mid-semester exam ontent 2018 semester 1 fileef201 mid-semester exam ontent 2018 semester 1 contents...

EFB201 MID-SEMESTER EXAM CONTENT

2018 SEMESTER 1 Contents EFB201: Lecture WK 1 – Intro to Financial Markets, Instruments and Institutions .................. 2

1. The Role of the Financial System ....................................................................................... 3

2. Financial Institutions .......................................................................................................... 4

3. Financial Instruments ......................................................................................................... 6

4. Financial Markets ............................................................................................................... 8

EFB201: Lecture WK 2 – Theories of Financial Markets .......................................................... 10

1. Market Efficiency Definition ............................................................................................. 10

2. Levels of Efficiency ........................................................................................................... 11

3. Misconceptions about Market Efficiency ......................................................................... 13

4. Implications of Efficiency ................................................................................................. 13

5. Anomalies ......................................................................................................................... 14

6. Anomaly Explanations ...................................................................................................... 14

EFB201: Tutorial Week 2 .......................................................................................................... 15

EFB201: Lecture WK 3 – Theories of Financial Markets .......................................................... 18

1. Market Efficiency .............................................................................................................. 18

2. Behavioural Finance ......................................................................................................... 19

A) Biases and Examples .................................................................................................... 20

B) Evidence ....................................................................................................................... 24

3. Discussion of Essay Topic ................................................................................................. 24


EFB201: Lecture WK 4 – Banking and Financial Markets......................................................... 28

1. Interest Rates ................................................................................................................... 28

2. Monetary Policy ............................................................................................................... 35

3. Commercial Banks ............................................................................................................ 35

A) Sources of Bank Funds ................................................................................................. 35

B) Bank Uses of Funds ...................................................................................................... 36

C) Off Balance Sheet Activities ......................................................................................... 37

D) Regulation .................................................................................................................... 37

4. Investment Banks ............................................................................................................. 37


EFB201: Lecture WK 5 – Debt Markets .................................................................................... 42

1. Corporate Debt Markets .................................................................................................. 42

1.1 Short-Term Debt Instruments .................................................................................... 42

1.2. Long-Term Instruments ............................................................................................. 46

2. Government Debt Markets .............................................................................................. 48

2.1 Background ................................................................................................................. 48

2.2 Treasury Bonds ........................................................................................................... 48

2.3 Treasury Notes ............................................................................................................ 50

2.4 State Government Securities (Semi-Government Debt) ............................................ 51

2.5 Overseas Government Securities ............................................................................... 51



EFB201: Lecture WK 1 – Intro to Financial Markets, Instruments and

Institutions

Reading: Kidwell, Chapter 1

Tutorial Questions: Kidwell, Chapter 1

Q1.1, 1.5, 1.6, 1.10, 1.12, 1.14, 1.16, 1.17, 1.21, 1.22, 1.23

1. The Role of the Financial System • The Financial System

o The financial system consists of financial markets, institutions and money

o The roles of the financial system are:

▪ To facilitate the flow of funds

• this is the main function of a financial system

• passing money from those that have it and want to invest, to those that have

something to invest in, but don’t have the money (investors to organisations with

investments to make)

▪ To provide the mechanism to settle transactions

• To change ownership or exchange cash

• This has improved greatly with technology

▪ To generate and disseminate information

• Accurate and timely information is important

• companies shouldn’t lie in their financial statements and share prices should have

reason

▪ To provide the means to transfer and manage risk

• Some participants don’t like risk – e.g. interest or foreign exchange fluctuation

• Transfers risk to someone else

• Derivative products are good for this

▪ To provide ways of dealing with incentive problems

• Management may not act in a way that is best for the shareholders – they may act

the way that is best for their organisation

• The Flow of Funds

o The financial system allows the flow of funds from surplus spending units (SSUs) to deficit

spending units (DSUs)

▪ People who have money transfer it to those that need it through financial markets –

creating financial instruments

• E.g. households investing in shares gives money to the business which will invest it in

their own profit

• Settlement of Transactions

o Transactions generate transfers of funds that must be settled within the system

o The financial system provides the mechanism for these settlements through what is called

the payment system

o The payment system permits the transfer of funds within the financial system

o This has been massively improved by technology e.g. electronic transfer of funds or

ownership

▪ This has made the process quicker and more efficient

• Financial Market Efficiency

o Financial Market Efficiency affects the efficiency and growth of the economy

o Three forms of market efficiency:

