ACST1001 Finance Fundamentals - Week 2: The Financial System
Week 2: The Financial System
Week 2 Learning Outcomes
Discuss the role of the financial system in an economy and how fund transfers take place.
Explain the differences between direct and indirect financing.
Explain the differences between debt and equity financing.
Describe the structure of Australia’s financial institutions and markets and their regulators.
Explain how interest rates are determined and calculate nominal and real interest rates.
Week 2 Lecture Outline
The role of the financial system
The two basic forms of finance
The structure of a financial system
Determinants of interest rates
The Role of the Financial System
The financial system includes financial institutions, financial instruments, and financial markets that facilitate financial decisions of individuals/households, firms, and governments.
Financial System Functions:
Payment Mechanism: Clearing and settling payments to facilitate the exchange of goods and services.
Risk Transfer:
Insurance companies offer policies for health, life, and physical assets.
Managed funds take savings and spread them out among the shares and bonds of many companies.
Liquidity: Individuals/households, firms, and governments can convert their assets into cash at short notice without loss of value.
The Flow of Funds: From those who have surplus funds (suppliers of funds) to those who need funds (users of funds).
The Flow of Funds Function
Suppliers of Funds: Investors, savers, or lenders who have surplus funds.
Funds are supplied mostly as bank deposits, investments, and superannuation contributions.
They require compensation forgoing the immediate use of the funds and for the risk the funds will not be returned.
Users of Funds: Include individuals/households (for housing loans, personal loans), firms (to finance their investment decisions), and the government (both State and Australian governments).
It allows those with surplus funds to invest in the productive opportunities of users of funds.
Ways of Arranging the Flow of Funds:
Direct Financing: Users of funds raise funds directly from suppliers of funds through the issue of financial instruments in the financial markets.
Financial instruments are contracts that specify the obligations of users of funds and the rights of suppliers of funds.
Financial instruments are broader than financial assets. They include financial assets such as bank accounts, bonds, and shares and other instruments such as derivative contracts (option contracts, futures contracts, swaps).
Indirect Financing: Funds are supplied as deposits to financial institutions, which in turn supply funds as loans to users of funds.
Allows firms that are too small and/or without the expertise and reputation to raise finance in the financial markets to approach a financial institution to act as an intermediary.
Flow of Funds Diagram
Suppliers of Funds: Individuals/households, Firms, Government, Rest of the world
Users of Funds: Individuals/households, Firms, Government, Rest of the world
Intermediaries: Financial Institutions
Mechanism: Financial Markets (Indirect and Direct Financing)
The Two Basic Forms of Finance
Debt
Borrowed funds, also known as “credit”.
Commits the borrower to make the agreed interest and loan repayments.
Provided indirectly by financial institutions (known as a loan) and directly by financial markets (known as a bond).
Failure to make repayments can result in bankruptcy.
Debt finance is arranged through a loan contract/agreement that specifies:
Interest calculations – fixed or variable interest rate.
A repayment schedule and maturity date.
Security arrangements such as a mortgage over property.
Equity
Equity capital is funds invested in a firm or investment by its owners; companies raise equity through the sale of ordinary shares.
This is a source of “permanent” capital as the funds are not repayable.
Shares are financial instruments that represent part-ownership of the firm.
Owners can vote for the company’s board of directors.
Receive dividends when these are paid by the company.
Share value depends on the share’s expected future returns.
Equity is referred to as risk capital because its returns (dividends and capital gains) are uncertain.
Shareholders have the lowest payment priority. That is, they have a residual claim on earnings (and, in the case of bankruptcy, on assets) because debt payments are paid first.
The Structure of a Financial System
Introduction
The main components of a financial system include:
Financial Institutions:
Authorised deposit-taking institutions that accept deposits and make loans.
Fund managers that manage investors’ funds.
Investment banks that assist their large company clients in accessing funds from the financial markets.
Financial Markets: Arrange trading in financial instruments.
Regulators: Oversee the institutions and markets.
Financial Institutions
Authorised Deposit-taking Institutions (ADIs):
Authorised by the Australian Prudential Regulation Authority (APRA) to accept deposits, make loans, and provide other financial services.
Include: The major banks (e.g., ANZ, CBA, NAB, Westpac) that provide a full range of banking services, Foreign banks, Credit unions and building societies that mainly serve households.
Fund Managers:
Pool and manage the money of many investors.
They have the advantage of large-scale trading and portfolio management.
Investors are assigned prorated share of the total funds according to the size of their investment.
Include: Superannuation funds (long-term investment schemes to generate income in retirement), Public unit trusts (voluntary investment vehicles that sell ‘units’ in their trust and then invest the funds), Insurance companies (manage funds as part of their operations, and some of their policies have an investment purpose).
Investment Banking Activities:
Advising and assisting corporates in obtaining financing in equity and debt markets.
Advising large companies on takeovers, mergers, and acquisitions.
Managing investment portfolios for both individual and institutional investors.
Trading in financial markets such as equity, debt, derivatives, and commodities.
Performed by: The four major banks and Macquarie bank, Foreign-owned institutions, Boutique advisory firms, Big four advisory firms.
Financial Markets
Primary Markets: Deal with issuing (selling) new financial instruments, e.g., Guzman Y Gomez issuing shares in an initial public offering (IPO).
Secondary Markets: Trade existing instruments, e.g., an investor buying Guzman Y Gomez shares from an existing shareholder through a broker.
Brokers are market specialists who bring buyers and sellers together in secondary markets; dealers are market-makers assuming risk on their own accounts.
Liquidity is an essential consideration in financial instruments traded in financial markets.
Financial instruments can be traded quickly at a fair price when a market has numerous buyers and sellers.
Financial instruments are traded on organised exchanges (ASX, NYSE) or over-the-counter.
The Money Market: Includes short-term debt instruments with maturities less than 1-year.
Instruments include Treasury notes, bank-accepted bills, and commercial paper.
The Bond Market: Includes medium and long-term debt instruments issued by:
Australian government (treasury bonds).
State governments (semi-government bonds).
Banks and Corporates (corporate bonds).
Equity Markets: Are for issuing (selling) new shares in the primary market and trading existing shares in the secondary market.
Some examples:
Australian Securities Exchange (ASX)
New York Stock Exchange (NYSE)
NASDAQ
London Stock Exchange (LSE)
Shanghai Stock Exchange
Financial Regulators
Reserve Bank of Australia (RBA)
Australian Securities and Investments Commission (ASIC)
Australian Prudential Regulation Authority (APRA)
These bodies, together with The Treasury (representing the government) form the Council of Financial Regulators
Determinants of Interest Rates
Demand and Supply for Funds
Interest rates are determined by the demand and supply for funds.
Demand: Return on Investment – Firms invest more in new projects (needing to borrow more money) when the economy is strong, and consumers want to buy more goods and services.
Supply: Time Preference – Individuals/households typically prefer consumption now rather than later. At low rates of interest offered on savings products, individuals have a low incentive to delay consumption, i.e., to save.
Borrowers (B) provide Demand for funds
Lenders (L) provide Supply for funds
Inflation and Nominal vs. Real Interest Rates
Inflation: Measures how the purchasing power of a given amount of currency decreases due to increasing prices. It is measured by the consumer price index (CPI).
Nominal Interest Rate: The rate at which your money will grow if invested for a certain period.
Most interest rates quoted by financial institutions and in financial markets are nominal rates.
It comprises the real interest rate and the expected inflation.
Real Interest Rate: The rate of growth of your purchasing power, after adjusting for inflation.
Example:
A pen costs $1 this year. If you have $100, you could buy 100 pens.
If you deposit that $100 in a bank account earning 5.06% per year, you would have 100 × 1.0506 = $105.06 at the end of the year.
If inflation was 3% over the year, that pen would cost 3% more, or $1.03 at the end of the year.
Thus, you could take your $105.06 and buy pens.
So, you are really only 2% better off. This 2% is the real interest rate – the growth of your purchasing power after adjusting for inflation.
We can calculate the rate of growth in purchasing power as follows:
Hence, the real interest rate can be calculated as:
That is, the real interest rate is approximately equal to the nominal interest rate less the inflation rate.
Lecture Example 1
Question: Suppose the interest rate on a 5-year Australian government bond is 4.2%, and the inflation rate is expected to be 2.8%. What is the estimated real interest rate using the exact/precise and approximate Fisher Equations?
Solution:
Exact/precise Fisher equation:
Approximate Fisher equation:
Interest Rates, the Business Cycle, and Inflation
Interest rates tend to follow the business cycle.
During periods of economic expansion, interest rates tend to rise.
During a recession, interest rates tend to fall.
Summary
The role of the financial system in the economy and fund transfers.
Direct versus indirect financing.
Debt versus equity financing.
Financial institutions, financial markets and regulators in the financial system.
Determining interest rates and calculating the nominal or real rate of interest.
Formula Summary
Exact/precise Fisher equation:
Approximate Fisher equation: