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AFC2000 Notes
Chapter 1
Role of the financial system
The financial system consists of financial markets, institutions and money. Financial markets – people buy and sell financial instruments such as stocks, bonds, future contracts or mortgage-backed securities. Financial markets has 5 primary functions:

1. Facilitating the flow of funds
2. Providing the mechanism for the settlement of transactions 3. Generating information for the settle of transactions
4. Providing means for the transfer and management of risk
5. Providing ways of dealing with the incentive problems that arise in financial contracting Flow of funds
Financial institutions allow the flow of funds from savers/surplus spending units (SSU, an economic unit whose income in a period exceeds expenditure) to borrowers/deficit spending unit (DSU, an economic unit whose income in a period is less than expenditure). Financial intermediaries are financial institutions that issue liabilities to SSU’s and use the funds obtained to acquire liabilities of DSU’s. Money acts as a medium of exchange and it is important to the efficiency of the financial system. It overcomes the divisibility problem caused if the mediums of exchange are not equal. Money helps by providing all participants with a means of exchanging value. The role of the financial system is to permit the flow and efficient allocation of funds throughout the economy. Check pg 6 figure 1.2. SSU’s are either risk averse, risk neutral or risk taking. The ease at which financial instruments can be converted back into cash without losing capital value is referred to as liquidity. The earlier the returns are realised, the lower the risk because with time comes uncertainty. For financial markets to operate efficiently they need to provide a range of financial instruments to meet the return, risk, timing and liquidity preferences of the market participants. Providing this will promote an increased flow of funds because savers will be able to structure savings to their needs. Over time, the flow of funds will increase and this in turn provides an increased pool of investment capital that can be used by DSUs to increase the overall economic growth in the economy. Providing the mechanism for the settlement of transactions

All economic units can be classified into 3 units: households, businesses, governments (local, state and federal) Any economic unit has one of three possible budget positions: balanced budget (income = exp), surplus (income > exp), deficit (income < exp). Financial claims are written promises to pay a specific sum of money (the principal) plus interest for the privilege of borrowing money over a period of time. Financial claims are issued by DSUs (liabilities) and purchased by SSUs (assets). Financial claims are sourced from either debt or equity funds. The ease at which financial claims can be resold is called its marketability. Debt funds are supplied in the form of a loan and can be classified into short or long term facilities. Short term loans are classified as money and long term loans are referred to as capital. Suppliers of loans face credit risk, which is the risk that the borrower will default on scheduled repayments as specified in the loan agreement. The lender is compensated with interest income. Equity funds involves the acquisition of an ownership share of a business. Equity investors face investment risk, which is the possibility that the investor’s expected return will not be realised. Equity investors are compensated with dividend payments and capital growth. A key role of the financial system is to provide the mechanism for these settlements to occur through what is known as the payments system. The payments system is a critical part of the financial system because it is the mechanism by which funds are actually transferred to complete transactions. Generating information for the settle of transactions

An efficient financial market provides sufficient economic and...
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