FINANCIAL MARKETS

VOCAB:

Security: A security is any type of financial asset that can be traded (ie bought and sold)
Interest: cost of borrowing. It is the amount charged by a lender for someone to borrow their money

ROLE

Direct funds from economic units with a surplus of funds (savers) to lend, to those economic units which have a shortage of funds (borrowers and investors) and want to borrow.
Diversity of instruments and products traded in markets serve the purpose of bringing savers and investors together and enhancing the efficiency of the economy by enabling the distribution of funds from surplus units to deficit units.
Efficiency is improved → people who save don’t always have access to the most profitable and productive investment opportunities with which to employ their surplus funds.
Financial intermediaries: firms that hold the savings of individuals or businesses as deposits and then make loans to other firms or individuals who can make use of them.
- an institution which holds funds for savers, and then lends them to borrowers. - acts as a link
- E.g. Banks, Building societies, Credit unions, Finance companies, Merchant banks (Investment banks)
- Sources funds from:
  - The proportion of household income that is not spent on consumer goods is saved
  - Businesses can save by not distributing all their profits to their owners. The funds that are not distributed can be supplied to financial markets until required.
  - When the government budgets for a surplus, this represents accumulated savings
  - There are foreign pools of savings supplied by individuals, firms and governments from other countries from which Australia can borrow.
Main reasons for borrowing:
- When consumer’s demand for goods and services exceeds their current capacity to pay for them - commonly used to purchase expensive items e.g. cars & houses
  - Borrow from banks or use credit cards (e.g. Mastercard, Visa, AMEX)
  - Cost of borrowing is called interest
- Entrepreneurs and business managers borrow to fund the operation or expansion of their businesses
  - Raise money through loans from a financial institution (bank → debt), issue securities e.g. shares (equity), options (debt), corporate bonds (debt)
- When government budgets a deficit
  - Borrowers money from sources such as:
    - Issuing Australian Government Securities, most commonly known as Treasury Bonds. (The total value of AGS issued at present is almost $900 billion)
    - Borrowing from overseas
- Australian financial institutions can lend money to overseas borrowers
Also viewed as factor markets for capital, since savings from households, businesses and governments can not only be used for future consumption, but also invest in capital which ultimately increases the productive capacity of the economy

Aims - done through financial intermediaries:

To facilitate or allow the exchange of money between borrowers and lenders
Allow for the movement of funds between those who have surplus funds to those who wish to borrow

TYPES OF FINANCIAL MARKETS

Direct and Indirect Finance - flows of funds in economy:

Direct finance approach: directly between lenders and borrowers
Indirect finance: occurs when a financial intermediary acquires funds by issuing a financial liability e.g. savings deposit/term deposit, and uses these funds to acquire a financial asset by lending money directly to a borrower, or by purchasing a financial aset in a financial market e.g. government bond. via institutions which act as financial intermediaries or go-betweens. E.g banks, building societies, life insurance companies and superannuation funds.

Primary, Secondary and Derivatives Market:

Financial markets transfer funds from surplus units to deficit units.

Primary Market: market for initial capital raisings through the first-time issue of either debt or equity securities by private or public corporations.

Where new financial securities (gov issued Australian government securities, debt, bonds, shares issued by businesses and options) are issued for the first time for capital raising purposes
Allows companies and governments to issue bonds or debentures in the fixed interest market and shares and options in equities market
money received from the investors goes directly to the government/business
E.g. Australian Securities Exchange

Secondary Market: market for trading in existing financial securities, where majority of financial transactions occur.

Where financial securities are bought and sold according to investment transfers for investors and institutions managing a portfolio of shareholdings. - not from government or company who issued security
Once securities are issued can be exchanged on market
Where ‘second-hand’ bonds are bought - can also be bought and sold many times
Government does not make any money from this - goes to other investors
Ownership of the bond goes from the original owner to the new owner. They now receive the quarterly interest payments and the original price of the bond back at maturity

Derivatives Market: where financial products which are derived from the financial securities traded in primary and secondary markets e.g swaps, futures and options, are traded through futures contracts.

E.g. Sydney Futures Exchange - part of ASX

Debt and Equity Markets

Ways to obtain funds in financial markets:

Debt Market: debt instruments (mortgages, personal loans, debentures, bonds, notes and bills) are issued at a fixed or variable rate of interest.

Equity Market: consists of issue of shares, options, warrants and rights for sale at a par value, in return for a share of the company’s future stream of profits in the form of dividends

Methods for issuing shares in share market:

Preference shares - shareholders don’t have voting rights. In case of bankruptcy, preference shareholders are given priority in dividend distribution, receiving share before common shareholders.
Common shares - shareholders do have voting rights,

→ both receive dividends in case of profit

Types of financing available to a company when it needs to raise capital:

Debt financing: involves the borrowing of money + business owner doesn’t give up any control of business
Equity Financing: involves selling a portion of equity in the company +no obligation to repay money acquired through it, places no additional financial burden on the company. - downsides can be large

Superannuation Industry:

Superannuation: compulsory payment by employers of 10.5% of the gross income of employees into a nominated superannuation fund to increase retirement savings for employees.

