Introduction to Financial Markets

Essay by filodreUniversity, Bachelor's December 2009

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1 Introduction to Financial Markets1.1 The financial system - financial institutions, markets and instruments supervised by a prudential regulator. Financial system provides economic and financial information to the markets. An efficient FS absorbs and reflects new information into the price of financial instruments.

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 nation's 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 assetstrade of existing financial assets in secondary financial marketsfacilitate portfolio structuring - Combination of assets and liabilities each comprising of return, risk, liquidity and timing of cash flows that best suit each saver's particular needs.

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

1.1.1 Surplus economic unitsThese 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 unitsThese 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 institutionsThese 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 assetsFinancial assets represent a claim or right that a surplus economic unit holds over a deficit economic unit. They provide the surplus economic unit with a store of value or future consumption or investment. To the deficit economic unit financial assets they have issued represent a liability or obligation.

Whenever, funds are lent and borrowed, financial assets (also referred to as financial instruments) 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. viz.:return or yield - Total financial benefit received (interest and capital gain) from an investment.

risk - Possibility/Probability that an actual outcome (return) will vary from expected outcome; uncertainty.

liquidity - Access to sources of funds to meet day to day expenses and commitments.

time pattern of return or cash flow - Frequency of periodic cash flows (interest and principal) associated with a financial instrument.

The financial assets that are created and exchanged can be divided into the following four broad types: These are also called financial instruments.

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 depositsContractual savings- eg life insurance, superannuationDiscount securities - eg commercial billsFixed interest securities - eg bonds, debenturesEquity: The sum of the financial interest an investor has in an asset; an ownership position. 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 - Principal form of equity issued by a corporation, bestows certain rights to the shareholder. Dividend is also another example - Part of a corp's profit that is distributed to shareholders.

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, mainly used to manage risk exposures.

Futures contract - involves entering into a contract today to buy or sell a specific amount of commodity or financial instrument at a predetermined future date.

Forward contract - over the counter agreement that locks in a price (interest or exchange rate) that will apply at a future date.

Option contract - The right but not an obligation to buy or sell a commodity or financial instrument at a predetermined price at a specified date or within a specified period. Buyer is not obliged to proceed with the contract and has to pay a premium to the writer of the option.

Swap contract - Agreement between two parties to swap future cash flows; interest rate swaps and currency swaps.

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 marketsAn 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 nation's 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.

Primary Markets - 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). Or when a corp issues additional ordinary shares to raise further equity funds for an investment project, or government selling long term bonds to finance spending on capital works, health or education, or people who borrow money from a bank to purchase a house.

Secondary Markets - 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. Company receives NO extra funds from the secondary market transactions, secondary market transactions have no direct impact on the amount of funds available to the company.

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 Foreign Exchange Market•The Money Market•The Debt-Capital Market•The Equity Market•The Derivatives MarketOBJECTIVE 2After 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 financeThe 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 - Funding obtained direct from the money and capital markets through a direct flow of funds.

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.

Broker - Agent who carries out the instructions of a client and receives fee for facilitating the transaction between the client and the supplier.

Dealer - Makes a market in a security by quoting both buy and sell offer prices.

Benefits of Direct finance:•Removes cost of a financial intermediary. Corporations or governments can raise funds directly from domestic or international markets at a lower cost than it would incur by borrowing through a financial intermediary such as a bank.

•Allows user of funds to access different funding markets, enabling diversification of funding sources. Reduces risk of exposure to a single funding source or market. As economic conditions change, traditional suppliers may not be able to provide further funding, eg this is evident in Thailand and Indonesia as a result of the Asian financial crisis in 1997-98.

•Greater flexibility in the types of funding instruments used for different financing needs. Users can increase funding by access of both domestic and international capital markets for direct finance, can finance more sophisticated funding strategies and raise international profile of the organisation, essential in establishing a good reputation for the firm's G&S.

Disadvantages of Direct finance:•Problem of matching preferences of suppliers and users of funds. A saver may need additional funds, and need to seek out additional suppliers. There may also be a mismatch in the maturity structure of the funding eg borrowers often prefer to borrow over a longer period while risk-averse investors prefer to invest for a shorter period.

•Liquidity and marketability of a financial instrument may be of concert. Not all financial instruments have an active secondary market through which the security may be sold.

•Transaction costs associated with a direct issue can be high. Eg cost of preparing prospectus, legal fees, taxation advice, accounting advice and other expert advise eg. Geologist.

•Can be difficult to assess level of risk of investment in a direct issue, particularly default risk - risk that a borrower may not meet financial commitments such as loan repayments when they are due. Accounting and reporting standards may also vary between nation-states.

1.2.2 Indirect finance - 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.

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 then 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: financial intermediaries, due to their size and specialisation in borrowing and lending are able to provide their customers with a range of services including 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.

Economies of scale: Financial and operational benefits gained from organisational size and volume of business.

1.2.4 Disadvantages of financial intermediationTheir 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 borrowersReduced 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 to describe this process.

OBJECTIVE 3After working through this section you should be able to explain the relationship between the financial system and the economic system.

1.3 The financial and economic systemsIn 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.

1.3.1 The economic systemA nation's economic system is concerned with the production and distribution of goods and services. In performing this function, a nation's economic performance is normally assessed in terms of the following economic objectives:economic growthfull employmentprice stabilityexternal balanceefficient allocation of resourcesequitable distribution of income and wealth1.3.2 The financial system and economic objectivesA nation's financial system will affect its performance with respect to each of the economic objectives listed above. Economic growthHistorically, there is a well established relationship between the development of a nation's 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 nation's economic growth rate. Full employmentThe 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. Price stabilityThe 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 nation's 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 ploicy. External balanceExternal balance refers to a desirable position in terms of a nation's international transactions, as reflected in that country's 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 nation's balance of payments will be significantly determined by domestic and international financial market conditions.

As international transactions determine the demand and supply for a nation's currency, financial market conditions will also have a significant affect on the foreign exchange value of that nation's currency. Efficient allocation of resourcesAn efficient allocation of resources is where a nation's 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. Equitable distribution of income and wealthNon-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 4After working through this section you should be able to outline the main reasons for, and methods of, government intervention into finance markets.

1.4 The government and finance marketsOver 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 1980's): During this period the Australian financial system was characterised by an extensive array of direct controls, particularly over banks.

Deregulation (1980's): 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 (1990's): 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 Topic 21.4.1 Reasons for government interventionAll 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 nation's 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.

1.4.2 Methods of government interventionThere 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 policythe financing of a budget deficit or disposal of a budget surplusindividual outlay and revenue items.

Monetary policyopen market operationsreserve asset requirements.

External policyexchange rate policyactions affecting exports and importscapital inflow/outflow controls.

Wages policy eg superannuation requirements.

Competition policyeg 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.

ReferencesViney, "Financial Institutions Instruments and Markets, 5th Edition", 2006, McGraw Hill