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:
The user raises the needed funds directly from savers (i.e.
selling shares to investors who are the savers).
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
Issued in various face values usually between $1,000 and
$25,000 and each issue indicated the rate of interest and the
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
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
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).
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
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