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RSM100Y1 (431)
Chapter 16

RSM100Y1 Chapter 16 Notes

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Rotman Commerce
Michael Khan

RSM100Y1 Textbook Notes Chapter 16  Financial system: the mechanism by which money flows from savers to users.  Households are generally net savers (save more money than they use).  Businesses and governments are net users (use more funds than they save).  Net worth: the difference between what you own and what you owe.  Funds can be transferred between savers and users in two ways: o Directly  The user raises the needed funds directly from savers (i.e. selling shares to investors who are the savers). o Indirectly  Using financial institutions to obtain funds (i.e. saver deposits money in a bank account that earns interest and the user takes out a loan from the bank).  Securities: financial instruments that represent the obligations of the issuers to provide the purchasers with the expected stated returns on the funds invested or loaned.  There are three categories of securities: o Money Market Instruments  Short-term debt securities that can be issued by:  Governments - Treasury Bills which mature in 30, 90, 180, or 360 days and must be at least $1,000.  Financial institutions - Certificate of deposit whose maturity dates can vary and up to $100,000 is insured by the Canadian Deposit Insurance Corporation.  Corporations - Commercial paper which can mature in 1 – 270 days.  The issuer pays interest to the investors for the use of their funds. o Bonds  Issued in various face values usually between $1,000 and $25,000 and each issue indicated the rate of interest and the maturity date.  Bondholders are creditors therefore their claim on the firm’s assets must be satisfied before any claims of shareholders if the firm enters into bankruptcy.  The types of bonds are: Issuer Types of Securities Risk Special Features Government of Canada Savings Virtually none. Affordable: can be Canada Bonds: mature in 10 purchased for as (government years, but can be little as $100. bonds) cashed at any time. Provincial and General obligation: Risk varies, local issued by provincial or depending on the governments local governmental financial health of (municipal units with taxing the issuer. Risk is bonds) authority; backed by generally very low. the full faith and credit of the province or municipality where the bonds are issued. Corporations Secured bonds: bonds Risk varies A few corporate that are backed by depending on the bonds are specific assets. financial health of convertible into the issuer. common shares of the issuing Unsecured bonds Most corporate company. (debentures): bonds bond issues are that are backed by the rated in terms of financial health and credit risk (AAA reputation of the or Aaa is the issuer. highest rating) Financial Mortgage-backed Generally very They pay monthly institutions securities low risk. income consisting of both interest and principal.  The price of a bond is affected by its risk and its interest rate.  Bond ratings provide insight into how risky a bond is and these rating are issued by several investment firms such as the Dominion Bond Rating Service, Moody’s, and Standard and Poor. o Rating of BBB+: investment-grade bonds. o Rating of BB-: speculative/junk bonds (pay high interest but are high risk).  Interest rates are determined by risk and also by face value among various other things.  Market interest rates fluctuate and thus as market interest rates rise, bond prices fall and vice-versa.  Call provision: allows the issuer to redeem, or cash, the bond before its maturity at a specified price (usually when market interest rates fall). o Shares  Common shares: the basic form of corporate ownership.  Common shareholders are the true owners of a corporation and they expect to either receive dividends or have the value of their shares increase.  Preferred shares: holders are paid fixed dividends no matter how prosperous a company is but have claims on a firm’s assets, should it go under, before common shareholders.  Some bonds and preferred shares have a conversion feature which gives the holder the right to exchange the bond/preferred share for a fixed number of common shares (pay lower interest rates).  Financial markets: markets where securities are issued (by firms and governments) and traded.  Primary markets: financial markets where firms and governments issue securities and sell them initially to the general public.  Share offering: investors are offered the opportunity to purchase ownership shares in a firm and to participate in a firm’s future growth, in exchange for providing the firm’s current capital.  Initial public offering: when a company offers shares for sale to the general public for the first time.  Securities are sold to the investing public in two ways: o Open Auctions  Almost all securities sold through here are Government of Canada securities. o Through Investment Bankers  Most corporate and municipal securities are sold here.  Underwriting: the process of financial institutions purchasing the issue from the firm or government and then reselling the issue to investors.  Financial institutions pay the issuing firm or government less than the price that they charge investors (usually about 5%).  The underwriter typically locates buyers for the issue and advises the issuer on several details: the general characteristics of the issue, its pricing, and the timing of the offering.  The issuer selects a primary financial institution who then forms a syndicate consisting of other financial institutions and then each member of the syndicate purchases a portion of the security issue to re-sell to investors.  Secondary market: a collection of financial markets where previously issued securities are traded among investors (TSX).  Stock markets (exchanges): markets where shares of stock are bought and sold by investors.  TSX is Canada’s largest stock exchange. For a company’s shares to be traded on the TSX, the firm must apply for a listing and meet certain listing requirements. Bonds are also traded on the TSX but accounts for 1% of the total value of securities traded on it.  NYSE is the world’s largest stock exchange and one of the oldest as well. Shares traded on the NYSE represent most of the largest, best-known companies in the US (total market value $13 trillion +).  Nasdaq (National Association of Securities Dealers Automated Quotation System) Stock Market is the world’s second largest stock exchange. All trading on Nasdaq takes place through its intranet, not on a trading floor.  The London Stock Exchange lists over 3,000 stock and bond issues from more than 70 countries around the world (most internation SX).  Electronic communications networks (ECNs): buyers and sellers meet in a virtual stock marke
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