Business Final Review
- Financial institutions facilitate flow of money
Four distinct legal areas /”pillars”:
- Chartered banks
- Alternate banks
- Life insurance companies
- Investment dealers
- Lines between pillars have been blurred due to deregulation
- Individuals, governments and businesses have a surplus of money, and our financial
system has ways to tap into that surplus, and put it into the hands of other individuals,
governments, and businesses that need it.
Pillar #1 – Chartered Banks
- Privately owned, publicly traded, profit seeking
- Regulated (not owned) by the government
- Largest and most important institution
- Concentrated and highly regulated industry
Five largest account for 90% of total bank assets
Bank Act limits foreign-controlled banks to <8% of total domestic bank assets
- Serve individuals, business, and others (government organizations)
- Major source of short-term loans for business
• Secured (Collateral) vs. Unsecured loans (No collateral)
- Secured loans require collateral such as house, car, bonds, stocks, etc.
- Expand money supply through deposit expansion
- Unsecured will have higher interest rates.
- Chartered banks also expand money supply through deposit expansion
- One source of revenue for banks is paying you next to nothing for your deposits, but
loaning your money to others for higher interest rates.
Changes in Banking:
- Changes in consumer demands
- Competition from foreign banks
Bank of Canada:
- Canada’s central bank
- Manages economy and regulates aspects of chartered bank operations.
- Manages money supply (picture in text book)
– Open Market operations
• Buy or sell govt securities
– Bank Rate
• Lower or raise the bank rate
Pillars #2 – Alternate banks
- Trust companies & credit unions Pillar #3 – Specialized lending/saving intermediaries
- Insurance companies, venture capital firms, pension funds.
- Venture capital firms will approve some loans to businesses that aren’t fully established
but are growing (well established banks won’t likely approve these loans)
- Will be harsh with the terms because they are taking a risk on the business.
Pillar #4 – Investment Dealers
- Facilitate trade of stocks, bonds and other products in Securities Markets.
- Primary Markets
• Investment bankers/dealers
• Advise, underwrite, distribute
- Secondary Markets
• Toronto Stock Exchange and other exchanges
International Banking & Finance
- Governments and corporations frequently borrow in foreign markets
International Bank Structure:
- Aims for stability
- World Bank provides limited services, funds national improvements.
- International Monetary Fund:
• Promotes stability of exchange rates
• Provides short-term loans to members
• Encourages member cooperation
• Promotes system for international payments
* The bank of Canada has a lot of power over our banking system (chartered banks)
Types of Investments: BONDS
- Represents debt for issuing corporation or government
- Legal, binding agreement
- Fixed rate of return (often paid semi-annually) no matter what happens in the economy.
- Fixed term – principal repaid at maturity
- Repaid to current owner (may have been traded)
- Priority over stockholders
Secured – more from governments (more trustable), they can just raise taxes to help pay
Unsecured – corporations
Bearer Bond (Less practical) – doesn’t keep track of who owns the bond, doesn’t keep
track of trades, if they are stolen, thief will get the money, if it burns, you lose it Up to the
bearer to claim the interest.
Registered Bond – keeps track and is sent out to current owner at the end of its life
Callable – gives issuer flexibility (allows them to pay that bond out earlier than maturity
- Pays out debt (less interest to pay in the future) Serial – staggering a series of redemption dates
- Instead of having to pay out a large sum of money all on one maturity date
Convertible – never works on Government (countries don’t issue stocks)
- Gives bond holder the option to convert their bond to common stocks (not usually for
What impacts Bond Value?
1) What impacts the coupon rate at bond issue?
• Prevailing interest rates
• Credit rating of issuer
• Features & Time to Maturity
2) What impacts bond price when traded?
• Coupon rate & prevailing rates of interest (relationship)
• Changes in credit rating
• Economic/Market Risk
Why are the coupon rates different for different bonds?
- Bondholders want higher interest rates for a longer bond period for putting their - - Money
away for a long time
- Prevailing interest rates in the economy.
- Risk premium (some countries and companies are riskier than others)
- If there are beneficial features for the bondholder, these will compensate for issuing the
bond with a lower interest rate
- Bond prices should fall if inflation is on the rise (vice versa)
What impacts bond values?
- If you lower the value of the lower interest rate bond. More people will buy it.
(Ex: New 8% bond with old 5% bond. 5% bond price will go down to make it
Concept of Yield:
- Percentage return on any investment
- Helps us to compare investments
Yield = what you made/what you paid = Interest + Capital Gain or Loss/what you paid
For a bond,
Interest = coupon rate x face value
Capital gain = face value – purchase price
* Always use a face value of $1,000 for bonds! Bond Pricing (Three scenarios to consider):
1) You pay less than face value for the bond priced “At a Discount”
- Coupon rate is less than expected yield
2) You pay more than face value for the bond priced “At a Premium”
- Coupon rate is more than the expected yield
3) You pay face value for the bond priced “At Par”
- Coupon rate is equal to expected yield
* Bond prices vary inversely with interest rates
Scenario 1: Pay at a “Discount”
- This scenario happens when the coupon rate is less than the expected yield.
- Example: You are buying a 2008 bond with a 3% coupon and today’s
expected bond yields are 5%
Notice: With a Yield expectation that is greater than the coupon rate, you would
need a capital gain to attain the Yield, which means you pay less than face value for
Scenario 2: Pay at “a Premium”
- This scenario happens when the coupon rate is more than the expected yield.
