Chapter 1 A modern financial system
Learning objective 1: explain the functions of a modern financial system The introduction of money and the development of local markets to trade goods were the genesis of the financial system of today. Money is a medium of exchange that facilitates transactions for goods and services. With wealth being accumulated in the form of money, specialised markets developed to enable the efficient transfer of funds from savers (surplus entities) to users of funds (deficit entities). A modern financial system comprises financial institutions, instruments and markets that provide a wide range of financial products and services. A financial system encourages accumulated savings which are then available for investment within an economy. Financial instruments incorporate attributes of risk, return (yield), liquidity and time-pattern of cash flows. Savers are able to satisfy their own personal preferences by choosing various combinations of these attributes. By encouraging savings, and allocating savings to the most efficient users, the financial system has an important role to play in the economic development and growth of a country.
Learning objective 2: categorise the main types of financial institutions, being depository financial institutions, investment banks and merchant banks, contractual savings institutions, finance companies and unit trusts A range of different financial institutions has evolved to meet the needs of financial market participants and to support economic growth. Chapters 2 and 3 examine the major types of financial institutions. At this stage the institutions are categorised by the nature of their principal activities. Depository institutions, such as commercial banks, building societies and credit unions, specialise in gathering savings in the form of deposits and use those funds in the provision of loans to customers. Investment banks and merchant banks tend to specialise in the provision of advisory services to clients (e.g. merger and acquisition advice). Contractual savings institutions, such as insurance offices and superannuation funds, enter into contracts in which they receive funds on the undertaking that they will pay a policy holder, or member of a fund, a specified sum when a nominated event occurs. Finance companies sell debt instruments directly to surplus entities and then use those funds to provide loans and lease financing to borrowers. Unit trusts sell units in a trust. The accumulated funds in the trust are pooled and invested in asset classes specified within the trust deed. Commercial banks dominate in terms of their share of the assets of financial institutions. Learning objective 3: define the main classes of financial instruments that are issued into the financial system; that is, equity, debt, hybrids and derivatives Financial instruments are central to any financial relationship between two parties. Where the saver acquires an ownership claim on the deficit entity, the financial instrument is referred to as equity. Where the relationship is a loan, the financial instrument is referred to as a debt instrument. A financial instrument that incorporates the characteristics of both debt and equity is known as a hybrid. Instructor’s Resource Manual t/a Financial Institutions, Instruments and Markets 5e, by Viney 8
Another category of instruments is derivatives (futures, forwards, swaps and options). The main use of a derivative is in the management of commodity and financial risks.
Learning objective 4: discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondary markets, direct finance and intermediated finance Financial markets and instruments allow borrowers to meet the requirements of the matching principle; that is, short-term assets should be funded by short-term liabilities and long-term assets should be funded by long-term liabilities and equity. ...
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