Chapter 1: Capital Market

Question 1

3 Components of wealth transfer process

Answer 1

1. Financial instruments (what is actually bought/sold)
2. Financial markets (facilitate buying/selling of 1)
3. Financial intermediaries (people/companies involved in 1 and 2)

Question 2

Capital

Answer 2

savings of individuals, corporations, and governments

Question 3

Direct Investment

Answer 3

assets that generate wealth (land, real estate, equipment, etc)

Question 4

Indirect Investment

Answer 4

• Financial assets: stocks (ownership of company), bonds (debt of company or government), treasury bills (debt of government)
• Companies and governments issue these financial assets and receive funds. The funds are used to invest in the funds directly
• Investors buy these financial assets to generate a return

Question 5

Efficient Allocation of Capital

Answer 5

Capital is mobile, scarce and sensitive (those who have capital will only transfer/invest if it is easy, cheap, and generates good return)

Question 6

Capital Flow Depends on…

Answer 6

• Political environment
• Economic trends
• Fiscal policy (government spending and taxation)
• Monetary policy (government by central banks)
• Investment opportunities
• Labour force (highly educated/laws governing rights of labour force)

Question 7

Sources of Capital

Answer 7

Retail, institutional and foreign investors provide capital

Question 8

Retail Investors

Answer 8

Individuals

Question 9

Institutional Investors

Answer 9

pension funds and mutual funds

Question 10

Foreign Investors

Answer 10

• foreign retail, institutional and government investors

- Investments are made directly in Canadian firms or through stocks/bonds for Canadian firms listed on foreign exchanges

Question 11

Financial Instruments

Answer 11

mechanisms by which wealth/capital is transferred (what is actually bought/sold)

Question 12

Debt

Answer 12

• Funds are borrowed
• At specific date (“maturity date”) these funds are paid back
• Between the borrowing and maturity date, interest payments are paid

Question 13

Equity

Answer 13

• Typically represented by stock/shares in a company
• As equity investor, you own part of the company
• At annual meetings, you have voting rights
• May receive regular dividend payments (not necessarily)

Question 14

Investment Funds

Answer 14

buys and sells stocks/bonds (typically through mutual funds)

Question 15

Derivatives

Answer 15

these products derive their value from another asset (stock, bond, commodity, currency) often used for hedging (ex. Mitigate the effect of a strong C$ or higher oil prices)

Question 16

Private Equity

Answer 16

• invest in both debt and equity
• typically investments are made directly in companies (not through stock or bonds)
• Funds are provided by pension funds, endowments, and wealthy individuals

Question 17

Efficient market properties

Answer 17

• Fast (can I buy / sell a stock with minimal delay)
• Cheap (low fees to buy / sell)
• Liquid (are there many buyers and sellers)
• Ex. Buying or selling a house may not be efficient, buying or selling a stock or a bond should be

Question 18

Primary Markets

Answer 18

• Securities (shares or bonds) are sold by issuers for the first time
• Issuer receives the money from this sale
• May be an IPO or subsequent equity offering

Question 19

Secondary Markets

Answer 19

• Where securities previously issued (above primary markets) are bought and sold (funds do not go to the issuer)
• Ex. If I buy 100 shares of TD bank on the TMX today - the funds go to the shareholder who sold me the shares (not TD)

Question 20

IPO (Initial Public Offering)

Answer 20

first time a company sells its shares to the public and the shares are listed on the stock exchange

Question 21

Auction Market

Answer 21

like any other market where items are bought and sold. A stock exchange is an auction market where stocks are bought and sold (all transactions converge in one location).

Question 22

How does the stock exchange make money?

Answer 22

• Transaction fees (you pay a fee when buying or selling a stock)
• Initial listing fees (company conducts IPO they pay a fee)
• Fees from companies making capital structure changes
• Sale of historic data

Question 23

Trends in stock exchanges

Answer 23

• Stock exchanges have largely transferred from physical locations to trading systems (speed and cost efficiency are crucial)
• Stock exchanges around the world have been joining together (through mergers & acquisitions) to become “bigger and better”

Question 24

Financial Intermediaries

Answer 24

People and companies that improve market efficiency by facilitating the flow of capital from buyers to sellers

• May work in their self interest
• Regulations are meant to be structured such that marker efficiency is a by-product of this self interest
• The financial crises exposed areas where firms were working in their self interest and also working against market efficiency/product economy

Question 25

Examples of Financial Intermediaries

Answer 25

Bank of Canada
Banks
Insurance companies
Pension Funds
Investment dealers
Private equity/venture capital firms

Question 26

Function of financial markets

Answer 26

Help facilitate transfer of capital

Question 27

Users of Capital

Answer 27

Companies/businesses
- Earn money internally through existing operations and reinvest that money
- Raise funds by issuing stocks/bonds
more and generate additional returns
Governments (federal, provincial, municipal) issue debt
- Treasury bills (debt due in less than one year), longer term debt, Canada Savings Bond (federal/provincial governments only)

Question 28

What do companies/businesses invest funds in?

Answer 28

New products/markets/machinery that they hope will grow the company more and generate additional returns

Question 29

What does the government invest funds in?

Answer 29

All forms of government spending that aren’t covered by tax and other revenues
Healthcare, education, infrastructure spending (roads, sewers, water, etc)