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ECON 3430
Elizabeth Farrell

ECON Midterm Study 1 – INTRO Financial markets: markets in which funds are transferred from people who have an excess of available funds to people who have a shortage The Bond Market and Interest Rates • Security (financial instrument): claim on issuer’s future income or assets • Bond: debt security that promises to make payments periodically for a specified period of time o Enables corporations and governments to borrow to finance activities o Where interest rates are determined • Interest rate: cost of borrowing or price paid for the rental of funds o Different interest rates have a tendency to move in unison The Stock Market: • Common Stock: share of ownership in a corporation o Claim on earnings and assets o Issuing stock is a way to finance activities Structure of the Financial System: • Financial Intermediaries: institutions that borrow funds from people who have saved and make loans to others o Banks, insurance companies, mutual funds, finance companies, investment banks • Financial Crises: major disruptions in financial markets characterized by sharp declines in asset prices and failures of many financial and nonfinancial firms • Banks: financial institutions that accept deposits and make loans o Chartered banks, trust and mortgage loan companies, credit unions, caisses populaires • Financial innovation: development of new financial products and services o Important force for making financial system more efficient o E-finance: new financial products and ability to deliver financial services electronically Money and Monetary Policy: • Money: anything that is generally accepted in payment for goods and services or in the repayment of debts o Liked to changes in economic variables and affect all of us and are important to the health of the economy • Aggregate Output: the total production of goods and services • Unemployment Rate: percentage of the available labour force unemployed) • Business Cycles: the upward and downward movement of aggregate output produced in the economy • Recession: periods of declining aggregate output • Monetary theory: theory that relates to the quantity of money and monetary policy changes in aggregate economic activity and inflation Money and Inflation • Aggregate Price Level: price level or average price of goods and services in an economy • Inflation: continual increase in the price level • Money Supply moves closely together with inflation • Inflation rate: rate of change of the price level • Monetary Policy: management of money and interest rates • Central bank: the main bank (Bank of Canada for Canada) • Fiscal policy: decisions about government spending and taxation • Budget deficit: excess of government expenditures over tax revenues for a particular time period • Budget surplus: tax revenues exceed governmental expenditures • Gross domestic product: measure of aggregate output International Finance: • Foreign exchange market: where conversion of currency takes place and it is instrumental for moving money between countries • Foreign exchange rate: price of one country’s currency in terms of another’s • Appreciation: when Canadian dollar can buy more • Depreciation: when dollar can buy less • Weaker dollar  more expensive foreign goods • Strong dollar  fewer exports; benefit by making foreign goods cheaper but eliminates jobs by cutting foreign sales Aggregate Output and Income: • GDP: market value of all final goods and services produced in a country during the course of the year • Aggregate income: total income of factors of production (land, labour, capital) from producing goods and services in the economy; should be equal to aggregate output • Real vs. Nominal GDP: adjusted or unadjusted for current price level Aggregate Price Level: • GDP Deflator: nominal GDP / Real GDP • CPI: consumer price index; price a basket of goods and services bought by a typical urban household 2 – FINANCIAL SYSTEM Function of Financial Markets: • Essential economic function of channeling funds from households, firms and governments with surplus funds to those with shortage of funds • Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments) • Indirect finance: financial intermediary borrows funds from lenders and uses funds to make loans • Financial markets are essential in promoting economic efficiency • Improve the well-being of consumers by allowing time to make purchases better Structure of financial markets • Debt and Equity Markets: o Debt: contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date when the final payment is made o Maturity: number of terms until the expiration date; Short term: less than a year; long term: 10 years or longer; Intermediate term: in between o Dividend: periodic payments to shareholders • Primary market: financial market in which new issues of a securities are sold to initial buyers by corporation or government agency • Secondary market: financial market in which securities can be resold o Investment bank: financial institution that assists in the initial sale of securities o Underwriting: guarantees price of securities and then sells them to the public o Other examples of secondary markets: foreign exchange markets, futures markets, options markets o Brokers: agents of investors who match buyers with sellers of securities o Dealers: link buyers and sellers buy buying and selling securities at stated prices o 2 important functions:  Financial instruments are more liquid  Determine the price of the security • Exchanges and OTC Markets: o Exchanges: where buyers and sellers of securities meet in one central location to conduct trades  TSE, ICE Futures, ME o OTC market: dealers at different locations stand ready to buy and sell securities to anyone who comes to them and is willing to accept their prices • Money and Capital Markets: o Money market: financial market in which only short-term debt instruments are traded o Capital market: longer-term debt and equity instruments are