1. 7 7 Chapter The Financial System and Interest Slides Developed by: Terry Fegarty Seneca College

2. © 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 7 – Outline (1) The Financial System  Raising and Spending Money in Business  Term  Financial Markets  Capital and Money Markets  Primary and Secondary Markets  Transfer of Funds from Investors to Businesses  Financial Intermediaries The Stock Market and Stock Exchanges  Trading—The Role of Brokers  Market Regulation  Process of Going Public

3. © 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 7 – Outline (2) Interest  The Relationship Between Interest and the Stock Market  Interest and the Economy  Supply and Demand for Money The Components of an Interest Rate  Different Kinds of Lending Risk  Putting the Pieces Together  Risk Free and Real Rates  The Risk-Free Rate  The Real Rate of Interest  Yield Curves—The Term Structure of Interest Rates

4. © 2006 by Nelson, a division of Thomson Canada Limited 4 The Financial System Producers/Borrowers  Companies need to raise money to finance business activities Savers/investors  People need a place to deposit their savings and to earn a return The financial system facilitates the flow of savings from savers to borrowers

5. © 2006 by Nelson, a division of Thomson Canada Limited 5 The Financial System Financial markets connect producers’ need for money with investors’ available savings  Buyers and sellers of securities meet in financial marketplace Companies issue shares or bonds to raise money Savers purchase these securities hoping to earn return on their savings (investment) Return comes as interest from bonds or dividends and price appreciation from shares

6. © 2006 by Nelson, a division of Thomson Canada Limited 6 Raising and Spending Money in Business Businesses spend money on:  Day-to-day operations (inventory, wages, etc.) Money for these operations comes from generating revenue  Capital investments (new capital assets such as new production line, expansion overseas, etc.) Money is raised for capital investments in the financial marketplace Borrowed money is debt financing Money raised through the sale of shares is equity financing

7. © 2006 by Nelson, a division of Thomson Canada Limited 7 Term Term — length of time between now and end (or termination) of something Maturity matching  Long-term projects (typically those lasting over 5- 10 years) are usually financed with long-term funds Debt (bonds) Equity  Short-term projects (typically those lasting less than 1 year) are usually financed with short-term funds Bank loans

8. © 2006 by Nelson, a division of Thomson Canada Limited 8 Financial Markets Vehicles through which financial securities are bought, sold, and traded Financial markets may be classified as:  Capital or money markets  Primary or secondary markets

9. © 2006 by Nelson, a division of Thomson Canada Limited 9 Capital and Money Markets Capital Markets  Market for shares and long-term debt Money Markets  Market for short-term, high-quality debt securities with maturities of 1-year or less  Marketable securities such as commercial paper, notes, bills Federal government issues Treasury bills

10. © 2006 by Nelson, a division of Thomson Canada Limited 10 Primary and Secondary Markets Primary Market  Issuers sell new securities to investors Secondary Market  Investors sell existing securities to other investors  Most transactions occur in the secondary market  Corporations don’t raise money in the secondary market

11. © 2006 by Nelson, a division of Thomson Canada Limited 11 Transfer of Funds From Investors to Businesses Primary market transactions can occur  Directly (issuing firm sells securities to investors through an investment dealer) Helps companies market their securities  Indirectly (issuing firm sells securities to an institutional investor—such as a mutual fund Mutual fund buys securities and sells shares in the fund to buyers) Mutual fund owns specific stocks/bonds Investor in mutual fund owner owns shares in the fund

12. © 2006 by Nelson, a division of Thomson Canada Limited 12 Figure 7.2: Transfer of Funds From Investors to Businesses

13. © 2006 by Nelson, a division of Thomson Canada Limited 13 Financial Intermediaries Institutional investors  Mutual funds and similar financial intermediaries  Play major role in financial markets Own ¼ of all stocks but make over ¾ of all trades  Examples include Mutual funds Pension funds Insurance companies Banks and trust companies

14. © 2006 by Nelson, a division of Thomson Canada Limited 14 The Stock Market and Stock Exchanges Stock market—network of exchanges and brokers  Exchange—physical or electronic marketplace (TSX, OTC, NYSE)  Brokers—individuals who assist people in buying and selling securities Work for brokerage firms

15. © 2006 by Nelson, a division of Thomson Canada Limited 15 The Stock Market and Stock Exchanges Security Exchanges (Example: TSX)  Financial marketplace with specific requirements for listing and trading securities  Often are associated with a market index (i.e. TSX, Dow Jones, S&P 500, NASDAQ) Over-the-counter (OTC) Market  Public stock issues not traded on stock exchange  Dealers act as market makers

