Introduction to Financial Markets – Lecture 1

Flashcards covering key concepts from Topic 1: structure and functions of the financial system, types of financial assets and markets, direct versus indirect financing, advantages/disadvantages of intermediation, links between finance and macroeconomic objectives, and government intervention.

What are the two core functions of a nation’s financial system?

1) Channel funds from surplus to deficit economic units in primary markets through creation of new financial assets. 2) Enable trade of existing financial assets in secondary markets.

Who are surplus economic units?

Individuals or groups (e.g., households, firms) with more funds than they currently need, making them savers and potential lenders.

Who are deficit economic units?

Individuals or groups that require additional funds to meet expenditure plans, making them potential borrowers.

What is the core business of financial institutions?

Borrowing and lending of funds (financial intermediation) and/or providing financial services to other economic units.

Define a financial asset (financial instrument).

A claim or right a surplus unit holds over a deficit unit, entitling the holder to specified future cash flows and creating a liability for the issuer.

List the four key attributes used to compare financial assets.

Return (yield), risk, liquidity, and time pattern of return (cash flow).

How do expected return, risk, and liquidity relate?

Expected return is positively related to risk and inversely related to liquidity.

Give two examples each of debt, equity, hybrid, and derivative instruments.

Debt: bank deposits, bonds; Equity: ordinary shares; Hybrid: preference shares, convertible notes; Derivative: options, futures.

Differentiate between primary and secondary financial markets.

Primary markets create and trade new financial assets in exchange for funds; secondary markets trade existing financial assets, changing ownership without new lending.

What distinguishes money markets from capital markets?

Money markets involve lending for less than one year; capital markets involve lending for one year or longer.

Name the five major Australian financial markets discussed.

Money Market, Debt-Capital Market, Foreign Exchange Market, Equity Market, and Derivatives Market.

Explain direct finance.

Surplus units lend funds directly to deficit units, receiving primary securities that represent direct claims on the borrowers.

Explain indirect (intermediated) finance.

Surplus units place funds with a financial intermediary, which then lends to deficit units; the intermediary issues secondary securities to savers and holds primary securities from borrowers.

What is the net interest margin in indirect finance?

The difference between the average interest earned on loans and the average interest paid on deposits, representing intermediary income.

State four advantages of financial intermediation.

Asset value transformation, maturity transformation, credit-risk reduction/diversification, and liquidity provision.

Give two main disadvantages of financial intermediation for participants.

Higher borrowing costs for deficit units and lower returns for surplus units; secondary assets are also less likely to be securitised.

What is disintermediation?

The tendency for large borrowers to bypass intermediaries and rely more on direct finance.

List the six macroeconomic objectives affected by the financial system.

Economic growth, full employment, price stability, external balance, efficient allocation of resources, and equitable distribution of income/wealth.

How does the cost and availability of funds influence full employment?

They affect aggregate demand and, consequently, the derived demand for labour.

Why is a developed financial system a pre-requisite for economic growth?

It mobilises savings and provides funds for infrastructure and investment, driving aggregate demand and growth.

Describe the relationship between monetary policy and price stability.

Central banks adjust interest rates and liquidity in financial markets to influence aggregate demand and keep inflation within target ranges (e.g., RBA’s 2–3% goal).

What period is labelled ‘Regulation’ in Australian finance, and what characterised it?

Pre-1980s; extensive direct controls over banks and other financial institutions.

What major change occurred during Australia’s ‘Deregulation’ era in the 1980s?

Progressive removal of direct controls, allowing the financial system to operate more like a competitive market.

How did government intervention evolve in the ‘Post-deregulation’ 1990s?

Government re-engaged with stronger oversight, but via different mechanisms than the pre-1980 controls.

Give three broad objectives motivating government intervention in finance markets.

Achieving macroeconomic goals, ensuring an efficient and competitive financial system, and promoting financial safety.

List at least five methods governments use to influence financial markets.

Fiscal policy, monetary policy, external (exchange-rate) policy, wages policy (e.g., superannuation), competition policy, consumer protection, and direct legislation.

Why can interest-rate ceilings affect income distribution?

They confer benefits to some borrowers (lower rates) while imposing higher costs on others, altering the equitable distribution of income.

What is allocative efficiency in the context of the financial system?

The directing of funds to the highest-yielding uses without non-market distortions, achieved best in competitive markets with minimal intervention.

Differentiate between primary and secondary securities.

Primary securities are issued by deficit units to raise funds; secondary securities are issued by intermediaries to surplus units. Both originate in primary markets but can later trade in secondary markets.

Why does indirect finance generally increase total national savings?

Intermediaries pool small savings, transform maturities, reduce risk, and provide liquidity, encouraging more people to save.