Mish 2ce Ch2 Rev

Chapter 2

An Overview of the Financial System

Mishkin/SerletisThe Economics of Money, Banking, and Financial Markets Fifth Canadian Edition

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

• Direct finance– borrowers borrow funds directly from lenders in financial

markets by selling them securities

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

Flows of Funds Through the Financial System

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

– Negotiable (marketable ie can sell) and non-negotiable• Commercial Paper• Repurchase Agreements

– Loans to banks, T-bills as collateral• 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

Capitalization of Equity Markets in Developed Countries (US$bn)

Market Capitalization of Developing Countries

• The other 25% is accounted for by the market capitalization of developing countries in “emerging markets”.– Latin America– Asia– Eastern Europe– Mideast/Africa

• Recently the growth rates in these emerging markets have been strong, but with more volatility than in developed countries

Market Capitalization in Selected Emerging Markets (US$ bn)

Function of Financial Intermediaries: Indirect Finance

1. Reduce transaction costs (time and money spent in carrying out financial transactions) – economies of scale (good at collecting funds)– liquidity services

2. Reduce the exposure (from deposits) 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 • 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

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– Finance Companies (lends to consumers ie IKEA, Toyota)– Mutual Funds

• Sell shares to shareholders, buy larger block of funds, diversified– Money Market Mutual Funds

• Like mutual funds but also offer deposit like instruments

Primary Assets and Liabilities of Financial Intermediaries

Relative Shares of Financial Institutions and Pension Plans

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 of 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

Institutions matter for growth

Mish 2ce Ch2 Rev

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