© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 2: The Domestic and Global Financial Marketplace

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter looks at the domestic and international financial marketplaces within which Canadian business firms operate.

© 2004 by Nelson, a division of Thomson Canada Limited 3 Central Banking  The Bank of Canada (Canada’s Central Bank) was created to: Manage the growth of the money supply Act as banker for Government of Canada Act as banker for Canadian chartered banks Act as lender of last resort Administer the Bank Act Administer and regulate the orderly buying and selling of Canadian dollars in foreign exchange markets

© 2004 by Nelson, a division of Thomson Canada Limited 4 Bank Reserve Ratios  Reserve Ratio: fraction of $1 on deposit with a chartered bank that must be held “in reserve” with the Central Bank Example: a 10% reserve ratio within the banking system New DepositBank LendsReserve $100$90.00$10.00 $90$81.00$9.00 $81$72.90$8.10 $72.90$65.61$7.29

© 2004 by Nelson, a division of Thomson Canada Limited 5 Bank Reserve Ratios  By adjusting the Reserve Ratio, the Central Bank can make the money supply more responsive to injections into or withdrawal from the banking system.  The higher the Reserve Ratio, the smaller the multiplier effect from an injection of new money into the banking system  The lower the Reserve Ratio, the greater the multiplier effect from an injection of new money into the banking system

© 2004 by Nelson, a division of Thomson Canada Limited 6 Bank Reserves  Historically, Canadian chartered banks were required to maintain both primary and secondary reserves at the Bank of Canada.  Requirement for holding primary reserves at the Bank of Canada was phased out by July,  Today, Canadian chartered banks attempt to maintain a zero balance in their settlement account at the Bank of Canada.  Secondary reserves for Canadian Chartered Banks were eliminated in June, 1992.

© 2004 by Nelson, a division of Thomson Canada Limited 7 Monetary Policy  Monetary Policy refers to the different tools and actions that the Bank of Canada can use to manage price stability (inflation) and Canadian interest rates.

© 2004 by Nelson, a division of Thomson Canada Limited 8 Interest Rates  Canadian interest rates affect domestic economic activity Low interest rates stimulate economic activity High interest rates dampen economic activity  The value of the Canadian dollar in foreign exchange markets Low interest rates – Canadian dollar falls High interest rates – Canadian dollar rises

© 2004 by Nelson, a division of Thomson Canada Limited 9 Important Interest Rates  Bank Rate: interest rate charged to borrow from the Bank of Canada. Set at upper bound of the “Operating Band”.  Overnight Rate: interest rate charged on short-term loans between chartered banks The Bank of Canada will attempt to keep this rate within the “Operating Band”.  Prime Rate: lowest published rate banks charge on loans to large, creditworthy business customers

© 2004 by Nelson, a division of Thomson Canada Limited 10 The Canadian Financial System  Primary function is to facilitate the flow of savings from savers to borrowers  This occurs through two primary channels: Financial intermediaries (such as Chartered Banks, Trust Companies & Credit Unions) Direct (but facilitated by Investment Banks)

© 2004 by Nelson, a division of Thomson Canada Limited 11 Canadian Financial System Savers Borrowers Intermediated: Banks & Near Banks Cash Securities Direct: Investment Banks Cash Securities Cash Securities

© 2004 by Nelson, a division of Thomson Canada Limited 12 Types of Financial Institutions  Chartered Banks  Trust Companies  Credit Unions (Caisses Populaires)  Investment Companies  Pension Funds  Insurance Companies

© 2004 by Nelson, a division of Thomson Canada Limited 13 Financial Assets  Debt securities: represent evidence of the indebtedness of Party A to Party B  Equity securities: represent evidence of ownership  Derivative securities: contracts deriving value from another underlying asset Note: every financial asset is offset by an identical financial liability somewhere in the financial system.

© 2004 by Nelson, a division of Thomson Canada Limited 14 Financial Markets  The vehicles through which financial assets are bought, sold, and traded.  Financial markets may be classified as: Money or capital markets Primary or secondary markets

© 2004 by Nelson, a division of Thomson Canada Limited 15 Money and Capital Markets  Money markets: market for short-term, high- quality debt securities with maturities of 1-year or less  Capital markets: market for long-term securities (both debt & equity) having maturities greater than 1-year

© 2004 by Nelson, a division of Thomson Canada Limited 16 Primary and Secondary Markets  Primary market: refers to the process whereby issuers sell new securities to investors  Secondary market: refers to the process whereby investors sell existing securities to other investors

© 2004 by Nelson, a division of Thomson Canada Limited 17 Secondary Markets  Security Exchanges (Example: TSX) Formal marketplace with specific requirements for listing and trading securities Often are associated with a market index (i.e. TSX, Dow Jones, S&P 500, NASDAQ)  Over-the-counter (OTC) Market Public stock issues not traded on any domestic stock exchange A virtual, negotiated market. Dealers act as market makers

