Introduction to financial markets
1. Direct finance:
Surplus economic units lend their funds “direct” to deficit economic units which are the ultimate borrowers. Financial institutions may facilitate this process by providing financial services in return for fees and commissions. The financial assets issued by the deficit units are held by the surplus units. Indirect finance:
Surplus economic units lend their funds to financial institutions (intermediaries) which in turn lend funds to the deficit units which are the ultimate borrowers. Financial intermediaries earn income by way of net interest margin. The financial assets issued by the deficit units are held by the financial intermediaries that issue separate financial assets to the surplus units.
Borrowers and (b)
0 Asset value transformation - the creation of secondary securities that differ in value from the primary securities. 1 Maturity transformation – meets the needs of lenders (who would prefer to lend short term) and borrowers (who would prefer to borrow long term). 2 Credit risk reduction and diversification - the spread and control of credit risk through risk management techniques and expertise. 3 Liquidity provision - the provision of a range of services with a high degree of liquidity e.g. Cheques, ATMs, EFTPOS.
4 Increased quantity of national savings.
5 Greater access to savings by investors.
6 Economic development and growth.
7 Increased cost of borrowing.
8 Reduced return from lending.
9 Financial assets issued by financial intermediaries are less likely to be securitised: ie. Able to be sold in a secondary market.
Financial assets represent claims which surplus units hold against deficit units in direct financing, or in the case of indirect financing, over financial intermediaries which hold claims over deficit units. The claims are created by the lending of funds as they represent an obligation to repay by borrowers and a right to receive by lenders. Only if funds are “given away” will no financial asset be created. 4.
Funds are lent and borrowed in the primary market and new financial assets are created. A new issue of shares represents the acquiring of equity funds by a corporation and the creation of new financial assets (the shares). This is often referred to as an Initial Public Offer (IPO) or “float”. The issue of treasury bonds by the government, to finance a budget deficit, for example, represents the creation of new financial assets (the bonds). This is done by a tender process and the bonds are usually sold to banks and other financial institutions.
Secondary market transactions represent the purchase and sale of existing financial assets. These transactions do not result in the creation of any new financial assets but simply represent a change in ownership of existing assets and not the borrowing and lending of new funds. The issuer of the financial assets does not directly participate in secondary market transactions. The main example of the secondary market for shares is the stock market, such as the Australian Stock Exchange (ASX) and the main example of the secondary market for government bonds is the trading of bonds amongst banks or between banks and the Reserve Bank of Australia (RBA).
Types of Financial Assets: Bank Deposits and Company Shares
Bank Deposits – Return are paid by way of interest on the balance of the account. Returns are very low compared to other forms of investment.
Company Shares – Returns can be earned by way of dividends, as well as a capital gain or loss when the shares are sold. Returns are highly variable but are generally higher than bank deposits because they represent greater risk. Risk
Bank Deposits – The risk is...
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