Capital Markets.pdf

UTS CRICOS 00099F
Topic 1:
Introduction to Capital Markets
University of Technology, Sydney
UTS Business School - Finance

1.1 Lecture Outline
1. Theory and facts in finance
2. The financial system and financial institutions
3. Financial instruments
4. Financial markets
5. Flow of funds, market relationships and stability
6. The payment system
25741 Capital Markets
Topic 1: Introduction to Capital Markets
Ester Felez Vinas

1.2 Theory and facts in finance
• Finance can seem like a complex field to study.
• In a financial markets course, students are asked to develop their understanding of
many different types of financial instruments exchanged on different markets.
• Despite the complexity, there are some underlying principles that hold everything
together:
Risk and
reward
Supply
and
demand
No
arbitrage
Time
value of
money
Ester Felez Vinas

Risk and
reward
All financial instruments yield some amount of return while being
characterised by some amount of risk. Returns are positively
related to risk.
Supply
and
demand
The price of financial instruments is determined by supply and
demand. When supply goes up while demand remains the same or
falls, the price must decline.
Ester Felez Vinas

No
arbitrage
A trader cannot buy a financial instrument in one market at a low
price while simultaneously selling that same asset at a higher
price in a different market. If so, the trader would earn infinite
returns at 0 risk (contradiction of risk-return trade off).
Time
value of
money
The value of $1 today is higher than the value of $1 later.
People are impatient to consume now and must be rewarded for
waiting. Where financial instruments represent a claim of future
cash flows, their current price must be the present value of those
cash flows.
Ester Felez Vinas

• Financial systems exist to provide services that meet the community’s financial needs.
The most common needs are to make payments, to store and/or invest savings, and to
borrow funds for major purchases.
• A principal role of financial institutions and markets is to bring together providers of
funds – savers – with users of funds – borrowers. The flow of funds function is
performed by channelling savings from suppliers (surplus units) to users of funds (deficit
units)
Suppliers of
funds
(surplus units)
Users of funds
(deficit units)
Financial
markets
Lenders
supply funds
receive
financial instrument
Borrowers
receive funds
issue
financial instrument
Ester Felez Vinas

The aim of this function is to efficiently use a financial system’s loanable funds.
Suppliers of funds expect to be rewarded by the users of funds. Where funds are lent,
the user is usually required to pay interests. This is because the suppliers are forgoing
the immediate use of their funds for consumption and are taking the risk that the users
of funds might not honour their promises.
Examples of this process:
• Purchase of shares from a company, which provides the company with
funds to enable it to implement its business plans.
• Depositing of savings with banks that enable the banks to make loans
Ester Felez Vinas

1.3 Financial systems and financial institutions
A financial system comprises a range of financial institutions, financial
instruments and financial markets that facilitate the flow of funds.
The financial system operates under the supervision of the central bank – the
Reserve Bank of Australia – and the prudential supervisor – APRA (Australian
Prudential Regulation Authority)
Providers of funds should consider their own particular needs when investing on an
asset. For it, they should consider 4 important attributes of financial assets:
Return Risk Liquidity
Timing of
cash flows
Ester Felez Vinas

Return Risk
Benefit received from an
investment (could be in the form
of interest and capital gain)
Uncertainty. Probability that an
actual outcome will vary from the
expected outcome.
Risk and return are positively related. This
is reasonable because an investor will not be
willing to take more risk to get the same
expected return as he would in an investment
that has lower risk.
Level of risk
Expected
rate
of
return
Risk-free
rate
Ester Felez Vinas

Liquidity
Timing of
cash flows
Access to cash and other sources of funds to meet day-to-day expenses and
commitments. Liquidity is important because it determines the ability to get
cash fast to pay potential liabilities.
Example of an illiquid asset: an expensive painting.
A painting may be very valuable, but it is not liquid. This is because it is difficult to
sell fast at a market value. So, if one has many expensive paintings but needs cash
fast, he may be in high risk of default.
The frequency of periodic cash flows (interest and principal) associated with
a financial instrument.
Financial institutions and markets provide instruments with different combinations of risk,
return, liquidity and timing of cash flows that best suit each investor.
Ester Felez Vinas

