Characteristics of Financial Instruments

1
Characteristics of Financial Instruments

• Reading Siklos Chapters 4

2
Objectives

• Characteristics of Financial Market Instruments
• Money Market Instruments
• Capital Market Instruments
• Financial Innovations and market efficiency

3
Money Market instruments have maturities of less
than one year and serve as a key link in the
transmission of monetary policy.
Capital Market instruments have maturities that
exceed one year.
4
Definitions

• Basis point one-hundredth of one percentage
  point.
• e.g. 0.5 is 50 basis points.
• Par value the value of a financial instrument
  that is equivalent to its maturity value.
• Open Market Operations the purchase or sale of
  government securities in the open market.
• Bank Rate the rate of interest charged by the
  Bank of Canada on loans made to chartered banks.
• Systematic Risk risk associated with the fact
  that changes in the price of an asset changes
  systematically with the price of other assets.

5
The Money Market(Most Important)

• Overnight Market

• shortest available term to maturity
• Lenders earn interest by making their surplus
  funds available until the following business day.
• The operating band for the overnight market
  consists of a basis point range for the overnight
  rate. The overnight rate fluctuates between the
  upper and lower limits of the operating band.
• Bank of Canada sets the overnight rate to
  conduct monetary policy.

6
The Money Market(contd)

• Treasury Bills

• Mature 91-365 days
• Sold at a discount relative to its par value.
• issued by the Federal Government through
  bi-weekly auctions
• large secondary market
• rate fluctuates according to overnight market
  band
• useful indicator of monetary policy stance

7
The Operating Band for the Overnight Market
Overnight Market Rates
Bank Rate
OPERATING BAND
BOC target rate mid-point of range
Rate on ve balances Bank rate less 0.50
Overdraft
Surplus
ON(BRtRtsb)/2
8
The Money Market contd

• The Large Value Transfer System (LVTS)
• Assists in the operations of the clearing system
• Attempting to reduce systematic risk
• Not, strictly speaking, an instrument
• Created by the CPA (Canadian payments Association

9
The Money Market (contd)

• Used to influence overnight rates
• Can be implemented at short notice and has been
  used more frequently of late.
• Widely used as a method of high quality
  short-term finance
• large and active secondary mkt.

• Special Purchase and Resale Agreements (SPRA)
• Bankers Acceptances
• Short-term loan used by BOC to affect liquidity
  in Financial Markets.

10
The Money Market (contd)

• Special Purchase and Resale Agreements (SPRA)
  (contd)

• If participant is LVTS is LVTSi while
  participant js LVTS balance are LVTSj then we
  would expect

LVTSi LVTSj 0
ONt gt ONt use an SPRA ONt lt ONt use an SSRA
11
The Money Market (contd)

• Interbank deposits
• Eurocurrency instruments

• Growth reflects globalization and importance of
  interbank transactions
• useful as a cash management tool
• offshore financial market in several centers
  (London UK most important)
• highly liquid, low tax and transactions costs
• useful guide for intl int rate developments

12
The Money Market (contd)

• Purchase and Resale Agreements (PRAs)
• Day-to-day Loans and Special Call Loans

• Operated like SPRAs but are initiated by money
  market dealers
• Represent the overnight market
• Ready source of liquidity
• Signals of monetary policy

13
The Money Market (contd)

• Corporate and Finance Company Paper
• Certificated of Deposits (CDs)

• Large firms borrowing funds from the money market
  directly
• Bank deposit promising a fixed return o a large
  sum for a specified maturity
• Penalties may be imposed for early withdrawal.

14
Bank of Canada Advances
Source Siklos, Pierre L., Money, Banking and
Financial Institutions, 4th Edition. McGraw-Hill
Ryerson2004
15

• Bank of Canada Advances
• lender of last resort loan
• access by CPA members
• Loans usually made for one business day
• Loan rate is equal to the bank rate
• Actively discouraged source of borrowing

16
Financing Through an SPRA
Source Siklos, Pierre L., Money, Banking and
Financial Institutions, 4th Edition. McGraw-Hill
Ryerson2004
17
Financing via a Bankers Acceptance
Importer
Exporter
Letter of credit issued
Stamped
BANKS
Secondary Market
Investment Dealers
Rediscounting
Investors
Source Siklos, Pierre L., Money, Banking and
Financial Institutions, 4th Edition. McGraw-Hill
Ryerson2004
18
Bank of Canada and Interest Rates

• The Bank of Canada can influence interest rates
  through
• Reserve bid on T-bills
• Manipulating government deposits
• Open Market Operations
• Drawdown and Redeposit
• Bank focuses on the overnight market.
• Phasing out of reserve requirements

19
The Capital Market Derivatives(most important)

• Govt of Canada bonds
• Stocks
• Derivatives

• Large secondary market
• principal source of debt finance across the term
  structure
• newly issued and large secondary market
• private source of debt
• Large variety
• can be a source of reduced or increased risk.

20
Main Groups Holding Government Debt
Source Siklos, Pierre L., Money, Banking and
Financial Institutions, 4th Edition. McGraw-Hill
Ryerson2004
21
Net New Issues of Stocks and Bonds
Source Siklos, Pierre L., Money, Banking and
Financial Institutions, 4th Edition. McGraw-Hill
Ryerson2004
22
Summary

• Financial Markets can be subdivided into the
  Money and Capital Markets
• Money Market instruments are short-term in nature
• Capital Market instruments are long-term in
  nature
• The principal Money market instruments are
  Tbills, Bank of Canada Advances, SPRAs, Bankers
  Acceptances, interbank deposits and the
  Eurocurrency market
• The principal capital market instruments are Govt
  bonds, stocks and derivative products