Midterm+Final Review (ch1-3).pdf

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Economics for Management Studies
Jack Parkinson

Chapter 1 *Why study financial market? - Financial market: markets in which funds are transferred from people who have excess of available funds to people who have a shortage - Financial Market channel funds from savers to investorspromote economic efficiency - It affects personal wealth and behaviour of business - Well-functioning financial markets are a key factor in producing high economic growth *The bond market and interest rates - Security(Financial Instrument): a claim on the issuer’s future income or assets - Assets: any financial claim or piece of property that is subject to ownership - Bond: a debt security that promises to make payments periodically for a specified period of time - The bond market is where interest rates are determined - Interest Rate: the cost of borrowing or the price paid for the rental of funds (Mortgage, car loan interests…) the price over time of borrowing money - Higher Interest Ratedeter purchases or investment, and encourage savings deter (prevent) you from buying a car or house & encourage you to save - Interest rates have an impact on the overall economy because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions - Short-term interest rates tend to fluctuate more and are lower on average than others - Prior to 1980, the rate of money growth and the interest rate on long-term bonds were closely tied together *The Stock Market - Common Stock(Stock): represents a share of ownership in a corporation - Stock: A security that is a claim on the earnings and assets of the corporation - Issue & sell stocksa way for corporation to raise funds to finance activities - Stock Market: where the earnings of corporation(share of stock) are traded  A place where people get rich and poor quickly with considerable fluctuations in stock prices - Stock prices are extremely volatile(unstable) - The stock market is also an important factor in business investment decisions because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending *Why study financial institutions and banking? - Banks and other financial institute are what make financial markets work - Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities CMC48 -1 *Structure of the Financial System - Financial institutions: banks, insurance companies, mutual funds, finance companies, investment banks…(regulated by government) - Financial Intermediaries: institutions that borrow funds from people who have saved and in turn make loans to others (Indirect Finance) - Financial Crises: major disruptions in financial markets that are characterized by sharp declines in asset prices and failure of many financial and nonfinancial firmscan cause significant shor term disruptions in the real economy(non neutrality) *Bank and Other Financial Institutions - Banks: financial institutions that accept deposits and make loans - Including chartered banks, trust, mortgage loan companies, credit unions, caisses popularities *Financial Innovation - Dramatic improvements in information technology have led to new means of delivering financial services electronically and higher profits result from creative thinking - ATM(automated teller machine) - E-Finance: delivering financial services electronically - The innovations impact the velocity of money (MV=PY) *Why study money and monetary policy? - Money: anything that is generally accepted in payment for goods or services or in the repayment of debts *Money and Business Cycle - Business cycle: movements in aggregate real output and unemployment - Aggregate output: total production of goods and services - Unemployment Rate: the % of the available labour force unemployed - Money plays an important role in generating business cycle, the upward and downward movement of aggregate output produced in the economy - Recessions: periods of declining aggregate output - Monetary Theory: the theory that relates changes in the quantity of money to change in aggregate economic activity and the price level *Money and Inflation - Aggregate price level(price level): the average price of goods and services in an economy - Inflation: a continual increase in the price level, affects individuals, businesses, and the government - inflation is generally an important problem of concern to politicians and policymaker - The price level and the money supply generally move closely together CMC48 -2 - QTM implies the continuing increase in the money supply might cause the continuing increase in the price level - Inflation is always a monetary phenomenon everywhere - Inflation rate: the rate of change of the price level - Recessions(unemployment) and booms(inflation) lead to changes in aggregate economic activity *Conduct of Monetary Policy - Every recession in the 20 century has been preceded by a decline in the rate of money growth, indicating that changes in money are also a driving force behind business cycle fluctuations - Not every decline in the rate of money growth is followed by a recession - Monetary policy: the management of money supply and interest rates - Central Bank: the organization responsible for the conduct of a nation’s monetary policy - Central Bank Canada: Bank of Canada = the Bank *Fiscal Policy and Monetary Policy - Fiscal policy: decisions about government spending and taxation - Budget Deficit: government expenditures > tax revenues for a particular time period - Budget Surplus: tax revenues > government expenditures - Any deficit is usually financed solely by borrowing - Deficits increase the national debt and make vulnerable(weak) to increase in world interest rate - Some believe the ability to issue public debt allows the government to smooth taxes and inflation over time - Large budget deficit might lead to a financial crisis and result in a higher rate of money growth, a higher inflation, and higher interest rates *The foreign exchange market - Exchange market: where funds to be transferred from one currency to another - Exchange rate: the price of one country’s currency in terms of another’s - 2 ways of quoting exchange rate:  As the amount of domestic currency that can be purchased with a unit of foreign currency  As the amount of foreign currency that can be purchased with a unit of domestic currency - Appreciation: when the exchange rate increases so that a CND dollar buys more units - Depreciation: when the exchange rate declines so that a CND dollar buys more units - A change in the exchange rate has a direct effect on Canadian consumers because it affects the cost of foreign goods - When the value of the dollars drops, Canadians decrease their purchases of foreign goods and increase their consumption of domestic goods - A strong dollar benefited Canadian consumers by making foreign goods cheaper but HURT Canadian business and eliminated some jobs by cutting both domestic and foreign sales of their products CMC48 -3 Chapter 2 *Function of Financial Markets  Lender-savers: those who have saved and are lending funds  Borrower-spenders: those who must borrow funds to finance their spending  The principle lender-savers are households  The most important borrower-spenders are business and the government (federal)  In direct finance: o Borrowers borrow funds directly from lenders in financial markets by selling them securities(financial instrument) which are claim on the borrower’s future income/assets o Securities = assets for the person who buys them = liabilities/IOUs/debts for the individual or firm that sells/issues them o o Ex.RIM needs to borrow funds to pay for a new factory to