Canadian Investment Funds Course: Unit 4

Canadian Investment Funds Course Unit 4: Economic Factors and Financial Markets Introduction As a Dealing Representative, your clients will expect you to have an understanding of the Canadian financial markets, and the economic factors that affect markets, including business cycles, government polic...

Canadian Investment Funds Course Unit 4: Economic Factors and Financial Markets Introduction As a Dealing Representative, your clients will expect you to have an understanding of the Canadian financial markets, and the economic factors that affect markets, including business cycles, government policies, and other elements. This unit takes approximately 1 hour and 30 minutes to complete. Lessons in this unit: Lesson 1: Economic Factors Lesson 2: Financial Markets Lesson 3: Canada’s Financial System © 2021 IFSE Institute 137 Unit 4: Economic Factors and Financial Markets Lesson 1: Economic Factors Introduction As a Dealing Representative, your clients will expect you to be familiar with economic indicators, business cycles, and government monetary and fiscal policies. This lesson takes 30 minutes to complete. By the end of this lesson you will be able to: describe commonly used economic indicators and how they reflect economic activity explain the concept of business cycles explain how government uses fiscal and monetary policy to stabilize or stimulate the economy 138 © 2021 IFSE Institute Canadian Investment Funds Course Economic Indicators The economic health of a region is represented by economic indicators. The three common indicators that your clients may ask you to explain are: Gross Domestic Product (GDP) Inflation Rate Unemployment Rate Gross Domestic Product (GDP) The quantity of goods and services produced by a country is one of the primary indicators of the health of the economy. Gross Domestic Product (GDP) is a measure of the total market value of all the final goods and services produced in the economy in a year. GDP is measured in dollars. GDP values are usually referred to as either “nominal” or “real”. Nominal GDP is expressed based on current market prices, while real GDP is adjusted for inflation, to remove the effect of price increases. An increase in real GDP is interpreted as a sign that the economy is doing well, while a decrease indicates that the economy is not working at its full capacity. An increase in GDP typically means higher profits for companies and increased dividends or higher stock and sector related mutual fund prices for investors. On the other hand, a decrease in GDP typically indicates lower company profits and decreasing returns to investors. Consumer Price Index (CPI) The cost to purchase goods and services within a country is an important economic indicator. A price index measures many different prices in the economy. The most well-known and widely used price index calculated by Statistics Canada is the Consumer Price Index (CPI). To prepare the CPI, Statistics Canada tracks the retail prices of a basket of about 600 goods and services purchased by a typical household. This includes food, housing, transportation, furniture, clothing, and recreation. Items in this basket of goods and services are weighted to reflect typical consumer spending habits. To give an accurate reflection of the price of goods and services, CPI is always calculated in relation to a base year. The current market value of this basket divided by its value in the base year and multiplied by 100, becomes the Consumer Price Index. An increase in CPI could mean that investors have less money available to invest. It could also mean that those who rely on investment income for living expenses may find that they need to use more of their investment income to cover their basic living expenses. © 2021 IFSE Institute 139 Unit 4: Economic Factors and Financial Markets Annual Inflation The rate of change in the price of goods and services is an important indicator of an economy’s price stability. Inflation is a rise in the general level of prices in an economy over a period of time. The amount that you can buy with your dollar, called purchasing power, falls as the rate of inflation rises. If the general price level falls, it is called deflation. The rate of change in the general price level, year over year, is called the inflation rate. On a year-to-year basis, the inflation rate is measured as follows: Inflation Rate = (current year CPI value – previous year CPI value) ÷ previous year CPI value X 100 The following table shows the relationship between CPI and the Annual Inflation Rate. Note that the CPI is always in relationship to a base year while inflation is the year to year change in CPI. Year CPI Annual Inflation Rate Base Year 100 1 105 (105 - 100) ÷ 100 x 100 = 5.0% 2 110 (110 - 105) ÷ 105 x 100 = 4.8% 3 115 (115 - 110) ÷ 110 x 100 = 4.6% Distributive Effects of Inflation A major effect of unanticipated inflation is a redistribution of real income from lenders to borrowers. Unanticipated inflation results in lenders receiving less real income and borrowers benefiting from cheaper than expected loans. Example Caitlyn borrows $100 from Terence in a year when prices are stable (the rate of inflation is zero) at a 2% interest rate. After one year, Terence expects to receive $2 in real income. If prices rise by 5%, then Terence would need $105 to buy what $100 bought a year ago. The $102 he receives represents a reduction in real income of $3. On the other hand, Caitlyn has benefited from a loan now worth $105 for only $102. The table below shows how unexpected inflation redistributes real income from lenders to borrowers. 