ACST101 Study Guide - Final Guide: Weighted Arithmetic Mean, Callable Bond, Capital Budgeting
8 May 2018
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FINANCE'1A'–'THE'FINANCIAL'SYSTEM'–'WEEK'1''
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THE!FINANCIAL!SYSTEM!!
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§ The!financial!system!provides!a!marketplace!for!money,!enabling!the!transfer!of!
purchasing!power!(funds)!between!market!participants!and!time!(present/future)!!
§ The!financial!system!consists!of:!!
o Financial!markets!(direct!financing):!wholesale!markets!for!the!creation!and!
exchange!of!financial!securities!e.g.!loans,!shares!and!bonds!
§ short!term!funds!=!money!market,!
§ long!term!funds!=!capital!market!!
o Financial!institutions!(indirect!financing):!credit/insurance!companies!which!
provide!financial!services,!acting!as!financial!intermediaries.!!
§ Collect!money!from!lenders-savers!and!facilitate!flows!to!borrowers-
spenders!through!loans.!
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!!!!!!!Sources!and!uses!of!funds!!
§ The!financial!system!moves!money!from!lender-savers!to!borrower-spenders!!
o Lender-savers:!income!exceeds!spending,!Typically!households!!
o Borrowers-spenders:!spending!exceeds!income,!typically!businesses/govt.!!
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§ Funds!can!flow!directly!through!financial!markets!!
o Lenders-savers!invest!directly!in!financial!securities!!
§ Funds!can!flow!indirectly!through!financial!institutions!
o Financial!institutions!mediate!between!lenders-savers!&!borrower-spenders!
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§ The!financial!system!is!critical!for!the!operation!&!competitiveness!of!an!economy!!
o Maximises!interest!rates!on!term!deposits!&!minimises!interest!on!loans!!
o Directs!money!to!the!best!investment!opportunities!,!contributing!to!higher!
production!and!overall!economic!efficiency!!
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DIRECT!FINANCING!!
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§ Companies!issue!their!own!securities!in!the!financial/capital!market!to!raise!finances!!
§ Funds!flow!directly!between!lender-savers!and!borrower-spenders!through!financial!
markets!–!borrowers!sell!securities!(shares/bonds)!to!lenders!in!exchange!for!money!!
§ Major!players!are!commercial!banks!&!other!financial!institutions!(companies/Govt.)!!
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!!!!!!!Direct!financing!transaction!–!without!market!intervention!!
§ Borrowers!engage!in!a!direct!financing!transaction!to!attain!funds!for!a!specific!
capital!project!!
§ Borrowers!sell!securities!(bonds/shares)!to!lenders!in!order!to!attain!funds,!which!
become!a!liability!that!must!be!paid!back!in!principal!&-!interest!for!the!use!of!
money!!
§ For!the!lender,!a!direct!financing!transaction!results!in!the!asset!of!securities!which!
earn!interest,!and!the!financial!claim!of!the!initial!principal!amount!which!is!re-paid!!
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!!!!!!!Investment!banks!and!direct!financing!!
§ Investment!banks!–!companies!that!assist!businesses!sell!new!debt!or!equity!by!
underwriting!new!security!issues!and!provide!broker-dealer!services!!
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§ Origination:!investment!banks!preparing!a!security!issue!for!sale!!
o Assists!the!client!company!determining!the!amount!of!capital!which!needs!to!
be!raised,!secure!a!credit!rating,!legal!clearances!and!a!prospectus!from!ASIC!!
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§ Underwriting:!investment!bank!guarantees!that!the!company!will!raise!the!expected!
funds!from!the!securities!its!issued!(all!shares!will!be!sold)!!
o Investment!banker!purchases!unsold!securities!at!the!offer!price!&!later!
resells!the!shares!at!a!prevailing!market!price!!
o Underwriting!is!a!common!occurrence!providing!both!assurance!and!a!
specific!amount!of!money!to!fund!a!particular!project!or!operation!!
§ Underwriters!bear!price!risk!!
o investment!bankers!overestimate!the!value!of!shares!in!its!initial!offer!price!!
o bears!the!risk!that!the!resale!price!of!the!unsubscribed!securities!is!lower!
than!what!they!initially!paid!(initial!market!price),!resulting!in!a!loss!!
§ underwriting!spread:!the!underwriter’s!compensation!for!the!risk!&!its!services!
o difference!between!the!total!amount!raised!(price!investment!banker!sells!
the!security)!and!the!total!amount!agreed!to!the!company!by!the!underwriter!
(initial!sale!price)!!