traded Financial Market Instruments: • Money market Instruments: least price fluctuations, least risky investments o Government of Canada Treasury Bills:  1, 3, 6 and 12 month maturities to finance federal government  Pay set amount at maturity  No interest payments  Pay interest by selling at discount  Most liquid and most actively traded  Almost no possibility of default o Certificate of Deposit:  Debt instrument sold by a bank to depositors  Pays annual interest of a given amount and at maturity back the original purchase price  Negotiable (bearer deposit notes)  Term notes (term deposit receipts): non-negotiable CDs sold by chartered banks o Commercial Paper:  Unsecured short-term debt instrument issued in currencies by large banks and well known corporations  Interest rate reflects the firm’s level of risk  Finance paper: short-term promissory note o Repurchase Agreements:  Short-term loans for which Treasury Bills serve as collateral  Corporation makes a loan to the bank and holds 1 million of bank’s treasury bills until the bank repurchases bills to pay off the loan o Overnight funds:  From banks to banks  Sensitive to credit needs of the deposit-taking institutions  Overnight interest rate is closely watched barometer of tightness of credit market conditions in the banking system and stance on monetary policy  High: banks are strapped for funds; low: needs are low • Capital Market Instruments: o Stocks: Equity claims on net income and assets of the corporation o Mortgages and mortgage-backed securities:  Mortgage: loan to households or firms to purchase housing, land, or other real structures  Provided by chartered banks, trust and mortgage loan companies, credit unions, caisses populaires, pension funds, life insurance companies  Mortgage-backed security: bond-like debt instruments backed by bundle of individual mortgages o Corporate bonds: long-term bonds issued by corporations with strong credit ratings o Government bonds: intermediate term and long term  Registered bond: name of owner appears on bond certificate  Call or redemption feature which allows them to be called on specific notice o Canada Savings Bonds o Provincial and Municipal Government Bonds: issue bonds to finance expenditures on schools, roads etc o Government Agency Securities o Consumer and Bank Commercial Loans: to consumers and businesses Internationalization of Financial Markets: • Foreign Bonds: traditional instruments in the international bond market o Sold in a foreign country and are denominated in that country’s currency • Eurobond: bond denominated in currency other than that of the country in which it is sold • Eurocurrencies: foreign currencies deposited in banks outside the home country • Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks Functions of Financial Intermediaries: Indirect Finance • Financial Intermediation: primary route for moving funds from lenders to borrowers • Reduce transaction costs: o Transaction costs: time and money spent in carrying out financial transactions (reduced) o Economies of scale: reduction in transaction costs per dollar of transaction as the size increases o Liquidity services: make easier for customers to conduct transactions • Reduce risk: o Risk: uncertainty about returns o Risk sharing: assets are created and sold with risk characteristics that people are comfortable with and intermediaries use the funds by selling these assets to purchase other assets with more risk (asset transformation) o Diversification: investing in a portfolio of assets whose returns do not always move together with the result that overall risk is lower than for individual assets • Asymmetric information: lack of information sufficient for accurate decision making o Adverse Selection (before transaction): borrowers with bad credit are the ones seeking out the loans and are more likely to be selected  Avoid selecting a risky borrower  Gather information about borrowers o Moral hazard: risk that borrower might engage in immoral activities that will make it less likely that the loan will be repaid • Economies of scope: lower the cost of information production for each service by applying one information resource to many different services o Conflicts of interest: type of moral hazard problem that arises when person has multiple objectives that conflict Types of financial intermediaries: • Banks (Depository Institutions): o Chartered banks: raise funds by issuing chequing and savings deposits and term deposits and use these funds to make loans and to buy securities o Trust and Loan Companies: obtain funds primarily through chequable and savings deposits, term deposits, GICs and debentures o Credit unions and CUCPs: small cooperative lending institutions organized around a particular group • Contractual Savings Institutions: o Life insurance companies: insure people against financial hazards following death and sell annuities; acquire funds from premiums that people pay to keep their policies in force and use them to buy corporate bonds and mortgages o P&C Insurance Companies: insure their policyholders against loss from theft, fire and accidents; also receive funds thru premiums; buy more liquid assets o Pension funds and government retirement funds: provide retirement income in the form of annuities to employees who are covered by the plan; acquired by contributions from employers and employees • Investment intermediaries: o Finance companies: raise funds by selling commercial paper and by issuing stocks and bonds; lend funds to consumers who make purchases of such items as furniture, automobiles and home improvements o Mutual funds: acquire funds by selling shares to many individuals and use proceeds to purchase diversified portfolios of stocks and bonds; pool resources to take advantage of low transaction costs and diversify o Money market mutual funds: characteristics of mutual funds but also function like banks Regulation of the Financial System • Increasing information available to investors: OSC and other commissions