chapter 8 book: An Overview of the Financial System Flashcards
what do financial markets do?
perform the essential economic function of channelling funds from households, firms, and governments who have saved surplus funds by spending less than their income to those who have a shortage of funds because they wish to spend more than they earn
lends money from those with surplus to those who need it
The most important borrower- spenders
businesses
the government
households
foreigners
the two routes by which funds flow from lender-savers to borrower-spenders
direct finance
indirect finance
direct finance
borrowers borrow funds directly from lenders in financial markets by selling them securities
securities
also called financial instruments
claims on the borrower s future income or assets
assets for the person who buys them
liabilities (IOUs or debts) for the individual or firm that sells (issues) them
bonds
type of securities
debt securities that promise to make payments periodically for a specified period of time
stocks
securities that entitle the owners to a share of the com- pany s profits and assets
Why is this channelling of funds from savers to spenders so important to the economy?
the people who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs
Without financial markets, it is hard to transfer funds from a person who has no investment opportunities to one who has them
if one wants a house and waits by saving up on his own, hell be too old to enjoy the house once he can afford it
with financing, this individual can ask for a loan and enjoy the house while he’s still young, while the lender enjoys constant cash flow from interest
A firm or an individual can obtain funds in a financial market in which two ways?
debt instrument
raising funds is by issuing equities
which is the most common for a firm or an individual between debt instrument and issuing equities?
debt instrument
debt instrument
such as a bond or a mortgage
a contractual agreement by the borrower to pay the holder of the instru- ment fixed dollar amounts at regular intervals
interest and principal payments until a specified date (the maturity date)
The maturity of a debt instrument
the number of years (term) until that instrument s expiration date
short term debt instrument
less than a year
long term debt instrument
maturity is ten years or longer
intermediate term debt instrument
Debt instruments with a maturity between one and ten years
dividends
periodic payments by equities (for ex: stocks) to their holders
equities
stocks and shit
often pay dividends
a type of security
are considered long-term securities because they have no maturity date
true or false
owning stock means that you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors
true
The main disadvantage of owning a corporation s equities rather than its debt
an equity holder is a residual claimant
residual claimant
the corporation must pay all its debt holders before it pays its equity holders
they get the residuals
they have less seniority
advantage of owning a corporation s equities rather than its debt
equity holders benefit directly from any increases in the corporation s profitability or asset value because equities confer ownership rights on the equity holders
A primary market
a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds
A secondary market
a financial market in which securities that have been previously issued can be resold
why are primary markets not well known to the public?
because the selling of securities to initial buyers often takes place behind closed doors
investment bank
An important financial institution that assists in the initial sale of securities in the primary market
It does this by underwriting securities
underwriting securities
it guarantees a price for a corporation s securities and then sells them to the public
Brokers
agents of investors who match buyers with sellers of securities
dealers
link buyers and sellers by buying and selling securities at stated prices
does a corporation acquire new funds when shares are sold in the secondary market or primary market?
when they are sold on the primary market
When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued the security acquires no new funds
two important functions of secondary markets
they make the financial instruments more liquid
they determine the price of the security that the issuing firm sells in the primary market
making a financial instrument more liquid
making it easier to sell the financial instrument to raise cash
makes them more desirable and thus easier for the issuing firm to sell in the primary market
two ways in which secondary markets can be organized
to organize exchanges
to have an over-the- counter (OTC) market
secondary market’s exchanges
buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades
ex: The Toronto Stock Exchange for stocks and the Winnipeg Commodity Exchange for commodities (wheat, oats, barley, and other agricultural commodities)
the secondary market’s over-the-counter (OTC) market
dealers at different locations who have an inventory of securities stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices
dealers are in computer contact and know the prices set by one another
market is very competitive and not very different from a market with an organized exchange
is the Canadian bond market a OTC market or part of the market exchanges?
OTC market
The money market
a financial market in which only short-term debt instruments are traded
generally those with original maturity of less than one year
the capital market
the market in which longer- term debt and equity instruments are traded
generally those with original maturity of one year or greater
which is more ideally traded, money market securities or capital market securities?
