an introduction to finance3256
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Prepared byKen Hartviksen
INTRODUCTION TO
CORPORATE FINANCELaurence Booth W. Sean Cleary
Chapter 1 An Introduction to Finance
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CHAPTER 1
An Introduction to Finance
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CHAPTER 1 - An Introduction to Finance 1 - 3
Lecture Agenda
Learning Objectives
Important Terms
Finance Defined
Real versus Financial Assets The Financial System
Financial Instruments and Markets
The Global Financial Community
Summary and Conclusions Concept Review Questions
Practice Problems
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Learning Objectives
1. What finance is and what is involved in the study of finance.
2. How financial securities can be used to provide financing forborrowers and simultaneously to provide investmentopportunities for lenders.
3. How financial systems work in general.
4. The channels of intermediation and the role played bymarket and financial intermediaries within this system.
5. The basic types of financial instruments that are available
and how they are traded.
6. The importance of the global financial system.
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Important Chapter Terms
Bourse de Montreal
Brokers
Canadian Trading andQuotation System Inc (CNQ)
Capital market securities
Common share
Corporate finance
Crown corporations
Over-the-counter markets(OTC)
Debt instruments
Equity instruments
Exchanges or auction markets
Finance
Financial assets
Financial intermediaries
Fourth market
Intermediation
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Important Chapter Terms
Investments
Market capitalization
Market intermediary
Marketable financial assets
New York Stock Exchange Non-marketable financial
assets
Ontario Securities Commission
Preferred shares
Primary markets
Real assets
Secondary markets
Toronto Stock Exchange
(TSX) TSX Group Inc.
TSX Markets
TSX Venture Exchange
Winnipeg CommodityExchange
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CHAPTER 1 - An Introduction to Finance 1 - 7
What is Finance?
Finance is the study of how and under whatterms savings (money) are allocated betweenlenders and borrowers.
Finance is distinct from economics in that itaddresses not only how resources are allocated butalso underwhat terms and through what channels
Financial contracts orsecurities occur whenever
funds are transferred from issuer to buyer.
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The Study of Finance
The study of finance requires a basicunderstanding of:
Securities Corporate law
Financial institutions and markets
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CHAPTER 1 - An Introduction to Finance 1 - 9
Real Versus Financial Assets
Real assets are tangible things owned bypersons and businesses Residential structures and property
Major appliances and automobiles
Office towers, factories, mines
Machinery and equipment
Financial assets are what one individual has lent
to another Consumer credit Loans
Mortgages
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CHAPTER 1 - An Introduction to Finance 1 - 10
Real Versus Financial AssetsThe Household Balance Sheet
Households hold both real and financial assets
Households also acquire some of those assetsthrough debt
A Household with no financial assets often facesfinancial problems because real assets cant be
used to pay off debt or to service debt (make loan
and interest payments) Real assets are not liquid
(See Table 1-2 on the next slide)
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CHAPTER 1 - An Introduction to Finance 1 - 11
Assets and Liabilities of Households,2005
Assets $ Billion Liabilities $ Billion
Houses 1,086 Consumer credit 260
Consumer Durables 435 Loans 131
Land 827 Mortgages 588Real Assets 2,348 Total Liabilities 979
Deposits 683
Debt 114
Pensions and insurance 1,200
Shares 1,254
Foreign and other 72Financial Assets 3323
Total Assets 5,671
Source: Statistics Canada. National Balance Sheet Acco unts, Quarterly Estimates, Fourth
Quarter 2005. Ottawa: M inister of Industry, 2006 (Catalo gue No . 13-214-XIE).
Table 1-2 Assets and Liabilities of Households, 2005
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The Financial System
An Introduction to Finance
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CHAPTER 1 - An Introduction to Finance 1 - 13
The Financial SystemOverview
The household is the primary provider of funds tobusinesses and government.
