CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 2:

The Domestic and Global Financial Marketplace

INTRODUCTION

This chapter looks at the domestic and international financial marketplaces within which Canadian business firms operate.

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CENTRAL BANKING

The Bank of Canada (Canada’s Central Bank) was created to:

Manage the growth of the money supply

Act as banker for Government of Canada

Act as banker for Canadian chartered banks

Act as lender of last resort

Administer the Bank Act Administer and regulate the orderly buying and selling of

Canadian dollars in foreign exchange markets

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BANK RESERVE RATIOS Reserve Ratio: fraction of $1 on deposit with a chartered

bank that must be held “in reserve” with the Central Bank

Example: a 10% reserve ratio within the banking system

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New Deposit Bank Lends Reserve

$100 $90.00 $10.00

$90 $81.00 $9.00

$81 $72.90 $8.10

$72.90 $65.61 $7.29

BANK RESERVE RATIOS By adjusting the Reserve Ratio, the Central Bank can make

the money supply more responsive to injections into or withdrawal from the banking system.

The higher the Reserve Ratio, the smaller the multiplier effect from an injection of new money into the banking system

The lower the Reserve Ratio, the greater the multiplier effect from an injection of new money into the banking system

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BANK RESERVES Historically, Canadian chartered banks were required to

maintain both primary and secondary reserves at the Bank of Canada.

Requirement for holding primary reserves at the Bank of Canada was phased out by July, 1994.

Today, Canadian chartered banks attempt to maintain a zero balance in their settlement account at the Bank of Canada.

Secondary reserves for Canadian Chartered Banks were eliminated in June, 1992.

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MONETARY POLICY

Monetary Policy refers to the different tools and actions that the Bank of Canada can use to manage price stability (inflation) and Canadian interest rates.

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INTEREST RATES

Canadian interest rates affect domestic economic activity Low interest rates stimulate economic activity High interest rates dampen economic activity

The value of the Canadian dollar in foreign exchange markets Low interest rates – Canadian dollar falls High interest rates – Canadian dollar rises

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IMPORTANT INTEREST RATES

Bank Rate: interest rate charged to borrow from the Bank of Canada. Set at upper bound of the “Operating Band”.

Overnight Rate: interest rate charged on short-term loans between chartered banks The Bank of Canada will attempt to keep this rate within the

“Operating Band”.

Prime Rate: lowest published rate banks charge on loans to large, creditworthy business customers

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THE CANADIAN FINANCIAL SYSTEM

Primary function is to facilitate the flow of savings from savers to borrowers

This occurs through two primary channels: Financial intermediaries (such as Chartered Banks, Trust

Companies & Credit Unions) Direct (but facilitated by Investment Banks)

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CANADIAN FINANCIAL SYSTEM

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Savers

Borrowers

Intermediated: Banks & Near

Banks

Cash

Securities

Direct:Investment

Banks

Cash

Securities

Cash

Securities

TYPES OF FINANCIAL INSTITUTIONS Chartered Banks

Trust Companies

Credit Unions (Caisses Populaires)

Investment Companies

Pension Funds

Insurance Companies

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FINANCIAL ASSETS Debt securities: represent evidence of the indebtedness of

Party A to Party B

Equity securities: represent evidence of ownership

Derivative securities: contracts deriving value from another underlying asset

Note: every financial asset is offset by an identical financial liability somewhere in the financial system.

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FINANCIAL MARKETS The vehicles through which financial assets are bought, sold,

and traded.

Financial markets may be classified as: Money or capital markets Primary or secondary markets

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MONEY AND CAPITAL MARKETS Money markets: market for short-term, high-quality debt

securities with maturities of 1-year or less

Capital markets: market for long-term securities (both debt & equity) having maturities greater than 1-year

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PRIMARY AND SECONDARY MARKETS Primary market: refers to the process whereby issuers sell

new securities to investors

Secondary market: refers to the process whereby investors sell existing securities to other investors

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SECONDARY MARKETS Security Exchanges (Example: TSX)

Formal 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 any domestic stock exchange A virtual, negotiated market. Dealers act as market makers

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MARKET REGULATION

The 10 provinces and three territories regulate the securities markets within their borders.

The Ontario and Quebec Securities Commissions are the most influential because they have the most investors and companies within their jurisdiction.

