Financial System Mod2

The Financial System: Deficit and Surplus Units

• The financial system acts as a mechanism to bring together deficit units and surplus units.

• Deficit Units: Individuals, households, companies, governments (state or sovereign), and municipalities (referred to as councils in Australia) that require money to run their operations or invest in their business. Since they lack sufficient cash, they seek to borrow money from external sources.

• Surplus Units: Individuals or organizations that possess excess money they wish to invest in the market.

• Roles and preferences of these units often fluctuate, as any category (households, governments, or companies) can be a deficit unit in one scenario and a surplus unit in another. For instance, a household is a deficit unit when borrowing for a house or car, and a surplus unit when investing savings.

Distinction Between Direct and Indirect Financing

• Indirect Financing: This involves a financial intermediary, such as a bank, connecting the two parties without a direct link.

  • Example: A surplus unit deposits $\$100$ into a bank account. The bank pays interest to the depositor but lends that money to a borrower. The depositor does not know the borrower, and the borrower does not know where the bank sourced the funds. The bank splits the transaction into two distinct parts.

• Direct Financing: There is a direct link between the surplus unit and the deficit unit, even when working through fund managers or investment banks.

  • Example: An investor buys shares in Qantas. The investor knows Qantas is the deficit unit, and Qantas registers the investor as a shareholder.

  • In sophisticated markets, investors do not go directly to headquarters to buy shares; instead, they use brokers or fund managers.

Structural Mismatches and the Role of Financial Markets

• Financial markets exist to resolve significant mismatches between surplus and deficit units regarding maturity, risk, and return.

• Contract Mismatch: Surplus units typically require flexible, short-term contracts (e.g., $5$ to $10$ years), while deficit units like Qantas often need to borrow over much longer time horizons.

• Risk Preference Mismatch:

  • Surplus units are generally risk-averse because they are investing their savings and do not want to lose capital.

  • Deficit units (companies) tend to be risk-takers because taking risks can lead to higher returns.

• Return/Cost Mismatch:

  • Surplus units desire the highest possible return in the form of interest or dividends.

  • Deficit units aim to pay the lowest possible cost of funds.

• Cost of Spread in Direct Financing: The difference between what the service unit pays and what the deficit unit receives after intermediary cuts. This represents the total cost of the direct financing process.

Revenue and Compensation for Market Participants

• Surplus Units: Receive compensation for supplying money in the form of interest or dividends.

• Deficit Units: Pay compensation for receiving money.

• Investment Banks: Take commissions and fees for organizing, brokering, and managing initial offerings.

• Fund Managers: Take a cut or commission from the returns generated on investments.

Alternative Financing: Crowdfunding Platforms

• Crowdfunding is a development in direct financing that operates outside traditional financial markets using online website platforms.

• It allows equity to be raised directly from investors, effectively cutting out the Initial Public Offering (IPO) process, fund managers, and investment banks.

• Benefits: It serves as a way for individuals to invest small sums without needing thousands of dollars for stock exchange transactions. It is frequently used for early-stage startups.

• Wefunder: An example platform where investors can participate in startups. For instance, a company named Levels raised roughly $\$5,000,000$ from $\$1,440$ investors, with an average investment of approximately $\$250$ per person.

• SeedInvest: Another platform recently acquired by a third company, often associated with concepts seen on television shows like Shark Tank.

The Primary Market: Listing and Regulation

• Definition: The primary market is the process where securities are listed for the very first time.

• The primary and secondary markets are not different physical locations; they are different terms for processes occurring within the same market framework.

• Initial Public Offering (IPO): The mechanism through which deficit units engage investment banks to sell shares to the public for the first time. The investment bank prepares a prospectus and charges a commission. Money from an IPO goes directly to the issuing company (e.g., Qantas).

• Bond and Money Market Participants: The Australian Government is a major participant in the primary market for bonds and treasury bills, which are typically issued through a tender offer rather than an investment bank.

• Rating Agencies: Standard & Poor's (S&P), Moody's, and Fitch Ratings judge the quality of instruments traded in the primary market, particularly for debt, money markets, and bonds.

• Security Register: Owners of new shares are recorded electronically in a security register as owners of the company.

The Secondary Market: Concept and Locations

• Definition: The market where individuals, companies, and fund managers buy and sell securities from other investors rather than from the issuing company itself. Once a company has its money from the primary market, it exits the transaction scene.

• Transactions require agreement on:

  1. The specific security (e.g., Qantas).

  2. The quantity (e.g., $\$100$ shares).

  3. The price (e.g., $\$6.50$).

• Key Exchanges:

  • ASX: The Australian Securities Exchange (formerly the Australian Stock Exchange). It deals in stocks, shares, forwards, futures, options, and warrants.

  • NZX: New Zealand Exchange.

  • NYSE: New York Stock Exchange (one of the last to use "Open Outcry").

  • NASDAQ: National Association of Security Dealers Automated Quotation (primarily for technology companies).

  • London Stock Exchange, Singapore, Hong Kong, Frankfurt.

Market Execution Models: Order-Driven vs. Quote-Driven

• Order-Driven Systems (Exchanges): Predominantly used for share or equity markets like the ASX.

  • Investors place orders through brokers specifying if they are buying or selling, the quantity, and the price.

  • Brokerages like Consec (part of CVI) provide apps for this.

  • The market facilitates the matching of individual buyers and sellers.

