Introduction to Financial Markets

- Read: Mishkin and Serletis, Ch. 2 Overview of the Financial System The Financial System

- What is the ‘Financial system’?- a set of interrelated markets for financial assets - a set of financial institutions dealing in these assets.

- Financial instrument (Financial Asset):

- contract which gives the holder (lender) a claim to a stream of future payments from the issuer of the asset (borrower).

- asset to the lender, liability or debt to the borrower.

- many different types of instruments

- different financial instruments play similar roles

- implication? substitutes for one another; markets closely related.

- Decision-makers in financial markets:

- lenders (savers)- may be households, businesses, governments or foreigners.

- borrowers- may be households, businesses, governments or foreigners.

- intermediaries: match borrowers and lenders.

Financial intermediary: borrows from savers by issuing one type of asset and lends to other borrowers in the form of a different asset.

- market intermediaries (brokers, dealers): buy-sell same asset.

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- Text Figure 2.1: Flow of Funds

- Direct Finance: - Lenders/savers matched to borrowers via financial markets

- borrowers sell financial instruments to lenders (possibly through a market intermediary)

e.g. bond markets, stock markets.

- Indirect Finance: - Lenders/savers lend to a financial intermediary.

e.g. bank

- Financial intermediary then lends these funds to the final borrowers.

- In most countries indirect finance is most important for businesses (text p.35)

- But big differences by country.

- Change over time: junk bonds (US); commercial paper markets (see text p. 255); European banking problems.

See: The Economist Dec. 2012, “Non-bank Finance: Filling the Bank-Shaped Hole” – Europe vs. US

( http://www.economist.com/news/briefing/21568365-europes-banks-are-shrinking-what-will-take-their-place-filling-bank-shaped-hole )

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The Canadian Financial System: Details and Terminology

Financial Markets

- Think of there being a "market" for any asset.

- Market: activities of the buyers (lenders) and sellers (borrowers) of that asset.

- Assets are exchanged in a variety of ways.

- dealing could occur in a specific location e.g old-style stock or commodity exchanges.

- “over-the-counter” markets: dealers ready to buy/sell assets, no specific location, usually electronic contact.

- auction arrangements for certain assets.

- delivered via financial intermediaries such as banks.

- “Market intermediaries”:

- Act to bring buyers and sellers together.- brokers: do only this

- agents: search for best price, may provide advice to their clients, etc.

- dealers: party to the transaction- buy assets and turn around and sell them.- profits on the price difference.

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Some Market Terminology:

Primary and Secondary markets:

- Primary: deals in newly created assets , e.g. new stock issues.

- Secondary: deals in existing assets.- via exchanges or over-the-counter.

- Importance of secondary markets

- they do not involve a transfer of new funds

- they do make assets more "liquid", i.e., it makes it easier and less costly to convert the asset into money.

- lenders will likely be more willing to hold the asset if it is more liquid.

- secondary market prices and returns are closely linked to what issuers can get in primary markets: indicates how much can be raised by issuing more assets.

Money and Capital Markets:

- General terms for market concerned with shorter term (Money Market) and longer term (Capital Market) lending and borrowing.

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Money Market

- Concerned with short-term financial assets (term of less than 1 year).- Most assets have a term-to-maturity of 3-months or less.- Can be very short term: day-to-day, overnight.

- A variety of lenders and borrowers are involved in the money market:

- Banks, Bank of Canada, corporations, governments.

- Treasury bills are a key asset (Governments are major borrowers)

- Paper: Commercial/Corporate paper, Sales and Finance paper

- important private assets: borrowers are corporations.

- Chartered Banks:

- Active lenders and borrowers in the overnight market: day-to-day loans.

- Reserve management through these short-term markets. - borrowing-lending between banks

- borrowing from Bank of Canada (B of C).

- Other assets: short-term deposits as money market instruments.

- Bank of Canada (Canada’s central bank) typically conducts monetary policy through the money market.

- lends and borrows (buys and sells assets) in these markets to affect interest rates and credit conditions.

- Key interest rates: overnight rate; Treasury bill rates; Prime Corporate Paper rate.

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Capital Market

- Concerned with longer-term borrowing.

- Major assets:- shares - bonds - mortgages

- longer term consumer and commercial loans.

- Corporate finance: stocks and bonds- bond market is smaller than the stock market but bonds are the more

important source of new funds.

