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Chapter 2

MGEC71H3 Chapter Notes - Chapter 2: Adverse Selection, Nasdaq, Eurodollar

Economics for Management Studies
Course Code
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
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
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(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
2. Long-term (maturity ≥ 10 year) – traded in the Capital
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
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
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
i. Some important Capital Market Instruments
1. Stocks
2. Mortgages
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