Households must accumulate financial resources throughout theirworking life times to have enough savings (pension) to live on intheir retirement years
Financial intermediaries transform the nature of thesecurities they issue and invest in
Banks, trust companies, credit unions, insurance firms, mutualfunds
Market intermediaries simply help make markets work Investment dealers
Brokers(See Figure 1-2 on the next slide)
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CHAPTER 1 - An Introduction to Finance 1 - 14
The Financial System
FIGURE 1-2
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CHAPTER 1 - An Introduction to Finance 1 - 15
The Financial SystemChannels of Intermediation
Funds can be channeled from saver to borrowerin three ways: Direct intermediation (direct transfer from saver to
borrower a non-market transaction)
Direct intermediation (a market-based transactionusually through a market intermediary such as abroker)
Indirect claims through a financial intermediary
(where the financial intermediary such as a bankoffers deposit-taking services and ultimately lendsthose deposits out as mortgages or loans)
(See Figure 1-3 on the next slide)
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Channels of Intermediation
FIGURE 1-3
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CHAPTER 1 - An Introduction to Finance 1 - 17
The Financial SystemFinancial Intermediaries
Banks and other deposit-taking institutions
Insurance companies
Pension Funds
Mutual Funds
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Financial IntermediariesCanadian Chartered Banks
Banks take deposits from numerous depositors from across Canada The deposits are pooled in the Bank The bank takes these pooled funds and lends them out to households and
businesses in the form of mortgages and loans The bank transforms the original nature of the savers (depositors) money:
Deposits are usually small in amountface little or no risk, and depositorsexpect to withdraw the amount at any time Loans and mortgages on the other hand usually have the following
characteristics: Large sums Borrowed for long periods of time Borrowed for risky purposes.
Banks can perform this transformation function because they becomeexperts at risk assessment, financial contracting (pricing the risk) andmonitoring the activities of borrowers.
(See Table 1-3 on the next slide)
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CHAPTER 1 - An Introduction to Finance 1 - 19
Financial IntermediariesCanadian Chartered Banks
Bank
Revenue
($ million)
Assets
($ million)
Profits
($ million)
Royal Bank of Canada 29,403 469,521 3,387Canadian Imperial Bank of Commerce
(CIBC) 18,677 280,370 -32
Bank of Nova Scotia 18,332 314,025 3,209
TD Canada Trust 18,665 365,210 2,229
Bank of Montreal 15,138 297,532 2,400
National Bank 5,320 107,598 855
Source: B M O Investo rLine website: www.bmoinves to rline.com, October 31, 2006.
Table 1-3 Chartered Banks: Financial Statistics, 2005
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CHAPTER 1 - An Introduction to Finance 1 - 20
Financial IntermediariesInsurance Companies
Insurers sell policies and collect premiums from customersbased on the pricing of those policies given the probability of aclaim and the size the policy and administrative fees.
They invest the premiums so that the accumulated value in thefuture will grow to meet the anticipated claims of thepolicyholders.
In this way, unsupportable risks (such as the death of wageearner or the burning down of a business) are shared among alarge number of policyholders through the insurance company.
Insurance allows households, business and government toengage in risky activities without having to bear the entire risk ofloss themselves.
(See Table 1-4 on the next slide)
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CHAPTER 1 - An Introduction to Finance 1 - 21
Financial IntermediariesInsurance Companies
Insurer
Revenue
($ million)
Assets
($ million)
Profits
($ million)Manulife Financial 32,187 322,171 3,294
Sun Life Financial 21,871 171,850 1,867
Great-West Lifeco 23,883 102,161 1,775
ING Canada 4,446 9,926 782
Source: Data fro m BM O Investo rLine website: www.bmoinvesto rline.co m, October 31, 2006.
Table 1-4 Insurance Companies: Financial Statistics, 2005
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CHAPTER 1 - An Introduction to Finance 1 - 22
Financial IntermediariesPension Plan Assets
Individuals and employers make payments over the entireworking life of a person with those funds invested to grow overtime.
Ultimately, the accumulated value in the pension can be used bythe person in retirement.
Pension plans accumulate considerable sums of money, andtheir managers invest those funds with long-term investmenttime horizons in diversified portfolios of investments. Theseinvestments are a major source of capital, fuelling investment inresearch and development, capital equipment, resourceexploration and ultimately contributing in a substantial way togrowth in the economy.
(See Table 1-5 on the next slide)
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CHAPTER 1 - An Introduction to Finance 1 - 23
Financial IntermediariesPension Plan Assets
Pension Plan Managers Net Assets($ billion)Caisse de depot et placement du Quebec 216.1
Canada Pension Plan (CPP) 98.0
Ontario Teachers (Teachers) 96.1
Ontario Municipal Employees (OMERS) 41.6
* The Caisse manages the investments of several pension plans.
Table 1-5 Pension Plan Assets, 2005
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CHAPTER 1 - An Introduction to Finance 1 - 24
Financial IntermediariesCanadian Mutual Fund Assets
Mutual funds give small investors access to diversified,professionally-managed portfolios of securities.
Small investors often do not have the funds necessary toinvest directly into market-traded stocks and bonds.