Money market securities are usually more widely traded than longer-term securities
this causes them to be more liquid
who has more fluctuations in prices, money market securities or capital market securities?
short-term securities have smaller fluctuations in prices than long-term securities
this makes them safer investments
who uses more the money markets? why?
corporations and banks
to earn interest on surplus funds that they expect to have only temporarily
who uses more the capital markets? why?
often held by financial intermediaries such as insurance companies and pension funds
they have more certainty about the amount of funds they will have available in the future
government of Canada treasury bills
short-term debt instruments of the Canadian government are issued in 1-, 3-, 6-, and 12-month maturities to finance the federal government
part of the money market
pay a set amount at maturity and have no interest payments
how do government of Canada treasury bills pay interest in the end?
pay interest by initially selling at a discount, that is, at a price lower than the set amount paid at maturity
Treasury bills
the most liquid of all the money market instruments because they are the most actively traded
safest of all money market instruments because there is almost no possibility of default
who mainly holds treasury bills?
banks
A certificate of deposit (CD)
a debt instrument sold by a bank to depositors
pays annual interest of a given amount
at maturity pays back the original purchase price
bearer deposit notes
traded (negotiated) certificates of deposit (CDs)
the buyer s name is neither recorded in the issuer s books nor on the security itself
issued in multiples of $100 000 and with maturities of 30 to 365 days
can be resold in a secondary market
term deposit receipts or term notes
non-negotiable CDs (they cannot be sold to someone else and cannot be redeemed from the bank before maturity)
issued in denominations ranging from $5000 to $100 000
with maturities of one day to five years
Commercial paper
unsecured short-term debt instrument
part of money market
issued in either Canadian dollars or other currencies by large banks and well-known corporations, such as Microsoft and Bombardier
issued in minimum denomi- nations of $50 000 and in maturities of 1 to 365 day
who can issue commercial paper?
only the largest and most creditworthy corporations issue commercial paper
a commercial paper’s interest rate
reflects the firm s level of risk
low relative to those on other corporate fixed-income securities
slightly higher than rates on government of Canada treasury bills
finance paper
issued by sales finance companies
short-term promissory notes
issued in minimum denomi- nations of $50 000 and in maturities of 30 to 365 day
Repurchase agreements, or repos
short-term loans (usually with a maturity of less than two weeks)
treasury bills serve as collateral
collateral
an asset that the lender receives if the borrower does not pay back the loan
overnight funds
overnight loans by banks to other banks
overnight interest rate
interest rate on overnight loans
high overnight interest rate
indicates that the banks are strapped for funds
low overnight interest rate
credit needs are low
money market instruments
government of Canada treasury bills
A certificate of deposit (CD)
Commercial paper
Repurchase agreements, or repos
overnight funds
capital market instruments
Stocks
Mortgages
corporate bonds
government bonds (Canada Savings Bonds (CSBs)
Provincial and municipal government bonds
government agency securities
consumer and bank commercial loans
stocks
owning equity in a corporation
mortgages
loans to households or firms to purchase housing, land, or other real structures
the structure or land serves as collateral for the loans
the largest debt market in Canada
The mortgage market
corporate bonds
long-term bonds issued by corporations with very strong credit ratings
send the holder an interest payment twice a year and pay off the face value when the bond matures
convertible bonds
a type of corporate bond
allow the holder to convert them into a specified number of shares of stock at any time up to the maturity date
more desirable than normal bonds
which is more liquid, Government of Canada bonds or corporate bonds? why?
Government of Canada bonds
Because the outstanding amount of both convertible and nonconvertible bonds for any given corporation is small
Government of Canada bonds
Intermediate-term bonds and long-term bonds
issued by the federal government to finance its deficit
registered bonds
the name of the owner appears on the bond certificate
recorded at the Bank of Canada
call (or redemption) feature in bonds
allows them to be called on a specific notice
usually 30 to 60 days
Canada Savings Bonds (CSBs)
offered exclusively to individuals, estates, and specified trusts
issued as registered bond
can be purchased from financial institutions or through payroll savings plans
they do not rise or fall in value
provincial bonds or provincials
bonds used by provincial governments to finance expenditures on schools, roads, and other large programs
municipal bonds or municipals
bonds used by municipalities governments to finance expenditures on schools, roads, and other large programs
government agency securities
long-term bonds issued by var- ious government agencies such as the Ontario Municipal Improvement Corporation
consumer and bank commercial loans
loans to consumers and businesses made principally by banks
foreign bonds
Bond issued in a domestic market by a foreign entity in the domestic market’s currency
Eurobond
a bond denominated in a currency other than that of the country in which it is sold
true or false
over 80% of the new issues in the international bond market are Eurobonds
true fam
Eurocurrencies
A variant of the Eurobond
foreign currencies deposited in banks outside the home country
Eurodollars
most important of the Eurocurrencies
U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks
indirect finance
funds moving from lenders to borrowers by a financial intermediary that stands between the lender-savers and the borrower-spenders
helps transfer funds from one to the other
financial intermediation
The process of indirect finance using financial intermediaries
the primary route for moving funds from lenders to borrowers
which is a more important source of financing for corporations: financial intermediaries or securities market?
