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Chapter 15 Money, Banking, and Securities Markets Copyright © 2006 Pearson Education Canada Inc. 15-1 Learning Objectives Define money and identify the different forms it takes in Canada’s money supply. Describe the different kinds of financial institutions that make up the Canadian financial system and explain the services they offer. Explain the functions of the Bank of Canada and describe the tools it uses to control the money supply. Copyright © 2006 Pearson Education Canada Inc. 15-2 Learning Objectives Discuss the value of common stock and preferred stock to shareholders and describe the secondary market for each type of security. Describe the investment opportunities offered by mutual funds and commodities. Explain the process by which securities are bought and sold. Copyright © 2006 Pearson Education Canada Inc. 15-3 Money Any object generally accepted by people as payment for goods and services Characteristics: Portable: lightweight and easy to handle Divisible: easily broken down to match the value of goods Durable: must not spoil or easily wear out Stable: must be stable enough to hold its value over time, apart from minor fluctuations Copyright © 2006 Pearson Education Canada Inc. 15-4 Functions of Money Medium of exchange A single medium of exchange for goods and services instead of barter Store of value Can be used for future purchases Unit of account Allows measurement of the relative value of goods and services Copyright © 2006 Pearson Education Canada Inc. 15-5 The Money Supply Buyers and sellers must agree on the value of money The value of money is dependent on its supply As supply increases, value decreases As supply decreases, value increases Consists of both M-1 and M-2 forms of money Copyright © 2006 Pearson Education Canada Inc. 15-6 M-1 Money Supply The most liquid forms of money Currency: paper money and coins issued by the Canadian government Demand deposits: money in chequing accounts, which can be transferred to others by cheque Copyright © 2006 Pearson Education Canada Inc. 15-7 M-2 Money Supply Everything in the M-1 money supply plus Savings deposits: savings account holdings Time deposits: deposit requiring prior notice before withdrawal of funds Money market mutual fund investments Measures the store of monetary value that is available for making financial transactions Copyright © 2006 Pearson Education Canada Inc. 15-8 Credit Cards Not included in M-1 or M-2 money supplies Major source of consumer spending Are a substitute for money, but they are not money Are privately issued and very profitable due to annual fees, merchants fees & interest Copyright © 2006 Pearson Education Canada Inc. 15-9 Financial Institutions Traditionally consisted of four financial pillars Chartered banks Alternate banks (trust companies, credit unions, caisses populaires) Life insurance companies and specialized lending and saving intermediaries Investment dealers Changes due to deregulation of the banking industry Copyright © 2006 Pearson Education Canada Inc. 15-10 Pillar #1: Chartered Banks Privately owned, profit-oriented, financial intermediary Largest and most important of financial institutions Each bank has many branches Schedule A banks Must be Canadian-owned with no more than 10% of voting shares controlled by a single interest (90% of all bank assets) Schedule B banks May be foreign-owned and need not meet the 10% limit (foreign-owned bank deposits cannot exceed 8% of the total domestic assets of all banks) Copyright © 2006 Pearson Education Canada Inc. 15-11 Services Offered by Banks Pension services Trust services International services Financial advice Buy/sell securities Electronic Fund Transfer (EFT) Debit Card Bank deposits Bank loans Bank accounts Copyright © 2006 Pearson Education Canada Inc. 15-12 Electronic Fund Transfers (EFT) Debit cards Plastic money that immediately adjusts the consumers account balance and pays the merchant Smart cards A credit card sized computer that can be programmed with “electronic money” Ecash Money that moves among consumers and businesses via digital electronic transmission Copyright © 2006 Pearson Education Canada Inc. 15-13 Bank Deposits Accept deposits from some customers to obtain money to lend to others Chequing accounts Term deposits (money that remains with the bank for a period of time with interest paid to the depositor) Copyright © 2006 Pearson Education Canada Inc. 15-14 Bank Loans Major source of short-term financing for business Banks prefer to finance inventories or accounts receivable rather than provide longterm loans to many businesses Secured loan Backed by collateral (e.g.: Inventory) Unsecured loan Not backed by property Prime rate of interest Lowest rate charged to best customers Copyright © 2006 Pearson Education