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Chapter 1-19

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Wilfrid Laurier University
Angela Trimarchi

Chapter 1: Why Study Money, Banking and Financial Markets? Financial Markets – markets in which funds are transferred from people who have an excess of available funds to people who have a shortage - ex. Bond and stock markets; these are crucial to promoting greater economic efficiency Security (financial instrument) – claim on the issuer’s future income or assets Bond – debt security that promises to make payments periodically for a specified period of time Interest Rate – cost of borrowing or the price paid for the rental of funds - ex. Mortgage rates, car loan rates, interest on bonds The interest rate on 3 month T-bills fluctuate more than other interest rates and is lower on average. The interest rate on Long Term corporate bonds is higher on average than the other interest rates, and the spread between it and the other rates fluctuates over time. Common Stock – represents a share of ownership in a corporate; a security that is a claim on the earnings and assets of the corporation The financial system is complex, comprising many types of private sector financial institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks, all of which are heavily regulated by the government. Financial Intermediaries – institutions that borrow funds from people who have saved and in turn make loans to others Financial Crises – major disruptions in financial markets that are characterized by sharp declines in asset prices and failures of many financial and nonfinancial firms Aggregate Output – total production of goods and services Monetary Theory – relates changes in the quantity of money to changes in aggregate economic activity and the price level Aggregate Price Level – the average price of goods and services in an economy Inflation – a continual increase in the price level The price level and the money supply generally move closely together. This indicates that increasing money supply is an important factor in causing the increase in price level (inflation). Monetary Policy – the management of money supply and interest rates Fiscal Policy – involves decisions about government spending and taxation Budget Deficit – excess of government expenditures over tax revenues for a particular time period Budget Surplus – tax revenues are greater than government expenditures The government must finance any deficit by borrowing, while a budget surplus leads to a lower government debt burden. Foreign Exchange Market – where the conversion of currency takes place; instrumental in moving funds between countries Foreign Exchange Rate – the price of one country’s currency in terms of another’s - this textbook expresses it as units of foreign currency per Canadian dollar Appreciation – exchange rate rises Depreciation – exchange rate declines A strong dollar makes foreign goods cheaper but can hurt Canadian businesses and eliminate jobs by cutting both domestic and foreign sales of products. Chapter 2: An Overview of the Financial System 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. Direct Finance – borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments) which are claims on the borrower’s futures income/assets Ways to Obtain Funds in a Financial Market 1. Issue Debt - contractual agreement to pay the holder of the instrument fixed $ at regular intervals until an end date 2. Issue Equity The main disadvantage of owning a corporation’s equities rather than its debt is that a corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because their confer rights of ownership. Primary Market – 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 Secondary Market – financial market in which securities that have been previously issued can be resold Primary markets take place behind closed doors; investment banks underwrite securities and guarantee a price for a corporation’s securities and then sells them to the public. The TSX, along with forex, futures and options markets are examples of secondary markets. Brokers are agents of investors who match buyers with sellers; dealers link buyers and sellers by buying and selling securities at stated prices. Secondary markets add liquidity to securities, making them easy to sell and more desirable while determining the price of the security that the issuing firm sells in the primary market. Secondary Markets a) Exchanges - meet in one central location to conduct trades b) Over-the-Counter Market (OTC) - dealers at different locations who have an inventory of securities stand ready to buy/sell securities “over the counter” to anyone who comes to them and is willing to accept their prices Another way to distinguish between markets is based on what kind of securities are traded. The money market is a financial market in which only short-term debt instruments are traded. The capital market is the market in which longer term debt (maturity > 1 year) and equity instruments are traded. Money market securities are usually more widely traded than longer-term securities and see smaller fluctuations in prices than long-term securities, making them safer investments. This is which corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily. Money Market Instruments The debt instruments in the money market undergo the least price fluctuations, and are the least risky investments. a) Government of Canada Treasury Bills – short term debt instruments in 1, 3, 6 and 12 month maturities to finance the federal government paying a fixed amount at maturity and have no interest payments but sell at a discount. There is almost no possibility of default (inability to pay principal or interest). b) Certificates of Deposit – sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price - often negotiable and in bearer form (buyer’s name is not recorded) - issued in multiples of $100k - chartered banks issue non-negotiable CDs in larger denominations that cannot be redeemed without penalty c) Commercial Paper – unsecured short-term debt instrument issued by large banks and corporations - the interest rate charged reflects the firm’s level of risk - the interest rate is less than those on corporate fixed-income securities and higher than rates on T-bills d) Repurchase Agreements – short-term loans (< 2 weeks) for which T-bills serve as collateral (an asset that the lender receives if the borrow does not pay back the loan) e) Overnight Funds – overnight loans by banks to other banks - might be used if a bank doesn’t have enough settlement deposits at the BoC and borrows these balances from another bank with excess settlement balances The overnight interest rate is a closely watched barometer of the tightness of credit market conditions in the banking system and the stance of monetary policy. When it is high, it indicates that