PowerPoint Slides
to accompany
McGrath’s Financial Institutions,
Instruments and Markets
Fifth Edition by Christopher Viney
Designed and Written by
Anthony Stanger
School of Commerce
The Flinders University of South Australia
Copyright  2007 McGraw-Hill Australia Pty Ltd
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-1
Chapter 1
A Modern Financial System
Websites:
www.rba.gov.au
www.treasury.gov.au
www.bis.org
www.ny.frb.org
www.asx.com.au
www.ft.com/asia/
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-2
Learning Objectives
• Explain the functions of a financial system
• Categorise the main types of financial institutions
• Describe the main classes of financial instruments
issued in a financial system
• Discuss the flow of funds between savers and
borrowers, including primary/secondary markets
and direct/intermediated finance
• Distinguish between various types of financial
markets according to function
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-3
Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6
Functions of a Financial System
Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-4
1.1
Functions of a Financial System
• Money
– Acts as medium of exchange
– Allows specialisation in production
– Solves the divisibility problem, i.e. where medium of
exchange does not represent equal value for the parties
to the transaction
– Facilitates saving
– Represents a store of wealth
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-5
1.1 Functions of a Financial System
(cont.)
• Role of markets
– Facilitate exchange of goods and services by
 Bringing opposite parties together
 Establishing rates of exchange, i.e. prices
• Surplus units
– Savers of funds available for lending
• Deficit units
– Borrowers of funds for capital investment and
consumption
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-6
1.1 Functions of a Financial System
(cont.)
• Financial instrument
– Issued by a party raising funds, acknowledging a financial
commitment and entitling holder to specified future cash
flows
• Double coincidence of wants satisfied
– A transaction between two parties that meets their mutual
needs
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-7
1.1 Functions of a Financial System
(cont.)
• Flow of funds
– Movement of funds through the financial system between
savers and borrowers giving rise to financial instruments
• Financial system
– Comprises financial institutions, instruments and markets
facilitating transactions for goods and services and
financial transactions
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-8
1.1 Functions of a Financial System
(cont.)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-9
Function of Financial Markets
© 2012 Pearson Prentice Hall. All rights reserved.
2-10
1.1 Functions of a Financial System
(cont.)
• Attributes of financial assets
– Return or yield
 Total financial compensation received from an investment
expressed as a percentage of the amount invested
– Risk
 Probability that actual return on an investment will vary from
the expected return
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-11
1.1 Functions of a Financial System
(cont.)
• Attributes of financial assets (cont.)
– Liquidity
 Ability to sell an asset within reasonable time at current
market prices and for reasonable transaction costs
– Time-pattern of the cash flows
 When the expected cash flows from a financial asset are to
be received by the investor or lender
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-12
1.1 Functions of a Financial System
(cont.)
• Facilitation of portfolio restructuring
– The combination of assets and liabilities comprising the
desired attributes of return, risk, liquidity and timing of
cash flows
• Implementation of monetary policy
– Actions of a central bank taken to influence interest rate
levels to achieve certain economic outcomes
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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1-13
1.1 Functions of a Financial System
(cont.)
• An efficient financial system
– Encourages savings
– Directs savings to the most efficient users
– Implements the monetary policy of governments by
influencing interest rates
– Is a combination of assets and liabilities comprising the
desired attributes of return, risk, liquidity and timing of
cash flows
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-14
Why Study Financial Markets?
Financial markets, such as bond and stock markets, are
crucial in our economy.
1. These markets channel funds from savers to
investors, thereby promoting economic efficiency.
2. Market activity affects personal wealth, the behavior
of business firms, and economy as a whole
Well functioning financial markets, such as the bond
market, stock market, and foreign exchange market, are
key factors in producing high economic growth.
© 2012 Pearson Prentice Hall. All rights reserved.
1-15
Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6
Functions of a Financial System
Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-16
1.2
Financial Institutions
• Financial institutions permit the flow of funds
between borrowers and lenders by facilitating
financial transactions
• Institutions may be categorised by differences in
the sources and uses of funds
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-17
1.2
Financial Institutions (cont.)
• Categories of financial institutions
– Depository financial institutions
– Investment banks and merchant banks (money market
corporations)
– Contractual savings institutions
– Finance companies
– Unit trusts
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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1-18
Categories of financial institutions (cont.)
Contractual savings institutions
• The liabilities of these institutions are contracts that specify, in
return for periodic payments to the institution, the institution
will make payments to the contract holders if a specified
event occurs, e.g.
– Life and general insurance companies and superannuation
funds
• The large pool of funds are then used to purchase both
primary and secondary market securities
• Payouts are made for insurance claims and to retirees
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-19
Categories of financial institutions (cont.)
