of financial services. e.g. Investment banks, general insurance companies and superannuation funds.

1.3.2 Current Institutional features

The Australian financial system comprises a range of different types of financial institutions providing financial intermediation or other financial services.

Total Assets (Percentage Share) of Financial Institutions

From this table a number of observations can be made concerning the institutional structure of the Australian financial system. These include:

The dominant role of banks with the commercial banks, as a group, comprising more than 50% of the total assets of all financial systems. During the period of regulation banks share of financial assets fell however, following deregulation it did increase.

Both building societies and credit unions are very small in terms of percentage share of financial assets. However, there are a large number of individual institutions with approximately 30 building societies and 320 credit unions. The decline in percentage share of financial assets owned by building societies has been particularly due to the conversion of a number of building societies into banks.

Life offices and superannuation funds, as a group, have experience a significant increase in the share of financial assets they control. The percentage share of life offices has declined in recent years while superannuation funds have represented one of the fastest growing sectors of the financial system. This is particularly due to government wages and taxation policy.

Other form of managed funds, particularly public unit trusts, have also grown significantly as retail investors have turned toward equity and other types of managed investments and away from traditional forms of investment such as bank deposits.

Mortgage originators and securitisation vehicles have only become recognised as a type of financial institution in recent years. Officially, the Reserve Bank did not collect statistics on them until December 1996. Mortgage originators have experienced considerable recent growth in the 90s but shrank following the Global Financial Crisis. Mortgage originators make housing loans and then sell these loans to securitisation vehicles set up as separate entities by financial institutions. Funds are raised through the issue of mortgage backed securities by the securitisation vehicles.

1.3.3.1 Commercial banks

Commercial banks are the largest group of financial institutions within a financial system and therefore they are very important in facilitating the flow of funds between savers and borrowers. The core business of banks is often described as the gathering of savings (deposits) in order to provide loans for investment.

The traditional image of banks as passive receivers of deposits through which they fund their various loans and other investments has changed since deregulation (for deregulation see topic 8). For example, banks provide a wide range of off-balance-sheet transactions such a underwriting where for instance the bank will commit to purchase unsold share after the share were issued to the market. The bank can also act as guarantor on some financial products such as money market bills (bank bills).

A wide range of non-bank financial institutions has evolved within the financial system in response to changing market regulation and to meet particular needs of market participants.

1.3.3.2 Building societies and credit unions

The majority of building society funds are deposits from customers. Residential housing is the main form of lending. Credit unions funds are sourced primarily from deposits of members. Housing loans, personal loans and credit card finance is available to their members. A defining characteristic of a credit union is the common bond of association of its members, usually based on employment, industry or community.

1.3.3.3 Investment banks and merchant banks

Investment banks and merchant banks play an extremely important role in the provision of innovative products and advisory services to their corporations, high-net-worth individuals and government.

Investment and merchant banks raise funds in the capital markets, but are less inclined to provide intermediated finance for their clients; rather, they advise their clients and assist them in obtaining funds direct from the domestic and international money markets and capital markets.

Investment banks specialise in the provision of off-balance-sheet products and advisory services, including operating as foreign exchange dealers, advising clients on how to raise funds in the capital markets, mergers and acquisitions, acting as underwriters and assisting clients with the placement of new equity and debt issues, advising clients on balance-sheet restructuring, evaluating and advising on corporate mergers and acquisitions, advising clients on project finance and, providing risk management services.

1.3.3.4 Managed funds

The main types of managed funds are cash management trusts, public unit trusts, superannuation funds (pension funds), statutory funds of life offices, common funds and friendly societies. Managed funds may be categorised by their investment risk profile, being capital guaranteed funds, capital stable funds, balanced growth funds, managed or capital growth funds.

Managed funds are a significant and growing sector of the financial markets due, in part, to deregulation, ageing populations, a more affluent population and more highly educated investors. In Australia, employers must contribute the equivalent of 9 per cent of an employees wage into a superannuation account in the name of the employee. The superannuation funds receive concessional taxation treatment.

