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; Securities): - 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: 1
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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.
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
- 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
- Government an important borrower. Financial intermediaries (Pension funds, Insurance companies, Mutual Funds, Banks all important)
- 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.
- 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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Financial Economics: 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 the 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 well-being (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.
- The financial system arises because potential for mutual gain exists.
- lenders (savers) have a surplus of funds (savings): possible current uses for these funds are of low value
- borrowers have 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 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)
- bond and credit rating agencies: assess riskiness of borrowers.
- On average people appear to dislike risk (existence of insurance; risk premia paid on risky assets). So reductions in risk raise well-being.
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(3) Activities of the financial system affect 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: a key to industrialization and economic growth?)
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Possible Problems Associate with Financial Systems
- Instability: are financial systems a source of economic instability? e.g. speculation, bubbles and crashes.
- it provides ways of taking on and creating risk.
- 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 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.