Financial Markets

Types of financial markets

Role of Financial markets in economy

Financial markets refers to markets for financial products and service which allows savings and investment to
occur by bridging together net savers (have excess funds) and net borrowers (need additional money).
Financial intermediaries facilitate borrowing and lending activities in the economy by receiving the
accumulated funds of individuals and firms and the lending these funds to those in need of the finance
Sources of savings
o Households (Y=C+S)
o Firms (retained profits not distributed in dividends)
o Government (Budget surplus where T > G)
o Overseas (foreign savings)
Reasons for borrowing
o Households (demand greater than income thus buy on credit, borrow for durables, property)
o Firms (business expansion. Investment for capital)
o Government (budget deficit G > T)
o Overseas demand for funds (however Australia are net borrowers for funds from overseas
Financial markets are also factor markets for capital as borrowed funds are used by firms to invest in capital
which increase economys productive capacity
When firms cannot access finance a credit supply shock occurs
o In 2012, RBA estimated that GDP falls by $5 billion
o In 2009 GFC, credit supply shock was so severe that GDP was reduced by 1% ($14 billion)

Primary and secondary financial markets

Primary financial market
o Markets in which firms raise funds by selling financial
assets (securities), such as shares and debentures, to
investors
Secondary financial market
o Markets in which investors trade financial assets, such
as shares or debentures, with other investors
Largest primary and secondary financial market is Australia is Australian Securities Exchange (ASX)
Four main financial markets
o Share (equity) market
Ownership shares in companies is issued or exchanged
E.g. Buying shares in Coca-Cola Amatil
o Debt market
Debt securities are exchanged, or cash is lent or borrowed
E.g. Lending money to McDonalds
o Derivatives market
People buy and sell financial assets that are based on the value of other financial assets
o Foreign exchange market
Financial assets defined in one countrys currency are exchanged for assets defined in another countrys
currency
Financial intermediaries
o Banks
E.g. Commonwealth bank, ANZ, NAB, Westpac, Macquarie bank, Bank of Queensland
o Non-bank financial intermediaries (NBFIs)
E.g. Finance companies, Credit unions, Permanent Building Societies, Mortgage originators,
Superannuation funds
Financial Market products
Consumer credit
o Allow consumers to purchase consumer goods and service is advance of actual payment
o Most common type is credit card
Allow consumers to purchase goods and repay their borrowings with interest at a later date
Offered by banks, credit unions and other businesses such as Woolworths, Qantas etc.
Interest rates 10-20%
o Other major type is personal loans
Offered by banks and credit unions at higher interest rates than housing loans
High interest rate of 15-20%
Housing loans
o Offered by banks or mortgage originators such as Aussie and RAMS
o Long-term loans to purchase property, requiring periodic payments with interest
o Loan rates are usually 1 or 2% higher than RBA cash rate
Business loans
o Form of debt that allows businesses to invest in their business operations such as with new technology
o Interest rates around 1% higher for large businesses and as much as 5% higher for small businesses
o Smaller companies borrow from banks and finance companies while larger businesses also borrow from
investment banks
Short-term money market
o Brings together businesses and people with temporary shortages or surpluses of funds
o Those with surplus funds issue various forms of debt securities (e.g. bank bills) to those in need of funds
o Those debt securities have date of maturity less than one year
Bonds
o Longer-term securities for which lenders receive regular fixed payments (coupon payment) from issuing
institution and receive principal value of debt (face value of the bond) at the end of bond period (date of
maturity)
o Issued by governments and a small number of companies and banks
o In 2014, Government debt securities was $546 billion while corporate bonds were $477 billion
Financial futures and options
o Contracts to trade in financial instruments (e.g. shares bonds) at a later date for a certain price
o Allows investors to protect themselves from adverse movements in share prices or interest rates
o Options give their holder the right to make a transaction, but not there is no obligation
Foreign exchange and forex market
o Market for buying and selling of foreign currencies
o Investors require foreign currencies to do business with people overseas
o Forex market provide market for people to buy and sell currencies

