Laurence Booth
Sean Cleary
1
An Introduction to Finance
LEARNING OBJECTIVES
1.1
1.2
1.3
1.4
1.5
Define finance and explain what is involved in the study of
finance.
List the major financial and real assets held by Canadians and
the major sectors in the financial system.
Explain how is money transferred from lenders to borrowers
and the role played by market and financial intermediaries.
Identify the basic types of financial instruments that are
available and explain and how they are traded.
Explain the importance of the global financial system and how
Canada is impacted by events in the U.S. mortgage market.
WHAT IS FINANCE?
• Finance is the study of how and under what
terms savings (money) are allocated between
lenders and borrowers.
– Finance is distinct from economics in that it
addresses not only how resources are allocated,
but also under what terms and through what
channels resources are allocated.
• Financial contracts or securities occur
whenever funds are transferred from issuer to
buyer.
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THE STUDY OF FINANCE
• The study of finance requires a basic
understanding of:
– securities
– corporate law
– financial institutions and markets
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1.1 REAL VERSUS FINANCIAL ASSETS
• Real assets are tangible items owned by persons and
businesses; e.g.:
–
–
–
–
Residential structures and property
Major appliances and automobiles (consumer durables)
Office towers, factories, and mines
Machinery and equipment
• Financial assets are what one individual has lent to
another, e.g.:
– Consumer credit
– Loans
– Mortgages
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1.1 REAL VERSUS FINANCIAL ASSETS
Households
• Households hold both real and financial assets
• Households also acquire some of those assets
through debt
• A household with no financial assets often faces
financial problems because real assets cannot be
easily used to pay off or service debt (i.e., make loan
payments)
• Real assets are not as liquid as most financial assets.
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1.1 REAL VERSUS FINANCIAL ASSETS
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1.2 THE FINANCIAL SYSTEM
Overview
• The household is the primary provider of funds to
businesses and government.
• Households must accumulate financial resources
throughout their careers to have enough savings
(pension) to live during their retirement.
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1.2 THE FINANCIAL SYSTEM
Overview
• Financial intermediaries transform the nature of the
securities they issue and invest in (e.g., banks, trust
companies, credit unions, insurance firms, mutual
funds)
• Market intermediaries, such as investment dealers
and brokers (investment advisors), simply help to
make markets work by adding liquidity.
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1.2 THE FINANCIAL SYSTEM
Channels of Intermediation
• Intermediation: Funds can be channeled from
lenders to borrowers in three ways:
1. Direct transfer from lender to borrower in a nonmarket transaction.
2. Direct intermediation through a market
intermediary such as a broker in a market-based
transaction.
3. Indirect claims through a financial intermediary
where the financial intermediary, such as a bank,
offers deposit-taking services and ultimately lends
the deposited funds out as mortgages or loans.
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1.2 THE FINANCIAL SYSTEM
Channels of Intermediation
Figure 1-4 Channels of Money Transfer
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Canadian Chartered Banks
• Deposits from numerous depositors from across
Canada are ‘pooled’ into banks
• Pooled funds are lent to households and businesses
in the form of mortgages and loans
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Canadian Chartered Banks (continued)
• The bank transforms the original nature of the
savers’ (depositors’) money:
• Individual depositors save in small amounts and
want to face little or no risk, but expect to be able
to withdraw their deposit at any time.
• Loans and mortgages are usually large in amount,
borrowed for long periods of time and for risky
purposes, and may not always be repaid in full.
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Canadian Chartered Banks (continued)
• Banks can perform this transformation function
because they become experts at risk assessment,
financial contracting (pricing the risk), and
monitoring the activities of borrowers.
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1.2 THE FINANCIAL SYSTEM
Intermediaries
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Insurance Companies
• Insurers sell policies and collect premiums from
customers based on the pricing of those policies given
the probability of a claim and the size of the policy and
administrative fees.
• Premiums are invested so that the accumulated value in
the future will grow to meet the anticipated claims of the
policyholders.
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Insurance Companies (continued)
• Risks that would be unsupportable by an individual,
such as the death of wage earners or the destruction
of a business’s assets by fire, are therefore shared
among a large number of policyholders through the
insurance company.
• Insurance allows households, business and
government to engage in risky activities without
having to bear the entire risk of loss themselves.
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1.2 THE FINANCIAL SYSTEM
Intermediaries
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Pension Plan Assets
• Individuals and employees make payments over their
entire working lives to pension plans, which invest those
funds to grow over time.
