Chapter 2: An Overview of the Financial System

What essential economic function do financial markets perform?

They channel funds from households, firms, and governments with surplus funds (spending less than income) to those with a shortage of funds (spending more than income).

Who are lender-savers?

Economic agents who have saved surplus funds and lend them out.

Who are the principal lender-savers in the economy?

Households are the principal lender-savers.

Which other groups can also be lender-savers?

Business enterprises, governments (particularly state and local governments), foreigners, and foreign governments.

Who are borrower-spenders?

Economic agents who need to borrow funds because they wish to spend more than their income.

Who are the most important borrower-spenders?

Businesses and the government, particularly the federal government.

Which other groups may be borrower-spenders?

Households and foreigners.

What types of purchases do households borrow for?

Cars, furniture, and houses.

What are the two routes through which funds flow from lender-savers to borrower-spenders?

Direct finance and indirect finance.

What is direct finance?

A process in which borrowers borrow funds directly from lenders in financial markets by selling securities.

What role do financial intermediaries play in the flow of funds?

They stand between lender-savers and borrower-spenders by borrowing funds from savers and lending them to borrowers

In direct finance, what do borrowers sell to obtain funds?

Securities, also called financial instruments.

What is a security?

A claim on the borrower’s future income or assets.

How are securities viewed by buyers and sellers?

Securities are assets to buyers and liabilities (IOUs or debts) to issuers.

What is a bond?

A debt security that promises to make periodic payments for a specified period of time.

What is a stock?

A security that entitles the owner to a share of the company’s profits and assets.

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

Because those who save are often not the same people who have profitable investment opportunities.

Who typically has profitable investment opportunities?

Entrepreneurs.

What happens to savings if financial markets do not exist and the saver has no investment opportunity?

The saver holds the funds without earning interest.

In the Carl the Carpenter example, how does borrowing improve outcomes?

The saver earns interest, and Carl increases his income by using the funds productively.

Why might mutually beneficial lending not occur without financial markets?

Because it is difficult for savers and borrowers to find each other and transfer funds efficiently.

How do financial markets promote economic efficiency?

By transferring funds from people without investment opportunities to those with productive uses.

Are financial markets beneficial only for business investment?

No, they are also beneficial for consumption purposes such as buying a home.

How do financial markets help consumers time their purchases?

They allow people to buy goods before they have saved the full purchase price and repay over time.

Why is borrowing for a house welfare-improving in the example?

The borrower enjoys housing earlier, and lenders earn interest on their savings.

What is capital as defined in the passage?

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

What is an efficient allocation of capital?

Capital flowing to its most productive uses in the economy.

How do financial markets contribute to higher overall production?

By ensuring capital is allocated efficiently to productive opportunities.

What happens when financial markets break down during financial crises?

Severe economic hardship can result.

What historical event is cited as an example of financial market breakdown?

The global financial crisis of 2007–2009.

What broader risks can arise from severe economic hardship caused by financial crises?

Dangerous political instability.

How do well-functioning financial markets affect consumer well-being?

They allow consumers to smooth consumption over time and improve economic welfare.

Overall, how do efficient financial markets affect society?

They improve the economic welfare of everyone in society.

What are the two main ways a firm or individual can obtain funds in a financial market?

By issuing a debt instrument or by issuing equities.

What is a debt instrument?

A contractual agreement by the borrower to pay the holder fixed dollar amounts at regular intervals until a specified maturity date.

What types of payments are made on a debt instrument?

Interest payments and principal payments.

What is the maturity date of a debt instrument?

The date when the final payment on the debt instrument is made.

What does the maturity of a debt instrument measure?

The number of years (term) until the instrument’s expiration date.

How is a short-term debt instrument defined?

A debt instrument with a maturity of less than one year.

How is a long-term debt instrument defined?

A debt instrument with a maturity of 10 years or longer.

How are intermediate-term debt instruments defined?

Debt instruments with maturities between 1 and 10 years.

What is an equity instrument?

A claim to share in the net income and assets of a business.

What does net income mean in this context?

Income after expenses and taxes.

What does owning common stock entitle an investor to?

A proportional share of the firm’s net income and assets.

If a firm has issued one million shares, what does ownership of one share represent?

A claim to one one-millionth of the firm’s net income and assets.

What are dividends?

Periodic payments often made to equity holders.

Why are equities considered long-term securities?

Because they have no maturity date.

What additional rights do stockholders have besides income claims?

Voting rights on important firm issues and the right to elect directors.

What is the main disadvantage of holding equities rather than debt?