▪ Allocational Efficiency: the market situation in which funds are allocated to their

highest value use

• The best projects get funded first and then progresses downwards

• If the share market is going up this may be a sign of allocational efficiency

▪ Informational Efficiency: the market situation in which market prices reflect all relevant

information about securities

• Price is a good indicator of value

• Price reacts quickly to information

• This is a huge area for financial research

• E.g. information on a crazy business decision will very quickly result in a change in

share prices because the value of the investment may decrease

▪ Operational Efficiency: the market situation in which the cost of conducting

transactions are as low as possible

• Lower transaction costs are better

• Regulation of Financial Markets

o A sound and stable financial system requires legislation and regulatory authorities

responsible for the prudential supervision of the market

▪ ASIC – Australian Securities and Investments Commission

• Ensures market integrity and prevents unethical and illegal behaviour

▪ ASX – Australian Securities Exchange

• Stock exchange

• Trading of securities

• Strong rules for trading

▪ APRA – Australian Prudential Regulation Authority

• Financial institutions doing the wrong thing (banks)

▪ ACCC – Australian Competition and Consumer Commission

• Preserve competition (e.g. preventing monopolies and scams)

o Probably responsible for Australia doing well in the GFC

2. Financial Institutions • Some common financial institutions:

o Banks, building societies and credit unions

▪ Banks are majority

o Foreign bank representatives

▪ Come and go depending on the market

o General and life insurers

▪ Long term investments

o Friendly societies

▪ Small part of financial institutions

o Money market corporation, finance companies and securitises

o Licensed trustees

o Superannuation entities

• Commercial Banks

o Commercial banks are the largest and most diversified intermediaries

o Australian-owned commercial banks hold more than $2 trillion in financial assets

o These assets consist of loans to consumers, businesses and governments

o Commercial banks’ liabilities consist of deposit accounts and other sources of funds

▪ Some funding from overseas

o Commercial banks might also be engaged in other activities such as underwriting

▪ Fees and guarantors (More in week 4)

• Non-Bank Financial Corporations

o NBFCs provide many of the same services and products that commercial banks provide

o NBFCs may be classified into four groups:

▪ Building Societies

▪ Credit Unions

▪ Money-market Corporations

▪ Finance Companies

• Leasing assets

• Other Financial Institutions

o Several groups of other financial institutions operate in the financial system

o These include:

▪ Life insurance companies

▪ General insurance companies

▪ Superannuation funds

▪ Managed Funds

• Choosing to put your fund with a professional investor

• More complex now-days

▪ Securitises

• Mortgage funds split into small amounts and ‘repackaged’

▪ Investment Banks

• Risks for Financial Institutions

o Credit risk

▪ Chance that the borrower defaults – can’t repay a loan

o Interest rate risk

▪ If interest rates go up, value goes down

▪ Negative relationship between interest rates and values

▪ Impacts asset and liability values

o Liquidity risk

▪ A crucial variable

▪ Liquidity is the ability to buy and sell something easily and the risk is low liquidity

▪ Financial institutions like liquid assets

o Foreign exchange risk

▪ Overseas exposure for most businesses

▪ Currency values changing creates risk

o Political risk

▪ E.g. governments banning imports on certain products

o Reputational risk

o Environmental risk

3. Financial Instruments • Financial Instruments

o Financial Instruments have four attributes:

▪ Return or yield

• Preference usually goes to higher return

• More on this in behavioural finance

▪ Risk

• Preference usually goes to low risk – we like certainty

• Government bonds are more certain

▪ Liquidity of asset

• Preference usually goes to liquid assets

▪ Time-pattern of cash flows

• Preference goes to reliable cash flows

o The average investor likes return and liquidity, dislikes risk and prefers reliable cash flows

o Investors and businesses will alter the composition of their financial instrument portfolio

by changing their preferences in relation to the four attributes of an instrument listed

above

o There are three categories of financial instruments:

▪ Equity (including hybrid instruments)

▪ Debt

▪ Derivatives

• Equity

o Equity is the ownership interest in a business corporation

▪ Ownership of a company

o Ordinary shares are the principal form of equity issued by a corporation

o The main characteristics of ordinary shares are that they have no maturity date, pay

dividends to shareholders and allow shareholders to vote at general meetings

o A hybrid security has characteristics of both equity and debt

▪ Preference shares

• where you get paid before ordinary shareholders (preference in payment in

dividends

• usually fixed dividends

• no matter how the business does the dividend remains the same

• don’t get to vote

▪ converting securities and convertible securities

• Both start out as debt, but may turn into equity

• Converting securities start like a loan where you get paid interest every 6 months

but then at some point it switches from debt to shares automatically

• Convertible securities start out as debt when you get paid interest every 6

months but at some point, you have the choice of being paid out the debt or

receiving shares

• Debt

o Debt is a loan (borrowed money) that has to be repaid – borrowed money

o The basic characteristic of debt is that the holder of a debt instrument will receive interest

and principal repayments from the debt issuer

▪ Could be equal repayment over the lifetime of the loan, interest only, short term, long

term etc.

