B U 2 8 3 — C h a p t e r
1
September 11th
1.2 Four Facets of Finance
Four Facets of Finance
1. Academic finance
2. The financial manager
3. Careers in finance
4. Personal finance
Self-Test
 The capital market connects entrepreneurs with people with money
 A financial advisor gives you advice on different stocks and bonds for your investment
portfolio and provides advice like “don’t put all of your eggs in one basket”
1.3 The Financial System
Financial System—The system that transfers money between suppliers and users. It comprises
financial intermediaries, markets, and instruments (securities).
Suppliers
 Individuals:
o The primary investors in the economy
o Ultimately, they own every business asset
o As individuals plan for retirement (or set aside money for other goals), they invest
their savings in the financial system with the exception of converting that savings
into greater savings in the future
 Businesses:
o Supply funds in the form of retained earnings
Financial Intermediaries
 Banks:
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o Take deposits from savers and lend to individuals (ex. mortgages) and businesses
(ex. lines of credit and commercial loans)
o Profit from spread between rate charged on loans and rate paid on deposits
Investment Banks:
o Help companies, municipalities, states and provinces raise capital by selling
securities to the public
o Profit from spread between price paid to security issuer and price charged to
investor
o Provide financial consulting to companies
Pension, Mutual and Hedge Funds:
o Invest in private businesses and financial securities on behalf of individual savers
o Profit from management fees charged to savers
Insurance Companies:
o Collect premiums from individuals/businesses for life and property insurance
o Invest premium income prior to paying out claims
o Profit if premium plus investment income exceeds claims
Users
 Individuals:
o Borrow to finance homes, cars and holidays
 Businesses:
o Use money to start new projects
o They borrow money and raise equity
 Governments:
o Borrow to pay for operating deficits and to fund real capital like new highways
Self-Test
 Individuals are the primary supplier of funds in the financial system
 Governments are a user but not a supplier of funds in the financial system
1.4 Money and Capital Markets
Stock—A security that represents ownership in an incorporated company
Bonds—A debt instrument issued by governments and corporations with a maturity of more than
1 year. Coupon bonds pay periodic (annual or semi-annual) interest payments to the holder
(called coupons) and pay a final lump-sum (called the face value) at maturity.
Money Market—The market for bonds with a maturity of less than 1 year. These bonds are all
zero-coupon bonds and include bankers’ acceptances, commercial paper, and government Tbills.
Capital Market—The capital market for long-term securities with original maturity greater than
1 year. The main securities are bonds and stocks issued by companies and governments.
Money Market
 Money is not traded in the money markets
 In a money market, the securities…
o Are fixed income securities (ex. bonds)
 Fixed income securities are a class of securities that is not equity and that
makes payments to the holder on a fixed schedule (ex. bonds)
o Are short-term
o Are highly liquid (easy to sell)
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o Mature in less than 1 year from their issue date
Money Market Mutual Funds (MMMFs):
o A pooling of investor money that is professionally managed. The investors own
shares (or units) in the pooled fund and are entitled to a proportionate share of
earnings. Each fund has a specific investment objective that guides the types of
securities that it owns. A money market fund owns money market securities.
Treasury Bills (T-Bills):
o Bonds issued by the U.S. government that have maturities of 91 days, 182 days,
or 52 weeks. T-bills are zero-coupon bonds.
