Topic 5: Financial Markets

Types of financial markets

Markets,
Domestic/glob Primary Money from an investor goes directly to the borrower.
al markets
- E.g. When shares are first floated and bonds and debt securities
are purchased directly from the issuer

Secondary Securities already issued in the primary market are traded between
investors. Companies who issued securities do not receive any money.
- E.g. Trading on the ASX
A Financial Market consists of agents, brokers, institutions, and intermediaries, facilitating
the sale and purchase of financial products.

Domestic Supply/demand of goods and services within a single country

Global Supply/demand of goods and services in the entire world

Consumer credit Allow an individual to buy now and pay back the original amount with
interest at a later date
- Aus. credit card debt $42.6 billion (ASCI,Jan 2020)
Housing Offered by financial institutions to purchase property.
loans/mortgage
Business loans Loan allowing business’ to invest in operations
- Support start up, expansion and cash flow management
Short term money Enables individuals, business’, financial institutions or government
market agencies to borrow or lend money for short periods of time
- Usually under 6 months but almost always under 1 year

Bond market Instrument of debt issued to raising funds through borrowing.

/Commonwealth
Government Face value Size of the loan; written on the bond document.
Securities (CGS) Coupon rate Fixed income that the bond holder receives.
Similar to an interest rate.
Yield 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒 𝑥 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒
𝑌𝑖𝑒𝑙𝑑 = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐵𝑜𝑛𝑑
- Interest rates falls, yield falls bond traded for less

Generally issued by government/large businesses to raise money

- Bond auctions; bid on interest rate/how much to invest
- Australian office of Financial Management allocates bond to
bidders with the lowest interest rates

Financial
futures/derivative Futures Contract to buy/sell a specific asset at a
s Contract predetermined price for a fixed quantity at some
future date.
 - Buyer and seller are obligated to fulfil the
terms of the contract at the future date

Options Option to buy or sell asset on or before the

Contract option’s expiration time at the pre agreed price
- Not an obligation, so typically more
expensive

‘Hedge’: minimising potential losses in the future

Foreign exchange Value of a currency in terms of another currency
- International transactions currency must be converted
- Traded for purpose of travel, trade, investment, speculation
- Fluctuate with changes in demand/supply of currency

Depreciation: downward movement of one currency against another

- Lowers value of AUS $ compared to foreign currencies
- Each foreign unit buys more AUS, One AUS $ buys less foreign $
Winners Losers
•Exporters of goods/services • Importers of goods/services
more profitability • Aus. tourists travelling
•Tourists visiting AUS overseas
•Aus. tourism industry • Australian consumers

Appreciation: Upward movement of one currency against another

- Rises value of AUS $ compared to foreign currencies
- Each foreign unit buys less AUS $, One AUS $ buys more foreign $
Winners Losers
•Importers of goods/services • Exporters of goods/services
•Aus. tourists travelling less profitability
•Australian consumers • Tourists visiting Australia

The Share Market

Market in which securities are bought and sold; a stock exchange.
Role
Shareholder - Primary reason for investment: capital gains
s - Right to vote for board of directors/receive dividends from profit
- Management fiduciary duty: run company to benefit shareholders
- Share price rise anticipation of future capital gains
Business - Publicly listed companies trade on stock exchange
- Float: selling shares for first time on ASX
- Business can raise funds through equity finance, not debt finance
- Issuing new shares dilutes control of existing shareholders
- High share price confidence in management etc
- Low share price expose company to a take over bid
Economy - Share-market performance indicator of country’s economic
performance
 - Indicator of ‘confidence/sentiment’ in the economy
- ‘bullish’ share market results in greater investment by shareholders
increase investment, higher growth rates
- Share markets are efficient allocators of scarce resources companies
with growth potential usually raise more funds in ASX

Function Facilitates:
- The sale of new shares or equities (primary market) - called a float
- Buying and selling of pre-existing shares (secondary market)
- Trading of other securities, eg. Options, futures and bonds
- Allows businesses to raise funds for establishment and growth
● Share price set by market forces of demand and supply
● Higher share price indicates a business is doing well
● Low share price forces management to improve performance

Impact
1. Efficient - Healthy share markets result in higher share liquidity (buy and sell
investment shares easily invest more)
and market - Preferable to avoid debt
capitalisatio - Easier access to investment funds higher investment spending
n increased production, GDP, economic growth
- Impact how companies manage investment (equity/finance)
- Efficient share market: more Equity instead of Debt Financing
2. Investors Rising share prices measured by the share market index (ASX 200). –
- Rising index indicates rising business confidence and investment
Falling share prices can result in the wealth effect (investors feel less
wealthy due to a fall in their share values).
- May lead to lower spending, higher leakages downturn
3. Share - Share market rising: investors demand more shares, pushing up prices
market and in comparison to other investment assets
investment - Share market falling: investors move funds to other investments
assets - In a bullish (rise) share market, investors might choose to speculate in
shares in anticipation of quick profits speculative bubble

