Chapter 2

Financial Markets

• markets in which funds are transferred from people/firms with an excess of available funds to people/firms with a shortage

• main financial markets: bond markets and stock markets

— lender → borrower markets

— both firms would be worse off without the market, borrowers have the opportunity to use the lenders’ money, which is saved with no function

— create economic growth, countries are richer with greater economic efficiency with financial markets

Flow of Funds Through the Financial System

2 paths from lender-savers to borrower-spenders

Indirect: L-S → funds → financial intermediaries → funds → financial markets OR → funds → borrower-spenders

Direct; L-S → funds → financial markets → funds → borrower spenders

Direct Finance

borrowers borrow funds directly from financial markets by selling securities/financial instruments

Indirect Finance

financial intermediaries borrow funds from lender-savers and use these funds to make loans to borrower-spenders

Security / Financial Instrument

• claim on the issuer’s future income or assets

• assets for the person who buys them

• liabilities/IOUs/debts for the individual or the firm that sells/issues them

Structure of Financial Markets

2 ways for an individual/firm to obtain funds in a financial market

• debt market: bond market

• equity market: stock market

Bond

• debt security/instrument that promises to make periodic payments for a specified period of time

• contract between a borrower (issuing the bond) and the lender (who owns it)

• maturity: number of years (term) until that instrument expires

Types of Interest Rates

• mortgage interest rates

• car loan rates

• treasury bill rates

• checking deposit rates

Effect of Interest Rates

affect consumers’ willingness to spend or save + business’ investment decision

• deters from spending - will need to pay back more, creates higher cost of financing

• encourages saving - can earn more income and gain back per dollar saved

Common Stock / STock

• represents share of ownership in a corporation

• security that is a claim on earnings/assets of the corporation

• don’t have maturity dates

— sometimes considered better than bonds

• some make dividend payments

• equity holders are residual claimants

— corporation must pay back shareholders (bank) before equity holders (stocks), can be a disadvantage if you’re trying to make money

Stock Market

• where stocks are bought and sold

• value of stocks reflect both the company’s assets and expectations regarding future growth

— if good news, price tmr is higher than yesterday and vice versa, unchanged price means no news

• big swings in stock/share prices

  • stock prices affect business investment decisions - amount the company raises when issuing shares

Primary Market

• financial market in which new issues of a security are sold to initial buyers by the corporations and government agency borrowing the funds

• investment banks assist in the issue

  • may underwrite the issue: guarantee a minimum price (payment) to the issuer

Secondary Market

• financial market in which previously issued securities can be resold

• types:

  • exchanges ie. New York Stock Exchange

  • over-the-counter (OTC) markets

    • different from exchanges, decentralized location, may not have met requirement to be in an exchange

Money and Capital Markets

distinguish markets by maturity of the securities being traded

Money Markets

• only short term (<1 year) debt instruments being traded

• money market instruments:

  • government of canada treasury bills

  • certificates of deposit

  • commercial paper

Capital Markets

• market for longer-term (1 year+) debt and equity instruments

• capital market instruments:

  • stocks

  • mortgages

  • mortgage-backed securities

  • corporate bonds

  • government of canada bonds

  • canada savings bonds

  • provincial and municipal government bonds

Financial Intermediation

• indirect financing

• funds move indirectly via financial intermediaries (such as banks)

  • banks and other financial institutions move funds from people who save to people who have productive investment opportunities

Lender-Savers

1. households

2. business firms

3. government

4. foreigners

Borrower-Spenders

1. business firms

2. government

3. households

4. foreigners

Types of Financial Intermediaries

institutions that borrow funds from people who have saved → make loans to people who need funds

1. banks

2. contractual savings institutions

3. investment intermediaries

Banks / Depository Institutions

• financial intermediaries that accept deposits from individuals and institutions and make loans

• chartered banks, trust and loan companies, credit unions, caisses populaires

Contractual Savings Institutions

• financial intermediaries that acquire funds at periodic intervals on a contractual basis

• life insurance companies, property and casualty insurance companies (natural disasters, property damage), pension funds, retirement funds

Investment Intermediaries

• finance companies, mutual funds, money market mutual funds

Primary Assets and Liabilities of Financial Intermediaries

Banks

• chartered banks: deposits → loans, mortgages, government bonds

• trust and loan companies: deposits → mortgages

• credit unions and caisses populaires: deposits → mortgages

Contractual savings institutions

• life insurance companies: premiums form policies → corporate bonds and mortgages

• Property and casualty insurance companies: premiums from policies → corporate bonds and stocks

• Pension funds: retirement contributions → corporate bonds and stocks

Investment Intermediaries

• finance companies: finance paper, stocks, bonds → consumer and business loans

• mutual funds: shares → stocks and bonds

• Money market mutual funds: shares → money market instruments

Main Roles of Financial Intermediates

1. lowers transaction costs (time, money spent in carrying out financial transactions)

2. improves risk sharing → asset transformation and diversification

3. solves asymmetric information problems → banks have an in-depth screening process

• adverse selection (BEFORE transaction): potential bad-quality/high-risk borrowers tend to seek out loans most actively

• moral hazard (AFTER transaction): borrowers engage in undesirable activities (from lender’s pov)

Reasons for Financial Market Regulation

1. increase information available to investors

   1. reduce adverse selection and oral hazard problems

   2. increase efficiency of financial markets

2. ensure soundness of financial intermediaries

   1. avoids financial panic

   2. includes: restrictions on entry and competition, restrictions on assets and activities, reporting requirements, deposit insurance

Financial Innovation

• development of new financial products and services

• can improve efficiency, increase profits BUT can also result in financial disasters

• ex. E-Finance: delivering financial services electronically

— creates ease for clients, increases profit for banks

Financial Crises

• major disruptions in financial markets

  • sharp declines in asset prices

  • failures of many financial and non financial firms

• feature of economies throughout history

• typically followed by severe business downturns

— GDP decreases, unemployment rises

ex. 2007, Great Recession

• defaults in subprime residential mortgages

• major losses in financial institutions (many failed)

International Finance

• globalization of financial markets has accelerated at rapid pace in recent years

  • financial markets are increasingly integrated

• borrowing/lending can cross borders

  • canadian companies borrow in foreign markets

  • foreign companies borrow in canadian markets

• financial institutions increasingly international

  • operations in many countries