• Quote-Driven Systems (Over-the-Counter/OTC): Predominantly used for the bond and money markets.

  • Also known as the "Over the Counter" market because it historically functioned like a physical shop with a counter.

  • Investors do not place orders in a central book; instead, they go to a dealer for a quote.

  • The dealer holds an inventory of securities and provides a bid (buy) and offer (sell) price.

The Central Order Book and Market Depth

• Central Order Book: The collection of all current buy and sell orders in an exchange-traded market.

• Bid and Ask:

  • Buyers enter the market at the "Bid" price.

  • Sellers enter the market at the "Offer" or "Ask" price.

• Market Depth: How many orders exist at various price points. For example, in Qantas trading:

  • $25$ buyers might want to buy $10,269$ shares at $\$6.58$.

  • $55$ sellers might want to sell $81,610$ shares at $\$6.59$.

  • The total number of buyers could be $590$ and sellers $776$.

• Spread: The difference between the highest bid ($\$6.58$) and the lowest offer ($\$6.59$). This $\$0.01$ difference is the spread.

• Limit Price vs. Market Price:

  • Limit Price: Buying or selling at a specific pre-set price (e.g., instructing to buy at $\$6.40$ when the market is $\$6.50$).

  • Market Price: Trading immediately at whatever the current best available price is.

Over-the-Counter (OTC) Markets and Market Makers

• Dealers vs. Brokers:

  • Brokers: matched buyers and sellers for a flat commission (e.g., $\$10$ per trade).

  • Dealers: Also known as Market Makers, they own the security inventory and profit from the spread between their buying and selling prices.

• Wholesale vs. Retail Clients:

  • Retail: Small investors or households.

  • Wholesale: Institutional clients (banks, companies, governments, councils).

  • OTC markets are mostly wholesale because instruments like government bonds often have minimum denominations of $\$1,000,000$.

• Market Determination: The "Market Quote" is determined by selecting the Highest Bid and the Lowest Offer among all individual dealers.

  • Example: If Dealer A bids at $\$65$ and Dealer C bids at $\$62$, the market bid is $\$65$.

  • If Dealer A offers at $\$70$ and Dealer C offers at $\$67$, the market offer is $\$67$.

  • Individual dealer spread (e.g., $\$5$ points) is often wider than the market spread (e.g., $\$2$ points).

• Regulation: The Australian Financial Markets Association (AFMA) sets the rules and regulations for the OTC market.

Assessing Market Quality: Liquidity and Price Discovery

• Liquidity: The ability to buy or sell an asset quickly at its true market value. It is measured by:

  1. Daily Turnover: High volume of shares traded (e.g., Qantas trading $3,600,000$ shares in a day).

  2. Bid-Ask Spread: A narrow range between the bid and offer (e.g., a one-cent spread).

  3. Price Resilience: The market's ability to absorb large orders without massive price swings. Qantas shows resilience by trading within a narrow range (e.g., a $\$0.10$ difference between the day's high and low despite millions of shares traded).

• Price Discovery: The process by which the market determines the true value of a security.

Market Strategies and Mechanics: Short Selling

• Short selling is a method used to profit when an investor believes a share price is overvalued.

• Process of Short Selling:

  1. Borrow shares from another owner.

  2. Sell the borrowed shares at the current high market price (e.g., $\$6.50$).

  3. Wait for the price to drop (e.g., to $\$5.00$).

  4. Buy the stock back at the lower price.

  5. Return the shares to the original owner.

  6. Keep the difference as profit (e.g., $\$1.50$ per share).

• The short seller must pay interest to the lender for borrowing the shares during this period.

Information Sources

• Traders rely on massive amounts of real-time information provided by companies like Bloomberg and Reuters.

• Institutions, such as the finance department at UTS, utilize Bloomberg terminals to access required company data and market information.

TUTORIAL Q1

Financial institutions facilitate the direct flow of funds in markets by connecting surplus units (investors with excess money) and deficit units (borrowers needing funds). They play key roles through services such as:

• Intermediation: Institutions like banks act as intermediaries that match depositors with borrowers, ensuring that excess funds are utilized efficiently.

• Investment Banking: They assist deficit units in raising capital directly by arranging equity or debt issues, such as during an Initial Public Offering (IPO).

• Cost Reduction: Financial institutions lower transaction costs and enhance market efficiency, making it easier for investors to access opportunities and for borrowers to secure funding. This streamlined process supports economic growth by optimizing resource allocation across various sectors.

Tutorial Q2

1. Risk Tolerance: Surplus units are generally risk-averse, focusing on preserving capital, while deficit units are more willing to take risks to pursue higher returns.

2. Return Expectations: Surplus units seek the highest possible returns in the form of interest or dividends, whereas deficit units aim for the lowest possible cost of borrowing.

3. Contract Maturity Preferences: Surplus units often prefer shorter-term contracts for flexibility, while deficit units frequently require longer-term financing to match their project needs.

4. Liquidity Needs: Surplus units usually prioritize liquidity, wanting quick access to their funds, while deficit units may prioritize stability in funding over immediate liquidity.

Tutorial Q3

The primary market is where securities are created and sold for the first time, allowing deficit units to raise capital through mechanisms like Initial Public Offerings (IPOs). In contrast, the secondary market is where previously issued securities are bought and sold among investors, facilitating liquidity and price discovery without involving the issuing companies.