Regulation of financial markets

Reserve Bank
Australia RBA - Conducting Monetary Policy
- Systemic Stability
- Control of Notes Issue/currency
- Regulation of the Payments System
- Banker to the bankers
- Responsible for holding Australia’s reserves of Gold and Foreign
- Banker and source of economic advice to the government
APRA Regulates and enforces guidelines set by the RBA for all deposit taking
financial institutions.
E.g: Banks, Insurance, Superannuation Funds, Credit Unions, Building Societies
- Issuing or withdrawing bank licenses
 - Setting standards regarding debt, risk and liquidity
- Approving changes to structures and operations
- Reviews of systems and management
- Enforcement of regulations if needed
APRA’s main responsibility is to ensure that all institutions are capable of
repaying the people who hold deposits and funds with them.
ASIC Responsible for monitoring the functioning of companies operating in Australia.
- Works to protect consumers and investors and maintain integrity in
company processes
Companies Securities Industry and Markets
- Formation - ASX
- Registration - Bonds markets
- Reporting - Futures markets
Australian Anticipate and analyse policy issues, understand government/stakeholder
Treasury circumstances and respond rapidly to changing events
- E.g: Manage Australian Government
Function
- Provide policy advice regarding budget, taxation, financial sector, foreign
investment, etc
- Manage federal financial relations
- Work with state governments on key policy areas
Council of Crisis management – promote stability of the Australian financial system and
Financial efficient regulation by Australian regulatory agencies
Regulators - Regulate all four other regulators (RBA, ASIC, APRA, treasury)
Function
- Identify important issues/trends in financial systems which impact financial
stability
- Ensuring appropriate coordination among agencies to respon to financial
instability
- Engage with work of international institutions, forums and regulators which
relate to financial system stability

Borrowers
Borrowers
Individuals Personal purposes (purchase products) mortgages, loans, credit
Business Expansion, R & D investment, overcome cash flow downturns
Government Running budget deficits (more spending than taxes) infrastructure, tax cuts

Factors affecting the demand for funds

Transactions
and Transactions motive Funds are held for day to day transactions + regular payments
speculative Precautionary motive Funds are kept aside to provide for future emergencies
motives Speculative motive Funds are kept aside to be invested in expectation of a higher return.
Financial innovations Changes in payment options reduce demand for cash money for
transactions (apple pay)
 Lenders
Individuals Lend to financial institutions for return shares, bonds, interest-bearing
deposit
Business Deposit if interest rates are more lucrative than internal investment
Government Whilst in surplus- a government may invest money (e.g international loans)
to maintain positive balances
International Known as foreign liability (must be repaid) - to finance domestic
consumption & investment

Financial Holds funds from lenders in order to make loans to borrowers

Intermediaries - Bank, building society, insurance company, superannuation funds

Financial aggregates measured by the Reserve Bank of Australia

Meausring
money supply Money Base All currency (notes and coins) in circulation + bank deposits with the RBA
M3 Money Base + Bank Deposits
Broad money M3 + NBFI deposits – NBFI deposits in banks

Interest rates
Types of rates
in the Lending rates Interest rate which banks charge for loans to their customers. This is higher
short/long than the borrowing rate.
term Borrowing rates Interest rate which banks pay their deposit holders for their funds. This is
lower than the lending rate.
Note: Profit is made by having a higher lending rate than borrowing rate. The difference
between the borrowing and lending rate is called the interest rate differential/margin

Short term Generally lower than long term rates due to low risk

Long term Generally higher than short term rates due to higher risk

Role of the RBA Cash rate: interest that every bank has to pay on the money it borrows
in determining Increasing cash RBA sells government securities/bonds decreases liquidity/ supply of
the cash rate rate funds in banks Exchange Settlement Accounts (ESA) cash rate increases

Decreasing cash RBA buys government securities/bonds increases liquidity/ supply of

rate funds in banks Exchange Settlement Accounts (ESA) cash rate decreases

Liquidity: Amount of funds available in the cash market

Summary: determine cash rate by altering supply of money

Influence of Interest rates usually mirror changes in the cash rate to some extent
the cash rate
on interest • Cash rate rises banks raise interest rates less consumption/investment decreases
rates economic activity inflation decreases
 • Cash rate falls banks reduce interest rates more consumption/investment increases
economic activity rising inflation

Topic 6: Government and the Economy

Free market: Operates without government intervention; prices determined by unrestricted
competition between individuals and businesses.

