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Chapter 1 Finance Defined

Chapter 1: Finance Defined
Recent financial crises have confirmed unequivocally that all parts of the financial system
are interrelated (business, household, government and international finance).
Total global debt totaled US199 trillion by the second quarter of 2014. Canada’s total debt
stood at US 221 billion, or 221 percent of GDP.
1.1 Introduction to Finance Finance
• Finance is the study of how and under what term savings (money) are allocated
between lenders and borrowers.
• Borrowers - people
• Lenders - institutions
• It examines under what terms and through what channels allocations are made - of
money (different from economics)
Financial securities: whenever funds are transferred, a financial contract, this is what the
financial contacts are called
1.2 Real Versus Financial Assets
Net worth - the difference between what is owned and what is owed
• Assets minus liabilities
• Canada has total assets with a market value of 6852 billion. It has net foreign
liabilities of 236 billion- we owe more to non-residents than we owned as foreign assets.
(end of 2011)
Residential structures: houses; non-residential structures: office buildings, factories, mines
Types of Assets
1. Real Assets - represents the tangible things that compose personal and business
• The balance sheet shows all real assets according to six major classifications Ex.
Houses, consumer durables, land
• Research calculates a more inclusive definition of wealth by including human capital
(skills and education) and natural capital- Canada was the third
2. Financial Assets - a claim that one individual has on another
• How much money you owe to other people, debt Ex. Deposits, debt, pensions and
NBSA - National Balance Sheet Accounts
• The basic idea behind this is to collect financial data on major agents in the financial
system and then track the borrowing and lending between these agents
Households- the major real assets are houses, consumer durables, and
land on which our houses are built
Main assets: houses, pension and insurance assets, the market value of
shares in corporations and houses
The two largest components of financial assets are of households are
insurance and pension assets, and direct investments in shares
Biggest liability is mortgage debt
Key decisions are saving to buy a house and saving for retirement- old
people lend and younger ones borrow
Mortgages were worth 61$ of the value of the housing stock- a shock
to the financial system, such as a recession and job loss or a collapse
in house prices, can have a huge impact on the mortgage market, and
through it, the whole financial system.
1.3 The Financial System
• Basic financial flow is "intermediated" through the financial system, which comprises
1. Financial intermediaries: transform the nature of the securities they issue and invest in
2. mMrket intermediaries: facilitate the working of markets and help provide direct
intermediation but do not change the nature of the transaction; also called brokers
• The households, take and give money to financial systems
• Financial institutions take money and then the same process happens to business,
government, nonresidents
Channels of intermediation
• Transfers money from those with a surplus (lenders) to those who need it
• Occurs through intermediation, which is the process of bringing these parties
Three ways of transfer of money from lenders to borrowers
1. Borrowers obtain funds directly from individual. From relatives and friends
• Non market transaction
2. Direct intermediation between the lender and borrower, but in this case some help is
needed, either because no one individual can lend the full amount, they need to find
a couple of lenders (o one individual can lend the full amount needed or the borrower
is not aware of the available lenders)
• Market intermediaries are called “brokers” the real estate market has real estate and
mortgage brokers, who help with the sale and financing of houses. The insurance
market has insurance brokers, who facilitate the sale of insurance, and the stock
market has stockbrokers, who facilitate the sale of financial securities, particularly
• Agency transactions
3. Financial intermediation, a situation in which the financial institution lends the money
to the ultimate borrowers but raises the money itself by borrowing directly from other
The ultimate lenders have only an indirect claim on the ultimate borrowers; their
direct claim is on the financial institution
Principal transactions
Market intermediaries help financial intermediaries, as well as individuals in
their dealings with the ultimate borrowers.
When market intermediaries help individuals, it is retail; when they help
financial intermediaries, it is institutional
When people are not willing to lend to financial intermediaries and those
intermediaries, in turn, have to restrict who they can lend to, we have a credit
crunch. It is a situation where financial intermediaries have to raise the cost of their
loans by a significant amount due to their own in ability to raise financing on
reasonable terms.