140 © 2021 IFSE Institute Canadian Investment Funds Course No Inflation Inflation at 5% How much Terrence will receive after 1 year $102 $102 Price of a $100 item after 1 year $100 $105 $102 - $100 = $2 Terrence gains $2 $102 - $105 = -$3 Terrence loses $3 no one Caitlyn (borrower) Real Income for Terrence (lender) Who received an unexpected benefit Measures of Employment and Unemployment The unemployment rate is the percentage of the labour force that actively seeks work but is unable to find any. The labour force is defined as the total of all those employed and unemployed in the economy. Individuals who do not have a job and are not actively looking for one are excluded from the labour force. The following table shows the components included and excluded from the labour force. Included in Labour Force Not Included in Labour Force Employed Retired persons Full time Students Part time Unpaid family workers Unemployed (actively looking for work) Others not looking for work In Canada, employment and unemployment numbers are collected monthly by Statistics Canada. The unemployment rate is defined as the percentage of the labour force that is currently unemployed and actively looking for work. The unemployment rate is a key indicator of the health of the economy. In general, when economic growth is strong, the unemployment rate tends to be low and when the economy is stagnating or in recession, unemployment tends to be higher. Variations in employment numbers can also reflect structural changes in the economy as new technology replaces labour or forces it to be employed in another way. Unemployment and GDP typically move in opposite directions. An increase in GDP typically means lower unemployment as companies hire additional labour to meet the growing demand. Lower unemployment typically means investors have more funds available to spend, save or invest. © 2021 IFSE Institute 141 Unit 4: Economic Factors and Financial Markets Full employment represents the highest number of both skilled and unskilled workers that a given economy can employ at any one time. In Canada, the full employment rate is considered to be less than 6% unemployment. Business Cycles The Canadian economy moves in cycles which include periods of economic expansion followed by periods of economic contraction. The period of economic expansion is not of the same length in every cycle. Furthermore, a period of economic expansion is not necessarily as long as a period of economic contraction. A period of at least six consecutive months of economic contraction is called a recession. These irregular waves in the level of economic activity are called business cycles or economic cycles. The GDP growth rate is the change in GDP compared to the previous year and is the indicator that is often used to illustrate the economic/business cycles and to compare growth between economic regions. A period of increase in GDP followed by a period of decrease in GDP is referred to as a business cycle. This graph shows two business cycles of economic expansion followed by economic contraction. Over time, the GDP rate moves in an opposite direction to unemployment rate. In periods of expansion stock prices tend to rise and in periods of contraction they fall. Fiscal Policy and Monetary Policy Governments and central banks try to stabilize their economies and maintain high employment, steady economic growth, and price stability. There are two main tools to accomplish this: fiscal policy and monetary policy. Fiscal Policy Fiscal policy is the government's use of taxes, transfer payments and spending to influence the overall level of economic activity. The government controls how much tax is collected from Canadian citizens and corporations. The government also controls their spending and transfer payments. Government spending refers to the amount that the government spends on product and services. Transfer payments are payments from the government without an exchange of goods or services. Examples of transfer payments are unemployment benefits, subsidies, social security payments, and other welfare benefit payments. 