This is called denomination intermediation because themutual fund makes investments available in smaller,more affordable amounts of money.
Canadian indirect investment in the markets throughmanaged products such as mutual funds and segregated
funds has grown exponentially.(see 1-4 Figure on the next slide)
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CHAPTER 1 - An Introduction to Finance 1 - 25
Financial IntermediariesCanadian Mutual Fund Assets
FIGURE 1-4
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CHAPTER 1 - An Introduction to Finance 1 - 26
The Financial SystemThe Major Borrowers
Public Debt
Governments Federal
Provincial
Municipal
Crown Corporations
Private Debt
Households Non-financial Corporations
(See Table 1-6 on the next slide)
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CHAPTER 1 - An Introduction to Finance 1 - 27
The Financial SystemLargest Non-financial Companies
Non-financial Companies
Revenue
($ million)
Assets
($ million)General Motors of Canada Ltd. 34,991 n/a
Loblaw Companies Ltd. 27,812 13,761Magna International Inc. 22,873 12,321
Imperial Oil Ltd. 26,936 15,582
Alcan Inc.* 20,408 26,638
BCE Inc. 19,150 40,630
Bombardier Inc.* 14,882 17,483
Petro-Canada 17,673 20,655
Onex Corp. 17,626 14,845
EnCana Corp.* 14,322 34,148
Source: Data f rom "The Top 1000 in 2005." Globe and M ail Report on B usiness website:
www.theglobeandmail.com.
Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005
*Company reports in U.S. dollars.
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Financial Instruments
An Introduction to Finance
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Financial Instruments
There are two major categories of financialsecurities:
1. Debt Instruments Commercial paper
Bankers acceptances
Treasury bills
Mortgage loans
Bonds
Debentures
2. Equity Instruments Common stock
Preferred stock
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CHAPTER 1 - An Introduction to Finance 1 - 30
Financial InstrumentsNon-marketable
Characteristics of Non-marketablesecurities
Cannot be traded between or among
investors May be redeemable (a reverse transaction
between the borrower and the lender)
Examples: Savings accounts Term Deposits
Guaranteed Investment Certificates
Canada Savings Bonds
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CHAPTER 1 - An Introduction to Finance 1 - 31
Financial InstrumentsMarketable
Characteristics of Marketable securities Can be traded between or among investors after their original issue
in public markets and before they mature or expire
The market value will change over time due to changes in thegeneral economic environment (for example, interest rate increases
or decreases) and/or changes in the issuer of the security.
Market Capitalization Is an important term in finance
It is the total market value of a company
It is found by multiplying the number of shares outstanding by themarket price per share.
shareperPricesharesofNumbertionCapitalizaMarket
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Financial InstrumentsMarketable
Markets can be categorized by the time to maturity: Money Market Securities (for short-term debt securities that are
pure discount notes)
Bankers acceptances
Commercial Paper
Treasury Bills
Capital Market Securities (for long-term debt or equitysecurities with maturities greater than 1 year)
Bonds
Debentures
Common Stock
Preferred Stock
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Financial Markets
An Introduction to Finance
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Financial Markets
Primary Market
Markets that involve the issue of new securities by theborrower in return for cash from investors (Capitalformation occurs)
Secondary Market
Markets that involve buyers and sellers of existingsecurities. Funds flow from buyer to seller. Seller
becomes the new owner of the security. (No capitalformation occurs)
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CHAPTER 1 - An Introduction to Finance 1 - 35
Financial MarketsTypes of Secondary Markets
Exchanges or Auction Markets Secondary markets that involve a bidding process that takes
place in specific location
For example TSX, NYSE
Dealer or Over-the-counter (OTC) Markets Secondary markets that do not have a physical location and
consist of a network of dealers who trade directly with one
another. For example the bond market
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Financial MarketsOther Markets
Third Market Trading of securities that are listed on organized exchanges
in the Over-the-counter market
Fourth Market Trading of securities directly between investors (usually
between two large institutions) without the involvement ofbrokers or dealers.