Finance companies
• Funds are raised by issuing financial securities, such as
commercial paper, medium-term notes and bonds, directly
into money markets and capital markets
• Funds are used to make loans and provide lease finance to
customers in the household and business sectors
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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1-20
Categories of financial institutions (cont.)
Unit trusts
• Formed under a trust deed and controlled and managed by a
trustee
• Funds raised by selling units to the public. Investors
purchase units in the trust
• Funds are pooled and invested by fund managers in a range
of asset classes specified in the trust deed
• Types of unit trusts include equity, property, fixed interest and
mortgage trusts
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-21
1.2
Financial Institutions (cont.)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-22
CHAPTER 7
Why Do Financial
Institutions Exist?
Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
Transaction Costs
 Transactions costs can hinder the flow of funds to
people with productive investment opportunities
 Financial intermediaries make profits by reducing
transactions costs
1. Take advantage of economies of scale
(example: mutual funds)
2. Develop expertise to lower transactions costs
• Also provides investors with liquidity, which explains Fact # 3
(slide 7-9)
© 2012 Pearson Prentice Hall. All rights reserved.
7-24
Adverse Selection Problems
 Adverse Selection Problem in Securities Markets
─ If we can't distinguish between good and bad
securities, willing pay only average of good and bad
securities’ value
─ Result: Good securities undervalued and firms won't
issue them; bad securities overvalued so too many
issued
 Financial intermediaries help Solve Adverse
Selection Problem
© 2012 Pearson Prentice Hall. All rights reserved.
7-25
Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6
Functions of a Financial System
Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-26
Major Classes of Financial Assets or
Securities
• Equity Securities
• Debt:
– Money market
– Bond market
• Derivative markets
2-27
1.3
Financial Instruments
• Equity
– Ownership interest in an asset
– Residual claim on earnings and assets
 Dividend
 Liquidation
– Types
 Ordinary share
 Hybrid (or quasi-equity) security
• Preference shares
• Convertible notes
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-28
1.3
Financial Instruments (cont.)
• Debt
– Contractual claim to
 Periodic interest payments
 Repayment of principal
– Ranks ahead of equity
– Can be
 Short-term (money market instrument), or medium- to longterm (capital/bond market instrument)
 Secured or unsecured
 Negotiable (ownership transferable, e.g. commercial bills
and promissory notes) or non-negotiable (e.g. term loan
obtained from a bank)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-29
1.3
Financial Instruments (cont.)
• Derivatives
– A synthetic security providing specific future rights that
derives its price from
 A physical market commodity
• Gold and oil
 Financial security
• Interest rate-sensitive debt instruments, currencies and
equities
– Used mainly to manage price risk exposure and to
speculate
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-30
1.3
Financial Instruments (cont.)
• Four basic derivative contracts
–
–
–
–
Futures contract (Chapter 18)
Forward contract (Chapters 17 & 18)
Option contract (Chapter 19)
Swap contract (Chapter 20)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-31
Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6
Functions of a Financial System
Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-32
3.1 What is a Market?
• A market is the means through which buyers
and sellers are brought together to aid in the
transfer of goods and/or services
• A market:
• Need not have a physical location
• Does not necessarily own the goods or services
involved
• Can deal in any variety of goods and services
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
3-33
3.1.1 Characteristics of a Good Market
• Characteristics of a good market:
1. Timely and accurate information on price and
volume of past transactions
2. Liquidity
•
•
•
Marketability
Price continuity
Depth
3. Low transaction costs
•
•
•
Cost of reaching the market
Brokerage costs
Cost of transferring the asset
4. Prices that rapidly adjust to new information
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posted to a publicly accessible website, in whole or in part.
3-34
1.4
•
•
•
•
•
•
Financial Markets
Primary and secondary market transactions
Exchanges and Over-the-Counter Markets
Direct and intermediated financial flow markets
Wholesale and retail markets
Money markets and Capital markets
Debt markets and Equity markets
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-35
Primary and secondary market transactions
• Primary market transaction
– The issue of a new financial instrument to raise funds to
purchase goods, services or assets by
 Businesses
• Company shares or debentures
 Governments
• Treasury notes or bonds
 Individuals
• Mortgage
– Funds are obtained by the issuer
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-36
Primary and secondary market transactions
(cont.)
• Secondary market transaction
– The buying and selling of existing financial securities
 No new funds raised and thus no direct impact on original
issuer of security
 Transfer of ownership from one saver to another saver
 Provides liquidity, which facilitates the restructuring of
portfolios of security owners
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-37
Structure of Financial Markets
We can further classify secondary markets as
follows:
1. Exchanges
─ Trades conducted in central locations (e.g., New
York Stock Exchange, CBT)
2. Over-the-Counter Markets
─ Dealers at different locations buy and sell
─ Best example is the market for Treasury securities
www.treasurydirect.gov
NYSE home page http://www.nyse.com
© 2012 Pearson Prentice Hall. All rights reserved.
