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© Natalya Brown 2008

ECON 2017 Money, Banking and the Canadian Financial System

Characteristics of Financial Instruments

Reading: Siklos: Chapters 4


LECTURE 4: Financial

Instruments Objectives

• Characteristics of Financial Market Instruments:– Money Market Instruments– Capital Market Instruments

• Financial Innovations and market efficiency



Instruments

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.



Instruments 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.



Instruments

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.



Instruments

The Money Market(cont’d)

• 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



Instruments

The Operating Band for the Overnight Market

OvernightMarket Rates

Bank Rate

Rate on +ve balances =Bank rate less 0.50%

OPERATING BAND

BOC target rate = mid-pointof range

Overdraft Surplus

ON*=(BRt+Rtsb)/2



Instruments

The Money Market [cont’d]

• 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]



InstrumentsThe Money Market (cont’d)

• Special Purchase and Resale Agreements (SPRA)

• Bankers’ Acceptances – Short-term loan used by

BOC to affect liquidity in Financial Markets.

• 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) (cont’d)

• If participant i’s LVTS is LVTSi while participant j’s LVTS balance are LVTSj then we would expect:

LVTSi + LVTSj = 0

ONt > ONt* use an SPRA

ONt < ONt* use an SSRA




• 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 int’l int rate developments




• 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




• 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.


LECTURE 4: Financial Instruments

Bank of Canada Advances

0

1000

2000

3000

4000

1985 1987 1989 1991 1993 1995 1997 1999 2001

3469.0

868.0

798.0

485.0

312.0

471.0

1174.0

224.0

131.0

447.0

545.0 554.0

363.0

656.0

561.0

952.0

647.0

Millio

ns

of d

olla

rs

Year

Source: Siklos, Pierre L., Money, Banking and Financial Institutions, 4th Edition. McGraw-Hill Ryerson2004



• 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



Financing Through an SPRA

Investment Dealer Bank of Canada

Bank

Call Loan

SPRA

T-bill Govt Dep.

Call loan

BOC Dep.

Assets Liabilities




Financing via a Banker’s Acceptance

Importer Exporter

BANKS

Investment Dealers

Investors

Letter of creditissued

Secondary Market

Rediscounting

“Stamped”




Instruments

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



Instruments

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.



Main Groups Holding Government Debt

0

10

20

30

40

50

60

70

80

90

1985 1987 1989 1991 1993 1995 1997 1999 2001

Bank of CanadaNonresidentsCanadian residents

Per

cent




Net New Issues of Stocks and Bonds

0

4000

8000

12000

16000

20000

24000

1985 1987 1989 1991 1993 1995 1997 1999 2001

Mill

ions

of d

olla

rs (par va

lue)

Stocks

Bonds

Year




Instruments 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, Banker’s Acceptances, interbank deposits and the Eurocurrency market

• The principal capital market instruments are Govt bonds, stocks and derivative products

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