Operates through the use of privately owned automatedsystems such as Instinet
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The Global Financial Community
Represents an important source of funds forborrowers
Provides investors with important alternatives asthey seek to build wealth through diversifiedportfolios
(See Table 1-7 on the next slide)
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The Global Financial Community
Total Assets
($ million)
1,016,031Canadian direct investments abroad 465,058
Canadian portfolio investments 284,604
Portfolio foreign bonds 82,374
Portfolio foreign stocks 189,175
Other portfolio investments 13,055
Other Canadian investments 266,369
Loans 48,325
Allowances
Deposits 120,694
Official international reserves 38,030
Other assets 59,319
Total Liabilities 1,184,534
Foreign direct investments in Canada 415,561
Foreign portfolio investments 508,398
Portfolio Canadian bonds 380,017
Portfolio Canadian stocks 107,598
Portfolio Canadian money market instrume 20,783
Other foreign investments 260,575
Loans 36,107
Deposits 201,639
Other liabilities 22,829
Canada's Net International Investment Position -168,503
Source: Statistics Canada.
Table 1-7 Canada's Internationa l Investments, 2005
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Summary and Conclusions
In this chapter you have learned about:
Financial systems in general, and the Canadianfinancial system in particular
Major participants in the Canadian financial system,including the different types of financial securities andfinancial markets
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Internet Links
BMO InvestorLine: www.bmoinvestorline.com Investment Funds Institute of Canada: www.ific.ca Globe and MailReport on Business: www.theglobeandmail.com Toronto Stock Exchange (TSX): http://www.tsx.com/
Canadian Trading and Quotation System Inc.: http://www.cnq.ca/ Ontario Securities Commission: http://www.osc.gov.on.ca/index.jsp Winnipeg Commodity Exchange: http://www.wce.ca/ New York Stock Exchange (NYSE): http://www.nyse.com/
http://www.bmoinvestorline.com/http://www.ific.ca/http://www.theglobeandmail.com/http://www.tsx.com/http://www.cnq.ca/http://www.osc.gov.on.ca/index.jsphttp://www.wce.ca/http://www.nyse.com/http://www.nyse.com/http://www.wce.ca/http://www.osc.gov.on.ca/index.jsphttp://www.cnq.ca/http://www.tsx.com/http://www.theglobeandmail.com/http://www.ific.ca/http://www.bmoinvestorline.com/ -
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Concept Review Questions
An Introduction to Finance
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Concept Review Question 1Finance
What is finance?
Finance is the study of how and under what
terms savings are allocated between borrowersand lenders.
It also examines under what terms and throughwhat channels resources are allocated.
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CHAPTER 1 - An Introduction to Finance 1 - 43
Concept Review Question 2Real and Financial Assets
Distinguish between real and financial assets.
Real assets are tangible property owned by
people and businesses such as buildings, land,machinery and equipment
Financial assets are paper claims that areevidence of contracts between people, or
between people and businesses (government)
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Concept Review Question 3Net Providers and Users of Funds
Which sectors of the economy are net providersof financing and which are the net users offinancing?
Households and the non-resident sectortraditionally are the net provider of financing forbusinesses and government.
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Concept Review Question 4Channels of Savings
Identify and briefly describe the three main channels ofsavings.
Direct claims through Non-market transactions A daughter arranging a loan through her mother
Direct claims through market intermediaries Purchase of a stock through a broker
Indirect claims through financial intermediaries Deposit in a savings accountthe funds eventually find themselves
lent by the bank to a business to finance purchase of equipment.
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CHAPTER 1 - An Introduction to Finance 1 - 46
Concept Review Question 5Market and Financial Intermediaries
Distinguish between market and financial intermediaries.
Market intermediaries help with the proper functioning offinancial markets
Investment dealers Financial intermediaries transform financial assets and
meet the needs of both savers and borrowerssimultaneously through the asset transformation function
Banks
Insurance firms Mutual funds
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CHAPTER 1 - An Introduction to Finance 1 - 47
Concept Review Question 6How financial intermediaries operate
Discuss how the three most important types of financialintermediaries operate.
Banks Deposit-taking and lending
Insurance Firms Sale of policies, collecting of premiums, investing premiums and
underwriting losses
Pension Plans Long-term accumulation of savings and channeling them to
productive long-term investments that will yield long-termpositive returns and provide financial security in old age forbeneficiaries.
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Concept Review Question 7Types of financial assets
Distinguish among the various types of financial assets.
Debt (represents a lending arrangement) Short-term debt is traded in the money market
Commercial paper
Bankers acceptances
Treasury Bills
Long-term debt is traded in the OTC capital market Bonds and debentures
Equity (represents an ownership claim) Common Stock Preferred Stock
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Concept Review Question 8Sources of financing used by governments and business
Identify the major sources of financing used bygovernments and businesses.
