Finance CH: 1-2

What is the definition of “Financial Markets”

Markets in which funds are transferred from people who have an excess of available funds, to people who have a shortage.

Give two examples of Financial Markets

Bond Market
Stock Market

What is a bond?

debt security that promises to make regular payments to the holder for a set period of time.

What does a bond do?

t lets governments and firms borrow money. The buyer (lender) pays the price today and gets interest payments plus the face value back at maturity. For the issuer, the interest rate is its cost of borrowing.

What is a stock?

share of ownership in a corporation that gives the holder a claim on the company's earnings and assets.

What does a stock do?

It lets companies raise money by selling ownership instead of borrowing. The buyer becomes a part owner who shares in profits (through dividends or a rising share price) and losses, with no promised payments.

What is a security?

(aka Financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership.

A security is a piece of paper (or, today, a digital record) that says you're entitled to part of someone else's money in the future.

Why are Financial Markets important?

crucial to promoting greater economic efficiency, as they channel funds from people who do not have a productive use for them to those who do.

When speaking about bonds/stocks, what is an issuer?

Whoever creates and sells the security to raise money (company or government)

What are Debt Markets

Markets where borrowers issue debt instruments (like bonds and mortgages) that promise fixed payments until maturity. Short-term is under 1 year, intermediate is 1 to 10 years, and long-term is 10+ years.

What is an interest rate?

The cost of borrowing money, or the price paid for the use of someone else's funds. It's usually shown as a percentage per year.

What does an interest rate do?

It rewards lenders for waiting to use their money and protects them against expected inflation. For borrowers, it's the cost of funds.

Higher rates discourage borrowing and spending, and encourage saving.

Why are interest rates so important (personal level)?

If interest rates (the cost to borrow) is high, you would be deterred from buying a house or car because the cost of financing it would be high. On the flip-side, high interest rates might encourage you to save because you can earn more interest by putting aside some of your earnings as savings,

Why are interest rates so important (general/holistic level)?

Interest rates have an impact on the overall health of the economy because they not only affect consumer’s willingness to spend or save, but also a businesses’ decisions.

Why are interest rates so important (business/government level)?

High interest rates, for example might cause a corporation to postpone building a new plant (since it would be more expensive to finance) and as a result an opportunity to provide jobs would be lost.

Are interest rates stable or volatile?

They are not stable (volatile) they rise and fall a lot

When do interest rates tend to fall?

During recessions and crises, because it affects everyone’s borrowing, savings, and spending allocations.

Why do economists often refer to "the" interest rate?

Because different interest rates tend to move up and down together, even though their levels can differ a lot.

How do three-month Treasury bill rates compare to other interest rates?

They fluctuate the most and are lowest on average. They're short-term and backed by the government, so lenders accept a lower rate.

How do long-term corporate bond rates compare to other interest rates, and why?

They're highest on average because lending to a company is riskier than lending to the government

What is a common stock?

A share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation.

What makes up the financial system?

Many types of private financial institutions, such as banks, insurance companies, mutual funds, finance companies, and investment banks, all heavily regulated by the government.

What are financial intermediaries?

Institutions that take in funds from savers and lend them to people or firms who need money. For example, instead of lending to Tesla directly, you deposit money at a bank, and the bank lends it out.

What are banks, and what does the term bank include?

Banks are financial institutions that accept deposits and make loans.

- Chartered banks
- Trust and loan companies
- Credit Unions

What financial intermediary does the average person interact with most frequently?

Banks

What is the definition of Money (Money Supply)?

Anything that is generally accepted as payment for goods or services or in the repayment of debts.

What is a business cycle?

The pattern of the economy's total output rising (expansion) and falling (recession) over time.

How does unemployment move during a business cycle?

Opposite to output. When output falls in a recession, firms produce less and lay off workers, so unemployment rises. When output grows in an expansion, firms hire again, so unemployment falls.

What is a recession? Give a Canadian example.

period when aggregate output is declining. In 1981–82, Canada's output fell and unemployment rose to nearly 12%. After 1982 the economy expanded, and unemployment fell to 7.5% by 1989.

What is the relationship between money growth and recessions?