Individuals have different preferences with regards to these four attributes
Individuals can be: risk averse, risk neutral or risk takers. More risk-averse individuals accept
lower expected returns for bearing lower levels of risk. They don’t avoid risk entirely, but
demand higher return for bearing higher risk
Example: Consider I come to you with the following 2 scenarios:
• A guaranteed payout of some undisclosed (but negotiable) amount
• A payout not guaranteed, but that may result in 0 or 100
You have 2 options:
1. I will flip a coin and you have to guess whether it is going to be heads or tails. If you guess correctly
you get 100, else you get 0.
2. Abstain from the toss and take the guaranteed payment. The expected payout in scenario 2 is 50
((100+0)/2)
What will a risk-averse, risk-neutral and risk-taker do?
Ester Felez Vinas

She will generally take the guaranteed payment. She believes that
something is better than nothing and would rather play it safe. Does this
mean she will always choose the guaranteed payout? NO. If the guaranteed
payout is very small then she would take the toss.
These type of investors tend to choose safer investments: e.g., saving
accounts, government bonds, whole-term life insurances
Risk-
averse
She will take the decision mathematically. Since the expected payout is 50,
the risk-neutral investor would choose the guaranteed payment if it is 50 or
more. Else, she flips the coin.
Risk-
neutral
Ester Felez Vinas

She will take her chances with the coin flip unless she is offered a large
guaranteed payout. The keener the investor is for risk, the higher the
guaranteed payout has to be for her to take it. A risk-seeking investor prefers
tossing the coin rather than opting for the guaranteed payout of 50.
These investors tend to invest in speculative investments, junk bonds and
even gambling. The idea of making big appeals them, even though they may
also lose big.
Risk-
seeking
Ester Felez Vinas

An efficient financial system encourages savings, which is important for economic
growth, and allocates these savings to the most efficient users of funds.
An efficient financial system provides timely and accurate economic and financial
information to the markets. An efficient financial system rapidly absorbs and reflects
the new information into prices.
The central bank uses the financial system to implement monetary
policy in order to target the level of inflation and achieve certain
economic objectives.
Inflation: Increase
in prices of goods
and services over
time. Measured by
the Consumer Price
Index (CPI)
Ester Felez Vinas

There are five categories of financial institutions:
Depository
financial
institutions
Obtain funds from deposits lodged by savers and provide loans to
customers. Commercial banks are a clear example.
Provide advisory services (e.g. M&A, risk management, portfolio
restructuring, issue of equity) for their corporate and government clients. May
also provide loans to clients, but it is not their principal business. They are
more likely to advise their clients to obtain funding from the capital markets.
Offer financial contracts such as insurance and superannuation. In
return for a periodic payment made to the institution, the holder of the
contract gets a specified payout if, and when, an event specified in the
contract occurs.
Investment
banks
Contractual
saving
institutions
Ester Felez Vinas

Finance
companies
and general
financiers
Raise funds by issuing financial instruments from the market and use
them to provide loans and lease finance to customers. The main
difference with depository financial institutions is that they get their fund from
issuing financial instruments in the money market or the capital market
rather than from client deposits.
Unit
trusts
Investors buy units issued by the trust. The pooled funds are then
invested in assets specified in the trust (e.g., an equity trust would invest in
certain types of shares). Trusts generally specialize in certain categories of
investments.
Ester Felez Vinas

1.4 Financial markets
Financial markets are a key part of the financial system. To understand financial
markets we need to be aware of the following aspects:
Matching
principle
Primary &
secondary
market
transactions
Direct &
intermediated
finance
Ester Felez Vinas

1.4.1 The matching principle
Matching
principle
Short-term assets should be funded with short-term (money market) liabilities. For
example, seasonal inventory funded by overdraft.
Longer term assets should be funded with equity or longer term (capital market)
liabilities. For example equipment funded by debentures.
Ester Felez Vinas
Lack of adherence to this principle accentuated the effects of frozen money markets with the ‘sub-
prime’ market collapse during the GFC.
Talking markets and strategy
Following the Global Financial Crisis (GFC), it became clear that one of the key reasons financial institutions
got themselves into so much trouble was that they had not been following the matching principle.
Lehmann Brothers was one of the most prominent failures of the GFC and its collapse worsened the crisis.
Lehmann had borrowed very short term with many of its loans having maturities of as little as one day. It used
the funds to fund its enormous balance sheet. With $600 billion in assets, $572 billion in borrowings (i.e. just
$28 billion in shareholder equity) and with most of its borrowings needing to be renewed each day, is it any
wonder that Lehmann collapsed?

