Topic 5- Financial Markets

What is a financial market?

A financial market is a market in which people, businesses and governments exchange financial assets and funds via financial institutions and intermediaries, such as banks.

What is the primary market?

A market that facilitates the creation of securities (financial instruments sold in the financial market) for the first time. In this market, money goes directly from the initial investor to the company.

Describe the secondary market:

Transactions occur with financial assets that have already been issued on a primary market. Investors in this market will buy and sell for financial gain. The company does not receive any additional funding from these transactions. Most ASX trades are conducted on the secondary market.

What is consumer credit?

Personal debt used to buy goods and services with no collateral (valuable assets a borrower pledges to a lender as a security guarantee). It taps into future streams of income to fund present consumption.

Give an example of consumer credit:

Credit cards.

What are housing loans?

Long term loans offered by banks to purchase property, requiring periodic payments with interest. The interest on these loans is typically 1-2% than the RBA cash rate.

What are business loans?

A form of debt that allows businesses to invest in their business operations.

What is the interest paid on business loans?

Rates that are typically higher than household lending rates, as mortgages are “secured by the property they are used to purchase.

What is the short term money market?

Borrowing that brings together people and businesses with temporary shortages or surpluses of funds through forms of debt securities, like bank bills. The loans generally have a maturity of less than a year, but can often only be required for as short as one day.

What is the purpose of the short term money market?

To provide a safe, highly liquid system for governments, banks and corporations to borrow and lend cash for short intervals of time. While cash in this market may not have large gains because of low risk assets gaining little interest, it is preferable to doing nothing with the cash.

What is yield?

The financial return on a bond, calculated by dividing the coupon payment by the bond price.

What is a bond?

A promise to pay back a loan under specific terms in a given period of time.

What does the bond market include?

Longer-term securities for which lenders receive regular fixed payments (coupon payments) from the issuing institutes, and receive the face value of the bond at the date of maturity.

Who are bonds issued by?

The government, and a small number of large companies and banks.

What are financial futures?

Legally binding, standard derivative contracts obligating a buyer to purchase, or a seller to sell, a specific financial asset at a predetermined price and future date.

What do financial futures allow investors to do?

Protect themselves against adverse movements in interest rates, currency fluctuations or share prices. Holders are able to trade their financial assets but do not have to.

What is the foreign exchange?

The buying and selling of foreign currencies.

What are forex markets?

Markets that allow people to buy and sell currencies, operating 24 hours a day.

What is the share market?

A financial market where investors buy and sell shares.

What are shares?

Financial assets that give their owner partial ownership of a company.

How does the share market play an important role in Australia’s economy?

It allows businesses to sell shares in their company to raise funds needed for growth, and it allows individuals or other businesses to gain returns on their surplus funds.

What is the market facilitator for shares called?

The stock market; it allows buyers and sellers to trade for a range of securities.

What is a derivative?

A kind of financial contract between two or more parties, the value of which fluctuates

What is the purpose of shareholders or investors?

To make capital gains from an increase in share prices.

Who decides how to maximise shareholder wealth?

Investors vote for a board of directors, who appoint company senior directors, who make the decisions.

What duty do managers of a company have, and what is it

They have fiduciary ethical duty to manage the company in a way that best serves the interests of the shareholders. Fiduciary ethical duty is just a high standard of trust which compels managers to put other’s interest above their own.

Give relevant information about dividends:

A proportion of company profits that may be returned to investors, awarded on a per-share basis.

What is an Initial Public Offering (IPO)/ Float?

When a company decides to list itself on the stock exchange and offer its share to the public for the first time.

What is the share market’s value indicative of?

A country's economic conditions, fluctuations in the share market mirror changes in economic growth.

What may rising share prices mean?

May suggest that an economy is enjoying good economic conditions, as an economy moving towards a recession will have fewer opportunities for companies to invest, leading to lower share prices.

Why are many shareholder purchases considered speculative?

Because a lot of them are based on market ‘hype’ rather than firm profitability, often leading to overvalued prices, drawing further investment and leading to a misallocation of resources.

Give some contemporary examples, statistics or evidence to do with Primary and Secondary markets:

In mid 2019, Australian households had outstanding borrowings of $1.1 trillion

Give some contemporary examples, statistics or evidence to do with Credit, Loans and Markets.

Business Loans: Large corporations pay similar rates to housing loans while small businesses may pay up to five per cent more, reflecting greater risks. 

Business: Australian businesses have around $950 billion in debt outstanding in 2019. 

Bonds: The 2008 global recession prompted a large increase in government borrowings.

The share market: In 2017, and estimated 27% of Australians owned shares. 

Give some contemporary examples of the Share Market:

In 2007, the Australian share market recorded several consecutive years of strong share prices growth, led by mining, energy and finance companies. In 2008-9, in the GFC, Australia’s share market plummeted by almost 30%.

Give some contemporary examples of Domestic and Global markets:

Foreign exchange market: The Australian dollar is valued at $0.70 compared to US currency. 

Equity Markets: Singapore's Stock exchange’s attempted takeover bid for the ASX in 2010 highlighted the trend towards increased global and regional integration of financial markets.