manufacture new productsit might borrow the funds from savers by selling them bonds or stocks o Bonds: debt securities that promise to make payments periodically for a specified period of time o Stocks: securities that entitle the owners to a share of the company’s profits and assets Indirect Finance Financial Fund s Lender-Savers Borrower-Spenders 1. Households Direct Finance 1. Business Firms 2. Business Fund Financial Market Fund 2. Government Firms 3. Households 3. Government 4. Foreigners  Why is this channeling of funds from savers to spenders so important to the economy? People who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs  Without financial markets, it is hard to transfer funds from a person who has no investment opportunities to one who has themfinancial markets=essential to promoting economic efficiency  Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy CMC48 -4  Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better  Financial markets that are operating efficiently improve the economic welfare of everyone in the society *Structure of Financial Markets-Debt and Equity Markets  A firm or an individual can obtain funds in a financial markets in 2 ways: issue a debt instrument &issue equities 1. Issue a debt instrument o A contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interests & principal payments) until a specified date(the maturity date), when a final payment is made o Ex. Bond or mortgage o Maturity of a debt instrument: the # of years until that instrument’s expiration date o Short- term: < 1 year o Long-term: >= 10years o Intermediate-term: 1~10 years 2. Issue equities o Ex. Common stock o Claims to share in the net income ( income after expenses and taxes) and the assets of a business o Ex. You own 1 share of common stock in a company that has issued one million sharesyou entitled 1 millionth of the firm’s net income and assets o Dividends: periodic payments that equities often make to their holders and are considered long-term securities because they have no maturity date o Owning stockshave the right to vote on issues important to the firm and to elect its directors  Disadvantages of owning a corporation’s equities: o An equity holder is a residual claimant o The corporation must pay all its debt holders before it pays its equity holders  Advantages of owning a corporation’s equities: o Equity holder s benefits directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders o Debt holders do not share in this benefitstheir dollar payments are fixed *Structure of Financial Markets-Primary & Secondary Markets  Primary Market CMC48 -5 o A financial market in which new issues of a security(bond, stock) are sold to initial buyers by the corporation or government agency borrowing the funds o The selling of securities often takes place behind closed doors o Investment Bank: An important financial institution that assists in the initial sale of securities in the primary market o Underwriting Securities: It guarantees a price for a corporation’s securities  Secondary Market o A financial market in which securities that have been previously issued can be resold o Ex. Toronto Stock Exchange(TSX), foreign exchange market, future markets, option markets o Securities brokers and dealers are crucial to a well-functioning secondary market o Brokers: agents of investors who match buyers with sellers of securities o Dealers: link buyers and sellers by buying & selling securities at stated prices  A corporation acquires new funds only when its securities are first sold in the primary market  Secondary markets serve 2 important functions: 1. They make it easier to sell these financial instruments to raise cash  They make the financial instruments more liquid  The increased liquidity of these instrument then make them more desirableeasier for the issuing firm to sell in the primary market 2. They determine the price of the security that the issuing firm to sell in the primary market  They investors that buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for this security  The higher the security’s price in the secondary market, the higher will be the price that the issuing firm will receive for a new security in the primary market and hence the greater the amount of financial capital *Exchange and Over-the-Counter Markets  Secondary markets can be organized in 2 ways: 1. Organize exchanges where buyers and sellers of securities meet in one central location to conduct trades  Ex. TSX for stocks and the Winnipeg Commodity Exchange for commodities (wheat, oats, barley…)  Ex. The Montreal Exchange(ME) offers a range of equity, interest rate, and index derivative products 2. Have an over-the-counter(OTC) market CMC48 -6  OTC: dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices  Other over-the-counter markets include those that trade other types of financial instruments such as negotiable certificates of deposit, overnight funds, and foreign exchange *Money and Capital Markets  Money Market: a financial market in which only short-term debt instruments (generally those which original maturity of less than one year) are traded  Capital Market: the market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded  Money market securities are more widely traded than longer-term securities more liquid  Short-term securities have smaller fluctuations in prices than long-term securitiessafer investment  Corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily  Capital market securities(stocks & long-term bonds) are often held by financial intermediaries(insurance companies & pension funds) which have more certainty about the amount of funds they will have available in the future *Money Market Instrument  Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments  Government of Canada Treasury Bills: they pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount at a price lower than the set amount paid at maturity  Treasury Bills: the most liquid of all the money market instruments because they are the most actively traded the safest of all money market instruments because there is almost no possibility of default(a situation in which the party issuing the debt instrument is unable to make interest payments or pay off the amount owed when the instrument matures) o The federal government is always able to meet its debt obligations because it can raise taxes to pay off its debts o Treasury bills are held mainly by banks  Certificates of Deposit(CD): a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price o Important source of funds for trust and mortgage loan companies CMC48 -7 o Negotiable - they can be traded, and in bearer form bearer deposit notes - The buyer’s name is neither recorded in the issuer’s books nor on the security itself - Can be resold in a secondary marketoffer the purchaser both yield and liquidity o Non-negotiable CDs=Term Deposit Receipts= Term Notes - Cannot be resold to someone else and cannot be redeemed from the bank before maturity without paying a substantial penalty  Commercial Paper: an unsecured short-term debt instrument issued in CND or other currencies by large banks and well-known corporations  ex. Microsoft & Bombardier o Because “unsecured”  only the largest and most creditworthy corporations issue commercial paper o The interest rate on commercial paper is low relative to those on other corporate fixed-income securities and slightly higher than rates on government of Canada treasury bills o Finance Paper: shot-term promissory notes o Most commercial and finance paper is issued on a discounted basis  Repurchas
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