FINS1612
Week 0
Week 1
Why study finance? For the money
Financial institutions are classified into five categories based on the differences between the
institutions’ sources and uses of funds
1.Depository financial institutions (Commercial banks)
 obtains a large proportion of their funds from deposits lodged by savers.
 A principal business of these institutions is the provision of loans to borrowers in the
household and business sectors
2.Investment banks and merchant banks
 Major function is to provide off-balance sheet advisory services to support their
corporate and government clients
 Off balance sheet business includes advising clients on mergers and acquisitions,
portfolio restructuring, and risk management. Off balance sheet means items that are
going to happen in the future such as contingent liabilities
 These institutions may provide some loans to clients but are more likely to advise
and assist a client to raise funds directly in the capital markets
 Not about collecting money but more about giving advice.
3.Contractual savings institutions
 Financial institutions such as life insurance offices, general insurers and
superannuation funds
 Their liabilities are mainly contracts which specify that, in return for periodic
payments to the institution, the institution will make specified payouts to the holder of
the contract if and when the event specified in the contract occurs. Think about
NRMA where you are paying money as premium. Can only get payout if event
specified in contract occurs.
 The periodic cash receipts received by these institutions provide them with a large
pool of funds that they invest.
 Gets advice from investment banks on where to invest
4.Finance companies
 These institutions raise funds by issuing financial securities such as commercial
paper, medium term notes and bonds in the money markets and the capital markets
 They use those funds to make loans and provide lease finance to their customers in
the household sector and the business sector
 Act as deficit and then act as surplus and pay back to households
5.Unit trust
 A unit trust is formed under a trust deed and is controlled and managed by a trustee or
responsible entity
 Unit trusts attract funds by inviting the public to purchase units in a trust. The funds
obtained from the sale of units are pooled and then invested by funds managers in
asset classes specified in the trust deed.
 There is a wide range of unit trusts, including equity trusts, property trusts, fixed
interest trusts and mortgage trust.
FINANCIAL ASSETS
A financial asset is defined as entitlement to future cashflows
-Attributes of financial assets:
 Return-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 •
 Liquidity-Ability to sell an asset within reasonable time at current market prices and
for reasonable transaction costs •
 Time pattern of Cash flows -When the expected cash flows from a financial asset are
to be received by the investor or lender (eg when dividends will come in)
A financial security is a financial asset that can be traded in secondary market.
All financial securities are assets but not all financial assets are securities.
Financial instruments
 Equity ◦ Ownership interest in an asset ◦ Residual claim on earnings and assets ◦
Dividend ◦ liquidation
 Debt ◦ Contractual claim to: ◦ periodic interest payments ◦ repayment of principal. ◦
Ranks ahead of equity
 Derivatives ◦ A synthetic security providing specific future rights that derives its price
from another asset ◦ Used mainly to manage price risk exposure and to speculate
 Hybrid ◦ Features both equity & debt characteristics. Eg. Preferred shares
Market economy vs Planned economy
- Planned is predetermined prices and set quantities
- Market economy is based on consumer behaviour
- Markets are needed to know how to set the price
Matching principle
 Short-term assets should be funded with short-term (money market) liabilities; e.g.
seasonal inventory needs funded by overdraft.
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Longer term assets should be funded with equity or longer term (capital market)
liabilities; e.g.: ◦ equipment funded by debentures ◦ lack of adherence to this principle
accentuated effects of frozen money markets with the ‘sub-prime’ market collapse
Unfortunately banks borrow short term and lend long term.
Primary vs Secondary market transactions
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Primary market transaction
o ◦ The issue of a new financial instrument to raise funds to purchase goods,
services or assets by:
Secondary market transaction
o ◦ The buying and selling of existing financial securities
Direct vs Intermediated finance Direct finance ◦ Users of funds obtain finance through primary
market via direct relationship with providers (savers) ◦ Advantages ◦ Avoids costs of intermediation ◦
Increases access to diverse range of markets ◦ Greater flexibility in range of securities users can issue
for different financing needs ◦ Disadvantages ◦ Matching of preferences ◦ Liquidity and marketability
of a security ◦ Search and transaction costs ◦ Assessment of risk, especially default risk
Direct financial flow transactions between institutional investors and borrowers • Involves larger
transactions eg government, big businesses
Money vs Capital markets 
Money markets: Wholesale markets in which Short-term securities are issued (eg 90 day debts)
Capital Markets: Wholesale markets in which Long-term securities are issued (equity and long term
loans)
Commercial banks
Overview: • Commercial banks provide a full range of financial services
Pre 1980’s (pre deregulation) - Asset management • Loans portfolio is tailored to match the
available deposit base
Post 1980’s - Liability management • Deposit base and other funding sources are managed to meet
loan demand
Banks have become very greedy and lend out lots of loans to get back interest.
Banks deposits are liabilities and loans are assets for the bank
Importance of banks
• A major “financial intermediation” which provides the following benefits to the financial system: •
Asset transformation • Maturity transformation • Credit risk diversification & transformation •
Liquidity transformation • Economies of scale
Take deposits and transform them into loans which they lend out which makes them intermediaries
Lend long and borrow short
Guest Lecturer (Veronica- UNSW Alumni)
Textbook Notes
Simplification of how financial institutions, instruments and markets work: (1) risk and reward; (2)
supply and demand; (3) no arbitrage; and (4) the time value of money.
