3. the financial environment

8/14/2019 3. the Financial Environment

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THE FINANCIAL ENVIRONMENTMARKETS,

INSTITUTIONS

&

INTREST RATES


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INTERACTION OF BUYERS &

SELLERS

How are they going to find eachother?

Problem:Search is expensive &

inefficientSolution:Need facilitator:

mechanisms & institutions

Market ?


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WHAT IS A MARKET?

A mechanism by which investors (firms,individuals, government) exchange assets

(real, financial)


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Capital Markets( Mortgages, Bonds, Leases & Stocks)

Primary Market New Capital Raised

Secondary Market Exchange of Ownership

(Brokerage services) Initial Public Offer Market

Mortgage & lease Market

Real Estate Market

CLASSIFICATIONS OF FINANCIAL

MARKETS


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Money MarketsT.Bs

Banks Negotiable Instruments Money Market Funds

Physical Goods Markets :( Tangible or Real Assets)

Future and Forward Vs Spot MarketsFutures and forward contracts can be used to

reduce risk associated with unforeseen events bylooking into an agreement today for the future

delivery of a specific asset at a specific time, place,

quantity and quality.


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Options:

The right, but not the obligation, to take aspecific action in the future. In finance,the actions refer to: " the right to buy aspecific asset at a discount and to sell a

specific asset at an agreed upon price inthe future"

Why SECP

Markets do not always function perfectly.To regulate these - Securities andExchange Commission (SEC).


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FINANCIAL INSTITUTIONS

Direct transfers of money and securities

Investment Banking House (Underwriters)

Financial intermediary

o Commercial Bankso Savings and Loan Associations

o Credit Unions

oPension Funds

o Life Insurance Companies

o Mutual Funds


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Capital Formation Process Direct Transfer

8. Indirect Transfer through Investment Banks(Underwriters) ?

Securities Securities

(Same)

Dollars Dollars

SaversBusiness

Dollars

Securities (Stocks orSecurities (Stocks or

Bonds)Bonds)

InvestmentBankingHouses(AJD, JS)

SaversBusinessBusiness


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1. Indirect Transfer Through a Financial

Intermediary

Business Intermediary's

Securities Securities

Dollars Dollars

BusinessFinancial

Intermediary

Savers


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THE STOCK MARKET

Physical Location Stock Exchanges

Formal Organisation

Tangible Physical Location

Conducts Auction Markets in designated (Listed)

Securities

KSE, LSE, ISE-NSE in the offing

Over the counter Markets (OTC)

Just a collection of brokers/ dealers

Connected electronically by Telephones & ComputersTrading in unlistedsecurities


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THE STOCK MARKET

Dealer MarketsIncludes all facilities needed to conduct

Security transactions

Conducted on an unorganized Exchange


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SECONDARY MARKET ROLE OF

A BROKER


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THE COST OF MONEY

Capital in free economy allocated

through the price system The interest rate is the price paid to

borrow debt capital. With equity capital,

investors expect to receive dividends andcapital gains, whose sum is the cost of

equity money


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RiskIn a financial market context thechance that an investment will

provide low or negative return-Effects?

Inflation

The amount by which pricesincrease over time- Effects?


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Allocation of Funds & Interest Rates

RISK

EXP

ECTEDRETU

RN(%)

T-Bills

Govt. Bond

Long term Govt. Bonds

Preferred Stock

Conservative Common Stock

Spec. Common Stock


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The Determinants of Market

Interest Rates

Real Risk-Free rate of Return( only T-Bills)Inflation Premium (IP)

Default Risk Premium (DRP)

Liquidity Premium (LP)

Maturity Risk Premium (MRP)

Reinvestment Rate Risk


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The Determinants of Market Interest Rates

Quoted Interest Rate = k = k*+IP+DRP+LP+MRP

where

K= The quoted, or nominal, rate of interest on a given security

K*=The real risk-free rate of interest on a risk less security ifZero inflation was expected

kRF = k* + IP=The quoted risk-free rate of interest on a security

such as a Govt. Treasury bill, which is very liquid

and also free of most risks.IP= Inflation Premium=The average expected inflation rate over

the life of the security.


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The Real Risk-free Rate Of Interest (K*)

The rate of interest that would exist on default- free Treasury billsif no inflation were expected.

It depends upon:

The rate of return Corporations and otherborrowers expect to earn on productive assets

People preference for current versus futureconsumption

The Nominal, or Quoted, Risk Free Rate of Return(KRF)

The real risk-free rate plus a premium for expected inflationKRF = K* + IP

The risk-free is the rate free of any type of risk

Risk free interest used with out modifier Real or Nominalgenerally means Quoted (Nominal ) rate, which includes IP and is

used for T-Bills


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Liquidity Premium (LP)

A Premium added to the equilibrium interest rate on a security if that

security can not be converted to cash on short notice and at closeto theFair Market Value

There is always some difference in the interest rates of least liquid

and most liquid financial assets provided all other risk elements are

the same

Maturity Risk Premium (MRP) The risk of capital losses to which investors are exposed because of

changing interest rates -The longer is the maturity period the higher

is this premium.

Reinvestment Rate Risk

The risk that a decline in interest rates will lead to lower income

when bonds mature and funds are reinvested


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7.700.534.672.5%30 Years

7.420.424.502.5%20 Years

6.780.284.002.5%10 years

6.080.183.42.5%5 years

5.50%0 %3 %2.5%1 year

YieldMRPIPK*Maturity

With Increasing

Expected Inflation


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6.360.533.332.5%30 Years

6.420.423.502.5%20 Years

6.780.284.002.5%10 years

7.280.184.602.5%5 years

7.50%0 %5%2.5%1 year

YieldMRPIPK*Maturity

With Decreasing Expected Inflation


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Corporate and Treasury Yield Curves

11.1%9.8%7.7%30 YEARS

10.2%9.2%7.4%20 YEARS

9.1%8.2%6.8%10 YEARS

8.1%7.4%6.1%5 YEARS

7.4%6.7%5.5 %

1 YEAR

BBB

RATED

BOND

AA RATED

BOND

TREASURY

BOND

TERM TO

MATURITY

INTEREST RATE


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Interest Rate %

Abnormal Yield Curve

Normal Yield Curve

Maturity Period


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What Determines Shape of the

Yield Curve

Expectation TheoryA theory which states that the shape of

the yield curve depends on the investors

expectations about future interest rates

Long term interest rates are the

weighted average of the current and

expected future short-term interest rates


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Working

(3%+5%+7%)/3

=5.0%

7%2001

(3%+5%)/2= 4.00%5%2000

3%/1= 3.0%3%1999

Expected Average Inflation

Rate From 1998 to

Indicated Year

Expected Annual (1-Year)

Inflation Rate


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Liquidity Preference TheoryInvestors prefers to hold short term

securities for reason of liquidityBorrowers prefer to long-term debt

because short term debt exposes them to

the risk of paying in adverse conditions Ready to pay higher interest for the long

term debts

Hence up sloping curve


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Investors Overseas

Country Risk-The risk that arises frominvesting or doing business in a particular

country

Exchange Rate Risk The risk that exchange

rate changes will reduce the number of dollars

provided by a given amount of a foreign

currency

Oth F t Th t I fl


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Other Factors That Influence

Interest Rate Levels

Federal Reserve Policyo The money has a major effect on both the economic activity andinflation rate;

o The SBP controls the money supply;

o Stimulation of Economy;

o Tightening of Economy

Budget Deficit or Surpluso More spending- Deficit Borrowing or Printing more Notes

What are the effects?

International Factorso Foreign Trade Deficit

o Foreign Trade Surplus


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3. the financial environment

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