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WEEK 2: Financial systems components (rate of return (default risk…
WEEK 2: Financial systems components
financial institutions
commercial bank or non bank ( credit unions, building societies, superannuations) acts as BROKER
transfer of funds = INTERMEDIATION = indirect finance ( investment bank)
customer service. credit union come back to compete against big commercial bank
financial instruments
classified according to the markets they are traded in
how they issued
debt
: provide holder with a contractual claim to defined periodic interest repayments and the repayments of principle
equity
: provide holder with an ownership interest in a assets ordinary share, preference share
derivative
: allow management on certain risks and speculation
DON'T
provide funds to borrowers
hybrids
: incorporates characteristics of debts & equity
maturity
(short/long term, money, capital)
MONEY MARKET
entitlement to the holder to a specified set of future cashflow)
users of funds (deficit units) obtain finance. users must prepare a legal document (financial instrument) defining the contractual arrangments.
Financial markets
provide forum for the
creation
and
exchange
of financial instrument good and service
role
: to transfer funds from Borrowers to Lenders CENTRAL GOAL
allocate funds bt alternative users
6 types:
money:
short terms financial instrument ( bank bill, promissory note)
Capital
: long term financial instrument (shares, corporate bonds, government bonds)
wholesale
: financial flow transaction occur directly bt institutional investor & borrower. Dollar amount
retail
: transaction= primarily, w/ financial intermediary by the household & small to medium size business sector
domestic
:
international
over the counter
issued & exchanged over the
dealer, bank
, no formal market for such instrument (foreign exchange market) physical trading floor
exchange trade
dealt via centralised exchange facility such as the sharemarket (ASX, NYSE)
buyer + seller meet in central location to trade
derivative
bond market
stock market
foreign exchange
indirect finance
1 financial assets
transfer of fund via institution
involve the purchase of financial claim w/ characteristic from Deficit -> TRANSFORMATION into financial claim w/ different set of characteristic
BENEFIT
Asset/ maturity transformation
investment bank
: underwrite issue, help raise capital or debt, fee and commission = broker, middle man of indirect financing
superanuation
credit risk diversification
liquidity transformation
economics of scale
direct finance
transfer without an intermediary
no transformation of financial in the process
allows deficit units to issue financial claims on themselves & sell them for $$ directly to surplus units IN FINANCIAL MARKET
ADVANTAGE
cost of intermediary avoided
increase access to a diverse range of market
provide great flexibility -> securities different financing need.
DISADVANTAGE
matching of preference difficult
liquidity 2 marketability depend upon other party
search & transactions costly
assessment of risk (default risk) difficult to find information
issue & trading financial instrument
public offering: issued to general public
private placement: issued to single investor or group
rate of return
delaying = compensated
required rate of return -> risk
reward for loss of purchasing power over time
INFLATION
default risk
corporate bond
risk for not being paid back $ you lent
maturity
longer term to maturity the greater the potential for price of the financial securities you have invested in
liquidity
less liquid: the higher risk = not converting into cash quickly
NOMINAL, REAL INTEREST RATE
NOMINAL = real rate of interest + inflation premium
real rate of interest= risk free rate + default + maturity + liquidity premium