chapter 8 powerpoint: An Overview of the Financial System Flashcards
Function of Financial Markets
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
direct finance
Borrow funds directly from lenders
Involves selling a liability (IOU or debt)
Bonds
Debt instruments
A contract between a borrower (who issues the bond) and lender (who owns it)
Regularly payments until Maturity
short term bond
< 1 year
intermediate term bond
1-10 years
long term bond
> 10 years
Equity
Shares in a corporation
Don’t have maturity dates
Some make dividend payments
Equity holders are residual claimants
who has more seniority, equity holders or debt holders?
debt holders
Primary Market
New security issues sold to initial buyers
Not well known to public; typically private
investment banks guarantee prices (called underwriting)
underwriting
investment banks guarantee prices in the primary market
Secondary Market
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
brokers
match buyers and sellers with each other
dealers
offer to buy and sell securities at stated prices
Two main ways to organize a secondary market
Exchanges
Over-the-Counter Markets (OTC)
secondary market Exchanges
Buyers and sellers meet in one central location
Toronto Stock Exchange for stocks
ICE Futures Canada for commodities (wheat, oats)
secondary market Over-the-Counter Markets (OTC)
Dealers have inventory, ready to buy/sell at stated prices
Many stocks are not traded OTC, but are on exchanges
Canadian government bond market is an OTC market or Exchanges?
OTC market
Money Markets
Only short-term debt instruments are traded (<1 year)
why do corporations and banks actively use money markets?
to each interest on temporary surplus funds
Capital Markets
Market for longer-term debt (>1 year)
are money markets or capital markets more liquid?
Money markets are more liquid than capital markets
Money Market Instruments
Gov. of Canada Treasury Bills
Certificates of Deposit
Commercial Paper
Repurchase Agreements
Overnight Funds
Gov. of Canada Treasury Bills
zero-coupon, risk-free bonds
Certificates of Deposit
debt instrument issued to depositors
Commercial Paper
short-term debt issued by banks and large corporations
Repurchase Agreements
short-term loans with T-bills as collateral
Overnight Funds
overnight loans between banks
Money Market Rates
Prime Rate
Overnight interest rate
T-bill rate
LIBOR (London Interbank Offer Rate)
Prime Rate
rate of interest on corporate bank loans
Overnight interest rate
on short-term loans between banks
LIBOR (London Interbank Offer Rate)
interbank rate on dollar deposits in the London market (being phased out)
Capital Market Instruments
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
Capital Market Instruments: Corporate bonds
high rating, long-term
Capital Market Instruments: Government of Canada bonds
highly liquid
Capital Market Instruments: Canada Savings bonds
floating-rate
redeemable
registered bonds
Foreign Bonds
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”)
Eurobond (a.k.a. International bond)
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
how widely used are Eurobonds?
over 80% of new issues are Eurobonds
Eurocurrencies
Variant of Eurobond
Foreign currencies deposited in banks outside home country
includes Eurodollars
Eurodollars
U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
Eurocurrency
Financial Intermediation
Indirect financing using financial intermediates (banks)
Primary route to move funds from lenders to borrowers
Four main roles of financial intermediates
Lowers Transaction Costs
Improves Risk Sharing
Help solve Asymmetric Information problems
uses Economies of Scope
how do financial intermediaries lower transaction costs?
Economies of scale
Liquidity services (e.g. checking accounts)
how do financial intermediaries improve risk sharing?
Asset transformation
Diversification
how do financial intermediaries help solve asymmetric information problems?
Financial intermediates can screen and monitor
reduce Adverse Selection and Moral Hazard
Adverse Selection
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
who usually has more information when It comes to adverse selection?
Buyers
Symmetric information
when both parties have equal knowledge
Moral Hazard
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
Asymmetric Information problems
Adverse Selection
Moral Hazard
Economies of Scope
spillover benefits from providing several services
negative effect of institutions using economies of scope
May create conflicts of interest
Types of Financial Intermediaries
Depository Institutions
Contractual Savings Institutions
Investment Intermediaries
Depository Institutions
Chartered Banks
Trusts and Mortgage Loan Companies
Credit Unions
Caisses Populaires
Contractual Savings Institutions
Life Insurance Companies
Property and Casual Insurance Companies
Pension Funds
Retirement Funds
Investment Intermediaries
Finance Companies
Mutual Funds
Money Market Mutual Funds
Hedge Funds
Investment Banks
chartered banks’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Deposits
use of funds: Loans, mortgages, government bonds
trust and loan companies’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Deposits
use of funds: Mortgages
credit unions and causes populaires’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Deposits
use of funds: Mortgages
Life insurance companies’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Premiums from policies
use of funds: Corporate bonds and mortgages
Property and casualty insurance companies’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Premiums from policies
use of funds: Corporate bonds and stocks
Pension funds’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Retirement contributions
use of funds: Corporate bonds and stocks
Finance companies’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Finance paper, stocks, bonds
use of funds: Consumer and business loans
Mutual funds’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Shares
use of funds: Stocks and bonds
’ primary liabilities (source of funds) and primary assets (use of funds)
source of funds: Shares
use of funds: Money market instruments
Primary Reasons for Regulation of Financial Markets
Increase information available to investors
Ensure soundness of financial intermediaries
what does increasing information available to investors do?
Reduce adverse selection and moral hazard problems
Increase efficiency of financial markets
what does ensuring soundness of financial intermediaries do?
Restrictions on entry and competition
reporting requirements
restrictions on assets and activities
Deposit insurance