142 © 2021 IFSE Institute Canadian Investment Funds Course An expansionary fiscal policy is meant to stimulate economic growth through increased spending, increased transfer payments, or reduced taxes. For instance: A person's disposable income is equal to his or her income, less taxes plus transfer payments. Reduced taxes or increased transfer payments will increase his or her disposable income. This represents an expansionary fiscal policy, and eventually this sort of policy can result in increased inflation as prices adjust to new levels of disposable income. Conversely, a restrictive or contractive policy is meant to slow down an overheating economy through reduced transfer payments, reduced spending, or increased taxes. The result of a restrictive or contractive policy is that real GDP and price levels eventually drop as economic activity slows. Monetary Policy The Bank of Canada serves as the central bank responsible for monetary policy. It is also the bank to the banks and for the federal government. Monetary policy is about making changes to the money supply for the purpose of changing short-term interest rates. The duties of the Bank of Canada are to: regulate currency and credit in the best interests of the economy control and protect the Canadian dollar influence the level of production, trade, prices and employment through monetary action To fulfill these duties, the Bank of Canada may do one or more of the following: increase (redeposit) or decrease (drawdown) the Government of Canada's deposits with the chartered banks participate in open market operations by buying or selling treasury bills through a designated group of investment dealers and banks change the bank rate to signal its intentions regarding monetary policy If increasing demand for credit and consumer products during a period of economic expansion causes prices to move upward too rapidly, the Bank of Canada can raise interest rates. This increases the cost of borrowing money and eventually reduces the amount of money moving around the economy. This can help to slow down an overheating economy. In contrast, during periods of recession, the Bank of Canada may reduce interest rates to stimulate growth. The cost of borrowing money goes down, more people and corporations borrow, there is more money in the system and economic activity accelerates. © 2021 IFSE Institute 143 Unit 4: Economic Factors and Financial Markets Lesson 2: Financial Markets Introduction Welcome to the Financial Markets lesson. In this lesson, you will learn the concept of supply and demand, as well as the importance of financial markets. This lesson takes approximately 30 minutes to complete. By the end of this lesson you will be able to: describe the concept of markets and the effects of supply and demand explain how supply and demand relates to financial markets describe how the financial markets facilitate the transference of capital from suppliers to those who require capital 144 © 2021 IFSE Institute Canadian Investment Funds Course Markets A market is a place where buyers and sellers meet. It can be a physical building or an electronic network. It can be local, national, or international. Markets are often categorized according to the products or services in which they deal. For example, there are labour markets, consumer goods markets, and financial markets. At the heart of each transaction in these markets are two elements: a selling side and a buying side. In economic terms, the selling side is often referred to as the supply side, while the buying side is called the demand side. The forces of supply and demand in a particular market determine the price at which goods and services will change hands. Just about any situation in economics can be explained in terms of supply and demand. Supply and Demand At its simplest, the price of any market transaction between a buyer and a seller is determined by supply and demand. Supply is the quantity of goods or services supplied at a particular price per unit. The quantity increases if sellers can charge a higher price per unit. Example A manufacturer may be willing to produce 40 calculators if it can charge $20 per unit; 60 calculators if it can charge $30; and 120 calculators if it can charge $60. The supply curve indicates the behaviour of sellers. The supply curve slopes upward to the right. © 2021 IFSE Institute 145 Unit 4: Economic Factors and Financial Markets Demand is the quantity of goods or services that buyers want to purchase at a given price per unit. Buyers demand more goods or services if the price decreases. The demand curve slopes downwards to the right because buyers tend to buy more when prices decline. Example Consumers are willing to purchase 20 calculators if the price is $50 per unit; 60 calculators if the price is $30; and 100 calculators if they pay only $10. Market Equilibrium Market equilibrium is the point where the supply curve and demand curve intersect. You can see from this graph that at a price of $30 consumers are willing to purchase 60 calculators and the producers are willing to sell the same amount. We say that the market for calculators clears at a price of $30. Financial Markets A financial market is a market in which financial assets are traded. In financial markets there are suppliers of capital and consumers of capital. Just as in other markets financial market prices reflect supply and demand. Supply The supply of capital in the Canadian financial markets comes from the following sources: household savings retained earnings that corporations have not paid out as dividends budget surpluses in the government sector 146 © 2021 IFSE Institute Canadian Investment Funds Course savings from abroad These sources of supply, commonly referred to as lenders, are willing to lend out capital to some entity with the expectation of profit in return. Demand The demand for investment capital comes from the spending decisions of the following: governments (federal, provincial, municipal) corporations Canadian households foreigners