1. Economics 2154 Money

2. Based on Mishkin/Serletis The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition Pearson copyright 2014

3. Function of Financial Markets 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 – i.e. venture capital, private equity

4. Function of Financial Markets (cont’d) Promotes economic efficiency by producing an efficient allocation of capital Directly improves the well-being of consumers by allowing them to time purchases better

5. Flows of Funds Through the Financial System

6. Structure of Financial Markets: Debt Markets 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)

7. Structure of Financial Markets: Equity Markets 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

8. Structure of Financial Markets: Equity Markets (cont’d) Brokers – agents of investors who match buyers with sellers of securities Dealers – link buyers and sellers by buying and selling securities at stated prices

9. Structure of Financial Markets: Secondary Markets 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

10. 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)

11. Money Market Instruments Government of Canada Treasury Bills Certificates of Deposit Commercial Paper Repurchase Agreements Overnight Funds

12. Principal Money Market Instruments

13. Capital Market Instruments 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

14. Principal Capital Market Instruments

15. Internationalization of Financial Markets Foreign Bonds – sold in a foreign country and denominated in that country’s 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

16. Function of Financial Intermediaries: Indirect Finance 1.Reduce transaction costs (time and money spent in carrying out financial transactions) – economies of scale – liquidity services 2.Reduce the exposure of investors to risk – risk Sharing (asset transformation) – diversification

17. Function of Financial Intermediaries: Indirect Finance (cont’d) 3.Deal with asymmetric information problems a.Adverse Selection before the transaction avoid selecting the risky borrower gather information about potential borrower b.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

18. Types of Financial Intermediaries 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

19. Types of Financial Intermediaries (cont’d) Investment Intermediaries – Finance Companies – Mutual Funds – Money Market Mutual Funds

20. Primary Assets and Liabilities of Financial Intermediaries

21. Relative Shares of Financial Institutions and Pension Plans

22. Regulation of Financial Markets Primary Reasons for Regulation: 1. Increase information to investors -reduce adverse selection and moral hazard problems -increase efficiency of financial markets by increasing the amount if information available to investors -provincial securities & exchange commissions require corporations to disclose information and restrict insider trading

23. Regulation of Financial Markets (cont’d) 2. Ensuring the soundness of intermediaries -prevents financial panics -restrictions on entry/assets/activities; disclosure; deposit insurance; limits on competition 3. Improve control of monetary policy

24. Principal Regulatory Agencies of the Canadian Financial System