1.4.2 Primary and secondary market transactions
Ester Felez Vinas
Primary
market
transactions
• The issue of a new financial instrument to raise funds to purchase goods, services
or assets by:
ü Businesses: issuing company shares or debentures
ü Governments: selling treasury notes or bonds
ü Individuals: entering into a mortgage
• Funds are obtained by the issuer of the security
• Economic growth is reliant on a strong primary market
Secondary
market
transactions
• The buying and selling of existing financial securities
• No new funds raised and therefore no direct impact on the original issuer of security
• Transfer of ownership from one saver to another saver
• Provides liquidity, which facilitates the restructuring of portfolios of security owners
and helps savers on their preferences for liquidity and aversion to risk
• A deep and liquid secondary market is one where there are many buyers and sellers
• The secondary market encourages savings and investment

1.4.3 Direct and intermediated finance
Ester Felez Vinas
Direct
finance
• Users of funds obtain finance through the primary market via a direct relationship with providers
(savers).
• The borrower issues securities in a financial market and they are purchased by investors.
Advantages
ü Avoids costs of intermediation
ü Increases access to diverse range of markets
ü Greater flexibility in the range of securities
users can issue for different financing needs
ü Enhance international profile (reputation)
Disadvantages
ü Matching of preferences
ü Liquidity and marketability of a security
ü Search and transaction costs
ü Assessment of risk, especially default risk

1.4.3 Direct and intermediated finance
Ester Felez Vinas
Intermediated
finance
Investors and borrowers deal indirectly with each other. The intermediary has an active role:
ü It acquires the ownership of the financial instrument that is created as part of the transaction
ü It also obtains the benefits and risks associated
Advantages
ü Asset transformation: Provide a range of products that meet customers’ varying portfolio preferences and needs
ü Maturity transformation: Borrowers and savers are offered products with a range of terms to maturity
ü Credit risk diversification and transformation: Saver’s credit risk limited to the risk of default of the intermediary.
Intermediary, (not the saver) which has expertise, is exposed to the credit risk of the ultimate borrower.
ü Liquidity transformation: Ability to convert assets into cash at current market price and low transaction cost.
ü Economies of scale: Financial and operational benefits of organisational size and business volume and expertise

1.5 Flow of funds, market relationships and stability
When we introduced the flow of funds as a picture of the financial system, we said that the flow
was from savers to borrowers. We can imagine, also, funds flowing between the sectors of
the economy:
ü Funds flow between business, financial institutions, government and household sectors
and the rest of the world
ü Net borrowing and net lending of these sectors of an economy vary between countries
ü The flow of funds can be influenced by:
Ø the impact of fiscal and monetary policy on savings and investment decisions
Ø policy decisions like compulsory superannuation, which increased the flow of
funds between businesses, households and financial institutions dramatically
Ester Felez Vinas

1.5 Flow of funds, market relationships and stability
The flow of funds between deficit and surplus units is an important contributor to economic
growth. For these benefits to be fully realised, the flow of funds must be characterised by
relative stability
The role of regulators is to balance the benefits of a free financial system against the costs
of instability. Worldwide, a set of global institutions play an important role in shaping and
managing the flow of funds across countries:
ü World Bank and the International Monetary Fund (IMF) can play an important role in
shaping the flow of funds into and out of developing countries.
ü Bank for International Settlements (BIS) has played a leading role in shaping banking
regulations around the world. For instance, requiring banks to hold more capital.
Ester Felez Vinas

1.6 The payments system
Facilitates the transfer of value of a financial instrument from one party to another. An
economy’s payments system ensures funds can flow easily between transactors. The payments
clearing system in Australia is coordinated by the Australian Payments Network (AusPayNet).
Transactions may be either high-value or low-value:
• High-value: large-value transactions for assets (e.g. property, wholesale market equity, debt
securities and FX transactions)
• Low-value: day-to-day payments for goods and services, particularly by the household
sector.
Ester Felez Vinas

Transactions may also be made in cash or non-cash:
ü Cash: Notes and coins. The use of cash when making a payment is decreasing. However,
cash still seems to be the most used payment method for retail transaction
ü Cheques: A cheque is an instrument that instructs a bank to pay a specific amount from the bank
account of the cheque writer to a particular party. Least used form of non-cash payment and
declining each year in use.
ü Debit cards: Debit card users have funds taken directly from their bank accounts when they
make a payment.
ü Credit cards: The average value of credit card payments is higher than debit card payments. A
credit card user can avoid paying interest if their monthly outstanding balances are paid by a
certain date. However, annual fees and benefit fees (e.g. for frequent flyer points) are required on
some credit cards.
Ester Felez Vinas

