ECON 345- Section 001Money and Banking

Chapter 2

FAll, 2015

Function of Financial Markets

I Channel funds from economic players that havesurplus funds to those that have a shortage offunds.

I Direct finance - borrowers borrow funds directlyfrom lenders in financial markets by sellingthem securities.

I Promotes economic efficiency by producing anefficient allocation of capital.

I Directly improves the well-being of consumersby allowing them to time purchases better.

Flows of Funds Through the FinancialSystem

Structure of Financial Markets: DebtMarkets

I Debt instruments : a contractual agreement bythe borrower to pay the holder of theinstrument fixed dollar amounts at regularintervals (interest and principal payments) untila specified date (the maturity date)

I Maturity : short-term (maturity <1 year)intermediate-term (maturity >1 and < 10years) long-term (maturity > 10 year)

Structure of Financial Markets: EquityMarkets

I Equity Markets - Common stocks−some make dividend payments−equity holders are residual claimants

I Primary Market: new security issues sold toinitial buyers.

I Secondary Market: securities previously issuedare bought and sold

I Brokers: agents of investors who match buyerswith sellers of securities

I Dealers : link buyers and sellers by buying andselling securities at stated prices.

Structure of Financial Markets: SecondaryMarkets

I Exchanges and Over-the-Counter (OTC)Markets−Exchanges: Toronto Stock Exchange, NYSE−OTC Markets: Dealers at different locationsbuy and sell

I Money and Capital Markets :−Money markets deal in short-term debtinstruments−Capital markets deal in longer-term debt andequity instruments

Structure of Financial Markets: Maturity

I Money and Capital Markets

I Money markets deal in short-term debtinstruments (maturity < 1 year)

I Capital markets deal in longer-term debt andequity instruments (maturity > 1 year)

Money Market Instruments

I Government of Canada Treasury Bills.

I Certificates of Deposit

I Commercial Paper

I Repurchase Agreements

I Overnight Funds

Principal Money Market Instruments

Capital Market InstrumentsI Stocks

I Mortgages and mortgage-backed securities

I Corporate bonds.

I Government of Canada bonds.

I Canada Savings bonds.

I Provincial and municipal government bonds.

I Government agency securities.

I Consumer and bank commercial loans.

Principal Capital Market Instruments

Internationalization of Financial Markets

I Foreign Bonds : sold in a foreign country anddenominated in that countrys currency.

I Eurobond: bond denominated in a currencyother than that of the country in which it issold.

I Eurocurrencies : foreign currencies deposited inbanks outside the home country.

I Eurodollars: U.S. dollars deposited in foreignbanks outside the U.S. or in foreign branches ofU.S. banks.

Function of Financial Intermediaries:Indirect Finance

I Reduce transaction costs: time and moneyspent in carrying out financial transactions.−economies of scale−liquidity services

I Reduce the exposure of investors to risk−risk Sharing (asset transformation)−diversification

Function of Financial Intermediaries:Indirect Finance (contd)

I Deal with asymmetric information problems(Adverse Selection) −before the transaction−avoid selecting the risky borrower−gather information about potential borrower

I Moral Hazard−after the transaction−ensure borrower will not engage in activitiesthat will prevent him/her to repay the loan−sign a contract with restrictive covenants

Types of Financial IntermediariesI Depository Institutions−Chartered Banks−Trusts and Mortgage Loan Companies−Credit Unions and Caisses Populaires

I Contractual Savings Institutions−Life Insurance Companies−Property and Casual Insurance Companies−Pension Funds and Government RetirementFunds

I Investment Intermediaries−Finance Companies−Mutual Funds−Money Market Mutual Funds

Primary Assets and Liabilities of FinancialIntermediaries

Relative Shares of Financial Institutionsand Pension Plans

Regulation of Financial Markets

Primary Reasons for Regulation:

I Increase information to investors−reduce adverse selection and moral hazardproblems −increase efficiency of financialmarkets by increasing the amount ofinformation available to investors−provincial securities & exchange commissionsrequire corporations to disclose information andrestrict insider trading

Regulation of Financial Markets (contd)

I Ensuring the soundness of intermediaries−prevents financial panics−restrictions on entry/assets/activities;disclosure; deposit insurance; limits oncompetition

I Improve control of monetary policy

Principal Regulatory Agencies of theCanadian Financial System