Share market
Share market is the financial market where investors buy and sell shares
Shares are types of financial assets that provides an individual with ownership over part of a business or
company
For a firm to issue shares it must be a company i.e. incorporated
o A separate legal entity from those individuals who own or manage the business
o Has limited liability as if the business fails the individuals who operate business are protected from
bankruptcy
Public company is an entity whose shares are traded freely on the share market, and are not subject to
any restrictions on being transferred to other parties
Private company is one that restricts ownership of shares to only a few individuals and place restrictions
so that shares cannot be freely bought and sold between individuals (known as Proprietary Limited or Pty
Ltd.)
Share market only deals with trade in shares of public companies
Share market brings together buyer and seller in medium of exchange
Most exchanges take place through market facilitator known as stock exchange
 Largest share market in Australia is
Australian Securities Exchange (ASX)
o Provides regulated environment for
investors to buy and sell shares

Role and function

Investors and shareholders
o Purchase shares to gain a stake in any company
o Gives investors right to votes for companys board of directors who appoint senior managers and ultimately
decide how to create maximum returns for shareholders
o Shareholders received dividends and can make capital gains
Dividends are the profit returns received by the shareholders (owners) of a business
Capital gains are the profits made by investors who sell their shares or assets a price above the level that
they originally paid for them
o Shareholders risk are also limited as if the company loses money or closes, they only lose the money they
invested in shares and dont incur any further debts
o Savings invested in shares are major form of income especially for those in retirement
Company
o Share market provides an opportunity to raise new funds for investment and business growth
o When company list itself on the stock exchange it is called a float or IPO
o After IPO, firms can raise further equity by releasing new shares however reduces the value of existing shares
o Sale of new shares is a primary market transaction
o When an existing shareholders sells their shares to another investors it is a secondary market transaction
o If share price rises
Shareholders are happier as the value of their investment is higher
Management may receive possible bonuses and increase job security
o If share price falls
Shareholders are unhappy as they value of their investment decrease and may replace managers
Management has increased pressure from shareholders and threat of possible takeover leads to job
insecurity

Effect on the economy

Share market values are indicators of countrys economic conditions
Fluctuations in share market mirror changes in economic activity
Downturn or upturn in share markets is measure by All Ordinaries Index
Share markets also act as method of allocating resource to different types of production
Areas with higher share prices reflect growth areas of economy as sectors with best growth prospects will use
investment funds more efficiently and will raise most funds when floated
However share market is not could to use as indicator for economys health or growth sectors
o As many share purchases as speculative - bought with the intention of being re-sold within short period
o Problem with this is purchases are made based on hype in the market and not real profitability of firms
o As a result, certain shares or industries have overvalued prices which represents misallocation of resources
Share price can rise and fall sharply, especially in comparison to actual economic growth
Domestic and global markets
Increased level of foreign investors = Increased influence of global markets on Australia
Vulnerability of domestic economy to events oversea is constant theme of economy
Resource-rich economy means Australia is dependent on oversea investment to finance development
Increased integration is reflective of improvements in information and communications technology
Foreign exchange market allows overseas borrowing and lending
o AUD is 5th most traded economy
Global debt markets are important to Australian economy due to reliance on foreign borrowing
o $827 billion in loans to foreign entities while have outstanding foreign loans of $1.693 billion
Equity markets exist in individual countries so foreign movement of funds occurs mainly through banks
o Australians own $918 billion of foreign companies, foreign ownerships of Australian companies -$917 billion
Some regulation of markets is performed by international organisations such as Bank of International
settlements and International Monetary Fund (IMF)
Benefits of global financial markets
o Allows Australian to access foreign capital to invest in houses and businesses, otherwise there would be
higher borrowing costs
o Also offer Australians to invest and earn returns from businesses overseas
Disadvantage of global markets
o Regular disturbances in oversea markets are more quickly transmitted to Australia

