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© 2003 McGraw-Hill Ryerson Limited 14 Chapter Capital Markets McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Based on: Terry Fegarty, Gitman et al, Gallagher et al, Prentice Hall Slides May 10, 2005
© 2003 McGraw-Hill Ryerson Limited Chapter 14 - Outline Financial System: Overview Financial Markets: Capital Markets vs. Money Markets Primary vs. Secondary Markets Organized Exchanges vs. OTC Financial Intermediaries Deregulation of the Financial Industry Changes to the Banking System Market Efficiency Summary and Conclusions PPT 14-2
© 2003 McGraw-Hill Ryerson Limited Financial System: Overview Central duty - to acquire funds.
© 2003 McGraw-Hill Ryerson Limited Financial System: Overview The Financial System is made up of two groups: suppliers of capital (entities and individuals that have excess funds), and demanders of capital (entities and individuals that need funds). The financial system makes it possible for participants to adjust their holdings of financial assets as their needs change. This is the liquidity function of the financial system, that is, the system allows funds to flow with ease.
© 2003 McGraw-Hill Ryerson Limited Financial System: Overview Along with this movement of funds through the financial system, funds are exchanged for financial products called securities. The financial system provides the network that brings the two groups (savers & users) together: Financial Markets Financial Intermediaries
© 2003 McGraw-Hill Ryerson Limited Funds Flow: No Intermediation Markets Intermediaries Surplus UnitsDeficit Units Markets Intermediaries Savers Users
© 2003 McGraw-Hill Ryerson Limited Direct Transfer of Funds Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Direct Transfer of Funds saver Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Direct Transfer of Funds saver firm Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Direct Transfer of Funds cash saver firm Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Direct Transfer of Funds cash securities saver firm Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Financial Markets Financial Markets provide a forum where suppliers of funds (savers) and demanders of funds (users) can transact business. bring savers and users of funds together to make a fair exchange that brings value to both parties. Financial transactions can take place in one central location or in a dispersed location. Example: Toronto Stock Exchange, Nasdaq
© 2003 McGraw-Hill Ryerson Limited Financial Intermediaries Financial Intermediaries act as the “grease” that enables the “machinery” of the financial system to work smoothly. Example: Chartered Banks, Investment Bankers, Stockbrokers, dealers, etc. Financial Intermediaries accomplish this by: reducing the cost of bringing borrowers and savers together bridging borrower’s and lender’s maturity preferences reducing investment risk through diversification
© 2003 McGraw-Hill Ryerson Limited The Flow of Funds Diagram Markets Intermediaries Savers Users
© 2003 McGraw-Hill Ryerson Limited Fund Flows via Intermediary Markets Intermediaries SaversUsers
© 2003 McGraw-Hill Ryerson Limited Movement of Savings Indirect Transfer using a Financial Intermediary
© 2003 McGraw-Hill Ryerson Limited Indirect Transfer using a Financial Intermediary financial intermediary Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Indirect Transfer using a Financial Intermediary financial intermediary firm Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Indirect Transfer using a Financial Intermediary funds financial intermediary firm Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Indirect Transfer using a Financial Intermediary funds firmsecurities financial intermediary firm Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Indirect Transfer using a Financial Intermediary funds firmsecurities financial intermediary firm saver Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Indirect Transfer using a Financial Intermediary fundsfunds firmsecurities financial intermediary firm saver Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Indirect Transfer using a Financial Intermediary funds intermediarysecurities funds firmsecurities financial intermediary firm saver Movement of Savings
© 2003 McGraw-Hill Ryerson Limited Fund Flows via Market Markets Intermediaries SaversUsers
© 2003 McGraw-Hill Ryerson Limited The Flow of Funds Diagram Markets Intermediaries Savers Users
© 2003 McGraw-Hill Ryerson Limited Financial Markets: Capital Markets vs. Money Markets Two Distinct Financial Markets: 1. Capital Markets are where L/T securities with maturities greater than 1 year are traded ex., Common Stock, Preferred Stock, Bonds, Mortgages, etc. 2. Money Markets are where S/T securities with maturities less than 1 year are traded ex., T-Bills, Commercial Paper, Negotiable Certificate of Deposits, Bankers’ Acceptances, Eurocurrency PPT 14-3
© 2003 McGraw-Hill Ryerson Limited Money Market Securities Securities traded in the Money Market include: Treasury Bills: Short-term instruments issued by the Canadian Government that are sold at a discount and pay face value at maturity. Negotiable Certificates of Deposits (CDs): certificates that can be traded in financial markets and represent amounts deposited at bank that will be repaid at maturity with a specified interest rate. Commercial Paper: unsecured short-term promissory notes issued by large corporations with strong credit ratings. Banker’s Acceptances: documents that signify a bank has a guaranteed payment of certain amount at a future date if the original issuer does not pay.