interested in the Canadian financial markets These consumers of capital are commonly referred to as borrowers. For example, if a government needs to borrow funds it issues bonds. Investors purchase those bonds and act as lenders to the government. Supply and Demand in the Financial Markets Financial markets are subject to the same supply and demand influences as any other market and can be viewed in the same manner. If there is a sudden increase in demand for stocks or bonds, then the cost of those investments rises as the demand curve shifts upwards. Investment capital has three related characteristics that affect the supply and demand curves in financial markets. Characteristics Description Scarcity There is a limited supply of investment capital and those seeking capital must therefore compete for it. Sensitivity Sensitivity is the degree to which investment capital is influenced by changes in financial markets and the overall economy. With the growing amount of investment options available and the increased ease of access to information about those investments, investors are becoming more discriminating in their investment choices. Mobility Improvements in technology have made it possible for capital to move quickly from one part of the world to another. For instance, the foreign exchange markets trade more than $1 trillion every day on a 24 hour a day basis. This mobility has increased efficiency but it also serves to increase financial crises through rapid flow of capital. © 2021 IFSE Institute 147 Unit 4: Economic Factors and Financial Markets Importance of Financial Markets Being able to convert idle savings into investment capital is critical for the long-term prosperity of an economy. For example, by lending money to buy new housing, banks help local infrastructures grow and meet the needs of an expanding population. The same is true when governments borrow money to build hospitals and roads or when corporations issue securities to finance expansion of their operations. Without access to investment capital, governments and companies are limited by the amount of capital they can access internally. Nations with low levels of savings tend to have low rates of investment and low rates of economic growth. Nations with healthy economic growth tend to have well developed financial markets that encourage saving and investing. Financial markets serve borrowers and lenders in three ways: channeling funds from lenders to borrowers facilitating the timing of purchases providing a mechanism for government policy Channelling Funds The movement of investment capital from the suppliers to those with demand may be done directly, but is usually handled indirectly by intermediaries such as banks, trust companies, and investment dealers. Direct Financing In the case of direct financing, a borrower deals directly with the lender. For example, if a person needs to borrow $1,000 he or she might approach friends and family members to find someone with $1,000 to lend. This is not efficient. Indirect Financing In the case of indirect financing, a borrower does not deal directly with the person who has money to lend. Instead, he or she approaches a financial intermediary who acts as a middleman, bringing many borrowers and lenders together. The most common financial intermediaries are banks. Banks have a large pool of funds from their many depositors (lenders) that they can make available to borrowers. Facilitating Timing of Purchases Financial markets enable people to time their spending and saving to fit their lifestyle and circumstances. Through financial markets, households have the opportunity to spend in some years and save in others. For instance, in their younger years people set aside savings and invest part of the income while they are working. 148 © 2021 IFSE Institute Canadian Investment Funds Course Later in life when they reach retirement, they begin to draw down from their savings and investments to help finance retirement expenses. Financial markets help facilitate the timing of when they want to save or invest and when they want to withdraw and spend. Providing a Mechanism for Government Policy Financial markets can be used as a mechanism to facilitate Federal government policy. For instance, one of the key monetary policies in Canada is inflation control. The Federal government and the Bank of Canada work together to set targets for the country's inflation rate. If the Canadian economy is perceived to be growing too quickly, it can be interpreted as a sign of inflationary pressure. The Bank of Canada can increase its overnight interest rate. Financial markets then transmit these changes to the rest of the economy. This rise in the overnight interest rate will result in a rise in longer-term interest rates in Canada. As a consequence, the cost of borrowing increases making it more expensive for borrowers like consumers looking to purchase homes or corporations wanting to invest in new equipment to access capital. In turn, this causes the economy to slow down and eventually eases the inflationary pressure which was the original concern of the Bank of Canada. © 2021 IFSE Institute 149 Unit 4: Economic Factors and Financial Markets Lesson 3: Canada's Financial System Introduction In this lesson, you