1203AFE Lecture Notes - Lecture 1: Interest Rate Risk, Friendly Society, General Insurance
30 May 2018
School
Department
Course
Professor
Week 1 Money, Banking and Finance Lecture notes
Introduction
The role of the financial system
• The financial system consists of financial markets, institutions and money
• The roles of the financial system are:
o 1. To facilitate the flow of funds
o 2. To provide the mechanism to settle transactions
o 3. To generate and disseminate information
o 4. To provide the means to transfer and manage risk
o 5. To provide ways of dealing with incentive problems
Money
• Money= Means of exchange
• Barter→ coins → paper → cashless
• Ho ell this happes= futio of effiie
• The financial system (i.e. financial markets, institutions and money) allowed the
efficient allocation of funds throughout the economy
The flow of funds
• The financial system allows the flow of funds from surplus spending units (SSUs) to
deficit spending units (DSUs)
• Economic units can be classified as:
o Households
o Businesses
o Governments
• A surplus unit is a unit whose income exceeds planned expenditure
• A deficit unit is a unit whose expenditure exceeds it receipts
• The financial system is concerned with funneling money from SSUs to DSUs
• The efficient flow of funds through the economy from savers to investors and
spenders creates wealth and provides information
find more resources at oneclass.com
find more resources at oneclass.com
Maagig ‘isks ad Ietie proles
• The financial system has a role to play in managing a variety of risks and incentive
problems
• Information Asymmetry: when one party in a transaction has more information than
the other party (e.g. car seller knows more about the condition of the car than the
buyer)
• Adverse Selection: a market process which produces a sub-optimal outcome due to
parties having asymmetric information (e.g. people with dangerous jobs or high risk
lifestyles tend to purchase life insurance)
• Moral Hazard: the tendency of people and/or organizations to change their behavior
oe the eoe part to a otrat. e.g. oure driig eoes riskier he ou
have insured your car versus an uninsured car)
Financial market efficiency
• Allocational efficiency:
o fuds are alloated to their highest-alue use
o funds are allocated to projects with the highest risk-adjusted returns which
promote economic growth
• informational efficiency: (ability to obtain accurate information)
o here arket pries reflet all releat iforatio aout seurities
o allows households and firms to make intelligent decisions
• operational efficiency: (we want to transact at lower cost)
o here the osts of odutig, trasatios are as lo as possile
o society is better off, economy grows, employment grows
Trasferrig Fuds fro SSUs to DSUs
• the two methods of financing are:
o Direct financing and
o Indirect financing
Direct Financing
• SSUs lend money to DSUs and accept a financial claim (an IOU) in return
• In direct financing, this exchange takes place directly
• That is to say, in the absence of a financial intermediary (banks, credits unions etc.)
find more resources at oneclass.com
find more resources at oneclass.com
Indirect Financing
• Indirect financing:
o Direct financing requires DSUs to find SSUs that want direct claims
o This problem is resolved through the involvement of a financial intermediary
o Financial intermediaries purchase direct claims from DSUs, transform them
into direct claims and sell them to SSUs
Benefits of Financial Intermediation
• When intermediaries transform direct claims into indirect ones, they perform five
services:
o Denomination divisibility
o Currency transformation
o Maturity flexibility
o Credit risk diversification
o Liquidity
Types of Financial Intermediaries
• Australian financial intermediaries include:
o Banks, building societies and credit unions
o Foreign bank representatives
o General and life insurers
o Friendly societies
o Money market corporations, finance companies and securities
o Approved trustees
o Superannuation entities
find more resources at oneclass.com
find more resources at oneclass.com
