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Chapter 2

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Department
Economics
Course
EC223
Professor
Angela Trimarchi
Semester
Fall

Description
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 b
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