will learn about key elements of the Canadian financial system. This includes the types of financial markets, how capital is raised, and financial market roles. This lesson takes approximately 30 minutes to complete. By the end of this lesson you will be able to: describe the main types of financial markets (capital, money, foreign exchange) explain how capital is raised in the primary market explain the purpose of the secondary market and the role played by exchanges and security firms 150 © 2021 IFSE Institute Canadian Investment Funds Course Capital and Money Markets The Bank of Canada defines Canada’s financial system as “the channel through which savings become investments, and through which money and financial claims are transferred and settled”. As a Dealing Representative, you are part of Canada’s financial system which consists of financial institutions, financial markets and payment systems. Types of Financial Markets There are three main types of financial markets in Canada’s financial system: capital markets money markets foreign exchange markets Capital Markets The capital market is a trading place for financial assets. Capital markets bring together organizations seeking capital, including corporations and governments, with investors and lenders. The capital market has the following characteristics: trades mainly stocks and bonds trades derivatives, which base their value on capital market securities generally a long-term market (as opposed to the money market, which deals with short-term fixed income securities) Money Markets The money market is a trading place for short-term financial assets, typically those with a maturity of less than one year, but sometimes up to three years. Money market instruments are used for raising short-term capital or for investing cash surpluses for a short period of time. Foreign Exchange Markets Currencies are traded on the foreign exchange markets between various international and domestic banks and dealers. Foreign exchange trading involves selling one currency and buying a different currency. In a currency market, the price of one currency in terms of another is called the foreign exchange rate. © 2021 IFSE Institute 151 Unit 4: Economic Factors and Financial Markets Example If the exchange rate is $1.01 Canadian (Cdn) dollar/U.S. dollar, then $1 U.S. dollar can purchase $1.01 Canadian dollars. Example If an American were to purchase a book worth $15.00 Cdn, how much would it cost in U.S. dollars? $15.00 Cdn / (1.01 Cdn/US) = $14.85 U.S. The Bank of Canada is also involved in the foreign exchange market. Through Canadian chartered banks and investment dealers, the Bank of Canada buys and sells Canadian and foreign currency in order to regulate the Canadian dollar. Example Jane wants to purchase a U.S. Growth Fund denominated in U.S. dollars. Currently, the exchange rate is $1.01 Canadian dollar/U.S. dollar. Jane has $10,000 Canadian to invest. How much will she be able to purchase in U.S. dollars? $10,000 Cdn / (1.01 Cdn/US) = $9,900.99 U.S. After five years, Jane's U.S. Growth Fund is worth $15,750 U.S. She wants to sell the investment and convert it back to Canadian dollars. The exchange rate is $1.01 Canadian dollar to U.S. dollar. What will Jane receive in Canadian dollars from this redemption? $15,750 U.S. x $1.01 Canadian/U.S. = $15,907.50 Canadian Newly Issued Shares Corporations issue new shares for many reasons such as: to go from a private to a public corporation by way of an initial public offering (IPO) to raise additional capital for an expansion, research and development, or for an increase in working capital to raise funds in a private company for the sale of an owner's share of the business 152 © 2021 IFSE Institute Canadian Investment Funds Course A corporation issues new shares in what is called the primary market. To do this, it will usually hire an investment dealer to help bring the shares to market. The dealer is a financial intermediary between the company and the primary market. The issuing company relies on the dealer's distribution channels instead of selling the shares itself to the market. The Underwriting Process Underwriting is the process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities. Primary and Secondary Markets When investors purchase an issue of new shares, money flows from the investor, through an underwriter, to the corporation that issued those shares. This is the primary market. Once these shares are purchased in the primary market they subsequently trade among investors, changing hands whenever a match can be found between people who want to sell their shares and those who want to buy them. These shares are said to be trading on the secondary market. The original issuing company has no further direct financial interest in the subsequent trading of these shares. The secondary market includes the many organized stock exchanges, as well as the over-the-counter markets. Stock Exchanges A stock exchange is established for the purpose of trading shares between members of the exchange and their clients. Members of the exchange are regulated by a strict code of conduct to ensure that markets operate smoothly and investors are treated fairly. Companies must apply to be listed on an exchange. If