Equity holders are residual claimants.

What does it mean to be a residual claimant?

Equity holders are paid only after all debt holders have been paid.

What is the main advantage of holding equities?

Equity holders benefit directly from increases in the firm’s profitability or asset value.

Why do debt holders not benefit from increased profitability?

Because their payments are fixed.

How does the size of the debt market typically compare to the equity market?

The debt market is often substantially larger.

What is a primary market?

A financial market in which new issues of securities are sold to initial buyers.

Who sells securities in the primary market?

Corporations or government agencies borrowing funds.

What is a secondary market?

A financial market in which previously issued securities are resold.

Why are primary markets less visible to the public?

Because initial sales of securities often occur behind closed doors.

What role do investment banks play in primary markets?

They assist in the initial sale of securities.

What does it mean for an investment bank to underwrite securities?

It guarantees a price for the securities and then sells them to the public.

What are the two ways secondary markets can be organized?

As exchanges or as over-the-counter (OTC) markets.

What is an exchange?

A centralized location where buyers and sellers meet to conduct trades.

What is an over-the-counter (OTC) market?

A market in which dealers at different locations buy and sell securities directly with customers.

Why are OTC markets highly competitive?

Dealers are connected electronically and know each other’s prices.

How does the trading of stocks differ across exchanges and OTC markets?

Many stocks trade OTC, but most large corporations trade on organized exchanges.

How is the Canadian government bond market organized?

As an over-the-counter market.

How do dealers operate in OTC bond markets?

They stand ready to buy and sell bonds at quoted prices.

What other instruments are traded in OTC markets?

Negotiable certificates of deposit, federal funds, and foreign exchange instruments.

What are brokers in secondary markets?

Agents of investors who match buyers with sellers.

What are dealers in secondary markets?

Participants who buy and sell securities at stated prices.

Does a corporation receive new funds when its securities trade in the secondary market?

No.

When does a corporation receive new funds from its securities?

Only when they are first sold in the primary market.

What is the first key function of secondary markets?

They increase the liquidity of financial instruments.

What does liquidity mean in this context?

The ease and speed with which securities can be sold for cash.

How does liquidity affect primary markets?

Greater liquidity makes securities easier to sell in the primary market.

What is the second key function of secondary markets?

They determine the price of securities sold in the primary market.

Why do primary market investors care about secondary market prices?

They will not pay more than the expected secondary market price.

How does a higher secondary market price affect firms issuing new securities?

It allows them to raise more financial capital.

Why are secondary markets especially important to corporations?

Because conditions there determine the prices at which new securities can be issued.

What is the money market?

A financial market for short-term debt instruments with original maturities of less than one year.

What is the capital market?

A market for longer-term debt instruments and equity instruments.

How does liquidity typically compare between money market and capital market securities?

Money market securities tend to be more liquid.

How do price fluctuations differ between short-term and long-term securities?

Short-term securities have smaller price fluctuations.

Why are money market securities considered safer investments?

Because they have smaller price fluctuations.

Why do corporations and banks use the money market?

To earn interest on surplus funds held temporarily.

Who typically holds capital market securities?

Financial intermediaries such as insurance companies and pension funds.

Why are insurance companies and pension funds suited to holding long-term securities?

Because they face little uncertainty about future fund availability.

Why are money market instruments considered the least risky investments?

Because their short terms to maturity result in the smallest price fluctuations.

How has the money market changed over the past three decades?

The amounts of some money market instruments have grown much more rapidly than others.

What are Government of Canada Treasury bills?

Short-term debt instruments issued by the Canadian federal government.

What maturities are available for Government of Canada Treasury bills?

1-month, 3-month, 6-month, and 12-month maturities.

What is the purpose of issuing Treasury bills?

To finance the federal government.

Do Treasury bills make interest payments?

No, they pay no interest payments.

How do Treasury bills effectively pay interest?

By selling at a discount to their face value and paying a higher amount at maturity.

Why are Treasury bills the most liquid money market instrument?

Because they are the most actively traded.

Why are Treasury bills the safest money market instrument?

Because the probability of default by the federal government is very low.

What is default?

A situation in which the issuer cannot make interest payments or repay the amount owed at maturity.

Why can the federal government always meet its debt obligations?

Because it can raise taxes or issue currency.

Who mainly holds Treasury bills?

Banks.

Which other groups hold small amounts of Treasury bills?

Households, corporations, and other financial intermediaries.

What is a certificate of deposit (CD)?

A debt instrument sold by a bank that pays annual interest and returns the original purchase price at maturity.