Money Market
 Issuers:
o Government of Canada:
 The Government of Canada is the largest of all money market borrowers
 IT issues T-bills to finance the national debt
 Short-term issues enable the government to raise funds until tax revenues
are received
o Companies:
 Corporations use commercial paper and bankers’ acceptances to finance
short-term needs such as financing the loans they extend to their
customers
 Ex. GMAC Financial Services borrows money by issuing commercial
paper and uses the money to make loans (ex. to consumers buying General
Motors cars with repayment to come from customers making their
monthly payments)
o Banks:
 Banks are the major issuers of commercial paper
 Instruments:
o T-Bills:
 Treasury bills are issued by the Government of Canada and auctioned by
the Bank of Canada, sold at a discount to par value
 They have the lowest possibility of default of all money market securities
 T-bills have maturities ranging from 1 month to 1 year
 T-bills account for approximately 28% of all money market trading
 T-bills have the lowest risk and therefore, lowest rate of return
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o Bankers’ Acceptances:
 A banker’s acceptance is a short-term promissory note bearing the
unconditional guarantee (acceptance) of a chartered bank
 Bankers’ acceptances are issued at a discount to face value
 The yields on bankers’ acceptances are slightly higher than the yields on
prime corporate commercial paper
 Bankers’ acceptances account for approximately 30% of the money
market
o Commercial Paper:
 Commercial paper securities are unsecured promissory notes issued by
corporations and banks
 Because these securities are (generally) unsecured, only the largest and
most creditworthy corporations issue commercial paper
 Commercial paper is issued at a discount to its face value
 Commercial paper (including asset-backed paper) accounts for
approximately 37% of the money market
Dealers:
o The primary function of dealers is to make a market for money market securities
by maintaining an inventory from which to buy or sell
o These firms are very important to the liquidity of the market because they ensure
that both buyers and sellers can readily market their securities
o Money market dealers are mainly the chartered banks
o The banks are also primary dealers at Bank of Canada auctions
o Primary dealers are the largest of the institutions who are allowed to bid at the
auctions
Buyers:
o Funds:
 Because many money market instruments are too large for the average
investor to afford, investors instead buy units in money market mutual
funds (MMMFs)
 The funds purchase money market securities
o Bank of Canada:
 The Bank of Canada is the Government of Canada's agent for the
distribution of all government securities
 The Bank holds a large inventory of Government of Canada securities
 The Bank's responsibility for the money supply makes it the single most
influential participant in the money market
o Insurance Companies:
 Property and casualty insurance companies must maintain liquidity
because of their unpredictable need for funds
 Ex. The Great Ice Storm of 1998, with its six days of freezing rain, caused
$2 billion (in 2011 dollars) in insured losses in Quebec and eastern
Ontario—to meet this demand for funds, the insurance companies had to
sell a portion of their money market holdings
o Pensions:
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Pension funds maintain a portion of their funds in the money market so
that they will be liquid enough to take advantage of investment
opportunities
Additionally, pension funds must have sufficient liquidity to meet their
obligations to beneficiaries
o Banks:
 Chartered banks hold a larger percentage of Government of Canada
securities than any other group of financial institutions (approximately
12%)
 This is partly because of regulations that limit the investment opportunities
available to banks
Self-Test
 Maximum maturity of securities that trade on the money markets is 1 year
 In money markets, securities have an original maturity of less than 1 year, are traded in a
dealer market, have an active secondary market, and are traded in large denominations
Capital Markets
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Issuers:
o Government:
 The Government of Canada is the largest issuer of bonds and accounts for
about 25% of the outstanding debt in Canada (private and public sector)
 A number of Crown corporations issue bonds, as do provincial and local
governments
 The Government of Canada issues bonds to fund the national debt
 Provincial and local governments issue bonds to finance projects such as
schools and prisons
o Companies:
 Corporations issue stocks and bonds to raise funds for projects and
acquisitions
 Bonds are an alternative to bank borrowing
o Banks:
 Banks will initiate mortgages and then sell off bundles (say, 100
mortgages) to an investment bank
 The investment bank sells the bundle to an investor
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The bundles are called mortgage- and asset-backed securities
Securities:
o Government Bonds:
 A bond is a security that requires the issuer to make a series of annual (or
semi-annual) interest payments followed by a final maturity payment
 A bond is like an IOU—Bondholders don’t have to wait for maturity to
get their money back
 Instead; they can sell their bonds to other investors in the bond market
 The Government of Canada issues bonds with maturities ranging from one
year to 30 years
 The Bank of Canada auctions off bonds as the Government of Canada’s
financial agent
o Common Shares:
 Stock represents ownership in a corporation
 A stockholder owns a percentage interest in a firm consistent with the
percentage of outstanding stock held
