Flashcards in Topic 1 - Financial System Overview Deck (61)
organized structure that facilitates the ﬂow of funds.
The financial system comprises of
Flow of funds from
surplus units (savers) to deﬁcit units (borrowers).
Financial Institutions and markets facilitate
ﬂow of funds resulting in ﬁnancial transactions
Financial instruments are created to
recognise financial transactions
Savers reason for investing:
to trade oﬀ current consumption for a larger future consumption.
Invest savings to improve their overall wealth.
The financial asset has 4 main attributes
Return or Yield
Time pattern of cashflows
There are ﬁve broad categories of ﬁnancial institutions based on how they source and use their funds:
Depository ﬁnancial institutions
Contractual savings institutions
Finance companies and general financiers
legal documents issued by parties raising funds, acknowledging a ﬁnancial commitment and entitling the holder to speciﬁed future cash ﬂows.
Three broad categories for financial instruments
The sum of the financial interest an investor has in an asset; an ownership allocation
2 types of equity
represents an ownership positions
shareholders are entitled to share in the proﬁts of the business in the form of dividend payments.
incorporates characteristics of both debt and equity
Example: an instrument issued which makes periodic interest payments, but offers a future ownership entitlement (e.g. convertible notes and preference shares).
Contractual claim against an issuer and require the borrower to make speciﬁc payments such as coupon or interest payments and the repayment of principal amount at the end of the maturity period.
Ranks ahead of equity
Features of Debt
can be short term or medium to long term.
secured or unsecured.
negotiable debt instrument (ownership transferable) or non-negotiable (e.g. term loan obtained from a bank).
Derivative security is a ﬁnancial instrument whose value depends (derives from) on another (fundamental) security such as stocks/bonds or commodity.
Primary use of Derivatives
Primarily used not to raise funds but to manage risk.
Types of Derivatives Contracts
Short-term assets ﬁnanced by short-term liabilities
Medium-to-long-term assets financed with equity and/or medium-to-long-term liabilities.
Categorization of ﬁnancial markets based on the type of transactions that occur within each market:
Primary and secondary markets
Direct and intermediated markets
Money and capital markets
Wholesale and retail markets
Primary Market Transactions
Markets where new instruments are sold and the money raised goes directly to the issuing entity.
eg - bonds, preferred stocks, common stocks
Secondary Market Transactions
Without a proper secondary market primary market issuers would have to provide a much higher return to compensate investors for the substantial liquidity risk.
A deep and liquid secondary market strengthens the primary market.
Funding obtained direct from the money and capital markets;
Contractual agreement is between the provider of funds and the user of funds. use of agents
Funds are not provided by the financial institutions.
through which the instructions of providers and users of the funds are carried out.
Do not provide finance, but receives a fee or commission for arranging transaction between two parties.
Advantages of Direct Finance
Removes cost of intermediary
allows the borrower to diversify funding
Greater flexibility in types of funding instruments used for different financing needs
Enhance international profile by carrying out transactions in international financial markets
Disadvantages of Direct Finance
Matching preferneces of lenders and borrowers
Liquidity and marketability of securities
Search and transaction costs
Difficult to assess risk, especially default risk
Supplier of funds (investor) contracts with a financial intermediary such as a bank (e.g. term deposit);
User of funds (borrower) also contracts with the intermediary (e.g. housing loan)
Claims of each party are with the intermediary; i.e. the investor has no claim against the borrower
Benefits of Intermediation
Credit risk diversification
Economies of Scale/Distribution of costs: