BFF1001 Week 1 Topic 1: What is finance

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1 BFF1001 Week 1 Topic 1: What is finance Definitions Deficit A deficit unit saves less money than it invests A deficit unit needs funds If saving is less than investment, a deficit occurs Surplus A surplus saves more money than it invests A surplus unit supplies funds If saving is greater than investment a surplus occurs Some defining terms: Saving: change in a unit or sector s net worth Dissaving: consumption exceeds income (reduction in net worth {wealth}) Investment: acquisition of new physical assets Flow of Funds Flow of Funds The flow of funds from surplus units (mainly households) to deficit units (mainly business firms and governments) is a fundamental function of the financial system. Economic units can be classified as: - Households - Businesses - Governments In addition, financial institutions and the rest of the world act to facilitate the interaction between these units

2 In the economy, these units generate and spend money. Some economic units generate more income than they spend (surplus units) while others generate less income than they spend (deficit units). Note the role of financial institutions in facilitating the flow of funds and the inclusion of the rest of the world in addition to domestic economic units of households, businesses and governments A well functioning (developed and efficient) financial sector will efficiently allocate funds from suppliers to users Financial System Components Financial institutions Include banks and non-banks financial institutions; financial institutions facilitate the transfer of funds by providing intermediation (indirect finance) They provide infrastructure for the system of payments Collectively, financial institutions provide the transmission mechanism for monetary policy; increasing or decreasing the cost of credit in the economy that affects consumer spending and corporate investment, thereby providing a primary means for promoting or dampening inflation and economic growth Financial instruments There are a variety of financial instruments which can be broadly classified according to the markets they are traded in, how they are issued (debt, equity, derivatives) and their maturity (short term or long term, also known as money and capital market instruments respectively). Financial instruments represent an entitlement to the holder to a specified set of future cash flows. When a user of funds (deficit unit) obtains finance, the user must prepare a legal document (or financial instrument) defining the contractual arrangement

3 The entitlement to future cash flows provided by financial instruments can be through equity or debt: Equity: this provides the holder with an ownership interest in an asset (e.g: ordinary share, hybrids {preference shares, convertible}) Debt: this provides the holder with a contractual claim to defined periodic interest repayments and the repayment of principal (e.g: debentures) Other important financial instruments are derivatives and hybrids Derivatives: allow management of certain risks and speculation. Derivatives don t provide funds to borrower. These include futures, forwards, options and swaps Hybrids: this type of instrument incorporates characteristics of debt and equity. Preference shares are a hybrid instrument as they have both equity and debt characteristics Financial markets These provide a forum for the creation and exchange of financial instruments The role of financial markets is to transfer the funds from borrowers to lenders (funds flow from surplus units to deficit units) and to allocate funds between alternative users Direct Financing and Intermediation This chart shows how the flow of funds within the financial system can occur There are two main paths for funds to be transferred; one path involves intermediation while the other path involves direct financing Intermediation Overview of Intermediation (indirect finance)

4 Financial intermediation involves the transfer of funds between ultimate savers (surplus units) and ultimate borrowers (deficit units) via financial institutions who act as intermediaries Intermediation involves the purchase of direct financial claims with one set of characteristics from deficit units and their transformation into indirect claims with a different set of characteristics Intermediation is also called indirect financing In this process, two financial assets are created Example: - Mary (surplus/saver unit) deposits $100 in her bank account and the bank on-lends those funds to a company (borrower/deficit unit) Why use intermediation? Intermediaries better satisfy the needs and preferences of both parties. Intermediation allows borrowers and savers to transfer funds without having to match the other party s preferences. This provides many benefits to both parties; Asset transformation: borrowers are offered a range of products Maturity transformation: borrowers and savers are offered products with a range of terms to maturity Credit risk diversification and transformation: savers credit risk is limited to the intermediary, which has expertise and information Liquidity transformation: liquidity refers to the ability to convert financial assets into cash. Borrowers and savers have different preferences for liquidity. Financial intermediation satisfies these different preferences by taking the intermediation role Economies of scale: this refers to the financial and operational benefits of organisational size and business volume produced by intermediaries it is cheaper to do a range of transactions together than to do them on a stand-alone basis Types of intermediaries Australian financial intermediaries include: Banks, building societies and credit unions Foreign bank representatives General and life insurers Friendly societies Money market corporations, finance companies and securitisers Licensed trustees Superannuation entities Commercial Banks Commercial banks are the largest and the most diversified intermediaries. Currently, the Australian banking sector is dominated by four major banks: - Australia and New Zealand Banking Group - Commonwealth Bank of Australia - National Australia Bank - Westpac Banking Corporation In 1990, the Commonwealth Government of Australia announced that it adopted a four pillars policy and would reject any mergers between these four banks

5 Australian-owned commercial banks hold more than $2 trillion in financial assets Commercial banks assets consist of loans to consumers, businesses and governments Commercial banks liabilities consist of deposit accounts and other sources of funds Commercial banks might also be engaged in other activities such as underwriting Non-bank financial corporations Non-bank financial corporations (NBFCs) provide many of the same services and products that commercial banks provide. For instance, there are many non-bank lenders competing in the home loan market. NBFCs may be classified into four groups: Building societies Credit unions Money-market corporations Finance companies Several groups of other financial institutions also operate in the financial system. These include: Life insurance companies General insurance companies Superannuation funds Managed funds Securitisers International Organisations In addition to domestic institutions, there are a number of important international organisations The Bank of International Settlements The World Bank The International Monetary Fund The Asian Development Bank Types of risks Financial institutions are exposed to a variety of risks which include: Credit risk: the risk of default on a debt that may arise from a borrower failing to make required payments Interest rate risk: the risk that an investment s value will change due to a change in interest rates Liquidity risk: the risk that may arise from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimise a loss Foreign exchange risk: chance that an investment s value will decrease due to changes in currency exchange rates Political risk: the risk that an investment s returns could suffer as a result of political changes or instability in a country Reputational risk: a threat to the reputation of a business or entity. In addition to having good governance practices and transparency, companies (including financial institutions) also need to be socially responsible and environmentally conscious to avoid reputational risk