Canada Inc. 15-15 Banks As Creators of Money Bank 1 2 3 4 5 6 7 8 9 Totals for the first nine banks Expansion limit for entire banking system New Deposit Reserve Requirement New Loan $100.00 $90.00 $81.00 $72.90 $65.61 $59.05 $53.14 $47.83 $43.05 $10.00 $9.00 $8.10 $7.29 $6.56 $5.91 $5.31 $4.78 $4.31 $90.00 $81.00 $72.90 $65.61 $59.05 $53.14 $47.83 $43.05 $38.74 $612.58 $61.26 $551.32 $1,000.00 $100.00 $900.00 Copyright © 2006 Pearson Education Canada Inc. 15-16 Other Changes in Banking Changes in customer preferences Deregulation is causing banks to shift from their historical role as intermediaries between borrowers and depositors ING direct, president’s choice financial Deregulation Diversification into other financial products Investment banking Commercial paper International banking Copyright © 2006 Pearson Education Canada Inc. 15-17 The Bank of Canada The central bank of Canada Managed by a Board of Governors Regulates operations of the chartered banks Manages the economy by manipulating the money supply to expand or restrict the economy Copyright © 2006 Pearson Education Canada Inc. 15-18 Monetary Policy Actions of the Bank of Canada Expansionary Policy Restrictive Policy Tools (stimulate business activity and increase the money supply) (slow down business activity and decrease the money supply) Open Market Operations Buy government securities: Sell government securities: (increases bank reserves (decreases bank reserves enabling banks to make loans to businesses and consumers) limiting the banks' abilities to make loans to businesses and consumers) Lower the bank rate: Raise the bank rate: (increase the willingness of (decrease the willingness of Bank Rate banks to borrow, more loans can be made to businesses and consumers) Copyright © 2006 Pearson Education Canada Inc. banks to borrow, fewer loans can be made to businesses and consumers) 15-19 Pillar #2: Alternate Banks Trust companies Safeguard funds and estates entrusted to it Serves as a trustee, transfer agent, & registrar for corporations Credit unions (Caisses Populaires) Cooperative savings and lending institution formed by a group of individuals with common interests Offer savings accounts, loans, mortgages to members Invest its own funds in corporate & government securities Copyright © 2006 Pearson Education Canada Inc. 15-20 Pillar #3: Specialized Lending and Savings Intermediaries Life insurance firms Factoring companies Financial corporations Venture capital or development firms Pension funds Copyright © 2006 Pearson Education Canada Inc. 15-21 Life Insurance Firms Life insurance companies Mutual or stock company that shares risks with policy holders for payment of premiums Some money from premiums is lent back out Substantial investments in real estate, mortgages and government bonds Largest financial intermediaries in Canada next to the chartered banks Copyright © 2006 Pearson Education Canada Inc. 15-22 Factoring Companies Buy uncollected accounts receivable from a firm for less than its face value Attempts to collect the face value of the receivables from customers The difference between the amount collected and the cost of the receivables is the firm’s profit Allows firms with old, or uncollectible, accounts receivable to redeem at least part of their value rather than writing them off completely Copyright © 2006 Pearson Education Canada Inc. 15-23 Financial Corporations Sales finance company Finances instalment purchases made by individuals or businesses Loans are secured by the item being financed (e.G.: Computer) Consumer finance company Makes personal loans to consumers Collateral may or may not be required Copyright © 2006 Pearson Education Canada Inc. 15-24 Venture Capital Firms Provide funds for new or expanding firms that have great potential Obtains funds from individual investors, financial intermediaries, retained earnings While accepting increased risk with new ventures, VC firms seek to earn higher than normal returns Copyright © 2006 Pearson Education Canada Inc. 15-25 Pension Funds Accumulate cash that will be paid out to subscribers in the future in the form of pension income Money is invested until it is needed Investments include stocks and bonds, mortgages Copyright © 2006 Pearson Education Canada Inc. 15-26 Pillar #4: Investment Dealers Stock brokers or underwriters Primary distributors of new stock and bond issues (underwriting) Facilitate trading of stocks and bonds, both on stock exchanges and on overthe-counter stock and bond markets Copyright © 2006 Pearson Education Canada Inc. 15-27 Other Sources of Funds Government financial institutions and granting agencies Business Development Bank of Canada (BDC) Canada Mortgage and Housing Corporation (CMHC) Export Development Corporation Canada and its provinces borrow from international sources of