ECMC48 Chapter 2.docx

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Economics for Management Studies
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Jack Parkinson

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Chapter 2: An Overview of Financial System 1. An Overview of Financial System a) Financial markets perform the essential economic function of channeling of funds from households, firms and governments who have surplus funds (savers) to those who have a shortage of funds (borrowers). b) Securities are assets to those who buy them, but liabilities to those who sell them; Some securities are transferable (i.e. can be resold) others cannot. c) A primary function of the Financial System is financial intermediation (Indirect finance). d) Direct finance – borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments), which are claims on the borrower’s future income or assets. 2. Function of Financial Markets a) Economic Efficiency i. Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy ii. Well-functioning financial markets also directly improve the welfare of consumers by allowing them to 1. Ease liquidity constraints (borrow); 2. Create a portfolio (save); 3. Diversify risks; 4. Lower transactions costs; 5. Earn a (positive) rate of return; 6. Obtain liquidity services iii. When financial markets break down during financial crises, severe economic hardship (at the micro & macro level) results which can even lead to dangerous political instability iv. Operational efficiency measures the degree of cost effectiveness of the operation of financial markets or institutions 1. Definition: how well the financial system undertakes the function of transferring funds from lenders to borrowers (operational costs) 2. If banks are highly competitive, the “costs” associated with this function should be small v. Allocational (or allocative) efficiency measures how effectively financial markets or institutions allocate funds (to borrowers) from society’s perspective 1. Definition: how well the financial system allocates funds which are transferred (through the financial system) from lenders to borrowers (from societies perspective) 2. (Private) Banks have a comparative advantage at (versus public banks and other institutions) at loan making a) Assessing Risk (i.e. deciding who gets a loan) b) Pricing Risk (i.e. setting the loan terms) c) Monitoring Risk (i.e. follow the loan thereafter) 3. Structure of Financial Markets a) Debt Markets – Bonds & other loans i. Can be characterized on the basis of credit quality/issuer (Government vs. corporate); term to maturity; etc 1. Short-term (maturity ≤ 1 year) – traded in the Money Market 2. Long-term (maturity ≥ 10 year) – traded in the Capital Market 3. Medium-term (maturity >1 and < 10 years) – traded in the Capital Market b) Equity Markets - Common stocks i. Some make dividend payments ii. Right to vote & No maturity date iii. Equity holders are residual claimants iv. Primary Market - New security issues sold to initial buyers v. Secondary Market - Securities previously issued are bought and sold 1. Brokers (agent: direct finance) the actions matter Dealers (principal: indirect finance) c) Exchanges (stock/futures/options/commodities) i. Trades conducted in central locations (e.g., Toronto Stock Exchange and New York Stock Exchange) ii. Brokers, dealers, Market makers, investment banks etc buy/sell on the exchange d) Over-the-Counter (OTC) Markets (bonds/FX) i. Dealers at different locations buy and sell e) Money market – trade in short-term debt instruments (maturity ≤ 1 year) i. Some important Money Market Instruments 1. Government of Canada Treasury Bills 2. Certificates of Deposit 3. Commercial Paper 4. Repurchase Agreements 5. Overnight Funds f) Capital Market – trade in longer term debt & equity (maturity > 1 year) i. Some important Capital Market Instruments 1. Stocks 2. Mortgages 3. Corporate bonds 4. Government of Canada bonds 5. Additional Instruments a) Canada Savings Bonds b) Provincial and Municipal Government Bonds c) Government Agency Securi
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