(National Balance Sheet 3rd quarter 2016: Corporate bonds $584 billion vs.$3,333 billion in shares)

- Key indicators: - Federal government bond yields- Stock market indices e.g. S&P TSX Composite- Mortgage interest rates (5-yr. variable; 5-yr. fixed) - Car loan rates.

( Bank of Canada’s Daily Digest: http://www.bankofcanada.ca/rates/daily-digest/ )

- Links between Capital and Money markets:

- common players: - many borrowers and lenders are active in both

markets (Financial intermediaries, dealers)

- yields in one market represent an opportunity cost to lenders in other markets or an alternative cost of funds for borrowers.

i.e., both types of markets satisfy similar needs.

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Key Financial Institutions

Depository Institutions (Deposit-takers)

- main function: - accept and manage deposits- make loans

- banks, credit unions (coop banks), trust and mortgage loan companies,.

- borrowers in the deposit market.

- lenders in the loan markets (consumer and business loans, mortgages)

- banks: also active in markets for government & corporate securities.

Insurance Companies

- Provide protection against uncertain events. - creates instruments (assets): insurance policies.

- Savings and premiums are invested in a portfolio of financial assets.- lends in mortgage, bond and stock markets.

Pension Plans- Pooled retirement savings of a group of employees.

- Lends mainly in the bond and stock markets.

Mutual Funds and Investment Funds

- Borrows by selling shares in the fund.

- Pooled savings invested in a portfolio of assets (bonds, money market assests and shares).

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Sales, Finance and Consumer Loan Companies

- Provide loans to consumers, businesses.- typically specialized: car loans, business equipment, etc.

- Raise funds (borrow) in bond, stock and “paper” markets.

- Finance cos. may have a parent company e.g. Ford Credit and car co.

Investment Dealers- Buy new corporate and government securities and sell them.

Investment Banks:- Guarantees a price for a borrower’s securities then sells the securities to

the public. (underwriting see text pp. 294-295)

- business borrowers important.

Hedge Funds:- Investment partnerships for the wealthy. i.e. minimum required investment

Sizes of Financial Institutions, Financial Assets 3rd quarter, 2016: Banks $3,689 billionPensions Plans $1,900 billionMutual Funds $1,950 billionLife Insurers $750 billion ($296b Segregated Funds)Credit Unions, Trust cos. $482 billionOther Insurance $153 billionSales Finance, $134 billion Consumer Loan Cos.

Source: Statistics Canada, National Balance Sheet Accounts (CANSIM database)

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Types of Financial Instruments:

- Many different types of financial assets (instruments) - all are claims to future payments.

- Some distinguishing characteristics:

- Timing of payments:- number and frequency of payments - term to maturity: time until the final payment is made.

- Size of payments:- equal sized or different- fixed by the contract or variable?

- Marketability/liquidity: is there an active resale market or not?

- Risk: (regarding size or value of payments)

Some sources of risk differences:

- future payments fixed in contract or contingent on performance.

- credit or default risk: possibility of full or partial default

- market risk: risk arising from possible changes in the market price of the asset (important if resale likely)

- inflation risk: inflation affects the value of the stream of payments – a source of risk if payments are not tied to inflation.

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Some Major Financial Instruments:

Currency and Deposits ($2,547 billion 3rd qtr. 2016)

- Currency and deposits in banks and other deposit-taking institutions- Deposits dominate this category.

- Assets to:- Mainly to persons.

- Debt to:- Banks and near-banks.

- Yield (return)?- explicit interest rate

- non-financial component: services from the deposit-taker.

- A variety of types of deposit: demand, term, w/wo chequeing privileges, etc.

- Distributed by the financial intermediary.

Mortgages ($1,622 billion 3rd qtr. 2016)

Loans made with property offered as security (collateral).

Asset to:- Mainly to banks and near banks (quasi-banks in National Balance

Sheet)Debt to: - Persons

- Non-financial businesses.

Yield? - Mortgage interest rate.

- Delivered through a financial intermediary (initially).

- Secondary market for mortgages and mortgage-backed securities.

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Loans ($3,706 billion 3rd quarter 2016, excludes mortgage loans)- Asset to:

- Banks, credit-unions (quasi-banks), sales finance & loan companies, non-residents, governments.

- Debt to:- Non-financial business, Households, Non-residents

- Yield?- explicit interest rate.

- Variability in terms and conditions?

- Loans: terms, fixed vs. variables rates, how is the principal paid, etc.

- Delivered through financial intermediaries.

Bonds ($3.5 trillion, 3rd qtr. 2016)A financial asset which pays the holder a stream of interest payments

(coupon payments) and the face value of the bond at maturity.