administer provincial acts requiring corporations issuing securities to disclose certain information about their sales, assets and earnings to public and restrict trading by largest stockholders in the corporation • Ensuring the soundness of financial intermediaries: o Financial panic: widespread collapse of financial intermediaries o Restrictions on entry: regulations on who is allowed to set up a financial intermediary etc. o Disclosure: reporting requirements and bookkeeping o Restrictions on assets and activities: what you are allowed to do and what assets to hold o Deposit insurance: insure people’s deposits so they do not suffer any financial loss o Limits on competition: • Improve control of monetary policy 3 – MONEY Meaning of money • Currency: paper money and coins • Economics views money broader: chequing deposits, etc. • Wealth: total collection of pieces of property that serve to store value • Income: flow of earnings per unit of time Functions of Money • Medium of Exchange: used to pay for goods and services o Promotes economic efficiency by eliminating time spent in exchanging goods and services o “Double coincidence of wants” o Allows people to specialize in what they do best o Lowers transaction costs  specialization and division of labour o Criteria:  Easily standardized  Widely accepted  Easily divisible  Easy to carry  Durable • Unit of Account: used to measure value in the economy o N * (N-1) / 2 o Reduces number of prices that need to be considered • Store of value: repository of purchasing power over time o Save purchasing power from the time income is received until the time it is spent o Liquidity: relative ease and speed with which an asset can be converted into a medium of exchange o Hyperinflation: when inflation is extreme at more than 50% per month Evolution of the Payments System • Payments System: method of conducting transactions in the economy • Commodity money: money made up of previous metals or another valuable commodity o Heavy o Hard to transport • Fiat money: paper currency decreed by governments as legal tender o Lighter than coins or precious metals o Can be accepted as medium of exchange only if there is trust in the authorities who issue it and counterfeiting is difficult o Easily stolen o Expensive to transport • Cheques: allow transactions to occur without carrying large amounts of currency o Reduces transportation costs and improves economic efficiency o Can be written for any amount up to the balance in the account o Loss from theft is reduced o Convenient receipts for purchases o Takes time to transport and process cheques • E-Money: money that exists only in electronic form o Debit card o Smart card: prepaid card o E-cash: money used online to buy stuff online Cashless society? • Expensive to set up technology • Raised security and privacy concerns Measuring Money • Definition of money: anything that can be generally accepted in payment for goods and services • Therefore money is defined by people’s behavior • Bank of Canada’s Monetary Aggregates: o Float: funds in transit between the time a cheque is deposited and the time the payment is settled o Monetary aggregates: measures of money supply • M1+ and M1++ o M1+ = currency outside of the banks + value of all chequable deposits at financial institutions o M1++ = same things + nonchequable deposits at financial institutions • M2, M2+ and M2++ o M2 = currency in circulation + personal deposits at banks, non-personal demand and notice deposits at banks and fixed-term deposits o M2+ = same things + deposits at trust and mortgage loan companies and CUCPs and life insurance company individual annuities, personal deposits at government-owned savings institutions and money market mutual funds o M2++ = same things + Canada Savings Bonds and other retail debt instruments and non-money market mutual funds • M3 = currency in circulation + personal deposits at banks, non-personal demand and notice deposits at banks and fixed-term deposits + non-personal term deposits at banks and foreign currency deposits of residents at banks • Money as a Weighted Aggregate 4 – UNDERSTANDING INTEREST RATES Measuring Interest Rates • Types of Credit Market Instruments: o Simple Loan: lender gives loan, borrower pays it back with interest o Fixed-payment loan: mortgages and car financing where you pay back portions of interest and principal o Coupon bond o Discount bond Current Yield = Cash Payment / price of the instrument Rate of return = (Coupon Pmts + Change in Price) / Initial Price Findings: • Rate of return that equals YTM means that holding period equals the maturity date • Prices and returns on long term bonds are more volatile than for short term bonds • When interest rates are low, more incentives to borrow and less incentives to lend Interest rate risk: riskiness of an asset’s return that results from interest rate changes Fischer Equation: Nominal interest rate = Real interest Rate + Expected rate of Inflation 5 – BEHAVIOUR OF INTEREST RATES Wealth: total resources owned by individual including all assets • An Increase in wealth raises the quantity demanded of an asset Expected return: return expected over the next period on one asset relative to alternative assets • An increase in an asset’s expected return relative to that of the alternative asset raises the quantity demanded of the asset Risk: degree of uncertainty associated with the return on one asset relative to alternative assets • If an asset’s risk rises relative to that of the alternative assets, its quantity demanded will fall Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets • The more liquid an asset is relative to the alternative assets, the more desirable it is and the greater quantity demanded Theory of Portfolio Choice: how much of an asset people want to hold in their portfolio • QD of an asset is positively related to wealth • QD of an asset is positively related to expected return relative to alt asset • QD of an asset is negatively related to risk of its