Chapter 2 An overview of the financial system PDF

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Chapter 2: An overview of the financial system Book notes Basic functions of financial markets Their essential economic function is to channel funds from households, firms, and governments who have saved surplus funds spending less than their income to those who have a shortage of funds because they...

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Chapter 2: An overview of the financial system Book notes Basic functions of financial markets ● Their essential economic function is to channel funds from households, firms, and governments who have saved surplus funds by spending less than their income to those who have a shortage of funds because they wish to spend more than they earn. ● This process can occur in two ways: ○ Direct finance: Borrowers borrow funds directly from lenders in financial markets by selling them securities (aka financial instruments). ○ Indirect finance: Instead of borrowers borrowing directly they go to a financial intermediary.

(*)Note: Securities are assets for the person who buys them but liabilities for the individual or firm that sells them. Structure of financial markets ● We can classify markets into two: ○ Primary market: Is a financial market in which new issues of a security such as bonds or stock are sold to initial buyers by the corporation or government agency borrowing the funds. ■ The issuer corporation acquires new funds here ○ Secondary market: Is a financial market in which securities that have been previously issued can be sold. ■ The issuer corporation acquires NO new funds here ● These two types of markets can either trade: ○ Debt instruments: The most common method for an individual or a firm to obtain funds. It’s a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amount at regular intervals, until a specified date, the maturity date, when a final payment is made. ■ Maturity: (of a debt instrument) is the number of years until that instrument’s expiration date. ● Short-term if maturity < 1 year ● Intermediate if maturity is between 1 and 10 years ● Long-term if maturity ≥ 10 years ○ Equities: second method of raising funds by a firm or individual. These are claims to share in the net income and the assets of the business. ■ Dividends: Periodic payments from the firm to shareholders. Not all firms pay dividends. ■ Equities are long term securities because they have NO maturity date, so we see it as is infinite years.

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Equities are residual claimant that is, the corporation must pay all its debt holder before it pays its shareholder. Shareholders are the last to get paid if the company defaults (goes bankrupt). ● Why are secondary markets important? ○ Not because they generate funds for enterprises because they don’t. In the secondary market the stocks are just being resold. ○ The secondary market makes it easier to sell and buy these equities, a.k.a more liquid. This makes it easier for the enterprises to sell their stocks in the primary market. ○ The secondary market determines the price of security that the issuing firm sells in the primary market. ○ For all of this reason, this is the most relevant for the firm. ● What are the types of secondary markets? ○ Exchanges: Buyers and seller of security meet in one central location to conduct trades. ■ It’s centralized ■ All the prices the same. ■ New York Stock Exchange es un ejemplo ○ Over the counter (OTC) market: Market in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them is willing to accept their prices. ■ It’s not centralized ■ Prices vary from dealer to dealer ■ Un buen ejemplo son currencies en un aeropuerto ● Difference between “dealers” and “brokers”? ○ Dealers buy and sell ○ Brokers simply represent buyer, compran a su nombre Financial Market Instruments ● Money market: is a financial market in which only short-term debt instrument ( generally those with maturity of less than one year) are traded. ○ More liquid than capital markets ○ Less price fluctuations than capital markets ● Money market instruments: ○ Government of Canada treasury bills ■ No interest payment but they effectively pay interest by selling at a discount. ■ The most liquid instrument in the money market. ○ Certificates of deposit ■ Pays annual interest ■ Negotiable CD: they can be traded ● Also known as bearer deposit notes ● Offers the purchaser both yield and liquidity ■ Non-negotiable CD ● Also called term deposit receipts or term notes. ○ Commercial paper ■ Unsecured short-term debt instruments issued in CA or other currency bu large banks and well known corporations. ■ The interest rate on commercial paper is low relative to those on other corporate fixed income securities and slightly higher than rates on government of Canada treasury bills. ○ Repurchase agreements ■ Short term loans usually with a maturity of less than two weeks. ■ Treasury bills serve as collateral. ● Collateral: An asset that the lender receives if the borrower does not pay back. ■ How does it work?