Asset to:- Financial institutions: pension plans, banks, insurers, mutual funds.- Non-residents- Persons

Debt to:- Government - Non-financial corporations.

Yield?- Determined by the size of the interest (coupon)

rate and the difference between the purchase price of the bond and its face value.

- Variety?- Maturity dates vary substantially.

- Delivered through markets.

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Treasury Bills (a kind of short-term paper, $157 billion 3rd qtr., 2016)Short-term government debt which entitles the holder to a single

payment upon maturity.

- Mainly federal government (about 90% in 2016)

- Asset to:- Quite widely held: financial institutions most important.

- Debt to:- Government.

- Yield?- Determined by the difference between the

sale price and the T-bill's value at maturity.

- Maturities: 91 days most common, there are also 30, 182 and 364 day bills.

- Delivered through market, actively trade so quite liquid.

Commercial Paper / Corporate Paper (a kind of short-term paper, $217 billion)Short-term corporate debt.

- Private version of a treasury bill.

Asset:- Non-financial business - Banks and near banks- Pension funds, Mutual funds, Insurance cos.

Debt to:- Non-financial business, banks.

Yield?- determined by the difference in the sale price

and the value at maturity.

- Delivered through markets.

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Shares (common)Gives the holder part-ownership in the firm and is a claim on

the firm's distributed profits.

Asset to:- Persons - Financial institutions: pension plans, mutual funds.

Debt to:- Businesses: financial and non-financial.

Yield? - Depends upon the size of dividend payments and changes in the share price.

- Delivered through a market.- primary market: underwriter buys shares from the

issuing firm and sells them.

- secondary market: stock exchange, dealing in already existing shares.

($3.3 trillion in Non-Financial Corporations 3rd qtr. 2016)

Insurance Claim to a payment conditional on the occurrence of some event.

(contingent instrument)

- Asset to:- Persons (this is the only type measured in the table)

- Debt to:- Insurance companies

Yield?- Determined by the size of premium paid relative to the

payment if the event occurs and the probability that the event will occur.

- Delivered through a financial intermediary.

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Pensions Claim to a stream of income upon retirement in return for payment of a

stream of premiums before retirement.

- Asset to:- Persons, contributors

- Debt to:- Pension plans

Yield?Depends upon the size of premium stream compared to the eventual payment stream and life expectancy.

- Delivered through a financial intermediary.

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National Balance Sheet and Flow of Funds: Overview of the System

- Data is from Statistics Canada National Balance Sheet Accounts (on CANSIM http://www5.statcan.gc.ca/cansim/a26?lang=eng&id=3780121 )

- Provides a good summary of the roles and importance of each broad sector in financial markets

- Reports the asset and debt positions of each sector of the economy at year end.

- Sectors key sectors in tables:

- Households

- Non-financial corporations- Incorporated businesses other than financial institutions.

- Governments, public enterprises and Canada and Quebec Pension Plans.

- Financial institutions (types by size of assets p. 17 of overheads)

- Non-residents (Rest-of-World).

- Sources of Funds to the Financial System: net lenders?

- Focus on their financial assets less debts/liabilities.

- Household sector: - Major source of funds:

Financial assets less debt, $4,404 billion for persons and unincorporated businesses, 3rd qtr. 2016.

- Social security funds (CPP, QPP biggest): $364 billion

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- Users of funds by sector: net borrowers? (Liabilities larger than assets)

- Non-financial corporations:- Major net user of funds: $3,254 billion more in

debts than assets.

- Governments:- Also a major net user of funds:

Federal government $695 billionProvincial governments $547 billionLocal and Aboriginal $104 billion

- Non-residents are net users in 2016 ($115 billion).

- Financial intermediaries:- big holders of financial assets but equally large debtors.

i.e., sector is a pipeline for funds not a source of them.

e.g. chartered banks $3,689 billion in financial assets and $3,879 billion in financial liabilities

- Non-residents: “Rest-of-World”- Financial assets and liabilities large in 3rd quarter 2016 ($4 trillion and

$4.1 trillion respectively) i.e. important in Canada.

- Scanning down the columns gives a good idea of what each sector or Institution is doing.

- Scanning across the rows gives a good idea of who issues and who holds a particular type of asset.

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Economics of the Financial System:

- Develops models to explain financial market outcomes .

- Develops models of intermediary behavior.

- Economic approach:

- Behavior: decision makers pursue their self-interest.

