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Solutions Tutorial 2: 1.

A modern financial systeman overview

Direct finance: Surplus economic units lend their funds direct to deficit economic units which are the ultimate borrowers. Financial institutions may facilitate this process by providing financial services in return for fees and commissions. The financial assets issued by the deficit units are held by the surplus units. Indirect finance: Surplus economic units lend their funds to financial institutions (intermediaries) which in turn lend funds to the deficit units which are the ultimate borrowers. Financial intermediaries earn income by way of net interest margin. The financial assets issued by the deficit units are held by the financial intermediaries that issue separate financial assets to the surplus units.

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Borrowers and (b) Lenders:

Asset value transformation - the creation of secondary securities that differ in value from the primary securities. Maturity transformation meets the needs of lenders (who would prefer to lend short term) and borrowers (who would prefer to borrow long term). Credit risk reduction and diversification - the spread and control of credit risk through risk management techniques and expertise. Liquidity provision - the provision of a range of services with a high degree of liquidity e.g. Cheques, ATMs, EFTPOS. (c) National Economy:

Increased quantity of national savings. Greater access to savings by investors. Economic development and growth.

Disadvantages: Increased cost of borrowing. Reduced return from lending. Financial assets issued by financial intermediaries are less likely to be securitised: ie. Able to be sold in a secondary market.

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Financial assets represent claims which surplus units hold against deficit units in direct financing, or in the case of indirect financing, over financial intermediaries which hold claims over deficit units. The claims are created by the lending of funds as they represent an obligation to repay by borrowers and a right to receive by lenders. Only if funds are given away will no financial asset be created. Primary Market: Funds are lent and borrowed in the primary market and new financial assets are created. A new issue of shares represents the acquiring of equity funds by a corporation and the creation of new financial assets (the shares). This is often referred to as an Initial Public Offer (IPO) or float. The issue of treasury bonds by the government, to finance a budget deficit, for example, represents the creation of new financial assets (the bonds). This is done by a tender process and the bonds are usually sold to banks and other financial institutions. Secondary Market: Secondary market transactions represent the purchase and sale of existing financial assets. These transactions do not result in the creation of any new financial assets but simply represent a change in ownership of existing assets and not the borrowing and lending of new funds. The issuer of the financial assets does not directly participate in secondary market transactions. The main example of the secondary market for shares is the stock market, such as the Australian Stock Exchange (ASX) and the main example of the secondary market for government bonds is the trading of bonds amongst banks or between banks and the Reserve Bank of Australia (RBA).

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Types of Financial Assets: Bank Deposits and Company Shares Return

Bank Deposits Return are paid by way of interest on the balance of the account. Returns are very low compared to other forms of investment. Company Shares Returns can be earned by way of dividends, as well as a capital gain or loss when the shares are sold. Returns are highly variable but are generally higher than bank deposits because they represent greater risk. Risk Bank Deposits The risk is quite low. Banks in particular are supervised by Government agencies to ensure the financial safety of the banking system. Other financial institutions are also governed by prudential regulation. Company Shares The risk is variable but generally quite high. Because share-holders have a residual claim over the assets of the company, their returns can be quite variable, and

therefore they face a greater level of risk. Share-holders stand to lose their entire investment if the company gets into financial difficulties. With both bank deposits and company shares, the level of return is commensurate with the risk.

Liquidity Bank Deposits These are not securities which can be sold, so the degree of liquidity depends on how accessible the deposits are. At call deposits are highly liquid and can usually be accessed using facilities such as ATMs and EFTPOS. Fixed term deposits are less liquid and can only be accessed at the end of the fixed term, or a penalty fee will be payable. Company Shares There is a highly liquid market for shares which are listed on the Stock Exchange (which constitute the vast majority of shares which change hands), so the liquidity for most shares is very high.

Time Pattern of Returns Bank Deposits Return are paid regularly, although the time pattern can vary between accounts and financial institutions. Interest can is usually paid annually, semi-annually or monthly. Company Shares In this case the time pattern of returns is highly variable. Some shares pay a constant level of dividend from year to year. Others vary the amount of dividend, and some pay no dividends. The capital gain or loss on sale of the share, which is a significant component of the return, has no time pattern because it is only realised when the share is sold.

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Debt: Debt financial assets (Loans, Debentures, Certificates of Deposit etc) represent contractual claims on deficit units to repay the respective contracts. The surplus unit literally lends money to the deficit economic unit, and does not obtain any ownership rights over the deficit economic unit. Equity: Equity financial assets (chiefly shares) represent ownership interests in companies (deficit units) by surplus units. Equity holders claims are to the profits of the company and the net assets of the company if it is liquidated. This is not a contractual claim but a residual claim. There is no contractual obligation to make repayments, but the profits of the company belong to the shareholders.

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An efficiently operating secondary market is important to the corresponding primary market as it increases the flow of savings for investment in real capital by providing liquidity to financial assets (debt, equity, derivatives) and lowering credit risks to investors. Investors are more likely to invest in financial assets if there is a liquid secondary market in which they can sell those assets at any time. Thus, liquidity in the secondary market results in increased liquidity in the primary market. This is an example of maturity value transformation, because deficit units can borrow long term (in the case of shares, indefinitely) whilst investors can borrow short-term because of the existence of a liquid secondary market in which they can recoup their investment.

Secondary markets also provide a price discovery mechanism which enables issuers of securities to determine the market value of those securities. This might be advantageous if they are contemplating new issues of the same security. 8. Investment banks and merchant banks play an extremely important role in the provision of innovative products and advisory services to their corporations, high-net-worth individuals and government. Investment and merchant banks raise funds in the capital markets, but are less inclined to provide intermediated finance for their clients; rather, they advise their clients and assist them in obtaining funds direct from the domestic and international money markets and capital markets. Investment banks specialise in the provision of off-balance-sheet products and advisory services, including operating as foreign exchange dealers, advising clients on how to raise funds in the capital markets, mergers and acquisitions, acting as underwriters and assisting clients with the placement of new equity and debt issues, advising clients on balance-sheet restructuring, evaluating and advising on corporate mergers and acquisitions, advising clients on project finance and, providing risk management services. Commercial banks are the largest group of financial institutions within a financial system and therefore they are very important in facilitating the flow of funds between savers and borrowers. The core business of banks is often described as the gathering of savings (deposits) in order to provide loans for investment. Investment bank: Macquarie Group Commercial bank: Commonwealth bank of Australia