Money growth usually declines before a recession, suggesting money plays a role in business cycles. But not every decline leads to a recession, so it's a warning sign, not proof of cause.

What is the aggregate price level?

The average price of goods and services in the economy.

What is inflation, and why does it matter?

A continual increase in the aggregate price level. It affects individuals, businesses, and the government, which makes it a top policy concern.

What is a positive association?

Meaning two things tend to move in the same direction.
When one is high, the other tends to be high.

What is the relationship between money growth and inflation across countries?

Countries with higher money growth tend to have higher inflation (e.g., Turkey, Russia, Brazil), while those with lower money growth tend to have lower inflation (e.g., Japan, the U.S.).

(Not always)

What is monetary policy, and who conducts it in Canada?

The management of money and interest rates. It's conducted by the central bank, which in Canada is the Bank of Canada.

Policymakers care about it because money affects business cycles, inflation, and interest rates.

What is the difference between a budget deficit and a budget surplus?

A deficit is when spending exceeds tax revenue, so the government must borrow (by issuing bonds). A surplus is when tax revenue exceeds spending, which lowers the debt burden.

What is GDP?

Gross domestic product, a measure of the economy's total output of goods and services.

What is the main role of financial markets?

To move funds from people who have extra money (lender-savers) to people who need more than they have (borrower-spenders).

Who are lender-savers?

People or groups who spend less than their income, so they have surplus funds to lend. Mainly households, but businesses, governments, and foreigners sometimes have extra funds too.

Who are borrower-spenders?

People or groups who want to spend more than their income, so they need to borrow. Mainly businesses and the federal government, but households and foreigners also borrow for things like cars and houses.

What are the two routes funds can take from lender-savers to borrower-spenders?

Indirect and Direct finance

Direct Finance: where borrowers get funds straight from lenders in financial markets
Indirect Finance: where funds go through a financial intermediary like a bank.

What is direct finance? Give an example.

When borrowers get funds directly from lenders by selling them securities. For example, Ford could fund a new factory by selling bonds or stock directly to savers

What is a security, and how is it viewed by the buyer vs. the issuer?

A claim on the issuer's future income or assets (also called a financial instrument). It's an asset for the buyer and a liability (a debt or IOU) for the issuer.

Why is channeling funds from savers to spenders important for the economy?

Because the people who save are often not the same people who have profitable investment opportunities, like entrepreneurs.

What is capital?

Wealth, either financial or physical that is employed to produce more wealth.

What are the two ways a firm or individual can raise money in a financial market?

By issuing debt (borrowing, such as bonds or mortgages) or by issuing equity (selling ownership, such as stock).

What is a debt instrument?

A contract where the borrower promises to pay the holder fixed amounts (interest and principal) at regular intervals until the maturity date, when the final payment is made.

Examples include bonds and mortgages.

What is maturity?

The number of years until a debt instrument expires and the final payment is made.

What is an equity?

A claim to a share of a business's net income (after expenses and taxes) and its assets. Common stock is the main example

Why are equities considered long-term, and what rights do they give owners?

They have no maturity date, so they're long-term. Owners also get voting rights, including electing the company's board of directors.

What is a primary market?

A market where new securities are sold for the first time by the corporation or government raising funds. It's not well known and often happens behind closed doors, with investment banks as the key players.

What is a secondary market?

A market where previously issued securities are resold by existing investors. It's very public (e.g., the TSX), with brokers and dealers as the key players.

What are the two ways secondary markets are organized?

Exchanges and over-the-counter (OTC) markets.

What is an exchange? Give Canadian examples.

A market where buyers and sellers (or their brokers) meet in one central location to trade. Examples include the TSX (stocks),

ICE Futures Canada (agricultural commodities like wheat and barley), and the Montreal Exchange (derivatives).

What is an over-the-counter (OTC) market? Give Canadian examples.

A market where dealers in different locations hold inventories of securities and buy or sell to anyone who accepts their prices. Examples include the Government of Canada bond market and many smaller stocks.

Why is the OTC market so competitive?

Dealers are spread out but connected by computers, so they can see each other's prices. This makes OTC work much like an exchange.

What is the money market?

A market for short-term debt only, with an original maturity of less than one year. It's more liquid and has smaller price swings, so it's safer. Mainly used by corporations and banks parking temporary surplus funds.