The Australian Prudential Regulation Authority (APRA) regulates most super funds
Main categories of super funds are small, industry, retail and corporate

Domestic and Global Financial Markets:

Financial markets/system are linked with global financial markets through offshore borrowings of all financial intermediaries which totalled $338.5b in Aug 2021
Aus banks registered financial corporation and large public companies issue debt and bond instruments in international credit markets to raise additional funds for lending and also have linkages with international investors (hedge funds in equity and foreign exchange markets)
Aus gov issue bonds offshore to enable to fund its budget deficit and Future Fund (2006) invests some of its portfolio in international financial assets to diversify risk and earn a rate of return on invested funds
Share/equity market: where ownership shares in companies are issued or exchanged
Debt market: where debt securities (bonds) are exchanged, or cash is lent and borrowed
Derivatives market: where people buy and sell financial assets that are based on the value of other financial assets
Forex market: where financial assets defined in one country’s currency are exchanged for assets defined in another country’s currency

→ Personal loans: other major form of consumer credit offered by banks and credit unions. Charged at a higher rate of interest than housing loans as personal loans generally have high interest rates of aroun 10-15%. This is because of the differences in the risk to the ultimate lender that the borrower will not be able to pay them back - unsecure.

→ Can measure the competitiveness of Australia’s financial markets through:

Daily transactions of Australian dollars in the forex market
Daily turnover rate
Market concentrations of market institutions

→ Market concentration: when smaller firms account for a large percentage of the total market. It measures the extent of domination of sales by one or more firms in a particular market. It is the proportion of a given market share. Has increased in the years following the GFC because it has been more difficult to finance companies to access credit to lend to customers → ramped up regulation. Larger banks dominate since Aus have been growing, making great profits → merging with others and takeover. Not unique internationally but on the high end.

→ Gov increased competition in the banking sector by:

Implementing policies to make it easier to switch between banks, introducing a ban on mortgage exit fees and imposing a duty on financial advisers to put the interests of their clients first in order to encourage greater competition
Lower barriers to entry for new participants seeking to enter markets and regulatory reforms by introducing subsidies, reducing compliance costs, regulatory reforms

→ Benefits for increased competition:

Improve allocation of resources in economy and make it easier for firms to raise funds
This will contribute to higher levels of investment, economic growth and improved standards of living.
More competitive interest rates → consumer sovereignty → more control over decisions
Access to more financial services
Increase in innovation → efficiency

→ Housing loans: offered by banks and non-bank financial institutions. Long-term loans used to purchase property requiring periodic repayments with interest.

→ Business loans: form of debt that allows businesses to invest in their business operations e.g. new technology. These rates are higher than household lending rates as mortgages are secured by the property they are used to purchase. Lenders can sell the property in situation when the borrowers default on their debt to off set losses on the loan, so they are not as risky to supply.

→ Bonds: debt security, a type of loan taken out by governments and large companies. It is a written financial document ‘issued’ by the borrower to the lender, an individual or company who is known as the ‘bondholder.’ Initial price of the bond is the size of the loan. Bondholder is entitled to a fixed stream of income paymentsl which are interest repayments and to the repayment of initial loan amount when bon ‘matures.’

When the government needs money to finance their debt, they often issue ’bonds’ or ‘securities’
bought by people overseas, superannuation companies and so on
When you buy these, at the end of a certain time period (say, 5 years), you are guaranteed to be paid back that amount of money
Every quarter (3 months) you also get paid interest! When you buy the bond, you know how much this interest will be)
Able to sell bonds in ‘bond market’ - market for buying second-hand bonds
Borrower sells bond in return for a loan. The holder of a bond receives interest payments and the final repayment.

→ Financial futures and options: contracts to trade in financial instruments (shares or bonds) at a later date for a certain price.

Futures: allow investors to protect themselves against adverse movements in interest rates, currency fluctuations or share prices by agreeing on a price and currency at which to buy or sell the financial product now, even though they don’t have to make the transaction until a later date.
Option: derivatives based on currencies, can let it expire or fulfill agreement- edging and people trying to make decisions on the basis of what they think is happening in the future - can do it with interest rates and foreign currencies. Give their holder the right to make such a transaction, but not the obligation → can choose to complete the transaction or they can choose not to.

→ Foreign exchange: market for buying and selling of foreign currencies. It provides a maret for people to buy and sell currencies, operating 24hrs a day. Allow for currency conversions, facilitating global trade (across borders), which can include investments, the exchange of goods and services and financial transactions.

→ Superannuation: mandated forced savings, main way people save for retirement → make contributions to get paid.