- Decisions are made based upon a comparison of the benefits and costs of the decision (“rationality”).

- Some distinctive features of the economics of financial systems:

- inter-temporal decisions are key

- lending and borrowing occur over time

- importance of uncertainty, risk

e.g. determining creditworthiness of borrowers, effects of future events and role of expectations.

- inter-temporal decisions and risk/uncertainty go hand in hand.

- interdependence of financial markets

- different assets are often close substitutes;

- intermediaries active in many markets.

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Economic Importance of the Financial System

- T. Philippon, VoxEu site: a two sentence statement

"The role of the finance industry is to produce, trade, and settle financial contracts that can be used to pool funds, share risks, transfer resources, produce information, and provide incentives. Financial intermediaries are compensated for providing these services."

Financial System and Well-Being:

- The financial system can raise welfare in a variety of ways.

(1) Matching those with surplus funds with those with uses for those funds

- The most basic function of the financial system.

- lenders or savers: - those whose current incomes exceed their expenditures

- borrowers, dis-savers: - economic agents whose desired expenditures exceed their incomes

- The financial system arises because potential for mutual gain exists.

- some agents have a surplus of funds (savings): possible current uses for these funds are of low value

- other agents (borrowers) have higher value uses for these funds.

- Deals or contract are possible where borrowers can

compensate lenders for use of their funds.

- This gives rise to financial markets:

i.e., mutually beneficial deals between lenders and borrowers

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- Matching lenders and borrowers with similar needs requires time,effort and much information e,g. credit checks.

- Institutions develop that specialize in matching agents.

- why? - a better and/or cheaper way of achieving matches.

- advantages: specialization can lower costs, economies of scale, risk pooling advantages.

- matching done in return for part of the gain from the match. i.e., financial intermediaries, brokers, dealers.

- Matching function is likely to raise economic welfare:

- matches are voluntary

- lenders, borrowers and intermediaries only deal if they all expect to benefit.

- These activities enhance flexibility

- timing of consumption and business decisions

- ability to transfer purchasing power over time, ability to pool funds across time.

- many businesses: hire people, buy inputs incur production costs now

realize sales and revenues in the future;credit and borrowing important until revenues come

in.

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(2) Risk Management:

- The financial system provides ways in which to reduce risk.

- Some financial instruments do this directly:

- insurance, forward and future contracts, options.

- The existence of many types of financial assets allows diversification: reduces risk.

- Some financial institutions arise to deal with risk:

- insurance companies

- mutual funds (diversification)

- banks: screen out high risk borrowers (assess creditworthiness, monitor borrowers)

- rating agencies: assess riskiness of borrowers.

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(3) Affects the size of the stock of physical capital and the economy’s potential to produce output.

- capital stock (machines, tools, buildings, infrastructure)

- reflects past decisions to use productive resources to create capital goods rather than consumption goods.

i.e., reflects past decisions to save and invest.

- Creating physical capital involves a decision to invest now in order to reap future returns.

- often financed with borrowed funds (terms dictated by financial market);

- when financed with own savings: return to lending in financial markets is an opportunity cost of investment.

- decisions to invest in physical capital are affected by the financial system: this affects ability to produce future output.

- An efficient financial system:

- encourages saving and investment: matching made easier- potentially better return for lenders; - potentially cheaper borrowing costs for borrowers.

- better investment: flows funds to highest return investment projects.

- allows pooling of savings to finance bigger projects.

- makes for a richer economy.

(‘capital’ in capitalist economies: is it key to industrialization and economic growth?)

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Possible drawbacks of financial systems: Some Concerns

- Are financial systems a source of economic instability? e.g. speculation, bubbles and crashes.

- provides ways of taking on and creating risk too.

- Reinhart and Rogoff (2009) This Time is Different –

financial and banking crises through history. Quite common.

- Minsky, Kindleberger and others: financial sector can produce cycles of boom and bust.

e.g. US: 2007-08 Financial crisis late-1990s, early 2000s: dot.com bubble Black Monday, 1987 Savings and loan crisis 1980s etc.

- Financial crises can cause recessions or depressions:- Great Depression: role of the 1929 stock market

crash, bank runs and banking collapses.- US financial crisis and recent recession.

- Economics of financial markets:- why are they prone to instability (information problems and

uncertainty – later in course)?

- Can regulation, deposit insurance and government lending to stabilize financial markets?

- Questions about the efficiency of financial systems? Do we get out money’s worth?

- Questions about concentration, power and inequality and the role of the financial system.

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