copyright © 2014 pearson canada inc. chapter 2 an overview of the financial system mishkin/serletis...

Copyright © 2014 Pearson Canada Inc.

Chapter 2

AN OVERVIEW OF THE FINANCIAL SYSTEM

Mishkin/Serletis

The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition

Copyright © 2014 Pearson Canada Inc. 2-2

Learning Objectives

1. Summarize the basic function performed by financial markets

2. Explain why financial markets have several classifications

3. Describe the principal money market and capital market instruments

4. Express why the government regulates financial markets and financial intermediaries


Function of Financial Markets• Channel funds from economic players that have surplus funds to

those that have a shortage of funds

• Indirect financing

- borrowers borrow funds through financial intermediaries from lenders(financial investors)

examples:

• Direct financing– borrowers borrow funds directly from lenders in financial markets by selling

them securities

examples:


Function of Financial Markets (cont’d)

• Promotes economic efficiency by producing an efficient allocation of capital

• Improves the well-being of consumers by allowing them to time purchases better


Flows of Funds Through the Financial System


Relative Shares of Financial Institutions and Pension Plans


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)


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


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


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


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

• Government of Canada Treasury Bills• Certificates of Deposit• Commercial Paper• Repurchase Agreements• Overnight Funds


Principal Money Market Instruments


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


Principal Capital Market Instruments


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


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


Function of Financial Intermediaries: Indirect Finance (cont’d)

3. Deal with asymmetric information problemsa. Adverse Selection

• before the transaction (ex ante)• avoid selecting the risky borrower• gather information about potential borrower

b. Moral Hazard • after the transaction (ex post)• 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

• 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


Types of Financial Intermediaries (cont’d)

• Investment Intermediaries

– Investment Bank(U.S.) and Brokerages example1; or Securities Houses(Canada; Common Wealth) example2– Finance Companies– Mutual Funds– Money Market Mutual Funds


Four Pillars of Canadian Financial System


Excellent Overview of the Canadian Financial System is given here.

At a personal level mindful of future careers in finance,you may click here.

(https://www.csi.ca/student/en_ca/careermap/index.xhtml?cid=RDT-CSICMT--I01 )


Primary Assets and Liabilities of Financial Intermediaries


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


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 competition3. Improve control of monetary policy


Principal Regulatory Agencies of the Canadian Financial System

copyright © 2014 pearson canada inc. chapter 2 an overview of the financial system mishkin/serletis...

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