ECON 345- Section 001

Money and Banking

Chapter 2

FAll, 2015

Function of Financial Markets

I

Channel funds from economic players that have

surplus funds to those that have a shortage of
funds.

Direct finance - borrowers borrow funds directly

from lenders in financial markets by selling
them securities.

Promotes economic efficiency by producing an

efficient allocation of capital.

Directly improves the well-being of consumers

by allowing them to time purchases better.

Flows of Funds Through the Financial

System

Structure of Financial Markets: Debt

Markets
I

Debt instruments : a contractual agreement by

the borrower to pay the holder of the
instrument fixed dollar amounts at regular
intervals (interest and principal payments) until
a specified date (the maturity date)

Maturity : short-term (maturity <1 year)

intermediate-term (maturity >1 and < 10
years) long-term (maturity > 10 year)

Structure of Financial Markets: Equity

Markets
I

Equity Markets - Common stocks

some make dividend payments
equity holders are residual claimants

Primary Market: new security issues sold to

initial buyers.

Secondary Market: securities previously issued

are bought and sold

Brokers: agents of investors who match buyers

with sellers of securities

Dealers : link buyers and sellers by buying and

selling securities at stated prices.

Structure of Financial Markets: Secondary

Markets
I

Exchanges and Over-the-Counter (OTC)

Markets
Exchanges: Toronto Stock Exchange, NYSE
OTC Markets: Dealers at different locations
buy and sell

Money and Capital Markets :

Money markets deal in short-term debt
instruments
Capital markets deal in longer-term debt and
equity instruments

Structure of Financial Markets: Maturity

Money and Capital Markets

Money markets deal in short-term debt

instruments (maturity < 1 year)

Capital markets deal in longer-term debt and

equity instruments (maturity > 1 year)

Money Market Instruments

I

Government of Canada Treasury Bills.

Certificates of Deposit

Commercial Paper

Repurchase Agreements

Overnight Funds

Principal Money Market Instruments

Capital Market Instruments

I

Stocks

Mortgages and mortgage-backed securities

Corporate bonds.

Government of Canada bonds.

Canada Savings bonds.

Provincial and municipal government bonds.

Government agency securities.

Consumer and bank commercial loans.

Principal Capital Market Instruments

Internationalization of Financial Markets

I

Foreign Bonds : sold in a foreign country and

denominated in that countrys currency.

Eurobond: bond denominated in a currency

other than that of the country in which it is
sold.

Eurocurrencies : foreign currencies deposited in

banks outside the home country.

Eurodollars: U.S. dollars deposited in foreign

banks outside the U.S. or in foreign branches of
U.S. banks.

Function of Financial Intermediaries:

Indirect Finance
I

Reduce transaction costs: time and money

spent in carrying out financial transactions.
economies of scale
liquidity services

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

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

Types of Financial Intermediaries

I

Depository Institutions
Chartered Banks
Trusts and Mortgage Loan Companies
Credit Unions and Caisses Populaires

Contractual Savings Institutions

Life Insurance Companies
Property and Casual Insurance Companies
Pension Funds and Government Retirement
Funds

Investment Intermediaries
Finance Companies
Mutual Funds
Money Market Mutual Funds

Primary Assets and Liabilities of Financial

Intermediaries

Relative Shares of Financial Institutions

and Pension Plans

Regulation of Financial Markets

Primary Reasons for Regulation:
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Increase information to investors

reduce adverse selection and moral hazard
problems increase efficiency of financial
markets by increasing the amount of
information available to investors
provincial securities & exchange commissions
require corporations to disclose information and
restrict insider trading

Regulation of Financial Markets (contd)

Ensuring the soundness of intermediaries

prevents financial panics
restrictions on entry/assets/activities;
disclosure; deposit insurance; limits on
competition

Improve control of monetary policy

Principal Regulatory Agencies of the

Canadian Financial System