© 2003 McGraw-Hill Ryerson Limited Figure 14-1 Canadian money market: securities outstanding PPT 14-4
© 2003 McGraw-Hill Ryerson Limited Capital Market Securities Major Securities traded in the Capital Market include: Bonds: Long-term securities that represent a promise to pay a fixed amount at a future date usually with interest payments made at regular intervals. Issued by the Canadian Federal, Provincial and Municipal Governments and Corporations. most widely used form of financing in recent years significant amounts raised abroad
© 2003 McGraw-Hill Ryerson Limited Figure 14-2 Canadian Bond Market: Securities Outstanding (Canadian Dollars) PPT 14-6
© 2003 McGraw-Hill Ryerson Limited Figure 14-3 Canadian bonds outstanding: foreign currencies PPT 14-8
© 2003 McGraw-Hill Ryerson Limited Capital Market Securities Major Securities traded in the Capital Market include: Shares: Preferred shares come with fixed dividends and usually no voting rights. least used of all L/T corporate securities Common shares may come with dividends, paid at the discretion of the board, and have voting rights. Common shareholders share in the residual profits of the firm. Shares of ownership interest in corporations. 23 % of net new financings in 2000 more equity is being raised abroad by Canadian corporations
© 2003 McGraw-Hill Ryerson Limited Figure 14-4 Net new corporate financings by type of security PPT 14-9
© 2003 McGraw-Hill Ryerson Limited Financial Markets: Primary Vs. Secondary Markets Both Capital and Money Markets have a Primary Market and a Secondary Market. Primary Market is the market: that creates and places an initial value on financial securities. where securities are traded for the first time. Secondary Market is the market: where previously issued securities are traded among investors. may occur on an exchange or OTC through your stockbroker.
© 2003 McGraw-Hill Ryerson Limited Figure Secondary Market: Daily trading averages PPT 14-16
© 2003 McGraw-Hill Ryerson Limited Organized Exchanges Organized Exchanges operate in a central location where previously issued securities are traded. Exchanges are therefore, 2 nd markets. Exchanges like the Toronto Stock Exchange (TSX) are organizations that facilitate the trading of stocks among investors. Corporations arrange for their company shares be listed for a fee on the Exchange so that investors may trade their shares at a designated “Post” or Exchange location.
© 2003 McGraw-Hill Ryerson Limited Organized Exchanges New York Stock Exchange (NYSE) largest and most important market for stocks in world Toronto Stock Exchange (TSX) largest and most important market for stocks in Canada smaller and less significant globally than NYSE
© 2003 McGraw-Hill Ryerson Limited Table 14-1 Global stock markets AustraliaKorea AustriaMexico BelgiumNetherlands BrazilNorway CanadaSingapore/ Malaysia DenmarkSpain FranceSweden GermanySwitzerland Hong KongUnited Kingdom ItalyUnited States Japan PPT 14-18
© 2003 McGraw-Hill Ryerson Limited OTC OTC stands for over the counter. It has no central location unlike Exchanges. It is a network of dealers around the globe who maintain inventories of securities for sale. Connected through computer terminals and telephones buy and sell securities which are not listed on a stock exchange bulk of all bond trading is done OTC NASDAQ is the best known OTC market and rivals the New York Stock Exchange in trading volumes.
© 2003 McGraw-Hill Ryerson Limited Financial Intermediaries: Functions/Roles Financial Intermediaries can assume the following roles: Investment Bankers - primarily involved in the underwriting of securities. Brokers – are agents who work on behalf of the investor Dealers – make a living by buying and reselling securities to others.
© 2003 McGraw-Hill Ryerson Limited Investment Banking How do investment bankers help firms issue securities? Underwriting 1 the issue. Distributing the issue. Advising the firm. 1 Underwriting refers to the process by which an investment banker (usually in cooperation with other investment banking firms) purchases all the new securities from the issuing company and then resells them to the public.