 Stockholders are residual claimants in the sense that they get whatever is
left over after all of the company’s liabilities are paid off
 Common shareholders exercise their control of the corporation by voting
for directors who sit on the board (typically one vote per share)
 Common shareholders receive a dividend at the discretion of the board
o Preferred Shares:
 The preferred stockholder receives a fixed dividend that does not change
 Preferred stockholders have a more senior claim against assets than
common shareholders and are entitled to their dividends before common
shareholders
 Preferred stockholders usually do not vote
o Corporate Bonds:
 Corporate bonds are similar to government bonds, but corporate bonds can
be more exotic in the sense of having more features
 Ex. Some corporate bonds give the bondholder the option to convert into
being a stockholder
o Mortgage and Asset Backed Securities:
 Mortgage-backed securities are bundles of mortgages
 The owner of a mortgage-backed security receives the stream of interest
and principal payments from the original borrowers
 Asset-backed securities are similar, but they are bundles of car loans or
credit-card receivables instead of mortgages
Buyers:
o Individuals:
 The largest purchasers of capital market claims are households
 Individuals invest in stocks and bonds as a means of preparing for
retirement
o Funds and Pensions:
 Mutual funds, hedge funds, and pensions are pools of money managed by
professional portfolio managers
 The funds can be invested in any type of security
 Different funds have different investment objectives
 Investors own units or shares in the fund
o Financial Institutions:
 Financial institutions are also large purchasers of capital market securities,
because individuals and households often deposit funds in financial
institutions, which use the funds to purchase capital market instruments
 Ex. Property and casualty insurance companies invest their premium
income in capital market securities (mainly bonds) to earn income on the
money before they must pay out a claim
Subprime Mortgage Crisis—The large number of mortgage defaults by subprime borrowers
that occurred after housing prices peaked in 2006. The triggering event of the financial crisis of
2007 and 2008.
Self-Test
 The difference between stocks and bonds is that companies can issue both but
governments cannot
1.5 Primary and Secondary Markets
Primary Market—The market where securities are traded for the first time and where initial
offerings to the public are made.
Secondary Market
 The market for trading securities after they have been issued.
 Secondary markets are much larger than primary markets
Investment Bank—A financial intermediary that purchases securities from corporate and
government issuers and resells them to the general public in the primary market.
IPO (Initial Public Offering) —Where a firm first offers shares to the public and the firm
becomes a public company.
Self-Test
 Primary markets are where securities are offered for sale for the first time
 Secondary markets are where securities are traded after the initial sale
Types of Secondary Markets
 Auction Markets:
o A form of securities trading. It features many competitive buyers and sellers who
simultaneously issue orders through brokers. The buyer’s price is called the bid,
and the seller’s price is called the ask. A transaction occurs (and a price is set)
when a buyer’s bid price equals a seller’s ask price. The New York Stock
Exchange and Chicago Mercantile Exchange are example of auction markets.
 Dealer Markets:
o A form of securities markets. An alternative to an auction market. Market
participants trade over the phone or electronic network. Trading does not occur
between buyers and sellers but, instead, through a network of middlemen called
dealers. Dealers carry inventories of securities and stand ready to buy at their bid
price and sell at their ask price. Some dealer markets, like NASDAQ, are
centralized through a computer network; most are not (ex. bond and foreign
exchange markets). Also called an over-the-counter market.
Electronic Limit Order Books—A form of security market. The market is online and has no
physical location. Trading is based around orders. Market orders are matched with the best
available buy or sell order based on price and time priority. Limit orders are entered into the limit
order book.
Limit Order—A conditional order to buy or sell a security where it is only filled if the sell price
is above a given level or the buy price is below a given level
Market Order—An order to buy or sell that is to be executed as soon as it is received by the
broker
Bid
 In dealer markets, dealers buy at the bid price, so traders sell to the dealer and receive the
bid
 In auction markets, the bid price is the highest of the competitive offers to buy
Ask
 In dealer markets, dealers sell at the bid price, so traders buy from the dealer and pay the
bid price
 In auction markets, the ask price is the lowest of the competitive offers to sell
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Dealers buy at the bid and sell at the ask
o Ask > Bid
 Dealers adjust their bid and ask prices to maintain their inventory
o When there is excess demand, they raise their prices
o When there is excess supply, they lower their prices
Self-Test
 Ask price is higher than the bid price
 Market orders are likely to be filled more quickly
Role of Secondary Markets—Their primary role is to provide the means for investors to tailor
their investment horizons (ex. to sell their shares according to the personal financial needs)
Liquidity
 A securities market with a high volume of trading activity in which it is easy to buy and
sell. Liquid markets also have depth, which means large quantities can be traded quickly
without impacting the price adversely.