What does the global integration of Australia’s financial sector mean?

Recent decades have seen a dramatic increase in the participation of foreign investors in Australia’s markets, through increased lending to Australia. This means that Australia is more influenced by developments in markets around the world.

Describe Australian Markets in relation to global markets:

Dependent on foreign sources of capital to finance its development, necessitating foreign participation in Australia's financial market.

Describe equity markets:

Regulated by national governments, thus primarily within individual countries.

Describe the Reserve Bank of Australia (RBA):

This is Australia’s central bank. It has the responsibility for monetary policy, payments systems regulation and the stability of the financial system.

What are the objectives of the RBA?

The stability of Australia’s currency (sustaining low and stable inflation of around 2 to 3%), maintenance of full employment, managing inflationary expectations on AD, and the Economic prosperity and welfare of the Australian people.

Note the functions of the RBA:

Conducting monetary policy on behalf of the government, systematic stability, control of note issue, regulation of the payment system, to be a banker to the banks, and to be a source of financial and economic advice to the government.

What does conducting monetary policy on behalf of the government mean?

Influencing the cost and availability of money in the Australian economy through influencing interest rates, with the aim of achieving a sustained low inflation rate, while encouraging economic growth.

What does systemic stability mean?

Reducing the risk of a financial crisis, e.g. the emergency funding facility for banks in 2015.

What does control of note issue mean?

Sole issuing authority of the Australian currency, ‘Note Printing Australia’, owned by the Reserve Bank.

What does regulation of the payment system mean?

Ensuring the efficiency of payment methods, promoting stability in the clearing and settling of large transactions in financial markets.

What does the banker of banks mean?

Banks hold exchange settlement accounts with the Reserve Banks, allowing banks to settle debts between themselves and within the Reserve Bank at the end of each day’s trading. 

Give a contemporary example to do with the RBA:

Australia was insulated from the GFC by better financial regulation, leading to the widespread recognition that governments have a key role to play in regulating markets to underpin confidence and stability in the financial sector and in the broader economy.

What is the responsibility of the Australian Prudential Regulation Authority (APRA)?

Responsible for prudential supervision and regulation of all deposit taking institutions, life and general insurance, and superannuation funds.

What are the regulatory roles of APRA?

It regulates institutes to ensure they meet their obligations to people who place their money with them, eg insurance companies, superannuation funds. They require:

-The maintenance of certain levels of funds

-Risk management. 

Also sorting out institutions financial difficulty, ensuring deposit-holders receive as much of funds as possible, supported by investigative powers that give APRA the right to intervene if it feels that they have become financially unviable.

What is the role of the Australian Securities and Investment Commission (ASIC)?

They are responsible for corporate regulations, consumer protection and oversight of financial service products.

What is the role of the Financial Treasury?

It advises the government on financial stability issues and the legislative and regulatory framework for the financial system. They influence how governments devise budgets, collect taxes, locate expenditure, implementation of monetary, labour market, market regulation policy.

What is the role of the Council of Financial Regulators?

They are the coordinating body for financial market regulation, providing collaboration amongst its four members. It is an informal body that allows information sharing and advice, but does not have a separate function from its individual members.

Why might individuals borrow money?

For personal, short term purposes like mortgages or a holiday.

Describe the type of loans individuals take:

Loans are mostly unsecured, meaning there is no asset the financial institute can claim if the borrower defaults on the loan, so there are higher interest rates.

Why might businesses borrow money?

To expand production, or to invest in research or development.

Describe the borrowing of the government:

Done deliberately in an effort to raise the level of economic activity, eg borrow money to stimulate the economy. Spending unintentionally grows faster than revenue, funding major infrastructure projects where asset is paid off over the lifetime of its use.

What is a transactional motive?

Day-to-day transactions for goods and services that cannot be purchased using financial assets.

What is a speculative motive?

The possibility of making capital gains or losses.

What is the main opportunity cost of holding liquid funds?

Forgone returns that would have been earned by holding financial assets.

What are the effects of financial innovations and give examples:

Affect consumer’s demands for liquidity and reshape financial markets, e.g. the increased use of technology to deliver payment, like a 24 hour ATM, people do not need to hold high levels of cash to cover day to day expenses.

Describe lenders:

Individuals, businesses and governments participate in financial markets as lenders when they are seeking a return on their wealth.

Describe individuals as lenders:

Lend money to institutes for the purpose of getting a return, investing in assets eg property, purchasing shares, placing money in an interest bearing deposit.

Describe businesses as lenders:

Businesses with strong cash flow and good profits with no immediate plans for expansion, if interest rates are at a level where maintaining deposit funds is more lucrative than investing.

Describe the government as a lender:

If the government is running on a surplus on budget, allowing it to pay off debts from the past or maintain positive financial balances.

Describe the international sector as a lender:

There is often a reliance on overseas savings to finance domestic consumption and investment.

Give contemporary examples/ statistics to do with household dept:

2000s: 131 per cent growth in household dept, by mid 2019 ratio of household debt to income reached 190 per cent. 