16. © 2006 by Nelson, a division of Thomson Canada Limited 16 Trading—The Role of Brokers What brokers do…  Investor will open an account with a broker and place trades via telephone or online  On TSX, buy and sell orders are matched electronically by exchange’s computerized system  Specialists make markets in designated securities  Confirmation of trade is forwarded to local broker and investor

17. © 2006 by Nelson, a division of Thomson Canada Limited 17 Market Regulation 10 provinces and three territories regulate own securities markets  Ontario Securities Commission — the most influential because it has the most investors and companies within its jurisdiction Securities law is primarily aimed at disclosure and prevention of unfair trading practices  For example, unfair use of insider information

18. © 2006 by Nelson, a division of Thomson Canada Limited 18 Process of Going Public (1) Assume a business is successful and the owner decides to raise money for expansion selling shares to others  Privately (closely) held companies—sale of securities severely restricted by regulation  Publicly traded (public) companies—have received approval of the Securities Commission to offer securities to general public Process of obtaining approval and registration is known as ‘going public’

19. © 2006 by Nelson, a division of Thomson Canada Limited 19 Process of Going Public (2) The Prospectus  Use investment dealer to determine If a market exists for shares of company The likely issue price for shares  Develop prospectus—provides detailed information about company Financial statements Key executives/background  Provincial Securities Commission reviews prospectus Prospectus not yet approved is called preliminary or a red herring

20. © 2006 by Nelson, a division of Thomson Canada Limited 20 Process of Going Public (3) The IPO  Once prospectus approved by SC, securities can be sold to public Initial sale is known as initial public offering (IPO) Market for IPOs very volatile and risky Prices can rise (or fall) very dramatically  Investment dealers usually line up buyers prior to actual sale of securities Buyers are usually institutional investors (bought deal)  IPO occurs in primary market

21. © 2006 by Nelson, a division of Thomson Canada Limited 21 Process of Going Public (4) The OTC Market  After company goes public, its shares are usually traded in over-the-counter (OTC) market  Nation-wide computerized network of brokers dealing in shares of small companies In U.S., The National Association of Securities Dealers Automated Quotation System (NASDAQ)  OTC trades are secondary market transactions

22. © 2006 by Nelson, a division of Thomson Canada Limited 22 Process of Going Public (5) Stock Exchange Listing  Eventually firm may wish to be listed on a stock exchange (ex; TSX)  Easier to sell future share issues  Must meet exchange’ requirements for size and length of time in business  Becomes listed company

23. © 2006 by Nelson, a division of Thomson Canada Limited 23 Figure 7.5: Stock Market Quotation for CIBC, Tuesday, June 22, 2004

24. © 2006 by Nelson, a division of Thomson Canada Limited 24 Interest Interest rates — the return on a debt instrument (for example, a bond)  Issuer of bond (borrower) pays interest to investor (lender)  There are many interest rates, including the prime rate, the bank rate, etc. Interest rates tend to move in tandem  Debt instruments are loans with a specified term (maturity date)

25. © 2006 by Nelson, a division of Thomson Canada Limited 25 The Relationship Between Interest and the Stock Market The stock market reacts to changes in interest rates Shares (equity) and bonds (debt) compete for investor’s dollars  Shares offer higher returns but have more risk If interest rates go up, bonds become more attractive The required return on shares would rise and therefore the price of shares would drop in the market  Interest rates and share prices move in opposite directions

26. © 2006 by Nelson, a division of Thomson Canada Limited 26 Interest and the Economy Would you be more likely to buy a house/car when interest rates are high or low? Interest rates have significant effect on the economy  Interest rates represent the cost of borrowing money (credit)  Lower interest rates stimulate business and economic activity

27. © 2006 by Nelson, a division of Thomson Canada Limited 27 Supply and Demand for Money Interest rates set by supply and demand in debt markets Supply—funds from those willing to lend money  Lenders (investors) buy debt securities such as bills, notes and bonds  Supply of borrowed funds depends on their willingness to invest their savings Affected by changes in the economy

28. © 2006 by Nelson, a division of Thomson Canada Limited 28 Supply and Demand for Money Demand — people, companies and governments desiring to borrow money  Borrowers sell bonds, etc. Demand for borrowed funds depends on  Opportunities available to use these funds  Attitudes of people and businesses about using credit If people feel good about the economy they will go on vacation, buy houses and cars, etc. Businesses will borrow for expansion and new projects

29. © 2006 by Nelson, a division of Thomson Canada Limited 29 Supply and Demand for Money The price — the interest rate  Borrowers will borrow more when interest rates low  Lenders will lend more (buy more bonds) when interest rates high

