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