What is the capital market?

A market for longer-term debt (one year or more) and equities (stocks), which have no maturity. It's less liquid and has larger price swings. Mainly used by insurance companies and pension funds.

Why does a company with temporary extra cash use the money market, while a pension fund uses the capital market?

The company needs its cash back in a few months, so it wants safe, easy-to-sell securities. The pension fund won't need most of its money for decades, so it can ride out price swings in stocks and long-term bonds.

Why are money market instruments considered the least risky investments?

They're short-term, so they have the smallest price swings.

What are Treasury bills?

Short-term federal government debt with maturities of 1, 3, 6, or 12 months. They pay no interest; instead they're sold at a discount and repaid at full value. They're the most liquid and safest money market instrument, held mainly by banks.

What are certificates of deposit (CDs)?

Debt issued by banks and trust and loan companies that pays interest yearly, then returns the original amount at maturity.

Negotiable CDs ($100,000+) can be resold. Non-negotiable CDs can't be resold and have a penalty for early withdrawal. GICs are a type of CD.

What is commercial paper?

Unsecured short-term debt issued by large banks and well-known corporations. Since there's no collateral, only very creditworthy firms can issue it. Its rate is slightly above T-bills, and it's usually sold at a discount.

What are repurchase agreements (repos)?

Very short loans (under two weeks) where banks borrow from corporations, using T-bills as collateral.

What are overnight funds?

Overnight loans between banks, using deposits they hold at the Bank of Canada.

What are capital market instruments, and which ones stand out?

Debt and equity with maturities over one year, with bigger price swings than money market instruments. Stocks are the largest by value, mortgages are the largest debt market, and Government of Canada bonds are the most liquid.

What are mortgages and mortgage-backed securities?

Mortgages are loans to buy land or buildings, with the property as collateral, provided by banks, trust and loan companies, and credit unions. Mortgage-backed securities bundle many mortgages into a bond-like security that pays investors the combined payments

What are corporate bonds, and what are convertible and call features?

Bonds issued by corporations with strong credit ratings, paying interest twice a year and face value at maturity. They're not very liquid.

What are Government of Canada bonds ("Canadas")?

Intermediate and long-term federal bonds used to finance deficits. They're the most liquid capital market security, held by the Bank of Canada, banks, households, and foreigners.

What are provincial/municipal bonds and government agency securities?

Provincial and municipal bonds fund schools, roads, and big programs, and can be issued in Canadian or foreign currencies.

How do you tell a money market (financial market) instrument from a capital market instrument?

Check the original maturity. Under one year is money market (e.g., T-bills, commercial paper). One year or more, or no maturity at all like stocks, is capital market (e.g., bonds, mortgages, stocks).

What is a foreign bond?

A bond sold in a foreign country, in that country's currency. For example, Porsche (German) selling a bond in Canada in Canadian dollars.

What is a Eurobond?

A bond sold in a country but in a different currency from that country's. For example, a bond in Canadian dollars sold in London. Eurobonds make up over 80% of new international bond issues.

How do you tell a foreign bond from a Eurobond?

Compare the bond's currency to the country where it's sold. Same currency as that country means foreign bond. Different currency means Eurobond.

What is indirect finance (financial intermediation)?

The route where a financial intermediary, like a bank, sits between lenders and borrowers. It borrows from savers (e.g., takes deposits) and lends those funds to borrowers (e.g., a loan to Tesla or buying a Canada bond).

It's the main way funds move through the economy, even though stock markets get more attention.

How do IOUs work in indirect finance?

There are two IOUs, with the bank in the middle. The bank owes you (your deposit), and Tesla owes the bank (its loan).

So the bank is a borrower from you and a lender to Tesla at the same time, and you never deal with Tesla directly.

What is the difference between direct and indirect finance?

In direct finance, you buy the borrower's security (e.g., a Tesla bond), so you hold it and bear the risk if Tesla doesn't pay.

Direct finance: Tesla sells you a bond, so you lend to Tesla directly.

Indirect finance: you deposit money at a bank, and the bank lends it to Tesla.