- Example: You are buying a 2004 bond with a 7% coupon and today’s
expected bond yields are 5%
Notice: With a Yield expectation that is less than the coupon rate, you would be
willing to pay more than face value (a premium) for the bond; in other words you
would take a capital loss.
The seller should demand more money as the coupon rate is higher.
The buyer would buy it even if it means incurring a capital loss. (Up to a certain point) Scenario #3: Pay “At Par”
- This scenario happens when the coupon rate is equal to the expected yield.
- Example: You are buying a 2006 bond with a 5% coupon and today’s
expected bond yields are 5%
Notice: Since your Yield expectation is met by the coupon rate, you would have no
capital gain, which means you pay face value for the bond.
Bond Pricing Summary
Bond prices vary inversely with interest rates
Interest rates increase Bond prices fall
Interest rates decrease Bond prices rise
Reading Bond Quotations
Bonds issued at $1,000 face value and redeemed at $1,000 face value at maturity
Types of Investments:
- Represents equity/capital for issuing company
- Voting rights
- No fixed term
- Variable return
- Discretionary payment (dividends)
- Risk Types:
Put bonds in another
column to compare
- Preferred = “hybrid investment” kind of like a common stock, kind of like a bond
- Preferred treatment over common stock holders
- Common shareholder takes most risk, so they get voting rights and choice who’s on BOD
- Preferred don’t get voting rights (unless things aren’t going well)
- More established, older companies will pay common stock dividends
- Preferred stocks have planned dividends won’t for sure happen (debt payments take
priority) just in the plan
Right – Other features company is offering an additional block of shares (secondary
public offering). They do this to expand more.
- If they did this, common stock owner would own less % of company
- Allow existing common shareholders to buy a certain amount of shares in order to
maintain their % ownership (ex. 20% of a company)
Redemption – make the company buy back your preferred stocks. There are certain times
you can do this.
Convertibility – covert your preferred shares to common shares.
What Impacts Stock Price?
- Demand and supply of stock due to negative or positive perceptions/facts
- Primary factors:
• Earnings - above or below expectations, rumours
• General market conditions - bull vs. bear markets, economy, interest (especially
• Speculation - bought or sold on belief price will soon move
- PRICE OF A SECURITY IS A COLLECTIVE EXPRESSION OF ALL OPINIONS OF THOSE WHO
ARE BUYING AND SELLING
Undervalued issue - offers higher return than stocks of similar risk
Less supply, much demand = increased price
More supply, less demand = decreased price
COMPARE AND CONTRAST BONDS AND STOCKS (Exam Question)
- Riskier (no way of knowing that we will get all of our capital back)
- Bond ongoing return (interest payment) - Stocks only might give some return (less likely)
- Stocks may or may not give out dividends, but if company has a bad year, they
don’t legally have to pay out dividends.
- Engaging in a transaction whose value is greater than the actual dollars you have available
- Creates potential to make a larger return or loss than indicated by the investment you
- Buying on margin
- Selling short
1) Buying on margin
- Put up only part of purchase price
- Broker lends remainder (with interest)
- Usually no more than half
*Min. requirements set and enforced by Securities Commission - crash of ‘29 - 10%
- Must qualify for margin account
- Must sign ‘hypothecation’ agreement (Margin Account Agreement Form) - pledging of
securities as collateral for a loan
- Must pay interest on loan
- The investors % equity (margin) in the margined stock must always be > the minimum
Example: Margin Call
• 1 month into the transaction the price of XYZ drops to $40
CMV = $40 x 200 shares = $8,000
• CMV - loan >/= % margin req’t
$8000 - $2700 = 66.25%
• Therefore, receive a ‘margin call’ from broker for amount ‘x’ that will bring %
equity back up to minimum requirement (increase equity by reducing loan)
Two ways to calculate margin call:
• Broker is only willing to lend 30% of market value
• CMV = $8,000 x .3 = $2,400 max. loan
• Current loan $2,700
• Therefore reduce loan by $300 (margin call)
• (CMV – loan) + margin call >/= margin req’t
($8,000-$2,700) + ‘x’) / $8,000 = 70% $5,300 + ‘x’ = $5,600
‘x’ = $300
• The amount of the margin call is used to reduce the debt to the broker
$2,700 owed - $300 call = $2,400 owing (after 1 month)
Impact on Interest
• Margin call 1 month into transaction
• Sell stocks after total of 3 months
Interest = $2,700 x 10% x 1/12 = $22.50
+ $2,400 x 10% x 2/12 = 40.00
2) Selling Short
- Buy low, sell high = sell high, buy low
- Sell shares you don’t own - borrow from broker
- Short deposit must be 150% CMV at all times
- Agreement may be terminated by either party at any time - forced to cover / “buy-in”
- Short sale price governed by ‘last sale’ rule
- Dividends declared are the responsibility of the seller
Short Selling Summary:
What is maximum profit you can make?
- Price of short
What is maximum loss?
- Anything goes; price can rise infinitely
- Unlimited losses
- Forced to cover short at disadvantageous price
- Dividends may be declared that you must cover
- Short calls
• Notice similarities and differences between margin buying and short selling
– Both face calls
Money today is worth less in the future because of risk, inflation, etc.
- Sometimes worth more in case of deflation
Annuity: multiple but equal payments over equal periods of time