Regulation of Canadian securities markets is a contentious issue, with several different proposals currently in circulation designed to increase harmonization among the provinces

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SERVICES OF INVESTMENT DEALERS Creation of offer documents (such as a Prospectus)

Providing long-range financial planning assistance

Providing guidance concerning the timing of security issues

Marketing securities to potential investors

Arranging private loans and leases

Negotiating mergers

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HOW SECURITIES ARE SOLD Public cash offering: securities are sold to the public

through an investment dealer

Private, or direct placement: securities are sold to one or more large investors

Rights offering: a new issue of common stock is sold to existing shareholders at an offer price below the current market price

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INTERNATIONAL FINANCE

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Global FinancialTransaction Decisions

Licensing Arrangements

Joint Ventures

Become a Multinational Corporation

Import

Export

Open a Foreign Branch

GLOBAL RISKS

Fluctuating exchange rates

Changing government regulations

Changing tax laws

Unfamiliar business practices

Shifting political environments

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EUROMARKET Euromarket: the market for loans/deposits in currencies

other than the currency of the country where the transaction occurs.

Eurocurrency: any currency on deposit outside of the country that issued the currency

Examples: Eurodollar – US dollars on deposit outside of the United States Euroyen – Japanese yen on deposit outside of Japan

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EURO

Currency used throughout the European Union (entered circulation Jan 1, 2002)

Symbol for the Euro is €

The Euro is currently used by 12 members of the European Union (Spring, 2004)

The Euro is not a Eurocurrency (although it would be if it were put on deposit outside of the European Union

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SOME IMPORTANT TERMS

Exchange rate: rate that one currency can be bought or sold for another

Direct quote: home currency price for one unit of foreign currency Example: $1.4230 CAD per $1.00 US

Indirect quote: foreign currency price of one unit of domestic currency Example: $0.7027 US per $1.00 CAD

Spot rate: current exchange rate

Forward exchange rate: exchange rate for a transaction to take place in the future 25

FUTURES & FORWARD CONTRACTS Both futures and forward contracts allow one to agree today

to an exchange to take place in the future, at a price agreed upon today.

May be used to either hedge (reduce risk) or speculate (assume additional risk with the hope of making a profit)

Example: An exporter has a US $100,000 receivable coming due in 30 days. To reduce exchange rate risk, the exporter can sell the US dollars today for delivery in 30 days time, at a price agreed upon today

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FUTURES VERSUS FORWARD CONTRACTS

Futures Forwards

Exchange traded Trade OTC

Standardized Customized

Marked-to-Market daily (profits & losses flow

through margin account)

Profits/losses realized only at contract expiry

Requires margin account No margin required

No default risk (due to Clearinghouse)

Default risk exists (no Clearinghouse)

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FOREIGN CURRENCY OPTIONS Call Option

buyer has the right, but not the obligation, to buy at a specified price for a specified period of time

Put Option buyer has the right, but not the obligation, to sell at a specified

price for a specified period of time

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EFFECT OF INCOME TAXES

Taxes affect most financial transactions:

Capital budgeting: after-tax cash flows, depreciation, net present value (NPV)

Capital structure policy: tax advantage of debt financing

Dividend policy: capital gains versus dividend policy

Leasing: motivated by tax effects

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CORPORATE TAX RATES Progressive Tax System

Marginal tax rate increases as income increases

Marginal Tax Rate Tax rate applied to the last dollar of income

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CANADIAN INCOME TAXATION

Corporate Income Tax

Average tax rate: Total taxes paid/total taxable income

Marginal tax rate: tax rate applied to the last dollar of taxable income

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CANADIAN INCOME TAXATION

Capital Gains 50% inclusion rate

Dividend Income dividends between Can. firms not taxed dividends received by a Can. firm from a non-Can. firm taxed

as ordinary income dividends received personally subject to gross-up & tax credit

Loss Carrybacks and Carryforwards current year losses may be used to reduce taxes paid in a prior

year or to reduce future tax liabilities32

MAJOR POINTS

The Bank of Canada plays a significant role in the management of the money supply.

Securities trade on exchanges or over-the-counter markets which may be classified as primary or secondary.

Market regulation is carried out by each province and territory.

Taxes affect all financial transactions and business decisions. 33