chapter 8 powerpoint: An Overview of the Financial System

Question 1

Function of Financial Markets

Answer 1

Channel funds from economic players that have surplus funds to those that have a shortage

Efficient allocation of capital

Allows consumers to time their purchases

Question 2

direct finance

Answer 2

Borrow funds directly from lenders

Involves selling a liability (IOU or debt)

Question 3

Bonds

Answer 3

Debt instruments

A contract between a borrower (who issues the bond) and lender (who owns it)

Regularly payments until Maturity

Question 4

short term bond

Answer 4

< 1 year

Question 5

intermediate term bond

Answer 5

1-10 years

Question 6

long term bond

Answer 6

> 10 years

Question 7

Equity

Answer 7

Shares in a corporation

Don’t have maturity dates

Some make dividend payments

Equity holders are residual claimants

Question 8

who has more seniority, equity holders or debt holders?

Answer 8

debt holders

Question 9

Primary Market

Answer 9

New security issues sold to initial buyers

Not well known to public; typically private

investment banks guarantee prices (called underwriting)

Question 10

underwriting

Answer 10

investment banks guarantee prices in the primary market

Question 11

Secondary Market

Answer 11

Previously issued securities can be bought and sold

Brokers match buyers and sellers with each other

Dealers offer to buy and sell securities at stated prices

Question 12

brokers

Answer 12

match buyers and sellers with each other

Question 13

dealers

Answer 13

offer to buy and sell securities at stated prices

Question 14

Two main ways to organize a secondary market

Answer 14

Exchanges

Over-the-Counter Markets (OTC)

Question 15

secondary market Exchanges

Answer 15

Buyers and sellers meet in one central location

Toronto Stock Exchange for stocks

ICE Futures Canada for commodities (wheat, oats)

Question 16

secondary market Over-the-Counter Markets (OTC)

Answer 16

Dealers have inventory, ready to buy/sell at stated prices

Many stocks are not traded OTC, but are on exchanges

Question 17

Canadian government bond market is an OTC market or Exchanges?

Answer 17

OTC market

Question 18

Money Markets

Answer 18

Only short-term debt instruments are traded (<1 year)

Question 19

why do corporations and banks actively use money markets?

Answer 19

to each interest on temporary surplus funds

Question 20

Capital Markets

Answer 20

Market for longer-term debt (>1 year)

Question 21

are money markets or capital markets more liquid?

Answer 21

Money markets are more liquid than capital markets

Question 22

Money Market Instruments

Answer 22

Gov. of Canada Treasury Bills

Certificates of Deposit

Commercial Paper

Repurchase Agreements

Overnight Funds

Question 23

Gov. of Canada Treasury Bills

Answer 23

zero-coupon, risk-free bonds

Question 24

Certificates of Deposit

Answer 24

debt instrument issued to depositors

Question 25

Commercial Paper

Answer 25

short-term debt issued by banks and large corporations

Question 26

Repurchase Agreements

Answer 26

short-term loans with T-bills as collateral

Question 27

Overnight Funds

Answer 27

overnight loans between banks

Question 28

Money Market Rates

Answer 28

Prime Rate Overnight interest rate T-bill rate LIBOR (London Interbank Offer Rate)

Question 29

Prime Rate

Answer 29

rate of interest on corporate bank loans

Question 30

Overnight interest rate

Answer 30

on short-term loans between banks

Question 31

LIBOR (London Interbank Offer Rate)

Answer 31

interbank rate on dollar deposits in the London market (being phased out)

Question 32

Capital Market Instruments

Answer 32

Stocks Mortgages and mortgage-backed securities Corporate bonds Government of Canada bonds Canada Savings bonds Provincial and municipal government bonds Government agency securities Consumer and bank commercial loans

Question 33

Capital Market Instruments: Corporate bonds

Answer 33

high rating, long-term

Question 34

Capital Market Instruments: Government of Canada bonds

Answer 34

highly liquid

Question 35

Capital Market Instruments: Canada Savings bonds

Answer 35

floating-rate redeemable registered bonds

Question 36

Foreign Bonds

Answer 36

Sold in foreign country denominated in that country’s currency For example, Canadian company selling bond in the United Kingdom denominated in British Pounds (“bulldog bonds”)

Question 37

Eurobond (a.k.a. International bond)

Answer 37

Sold in foreign country, denominated in another currency Relatively recent development For example, Canadian (or, say, Mexican) company selling bond in the United Kingdom denominated in CAD

Question 38

how widely used are Eurobonds?