The returns that investors expect to earn are positively related to the risk they must bear. We might
speak of shareholder returns, bond yields, interest rates or cash flows from a project. These are just
different names for the returns that can be earned by bearing some degree (perhaps zero) of risk.
When the risk is perceived to be greater, the returns that investors demand will be higher. Whatever
we might call them, the rewards from investing depend on the risk that the investor must bear. All
investment returns follow the same rules. If the risk is greater, the expected return is higher.
no arbitrage: trader cannot buy a financial instrument in one market at a low price while
simultaneously selling that same thing at a higher price in a different market. If this were possible,
the trader could earn infinite returns at zero risk. That would contradict the risk–reward trade-off
interest: the reward for waiting.
pure time value of money is positive because people are generally impatient to consume now and
must be rewarded for waiting. All of the rates of return that we observe on the financial markets
consist of the pure time value of money, plus a premium for risk, plus a premium for inflation. This is
the case for every rate of return we observe. Whether it is a shareholder’s return, a bondholder’s
bond yield or a conservative investor’s term deposit rate, the return is a sum of the pure time value
of money, a premium for risk and a premium for inflation. The risk premium may, of course, be zero
for risk-free investments
Advantages of money:
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makes it easier for individuals to save their surplus earnings. Saving may be defined as
deferring consumption into the future. The funds saved by surplus units—those savers with
current excess funds—can be put to use by those whose current demand for goods and
services is greater than their current available funds. Such users of funds are called
borrowers or deficit units
When a financial transaction takes place, it establishes a claim to future cash flows. This is
recorded by the creation of a financial asset on the balance sheet of the saver. The financial
asset is represented by a financial instrument that states how much has been borrowed, and
when and how much is to be repaid by the borrower. For example, if you invested money in
a term deposit with a bank, the bank would issue a term deposit receipt to you. This is a
financial instrument.
2 Describe the flow of funds that characterises any financial system. (LO 1.1)
4 Risk preferences shape the decisions that people and businesses make when under
conditions characterised by risk and uncertainty. Outline the three ways in which economists
categorise decision makers and explain how each type of decision maker will choose
differently when confronted with a risky choice. (LO 1.2)
6 Financial instruments may be categorised as equity, debt or derivatives. Discuss each
category. In your answer, make sure you explain the differences between debt, equity and
derivatives. (LO 1.3)
7 During the GFC, the funding of longer-term assets with short-term borrowing was identified
as a point of weakness in the operations of financial institutions. Discuss this statement with
reference to the matching principle. (LO 1.4)
9 Explain the meaning of the terms ‘financial assets’, ‘financial instruments’ and ‘securities’.
What is the difference between these terms? Give examples of financial instruments and
securities. (LO 1.4)
10 Banks are the major providers of intermediated finance to the household and business
sectors of an economy. In carrying out the intermediation process, banks perform a range of
important functions. List these functions and discuss their importance for the financial
system. (LO 1.4)
13 Discuss the sectorial flow of funds. In your answer, identify five sectors that are
representative of the sectorial flow of funds. Why is an understanding of the sectorial flow of
funds important for economic policy determination? (LO 1.6)
Chapter 2: 1, 3, 4, 5, 6, 7, 8, 9, 11, 12
1 ‘Deregulation has changed banking practices in Australia.’ Discuss this statement with reference to
banks’ asset and liability management. (LO 2.1)
3 A customer has approached your commercial bank seeking to invest funds for a period of six
months. The customer is particularly worried about geopolitical risk following recent tensions in the
Middle East and elsewhere. Explain the features of call deposits, term deposits and CDs to the
customer, and provide advice on risk-reward trade-offs that might be associated with each
product. (LO 2.2)
4 Discuss the four main uses of funds by commercial banks and identify the role that the purchase of
government securities plays in commercial banks’ management of their asset portfolios. (LO 2.3)
5 Commercial banks are the principal providers of loan finance to the household sector. Identify five
different types of loan finance that a bank offers to individuals. Briefly explain the structure and
operation of each of these types of loans. (LO 2.3)
6 ABC Limited plans to purchase injection moulding equipment to manufacture its new range of
plastics products. The company approaches its bank to obtain a term loan. Identify and discuss
important issues that the company and the bank will need to negotiate in relation to the term
loan. (LO 2.3)
7 The off-balance-sheet business of banks has expanded significantly and, in notional dollar terms,
now represents over nine times the value of balance-sheet assets. (a) Define what is meant by the
off-balance-sheet business of banks. (b) Identify the four main categories of off-balance-sheet
business and use an example to explain each category. (LO 2.4)
8 Following the GFC, the off-balance-sheet activities of commercial banks attracted a great deal of
attention among commentators. With reference to the size and composition of commercial banks’
off-balance-sheet activities, outline some of the possible reasons for this concern. (LO 2.4)
9 Bank regulators impose minimum capital adequacy standards on commercial banks. APRA has
stressed the importance of CET1 capital. Explain what this is and why APRA places such emphasis
upon it. (LO 2.5)
11 Provide an overview and rationale for the two new liquidity standards introduced by Basel III. (LO
2.6)
12 The final version of Basel III, released in 2017, focuses more attention on the denominator of the
minimum capital ratios that banks must maintain. Discuss this statement. (LO 2.7)