FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTER TWO CHAPTER TWO The Canadian Financial Environment

Learning Objectives 1.Describe the difference between surplus- spending units and deficit-spending units, and discuss how each contributes to the development of efficient financial markets. 2.Explain how financial intermediation operates in channelling funds between savers and users of funds.

Learning Objectives 3.Describe the different functions of primary and secondary markets. 4.Discuss the difference between traditional stock exchanges and over-the-counter (OTC) markets using examples from Canada and the United States. 5.Identify some major stock indexes, and discuss their strengths and weaknesses.

The Role of Financial Assets n Two types of assets: Real assets – physical property such as land, buildings, inventories Financial assets – paper claims entitling the holder to some future payment such as interest and principle on a debt certificate

Financial Assets n Two categories of financial assets: Debt – entails a contractual loan with the purchaser entitled to future interest and repayment of principle Equity – the sale of ownership certificates in a firm

Financial Intermediaries n Financial intermediaries create a system of indirect financing. n Sources of indirect capital - Individuals - Foreign investors n Governments have been net borrowers in recent years to fund their deficits

Financial Intermediaries n The “four pillars” of Canada’s financial system include: 1.Chartered banks 2.Trust companies 3.Insurance companies 4.Investment dealers

Financial Markets n Encompass the institutions and procedures involved in the buying and selling financial assets n Their main purpose is to efficiently match buyers and sellers

Primary Markets n Primary market - where borrowers issue new securities in exchange for cash from investors n Selling of new securities is handled by investment dealers n Investment dealers act as intermediaries between buyers and sellers

Secondary Markets n Secondary market - where existing securities trade n Secondary markets exist for: - T- Bills - Stocks - Bonds & debentures - Derivatives

Global Perspective n Investment banks act as global coordinators linking separate underwriting syndicates globally in selling equity issues n Reasons for raising fund internationally include: 1.The limited size of the Canadian market 2.Management of foreign exchange exposure 3.Interest rate differentials 4.Availability of private placements

Money Market n Dominated by financial institutions n Operates as a dealer or over-the-counter market (OTC) n Sold in denominations > $100,000 n Most recognized money market instrument are T-bills n T-bills are highly liquid and sold in 91, 182, 364 day maturities n Other money market instruments include commercial paper, Banker Acceptances, eurodollars

Debt Markets n Bond markets represent the most important markets for intermediate and long-term debt n The bond market operates as OTC market n Other important debt markets include - Asset-backed Securities (ABS) - Mortgage-backed securities (MBS)

Equity Markets n Common stocks, preferred stock and warrants trade in equity markets n Equity securities trade on stock exchanges n Stock exchanges operate as: - Auction markets (TSE, NYSE, CDNX, ME) or - Over-the-counter (NASDAQ)

Other Markets n Third market – an OTC market for trading securities listed on organized exchanges n Fourth Market – involves transactions made directly with large institutions by passing brokers and dealers

Derivatives Markets n Derivative securities - derive the value from underlying assets such as common shares or bonds n Option - a contract that grants the holder the right to buy or sell a security at a given price on or before a given date n Future contracts - agreements to trade assets at a specific price and time in the future n Two types of futures: -  commodity futures contract - Real commodities  commodity futures contract -  financial future contract - Financial obligations  financial future contract

Derivative Markets n Options trading occurs on: - Montreal exchange (ME) - Canada - Chicago Board Options Exchange (CBOT) - US n Option positions are issued and guaranteed by a clearing corporation: - Canadian Derivatives Clearing Corporation (CDCC) (Canada) - Options clearing corporation (OCC) (US)

Derivative Markets n Canada’s only commodity exchange is the Winnipeg commodity exchange (WCE) n Major North American Commodity exchanges include: - Chicago Board of Trade (CBOT) - Chicago Mercantile Exchange (CME)

Stock Market Indicators n Canadian indicators include: - TSE S & P TSE 60 - CDNX n International indicators include - Dow Jones Industrial Average (US) - S & P 500 Index (US) - Nasdaq Composite Index (US) - Nikkei 225 Average (Japan) - FTSE 100 Index (UK)

Summary 1.Efficient financial markets are required to channel funds from surplus-spending units (savers) to deficit-spending units. Typically, such securities entitle the holder to a stream of periodic future cash payments. 2.Financial intermediaries allow economies of scale to be realized when matching surplus- spending units with deficit-spending units. Greater opportunities for portfolio diversification and money management can be gained.

Summary 3.Financial markets encompass the institutions and procedures involved in the trading of financial assets. They include the money market (trading of short-term debt instruments) and the capital market (trading of long-term securities). The capital market can be subdivided further into the equity market and the bond market. 4.Equities are traded either on organized security exchanges, or on the over-the- counter market.

Summary 5.The Toronto Stock Exchange (TSE) is the largest secondary market in Canada. The New York Stock Exchange (NYSE) is the world’s premier secondary market. 6.Canadian OTC trading takes place through the Canadian Venture Exchange (CDNX). Most OTC trading in the United States takes place on the Nasdaq Stock Market.

Summary 7. The best-known market indicator in Canada is the TSE 300 Composite Index. The best- known stock market indicator in the United States is the Dow Jones Industrial Average (DJIA).