Answer 38

over 80% of new issues are Eurobonds

Question 39

Eurocurrencies

Answer 39

Variant of Eurobond Foreign currencies deposited in banks outside home country includes Eurodollars

Question 40

Eurodollars

Answer 40

U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks Eurocurrency

Question 41

Financial Intermediation

Answer 41

Indirect financing using financial intermediates (banks) Primary route to move funds from lenders to borrowers

Question 42

Four main roles of financial intermediates

Answer 42

Lowers Transaction Costs Improves Risk Sharing Help solve Asymmetric Information problems uses Economies of Scope

Question 43

how do financial intermediaries lower transaction costs?

Answer 43

Economies of scale Liquidity services (e.g. checking accounts)

Question 44

how do financial intermediaries improve risk sharing?

Answer 44

Asset transformation Diversification

Question 45

how do financial intermediaries help solve asymmetric information problems?

Answer 45

Financial intermediates can screen and monitor reduce Adverse Selection and Moral Hazard

Question 46

Adverse Selection

Answer 46

Potential borrowers who are more likely to default will most actively seek out loans in this case, the buyer has more information than the seller problem that happens before the transaction occurs results from Asymmetric Information

Question 47

who usually has more information when It comes to adverse selection?

Answer 47

Buyers

Question 48

Symmetric information

Answer 48

when both parties have equal knowledge

Question 49

Moral Hazard

Answer 49

Borrowers might engage in activities that are undesirable from a lender’s point of view happens after the transaction happened the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity a problem cause by asymmetric information

Question 50

Asymmetric Information problems

Answer 50

Adverse Selection Moral Hazard

Question 51

Economies of Scope

Answer 51

spillover benefits from providing several services

Question 52

negative effect of institutions using economies of scope

Answer 52

May create conflicts of interest

Question 53

Types of Financial Intermediaries

Answer 53

Depository Institutions Contractual Savings Institutions Investment Intermediaries

Question 54

Depository Institutions

Answer 54

Chartered Banks Trusts and Mortgage Loan Companies Credit Unions Caisses Populaires

Question 55

Contractual Savings Institutions

Answer 55

Life Insurance Companies Property and Casual Insurance Companies Pension Funds Retirement Funds

Question 56

Investment Intermediaries

Answer 56

Finance Companies Mutual Funds Money Market Mutual Funds Hedge Funds Investment Banks

Question 57

chartered banks' primary liabilities (source of funds) and primary assets (use of funds)

Answer 57

source of funds: Deposits use of funds: Loans, mortgages, government bonds

Question 58

trust and loan companies' primary liabilities (source of funds) and primary assets (use of funds)

Answer 58

source of funds: Deposits use of funds: Mortgages

Question 59

credit unions and causes populaires' primary liabilities (source of funds) and primary assets (use of funds)

Answer 59

source of funds: Deposits use of funds: Mortgages

Question 60

Life insurance companies' primary liabilities (source of funds) and primary assets (use of funds)

Answer 60

source of funds: Premiums from policies use of funds: Corporate bonds and mortgages

Question 61

Property and casualty insurance companies' primary liabilities (source of funds) and primary assets (use of funds)

Answer 61

source of funds: Premiums from policies use of funds: Corporate bonds and stocks

Question 62

Pension funds' primary liabilities (source of funds) and primary assets (use of funds)

Answer 62

source of funds: Retirement contributions use of funds: Corporate bonds and stocks

Question 63

Finance companies' primary liabilities (source of funds) and primary assets (use of funds)

Answer 63

source of funds: Finance paper, stocks, bonds use of funds: Consumer and business loans

Question 64

Mutual funds' primary liabilities (source of funds) and primary assets (use of funds)

Answer 64

source of funds: Shares use of funds: Stocks and bonds

Question 65

' primary liabilities (source of funds) and primary assets (use of funds)

Answer 65

source of funds: Shares use of funds: Money market instruments

Question 66

Primary Reasons for Regulation of Financial Markets

Answer 66

Increase information available to investors Ensure soundness of financial intermediaries

Question 67

what does increasing information available to investors do?

Answer 67

Reduce adverse selection and moral hazard problems Increase efficiency of financial markets

Question 68

what does ensuring soundness of financial intermediaries do?

Answer 68

Restrictions on entry and competition reporting requirements restrictions on assets and activities Deposit insurance