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EC223 (81)
Chapter 2

Chapter 2 EC223.docx

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Angela Trimarchi

EC223 Chapter 2 – An Overview of the Financial System Week 2 Function of Financial Markets -Financial markets perform the essential economic function of channelling funds from households, firms, and governments who have saved surplus funds by spending less than their income to those who have a shortage of funds because they wish to spend more than they earn -The principal lender-savers are households, but business enterprises and the government, as well as foreigners and their governments, sometimes also find themselves with excess funds and so lend them out -In direct finance, borrowers borrow funds directly from lenders in financial markets by selling them securities -Securities are assets for the person who buys them but liabilities for the individual or firm that sells them -Without financial markets, it is hard to transfer funds from a person who has no investment opportunities to one who has them -The existence of financial markets is beneficial even if someone borrows for a purpose other than increasing production in a business -Without financial markets you could not take out a mortgage -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 Structure of Financial Markets Debt and Equity Markets -The maturity of a debt instrument is the number of years until that instrument’s expiration date -A debt instrument is short-term if its maturity is less than a year and long-term if its maturity is ten years or longer -Debt instruments with a maturity between one and ten years are said to be intermediate-term -Equities common stock -Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date Primary and Secondary Markets -A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds -A secondary market is a financial market in which securities that have been previously issued can be resold -Investment bank – a financial institution that assists in the initial sale of securities in the primary market -It does this by underwriting securities; it guarantees a price for a corporation’s securities and then sells them to the public -Examples of secondary markets are foreign exchange markets, and options markets -Brokers are agents of investors who match buyers with sells of securities -Dealers link buyers and sellers by buying and selling securities at stated prices -When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued eh security acquires no new funds -Secondary markets make it easier to sell financial instruments to raise cash -Secondary markets determine the price of the security that the issuing firm sells in the primary market Exchanges and Over-the-Counter Markets -Secondary markets can be organized in two ways EC223 Chapter 2 – An Overview of the Financial System Week 2 -One is to organize exchanges, were buyers and sellers of securities meet in one central location to conduct trades -The other method is to have an over-the-counter (OTC) market in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices -Many common stocks are traded over the counter Money and Capital Markets -Money market – a financial market in which only short-term debt instruments are traded -Capital market – the market in which longer-term debt and equity instruments are traded -Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid -Capital market securities, such as stocks and long-term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which have more certainty about the amount of funds they will have available in the future Financial Market Instruments Money Market Instruments -The debt instruments traded in the money market undergo the least rice fluctuations and so are the least risky investments Government of Canada Treasury Bills -Short term debt instruments of the Canadian government issued in 1-, 3-, 6- and 12-month maturities to finance the federal government -They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount -Treasury bills are the most liquid of all the money market instruments because they are the most actively traded -They are also the safest -The federal government is always able to meet its debt obligations because it can raise taxes to pay off its debts -Treasury bills are held mainly by banks Certificates of Deposit -A debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price -Bearer deposit notes – the buyer’s name is neither recorded in the issuer’s books nor on the security itself -Maturities of 30 to 365 days and can be resold in a secondary market -Non-negotiable certificate of deposits – sold in denominations ranging from $5 000 to $100 000 -Important source of funds for trust and mortgage loan companies Commercial Paper -An unsecured short-term debt instrument issued in either Canadian dollars or other currencies by large banks and well-known corporations, such as Microsoft -The interest rate the corporation is charged reflects the firm’s level of risk -The interest rate on commercial paper is low relative to those on other corporate fixed-income securities and slightly higher than rates on government of Canada treasury bills -Finance paper – short-term promissory notes – issued in minimum denominations of $50 000 and in maturities of 30 to 365 days for finance paper and 1 to 365 days for commercial paper – issued on a discount basis EC223 Chapter 2 – An Overview of the Financial System Week 2 Repurchase Agreements -Short-term loans for which treasury bills serve as collateral, as asset that the lender receives if the borrower does not pay back the loan -They are now an important source of bank funds, with the most important lenders in this market being large corporations Overnight Funds -Made by banks to other banks -One reason why a bank might borrow in the overnight funds market is that it might find it does not have enough settlement deposits at the Bank of Canada – it can then borrow these balances from another bank with excess settlement balances -Overnight interest rate – the interest rate on overnight loans -When it is high, it indicates that the banks are strapped for funds, when it is low, bank’s credit needs are low Capital Market Instruments -Debt and equity instruments with maturities of greater than one year Stocks -Equity claims on the net income and assets of a corporation Mortgages -Loans to households or firms to purchase housing, land, or other real structures, where the structure or land serves as collateral for the loans -The federal government also plays an active role in the mortgage market via the Canada Mortgage and Housing Corporation (CMHC), which provides funds to the mortgage market by selling bonds and using the proceeds to buy mortgages Corporate Bonds -Long-term bonds issued by corporations with very strong credit ratings -Sends the holder an interest payment twice a year and pays off the face values when the bond matures -Some corporate bonds, called convertible bonds have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date Government of Canada Bonds -Intermediate-term bonds and long-term bonds are issued by the federal government to finance its deficit -Most liquid security traded in the capital market -Registered bonds – the name of the owner appears on the bond certificate and is also recorded at the Bank of Canada -Call feature – allowing them to be “called” on specified notice Canada Savings Bonds -Nonmarketable bonds issued by the government of Canada and sold each year -Denominations of $100 to $10 000 -They do not rise or fall in value -They have the valuable option of being redeemable at face value plus accrued interest at any time prior to maturity Provincial and Municipal Government Bonds -Provincial and municipal governments also issue bonds to finance expenditures on schools, roads, and other large programs -The securities issued by provincial governments are provincial bonds or provincials, and those issued by EC223 Chapter 2 – An Overview of the Financial System Week 2 the municipal governments as municipal bonds or municipals – the securities issued by the federal government are referred to as Canadas Government Agency Securities -Long-term bonds issued by various government agencies to assist municipalities to finance such items as mortgages, farm loans, or power-generating equipment Consumer and Bank Commercial Loans -Loans to consumers and businesses made principally by banks Internationalization of Financial Markets -The extraordinary growth of foreign financial markets has been the result of both large increases in the pool of savings in foreign countries such as Japan and the deregulation of foreign financial markets, which has enabled foreign markets to expand their activities -Canadian corporations and banks are now more likely to tap international capital markets to raise needed funds International Bond Market, Eurobonds, and Eurocurrencies -Foreign bonds – the traditional instruments in the international bond market -Eurobond – a bond denominated in a currency other than that of the country in which it is sold -Eurocurrencies – foreign currencies deposited in banks outside the home country -The most important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks outside the United States or in foreign branched of U.S. banks -Eurodollars are now an important source of funds for Canadian banks World Stock Markets -Stock markets in all countries have been growing in importance -The increased interest in foreign stocks has prompted the development in Canada of mutual funds that specialize in trading in foreign stock markets Function of Financial
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