accepted, companies must obey its listing requirements, including rules concerning the disclosure of information. Some of the benefits a company enjoys by listing on an exchange include: increased marketability of shares due to greater market exposure increased public confidence in the company due to the exchange's disclosure rules an active secondary market that can broaden a company's shareholder base Over-the-Counter (OTC) The shares of publicly traded companies that are not listed on a stock exchange may still be traded on the over-the-counter market (OTC), sometimes referred to as the unlisted market. Unlisted securities trade in the OTC market through a network of dealers. © 2021 IFSE Institute 153 Unit 4: Economic Factors and Financial Markets There are many reasons a company might consider listing in the OTC market including: unwillingness to abide by the disclosure rules of an exchange low volume of trading in its shares low investor interest inability to meet the requirements to be listed, usually because it is a small company The OTC market also plays a part in the primary market. Many new stock issues that are underwritten by securities firms are first sold over-the-counter before becoming listed on a stock exchange. Large blocks of outstanding shares offered for sale by a single investor, whether listed on an exchange or not, are sometimes sold in the OTC market. Often a securities firm will underwrite the block itself and offer it for sale in the OTC market in the same manner as a new issue. This process is referred to as secondary distribution. The disclosure standards for the OTC market are not as stringent as those imposed by an exchange. A corporation whose shares are listed on an exchange is generally not allowed to list or trade in the OTC market, with the exception of secondary distributions. Secondary Debt Markets There is a large and active market for bond trading. Except for a few exchange listed debentures, bonds trade in the dealer market or over-the-counter (OTC). In other words, trading is conducted directly between financial institutions. The Roles of Securities Firms The trading of securities in the primary and secondary markets is facilitated by a network of securities firms, including securities dealers and stockbrokers. A securities firm is any company that specializes in the trading of securities by performing one or more of the following functions: underwriting new issues and secondary distributions stock brokerage market research and the provision of investment advice portfolio management A securities firm may be organized as a private corporation or partnership, or it may itself be a publicly traded company. 154 © 2021 IFSE Institute Canadian Investment Funds Course Dealers and Brokers Dealers When a securities firm underwrites a new issue or a secondary distribution, it purchases the securities from the issuing company or the selling investor at a fixed price, and attempts to sell them in the market at a profit. This is called a bought deal. In this case, the securities firm is referred to as a dealer, which is a company that acts as the principal in a securities transaction, buying and selling for its own account. The securities firm is in the position where if the securities do not sell at the anticipated price, the firm will realize a loss. A securities dealer makes its money by purchasing securities and selling them at a profit, in addition to earning commissions charged on transactions handled by the firm on behalf of clients. Brokers In some cases, a securities firm will agree to sell new issues only to the best of its abilities, meaning that it will try to sell as many shares as possible at a stated price, but it does not accept any responsibility if all the shares are not sold. This is called a best effort deal. In this case, the securities firm is acting as a securities broker or an agent on behalf of the issuer. A broker arranges for the purchase or sale of securities, handles the flow of cash and may provide clients with investment advice. A brokerage firm makes its money on the commissions charged on each trade it handles on behalf of clients. Most securities firms have their own research departments, which are responsible for gathering and analyzing information that will assist both themselves and their clients in making investment decisions. The research department may include people who specialize in the technical and fundamental analyses, as well as analysts who specialize in particular industries such as mining or biotechnology. The information developed by the research department is usually distributed to clients and potential clients free of charge in the hope that the recipient will decide to become a client of the securities firm. © 2021 IFSE Institute 155 Unit 4: Economic Factors and Financial Markets Summary Congratulations, you have reached the end of Unit 4: Economic Factors and Financial Markets. In this unit you covered: Lesson 1: Economic Factors Lesson 2: Financial Markets Lesson 3: Canada's Financial System Now that you have completed these lessons, you are ready to assess your knowledge with a 10-question quiz. To start the quiz, return to the IFSE Landing Page and click on the Unit 4 Quiz button. 156 © 2021 IFSE Institute