the banks are strapped for funds. When it is low, banks’ credit needs are low. Capital Market Instruments Debt/equity instruments with maturities of > 1 year. They have much greater price fluctuations than money market instruments and are considered to be fairly risky. These include stocks, mortgages, corporate bonds, Government of Canada bonds, Canada Savings Bonds, Provincial/Municipal Government bonds, government agent securities, and consumer/bank commercial loans. Government of Canada Bonds - intermediate or long term bonds issued by government to finance its deficit - most widely traded/liquid security traded in the capital market - issued in either bearer or registered form Canada Savings Bonds - nonmarketable bonds issued by the government and sold each year - floating-rate bonds issued as registered bonds that can be bought from financial institutions - do not rise or fall in value and can be redeemed at face value + accrued interest at any time prior to maturity; there are also Canada Premium Bonds which offer slightly higher coupon rates that can only be redeemed once a year (on the anniversary of the issue date and during the month after that date) Foreign Bonds are the traditional instruments in the international bond market. They are sold in a foreign country and are denominated in that country’s currency. Ex. Porsche sells a bond in Canada denominated in CDN dollars Eurobond – a bond denominated in a currency other than that of the country in which it is sold Ex. A bond issued by a Canadian corporation that is denominated in Japanese yen and sold in Germany Eurocurrencies – foreign currencies deposited in banks outside the home country - most importantly are Eurodollars (US dollars deposited in foreign banks) The internationalization of financial markets is having profound effects on Canada. Foreigners not only are providing funds to corporations in Canada but also are helping finance the federal government. Without these foreign funds, the Canadian economy would have grown far less rapidly in the last twenty years. The internationalization of financial markets is also leading the way to a more integrated world economy in which flows of goods and technology between countries are more commonplace. In later chapters we will encounter many examples of the important roles that international factors play in our economy. Indirect Finance – involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other - the intermediary borrows funds from lenders-savers and then uses these funds to make loans to borrowers-spenders Financial Intermediation – the process of indirect finance using financial intermediaries is the primary route for moving funds from lenders to borrowers; financial intermediaries are a far more important source of financing for corporations than securities markets are Transaction Costs – the time and money spend in carrying out financial transactions - financial intermediaries are able to reduce transaction costs and can provide its customers with liquidity services which make it easier for customers to conduct transactions while reducing exposure to risk/uncertainty through risk sharing Risk Sharing – creating and selling of assets with risk characteristics that people are comfortable with; the intermediaries use the funds they acquire by selling these assets to purchase other assets that may have far more risk (sometimes called asset transformation) Asymmetric Information – an inequality whereby one party often does not know enough about the other party to make accurate decisions Ex. A borrower who takes out a loan usually has better information about the potential returns and risks associated with the investment for which the funds are kept than the lender does. Adverse Selection – the problem created by asymmetric information before the transaction occurs Ex. Potential borrowers who are most likely to produce an undesirable outcome (bad credit risks) are the ones who most actively seek out a loan and are thus most likely to be selected. Moral Hazard – the problem created by asymmetric information after the transaction occurs; in financial markets, it is the risk that the borrower might engage in activities that are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back Regulation of the Financial System The financial system is among the most heavily regulated sectors of the Canadian economy. It is regulated by the government to increase the information available to investors, to ensure the soundness of the financial system, and to improve control of monetary policy. Asymmetric information can lead to widespread collapse of financial intermediaries, known as a financial panic. Since providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are safe, they may want to pull their funds out of both sound and unsound institutions. The possible outcome is a financial panic that produces large losses for the public and serious damage to the economy. The government have regulations in place to protect the public. Chapter 3: What is Money? Wealth not only includes money, but also stocks, bonds, land, furniture, cars, and houses. Income is a flow of earnings per unit of time. Money serves three primary functions: a) a medium of exchange b) a unit of account c) a store of value Medium of Exchange – money is used to pay for goods and services Unit of Account – measures value in the economy Store of Value – it is a repository of purchasing power over time How good a store of value money is depends on the price level, because its value is fixed in terms of the price level. A doubling of all prices means that the value of money has doubled. During a period of high inflation, when the price level is increasing rapidly, money loses value rapidly, and people will be reluctant to hold their wealth in this form. This is especially true during periods of extreme inflation, known as hyperinflation, in which the inflation rate > 50% per month. Payments System – the method of conducting transaction in the economy Commodity Money – money made up of precious metals or another valuable commodity Flat Money – paper currency decreed by governments as legal tender but not convertible into coins or precious metal Electronic Money (E-Money) – money that exists only in electronic form Float – funds in transit between the time a cheque is deposited and the time the payment is settled We probably should not pay much attention to short run movements in the money supply numbers but should be concerned only with longer-run movements. Chapter 4: Understanding Interest Rates Interest rates are the most closely monitored variables in the economy and have important consequences for the health of the economy whether it be related to personal saving/consumption or business investment decisions. - CF is the cash flow, i is the annual interest rate and n is the number of years Types of Credit Market Instruments 1. A simple loan - lender provides borrow with funds that must be repaid at maturity along with interest - ex. commercial loans to businesses 2. A fixed-payment loan (fully amortized loan) - lender provides the borrowers with an amount of funds, which must be repaid by making the same payment every period consisting of part of the principal and interest for a set number of years 3. A coupon bond - pays the owner a fixed interest payment every year until the maturity date, when a specified final amount is repaid (face value/par value) 4. A discount bond - bought at a price below face value and the face value is repaid at maturity There are also consols (perpetuities) that have no maturity date and no repayment of principal. These bonds make fixed coupon payments forever. The return on a bond will not necessarily equal the yield to maturity on that bond. The return on a bond held from time t to time t+1 can be written as The return on a bond is the current yield i plcs the rate of capital gain g. Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. Interest Rate Risk – the riskiness of an asset’s return that results from interest-rate changes Long-term debt instruments have substantial interest-rate risk but short-term debt instruments do not. Bonds with a maturity that is as short as the holding period have no interest-rate risk. Real Interest Rate – the interest rate that is adjusted by subtracting expected changes in the price level (inflation) so that is more accurately reflects the true cost of borrowing The Fischer equation states that nominal interest rate i = real rate interest rate + expected inflation rate Indexed Bonds – interest and principal payments are adjusted for changes in the price level Chapter 5: The Behaviour of Interest Rates When determining whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: 1. Wealth 2. Expected Return 3. Risk 4. Liquidity An increase in wealth raises the quantity demanded of an asset. An increase in an asset’s expected return relative to that of an alternative asset raises the quantity demanded of the asset. If an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded. The demand curve shows the relationship between the quantity demanded and the price when all other economic variables are held constant (ceteris paribus). The supply curve, shows the relationship between the quantity supplied and the price. Market equilibrium occurs when the amount of people are willing to buy equals the amount that people are willing to sell at a given price. Excess supply: quantity supplied > quantity demanded Excess demand: quantity supplied < quantity demanded Asset Market Approach is for understanding behaviour in financial markets (which emphases stocks of assets rather than flows in determining asset prices). Expected Return on the Bond In a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. In a recession, when income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left. Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand, and shift the demand curve to the left. Lower expected interest rates in the future increase the demand for long-term bonds and shift the demand curve to the right. An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left. An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right. Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right. Increased liquidity of alternative assets lowers the demand for bonds and shifts the demand curve to the left. In a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. In a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls and the supply curve shifts to the left. An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right. Higher government deficits increase the supply of bonds and shift the supply curve to the right. On the other hand, government surpluses decrease the supply of bonds and shift the supply curve to the left. Response to Change in Expected Inflation Fischer Effect - When expected inflation rises, interest rates will rise. Response to a Business Cycle Expansion Response to a Lower Savings Rate The quantity of bonds and money supplied must equal the quantity of bonds and money demanded. Opportunity Cost – the amount of interest (exp.return) sacrificed by not holding the alternative asset Equilibrium in the Market for Money Shifts in the Demand for Money A higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right. A rise in the price level causes the demand for money at each interest rate to increase the demand curve to shift to the right. Shifts in the Supply of Money An increase in the money supply engineered by the Bank of Canada will shift the supply curve for money to the right. Changes in Income When income is rising during a business cycle expansion, interest rates will rise. Changes in the Price Level When the price level increases interest rates will rise. When the money supply increases, interest rates will decline. Response to a Change in Income or Price Level Response to a Change in the Money Supply Income Effect: The income effect of an increase in the money supply is a rise in interest rates in response to a higher level of inflation Price-Level Effect: The price-level effect from an increase in the money supply is a rise in interest rates in response to the rise in the price level Expected-Inflation Effect: The expected inflation effect of an increase in the money supply is a rise in interest rates in response to the rise in the expected inflation rate Chapter 6: The Risk and Term Structure of Interest Rates Bonds with the same term to maturity can have different interest rates. The relationship among these interest rates is called the risk structure of interest rates. A bond’s term to maturity also affects its interest rate and the relationship among interest rates on bonds with different terms to maturity is called the term structure of interest rates. Risk of Default – the issuer of the bond is unable to make interest payments when promised to pay off the face value when the bond matures Default-Free Bonds – bonds with no risk of default Risk Premium - spread between the interest rates on bonds with default risk and default-free bonds Response to an Increase in Default Risk on Corporate Bonds A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium. Credit-Rating Agencies – investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default Junk Bonds – bonds with ratings blow BBB which have higher default risk Fallen Angels – investment-grade securities whose rating has fallen to junk levels Expectations Theory – the interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond Segmented Markets Theory – sees markets for different-maturity bonds as being completely separate and segmented; the interest rate for each bond with a different maturity is then determined by the sup
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