Financial Institutions, Instruments and Markets
8th edition
Instructor’s Resource Manual
Christopher Viney and Peter Phillips
Chapter 1
A modern financial system
Learning objective 1.1: Understand the effects and consequences of a financial crisis
on a financial system and a real economy.
• The global financial crisis (GFC) had a significant effect on financial systems and the
real economies of many countries and highlighted the interconnectedness of the
world’s financial markets.
• The interconnected global financial system traces its origins to the introduction of
money and the development of local markets to trade goods.
• Money is a medium of exchange that facilitates transactions for goods and services.
• With wealth being accumulated in the form of money, specialised markets developed
to enable the efficient transfer of funds from savers (surplus entities) to users of funds
(deficit entities).
,• Financial instruments incorporate attributes of risk, return (yield), liquidity and time-
pattern of cash flows. Savers are able to satisfy their own personal preferences by
choosing various combinations of these attributes.
• By encouraging savings, and allocating savings to the most efficient users, the
financial system has an important role to play in the economic development and
growth of a country. The real economy and the financial system are connected.
Learning objective 1.2: Explain the functions of a modern financial system and
categorise the main types of financial institutions, including depository financial
institutions, investment banks, contractual savings institutions, finance companies and
unit trusts.
• A financial system encourages accumulated savings that are then available for
investment within an economy.
• A modern financial system comprises financial institutions, instruments and markets
that provide a wide range of financial products and services.
• A range of different financial institutions has evolved to meet the needs of financial
market participants and to support economic growth.
• Depository institutions—such as commercial banks, building societies and credit
unions—specialise in gathering savings in the form of deposits and using those funds
in the provision of loans to customers.
• Investment banks tend to specialise in the provision of advisory services to clients
(e.g. merger and acquisition advice).
• Contractual savings institutions, such as insurance offices and superannuation funds,
enter into contracts in which they receive funds on the undertaking that they will pay a
policy holder, or member of a fund, a specified sum when a nominated event occurs.
,• Finance companies sell debt instruments directly to surplus entities and then use those
funds to provide loans and lease financing to borrowers.
• Unit trusts sell units in a trust. The accumulated funds in the trust are pooled and
invested in asset classes specified within the trust deed.
• Commercial banks dominate in terms of their share of the assets of financial
institutions.
Learning objective 1.3: Define the main classes of financial instruments that are issued
into the financial system, that is, equity, debt, hybrids and derivatives
• Financial instruments are central to any financial relationship between two parties.
• Where the saver acquires an ownership claim on the deficit entity, the financial
instrument is referred to as equity.
• Where the relationship is a loan, the financial instrument is referred to as a debt
instrument.
• A financial instrument that incorporates the characteristics of both debt and equity is
known as a hybrid.
• Another category of instruments is derivatives (futures, forwards, swaps and options).
The main use of a derivative is in the management of commodity and financial risks.
Learning objective 1.4: Discuss the nature of the flow of funds between savers and
borrowers, including primary markets, secondary markets, direct finance and
intermediated finance
• Financial markets and instruments allow borrowers to meet the requirements of the
, matching principle; that is, short-term assets should be funded by short-term liabilities
and long-term assets should be funded by long-term liabilities and equity.
• The markets in which new debt and equity securities are issued are known as primary
markets.
• Markets that facilitate the sale of previously issued securities, such as a stock
exchange, are called secondary markets.
• By providing a market for the trading of existing securities, secondary markets serve
the most important function of adding liquidity to financial instruments.
• Where an active secondary market exists for a financial instrument, the instrument is
usually referred to as a security.
• In the primary market, surplus entities may acquire assets directly from the issuer.
• Alternatively, the flow of funds may be through a financial intermediary, in which
case the surplus entity establishes a financial relationship with the intermediary rather
than with the ultimate borrower.
• Intermediated flows are attractive to many savers since the intermediary provides a
range of financial attributes that may not otherwise be available.
• The advantages of financial intermediation include asset transformation, maturity
transformation, credit risk diversification and transformation, liquidity transformation
and economies of scale.
Learning objective 1.5: Distinguish between various financial market structures,
including wholesale markets and retail markets, and money markets and capital
markets
• The financial markets are categorised as money markets (short-term securities) and
capital markets (longer-term securities).
