ECMC48 Chapter 2.docx

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Economics for Management Studies
Jack Parkinson

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 Intermediaries Fund s Lender-Savers Borrower-Spenders 1. Households Direct Finance 1. Business Firms 2. Business Firms Fund Financial Market Fund 2. Government 3. Government 3. Households 4. Foreigners 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  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 ECMC48 Chapter2-----1 *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 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 ECMC48 Chapter2-----2 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 t
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