funds, including other nations The Canadian Capital Market (international funds) Copyright © 2006 Pearson Education Canada Inc. 15-28 Exchange Rates and Trade Exchange rates influence the willingness of Canadians to invest abroad and buy imported items (or vice versa) A trade surplus occurs when Canada is exporting more products than it is importing (likely to occur when the dollar is undervalued) A trade deficit occurs when Canada is importing more products than it is exporting (likely to occur when the dollar is overvalued) Copyright © 2006 Pearson Education Canada Inc. 15-29 The Law of One Price A basic commodity should be priced equally across all countries If prices differ it is assumed to be due to over or under valuation of the local currency Country The Big Mac Index Big Mac Price (Local Dollar) Big Mac Price Equiv. (US Dollars) Over/Under Valuation $2.71 $2.71 -- Denmark 27.75 krone 4.10 +51% Switzerland 6.30 Francs 4.50 +69% Britain 1.99 pounds 3.14 +16% Japan 262 yen 2.19 -19% United States Copyright © 2006 Pearson Education Canada Inc. 15-30 International Payments Process Local banks convert payments to the currency required by foreign trade associates Local banks then send payment, in foreign currency, to the foreign trade partner The foreign trade partner deposits the payment in his/her own foreign-based bank When equal values of money are moving back and forth between nations, no real funds need to be transferred between nations because the payments are in balance Banks also trade currencies Copyright © 2006 Pearson Education Canada Inc. 15-31 International Bank Structure International banking is governed by a network of loose agreements between individual countries or groups of countries. The World Bank and the International Monetary Fund (IMF) assist by financing international trade IMF 150 nations who combined resources to promote stable exchange rates, provide temporary short-term loans, encourage cooperation on international monetary issues, and develop a system for international payments Copyright © 2006 Pearson Education Canada Inc. 15-32 Securities Primary securities market Sale and purchase of newly issued stocks or bonds offered by firms and governments Secondary securities market Sale & purchase of previously issued stocks & bonds Investment banker Any financial institution engaged in purchasing and reselling new stocks and bonds Copyright © 2006 Pearson Education Canada Inc. 15-33 Characteristics of Common Stocks Market value Current price of a share the secondary securities market Capital gains Profits from the sale of an asset (i.e.: Stocks) Book value Shareholders’ equity divided by the number of shares of common stock outstanding Of limited usefulness in evaluating investments Copyright © 2006 Pearson Education Canada Inc. 15-34 Preferred Stock Issued with a stated par value Dividends paid based on a percentage of par value Value of the stock can rise or fall with the fortunes of the company Less risky than common stock Limited growth potential due to the fixed dividend Copyright © 2006 Pearson Education Canada Inc. 15-35 Stock Exchanges Voluntary organization of individuals formed to provide an institutional setting where members can buy and sell stock for themselves and their clients in accordance with the rules of the exchange To become a member a firm must purchase seats Only members (or their representatives) are allowed to trade on the exchange All trading must go through members of the exchange Copyright © 2006 Pearson Education Canada Inc. 15-36 Stockbrokers Individuals licensed to buy and sell securities for customers in the secondary market Full-service brokerage For a reasonable fee, offers a variety of services including buying, selling, and investment advice Discount brokerage For a reduced fee, buys and sells securities, but has limited service offerings Copyright © 2006 Pearson Education Canada Inc. 15-37 The Over-the-Counter Market (OTC) Organization of securities dealers formed to trade stock outside the formal institutional setting of the organized stock exchanges Many securities are not listed on a stock exchange OTC markets consist of numerous dealers who own the securities that they buy and sell at their own risk Also trade all fixed-income securities, which includes bonds and debentures Copyright © 2006 Pearson Education Canada Inc. 15-38 Bonds Bond A written promise that the borrower (firm) will pay the lender (investor) at a stated future date, the principal plus a stated rate of interest Bonds differ from one another in terms of maturity (payment date), tax status, potential yield (interest rate) Several companies rate the quality of various bonds (Moody’s, Standard and Poor’s) Copyright © 2006 Pearson Education Canada Inc. 15-39 Corporate Bonds Secured Assets are pledged as security for the bond