Transactions may also be made in cash or non-cash:
ü Direct credits: credit payment through the internet. Over the internet the payer provides their
bank with the payment details and bank account of the intended recipient.
ü Direct debits: debit payment through the internet. The payer must provide authorisation over the
internet to request a direct-entry debit payment be made from their bank account to another
party. An easy way to pay mortgage payments and other regular bills
ü BPAY: similar to direct debit. A secure scheme introduced by financial institutions to pay bills over
the phone or internet
Ester Felez Vinas

Ester Felez Vinas
Over recent decades, there has been a trend rise in
the use of electronic payment methods for retail
transactions and a decline in ‘paper based’ methods
such as cash and cheques
Retail payments
Cash use is declining but it is still important. Although
the use of cash has continued to fall, a significant
minority of people still heavily rely on cash for many
of their payments (e.g., older Australians, people in low
income levels)
Cash payments

Ester Felez Vinas
Retail payments around the world
Consumers globally are shifting away from cash to
cards, although there are also some notable differences
across countries.
Sweden and Norway are prominent examples of countries
where cash is now used for a relatively small proportion of
consumer payments, whereas cash is still commonly used
in some Euro area countries like Spain and France.

The most recent developments in Australia’s payments system include the New Payments System
(NPP), which was publicly launched in February 2018, it facilitates real-time retail payments.
That is, following a retail transaction, funds are transferred in real time to the seller’s account. Also,
whereas an interbank fund transfer used to take overnight, it can now be facilitated instantly. This has
been called ‘fast payments’.
Ester Felez Vinas
In Australia, NPP transactions
picked up significantly over
2019/20 as financial institutions
progressed the rollout of core
functionality to end users.
The adoption of the NPP since its
launch, compares favourably with
the more successful fast
payments systems that have
been launched in other countries.

Exchange settlement accounts (ESA) are a special account held with the Reserve
Bank to facilitate the settlement of value transactions within the payments system.
These accounts are held by banks and other providers of payments services.
Applicants of the ESA are required to demonstrate that they have the ability to provide
ongoing liquidity for the operation of such account, especially in times of stress and
peak periods. Australian institutions are supervised by APRA and they are eligible for
ESAs.
Exchange settlement account transactions use same-day funds (funds not requiring
clearing through the payments system)
Ester Felez Vinas

Since June 1998, Australia operates a system of Real-Time Gross Settlement (RTGS) for the
clearing and settlement of high value transactions.
This requires that each high-value payment transaction be settled immediately through
exchange settlement accounts. RTGS are irrevocable
Purpose of RTGS: Reduce the risk that a high value transaction ends up not being settled,
which could put in high risk the stability of the financial system.
The Reserve Bank requires banks to maintain their exchange settlement accounts in credit with
same-day funds. To facilitate management of liquidity, the Reserve Bank provides intra-day
repurchase arrangement (repo agreement) for exchange settlement account holders.
A repo is the sale of eligible debt securities to the Reserve Bank on the condition that the seller
(financial institution) will normally buy them back by day’s end. It provides intra-day liquidity
for same-day funds for exchange settlement account holders.
Ester Felez Vinas

1.7 Summary
ü Studying the financial markets can be intimidating because there seems to be a lot of
information to cover. Remember though that everything is held together by a few
fundamental principles: risk-reward, supply-demand, no arbitrage, time value of money.
ü Primarily, the financial system is organised to facilitate the flow of funds from savers to
borrowers. It has evolved, also, to facilitate portfolio composition according to particular
needs and to facilitate the operation of a central bank’s monetary policy.
ü Providers of funds should consider 4 important attributes of financial assets when investing
on an asset: return, risk, liquidity and timing of cash flows.
ü There are five categories of financial institutions: depository financial institutions,
investment banks, contractual saving institutions, finance companies and general financiers
and unit trusts.
ü To understand financial markets we need to be aware of the following 3 principles: matching
principle, primary and secondary market transactions and direct and intermediated finance.
Ester Felez Vinas

1.7 Summary
ü The payments system facilitates the transfer of value from one party to another.
ü Over recent decades, there has been a rise in the use of electronic payment systems
and a decline of paper-based methods.
ü The most recent developments in Australia’s payments system include the New Payments
System (NPP), which facilitates real-time retail payments.
ü Exchange settlement accounts (ESA) are a special account held with the Reserve Bank
ü Australia operates a system of Real-Time Gross Settlement (RTGS) for the clearing and
settlement of high value transactions which has the purpose to reduce systemic risk and
increase certainty.
Ester Felez Vinas

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