Preliminary Economics Topic Five

Financial Markets
Types of financial markets

1.1 Types of financial markets:

Direct finance: between lenders and borrowers; Indirect

finance: through financial intermediaries
The primary market is where financial securities such as
debt, shares, bonds and options are issued for the first
time for capital raising purposes
The secondary market is where financial securities are
bought and sold according to investment transfers for
investors managing a portfolio of shareholdings
The derivatives market is where financial products that
are derived from financial securities (swaps, futures,
options) are traded
Debt instruments mortgages, personal loans,
debentures, bonds, notes and bills
Equity shares

The roles of the share market are: providing a link

between listed public companies needing equity funds to
expand their operations and people with funds to invest
(who are seeking capital gains/dividend income), and to
provide a marketplace for the trading of shares
Regulation of financial markets

2.1 The role and functions of current institutions:

The Reserve Band of Australia (RBA) six functions

include: issuing banknotes, the banker to commercial
banks through Exchange Settlement Accounts (ESAs), the
banker and advisor to the Commonwealth Government,
The custodian of Australias international resources of
gold, foreign exchange and Special Drawing Rights, the
prudential supervision of the payments system (through
the Payments System Board), and the conducting of
monetary policy to achieve objectives such as 2-3%
inflation
Australian Prudential Regulation Authority (APRA)
responsible for the prudential supervision of deposit
taking institutions (DTIs; banks and non bank financial
intermediaries (NBFIs)
Australian Securities and Investments Commission (ASIC)
responsible for market integrity, consumer protection
and dispute resolution across the entire financial system
Australian Treasury responsible for advising the
Australian government on financial stability issues and for
legislation and regulatory framework
Council of Financial Regulators All four institutions above
meet to discuss policies for the prudential supervision of
the Australian financial system

Borrowers

3.1 Borrowers:

Borrowers in debt market: individuals, businesses,

governments
Individual Debt Instruments mortgage loans, redraw
facilities, personal loans, loans for home additions and
renovations, overdrafts and credit cards
Business Debt Instruments small and large business
loans (secured by asset typically), debentures and notes
(larger companies which are issued in financial markets,
guaranteeing a fixed rate of interest; debentures are
secured by assets), commercial bills and promissory notes
(short term instruments issued by companies to raise
finance; commercial bills bought by banks), leasing loans
(lease agreement in purchasing a new item of
capital/transport), bill of exchange (borrower/drawer
draws a bill on the drawee/lender), certificates of deposit
 (sold by banks to depositors, pays interest and original
price at maturity), corporate bonds, convertible bonds
Government Debt Instruments treasury notes and bonds
(short term discount securities), Commonwealth
government bonds, state government bonds, semi
government bonds

Factors affecting the demand for funds

4.1 Factors affecting the demand for funds:

The demand for funds is driven by three major motives:

the transactionary motive (demanding funds for buying
goods and services), the precautionary motive
(demanding funds for the unforeseeable future), the
speculative motive (demanding funds to invest)

Lenders

5.1 Lenders:

The main lenders in the Australian financial system are

banks and non bank financial intermediaries (NBFIs)
The lenders in the financial system are: individuals,
businesses, governments and international (foreign
investment, etc)

Financial aggregates measured by the Reserve Bank of

Australia

6.1 Financial aggregates measured by the RBA:

Four functions of money: act as a medium of exchange,

store of value, standard for deferred payments, measure
of relative value
Aggregates: Currency comprises holdings of notes and
coins by the private non bank sector
Bank Deposits all bank deposits, excluding
Commonwealth, state government and inter-bank
deposits
M1 currency plus bank current deposits of the private
non-bank sector
M3 M1 plus all other Authorised Deposit-taking
Institutions' (ADI) deposits of the private non-ADI sector
Broad money M3 plus non-deposit borrwings from the
private sector by All Financial Intermediaries, less the
 holdings of currency and bank deposits by Registered
Financial Corporations & cash management trusts
Money base holdings of notes and coins by the private
sector plus deposits of banks (with RBA to private non-
bank sector)
Credit loans and advances by (AFI) plus total bank bills
outstanding or on issue

Interest Rates

7.1 Interest rates:

Real interest rate = nominal interest rate inflationary

expectations
Interest rate spread or margin = lending rate borrowing
rate
Profit = interest income + other income costs
Yield curve (years to maturity, interest rate) types:
normal yield curve is upward sloping as short term
interest rates are lower than long term rates, an inverse
yield curve is downward sloping and this occurs when
there is expectations of economic instability or lower
interest rates in the future, a flat yield curve is when
interest rates are the same no matter the length of the
loan
Monetary policy is the use of interest rates to affect the
level of economic activity. The RBA does this through
open market operations
If the RBA wants in increase cash rates, it will require
banks to purchase commonwealth government securities
(CGSs) using money from their exchange settlement
funds. This reduces the cash supply in these accounts
causing the cash rate to rise
If the RBA wants to decrease cash rates, it will require
banks to sell commonwealth government securities. This
increases the cash supply in the ESAs causing the cash
rate to fall
Changes in the cash rate influence changes in interest
rates because the cash rate is an interest rate itself the
overnight interest rate on ESAs; also a change in the cash
rate will lead to cheaper or more expensive costs of
 borrowing funds in the market and banks will tend to pass
these onto consumers
Objectives of monetary policy: 2-3% inflation, full
employment, long term economic growth to improve
living standards