© 2004 by Nelson, a division of Thomson Canada Limited 18 Market Regulation  The 10 provinces and three territories regulate the securities markets within their borders.  The Ontario and Quebec Securities Commissions are the most influential because they have the most investors and companies within their jurisdiction.  Regulation of Canadian securities markets is a contentious issue, with several different proposals currently in circulation designed to increase harmonization among the provinces

© 2004 by Nelson, a division of Thomson Canada Limited 19 Services of Investment Dealers  Creation of offer documents (such as a Prospectus)  Providing long-range financial planning assistance  Providing guidance concerning the timing of security issues  Marketing securities to potential investors  Arranging private loans and leases  Negotiating mergers

© 2004 by Nelson, a division of Thomson Canada Limited 20 How Securities are sold  Public cash offering: securities are sold to the public through an investment dealer  Private, or direct placement: securities are sold to one or more large investors  Rights offering: a new issue of common stock is sold to existing shareholders at an offer price below the current market price

© 2004 by Nelson, a division of Thomson Canada Limited 21 Global Financial Transaction Decisions International Finance Licensing Arrangements Joint Ventures Become a Multinational Corporation Import Export Open a Foreign Branch

© 2004 by Nelson, a division of Thomson Canada Limited 22 Global Risks  Fluctuating exchange rates  Changing government regulations  Changing tax laws  Unfamiliar business practices  Shifting political environments

© 2004 by Nelson, a division of Thomson Canada Limited 23 Euromarket  Euromarket: the market for loans/deposits in currencies other than the currency of the country where the transaction occurs.  Eurocurrency: any currency on deposit outside of the country that issued the currency Examples: Eurodollar – US dollars on deposit outside of the United States Euroyen – Japanese yen on deposit outside of Japan

© 2004 by Nelson, a division of Thomson Canada Limited 24 Euro  Currency used throughout the European Union (entered circulation Jan 1, 2002)  Symbol for the Euro is €  The Euro is currently used by 12 members of the European Union (Spring, 2004)  The Euro is not a Eurocurrency (although it would be if it were put on deposit outside of the European Union

© 2004 by Nelson, a division of Thomson Canada Limited 25 Some Important Terms  Exchange rate: rate that one currency can be bought or sold for another  Direct quote: home currency price for one unit of foreign currency Example: $ CAD per $1.00 US  Indirect quote: foreign currency price of one unit of domestic currency Example: $ US per $1.00 CAD  Spot rate: current exchange rate  Forward exchange rate: exchange rate for a transaction to take place in the future

© 2004 by Nelson, a division of Thomson Canada Limited 26 Futures & Forward Contracts  Both futures and forward contracts allow one to agree today to an exchange to take place in the future, at a price agreed upon today.  May be used to either hedge (reduce risk) or speculate (assume additional risk with the hope of making a profit) Example: An exporter has a US $100,000 receivable coming due in 30 days. To reduce exchange rate risk, the exporter can sell the US dollars today for delivery in 30 days time, at a price agreed upon today

© 2004 by Nelson, a division of Thomson Canada Limited 27 Futures versus Forward Contracts FuturesForwards Exchange tradedTrade OTC StandardizedCustomized Marked-to-Market daily (profits & losses flow through margin account) Profits/losses realized only at contract expiry Requires margin accountNo margin required No default risk (due to Clearinghouse) Default risk exists (no Clearinghouse)

© 2004 by Nelson, a division of Thomson Canada Limited 28 Foreign Currency Options  Call Option buyer has the right, but not the obligation, to buy at a specified price for a specified period of time  Put Option buyer has the right, but not the obligation, to sell at a specified price for a specified period of time

© 2004 by Nelson, a division of Thomson Canada Limited 29 Effect of Income Taxes  Taxes affect most financial transactions: Capital budgeting: after-tax cash flows, depreciation, net present value (NPV) Capital structure policy: tax advantage of debt financing Dividend policy: capital gains versus dividend policy Leasing: motivated by tax effects

© 2004 by Nelson, a division of Thomson Canada Limited 30 Corporate Tax Rates  Progressive Tax System Marginal tax rate increases as income increases  Marginal Tax Rate Tax rate applied to the last dollar of income

© 2004 by Nelson, a division of Thomson Canada Limited 31 Canadian Income Taxation  Corporate Income Tax Average tax rate: Total taxes paid/total taxable income Marginal tax rate: tax rate applied to the last dollar of taxable income

© 2004 by Nelson, a division of Thomson Canada Limited 32 Canadian Income Taxation  Capital Gains 50% inclusion rate  Dividend Income dividends between Can. firms not taxed dividends received by a Can. firm from a non- Can. firm taxed as ordinary income dividends received personally subject to gross- up & tax credit  Loss Carrybacks and Carryforwards current year losses may be used to reduce taxes paid in a prior year or to reduce future tax liabilities

© 2004 by Nelson, a division of Thomson Canada Limited 33 Major Points  The Bank of Canada plays a significant role in the management of the money supply.  Securities trade on exchanges or over-the- counter markets which may be classified as primary or secondary.  Market regulation is carried out by each province and territory.  Taxes affect all financial transactions and business decisions.