Finance Fundamentals: The Financial System and Interest Rates

Definition: The financial system comprises financial institutions, instruments, and markets facilitating decisions by households, firms, and governments.
Payment Mechanism: Facilitates the clearing and settling of payments for goods and services exchange.
Risk Transfer: Provides mechanisms like insurance policies and managed funds to spread or transfer risk.
Liquidity: Allows for the conversion of assets into cash quickly without significant loss in value.
Flow of Funds: Transfers surplus funds from suppliers (investors/savers) to users (borrowers) who have productive opportunities.

Direct Financing: Users raise funds directly in financial markets by issuing financial instruments (e.g., bonds, shares, or derivatives like options and futures).
Indirect Financing: Financial institutions act as intermediaries. Suppliers provide deposits to institutions, which then provide loans to users. This is essential for firms lacking the reputation or expertise to access direct markets.

Debt Finance (Credit):
- Involves borrowed funds with a commitment to interest and principal repayment.
- Can be provided indirectly (loans) or directly (bonds).
- Failure to meet obligations can lead to bankruptcy.
- Contractual features include maturity dates, security (e.g., mortgages), and fixed or variable rates.
Equity Capital:
- Funds invested by owners, primarily through ordinary shares; it is "permanent capital" (not repayable).
- Owners have voting rights, receive dividends, and hold a residual claim on earnings/assets.
- Risk capital: Returns are uncertain, and shareholders have the lowest payment priority, often demanding higher returns than debtholders.

Financial Institutions:
- Authorised Deposit-taking Institutions (ADIs): Regulated by APRA. Includes major banks (ANZ, CBA, NAB, Westpac), foreign banks, and credit unions.
- Fund Managers: Pool money for large-scale trading (e.g., Superannuation funds, Public unit trusts like Perpetual or UniSuper).
- Investment Banks: Provide advisory services for financing, mergers, and acquisitions (e.g., UBS, Macquarie Bank).
Financial Markets:
- Primary Markets: Issuing new instruments (e.g., Guzman Y Gomez IPO).
- Secondary Markets: Trading existing instruments via brokers or dealers.
- Money Market: Short-term debt (< 1 \text{ year}) like Treasury notes and commercial paper.
- Bond Market: Long-term debt issued by governments or corporates.
- Equity Markets: Exchanges such as the ASX, NYSE, and NASDAQ.

Reserve Bank of Australia (RBA): Responsible for monetary policy and system stability.
Australian Securities and Investments Commission (ASIC): Market integrity and consumer protection regulator.
Australian Prudential Regulation Authority (APRA): Oversees ADIs, insurance, and superannuation.
The Treasury: Represents the government in the Council of Financial Regulators.

Demand for Funds: Driven by the Return on Investment. Firms borrow more when the economy is strong.
Supply of Funds: Driven by Time Preference. Higher interest rates incentivize individuals to delay consumption and save.
Business Cycle: Interest rates typically rise during economic expansion and fall during recessions.

Nominal Interest Rate ( $i$ ): The quoted rate at which money grows.
Real Interest Rate ( $r$ ): The growth of purchasing power after adjusting for inflation ( $\text{CPI}$ ).
Exact Fisher Equation: $\text{Real Rate} = \frac{1 + \text{Nominal Rate}}{1 + \text{Inflation Rate}} - 1$
Approximate Fisher Equation: $\text{Real Rate} \times 100 \text{ (approx)} \approx \text{Nominal Rate} - \text{Inflation Rate}$
Lecture Example 1 (Australia):
- Given: Nominal rate $4.2\%$ , Inflation rate $2.8\%$ .
- Exact: $\frac{1.042}{1.028} - 1 = 1.36\%$ .
- Approximate: $4.2\% - 2.8\% = 1.40\%$ .
Lecture Example 2 (Argentina):
- Given: Nominal rate $22\%$ , Inflation rate $12\%$ .
- Exact: $\frac{1.22}{1.12} - 1 = 8.92\%$ .
- Approximate: $22\% - 12\% = 10\%$ . Note: The approximation becomes less precise as inflation increases.