In indirect finance, you deposit money and the bank lends it to Tesla, so you hold a claim on the bank and the bank bears Tesla's risk.

What are transaction costs, and how can they block lending?

The time and money spent carrying out financial transactions, like legal fees and paperwork. For example, lending Carl $1,000 might earn $100 in interest, but a $500 loan contract makes it not worth it.

How do financial intermediaries lower transaction costs?

Through expertise (they know how to do transactions cheaply) and economies of scale (the cost per dollar falls as transactions grow). A bank can reuse one $500 contract for 1,000 loans, cutting the cost to $0.50 per loan.

What is risk, and what is risk sharing?

Risk is uncertainty about the returns you'll earn on an asset. Risk sharing is when an intermediary sells safe assets (like savings deposits) and uses the funds to buy riskier assets (like business loans).

It earns the spread between the two as payment for taking on the risk.

What is asset transformation? Give an example.

Turning risky assets into safe ones from the investor's point of view. For example, you deposit $5,000 at a guaranteed 2%, and the bank lends it to businesses at 7%.

If a borrower defaults, the bank absorbs the loss, not you. The bank keeps the 5-point spread.

What is diversification?

Holding a portfolio of assets whose returns don't always move together, so overall risk is lower than holding any one asset. It's the "don't put all your eggs in one basket" ide

How do financial intermediaries help with diversification?

They can cheaply pool many assets into one new asset and sell it to individuals. For example, with $100 in a mutual fund or index ETF, you own a small piece of hundreds of companies, which would be far too costly to buy one by one.

How do risk sharing and diversification depend on transaction costs?

Both rely on the low transaction costs intermediaries get from economies of scale. Without them, managing thousands of loans or pooling hundreds of stocks wouldn't be worth it, so intermediaries couldn't turn risky assets into safe ones or let investors diversify cheaply.

How do financial intermediaries solve information problems, and what are their three main functions?

They fix adverse selection by screening borrowers before lending, such as checking credit scores, income, and employment.

They fix moral hazard by monitoring borrowers after lending, such as requiring regular financial statements.

Overall, intermediaries lower transaction costs and provide liquidity, promote risk sharing, and solve information problems.

What is asymmetric information, and what are adverse selection and moral hazard?

symmetric information is when one party knows more than the other, usually the borrower knowing more about their own risk than the lender.

Adverse selection happens before the loan: the riskiest borrowers, like someone with a get-rich-quick scheme, are the most eager to borrow.

Moral hazard happens after the loan: the borrower uses the money in a riskier way than promised, like borrowing for equipment but gambling it instead.

Both can make lenders refuse to lend, even to good borrowers.

What are economies of scope, and how do they differ from economies of scale?

Economies of scope lower costs by reusing one information resource across several different services. For example, a bank's credit analysis of a firm can be used both to approve a loan and to judge whether the firm's bonds will sell.

Economies of scale lower costs by doing more of the same thing, like reusing one loan contract for thousands of loans.

What is a conflict of interest in financial institutions?

When an institution has multiple objectives that clash, usually because it offers several services. It's a type of moral hazard and can lead to hiding information or spreading misleading information.

For example, a bank that lent to a struggling company may talk up that company's new bonds to investors, since the bond money helps repay the bank's loan.

What are the three categories of financial intermediaries?

Depository institutions (deposits)

contractual savings institutions (premiums and contributions)

investment intermediaries (selling shares or securities).

What are depository institutions, and why do they matter?

Institutions that accept deposits and make loans, like chartered banks and credit unions. Their deposits make up a big part of the money supply.

Why do contractual savings institutions invest long-term?

Insurers and pension funds can predict their payouts, so they don't need much liquidity and can invest in long-term securities.

What are the main investment intermediaries?

Finance companies (lend to consumers and small businesses), mutual funds (pool money into diversified portfolios), and money market mutual funds (invest in short-term instruments).

What do OSFI, CDIC, and provincial securities commissions do?

OSFI sets standards for banks and insurers. CDIC insures deposits up to $100,000. Provincial commissions oversee securities markets.

What are the three types of deposits chartered banks use to raise funds?

Chequable deposits (you can write cheques on them), savings deposits (payable on demand), and term deposits (fixed term to maturity, like a GIC)