30. © 2006 by Nelson, a division of Thomson Canada Limited 30 The Components of an Interest Rate Interest rates include base rates and risk premiums Interest rate = k  k = base rate + risk premium Base Rate  Pure interest rate  Inflation adjustment Premium for Lender’s risk  Default risk  Liquidity risk  Maturity risk

31. © 2006 by Nelson, a division of Thomson Canada Limited 31 The Components of an Interest Rate The Base Rate  Base rate is pure interest plus expected inflation Rate at which people lend money when no risk is involved  Pure interest rate is rent paid to lenders for the use of their money An abstract rate that would exist in a perfect economy with no inflation or risk Generally considered to be between 2% and 4%

32. © 2006 by Nelson, a division of Thomson Canada Limited 32 The Components of an Interest Rate The Inflation Adjustment  Inflation — general increase in prices Money loses some of its value  If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year  Lender must charge interest rate higher than inflation rate Interest rates include estimates of average annual inflation over loan periods

33. © 2006 by Nelson, a division of Thomson Canada Limited 33 The Components of an Interest Rate Risk Premiums  Some loans are more risky than others  Lenders demand a risk premium of extra interest for making risky loans

34. © 2006 by Nelson, a division of Thomson Canada Limited 34 Different Kinds of Lending Risk Default Risk  The chance the borrower won't pay principal or interest, or will repay late Losses can be portion of or entire amount  Lenders demand a default risk premium which depends on lender’s perception of creditworthiness of the borrower Perception is based on the borrower’s financial condition and credit record

35. © 2006 by Nelson, a division of Thomson Canada Limited 35 Different Kinds of Lending Risk Liquidity Risk  Bond lending losses can be associated with fluctuations in prices of bonds  Associated with being unable to sell the bond of little known issuer  Sellers may have to reduce their prices to encourage investors to buy the illiquid securities  Liquidity risk premium is extra interest demanded by lenders as compensation for bearing liquidity risk  Very short-term securities (ex; commercial paper) usually bear little liquidity risk

36. © 2006 by Nelson, a division of Thomson Canada Limited 36 Different Kinds of Lending Risk Maturity Risk  Bond prices and interest rates move in opposite directions  If interest rates increase after an investor purchases a bond, its price will decline The investor will take a loss if he or she sells before maturity  Long-term bond prices change more with interest rate swings than short-term bond prices Gives rise to maturity risk  Investors demand a maturity risk premium Ranges from 0% for short-term securities to 2% or more for long-term issues

37. © 2006 by Nelson, a division of Thomson Canada Limited 37 Putting the Pieces Together The Interest Rate Model  k = k Pure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium  k — the nominal or quoted interest rate  Model explains interest rate needs of investors  However, rates set by supply and demand

38. © 2006 by Nelson, a division of Thomson Canada Limited 38 Risk-Free and Real Rates Federal Government Securities  Federal government issues many short-term securities Treasury bills and short-term bonds Treasury bills have terms from 90 days to a year ST bonds have terms from 1 to 10 years  No default risk associated with federal government debt Can print money to pay off its debt  No liquidity risk for federal government debt Always an active market

39. © 2006 by Nelson, a division of Thomson Canada Limited 39 The Risk-Free Rate The risk-free rate is approximately the yield on short-term Treasury bills  Includes the pure rate and an allowance for inflation Same as the base rate discussed earlier Viewed as current minimum interest rate  No investment that does have risk can offer a lower rate

40. © 2006 by Nelson, a division of Thomson Canada Limited 40 The Real Rate of Interest The real interest rate is current interest rate less inflation adjustment Tells investors whether or not they are getting ahead  If you earn a real rate of 8% on investment and inflation is 10%, you are losing purchasing power on investment The Real Risk-Free Rate  Implies that both the inflation adjustment and the risk premium are zero  = the pure interest rate

41. © 2006 by Nelson, a division of Thomson Canada Limited 41 Yield Curves—The Term Structure of Interest Rates Interest rates generally vary with term of debt  The relationship is known as the term structure of interest rates  The yield curve is a graph of interest rates compared to terms for similar loans Most of the time short-term rates are lower than long-term rates (normal yield curve)  At times opposite is true Known as an inverted yield curve

42. © 2006 by Nelson, a division of Thomson Canada Limited 42 Figure 7.6: Yield Curves

43. © 2006 by Nelson, a division of Thomson Canada Limited 43 Yield Curves—The Term Structure of Interest Rates Theories to explain the term structure of interest rates  Expectations theory Today's rates rise or fall with term as future rates are expected to rise or fall  Liquidity preference theory Lenders prefer shorter term loans and must receive higher interest rates to make longer loans  Market segmentation theory Loan terms define independent segments of the debt market which set separate rates