returns relative to alt asset • QD of an asset is positively related to liquidity relative to alt asset Supply and Demand in the Bond Market Ceteris Paribus: all other things being equal Demand curve: shows relationship between QD and price • Bond: at lower prices, QD is higher Supply curve: shows relationship between QS and price • Bond: at lower prices, QD is lower Market Equilibrium: Occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price • B = B defines the equilibrium (or market clearing) price and interest rate • When B > B , there is excess demand, price will rise and interest rate will fall d s • When B < B , there is excess supply, price will fall and interest rate will rise • Asset market approach: emphasizes stocks of assets rather than flows in determining asset prices Changes in Equilibrium Interest Rates Changes in Demand • Wealth: o When increases, demand curve shifts to the right • Expected Returns: o Higher expected interest rates in the future lower expected returns for long-term bonds, demand curve shifts to the left o An increase in expected rate of inflation lowers the expected return on bonds causing demand to decline and demand curve shift to the left • Risk: o Increase in riskiness of bonds causes demand for bonds to decrease and demand curve shift to the left • Liquidity o Increased liquidity of bonds results in the demand curve shifting right Changes in Supply • Expected profitability of investment opportunities o Expansion, supply curve shifts to the right • Expected inflation o An increase in expected inflation shifts the supply curve for bonds to the right (real cost of borrowing falls) • Government Budget: o Higher government deficits increase supply of bonds and shift the supply curve to the right When Expected inflation rises, interest rates will rise The Liquidity Preference Framework Liquidity Preference Framework: • Developed by Keynes • Determines the interest rate in terms of the supply and demand for money (rather than for bonds) • Total economy’s wealth = total quantity of bonds + money in the economy • If the bond market is in equilibrium then the money market must also be in equilibrium (supply=demand) • As the interest rate increases: the opportunity cost of holding money increases…and therefore the quantity demanded of money decreases Shift in Demand for Money • Income Effect: o Economy expands, income rises, wealth increases and people want to hold more money as a store of value o Economy expands, income rises, people want to carry out more transactions using money o Higher level of income causes demand for money at each interest rate to increase and demand curve shifts to the right • Price-level Effect o Rise in price level causes demand for money at each interest rate to increase and demand curve to shift to the right Shift in Supply of Money: an increase in money supply engineered by Bank of Canada will shift supply curve for money to the right When income rises during expansion, interest rates will rise When price level increases interest rates will rise When money supply increases interest rates will decline Increase in money supply: • Income effect  rise in interest rates • Price-level effect  rise in price level • Expected-inflation effect  rise in expected inflation rate Term structure of interest rates: term to maturity influences rate on bond Yield curve: plot of yields on bonds with differing terms but same risk, liquidity and tax considerations Facts about interest rates on Government of Canada Bonds : 1. Interest rates on bonds of different maturities move together over time 2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted 3. Yield curves almost always slope upward Expectations theory: interest rate on a long term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond • Assumption: buyers of bonds do not prefer different maturities so they will not hold any quantity of bond if its expected return is less than that of another bond with a different maturity • Perfect substitutes: bonds with different maturities that have the same expected return Price of stocks affects ability of people to make optimal consumption decisions. Common stock is the principal way that corporations raise equity capital DIV 1 P1 P 0 + (1+k ) (1+k ) e e Gordon Growth D (1+g) 0 D 1 P 0 = k −g k −g e e • Dividends are assumed to continue growing at a constant rate forever. • The growth rate is assumed to be less than required return on equity Price Earnings Valuation • The price earnings ratio (PE) represents how much the market is willing to pay for $1 of earnings from the firm 1. a higher than average PE may mean the market expects earnings to rise in the future 2. a high PE may also mean the market feels the firm’s earnings are very low risk • (P/E) x E = P The price is set by the buyer willing to pay the highest price • The market price will be set by the buyer who can take best advantage of the asset • Superior information about an asset can increase its value by reducing its perceived risk Information is important for individuals to value each asset • When new information is released about a firm, expectations and prices change • Market participants constantly receive information and revise their expectations, so stock prices change frequently Theory of Rational Expectations • Adaptive expectations: – expectations are formed from past experience only – changes in expectations will occur slowly over time as data changes • However, people use more than just past data to form their expectations and sometimes change their expectations quickly • identical to optimal forecasts using all available information • prediction based on it may not always be perfectly accurate – it takes too much effort to make the expectation the best guess possible – best guess will not be accurate because predictor is unaware of some relevant information • • Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return of * of R >R ⇒ P ↑⇒R ↓ t of of R
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