(a) Governments
Tax revenue (income taxes, excise taxes, consumption taxes(PST and GST), property taxes
Borrowing (short-term through Treasury bills, and long-termthrough Government bonds)
(b) Businesses
Reinvested Profits Common Stock
Bonds
Short-term loans from banks
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Concept Review Question 9Primary and Secondary Markets
Distinguish between primary and secondarymarkets.
Primary market is where new securities are sold for thefirst time. This is where the corporate issuer raisescapital.
Secondary markets occur when existing securities aretraded among and between investors without capitalformation occurring.
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Concept Review Question 10Importance of global financial markets to Canadians
Explain why global financial markets are so importantto Canadians.
Canadians as savers need to diversify their investmentportfolios, and access to global financial markets allowsthat diversification to be more complete.
Having access to funds in global markets, Canadiancompanies can raise more capital more cheaply
making them more competitive in their chosen industry.
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Concept Review Question 11Major U.S. Stock Markets
Identify and briefly describe the two major stockmarkets in the United States.
1. New York Stock Exchange (NYSE) Worlds largest
Most famous
Market capitalization US $21.2 trillion (2005)
2. Nasdaq Second largest and most important in U.S.
Third largest in the world
More listed companies than the NYSE
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Practice Problems
An Introduction to Finance
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Practice Problem 1The Four Major Financial Sectors
State the four major financial sectors in the financial system anddiscuss how they relate to one another
1. Borrowers Deficit spending economic units (households, businesses, government)
require funds now for investment and are willing to pay investors a returnfor the use of these funds
2. Lenders/investors Surplus saving economic units (households, businesses, government)
have a surplus of funds available that they want to earn a return on sothey lend or invest these funds to net borrowers
3. Financial intermediaries Banks, trusts, credit unions, pension funds, mutual funds, channel surplus
savings to deficit spending economic units
4. Financial markets Money, bond and equity markets bring buyers (lenders/investors) and
sellers (borrowers) of financial assets together to trade in those assetsand establish market prices for them.
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Practice Problem 2The role of different financial intermediaries in the financial system.
Explain how banks, pension funds, insurance firms, and mutualfunds work in the financial system.
1. Banks
Accept deposits, pool the funds and lend them out as mortgages andloans
2. Pension Funds Professionally managed pools of funds that fuel current investment in
Canadian business and government but at the same time provide for thelong-term financial security of the plan beneficiaries
3. Insurance Firms
Facilitate the pooling or sharing of risks among the many policyholdersthereby underwriting economic activity and minimizing the negativeimpacts of unsupportable losses.
4. Mutual Funds
Permits small investors with access to direct claims that are market tradedsuch as stocks and bonds.
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Practice Problem 3Why financial intermediaries and markets exist.
Briefly describe why financial and marketintermediaries exist in our financial system.
Financial and market intermediaries serve to channel scarcefinancial resources from economic units that have a surplus of
savings to economic units that have a deficit of savings. Ideally, financial and market intermediaries will ensure thatthese scarce financial resources will be put to the greatest andbest use (ie. Perform their functions with effectiveness)
Ideally, financial and market intermediaries will perform thechanneling function at a low net cost to both borrower andsaver (ie. Perform their functions with efficiency).
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Practice Problem 4Primary Market Transactions
List the two main types of primary markettransactions and concisely explain them.
Debt Offerings When governments or businesses sell bonds to investors
in return for cash that the issuer needs
Equity Offerings When businesses sell shares to the investing public in
return for cash that the issuer needs.
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Practice Problem 4Secondary Market Transactions
What are secondary market transactions? How dosecondary markets facilitate the primary markets?
Secondary market transactions occur between two parties thatwish to trade in a financial asset.
Funds flow from the purchaser to the seller of the financial asset No funds flow to the issuer of the financial asset
Secondary markets provide liquidity in the market place andcontinuous pricing function. The fact that securities with long terms to maturity (or non-
maturing securities such as stock) can be sold, allows investorswith shorter investment time horizons to consider their purchase.
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Copyright
Copyright 2007 John Wiley & SonsCanada, Ltd. All rights reserved.Reproduction or translation of this workbeyond that permitted by AccessCopyright (the Canadian copyrightlicensing agency) is unlawful. Requestsfor further information should be
addressed to the PermissionsDepartment, John Wiley & Sons Canada,Ltd. The purchaser may make back-upcopies for his or her own use only andnot for distribution or resale. The authorand the publisher assume noresponsibility for errors, omissions, or
damages caused by the use of these filesor programs or from the use of theinformation contained herein.
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