▪ Could be banks, issues or the general public

o Secured debt is where the lender can take possession of the borrower’s assets that have

been pledged as collateral if the borrower defaults

▪ e.g. building could be sold if debt can’t be met

o Unsecured debt cannot make a claim against specific assets of the firm

▪ If they default you must sue for the money

• Derivatives

o A derivative instrument is an instrument whose value is in part derived from the value of

another instrument

▪ E.g. if you were to agree on the price of gold, then set out to find it the price of the gold

may not be what it is actually worth later at the time of the exchange, it is derived from

the earlier value

o Derivatives may be used to hedge risk or to speculate on financial instruments

▪ Demand is hedger driven e.g. it is safer for someone setting out to find gold for them to

lock the price now, making cash flows for the business more certain

• Hedging is using financial instruments to lock in a price now e.g. a borrower might

be worried that in the future the interest rate on their loan might increase, the

borrower can then use a derivative instrument to lock in a future interest rate

now

• Speculating is trying to predict how the price will go - e.g. betting the price will

fall so using a forward contract

o Four types of derivative contract

▪ Forward contract: This is a contract to buy or sell a specified amount of an asset at a

price decided upon today, with delivery to take place at a future date

• This is an Over the Counter contract (a private contract between two parties)

▪ Futures Contract: This contract is like a forward contract, but it is traded on a futures

exchange. Having a secondary market means the contract can be traded out of at any

time (i.e. a futures buyer would sell to get out and a futures seller would buy to get out)

• A tradable forward contract where the price of the contract may change

▪ Option Contract: A contract that gives the holder the right, but not the obligation, to

buy (Call) or sell (Put) an asset at a set price on or before a given date. Unlike a futures

or forward contract the buyer of an option does not have the obligation to proceed with

the contract, hence the buyer must pay the seller (writer) of the contract a premium (or

price) for the right

• Where you agree to the forward contract but the holder gets the option of going

through with it – there is usually a fee associated with gaining this option (the

premium)

▪ Swap Contract: This is an arrangement to swap specified future cash flows. An interest

rate swap occurs when there is an exchange (or swap) of interest rate payments at

future dates. These interest payments are based on a notional principal

4. Financial Markets • Primary and secondary markets

o Primary markets are where financial claims are initially sold by DSUs

▪ Where a financial instrument is originally issued

▪ The source of funding for the issuer

▪ This might take place through an initial public offering of shares to the public

o Secondary markets are where previously issued financial claims are exchanged among

investors

▪ When the initial financial instrument is given to a new investor

• Organised and Over-the-Counter Markets

o Once issued, the exchange of claims can take place on an organised exchange

▪ E.g. ASX

o Financial claims can also be exchanged

▪ Over-the Counter (OTC). E.g. The Swap market

• Unlike an exchange on which trading can take place at one physical location (or

may be virtual), OTC trading occurs through direct telephone or computer

negotiations between buyers and sellers

• OTC markets have no central location – they are usually virtual

• Money Markets

o Financial markets are usually classified into either money or capital markets

o Money markets are where a certain type of debt security is traded

▪ Short term and a debt security

▪ Specifically, a wholesale short-term to maturity (less than 12 months) claim is classified

as a money market transaction

▪ Banks and businesses adjust their liquidity positions by borrowing and lending for a

short time on the money market

▪ The RBA also conducts monetary policy on the money markets

▪ The money market consists of a collection of markets each trading a different financial

instrument

▪ All the instruments have characteristics very similar to money: high liquidity and low

default risk

o The instruments traded on the money market include:

▪ Treasury notes

▪ Commercial paper

▪ Commercial bills

▪ Negotiable certificates of deposit

▪ Secured and unsecured notes

• Capital Markets

o Capital markets: markets in which capital goods are financed with stock or long-term debt

instruments

▪ Long term debt instruments or equities

▪ Capital market instruments are less marketable, have varying default levels and have

maturities up to thirty years

• Less liquid, more risk

▪ Typically used to buy property and capital

mid-semester exam ontent 2018 semester 1 fileef201 mid-semester exam ontent 2018 semester 1 contents...

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