Introduction to Financial Systems

Posted on Jun 3, 2024 in Economy

1.1 Functions of a Financial System

The financial system serves several important functions. Firstly, money acts as a medium of exchange, allowing for the smooth transaction of goods and services. Additionally, money serves as a means of saving and representing a store of wealth or value.

In the financial system, there are surplus units, which are savers that make funds available for lending. These savers are willing to sacrifice present consumption to increase future consumption. They can choose to invest their funds or purchase financial instruments such as shares or term deposits.

On the other hand, there are deficit units, which are borrowers that require funds for capital investment and consumption. These borrowers increase their current consumption but will need to reduce future consumption. They can sell financial instruments or borrow from financial institutions to obtain the funds they need.

Financial instruments, also known as financial assets, are issued by parties raising funds. These instruments acknowledge a financial commitment and entitle the holder to future cash flows. Examples of financial instruments include shares and bank deposits. When these instruments can be bought and sold on a formal market, they are referred to as financial securities.

The financial system, consisting of financial institutions, instruments, and markets, facilitates transactions for both goods and services and financial transactions. Markets play a crucial role in bringing together opposite parties and establishing exchange rates or prices. Financial markets specifically cater to the needs of borrowers and savers by issuing financial instruments.

The flow of funds within the financial system involves the movement of funds between savers and borrowers, giving rise to various financial instruments.

When considering investment, financial assets possess certain attributes that investors should consider. These attributes include:

Rate of return or yield: Represents the total financial compensation received from an investment as a percentage of the amount invested.
Risk: Refers to the probability that the actual return on an investment will differ from the expected return.
Liquidity: The ability to sell an asset at current market prices within a reasonable time and with reasonable transaction costs.
Time-pattern of cash flows: Indicates when the expected cash flows from a financial asset will be received by the investor or lender.

Investors have different preferences and may be categorized as risk-averse, risk-neutral, or risk-seeking.

Risk-averse individuals dislike risk and will only choose a risky investment if the expected return is high enough to compensate for the extra risk.
Risk-neutral investors are indifferent to risk and base their investment decisions solely on expected return.
Risk-seeking investors enjoy risk and may choose a risky investment even if the expected return is lower than that of a less risky investment.

1.2 Financial Institutions

Financial institutions play a crucial role in facilitating the flow of funds between borrowers and lenders through financial transactions. These institutions can be categorized based on differences in the sources and uses of funds.

Most individuals have interacted with financial institutions at some point, even if it was simply through a basic bank account. Financial institutions specialize in various areas such as taking deposits, providing advice to corporate and government clients, or offering financial contracts like insurance. They are essential for the operation of the modern financial system.

Categories of Financial Institutions

Authorized deposit-taking institutions: Attract savings from depositors through on-demand and term deposit accounts. Commercial banks, building societies, and credit cooperatives fall under this category. These institutions mainly provide loans to borrowers in the household and business sectors.
Investment banks and merchant banks (money market corporations): Primarily offer off-balance-sheet advisory services to support corporate and government clients. They provide advice on mergers and acquisitions, portfolio restructuring, finance, and risk management. While they may offer loans, their main focus is on advising clients on raising funds directly in capital markets.
Contractual savings institutions: Have liabilities in the form of contracts that specify payments to contract holders if a specified event occurs. Examples include life and general insurance companies and superannuation funds. These institutions use the funds collected to purchase a range of financial instruments and make payouts for insurance claims and retirements.
Finance companies: Raise funds by issuing financial securities such as commercial paper, medium-term notes, and bonds into money markets and capital markets. They utilize these funds to provide loans and lease finance to customers in the household and business sectors.
Unit trusts: Formed under a trust deed and are controlled and managed by a trustee. Funds are raised by selling units to the public, and investors purchase these units. The pooled funds are then invested by fund managers in various asset classes specified in the trust deed. Types of unit trusts include equity, property, fixed interest, and mortgage trusts.

Categories of Financial Instruments

Financial instruments can be categorized into three categories:

Equity: Represents ownership in an asset, such as shares in a company.
Debt: A contractual claim to interest payments and repayment of principal, such as a loan or bond.
Derivatives: Derive their value from a physical market commodity or financial security, such as options or futures contracts.

These financial instruments are considered financial assets as they entitle the holder to future cash flows. Financial securities are financial assets that can be bought or sold on a formal market, such as shares on a stock exchange.

Equity investments involve buying shares in a company, giving the investor ownership and entitlement to a share of the profits. There are different types of equity, such as ordinary shares and hybrid securities like preference shares and convertible notes.
Debt instruments involve making a loan to the party issuing the instrument, with periodic interest payments and repayment of principal. Debt ranks ahead of equity and can be secured or unsecured, negotiable or non-negotiable.
Derivatives are synthetic securities that derive their price from a physical market commodity or financial security. They are used to manage price risk exposure and speculate on future price movements. Examples of derivatives include futures contracts, forward contracts, options, and swaps.

Financial Markets

Financial markets are where financial instruments are bought and sold. Examples of financial markets include stock exchanges like the ASX, where shares of listed companies are traded. Matching principle is an important consideration in financial markets, where short-term assets should be funded with short-term liabilities and longer-term assets should be funded with longer-term liabilities or equity.

Types of Financial Markets

Primary markets: Involve the issuance of new financial instruments to raise funds.
Secondary markets: Involve the buying and selling of existing securities.
Direct financial flow markets: Involve users of funds obtaining finance directly from savers.
Intermediated financial flow markets: Involve a financing arrangement with an intermediary providing funds to the ultimate user of funds.
Wholesale markets: Involve direct transactions between institutional investors and borrowers.
Retail markets: Involve transactions primarily conducted with financial intermediaries by households and small to medium-sized businesses.
Money markets: Wholesale markets for short-term securities.
Capital markets: Markets for longer-term securities. Capital markets include equity markets, corporate debt markets, and government debt markets.
Foreign exchange market: Involves the buying and selling of currencies, facilitating the exchange of value from one currency to another. It is a global network of electronic connections between forex dealers, brokers, and customers.
Derivatives market: Provides risk management products to manage risks such as interest rate, foreign exchange, and price risks. Derivatives can also be used for speculation.

Financial Market Participants

Arbitragers: Exploit anomalies to make a profit without taking risks.
Hedgers: Cover open positions to reduce or eliminate risk.
Speculators: Take risks to attempt to make a profit.