Lecture 1 Notes

Explain the functions of a financial system

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Money (medium of exchange, store of wealth, facilitates savings, solved divisibility problem)
5 sector economy;
o Household sector provide labour, pay for consumption, invest surplus funds
o Firms sector provide payment for labour, receive money from sales, borrow money
o Financial Sector receive funds from savings, lend funds to firms
o Government sector receive funds through taxation, use funds through govt
expenditure
o Overseas Sector receive funds through exports, spend funds through imports
Overall Function: Financial Sector facilitates the flow of funds between deficit and surplus
funds through borrowing and lending.
Breakdown of functions;
o Provide investment products for surplus funds
o Provide alternative funding sources for deficit
o Provide risk management products
Financial system = institutions + instruments + market, to facilitate the flow of funds
Primary Financial Market facilitate transfer of funds by creation of new financial assets
Secondary Market transfer of funds by arranging trades of existing financial assets
Efficient financial system = directs surplus funds to most efficient users of those funds (not the
same as most needed users of funds)
Overseeing the financial system by the prudential supervisor

Categorise the main types of financial institutions

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Classified into 5 categories based on the source and uses of funds:

Depository financial institutions (commercial banks)

o Obtain large proportion of their funds from deposits from saver
o Provide loans to borrowers in household and business sector
Investments banks and merchant banks
o Provide off-balance sheet advisory services to support corporate and govt client (i.e.
M&A, portfolio restructuring and risk management) = source of funds
o May provide some loans but more likely to assist client in directly raising the funds
Contractual savings institutions
o Example Life insurance offices, general insurers and superannuation funds
o Source of funds periodic payments received in exchange for the
insurance/superannuation contract
o Use of funds Specified payout to the holder of the contract if and when the specific
event occurs as per the contract
o Use of funds the periodic payments are invested by receiving advice from investment
banks

Finance companies
o Source of funds Issue financial securities to raise money
o Use of funds Make loans and provide lease finance to customers in household and
business sector
o Essentially borrow large, lend into smaller components
Unit trust
o Formed under trust deed and controlled + managed by trustee/responsible entity
o Source of funds BY getting investors to purchase units in a trust
o Use of funds Invested by fund managers in asset classes speficied in trust deed
o Types: Equity trusts, property trusts, fixed interest trusts and mortgage trusts

Describe the main classes of financial instruments issued in a financial system

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Financial Asset: entitlement to future cash flows (shares, deposits)

Financial Instrument: used to describe financial where is no organized secondary market where
that instrument can be traded
Financial security: financial asset that can be traded in secondary market
Financial Assets Attributes
o Return or yield total financial compensation received expressed as % of amount
invested
o Risk probability that actual return on an investment will vary from the expected return
(can be positive risk)
o Liquidity ability to sell within reasonable time, at current market price and for
reasonable transaction costs (time, price, cost)
o Time-pattern of cash flows when the expected cash flows are to be received (doesnt
mean maturity)
Types of financial instruments:
o Equity ownership interest in an asset
o Debt - Contractual claim to interest payments and repayment of principal
o Derivatives Facilitate the management of certain related risk (futures, forward, option
& swap contracts)
o Hybrid Incorporates the characteristics of both debt and equity (i.e. preference shares)

Distinguish between various types of financial markets according to function

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Financial markets are characterized by lending and borrowing funds & creation and trading of
financial assets
Distinguished from other economic markets such as market for final goods
Categorized according to type of transaction (i.e. debt, equity )
Matching principle
o short-term assets should be funded with short-term liabilities
o long-term assets should be funded with equity or longer-term liabilities

lack of adherence to this principle accentuated effects of frozen money markets with
the subprime market collapse
Primary market
o Issue of new financial instruments to raise goods
Secondary market
o Buying and selling existing financial securities
o No new funds being raised (no impact on original issuer)
o Transfer of ownership
o Provides liquidity
Direct Finance and Intermediated Finance
o Issue of new financial instruments generates flow of funds from investor to user of
funds. Flow occurs in 2 ways:
o Direct relationship from provider of funds to user only available to corporations and
govt authorities with good credit.
o Intermediated flow: provide fund to intermediary and they pass the funds on
Wholesale vs retail markets
o Wholesale markets direct flow between institutional investor and borrower (involves
large transactions)
o Retail market - transactions conducted with financial intermediaries by household and
SME business sector (involves smaller transactions)
Money market vs capital market
o Money market is for short-term securities (less than year). Based on maturity of the
financial security. Doesnt include equity
o Capital market longer-term securities (more than a year). Includes equity

Discuss the flow of funds between savers and borrowers, including primary/secondary markets and
direct/intermediated finance