The world in 2008-2009 experienced the worst credit crunch in over 75
years because major financial intermediaries in the US and Europe purchased
direct claims from issuers who could not repay them. Consequently, other lenders
were unwilling to lend to major financial intermediaries, causing the biggest ever
bankruptcy in the US (Lehman Brothers) and bank failure (Washington Mutual)pushed to first ever global recession
Chartered Banks
• Involved in almost all areas of the financial system
• Core activity is to act as deposit takers and lenders
• Canadian banks among the soundest banks in the world, and became paragons of
• But the net income is low- banking is a low-margin, high-turnover business, which
means it makes a lot of “sales”, that is loans, but each is not highly profitable.
After a couple of years of losses, investors may start to worry about whether the
bank can survive, and a full-scale credit crunch will erupt (2008 US, biggest bank in
the world, Citigroup saw overall market value drop from 260 billion to 5 billion.)
Insurance Companies
• Classified as contractual savers, they take premiums every month so they can cover the
costs when an emergency or tragedy happens
• (technically life insurance is not insurance, we are all going to die, so we can’t insure
against it- it is often a form of savings)
• Many view selling insurances as simply a way of getting “free” money to invest
• Big three in Canada: Manulife, Great West Lifeco, Sunlife
• They also invest the money given by premiums to make money – as long as you earn a
good return, you will be fine. But in 2006 to 2008, AIG invested in exotic financial securities
issued by major US banks- the US government had to inject over US 170 billion into AIG to
“rescue” it.
Pension Funds
• The funds in pension plans are held directly for their pensioners, and they substitute for
having individual save for themselves for their retirement
• Contractual savers and get a steady flow of money each month
• They keep the money and give it to people when they need
Mutual funds
• Act as a "pass through" for individuals, providing them with a convenient way to invest in
the equity and debt markets
• Perform 2 major functions
1. They pool small sums of money so they can make investments that would not be
possible for smaller investors
2. They offer professional expertise in the management of those funds
Assessing debt
• Divide the amount go debt by a country's GDP
• Canada’s federal government debt to GDP ratio hit 33.3 percent in 2012-2013, up from
29.2 in 2007-8, but still far from 67 percent in 1995-1996.
The Major Borrowers
 Money is transferred from lenders to borrowers either directly through market
intermediaries or indirectly through financial intermediaries
 Governments have huge power to raise money from citizens, either through direct
taxation, or by monopolizing and charging higher fees for things that we want, such as
gambling, alcohol and cigarettes (sin taxes), so government debt is generally regarded
as “default free”
 Governments can also print national currency
1.4 Financial Instruments and Markets
• Instruments and institutional arrangements that are used to transfer these funds
Financial instruments
• Financial instruments are formal legal documents that set out rights and obligations of all
parties involved
1. Debt instruments; legal obligation to repay borrowed funds at a specified maturity date
and provide them with interim interest payments.
Ex. Bank loans, mortgage loans, bonds, treasury bills
2. Equity instruments: these represent an ownership stake in a company Ex. Common
shares, preferred shares
Financial instruments can be categorized in several additional ways. One way is to distinguish
between non- marketable financial assets and marketable ones
1. Non marketable assets: savings accounts, demand deposits with banks (available on
demand). Canada Savings Bond (CSB): issued by the federal or provincial governments,
non-marketable, not tradable, can be cashed out any time. Non-tradeable
2. Marketable assets: those that can be traded among market participants, categorized
not only according to debt and equity but also to term to maturity.
Ex. T-Bills, commercial paper, BA's, bonds, debentures
Money Market securities: short term (maturities less than one year) debt
instruments, such as T bills, commercial paper and BAs
Capital Market securities: debt securities with maturities greater than one year, such
as bonds, debentures and so on. Also include equity securities.
