Chapter 2

FINANCE IN A FINANCE IN A CANADIAN SETTINGCANADIAN SETTING

Sixth Canadian EditionSixth Canadian Edition

Lusztig, Cleary, Lusztig, Cleary, SchwabSchwab

CHAPTER TWOCHAPTER TWO

The Canadian Financial The Canadian Financial EnvironmentEnvironment

Learning ObjectivesLearning Objectives

1.1.Describe the difference between Describe the difference between surplus-spending units and deficit-surplus-spending units and deficit-spending units, and discuss how each spending units, and discuss how each contributes to the development of contributes to the development of efficient financial markets.efficient financial markets.

2.2.Explain how financial intermediation Explain how financial intermediation operates in channelling funds between operates in channelling funds between savers and users of funds.savers and users of funds.

Learning ObjectivesLearning Objectives

3.3.Describe the different functions of Describe the different functions of primary and secondary markets.primary and secondary markets.

4.4.Discuss the difference between Discuss the difference between traditional stock exchanges and over-the-traditional stock exchanges and over-the-counter (OTC) markets using examples counter (OTC) markets using examples from Canada and the United States.from Canada and the United States.

5.5.Identify some major stock indexes, and Identify some major stock indexes, and discuss their strengths and weaknesses.discuss their strengths and weaknesses.

The Role of Financial The Role of Financial AssetsAssets

Two types of assets:Two types of assets:

Real assetsReal assets – physical property – physical property such as land, buildings, such as land, buildings, inventoriesinventories

Financial assetsFinancial assets – paper claims – paper claims entitling the holder to some entitling the holder to some future payment such as interest future payment such as interest and principle on a debt certificate and principle on a debt certificate

Financial AssetsFinancial Assets

Two categories of financial Two categories of financial assets:assets:

Debt Debt – entails a contractual loan – entails a contractual loan with the purchaser entitled to with the purchaser entitled to future interest and repayment of future interest and repayment of principleprinciple

EquityEquity – the sale of ownership – the sale of ownership certificates in a firmcertificates in a firm

Financial IntermediariesFinancial Intermediaries

Financial intermediaries create a Financial intermediaries create a system of system of indirectindirect financing. financing.

Sources of indirect capitalSources of indirect capital- Individuals - Individuals - Foreign investors- Foreign investors

Governments have been net Governments have been net borrowers in recent years to fund borrowers in recent years to fund their deficits their deficits

Financial IntermediariesFinancial Intermediaries

The “four pillars” of Canada’s The “four pillars” of Canada’s financial system include:financial system include:

1.1. Chartered banksChartered banks

2.2. Trust companiesTrust companies

3.3. Insurance companiesInsurance companies

4.4. Investment dealersInvestment dealers

Financial MarketsFinancial Markets

Encompass the institutions and Encompass the institutions and procedures involved in the buying procedures involved in the buying and selling financial assetsand selling financial assets

Their main purpose is to efficiently Their main purpose is to efficiently match buyers and sellers match buyers and sellers

Primary MarketsPrimary Markets

Primary marketPrimary market - - where borrowers where borrowers issue new securities in exchange issue new securities in exchange for cash from investorsfor cash from investors

Selling of new securities is handled Selling of new securities is handled by investment dealersby investment dealers

Investment dealers act as Investment dealers act as intermediaries between buyers intermediaries between buyers and sellersand sellers

Secondary MarketsSecondary Markets

Secondary market - Secondary market - where existing where existing securities tradesecurities trade

Secondary markets exist for:Secondary markets exist for:- T- BillsT- Bills- StocksStocks- Bonds & debenturesBonds & debentures- DerivativesDerivatives

Global PerspectiveGlobal Perspective

Investment banks act as global Investment banks act as global coordinators linking separate underwriting coordinators linking separate underwriting syndicates globally in selling equity issuessyndicates globally in selling equity issues

Reasons for raising fund internationally Reasons for raising fund internationally include:include:

1.1. The limited size of the Canadian marketThe limited size of the Canadian market2.2. Management of foreign exchange Management of foreign exchange

exposureexposure3.3. Interest rate differentialsInterest rate differentials4.4. Availability of private placementsAvailability of private placements

Money MarketMoney Market

Dominated by financial institutionsDominated by financial institutions Operates as a Operates as a dealerdealer or or over-the-counterover-the-counter

market (OTC)market (OTC) Sold in denominations > $100,000Sold in denominations > $100,000 Most recognized money market instrument Most recognized money market instrument

are T-billsare T-bills T-bills are highly liquid and sold in 91, 182, T-bills are highly liquid and sold in 91, 182,

364 day maturities364 day maturities Other money market instruments include Other money market instruments include

commercial paper, Banker Acceptances, commercial paper, Banker Acceptances, eurodollars eurodollars

Debt MarketsDebt Markets

Bond markets represent the most Bond markets represent the most important markets for intermediate important markets for intermediate and long-term debtand long-term debt

The bond market operates as OTC The bond market operates as OTC marketmarket

Other important debt markets Other important debt markets includeinclude

- Asset-backed Securities (ABS)Asset-backed Securities (ABS)- Mortgage-backed securities (MBS)Mortgage-backed securities (MBS)

