Week 1 Surplus economic units: Individuals, households, companies with more funds than required for immediate expenditure Saver Potential lenders Deficit economic units Individuals, households, companies who require additional funds to meet expenditure plans Potential borrowers Financial Institutions Organisations whose core business involves: Borrowing and lending (financial intermediation) Provision of financial services Financial assets / financial instruments Issued by a deficit economic unit, financial assets (financial instruments) acknowledge a financial commitment and entitle the holder to specified future cash flows Attributes of financial assets Return or yield Risk Liquidity Time pattern of return or cash flow Lenders of funds are able to satisfy their own personal preferences by choosing various combinations of these attributes. Debt financial assets Represent an obligation on the part of the borrower to repay principal and interest. Eg. Deposits and loans Contractual savings Discount securities Fixed interest securities Equity financial assets Represent an ownership claim over the profits and assets of a business. Eg. Ordinary shares Hybrid financial assets Financial assets which have features of both debt and equity. Eg. Preference shares Convertible notes (bonds) Derivatives: Financial assets whose value is derived from another financial asset, rate or index. Eg. Forward contracts Futures Options Swaps Financial markets: Economic markets in which financial assets are created or exchanged. Primary/Secondary Money (<1 year) / Capital (>1 year) By type of financial asset Money Market (topic 3) Debt-Capital Market (topic 4)
Foreign Exchange (topic 5) Equity Market (topic 6) Derivatives Market (topic 7) Primary markets Markets in which financial assets are first created Markets in which funds flow from surplus economic units to deficit economic units Secondary markets Markets in which existing financial assets are traded Financial Securities Deficit economic units do not directly participate in secondary market transactions Money markets Markets where funds are lent for periods of less than 12 months A market in which short-term debt financial assets are created and traded Debt Capital markets Markets where funds are lent for periods of 12 months or more A market in which long-term debt financial assets are created and traded Direct finance Funds are transferred directly from surplus economic units to deficit economic units Primary financial assets are issued directly from deficit units to surplus units Financial institutions play a role in direct finance by providing financial services, such as financial advice, underwriting, etc., in return for fees and commissions Indirect finance Also known as intermediated finance Financial institutions act as intermediaries, borrowing from surplus units and lending to deficit units Primary financial assets are issued by deficit units to intermediaries, and secondary financial assets are issued by intermediaries to surplus units Financial institutions earn income by way of net interest margin Advantages of financial intermediation: Asset value transformation Maturity transformation Credit risk reduction and diversification Liquidity provision Disadvantages of financial intermediation Increased cost of funds for borrowers Reduced return from lending for savers Deposit Taking Financial Institutions: attract the savings of depositors through on-demand deposit and term deposit accounts. e.g. commercial banks, building societies and credit cooperatives. Non Deposit Taking Financial Institutions: may managed funds under contractual arrangements and provide a wide range of financial services. e.g. Investment banks, general insurance companies and superannuation funds. Main types of financial institutions: Commercial banks Building societies and credit cooperatives Investment banks and Merchant Banks Managed funds Life insurance offices and general insurance offices
Finance companies and general financiers Government policy In terms of government regulation, the last 50 years can be divided into the following distinct periods: Regulation (pre-1980s) Deregulation (1980s) Post-deregulation (1990s onward) Reasons for government intervention Macroeconomic objectives: growth, full employment, price stability, external balance Efficient, fair and competitive financial system Promotion of financial safety Methods of government intervention Fiscal policy (budget and taxes) Monetary policy (RBA) External policy (tariff and cap on fund flows) Wages policy (superannuation) Direct legislation (corporation law) Competition policy (avoid oligo/monopolies) Consumer protection (ombudsman, ACCC) Topic 2 Interest rates can represent: the cost of borrowing funds the rate of return from lending the opportunity cost of holding money the time value of money Simple interest Compound interest formula for interest compounded annually Effective/comparative rate interest rate
Price of a discount security Price of long term fixed-interest security The level of interest rates The overall position of interest rates, as a whole, within the aggregate economy or financial system Note: In finance, when we refer the interest rate, we normally refers to the nominal rate Nominal rate = Real rate + Inflation effect Determination of the level of interest rates Loanable funds theory The level interest rate can partially be explained by the loanable fund theory. The price of loanable funds (ie. the interest rate) will be the equilibrium price established by the interaction of the supply of and demand for loanable funds Inflationary expectations Suppliers of loanable funds will demand a higher rate of interest to maintain the real (after
