The financial sector

Question 1

Functions of banks (5)

Answer 1

1. financial intermediary (make money by charging higher interest rates than they pay)
2. pool savings
3. spread lending risk
4. payment services
5. long term loans from short-term deposits (creates the risk of bank runs)

Question 2

maturity transformation

Answer 2

using short-term deposits to make long-term loans

Question 3

Explain the fractional reserve system

Answer 3

hold a small percentage of deposits in cash

Question 4

Is there a legal reserve requirement in Canada?

Answer 4

No

Question 5

Explain a bank run, is it frequent in Canada?

Answer 5

if all or most depositors try to withdraw their money, the bank doesn’t have enough cash to give everyone their money
- very infrequent in Canada

Question 6

Are banks in Canada conservative

Answer 6

Yes, they have required capital ratios, but capital doesn’t have to be held in cash

Question 7

Canadian Deposit Insurance

Answer 7

deposits insured for up to $100,000 in a wide range of deposits

Question 8

Shadow banks

Answer 8

Get their funds from depositors who can withdraw their money at any time, and they use those funds to make long-term loans to investors (no deposit insurance, more freedom)

Question 9

Functions of bonds (3)

Answer 9

• move money from savers to borrowers (mostly for investment)
• fund government debt
• spread risks and creates liquidity – lenders can sell debt easily

Question 10

Risks of bonds (3)

Answer 10

default risk – risk of not being paid
term risk – changes in interest rates change the value of a bond
liquidity risk – bonds might be hard to sell
- government bonds are the safest bonds

Question 11

Functions of the stock market (3)

Answer 11

• channel funds from savers to borrowers
• spread risks
• reallocate control

Question 12

Bonds vs Stocks (3 characteristics)

Answer 12

bonds: specified future interest payments, first in line to get paid if the company goes bankrupt, no control in the company
stocks: uncertain dividends, last in line to get paid, have a vote on how the company is run

Question 13

What drives the price of shares

Answer 13

demand – how many stocks investors will buy at each price (risk and interest rates)
supply – how many stocks investors will sell at each price

Question 14

2 types of stock valuation

Answer 14

1. fundamental analysis
2. relative valuation

Question 15

fundamental analysis (what is it and how do you do it)

Answer 15

assesses an asset’s fundamental value (forecast and value future profits)

  how to assess a business’s fundamental value:
1. forecast future profits
2. discount these profits
3. add up the sum of those discounted future profits
4. divide the company’s fundamental value by the total number of shares

Question 16

fundamental value of a business

Answer 16

the PV of the future profits it will earn

Question 17

2 relative-valuation ratios

Answer 17

a) price-to-book ratio (relative to the book value per share, net assets per share)
b) price-to-earnings ratio (relative to last year’s profits, earnings per share)

Question 18

The idea of Efficient Markets Hypothesis and 4 statements

Answer 18

Idea: stock prices reflect all publicly available information about a company’s fundamental value

• financial prices move unpredictably (with new info)
• technical analysis shouldn’t work
• expert advice is mostly useless
• stock market is a useful predictor of future economic events

Question 19

How do mutual funds work and 2 types

Answer 19

buy a portfolio of stocks:
a) actively managed – expert stock pickers invest your money
b) index funds – a computer program picks stocks (S&P 500 or some other broad market index)

Question 20

greater fool theory:

Answer 20

people buy an investment because they expect other people to buy it from them at a higher price (even if you pay more than it’s worth, there is someone that will pay even more)

Question 21

Asset bubbles (what is it, when does it happen, why do they last long)

Answer 21

• the price of an asset moves far above its fundamental value (speculative bubble)
• usually accompanied by large uncertainty about future returns (the beginning of the Internet)

Why can bubbles last a while?
- hard to spot – there is uncertainty about future value
- sometimes hard to bet against – futures markets aren’t complete
- timing the bursting bubble is hard – and you look like you are losing money while you wait

Question 22

Factors that affect housing prices in Canada

Answer 22

• supply is relatively inelastic
• demand: population (immigration), interest rates, working from home