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A big corporation has excess funds in their bank account So the big corporation decides to buy treasury bills to a big bank only if the bank promises that he is gonna buy it back in x amount of time for a higher price. ○ Overnight funds ■ Overnight loans by banks to other banks ■ Banks do this when it finds that it does not have enough settlement deposits at the Bank of Canada. ■ The interest rate of these loans are called overnight interest rate( OIR ). OIR is indicative of the tightness of credit market conditions. ■ if OIR ↑ ⇒banks are strapped for funds ● if OIR ↓ ⇒bankscredits needs are low ● ● Capital market: Is the market in which longer term debt, original maturity ≥ one year , and equity instruments are traded. ○ Higher price fluctuation than money market ○ Fairly risky ● Capital market instruments ○ Stocks ■ Claim on a firm net income and assets ■ Individuals hold about around half the value of stocks ○ Mortgages ■ Loans to households or firms to purchase housing, land, or other real structures where the mentioned serves as collateral. ■ Mortgage market is the largest debt market in Canada. ○ Corporate bonds ■ Long-term bonds issued by corporations with very strong credit ratings. ■ Typically they pay interest twice a year and face value at the end. ■ There’s a type of corporate bonds called convertible bonds ● These type of bonds have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date. ■ Market is small in comparison with the stock market but is growing way faster than the stock market. ○ Government of canada bonds ■ The most liquid as it is the most traded ■ Issued by the federal government to finance their deficit ■ They can either be registered or bearer. ■ Some can be “called” with 30-60 days of advance. ○ Canada savings bonds ■ Exclusive to individuals, estates and specified trusts ■ Non-marketable bonds ■ Floating rate bonds ■ Redeemable at face value plus accrued interest at any time prior maturity. ○ Provincial and municipal government bonds ○ Government agency securities ○ Consumer and bank commercial loans Internationalization of financial markets ● Foreign bonds: Bonds sold in a foreign country and one denominated in that country’s currency. ○ For example, if the German automaker Porsche sells a bond in Canada denominated in Canadian dollars, it is classified as a foreign bond. ● Eurobonds: A bond denominated in a currency other than that of the country in which it is sold. ○ For example, if Apple sells bonds in Canada denominated in American dollars, it is classified as an eurobond.

■ These bonds ARE NOT necessarily in euros. ● Eurocurrencies: Foreign currencies deposited in banks outside the home country. ○ For example, if a deposit American dollars in my Canadian bank, these currencies are classified as eurocurrencies; specifically eurodollars. Which are the most important and abundant. Function of financial intermediaries 1. They reduce transaction costs a. Transaction costs: The time and money spent in carrying out financial transactions. b. They can lower the costs because they can take advantage of economies of scale. i. For example, contract 2.50 vs 500 if you only have one client vs if you have 200 clients. 2. They provide liquidity services a. Because of their low transaction costs they can provide services like chequings account with no problem. 3. They help reduce the exposure a. How? Risk sharing(also called asset transformation): i. They create and sell assets with risk characteristics that people are comfortable with. ii. They use the funds they got from selling these assets to purchase other assets that may have far more risk. iii. They earn a profit from the spread between the return they earn on risky assets and the payments they make on the assets sold. 4. They reduce losses due to adverse selection a. Asymmetric information: Also known as information failure, occurs when one party to an economic transaction possesses greater material knowledge than the other party. b. Adverse selection: The problem created by asymmetric information before the transaction occurs. i. It occurs when the potential borrowers who are the most likely to produce an undesirable outcome (like not paying back) are the ones who most actively seek out a loan and are thus most likely to be selected. c. Moral hazard: The problem created by asymmetric information after the transaction occurs. i. It occurs when there’s time inconsistency rationality. For example, when you ask for a loan its on your best interest to say and promise you will pay back but once you get it it's on your best interest to run and not pay. d. How do financial intermediaries solve this problem? i. They are equipped and specialized to screen out good from bad credit risks. Types of financial intermediaries 1. Depository institutions: Intermediaries that accept deposits from individual and institutions and make loans. They are several types: a. Chartered banks: They raise funds primarily by issuing chequeable funds deposits, savings deposits and term deposits. i. They use these funds for mortgage loans and to buy Canadian government securities. b. Trust and mortgages loan companies i. Currently it’s hard to differentiate between these and chartered banks. c. Credit unions and caisses populaires 2. Contractual savings institutions: Financial intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with reasonable accuracy how much they will have to pay out in the coming years, they don’t have to worry as much as depository institutions about losing funds. a. Life insurance companies i. Mainly buy corporate bonds and mortgages and stocks but are limited in the amount they can hold. b. Property and casualty insurance companies

i. They use their funds to buy more liquid assets than life insurance companies do ii. In case of disaster(unpredictable) they have a greater possibility of loss of funds. c. Pension funds and government funds 3. Investment intermediaries a. Finance companies i. Raise funds by selling commercial papers ii. Lend to consumer to buy furniture, consumer electronics, etc. b. Mutual funds c. Money market mutual funds...