Chapter 8 (Saving, Investment, and the Financial System) Flashcards
The financial system consists of those institutions in the economy that
help to match one person’s saving with another person’s investment.
At the broadest level, the financial system moves the economy’s scarce resources from
savers (people who spend less than they earn) to borrowers (people who spend more than they earn)
Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date.
Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date
The Office of the Superintendent of Financial Institutions (OSFI) is an independent agency of the federal government that reports to the Department of Finance Canada
The OSFI is the primary regulator of federally regulated banks, insurance companies, and pension plans in Canada.
Credit unions and caisses populates, securities dealers, and mutual funds are largely regulated by provincial governments
Finally, Canada’s central bank, the Bank of Canada, also plays an important role in regulating the Canadian financial system.
Financial institutions can be grouped into two categories
financial markets and financial intermediaries
Financial markets
are the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow. The two most important financial markets in our economy are the bond market and the stock market
A bond is a
certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Put simply, a bond is an IOU.
It identifies the time at which the loan will be repaid, called the
date of maturity and the rate of interest that will be paid periodically until the loan matures
The buyer of a bond gives his or her money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the
principal).
The first characteristic is a bond’s term
the length of time until the bond matures
The British government has even issued a bond that
never matures, called a
perpetuity.
Long-term bonds are riskier than short-term bonds because holders of long-term bonds have
to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds usually
pay higher interest rates than short-term bonds.
The second important characteristic of a bond is its credit risk
the probability that the borrower will fail to pay some of the interest or principal.
a borrowers failure to pay some of the interest or principal s called a
default
Corporate bonds tend to pay higher rates of interest than provincial and territorial bonds because corporate revenues are likely to be more volatile than provincial and territorial revenues
Financially shaky corporations raise money by
issuing junk bonds—which, as the name suggests, pay considerably higher interest rates than the bonds issued by more secure corporations and by governments
Buyers of bonds can judge credit risk by
checking with various private agencies, such as Standard & Poor’s or Dominion Bond Rating Service, that rate the credit risk of different bonds
Stock represents
ownership in a firm and is, therefore, a claim to the profits that the firm makes.
The sale of stock to raise money is called
equity finance
the sale of bonds is called
debt finance.
The most important stock exchanges in the U.S. economy are the
New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automatic Quotation system)
The most important stock exchange in Canada
Toronto Stock Exchange (TSX)
Price (of stock)
The single most important piece of information about a stock is the price of a share. The newspaper usually presents several prices. The “last” or “closing” price is the price of the last transaction that occurred
before the stock exchange closed the previous day. Many newspapers also give the “high” and “low” prices over the past day of trading and, sometimes, over the past year as well.
Volume (of stock)
Most newspapers present the number of shares sold during
the past day of trading. This figure is called the daily volume
Dividend (of stock)
Corporations pay out some of their profits to their shareholders; this amount is called the dividend. (Profits not paid out are called retained earnings and are used by the corporation for additional investment.) Newspapers often report the dividend paid over the previous year for each share of stock. They sometimes report the dividend yield, which is the dividend
expressed as a percentage of the stock’s price.
Price/earnings ratio (of stock)
A corporation’s earnings, or profit, is the amount
of revenue it receives for the sale of its products minus its costs of production as measured by its accountants. Earnings per share is the company’s total earnings divided by the number of shares of stock outstanding. Companies use some of their earnings to pay dividends to shareholders; the rest is kept in the firm to make new investments. The price/earnings ratio, often called the P/E, is the price of a corporation’s
stock divided by the amount the corporation earned per share over the past year. Historically, the typical price/earnings ratio is about 15. A higher P/E indicates that a corporation’s stock is expensive relative to its
recent earnings; this might indicate either that people expect earnings to rise in the future or that the stock is overvalued. Conversely, a lower P/E indicates that a corporation’s stock is cheap relative to its recent
earnings; this might indicate either that people expect earnings to fail or that the stock is undervalued.
Financial intermediaries
are financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers Banks and mutual funds)
The small grocer, therefore, most likely finances his business expansion with a loan from a
local bank because it would be difficult for him to do so through stocks and bonds because it’s a small business and unfamiliar
A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow.
Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their
loans
Banks facilitate purchases of goods and services by allowing people
to write cheques against their deposits. In other words, banks help create a special asset that people can use as a medium of exchange
A medium of exchange
is an item that people can easily use to engage in transactions. A bank’s role in providing a
medium of exchange distinguishes it from many other financial institutions
Stocks and bonds, like bank deposits, are a possible
Stocks and bonds, like bank deposits, are a possible
A mutual fund is
an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks or bonds, or both stocks and bonds.
If the value of the portfolio rises, the shareholder benefits
if the value of the portfolio falls, the shareholder suffers the loss.
