RMIT Classification: Trusted

Introduction to Financial System

FINANCIAL MARKETS AND INSTITUTIONS

Topic 1

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Overview

Nature and
Financial system Direct and
classification of
Components indirect finance
financial markets

Relationship
The government
between financial
and financial
markets and the
markets
real economy

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What is financial system?

1. Financial system comprises a range of financial institutions, instruments, markets that

facilitate the flow of funds through the financial system.

2. The key elements of the financial system are

o Financial instruments: Equity, debt, derivatives, etc.

o Financial markets: Primary/ Secondary markets; etc.

o Financial institutions: banks, finance companies, etc.

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Functions of the financial system

• To facilitate the transfer of funds from surplus economic

units to deficit economic units, by the creation of new
financial assets.

• To facilitate the trade of existing financial assets.

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Components of the financial system

• Surplus & Deficit economic units

• Financial institutions

• Financial assets

• Financial markets

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• Surplus economic units

 Individuals, households and companies with more funds than
required for immediate expenditure
 Savers
 Potential lenders
• Deficit economic units

 Individuals, households, companies who require additional funds to

meet expenditure plans

 Potential borrowers
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• Financial Institutions

Organizations whose core business involves:

 Borrowing and lending (financial intermediation)

 Provision of financial services

• Financial assets/financial instruments

Are issued by a deficit economic unit

 Acknowledge a financial commitment and entitle the holder to specified future cash
flows
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THE FINANCIAL SYSTEM:
The financial markets and flow of funds

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Financial instruments
Acknowledges a financial commitment and represents an entitlement to future
cash flows

Equity: the sum of the financial interest an investor has in an

asset; an ownership position (Ex: Common stock)

Debt instruments: specify conditions of a loan agreement: issuer/

borrower, amount, return, timing of cash flows, maturity date; debt
must be repaid (Ex: Bond, loan contract)

Derivatives: a synthetic security that derives its price from a

physical market commodity or security; mainly used to manage
risk exposures (Ex: Futures/ Forward/ Option/Swap contract)

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Attributes of Financial assets

Return or yield:
the financial benefit gained from investment of
A major function of the savings; expressed in percentage terms

financial system is to facilitate Risk:

portfolio structuring and the possibility or probability that an actual outcome
will vary from the expected outcome; uncertainty
restructuring through the
buying and selling of a wide Liquidity:
access to cash and other sources of funds to meet
range of financial instruments day- to-day expenses and commitments

Time-pattern or cash flows:

the frequency of periodic cash flows (interest and
principal) associated with a financial instrument

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Attributes of financial assets

• Return vs Risk
o Return = The gain or loss of an investment over a specified period, expressed
as a percentage increase over the initial investment cost
o Gains/losses on investments = periodic income received from the security +
realized capital gains / losses

• Risk = The chance that an investment's actual return will be different than
expected.

 There is always a trade off between risk and return.

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Attributes of financial assets

Liquidity

 The degree to which an asset or security can be bought or sold in the

market without affecting the asset's price.

 The ability to convert an asset to cash quickly. (also known as

"marketability”)

 Particularly critical with a high level of trading activity.

 It is safer to invest in liquid assets than illiquid ones because it is easier

for you to get your money out of the investment.
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Attributes of financial assets

Time pattern of the cash flows

 When the specified or expected cash flows related to a

financial asset are to be received by an investor.

 When, how much, how often?

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Attributes of financial assets

Portfolio structuring:
 A combination of assets and liabilities to maximize the
returns from a set of investment for a given level of risk.

 A good portfolio is not simply a collection of individually good

investments.
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Classification of Financial Markets

Classification

By
By nature of By maturity of By timing of
organizational
claim claim delivery
structure

Exchange Over the

Debt market Equity market Money market Capital market Cash market Futures market
Traded Market counter market

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How to borrow/ invest?

• Direct financial flows:

• Intermediated financial flows:

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The benefits and disadvantages of
direct finance
Benefits:

• Remove the cost of financial intermediary

• Allows a borrower to diversify funding sources
• Greater flexibility in the types of funding instruments

Disadvantages:

• Problem of matching the preferences of lenders and

borrowers
• Liquidity and marketability may be of concern
• Search and transaction costs can be quite high
• Difficult to assess the level of risk of investment

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The benefits and disadvantages of

financial intermediation
Benefits:

• asset transformation
• maturity transformation
• credit risk diversification and transformation
• liquidity transformation
• economies of scale.

Disadvantages:

• Increased cost of funds for borrowers

• Reduced return from lending for savers
• It is less likely for secondary financial assets to be securitised
(i.e. Financial securities)

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Economic markets

Circular Flow
• Resource markets

• Output markets

(goods & services)

• Financial markets

Source: "Interactive Economics 2000" is copyright Michael Jarrett 2000

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How does the financial system impact on

macroeconomic economic objectives?
Economic growth

Full employment

Price stability

External balance

Efficient allocation of resources

Equitable distribution of income and wealth

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End of Topic 1

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