2-38
3.3.1 Why Secondary Markets Are Important
• Provides liquidity to the individuals who acquired
these securities
• Important to those selling seasoned securities
because the prevailing market price of the
securities (price discovery) is determined by
transactions in the secondary market
• Affects market efficiency and price volatility
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posted to a publicly accessible website, in whole or in part.
3-39
Direct and intermediated financial flow
markets
• Direct financial flow markets
– Users of funds obtain finance directly from savers
 Advantages
• Avoids costs of intermediation
• Increases range of securities and markets
 Disadvantages
•
•
•
•
Matching of preferences
Liquidity and marketability of a security
Search and transaction costs
Assessment of risk, especially default risk
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-40
Direct and intermediated financial flow
markets (cont.)
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1-41
Direct and intermediated financial flow
markets (cont.)
• Intermediated financial flow markets
– A financing arrangement involving two separate
contractual agreements whereby saver provides funds to
intermediary and the intermediary provides funding to the
ultimate user of funds
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-42
Direct and intermediated financial flow
markets (cont.)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-43
Direct and intermediated financial flow
markets (cont.)
• Advantages
– Asset transformation
 Borrowers and savers 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
 Saver’s credit risk limited to the intermediary
– Liquidity transformation
 Ability to convert financial assets into cash
– Economies of scale
 Financial and operational benefits of organisational size and
business volume
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1-44
Wholesale and retail markets
• Wholesale markets
– Direct financial flow transactions between institutional
investors and borrowers
 Involves larger transactions
• Retail markets
– Transactions conducted primarily with financial
intermediaries by the household and small- to mediumsized business sectors
 Involves smaller transactions
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-45
Classifications of
Financial Markets
We can also further classify markets by the
maturity of the securities:
1. Money Market: Short-Term
(maturity <= 1 year)
2. Capital Market: Long-Term
(maturity > 1 year) plus equities
© 2012 Pearson Prentice Hall. All rights reserved.
2-46
Money markets
• Wholesale markets in which short-term securities
are issued (primary market transaction) and traded
(secondary market transaction)
– Securities highly liquid
 Term to maturity of one year or less
 Highly standardised form
 Deep secondary market
– No specific infrastructure or trading place
– Enable participants to manage liquidity
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-47
Money markets (cont.)
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1-48
Money markets (cont.)
• Money market submarkets exist for
–
–
–
–
–
Central bank: system liquidity and monetary policy
Inter-bank market
Bills market
Commercial paper market
Negotiable certificates of deposit (CDs) market
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Slides prepared by Anthony Stanger
1-49
Capital markets
• Markets in which longer-term securities are issued
and traded with original term-to-maturity in excess
of one year
– Equity markets
– Corporate debt markets
– Government debt markets
• Also incorporate use of foreign exchange markets
and derivatives markets
• Participants include individuals, business,
government and overseas sectors
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-50
Structure of Financial Markets
1. Debt Markets
─
─
─
─
Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $52.4 trillion at the end of 2009.
2. Equity Markets
─
─
─
Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $20.5 trillion at
the end of 2009.
© 2012 Pearson Prentice Hall. All rights reserved.
2-51
Importance of Financial Markets
 Financial markets are critical for producing an
efficient allocation of capital, allowing funds to
move from people who lack productive
investment opportunities to people who have
them.
 Financial markets also improve the well-being
of consumers, allowing them to time their
purchases better.
© 2012 Pearson Prentice Hall. All rights reserved.
2-52
Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6
Functions of a Financial System
Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-53
1.5
Flow of Funds and Market
Relationships
• Sectorial flow of funds
– The flow of funds between business, financial institutions,
government and household sectors and the rest of the
world
– Net borrowing and net lending of these sectors of an
economy vary between countries
– Influenced by
 The impact of fiscal and monetary policy on savings and
investment decisions
 Policy decisions like compulsory superannuation
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-54
Chapter Organisation
1.1
1.2
1.3
1.4
1.5
1.6
Functions of a Financial System
Financial Institutions
Financial Instruments
Financial Markets
Flow of Funds and Market Relationships
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
1-55
1.6
Summary
• The financial system is composed of financial
institutions, instruments and markets facilitating
transactions for goods and services and financial
transactions
• Financial instruments may be equity, debt or hybrid
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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1-56
1.6
Summary (cont.)
• Financial markets may be classified according to
–
–
–
–
–
–
Primary and Secondary transactions
Direct and Intermediated flows
Wholesale and Retail markets
Money markets and Capital markets
Debt markets and Equity markets
Exchanges and Over-the-Counter Markets
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Anthony Stanger
1-57