1.3.3.5 Life insurance offices and general insurance offices

Life insurance offices are contractual savings institutions. They generate funds primarily from the receipt of premiums paid for insurance policies written. Life insurance offices are also major providers of superannuation savings products.

Whole-of-life insurance policies include an insurance risk component and an investment component. The policy will accumulate a surrender value over time. A term-life policy provides life insurance cover for a specified period. If the policyholder dies during that period, an amount is paid to the named beneficiary.

Related insurance policies include total and permanent disablement insurance, trauma insurance, income protection insurance and business overheads insurance. General insurance policies include house and contents insurance. Motor vehicle insurance includes comprehensive, third party fire and theft, third party only and compulsory third party insurance.

1.3.3.6 Finance companies and general financiers

Finance companies derive the largest proportion of their funding from the sale of debentures (Debt). They provide loans to individuals and businesses, including lease finance, floor plan financing and factoring. Deregulation of commercial banks has resulted in a significant decline in finance companies. Many finance companies are now operated by manufacturers, such as car companies, to finance sales of their product.

i.e. AGC, CBFC and ESANDAObjective 4After working through this section you should be able to explain the relationship between the financial system and the economic system.

1.4 The financial and economic systems

In the study of economics, it is normal to treat the financial system as a component part of the larger economic system. The economic system is seen as comprising, inter alia, real output markets (for goods and services), resource markets and financial markets.

The role of the financial system is to facilitate the operation of the overall economic system and in particular the output markets for goods and services. 1.4.1 The economic system

A nations economic system is concerned with the production and distribution of goods and services. In performing this function, a nations economic performance is normally assessed in terms of the following economic objectives: economic growth

full employment

price stability

external balance

efficient allocation of resources

equitable distribution of income and wealth

1.4.2 The financial system and economic objectives

A nations financial system will affect its performance with respect to each of the economic objectives listed above.

1.4.2.1 Economic growth

Historically, there is a well established relationship between the development of a nations financial system and economic development. The establishment of a well developed financial system is seen as a necessary prerequisite for a country to raise sufficient funds, to finance the necessary infrastructure projects required for sustained economic development.

For developed economies, the cost and availability of funds, determined in the financial system, are significant determinants of aggregate demand, particularly private investment demand. The level and rate of growth of aggregate demand, in turn, has a major impact on a nations economic growth rate.

1.4.2.2 Full employment

The demand for resources, including labour, is derived from the demand for final goods and services. Thus, the level of employment in the economy is directly related to aggregate demand and the rate of economic growth. As the cost and availability of funds is a significant determinant of aggregate demand, it is also a significant determinant of the level of employment.

1.4.2.3 Price stability

The rate of inflation is also significantly determined by the growth of aggregate demand. Consequently, the cost and availability of funds in the financial system will have some bearing on whether a nation is experiencing inflation or relative price stability.

A nations monetary policy normally involves Central Bank intervention into the financial system in pursuit of macroeconomic objectives, particularly price stability. In Australia, at the present time, the Reserve Bank of Australia has set an inflation target of 2 - 3% per annum for determining the conduct of monetary policy.

1.4.2.4 External balance

External balance refers to a desirable position in terms of a nations international transactions, as reflected in that countrys balance of payments, and exchange rate value of its currency. Both the balance of payments and the exchange rate will be significantly affected by the financial system.

The cost and availability of funds will affect the level and rate of change of the export and import of goods and services. In addition, borrowing from overseas (capital inlow) and overseas investment of funds (capital outflow) are directly affected by conditions in financial markets both domestically and globally.

Thus, both current and capital account transactions of a nations balance of payments will be significantly determined by domestic and international financial market conditions.

As international transactions determine the demand and supply for a nations currency, financial market conditions will also have a significant affect on the foreign exchange value of that nations currency.