© 2003 McGraw-Hill Ryerson Limited Investment Banking -Distribution Methods Negotiated Purchase Issuing firm selects an investment banker to underwrite the issue. The firm and the investment banker negotiate the terms of the offer. Competitive Bid Several investment bankers bid for the right to underwrite the firm’s issue. The firm selects the banker offering the highest price.
© 2003 McGraw-Hill Ryerson Limited Investment Banking - Distribution Methods Best Efforts Issue is not underwritten. Investment bank attempts to sell the issue for a commission. Privileged Subscription Issue is not underwritten also. Investment banker helps market the new issue to a select group of investors. Usually targeted to current stockholders, employees, or customers.
© 2003 McGraw-Hill Ryerson Limited Financial Intermediaries-Underwriting Direct Sale No investment banker is involved. Issuing firm sells the securities directly to the investing public.
© 2003 McGraw-Hill Ryerson Limited Principal Financial Intermediaries Principal Financial Intermediaries in Canada: Chartered Banks Trust Companies Credit Unions Finance Companies Insurance Companies Mutual Funds Companies Pension Funds Companies Bank of Canada
© 2003 McGraw-Hill Ryerson Limited Principal Financial Intermediaries Chartered Banks – are financial institutions that exist primarily to lend money to businesses (commercial loans). Example: Royal Bank, CIBC, TD Trust Companies – like chartered banks, are in business to take in deposits and lend money, primarily mortgage loans. Example: TD Canada Trust, BMO Trust, AGF Trust Credit Unions – are member-owned financial institutions. They pay interest on shares bought by, and collect interest on loans made to the members. Example: Caisses Populaires
© 2003 McGraw-Hill Ryerson Limited Principal Financial Intermediaries Finance Companies are non-bank firms that make short-term and long-term loan to consumers and businesses. Often serve customers who do not qualify for loans at other financial institutions. Funds are obtained from banks or by selling Commercial Paper. Example: Household Finance, Beneficial Finance Insurance Companies Are firms, for a fee (premiums), will assume risks for their customers. Will pay beneficiaries of insured person when this person dies (Life Insurance). Example: Standard Life, RBC Insurance, London Life
© 2003 McGraw-Hill Ryerson Limited Principal Financial Intermediaries Mutual Funds Companies Are investment companies that receive money from individuals for investment in both the money and capital markets. Professionals manage these money and may have the objective of safety, growth, income, high-risk, liquidity. Example: AIM Trimark, ING Funds, Standard Life Mutual Funds, Scotia Mutual Funds Pension Funds Companies Take in funds, usually contributed both by the employee and the employer, and invest those funds for future payment to the employee. Example: Altamira Financial Services, Fidelity Investments
© 2003 McGraw-Hill Ryerson Limited Figure 14-8 Total assets of financial intermediaries PPT 14-14
© 2003 McGraw-Hill Ryerson Limited Deregulation of the Financial Industry Prior to deregulation in 1987, financial institutions were allowed to operate only in one of the “four pillars”: chartered banks alternate banks (trust companies, credit unions, caisses populaires) life insurance companies and specialized lending and saving intermediaries investment dealers Intense global competition led to major restructuring of the financial industry. These “4 pillars” were dismantled in the 1987 deregulation.
© 2003 McGraw-Hill Ryerson Limited This led to 1-stop banking where: U.S.-based banks may compete in the Canadian market Banks may own securities dealers Banks may own insurance companies and sell commercial paper Banks may create mutual fund subsidiaries Trust companies have been taken over by banks or have been reduced in their importance. Changes to the Banking System PPT 14-22
© 2003 McGraw-Hill Ryerson Limited Market Efficiency Market Efficiency refers to the ease, speed and cost of trading securities. In an efficient market, securities can be traded easily, quickly, and at low costs. Markets lacking these qualities are considered inefficient. The major stock markets are considered efficient because investors can trade thousands of dollars worth of shares in minutes by making a phone call and paying a relatively small commission. PPT 14-20
© 2003 McGraw-Hill Ryerson Limited Summary and Conclusions Capital markets refer to the trading of financial assets with long terms to maturity, including stocks, bonds, and mortgages. Canadian corporations seek funds from both stock and bond markets, Canadian and foreign The Toronto Stock Exchange (TSX) is the dominant Canadian exchange. Bonds are traded in the Over-The -Counter market Major changes in the Canadian financial market include one-stop financial services, more investment banking, and more foreign banks. PPT OK, LET’S RECAP...
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