1. Copyright © 2014 Pearson Canada Inc. Chapter 2 AN OVERVIEW OF THE FINANCIAL SYSTEM Mishkin/Serletis The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition

2. Copyright © 2014 Pearson Canada Inc. 2-2 Learning Objectives 1.Summarize the basic function performed by financial markets 2.Explain why financial markets have several classifications 3.Describe the principal money market and capital market instruments 4.Express why the government regulates financial markets and financial intermediaries

3. Copyright © 2014 Pearson Canada Inc. 2-3 Function of Financial Markets Channel funds from economic players that have surplus funds to those that have a shortage of funds Direct finance –borrowers borrow funds directly from lenders in financial markets by selling them securities

4. Copyright © 2014 Pearson Canada Inc. 2-4 Function of Financial Markets (cont’d) Promotes economic efficiency by producing an efficient allocation of capital Directly improves the well-being of consumers by allowing them to time purchases better

5. Copyright © 2014 Pearson Canada Inc. 2-5 Flows of Funds Through the Financial System

6. Copyright © 2014 Pearson Canada Inc. 2-6 Structure of Financial Markets: Debt Markets Debt instruments –a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date) Maturity –short-term (maturity < 1 year) –intermediate-term (maturity >1 and < 10 years) –long-term (maturity > 10 year)

7. Copyright © 2014 Pearson Canada Inc. 2-7 Structure of Financial Markets: Equity Markets Equity Markets - Common stocks –some make dividend payments –equity holders are residual claimants Primary Market –new security issues sold to initial buyers Secondary Market –securities previously issued are bought and sold

8. Copyright © 2014 Pearson Canada Inc. 2-8 Structure of Financial Markets: Equity Markets (cont’d) Brokers –agents of investors who match buyers with sellers of securities Dealers –link buyers and sellers by buying and selling securities at stated prices

9. Copyright © 2014 Pearson Canada Inc. 2-9 Structure of Financial Markets: Secondary Markets Exchanges and Over-the-Counter (OTC) Markets –Exchanges: Toronto Stock Exchange, NYSE –OTC Markets: Dealers at different locations buy and sell Money and Capital Markets –Money markets deal in short-term debt instruments –Capital markets deal in longer-term debt and equity instruments

10. Copyright © 2014 Pearson Canada Inc. 2-10 Structure of Financial Markets: Maturity Money and Capital Markets –Money markets deal in short-term debt instruments (maturity < 1 year) –Capital markets deal in longer-term debt and equity instruments (maturity > 1 year)

11. Copyright © 2014 Pearson Canada Inc. 2-11 Money Market Instruments Government of Canada Treasury Bills Certificates of Deposit Commercial Paper Repurchase Agreements Overnight Funds

12. Copyright © 2014 Pearson Canada Inc. 2-12 Principal Money Market Instruments

13. Copyright © 2014 Pearson Canada Inc. 2-13 Capital Market Instruments Stocks Mortgages and mortgage-backed securities Corporate bonds Government of Canada bonds Canada Savings bonds Provincial and municipal government bonds Government agency securities Consumer and bank commercial loans

14. Copyright © 2014 Pearson Canada Inc. 2-14 Principal Capital Market Instruments

15. Copyright © 2014 Pearson Canada Inc. 2-15 Internationalization of Financial Markets Foreign Bonds –sold in a foreign country and denominated in that country’s currency Eurobond –bond denominated in a currency other than that of the country in which it is sold Eurocurrencies –foreign currencies deposited in banks outside the home country –Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

16. Copyright © 2014 Pearson Canada Inc. 2-16 Function of Financial Intermediaries: Indirect Finance 1.Reduce transaction costs (time and money spent in carrying out financial transactions) –economies of scale –liquidity services 2.Reduce the exposure of investors to risk –risk Sharing (asset transformation) –diversification

17. Copyright © 2014 Pearson Canada Inc. 2-17 Function of Financial Intermediaries: Indirect Finance (cont’d) 3.Deal with asymmetric information problems a.Adverse Selection before the transaction avoid selecting the risky borrower gather information about potential borrower b.Moral Hazard after the transaction ensure borrower will not engage in activities that will prevent him/her to repay the loan sign a contract with restrictive covenants

18. Copyright © 2014 Pearson Canada Inc. 2-18 Types of Financial Intermediaries Depository Institutions –Chartered Banks –Trusts and Mortgage Loan Companies –Credit Unions and Caisses Populaires Contractual Savings Institutions –Life Insurance Companies –Property and Casual Insurance Companies –Pension Funds and Government Retirement Funds

19. Copyright © 2014 Pearson Canada Inc. 2-19 Types of Financial Intermediaries (cont’d) Investment Intermediaries –Finance Companies –Mutual Funds –Money Market Mutual Funds

20. Copyright © 2014 Pearson Canada Inc. 2-20 Primary Assets and Liabilities of Financial Intermediaries

21. Copyright © 2014 Pearson Canada Inc. 2-21 Relative Shares of Financial Institutions and Pension Plans

22. Copyright © 2014 Pearson Canada Inc. 2-22 Regulation of Financial Markets Primary Reasons for Regulation: 1. Increase information to investors -reduce adverse selection and moral hazard problems -increase efficiency of financial markets by increasing the amount if information available to investors -provincial securities & exchange commissions require corporations to disclose information and restrict insider trading

23. Copyright © 2014 Pearson Canada Inc. 2-23 Regulation of Financial Markets (cont’d) 2. Ensuring the soundness of intermediaries -prevents financial panics -restrictions on entry/assets/activities; disclosure; deposit insurance; limits on competition 3. Improve control of monetary policy

24. Copyright © 2014 Pearson Canada Inc. 2-24 Principal Regulatory Agencies of the Canadian Financial System