Midterm: Saturday Oct 12, 1:00PM
Part 1: Introduction ch.1-3
Chapter 1: The Economics of Money, Banking, and Financial Markets
Chapter 2: An overview of the financial system:
The Growth of Finance:
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Much growth is related to asset management and household credit
Function of Financial Markets:
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Channel funds from economic players that have surplus funds to those that have a shortage of
funds
Plays important role in the economy
o Promote efficiency: efficient allocation of capital
o Improve consumer’s wellbeing allows consumers to time their purchases
Direct and indirect finance
o Direct: borrow funds directly from lenders by selling securities
o Indirect: borrow funds through financial intermediaries
Classification of financial markets
o Debt and equity
o Primary and secondary (OTC, organized exchange)
o Money markets and capital markets
Debt and equity markets
o Debt: A contract between a borrower and lender
o Maturity: the number of years until the debt instruments expiration
 Short term < 1 year
 Long term>10 years
 Intermediate 1<10
Equity
o Dividends: [periodic payments
o Capital gain: increase in price
o Disadvantage
 Shareholder is a residual claimant
o Advantage
 Confers ownership rights on the equity holders
Primary and secondary markets:
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Primary markets: new issues of a security are sold to initial buyers by the corporation or
government agency borrowing the funds.
o Not well known to the public
o Investment bank assists in the initial sale of securities by underwriting securities
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Secondary market:
o Stock Exchange
o Bond market
o Other examples of secondary markets:
 FX markets
 Future markets
 Options markets
o Brokers and dealers are crucial for well functioning secondary markets
 Brokers: agents who match buyers with sellers of securities
 Dealers: buying and selling securities at stated prices
o Functions of the secondary markets
 Increase the liquidity of instruments
 Determine the price of the security that the issuing firm sells in the primary
market
o Secondary market: Echanges and OTC markets
 Organize exchanges: buyers and sellers of securities meet in one central location
to conduct trades
 OTC market: Networks of dealers at different locations who have an inventory
of securities stand ready to buy and sell securities
 Small stocks, bonds, etc.
o Money and Capital Markets
 Money Market – trade short-term debt instruments
 Capital Market – trade longer term debt and equity
o Money Market is more liquid:
 Less price fluctuation
 Corps and banks actively use money markets
Money Market Instruments
o Government of Canada Treasury Bills
o Commercial Paper
o Repurchase Agreement
o Overnight Funds
Government of Canada Treasury Bills
o The most liquid of all the money market instruments
o The safest of all money market instruments
Commercial Paper
o Unsecured short-term debt instrument is issued by large banks and well-known corps
o Only the largest and most credit worthy corps issue commercial paper
o The interest rates the corp is charged reflects the firm’s level of risk
o Interest rate is low
Repurchase Agreements
o Short term loans for which treasury bills serve as collateral
 Collateral: an asset that lender receives if the borrower does not pay back the
loan
 Important source of bank funds
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 The most important lenders are large corporations
Overnight Funds:
o Loans by banks to other banks
o The overnight market responds to the credit needs of the deposit-taking institutions
 Overnight interest rate is closely watched barometer of the tightness of credit
market conditions in the banks system
Capital Market Instruments: Debt and equity instruments with maturities > 1 year
o Stocks
o Mortgages and mortgage-backed securities
o Corporate bonds
o Government of Canada bonds
o Consumer and bank commercial loans
Mortgages
o Loans to households or firms to purchase housing, land, or other real structures, where
the structure or land serves as collateral for the loans.
o The mortgage market is the largest debt market in Canada
o Mortgage-backed securities is a bond-like debt instrument which is backed by a bundle
of individual mortgages
Corporate bonds
o Issued by corporations with strong credit rating
o The corporate bond market is far more important to a firm’s financing decisions than
the behaviour of the stock market:
 Although the size of the corporate bond market is substantially smaller than
that of the stock market, the volume of new corporate bonds issued each year is
substantially greater than the volume of new stock issues
 Not as liquid as Government of Canada bonds
Government of Canada Bonds
o Intermediate-term and long-term bonds
o The most liquid security traded in the capital market
o They are held by the Bank of Canada, banks, households, and foreign investors
Consumer and Bank Commercial Loans
o Loans to consumers and businesses made principally by banks
o Consumer loans by finance companies
o Canadian household debt to income ratio is 170.4 % in 2017
 Canadians now spend an average of 14% of after-tax income on their debts, up
from 11% in 1990
 Consumer debt: Mortgage, bank loan, credit card, auto loan
Function of Financial Intermediaries: indirect Finance
o Reduce transaction costs (time and money spent in carrying out financial transactions)
o Economics of scale:
 Loan contract can be used for many loans
 Specialized software / expertise for risk management
o Risk Sharing
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Asset transformation: Financial intermediaries create and sell assets with risk
characteristics that people are comfortable with
 Diversification: investing in a collection (portfolio) of assets whose returns do
not always move together
 Deal with asymmetric information problems
 Asymmetric information: one party does not know enough about other
party
Types of Financial Intermediaries
o Depository Institutions
 Chartered Banks
 Trusts and Mortgage Loan Companies
 Credit Unions
o Contractual Savings Institutions
 Life Insurance companies
 Property and Casual Insurance Companies
 Pension Funds and Government Retirement Funds
o Investment Intermediaries: Finance Companies, Mutual Funds
Depository Institutions
o Raise funds by issuing deposits
 Liability: Source of fund
o Use these funds to mark commercial, consumer, and mortgage loans and to buy
Canadian government securities and municipal bonds
 Assets: use of fund
Contractual Saving Institutions
o Acquire funds at periodic intervals
 Primum from policies (liability)
o Can predict with reasonable accuracy how much they will have to pay out in benefits in
the coming years
o Liquidity of assets is not as important a consideration for them as it is for depository
institutions
o Tend to invest their funds primarily in long-term securities such as corporate bonds,
stocks, and mortgages (assets)
Investment Intermediaries
o Financing companies:
 Raise funds by issuing CP, stocks and bonds (liabilities)
 Lend the money to consumers and small businesses (assets)
o Mutual Funds (MF) and Money market mutual funds (MMF):
 Raise funds by selling shares (liabilities)
 Use the fund to purchase stocks and bonds (assets)
o Investment banks:
 Advise the corporation on which type of security to issue
 Then underwrites the securities by purchasing them from the corporation at a
predetermined price and reselling them in the market
Regulation of Financial Markets: Primary Reasons for Regulation:
o Increase information to investors
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Ex. Provincial securities and exchange commissions require corporations to
disclose information and restrict insider trading
Ensuring the soundness of intermediaries
 Disclosure, periodic inspection, report information to the public
 Deposit insurance, Canada Deposit Insurance Corp ensures each depositor to a
loss of $100, 000 per account