financial intermediaries
Transaction costs
the time and money spent in carrying out financial transactions
a major problem for people who have excess funds to lend
how do financial intermediaries reduce transaction costs?
what does this mean in the end?
reduce transaction costs because they have developed expertise in lowering cost
reduce transaction costs because their large size allows them to take advantage of economies of scale
it can provide its customers with liquidity services
liquidity services
services that make it easier for customers to conduct transactions
how do low transaction costs reduce investors’ risks?
through risk sharing
risk sharing with low transaction costs from financial intermediaries?
create and sell assets with risk characteristics that people are comfortable with
use the funds they acquire by selling these assets to purchase other assets that may have far more risk
sometimes referred to as asset transformation
risky assets are turned into safer assets for investors
Diversification
investing in a portfolio whose returns do not always move together
overall risk is lower than for individual assets
asymmetric information
in financial markets, one party often does not know enough about the other party to make accurate decisions
Adverse selection
problem created by asymmetric information before the transaction occurs
occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome are the ones who most actively seek out a loan
this causes that these are most likely to be selected
Moral hazard
problem created by asymmetric information after the transaction occurs
the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender s point of view
lowers the probability that the loan will be repaid
problems created by asymmetric information
Adverse selection
Moral hazard
types of financial intermediaries
depository institutions (banks and near banks)
contractual savings institutions
investment intermediaries
Depository Institutions (Banks)
financial intermediaries that accept deposits from individuals and institu- tions and make loans
types of banks
chartered banks
trust and mortgage loan companies
credit unions
caisses populaires
chartered banks
raise funds primarily by issuing chequable deposits, savings deposits, and term deposits
use these funds to make commercial, consumer, and mortgage loans and to buy Canadian government securities and provincial and municipal bonds
chequable deposits
deposits on which cheques can be written
savings deposits
deposits that are payable on demand but do not allow their owner to write cheques
term deposits
deposits with fixed terms to maturity
trust and mortgage loan companies
obtain funds primarily through:
chequable and nonchequable savings deposits
term deposits
guaranteed investment certificates
debentures
credit unions and causes populaires
small cooperative lending institutions organized around a particular group
ex: union members, employees of a particular firm, and so forth
they acquire funds from deposits
primarily make mortgage and consumer loans
contractual savings institutions
financial intermediaries that acquire funds at periodic intervals on a contractual basis
they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years
do not have to worry as much as depository institutions about losing funds
types of contractual savings institutions
Life insurance companies
property and casualty insurance companies
pensions funds and government retirement funds
Life insurance companies
insure people against financial hazards following a death
sell annuities (annual income payments upon retirement)
acquire funds from the premiums that people pay to keep their policies in force
property and casualty insurance companies
insure their policyholders against loss from theft, fire, and accidents
very much like life insurance companies, receiving funds through premiums for their policies
who has a greater possibility of loss of funds between Life insurance companies and property and casualty insurance companies when a major disaster occurs?
property and casualty insurance companies
pensions funds and government retirement funds
provide retirement income in the form of annuities to employees who are covered by a pension plan
Funds are acquired by contributions from employers and/or from employees
the investment intermediaries
finance companies
mutual funds
money market mutual funds
finance companies
raise funds by selling commercial paper and by issuing stocks and bonds
mutual funds
acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds
allow shareholders to hold more diversified portfolios than they otherwise would
money market mutual funds
have the characteristics of mutual funds
function to some extent as depository institutions because they offer deposit-type accounts
why does the government regulate financial market?
to increase the information available to investors
to ensure the soundness of the financial system
to improve control of monetary policy
financial panic
widespread collapse of financial intermediaries caused by ssymmetric information
regulations to avoid financial panic
restriction one entry
disclosure
restrictions on assets and activities
deposit insurance
limits on competition
restriction on entry
tight regulations gov- erning who is allowed to set up a financial intermediary
Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance com- pany, must obtain a charter from the provincial or federal government
disclosure
financial intermediaries’ bookkeeping must follow certain strict principles
restrictions on assets and activities
There are restrictions on what financial intermediaries are allowed to do and what assets they can hold
deposit insurance
The government can insure people s deposits so that they do not suffer any financial loss if the financial intermediary that holds these deposits fails
limits on competition
Politicians have often declared that unbridled competi- tion among financial intermediaries promotes failures that will harm the public