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TYPES!OF!FINANCIAL!MARKETS!!
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!!!!!!!Primary!Market!!
§ financial!market!where!companies!sell!new!security!issues!to!initial!investors!!
§ Initial!public!offering!(IPO)!–!company’s!shares!are!first!listed!on!the!stock!exchange!!
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!!!!!!!Secondary!Market!
§ Financial!market!where!current!owners!of!outstanding!(pre-existing)!securities!are!
re-sold!to!other!new!investors!!
§ Investors!are!more!willing!to!buy!and!pay!more!for!securities!which!have!a!
secondary!market,!compared!to!those!without.!!
§ Hence,!companies!with!active!secondary!markets!enjoy!lower!funding!costs!
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Marketability!–!security!characteristic!!
§ The!ease!in!which!a!security!can!be!sold!and!converted!into!cash!!!
§ Dependant!on!the!availability!of!buyers!and!transaction!costs!!
§ Secondary!markets!increase!a!security’s!marketability!(easier!to!trade)!!
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Liquidity!–!security!characteristic!!
§ The!ability!to!convert!an!asset!into!cash!without!the!loss!of!value!!
§ Unlike!marketability,!liquidity!means!the!value!of!the!security!is!preserved!when!sold!!
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Brokers!&!Dealers!–!facilitate!transactions!in!secondary!markets!
§ Brokers:!market!specialists!who!bring!buyers!and!sellers!together!for!a!sale!!
o Execute!transaction!for!both!sides!and!charge!a!commission!for!their!services!!
o Bear!no!risk!of!securities!ownership!!
§ Dealers:!market!specialists!who!make!markets!for!securities!!
o Buy!and!sell!from!an!inventory!of!securities!they!own!!
o Bear!price!risk!!
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!Exchange!&!Over!the!Counter!(OTC)!market!
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§ Exchange!market:!!
§ traditional!central!trading!location!(e.g.!ASX,!NYSE)!
§ provides!a!platform!and!facilities!for!members!(brokers)!to!facilitate!client’s!
transactions!(buy!and!sell!securities)!under!a!specific!set!of!rules!and!regulations!!
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§ Over!the!counter!market:!!
§ Securities!not!listed!on!an!exchange!with!no!central!trading!location!!
§ Investors!execute!OTC!transactions!by!telephoning!an!OTC!dealer!or!using!a!
computer!based!electronic!trading!system!!
§ OTC!shares!are!usually!those!of!smaller!companies!!
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Money!and!Capital!markets!!
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§ Money!market:!markets!where!short-term!financial!instruments!are!traded!!
o Wholesale!market:!transactions!>!$1!million!!
o Short!term:!maturities!<!1!year!!
o Low!risk!due!to!high!liquidity!!
o Main!participants!are!financial!institutions!
§ !enables!them!to!adjust!their!liquidity!positions!to!manage!a!
temporary!cash!shortfall!between!their!receipts!and!expenditures!!
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§ Capital!market:!markets!where!intermediate/long'term!financial!instruments!(debt!
and!corporate/equity!shares)!are!traded!-!ASX!
o Greater!risk!and!and!longer!maturities!than!the!money!market!!
o Companies!raise!funds!to!finance!capital!assets!(property,!equipment!etc.)!!
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Public!and!Private!markets!!
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§ Public!market:!organised!financial!markets!where!securities!listed!on!an!exchange!
are!sold!to!the!public!!
o Public!markets!enable!companies!to!sell!securities!at!competitive!prices!with!
minimal!transaction!costs!!
o ASIC!–!regulatory!body!of!the!Australian!public!market!(ASX)!which!enforces!
regulations!of!compliance!within!public!markets!where!securities!are!traded!!
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Document Summary
Finance 1a the financial system week 1. The financial system provides a marketplace for money, enabling the transfer of purchasing power (funds) between market participants and time (present/future) The financial system consists of: financial markets (direct financing): wholesale markets for the creation and exchange of financial securities e. g. loans, shares and bonds. Short term funds = money market, long term funds = capital market: financial institutions (indirect financing): credit/insurance companies which provide financial services, acting as financial intermediaries. Collect money from lenders-savers and facilitate flows to borrowers- spenders through loans. The financial system moves money from lender-savers to borrower-spenders: lender-savers: income exceeds spending, typically households, borrowers-spenders: spending exceeds income, typically businesses/govt. Funds can flow directly through financial markets: lenders-savers invest directly in financial securities. Funds can flow indirectly through financial institutions: financial institutions mediate between lenders-savers & borrower-spenders. Companies issue their own securities in the financial/capital market to raise finances.