Equity MarketsEquity Markets

Common stocks, preferred stock and Common stocks, preferred stock and warrants trade in equity marketswarrants trade in equity markets

Equity securities trade on stock Equity securities trade on stock exchangesexchanges

Stock exchanges operate as:Stock exchanges operate as:- Auction markets Auction markets (TSE, NYSE, CDNX, ME)(TSE, NYSE, CDNX, ME)

oror- Over-the-counter Over-the-counter (NASDAQ)(NASDAQ)

Other MarketsOther Markets

Third marketThird market – an OTC market for – an OTC market for trading securities listed on trading securities listed on organized exchangesorganized exchanges

Fourth MarketFourth Market – involves – involves transactions made directly with transactions made directly with large institutions by passing large institutions by passing brokers and dealersbrokers and dealers

Derivatives MarketsDerivatives Markets

Derivative securitiesDerivative securities - derive the value from - derive the value from underlying assets such as common shares or underlying assets such as common shares or bondsbonds

OptionOption - a contract that grants the holder the - a contract that grants the holder the right to buy or sell a security at a given price right to buy or sell a security at a given price on or before a given dateon or before a given date

Future contractsFuture contracts - agreements to trade assets - agreements to trade assets at a specific price and time in the futureat a specific price and time in the future

Two types of futures:Two types of futures:- Real commodities commodity futures contractcommodity futures contract- Financial obligations financial future contractfinancial future contract

Derivative MarketsDerivative Markets

Options trading occurs on:Options trading occurs on:- Montreal exchange (ME) - CanadaMontreal exchange (ME) - Canada- Chicago Board Options Exchange (CBOT) Chicago Board Options Exchange (CBOT)

- US- US Option positions are issued and Option positions are issued and

guaranteed by a clearing corporation:guaranteed by a clearing corporation:- Canadian Derivatives Clearing Canadian Derivatives Clearing

Corporation (CDCC) (Canada)Corporation (CDCC) (Canada)- Options clearing corporation (OCC) (US)Options clearing corporation (OCC) (US)

Derivative MarketsDerivative Markets

Canada’s only commodity exchange Canada’s only commodity exchange is the Winnipeg commodity is the Winnipeg commodity exchange (WCE)exchange (WCE)

Major North American Commodity Major North American Commodity exchanges include:exchanges include:

- Chicago Board of Trade (CBOT)Chicago Board of Trade (CBOT)- Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)

Stock Market IndicatorsStock Market Indicators

Canadian indicators include:Canadian indicators include:- TSE 300TSE 300- S & P TSE 60S & P TSE 60- CDNXCDNX International indicators includeInternational indicators include- Dow Jones Industrial Average (US)Dow Jones Industrial Average (US)- S & P 500 Index (US)S & P 500 Index (US)- Nasdaq Composite Index (US)Nasdaq Composite Index (US)- Nikkei 225 Average (Japan)Nikkei 225 Average (Japan)- FTSE 100 Index (UK)FTSE 100 Index (UK)

SummarySummary

1.1. Efficient financial markets are required to Efficient financial markets are required to channel funds from surplus-spending units channel funds from surplus-spending units (savers) to deficit-spending units. Typically, (savers) to deficit-spending units. Typically, such securities entitle the holder to a stream of such securities entitle the holder to a stream of periodic future cash payments.periodic future cash payments.

2.2. Financial intermediaries allow economies of Financial intermediaries allow economies of scale to be realized when matching surplus-scale to be realized when matching surplus-spending units with deficit-spending units. spending units with deficit-spending units. Greater opportunities for portfolio Greater opportunities for portfolio diversification and money management can be diversification and money management can be gained.gained.

SummarySummary

3.3. Financial markets encompass the Financial markets encompass the institutions and procedures involved in the institutions and procedures involved in the trading of financial assets. They include the trading of financial assets. They include the money market (trading of short-term debt money market (trading of short-term debt instruments) and the capital market instruments) and the capital market (trading of long-term securities). The (trading of long-term securities). The capital market can be subdivided further capital market can be subdivided further into the equity market and the bond into the equity market and the bond market.market.

4.4. Equities are traded either on organized Equities are traded either on organized security exchanges, or on the over-the-security exchanges, or on the over-the-counter market.counter market.

SummarySummary

5.5. The Toronto Stock Exchange (TSE) is the The Toronto Stock Exchange (TSE) is the largest secondary market in Canada. The largest secondary market in Canada. The New York Stock Exchange (NYSE) is the New York Stock Exchange (NYSE) is the world’s premier secondary market.world’s premier secondary market.

6.6. Canadian OTC trading takes place Canadian OTC trading takes place through the Canadian Venture Exchange through the Canadian Venture Exchange (CDNX). Most OTC trading in the United (CDNX). Most OTC trading in the United States takes place on the Nasdaq Stock States takes place on the Nasdaq Stock Market.Market.

SummarySummary

7.7. The best-known market indicator in The best-known market indicator in Canada is the TSE 300 Composite Index. Canada is the TSE 300 Composite Index. The best-known stock market indicator The best-known stock market indicator in the United States is the Dow Jones in the United States is the Dow Jones Industrial Average (DJIA).Industrial Average (DJIA).