1.4.2.5 Efficient allocation of resources

An efficient allocation of resources is where a nations limited resources are allocated to produce that output mix of particular goods and services that maximises the satisfaction of society. This is best achieved by competitive markets where the allocation of resources is determined by demand and supply for individual goods and services.

Any non-market distortions that influence the levels of demand or supply will reduce the efficient allocation of resources. Non-market distortions can result from factors in resource markets, finance markets or in the markets for goods and services themselves.

The efficient allocation of resources requires that factors in finance markets do not distort the pattern of demand for individual goods and services from that which would otherwise take place. Allocative efficiency requires that the financial system directs funds to the highest yielding forms of expenditure. This is best achieved by competitive financial markets with a minimum of government intervention and controls.

1.4.2.6 Equitable distribution of income and wealth

Non-market distortions that affect the cost and flow of funds not only reduce allocative efficiency but have effects that are not spread evenly over the community. For example, ceilings on particular interest rates means some groups receive benefits, or an effective subsidy, while other groups are required to pay higher cost for funds than would otherwise be the case. As a result, the distribution of income between different groups in the community is affected.

At different times, governments have intervened into finance markets for the main purpose of altering the distribution of income to one that it views as more socially desirable or equitable.

Objective 5After working through this section you should be able to outline the main reasons for, and methods of, government intervention into finance markets.

1.5 The government and finance markets

Over the past fifty years, the Australian government and government bodies, such as the Central Bank, have significantly altered both the extent, and methods, of intervention into financial markets. Similar changes have been experienced in financial markets around the world.

In general terms, we can divide the past 50 years into the following three periods:

Regulation (pre 1980s): During this period the Australian financial system was characterised by an extensive array of direct controls, particularly over banks. Deregulation (1980s): During the first half of this decade the direct controls and other types of government regulation were progressively removed and the financial system took on the features of a competitive market. Post-deregulation (1990s): During the first half of this decade, the role of government changed again with a strengthening of government intervention. However, this was different in nature from the regulations that existed in the pre-1980 period.These three periods are outlined in more detail in the next objective.

1.5.1 Reasons for government intervention

All government policy actions are aimed at the achievement of particular objectives. In particular, the following objectives have been important reasons for government intervention into finance markets:

Macroeconomic objectives of economic growth, full employment, price stability and external balance. The previous section outlines how the financial system can affect a nations performance with respect to these objectives and they have always been a major rationale for government intervention. An efficient, fair and competitive financial system.

The promotion of financial safety.

1.5.2 Methods of government intervention

There are numerous ways in which government actions can affect conditions in finance markets either directly or indirectly. This includes the main arms of economic policy as well as direct legislation. The main methods are:

Fiscal policy

the financing of a budget deficit or disposal of a budget surplus

individual outlay and revenue items.

Monetary policy

open market operations

reserve asset requirements.

External policy

exchange rate policy

actions affecting exports and imports

capital inflow/outflow controls.

Wages policy eg superannuation requirements.

Competition policy

eg attitude of the Australian Consumer and Competition Commission towards bank mergers.

Consumer protection - voluntary and legislative.

Direct legislation - eg aspects of corporations law, superannuation legislation.

TOPIC 1: Summary

In this introduction to finance markets the emphasis has been on the nature and characteristics of the financial system and its relationship to the larger financial system.

The financial system comprises both primary and secondary markets, each of which performs a different role. The primary markets are concerned with mobilising the savings of surplus economic units and transferring the surplus funds, either by means of direct or indirect finance, to deficit economic units in exchange for newly created financial assets. The secondary markets are concerned with the trade of existing financial assets.

There are many different financial assets that are created and traded in financial markets. Financial assets can be classified as debt, equity, hybrid or derivatives and can be distinguished from each other on the basis of return, risk, liquidity and time pattern of return..

Conditions in finance markets will have a significant influence on the overall economic system and the achievement of economic objectives have always been main reasons for explaining government intervention into finance markets.

1762012 Topic 1 Introduction to Financial Markets