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1

financial system

organized structure that facilitates the flow of funds.

2

The financial system comprises of

Financial institutions
Financial markets
Financial instruments

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Flow of funds from

surplus units (savers) to deficit units (borrowers).

4

Financial Institutions and markets facilitate

flow of funds resulting in financial transactions

5

Financial instruments are created to

recognise financial transactions

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Savers reason for investing:

to trade off current consumption for a larger future consumption.
Invest savings to improve their overall wealth.

7

The financial asset has 4 main attributes

Return or Yield
Risk
Liquidity
Time pattern of cashflows

8

There are five broad categories of financial institutions based on how they source and use their funds:

Depository financial institutions
Contractual savings institutions
Investment Banks
Finance companies and general financiers
Unit Trusts

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Financial instruments

legal documents issued by parties raising funds, acknowledging a financial commitment and entitling the holder to specified future cash flows.

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Three broad categories for financial instruments

Equity
Debt
Derivatives

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Equity

The sum of the financial interest an investor has in an asset; an ownership allocation

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2 types of equity

Ordinary Shares
Hybrid Securities

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ordinary shares

represents an ownership positions
shareholders are entitled to share in the profits of the business in the form of dividend payments.

14

Hybrid Security

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).

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Debt

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

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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).

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Derivatives

Derivative security is a financial instrument whose value depends (derives from) on another (fundamental) security such as stocks/bonds or commodity.

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Primary use of Derivatives

Primarily used not to raise funds but to manage risk.

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Types of Derivatives Contracts

Futures contract
Forwards contract
Option contract
Swap contract

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matching principles

Short-term assets financed by short-term liabilities
Medium-to-long-term assets financed with equity and/or medium-to-long-term liabilities.

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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

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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

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Secondary Market Transactions

Provides liquidity
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.

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Direct Finance

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.

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Agents

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.

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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

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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

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Intermediated Finance

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

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Benefits of Intermediation

Asset transformation
Maturity transformation
Credit risk diversification
Liquidity transformation
Economies of Scale/Distribution of costs:

30

Asset Transformation

Ability to prove a range of products that meet customers portfolio preferences