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Funding, Debt, and Finance: an Introduction

Financial Systems:

Facilitates the efficient flow of funds between lenders and borrowers via financial instruments
Allows individuals to allocate funds according to current and future consumption
Facilitates the implementation of government monetary policy

Financial Instruments:

Attributes of financial instruments
¨      Return or yield
¨      Risk
¨      Liquidity
¨      Time pattern of cash-flows

Equity
¨      Shares represent an ownership position
¨      An entitlement to share in the profits of the organisation
¨      Equity types
–      Ordinary shares
–      Preference shares
–      Quasi-equity instruments

Debt
¨      Debt instruments represent a contractual claim on the borrower to make specific payments in the form of interest and principal amounts
¨      Debt may be issued with a fixed or floating interest rate, or at a discount, secured or unsecured, short or long-term

Derivates
¨      Derivate instruments derive their price from physical market instruments (either equity or debt)
¨      Futures, forwards, options and swaps
¨      Used to manage financial risk

Financial Markets

Financial markets facilitate the flow of funds between borrowers and lenders
Categories of financial markets
¨      Primary markets
¨      Secondary markets
¨      Wholesale and Retail markets
¨      Money markets
¨      Capital markets

Primary Markets
Primary markets involve the issue of new financial instruments
¨      Used by businesses, governments and households to raise funds
¨      Examples: initial issue of shares by a company or government-bond issue by a government
¨      The flow of funds can be either
–      Direct finance
–      Intermediated finance

(a) Direct flow markets
Funds flow directly from savers to users
¨      Advantages
–      Avoids costs of intermediation
–      Increases range of financial markets and financial instruments
¨      Disadvantages
–      Matching of preferences
–      Search and transaction costs
–      Liquidity of secondary market
–      Assessment of risk

(b) Intermediated Flow markets
Ultimate borrowers and lenders contract with an intermediary
¨      Advantages
–      Asset transformation
–      Maturity transformation
–      Credit risk diversification
–      Provision of liquidity to savers
–      Distribution and costs

Secondary Markets
Secondary markets are used to trade existing financial instruments
¨      Features
–      Increase the liquidity of public issue instruments
–      Examples: subsequent selling of shares purchased through the primary market
–      No new funds are raised by the original issuer

Wholesale and retail markets
Wholesale markets involve large transactions (>$100,000) in short term finds by institutional investors and borrowers
Retail markets generally involve transactions of household and small business sectors using financial intermediaries

Money markets
Money market securities provide short-term funding (lees than 12 months to maturity)
Deep secondary markets
Enable participants to manage liquidity
Money market participants
¨      Includes the reserve bank transactions affecting
–      Financial system liquidity
–      Exchange settlement account funds
–      Monetary policy
Money market participants
¨      Banks
¨      Money market corporations
¨      Finance companies
¨      Funds managers
¨      Building societies
¨      Credit unions
¨      Cash management trusts
¨      Companies
Money market sub-markets
¨      Inter-company market
¨      Inter-bank market
¨      Bills market
¨      Commercial paper market
¨      Negotiable CDs market

Capital markets
Capital market instruments provide medium-to-long term finding (>1year)
Associated markets include
¨      Equity market
¨      Corporate debt market
¨      Government debt market
¨      Foreign exchange market
¨      Derivates market

Globalisation of financial markets
¨      Refers to the interdependence of national financial systems
¨      Global standardisation of financial instruments
¨      Facilitates the movement of funds between borrowers and lenders in different countries

Financial Institutions

Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial transactions
Categories of financial institutions
¨      Depository financial institutions
¨      Contractual savings institutions
¨      Finance companies
¨      Money market corporations
¨      Unit trusts

Depository financial institutions
Attract savings from depositors and investors to provide loan facilities to borrowers
Examples include
¨      Banks
¨      Building societies
¨      Credit unions

Contractual savings institutions
The liabilities of these institutions are contracts that generate periodic cash flows and are then used to purchase both primary and secondary market securities
Examples include
¨      Insurance companies
¨      Superannuation funds

Finance companies
These institutions raise funds by issuing financial securities direct into money markets and capital markets
These funds are used to make loans to ultimate borrowers

Money market corporations
Raise short-term funds in the wholesale money market
Provide short-to-medium term loans to ultimate borrowers
Examples include
¨      Merchant banks
¨      Investment banks

Unit trusts
Investors purchase units in the trust
The trust manager invests in a specified range of investment types
Types of unit trusts
¨      Cash management trusts
¨      Equity trusts
¨      Property trusts
¨      Mortgage trusts