Regulation of financial markets

Council of financial regulators is coordinating body for financial market regulation that provides cooperation
collaboration amongst four members: RBA, APRA, ASIC and Treasury
Reserve Bank of Australia (RBA)
o Responsible for monetary policy, payments system regulation and stability of financial system
o Central Banks Of Australia
o Roles:
Conducting monetary policy on behalf the government
Designed to influence cost and availability of money through general level of interest rates
Aims to achieve sustained low inflation rate while encouraging economic growth
Systemic stability- provides guidelines to foster stability of individual financial institutions
Control of note issue - sole issuing authority for Australian currency
Regulation of payment system - ensuring efficiency of payment methods such as credit cards
Banker to the banks - Banks hold exchange settlement accounts
Responsibility of holding Australias reserves of gold and foreign currency dealings
Australian Prudential Regulation Authority (APRA)
o Responsible for prudential supervision and regulate of all deposit-taking institutions (DPIs) including life and
general insurance, superannuation funds, credit unions and building societies
o Two main roles
Encourages behaviour by institutions that will ensure they meet their obligations:
Deposit-holders are able to take back their money when they want
Insurance companies meet their policy obligations
Superannuation funds can pay people who withdraw their savings
For institutions that experience financial difficulty, APRA sorts out their financial situation
Ensures that policy or deposit holders receive as much of their funds as possible
Australian Securities and Investment Commission (ASIC)
o Responsible for corporate regulation, consumer protections and oversight of financial service products
o Has power to monitor, investigate and act in situations where integrity of financial system is undermined
o ASIC is critical to lifting standards of corporate behaviour and maintain confidence in financial markets
o Role has been expanded to consumer credit and increase responsibilities for supervising security markets
Australian Treasury
o Advises the Government on financial stability issues, and regulatory framework for the financial system
o Can influence how Governments devise budgets, collect taxes, allocated expenditure and implement other
policies such as monetary policy, labour market policy and market regulations
The money market

Borrowers: The demand for funds

Individuals
o Home loans
o Personal loans
o Credit cards
Governments
o Borrow when expenditure exceeds revenue
Businesses (does most borrowing)
o Starting up a business
o Expanding a business
o Managing cash slow

Factors affecting the demand for funds

Individuals with surplus funds can either keep the money (currency and bank deposits) or purchase financial
assets (securities e.g. shares and bonds)
Return is the benefit of purchasing financial assets but there is a risk involved
o E.g. the dividends earned from owning shares in a company
o In contrast holding cash has no return
Liquidity is benefit of holding money
o The ease which a financial asset can be transformed into cash so it can be used as a medium of exchange
o Reasons for keeping liquid funds instead of investing in financial assets
Transactions motive
For day to day, regular and predictable transactions
Precautionary motive
For emergencies and unpredictable transactions
Speculative motive
To avoid capital losses by selling financial assets and converting to money if market values fall
Financial innovation
o Increased use of technology to deliver financial services e.g. ATMs, EFTPOs, internet banking
Decrease need to hold high volumes of liquid funds for day to day transactions
o Growth of internet-based discount stockbrokers such as E-trade and CommSec
Brought down cost of trading shares and made it easier for small individual investors to invest
o Creation of digital currencies such as Bitcoin
Allow payment systems to operate without need for intermediaries such as banks, decreasing transaction
costs

Lenders: the supply of funds

Individuals
o Place deposits in financial institutions are lending their money to that institution for a return
Businesses
o Successful business with strong cash flow and good profits may deposit its funds in an institution
If interest rates are at a level where depositing money is more lucrative than expanding the firm
Government
o When revenue is more than expenditure, government is a lender
International sector
o Australia has had historically a savings investment gap
i.e. We do not generate enough domestic savings to satisfy our demand for funds
Therefore we borrow from overseas savings
Leads to increase in net foreign debt of $924.8 billion (2014)
Money and money supply

Characteristics of money
o Medium of exchange
Goods, services and resources are exchanged for money
o Measure of value
Money can be used to compare the relative value of goods, service and resources
o Store of value
Money can be used to measure the value of goods, services and resources over time
o Method of deferred payment
Money allows the development of a system of lending and borrowing
Money supply is the total amount of funds in an economy that can be used as a medium of exchange, a
measure of value, a store of value and a method of deferred payment
o Monetary aggregates
Money Base
Currency + Bank Deposits with RBA
M3
Money base + Bank deposits
M3 is official measure of money supply for
Broad money
M3 + NBFI deposits - NBFI deposits in banks
Broad Money takes too long to compile relevant statistic despite being more accurate
o Bank deposits take up around 95% of M3
Credit is also important as a monetary aggregate but is not a measure of money supply as does not serve as
store of value

Interest rates
Interest rates are the cost of borrowing money expressed as a percentage of the total amount borrowed
o Price that bring equilibrium in the financial market, where quantity of funds supplied by lenders is equal to
funds demanded by borrowers
Borrowing rates differ from lending rates (Look at from perspective of financial institution)
o Borrowing rate is the rate of interest offered by a bank to the individual for the surplus funds
o Lending rate is the rate of interest charged by a bank to a firm that wants to borrow the funds for investment
purposes
o Interest rate differential is interest rate margin between the two
Interest rates will also differed depending on:
o Length of time to maturity
o Liquidity
o Risk
Factors that affect supply and demand influence general level of interest rates
o Level of investment
Increased investment = Increased demand for funds = Higher interest rates)
o Level of savings
Increase savings = Increased supply of funds = Lower interest rates)
o Demand for liquid funds
(Increase liquid funds = Increase supply of funds = Lower interest rates)
o Inflationary expectations
Reduce value of money = Higher interest rates to compensate for lower value of financial assets)
o Government budget
Budget deficit = Increase demand for funds = Higher interest rates)
o International interest rates
Lower interest rates than overseas = People moving deposits overseas = Decrease in supply of funds =
Higher interest rates)
o Monetary policy by the RBA
Domestic Market operations by the Reserve Bank

RBA influences interest rates through its conduct of monetary policy (MP)
Involves RBA controlling supply of fund through domestic market operations (DMOs) by either buying and
selling second hand Commonwealth government securities (CGS) in order to influence cash rate in short term
money market
Changes to cash rate then flow on to other interest rates
Exchange settlement accounts (ESA)
o Banks need to hold certain proportion of funds with Reserve Banks in ESAs in order to settle payments with
other banks and the RBA
o When transactions between different banks occur, money is transferred from one banks ESA to the others
o At the end of trading day, settlements will cancel out so there will be not net impact on money supply
o Banks try to keep minimal amount in ESA however they will increase money in ESA if they expect large
outflow of money
Changing monetary policy
o Tightening monetary policy
Contractionary stance
RBA announces intention to raise cash rate
RBA sells CGS to banks and other institutions in cash market
Banks withdraw funds from ESA to make payment to RBA
Causes fall in cash supply in cash market
Shortage of supply in cash relative to demand will cause an increase in the cash rate
Flows onto other interest rates
Interest rates rise
o Loosening monetary policy
Expansionary stance
RBA announces intention to lower cash rate
RBA buys CGS from banks and other institutions in cash market
Banks have funds put into their ESA as a payment from RBA
Causes rise in cash supply in cash market
Increase in supply of cash relative to demand will cause an fall in the cash rate
Flows on to other interest rates
Interest rates fall
Impacts of monetary policy
o Contractionary monetary policy
Decreased consumption due to high mortgage & credit card rates and high repayments on existing loans
Increase savings due to great incentives to save
Decrease investment to increased price of capital goods
Appreciation of the dollar due overseas of investors seeking higher returns
Decreases aggregate demand
Decreases economic growth
Increase unemployment
Decrease inflation
o Expansionary monetary policy
Increases consumption due lower mortgage & credit card rates and lower repayments on existing loans
Decrease savings due to reduced incentives to save
Increased investment to decreased price of capital goods
Depreciation of the dollar as investors seek higher interest rates in other country
Increased aggregate demand
Increases economic activity
Decrease unemployment
Increases inflation
Superannuation

Superannuation is a form of savings that individuals cannot access until retirement age
Employers are obliged to pay superannuation contributions into accounts on behalf of their employees
Funds are used as retirement income as either regular payments or a lump sum
Superannuation guarantee is is a compulsory system of superannuation support for Australian employees, paid
for by employers
Superannuation guarantee was increased from 9% to 9.5% in July 2014 and is planned to increase gradually to
12% in 2025
Superannuation also plays role in promoting economic growth as superannuation funds are loaned to financial
institutions and households
Can also be directly invested in new shares issuances from business to raise money for new capital investment
Over $2.1 trillion of superannuation in management, is fourth largest funds management industry
Due to high factor of superannuation invested in shares, share markets are main driver of superannuation
Increases in superannuation balance causes people to leave workforce earlier while decrease can make people
stay in the workforce for longers