6 Environmental risk: all financial institutions are exposed to some level of environmental and social risk. If left unmanaged, these risks can lead to a decline in the financial institutions reputational image, costly litigation, or loss of revenue Direct Financing Overview of Direct Finance Direct finance involves the transfer of funds between ultimate savers and ultimate borrowers without an intermediary. There is no transformation of financial claims in the process Direct financing allows deficit units to issue financial claims on themselves and sell them money directly to surplus units. These financial claims are bought and sold in financial markets. Surplus units and deficit units deal directly with each other A broker or dealer may be involved in getting these parties together however, no intermediation occurs - An example of direct financing would be BHP issuing shares and raising capital directly from shareholders, or bonds Advantages of direct finance Through direct finance, costs of intermediation can be avoided Direct finance can increase access to a diverse range of markets Direct finance can also provide greater flexibility in the range of securities that deficit units can issue for different financing needs Disadvantages of direct finance Matching of preferences can be difficult (borrowers and lenders may have different preferences in terms of amount, security, etc ) Liquidity and marketability of a security is dependent upon the other party (will the buyer be able to sell it easily? Is there a secondary market for that security?) Search and transaction costs may be high Assessment of risk, especially default risk can be difficult (information may be limited) These disadvantages highlight the important role financial intermediaries play in transferring funds from savers to borrowers Types of Financial markets Various financial markets play an important role in facilitating the transfer of funds between surplus and deficit units in direct finance. Financial markets can be classified as: Primary markets Markets where investors purchase financial securities from the original issuer. This might take place through an initial public offering (IPO) of shares to the public or through a private placement

7 Secondary markets Markets where investors trade their securities with other investors. Secondary markets are where previously issued financial claims are exchanged among investors A main (and important) function of secondary markets is to provide liquidity by making it easier to sell financial instruments Financial market classifications Financial markets can also be classified as: Money markets: markets for short-term (less than 12 months) (financial instruments example; bank bills) Capital markets: markets for long-term (12+ months) (financial instruments example; shares) Wholesale markets: markets where financial flow transactions occur directly between institutional investors and borrowers; this involves larger transactions Retail markets: markets where transactions are conducted primarily with financial intermediaries by the household and small to medium sized business sector; this involves smaller transactions Markets can also be classified geographically (domestic and international markets), depending on how instruments are traded: (over the counter and exchange traded markets) and depending on which instruments are traded (for example, bond, stock and derivatives market) Issuing and trading financial securities Issuing and trading financial securities: Financial securities can be traded by: Public offering: securities are issued to the general public Private placement: securities are issued to a single investor or group. This is the simplest method of transferring funds between savers and borrowers. A deficit unit (usually a large corporation) sells an entire security issue to a single institutional investor or to a small group of investors Liquidity of financial markets Liquidity is an important characteristic to consider when trading in financial markets and financial instruments Liquidity refers to the ease of buying and selling without large price fluctuations; it is related to the volume of the turnover Liquidity depends on the depth, breadth, resilience of markets. Dealers and brokers help create liquidity Liquidity refers to how easily assets, (e.g: shares of stock) can be converted into cash. The market for a stock is said to be liquid if the shares can be rapidly sold and the act of selling has little impact on the stock s price Among market participants who add liquidity to financial markets there are: Market-makers: traders who quote prices at which they are willing to buy or sell any time (dealers) Speculators: players who take an open position in the market, hoping to profit but also risking a loss

8 Arbitragers: take offsetting positions in twin markets for profit without risk Other qualities of financial markets Stability is another desirable feature of financial markets. Stability can be disrupted by speculative waves or by short selling Negotiability is a desirable characteristic of a financial security. It refers to the ability to transfer ownership from one party to another Low risk in financial markets is desirable as less risky securities are more attractive to investors. Various facets need to be considered, including default risk, capital risk and inflation risk among others

9 Week 2 Topic 2: Financial Markets and Regulation Origins and roles of central banks Central banking has a long history that stretches back as far as the 17th Century The main role of central banks is to regulate a nation s money supply and its financial institutions Central banks aim to maintain a stable economic environment and effective payments system The functions performed by central banks include: - Developing and implementing monetary policy - Issuing currency - Providing banking services for the government - Overseeing the operations of the financial system - Facilitating the payments system Australia s Monetary Authorities In Australia, the role of monetary authority is split among three independent agencies: The Reserve Bank of Australia (RBA): responsible for monetary policy, the payments system and the stability of the entire financial system The Australian Prudential Regulation Authority (APRA): responsible for prudential supervision of financial institutions including banks, credit unions, building societies, insurance and superannuation companies The Australian Securities and Investment Commission (ASIC): responsible for the enforcement of company and financial services laws. The objective is to protect consumers, investors and creditors. Also responsible for licensing and monitoring financial markets and advisors as well as monitoring the disclosure and conduct of Australian companies and service providers Bank for International Settlements The BIS is an international monetary authority based in Basel, Switzerland The BIS is a facilitator of central banking co-operation. This is accomplished by providing a meeting place and resources for meetings of central banks The BIS also acts as a bank to the central banks, providing services related to their financial operations Reserve Bank of Australia The RBA has the following functions: Determines and implements monetary policy Issues Australia currency notes Oversees the payments system Acts as the government s banker