inflation) rate of return Demanders of loanable funds will increase their demand for funds to maintain their preinflation investment plans Central bank action Central banks intervene in the money market to influence the money supply, by buying and selling government securities The increase or decrease in the money supply (respectively) will result in a change in the equilibrium interest rate Determinants of the shape of the yield curve 1. Market (pure) expectations theory The term structure of interest rates is determined by: a. Current short-term rates b. Expected future short-term rates c. Predicts that long-term rates will be the average of the expected future shortterm rates over the period Assumptions: d. Investors are primarily concerned with maximising returns e. They see all investments, regardless of maturity, as perfectly substitutable f. Financial markets operate efficiently 2. Expectations plus liquidity premium In order to encourage investors to invest long-term, borrowers must offer higher returns for long-term investments - a liquidity premium Predicts that the yield curve will show an upward bias compared to the yields predicted by pure expectations Assumption: Investors are indifferent between short and long-term investments, BUT require a liquidity premium to compensate them for the higher risk associated with longterm investments 3. Segmented market approach Markets for financial assets with different terms to maturity are seen as separate markets from each other Predicts that yield for different maturities will be a function of supply of and demand for investments with that maturity
Assumptions: Investors see investments with different maturities as imperfect substitutes They are primarily concerned with matching the maturity of assets and liabilities in order to minimise risk Topic 3 Money Market Nature of the market Borrow and lending for less than 1 year Buying and selling of financial assets with maturities of less than 1 year Only debt financial assets are traded in the Money Market Features of the market No physical location The Money Market is a world-wide communications network and a mechanism which allows short-term debt assets to be created and traded Over the Counter (OTC) market There is no central exchange. Market participates must contract directly with another counterparty to complete a transaction Primarily a wholesale market The majority of Money Market transactions are of the order of several million dollars in value Functions of the market Transfer of funds from surplus economic units to deficit economic units for periods of less than 1 year Trading of existing debt financial assets which have maturities of less than 1 year Short-term government funding Instrument of monetary policy Indirect (intermediated) finance Liquidity Management need to match maturity of assets and liabilities Interest Rate Management maintain a match between fixed and variable interest rates Capital Management Central bank require corporations to maintain minimum ratios of capital to assets (Basel 3 Capital Accord) Participants Central banks Commercial banks Merchant banks Finance companies Brokers Corporations
Alternative sources of short-term finance for corporations Trade credit Using credit terms from suppliers to delay payment of invoices Accruals Delaying payment of obligations such as tax and leave entitlements Factoring/debtor finance Selling the companies debtors debts (account receivables) Cash products Overnight cash (11 am cash) Initial deposit or loan is made overnight Deposits/withdrawals by 11am the following day, or the loan/deposit is rolled over for another day Interest rate reset daily Parcels of 5/10 million Market mainly used by Banks 7-day cash (24 hour cash) Initial period of deposit/loan is 7 days After 7 days, deposits/withdrawals require 24 hours notice Interest rate reset daily after initial 7 day period Bid is the buying rate of the price maker Offer is the selling rate of the price maker Other short-term loans Committed loans Uncommitted loans Bank overdrafts Customer permitted to overdraw cheque account up to agreed limit Interest charged daily (compounded daily) Repayable on demand Rate higher than fully-drawn loans Rate are usually follow Bank Bill Swap Index (BBSW) Discount Securities Commercial Bills Promissory Notes Treasury Notes Certificates of Deposit Repurchase Agreements (Repos) Commercial Bills An unconditional order in writing addressed by one person to another, signed by the person to whom it is addressed to pay on demand or at a fixed or determined future time a sum certain in money to or to the order of a specified person(s). Usually involve 3 parties: Drawer (borrower) Acceptor/Drawee/Guarantor Discounter (lender) If the bill is sold in the secondary market, it must be endorsed, which incurs a contingent liability
Promissory Notes Also known as P-Notes or Commercial Paper Essentially an IOU Only issued by large companies with excellent credit ratings No contingent liability when sold Higher yields than BABs