 Trades:
o A large number of trades means it is possible to buy or sell at any time
 Traders:
o A large number of traders produces a competitive market in which no individual
trader has monopoly power and there are many available traders
 Depth:
o Depth refers to the quantity of shares available to be traded
o In a deep market, the quantities are large
o When markets are deep, they can absorb large transactions while maintaining fair
prices
o When large pension funds or mutual funds sell hundreds of thousands of shares at
a time, it is important that they not depress the market price of the securities
1.6 Corporate Governance
Governance—The way an organization is formed, structured, and controlled. It refers to the
structure of authority within an organization.
Sole Proprietorship—A type of business entity owned and run by one person.
Partnership—A type of business entity owned and run by two or more persons who have agreed
to work together.
Corporations—A type of business entity that is independent of its owners, the shareholders.
Corporations may enter into contracts in their own name.
Principal Agent Problem—The problems and costs that occur when an agent does not
maximize the utility of the principal.
Advantages and Disadvantages
Advantages
Disadvantages
Sole Proprietorship
 Least regulated form
 Unlimited liability;
of business—no
owner is responsible
license, charter, or
for all business debts
agreement is legally
 No access to capital
required
markets; just bank
lending
 No conflict between
owner and manager;
 Ownership is difficult
manager acts in
(impossible) to
owner’s best interests
transfer
 Pay personal taxes on
business income
Partnership
 No license, charter or
 Partnership agreement
agreement is legally
is recommended
required
 Partners share joint
 Pay personal taxes on
liability for
all business income
company’s debts
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Corporation
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Ownership is easy to
transfer
Shareholders’ liability
to their investment;
not liable for
corporate debts
beyond their
investment
Corporation can
outlive owners
Can raise money
using capital markets
(debt and equity)
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No access to capital
markets; just bank
lending
Moral hazard; when
profits are shared each
partner has an
incentive to shirk on
effort
Ownership is difficult
to transfer
Expensive to set up;
must register with the
state or government;
need corporate charter
Pay corporate tax on
business income and
personal tax on
distributions of profits
Agency problems due
to separation of
ownership and control
Self-Test
 In Canada, 7% of business GDP is generated by sole proprietorships
Organizational Structure of a Corporation
Fiduciary Duty—A duty of care, loyalty, and good faith.
Capital Structure—The mix of long-term debt and equity used by the firm to finance its assets.
Distribution—A payment of cash to shareholders; either in the form of a dividend or share
repurchase.
Dividends—Periodic distributions of cash made by a firm to its stockholders, usually paid
quarterly.
1.7 Six Important Ideas in Finance
Time Value of Money—A dollar today is worth more than the promise of a dollar next year
Risk and Return—We should not expect to earn high returns without taking high risks
Efficient Markets Hypothesis (EMH) —The hypothesis that markets price securities fairly at
all times and that new information is rapidly reflected in the price
Law of One Price—Law that says that two equivalent investments that trade in different
markets must have the same price. If the prices aren’t equal, then an arbitrage opportunity is
created and the resulting trading pushes prices back to equality. The equality implied by the law
of one price only holds exactly if there are no trading frictions or barriers between the markets.
Arbitrage—A trading strategy that involves the simultaneous purchase and sale of an identical
security in two different markets at two different prices. Perfect arbitrage involves no investment
and no risk.
Information Asymmetry—When information is not spread evenly among all participants.
When some know more than others.
Profit
 The profit from an investment comprises any change in value in the asset that was
purchased plus interest, dividends, or other cash flows that the investor received from
owning the asset.
 Profit = Cash Flows Received – Investment
 Rate of Return = Profit / Investment
 Rate of Return = (Cash Flows Received – Investment) / Investment
Self-Test
 You cannot simply add dollars together that are received at different points of time
 Efficient Market Hypothesis is the concept that securities are always correctly priced by
the market