Government raise new financing via debt markets. They issue T-Bills for short term
financing, and traditional bonds, CSBs for long term financing
Businesses raise loans, issuing commercial paper, BAs, and so on for short term,
and bonds, other long-term debt instruments or common, preferred shares for
Financial Markets
• The markets that permit the issue and trading of these instruments
• Involve the issue of new securities by the borrower in return for cash from investors
• Key to the wealth creation process, since they enable money to be transferred to those
who can use it to develop
• Will not work properly without well-functioning secondary markets
Ex. Company selling's shares to the public, governments sell T-bills
• Permit investors to buy and sell existing securities
Two major types
1. Exchanges or auction markets
2. Dealer or Over the counter markets
Trading on most major exchanges is fully computerized. OTC markets become
increasingly automated, reducing the amount of direct haggling between dealers\
Secondary market in equity securities is many times greater than the size of
primary market. Vice versa for debt securities
 Great majority of equity market transactions take place through a stock
exchange, although there is a small OTC equity market in Canada
Stock Exchanges
• Canada went from 5 stock exchanges to two
• Stock exchanges used to be not-for-profit organizations, membership was sold to
individual to allow them to trade on the exchange
• Now TSX convert into a regular corporation, seats were exchanged for shares- trend in
the conversion of stock exchanges to competitive private companies, as global
competition to list and trade securities increase.
• On April 23, 1997, the TSX closed its trading floor, and trading is now mostly
• The barometer is the standard and Poor’s/ Toronto stock exchange- S&P/TSX
2014 World Stock Markets
Other markets
• Common shares are also traded in the OTC and unlisted markets (in addition to stock
• Trades in unlicensed securities do not need to be reported, except in Ontario, where the
Ontario Securities Commission (OSC) required they be reported on the Canadian
unlisted board Inc. automated system.
The first Canadian quotation and reporting systems, the Canadian Trading and
Quotation system, launched in 2003 has been renamed CNSX Markets Inc.
requirements to trade are less stringent
Third and fourth markets
1. Third market: refers to the trading securities that are listed on organized in the OTC
market, market is important for "Block Trades", which are extremely large transactions
2. Fourth market: refers to trades that are made directly between investors (usually large
institutions), without the involvement of brokers or dealers. Operates through privately
owner automated systems. Ex. Instinet most popular
1.5 The Global Finance Community
Global markets represent important sources of funds for borrowing and provide
investors with important alternatives.
• Canada borrows and invests abroad (because Canadian debt and equity markets
represent only a small proportion of the total global marketplace.)
• It's easier to invest internationally
• A lot of Canadian companies are listed on more than one stock market, on other country
stock markets
Global Financial Markets
• U.S markets representing the largest and most active debt markets in the world
• NYSE is the world's largest stock market; although it has been steadily losing ground
in the trading of its listed securities to alternative trading's mechanisms (the other
• Second most important Nasdaq, has more listed companies the NYSE, but larger
firms list on the NYSE
• NYSE and Euronext merged, creating the first truly global securities exchange,
NYSE Euronext
• As trading computerized, the barriers between markets get smaller, the main
constraint becomes the capacity and sophistication of the computer program that
manages the trading
• Linkage between the markets are getting tighter
• Great example would be the 2008 crisis, emanated from abnormally large defaults
on mortgage loans, caused by poor lending practices and subsequent decline in real
estate prices- reinforce the fact that there is only one finance, business finance is simply
a subset of finance-, then triggered a world sell off of stocks including on TSX
• Central message is that businesses and investors are currently living with significant
uncertainty generated not from problems in the business sector but from low risk
1. Household mortgages
2. Government debt
• Emphases that there is only one big financial market, and all parts are
interconnected0 uncertainty generates not only from business sector but two sectors
normally regarded as lowest risk- household mortgages and government debt
• US depression happened because to many mortgages, that people couldn't pay
back causes banks to go empty and everything crashed. Canada used common
sense when it came to giving out mortgages