• The accumulated value of the pension can be used to
fund retirement.
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Pension Plan Assets (continued)
• Pension plans accumulate large sums of money;
their managers invest those funds with long-term
investment time horizons in diversified investment
portfolios.
• These investments are a major source of capital,
fuelling investment in research and development,
capital equipment, and resource exploration,
which ultimately contributes to the growth of the
economy.
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1.2 THE FINANCIAL SYSTEM
Intermediaries
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Canadian Mutual Fund Assets
• Mutual funds give small investors access to diversified,
professionally-managed portfolios of securities.
• Small investors often do not have the funds necessary to
invest directly into market-traded financial instruments
(e.g., stocks and bonds).
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Canadian Mutual Fund Assets (continued)
• This process is called denomination intermediation
because the mutual fund divides investments
denominated in larger amount of fund into smaller,
more affordable amounts. (e.g., a $1 million Treasury
bill could be purchased in $10 units in a moneymarket fund.)
• Canadian indirect investment in the markets through
managed products such as mutual funds and
segregated funds has grown exponentially in recent
years.
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1.2 THE FINANCIAL SYSTEM
Intermediaries
Figure 1-5 Canadian Mutual Fund Assets, 1963–2010 ($Billion)
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1.2 THE FINANCIAL SYSTEM
The Major Borrowers
• Public Debt:
– Government of Canada (the federal government)
– Provincial and territorial governments
– Municipalities
– Crown corporations
• Private Debt:
– Households
– Non-financial corporations
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1.2 THE FINANCIAL SYSTEM
The Major Borrowers
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Instruments
• There are two major categories of financial
securities:
1. Debt instruments: Examples: commercial paper,
bankers’ acceptances, Treasury bills (T-bills),
mortgage loans, bonds, debentures
2. Equity instruments: Examples: common share,
preferred share
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Instruments
• Non-Marketable Assets:
– Cannot be traded between or among investors
– May be redeemable (a reverse transaction
between the borrower and the lender): Examples:
savings accounts, term deposits, guaranteed
investment certificates (GICs), Canada Savings
Bonds
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Instruments
• Marketable Assets:
– Can be traded between or among investors after
their original issue in public markets and before
they mature or expire
– The market value will change over time due to
changes in the general economic environment (for
example, interest rate increases or decreases)
and/or changes in the financial condition or
prospects of the issuer of the security.
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Instruments
• Marketable securities can be categorized
according to their time to maturity:
– Money market securities are short-term debt
securities that are pure discount notes and usually
have maturities less than one year.
• Examples: Bankers’ acceptances, commercial
paper, Treasury bills.
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Instruments
– Capital market securities are long-term debt
or equity securities with maturities greater
than one year.
• Examples: bonds, debentures, common and
preferred shares
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Markets
1. Primary Markets: Markets that involve the issue of
new securities by a company in exchange for cash
from investors.
2. Secondary Markets: Markets that involve buyers
and sellers of existing securities. Funds flow from
the buyer to the seller of the securities, and the
buyer becomes the new owner of the security. No
new capital is formed; this is only the exchange of
already existing securities representing already
formed capital.
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Markets
Types of Secondary Markets
• Exchange or auction markets involve a bidding
process that takes place in a specific location.
– Examples: Toronto Stock Exchange (TSX), New York
Stock Exchange (NYSE)
• Dealer or over-the-counter (OTC) markets do not
have a physical location and consist of a network
of dealers who trade directly with each other.
– Example: bond market
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Markets
Market Capitalization
• The total market value of a company
• Calculated by multiplying the number of shares
outstanding by the market price of each share:
Market Capitalization = # of Shares × Share Price
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1.3 FINANCIAL INSTRUMENTS AND MARKETS
Financial Markets
3. Third Market: The trading of securities that are
listed on organized exchanges in the over-thecounter (OTC) market
4. Fourth Market: The trading of securities directly
between investors (usually between two large
institutions) without the involvement of brokers or
dealers
– Operates through the use of privately owned
automated systems such as Instinet
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1.4 THE GLOBAL FINANCIAL COMMUNITY
• Represents an important source of funds for borrowers
as seen in Table 1-9
• Provides investors with important alternatives as they
seek to build wealth through diversified portfolios
• Money markets and bond markets are global
• Domestic equity markets are increasingly linked because
of globalization and consolidation
• The correlation between markets is high, especially
during a systemic downturn as seen in Table 1-10
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