Provision of
goods and Goods and - Underproduction: not at the socially optimal position because they are
services services not valued sufficiently by consumers
- Overproduction: cause negative externalities because costs associated
with the production/consumption are not included in the price
mechanism

Public goods Goods not provided by private sector as they annot make profit selling
them
- Nonexcludable/non rival (electricity)
- Government collects taxation revenue to fund these services

Merit goods Positive unintended consequences of consumption/production of the good

Distribution of
income Disadvantaged Free market result in wider difference in income and higher income
groups equality.
- The aged (no pensions or medicare)
- Disabilities (no NDIS)
- Young (no youth wage, minimum wage)
- Hard re-entry into labour market (no paid parental leave)
- Structural unemployment (no ov. Training)
- No unemployment benefits
- Indigenous worse off (no funding on welfare, training, healthcare)
- Lower income/jobs for migrants (no gov. support)

Relative poverty Lives on less than 30% of the average income within the economy
Free market: Households do not pay taxes and do not receive welfare payments.
- No laws in relation to minimum wage and conditions
- Advantages people with high income jobs
Gov intervention improves:
- Equality: taxes higher income earners more which reduces difference
- Redistribution: tax used to fund welfare for low earners, reduces difference in income
 Monopoly
Power Formation 1. Natural: may be due to limited infrastructure (Sydney water gov.
owned)
- Not feasible/cost worthy to establish competition
2. Owernship of scarce resource: owner has exclusive control over a
physical resource (only supplier of raw metal)
- Exclusive control of intellectual property
3. Acquistion/merger: after acquisition there is only one supplier.
- If Coles and Woolworths merged

Risk of high pricing, no incentive for productivity improvmenets and less

innovation. Achieve higher profits through the absence of competition
Privitisation The transfer of a business, industry, or service from the Government sector
to private ownership and control.

Corporisation Change a government owned organisation into a privately owned company.

- Shares owned by Government
- Commerical funding arrangements (interest paid on loans/expectation
of return from dividends)

Competition If there are no laws that prevent anti-competitive behaviour firms may
pursue profit maximisation to increase price and profit
- Buyout/takeover: Possible if company has large market share.
Establishes monopolist supplier with no competition can increase
prices and profit
- Collude with competiton: Collectively agree on higher prices to be
charged by all suppliers.
Reduces competition, increases prices, negatively impacts customers

Fluctuations in
economic Booms Increases inflationary pressures
activity (econoimc Reduces international compeitiveness reduces exports, increases imports
growth) Eroders real wages/value of savings
Increased wages must be greater than inflation to maintain living standards
Recession Decreases inflationary pressures
(reduced Lower levels of demand lower demand for labour
growth) Unemployment rises quickly in recession and reduces slowly in expansion
No social/unemployment welfare lower living standard for unemployed
Without government intervention, there can be no moderations in economic activity.

The Role of Government

Rellocation of
resoruces Direct Tax Taxes where impact and incidence are the same.
- Income tax, corporate tax
Indirect Tax Tax which is imposed on one entity but is passed on to another entity.
Incidence and impact are different.
- Goods and services tax
Expenses
 Redistribution
of income Progressive Tax rate increases as the taxable amount (income) increases
Regressive Tax rates higher for low-income earners than high-income earners
Proportional Same rate of tax from each taxpayer, irrespective of income
Gov. welfare Government funded services (education,healthy) and provision of minimum
income (Newstart Allowance, Pensions)

Stabilisation of
econoimc Monetary policy - Open market operations (buying/selling of CGS)
activity - Transmission mehchanism
Fiscal policy - Adjustment of government spending and taxation through the Federal
Budget
- Aims to ensure internal and external stability of the economy
Automatic Features of budgets that moderate the economy
Stabilisers without direct intervention by policymakers.
- Taxation and Welfare
Discretionary Deliberate changes in government spending or taxation
spending in response to domestic or global economic events
- NDIS funding

Budget Stance
Expansionary Net increase in government expenditure
- May be due to lower tax or increased gov. spending
Contractionary Net decrease in government expenditure
- May be due to higher tax or lower gov. spending
Neutral Government Expenditure = Taxation Revenue

Budget Outcomes
- Surplus - T > G
- Balanced – T = G
- Deficit - T < Gs