Unsecured (debentures) These bonds are not backed by any security Only sold by financially strong corporations that carry lower risk for investors Bearer (coupon) bonds Holders clip coupons from the bond to receive interest payments: anyone with the coupon can redeem it Registered bonds Certificates are only of value to registered holders Copyright © 2006 Pearson Education Canada Inc. 15-40 Retiring Bonds Callable bonds May be called at anytime, or after a certain minimum period of time, for a specified fee Sinking fund provision The company must put money into a special bank account each year, such that at the time of maturity, there is sufficient money to retire the bonds Serial bond Redemption rates are staggered so that the bond is paid off gradually over time Convertible Option of receiving common stock in lieu of cash Copyright © 2006 Pearson Education Canada Inc. 15-41 Mutual Funds A company pools the resources of many investors and uses funds to purchase various types of financial securities (a portfolio) Different funds have different goals (stability, growth, etc.) And different levels of risk Investments are professionally managed No-load fund Investors are not charged a sales commission when they buy into or sell out of a fund Copyright © 2006 Pearson Education Canada Inc. 15-42 Commodities Futures contract Agreement to purchase specific amounts of a commodity at a certain price on a set date in the future Risky investment with many variables Commodities market A market in which futures contracts are traded Investors can buy on “margin,” with a minimal amount as a down payment Copyright © 2006 Pearson Education Canada Inc. 15-43 Stock Options Stock option The purchased right to buy or sell a stock Call option The purchased right to buy a particular stock at a certain price until a specified date Put option The purchased right to sell a particular stock at a certain price until a specified date Copyright © 2006 Pearson Education Canada Inc. 15-44 Reading Bond Quotations Company Name Maturity Date Coupon (April 8, 2022) (interest rate %) Your Daily Paper Issuer Coupon BC Tel 9.65 Maturity Price Apr 8-22 138.5 Yield Change 6.488 +1.118 Change Price (Last transaction price = $138.50) Yield (Annual interest Market price) Copyright © 2006 Pearson Education Canada Inc. (Closing price up $1.11 from previous day) 15-45 Reading Stock Quotations Stock Sales Close (Total number of shares traded) (Last price paid at close of trading) Your Daily Paper Company Inco Sales High Low Close 376 030 29.150 28.500 28.600 High (Highest price paid per share for the day was $29.15) Change -.400 Change Low (Lowest price paid per share for the day was $28.50) (Difference between today’s price and previous day’s. A .40 decrease) Copyright © 2006 Pearson Education Canada Inc. 15-46 Reading the Market Market indexes A measure of the market value of stocks Summarize trends in the stock market and specific industries S&P/TSE Average, Dow Jones Industrial Average Standard & Poor’s composite index, NASDAQ Composite Index Bear market: a period of falling stock prices Bull market: a period of rising stock prices Copyright © 2006 Pearson Education Canada Inc. 15-47 Buying and Selling Stocks Market order Order to buy/sell a security at the current market price Limit order An order to buy a security but only if its price is less than, or equal to, a certain level Stop order Order to sell a security if its price falls below a level Round lot The purchase or sale of shares in units of 100 Odd lot The purchase or sale of shares in units of other than 100 Copyright © 2006 Pearson Education Canada Inc. 15-48 Margin Trading The investor makes a down payment on a portion of the price with the rest financed by the broker The broker borrows the amount from the bank, secured by stock The broker charges the investor a higher rate of interest than he/she pays the bank Investors can pay off the financing when they sell the stock, hopefully at a profit Margin trading is very risky Copyright © 2006 Pearson Education Canada Inc. 15-49 Short Sale An investor sells shares from the broker without paying for them The investor is “borrowing” the shares from the broker for a period of time In order to return the borrowed shares, the investor must purchase the equal number of shares later and return them to the broker Profit or loss is based on the spread between the selling price and the purchasing price Copyright © 2006 Pearson Education Canada Inc. 15-50 Securities Regulations Brokers are licensed and securities are registered Blue-sky law Laws regulating how firms back up securities Prospectus A detailed registration statement about a new stock Insider trading Illegal activity of using special (inside) knowledge about a firm to make a profit Copyright © 2006 Pearson Education Canada Inc. 15-51