8th edition
Instructor’s Resource Manual
Christopher Viney and Peter Phillips
Chapter 1
A modern financial system
Learning objective 1.1: Understand the effects and consequences of a financial crisis
on a financial system and a real economy.
• The global financial crisis (GFC) had a significant effect on financial systems and the
real economies of many countries and highlighted the interconnectedness of the
world’s financial markets.
• The interconnected global financial system traces its origins to the introduction of
money and the development of local markets to trade goods.
• Money is a medium of exchange that facilitates transactions for goods and services.
• With wealth being accumulated in the form of money, specialised markets developed
to enable the efficient transfer of funds from savers (surplus entities) to users of funds
(deficit entities).
,• Financial instruments incorporate attributes of risk, return (yield), liquidity and time-
pattern of cash flows. Savers are able to satisfy their own personal preferences by
choosing various combinations of these attributes.
• By encouraging savings, and allocating savings to the most efficient users, the
financial system has an important role to play in the economic development and
growth of a country. The real economy and the financial system are connected.
Learning objective 1.2: Explain the functions of a modern financial system and
categorise the main types of financial institutions, including depository financial
institutions, investment banks, contractual savings institutions, finance companies and
unit trusts.
• A financial system encourages accumulated savings that are then available for
investment within an economy.
• A modern financial system comprises financial institutions, instruments and markets
that provide a wide range of financial products and services.
• A range of different financial institutions has evolved to meet the needs of financial
market participants and to support economic growth.
• Depository institutions—such as commercial banks, building societies and credit
unions—specialise in gathering savings in the form of deposits and using those funds
in the provision of loans to customers.
• Investment banks tend to specialise in the provision of advisory services to clients
(e.g. merger and acquisition advice).
• Contractual savings institutions, such as insurance offices and superannuation funds,
enter into contracts in which they receive funds on the undertaking that they will pay a
policy holder, or member of a fund, a specified sum when a nominated event occurs.
,• Finance companies sell debt instruments directly to surplus entities and then use those
funds to provide loans and lease financing to borrowers.
• Unit trusts sell units in a trust. The accumulated funds in the trust are pooled and
invested in asset classes specified within the trust deed.
• Commercial banks dominate in terms of their share of the assets of financial
institutions.
Learning objective 1.3: Define the main classes of financial instruments that are issued
into the financial system, that is, equity, debt, hybrids and derivatives
• Financial instruments are central to any financial relationship between two parties.
• Where the saver acquires an ownership claim on the deficit entity, the financial
instrument is referred to as equity.
• Where the relationship is a loan, the financial instrument is referred to as a debt
instrument.
• A financial instrument that incorporates the characteristics of both debt and equity is
known as a hybrid.
• Another category of instruments is derivatives (futures, forwards, swaps and options).
The main use of a derivative is in the management of commodity and financial risks.
Learning objective 1.4: Discuss the nature of the flow of funds between savers and
borrowers, including primary markets, secondary markets, direct finance and
intermediated finance
• Financial markets and instruments allow borrowers to meet the requirements of the
, matching principle; that is, short-term assets should be funded by short-term liabilities
and long-term assets should be funded by long-term liabilities and equity.
• The markets in which new debt and equity securities are issued are known as primary
markets.
• Markets that facilitate the sale of previously issued securities, such as a stock
exchange, are called secondary markets.
• By providing a market for the trading of existing securities, secondary markets serve
the most important function of adding liquidity to financial instruments.
• Where an active secondary market exists for a financial instrument, the instrument is
usually referred to as a security.
• In the primary market, surplus entities may acquire assets directly from the issuer.
• Alternatively, the flow of funds may be through a financial intermediary, in which
case the surplus entity establishes a financial relationship with the intermediary rather
than with the ultimate borrower.
• Intermediated flows are attractive to many savers since the intermediary provides a
range of financial attributes that may not otherwise be available.
• The advantages of financial intermediation include asset transformation, maturity
transformation, credit risk diversification and transformation, liquidity transformation
and economies of scale.
Learning objective 1.5: Distinguish between various financial market structures,
including wholesale markets and retail markets, and money markets and capital
markets
• The financial markets are categorised as money markets (short-term securities) and
capital markets (longer-term securities).