Housing debt makes up 70% of total household debt, with growth attributed to:

-Low interest rates

-rising house prices

-increasing superannuation

Give contemporary examples/ statistics to do with the international sector:

Net foreign debt is $1.45 trillion AUD as of March 2026.

Significance of international sector to Australian lenders when there was a shortage of credit internationally, increase of interest rates to attract overseas funds and government guarantee

What is the currency/ money base?

All currency in circulation + Bank deposits with the reserve bank. It is a measure of the most liquid financial assets that can be used instantaneously.

What is Broad Money?

M3 (Measure of money supply– all currency in circulation, bank deposits with RBA, private sector deposits in banks) + Non bank financial institutes (NBFI) deposits - NBFI deposits in banks. 

What is credit?

The system that allows for purchase payments to be deferred. Refers to loans that are provided by banks/ lenders to household and business borrowers.

Describe interest rates:

Price that brings about equilibrium in a financial market, where the quantity of funds supply is equal to that demanded by borrowers. Factors of Production (FOP) for capital, Annual % Return paid by borrowers received by Lenders.

How do you find Real Interest Rate (Real IR)?

Real IR = Nominal IR- Inflation.

Describe interest rate vs quality of funds curve:

The relationship between interest rates and the quality of funds assumes lenders offer a higher quantity of funds as interest rate increases and borrowers tend to borrow more at lower interest rates.

What is an interest rate?

Rate of return (yeild) on financial assets or financial instruments. It is the annual % paid by borrowers, and received by lenders. It has a massive influence on level of borrowing and lending in an economy.

What is the result of high interest rates?

Less consumption, investment and Government spending.

What are borrowing rates?

The rate of interest offered on funds.

What are lending rates?

Additional rate of interest charged to customers, allowing institutions to make a profit that charges a lending rate exceeding borrowing rate. The difference between comparable financial assets is known as the interest rate differential, or net interest margin

What is the cash rate?

The interest rate in the overnight market (fundamental financial market for short-term loans between banks) that every bank has to pay on the money it borrows.

Describe exchange settlement accounts:

-Banks must hold a certain proportion of their funds with the RB in Exchange Settlement (ES) accounts, to settle payments with other banks and RB.

-At the end of the day, some banks may not have enough funds in their ES account to satisfy all their interbank obligations for the day, whilst other banks may have surpluses that they do not need to hold. 

-The overnight/ short-term money market enables banks to always settle interbank payment obligations. 

-The RBA intervenes heavily to ensure the actual cash rate lines up with RBA target, announced monthly, by using a policy rate corridor and open market operations.

What is the function of the payment system Banker to Banks?

To simplify the volume of transactions between financial institutes. It also transfers net balance.

What is the function of the Cash Market for Economic stability?

To be a platform to control the Quantity of Cash supplied to the Cash Market. It trades in Repo agreements to maintain the predetermined Cash Supply.

Describe how the RBA deposit rate creates a floor/ minimum value for cash rate:

Pays interest rate to bank on funds held in an Exchange Settlement account that is 0.25 percentage points below CR target, meaning banks with excess ES balance are not incentivised to lend if CR is less than 0.25 PP below target. Banks could earn returns by simply leaving extra funds in ES accounts. 

Describe how the RBA lending rate creates a ‘ceiling’/ maximum value for cash rate:

RBA is willing to lend ES balances directly to banks outside of the overnight market, with interest rates equal to 0.25 percentage points above cash rate target. Thus, banks that need to borrow ES balances do not want to pay a rate higher than the RBA’s lending rate in the overnight market, incentivising banks from borrowing funds directly from RBA outside of the overnight money market.

How is it ensured the actual cash rate closely follows the RBA target cash rate?

The floor and ceiling created by the RBA deposit rate and lending rate form the policy rate corridor for the cash rate, no banks have an incentive to complete transactions in the overnight money market outside of this corridor.

What is the Actual Cash rate?

Price at which demand intersects with the supply of ES funds that are available, RBA manages levels of supply of ES funds so it meets demand at a price equal to the RBA cash market.

What is ‘Open Market Operations’ (OMO)?

The purchase and sale of financial securities by the RBA in exchange for ES balances or repurchase agreements (repos), agreeing to buy back bond/ security at a later date = more flexible and precise.

Why do purchases and sales affect the supply of ES funds?

Because they are used to complete the transactions, demand for the ES funds increases, RBA must increase supply of ES funds to maintain cash rate at target, ceteris paribus.

Why does the RBA buy financial securities held by banks?

To exchange for depositing additional funds into their ES accounts, increasing the supply of ES funds so it can meet additional demand OR sell financial securities in exchange for ES funds to decrease the supply of ES funds.

What is the result of an increased cash rate?

More expensive for financial institutes to obtain funds, thus increasing the cost of borrowing.

What is monetary policy?

The RBA’s influence on interest rates to affect the level of economic activity.

Give contemporary evidence/ statistics about interest rates:

Household borrowing: almost 10 trillion 2024. Average of $275000, total 3.7 trillion. 

Mortgage and investment property: Total 3.3 trillion

Federal government debt: total 900 billion.

Monetary policy: 60% of aggregate demand