Download - Financial Markets & Institutions-FAST
-
8/3/2019 Financial Markets & Institutions-FAST
1/45
Lecture 1 & 2
-
8/3/2019 Financial Markets & Institutions-FAST
2/45
Course OutlineRequired Text
Financial Markets and Institutions
By Frederic S. Mishkin and Stanley G. Eakins (PearsonInternational) 5th Edition
Text for Derivatives section shall be specified later.
Methodology
Primarily Lecture method based on assigned readings.Class discussions on assigned topics. Various reportsand; current developments.
-
8/3/2019 Financial Markets & Institutions-FAST
3/45
Course Objectives Expected
outcome & Policy The course is designed to equip students with knowledge
of a financial system and its regulatory framework andenvironments in Pakistan, and as it exists in developedeconomies. On completion of the course the students shallbe able to demonstrate an understanding of the subjectmatter and financial markets in Pakistan.
Course is fairly lengthy covering all types of financialinstitutions and markets; therefore focus of this course ison breadth rather than depth of analysis of the subject. The
course policy envisages positive learning environments inthe class. A productive participation conditional onattendance shall be rewarded. Tardiness and casualattitude shall be strongly discouraged
-
8/3/2019 Financial Markets & Institutions-FAST
4/45
Course Evaluation and Rewards Quizzes 10%
There shall be total of 7 quizzes from the assigned and
the last reading, Best 5 will be counted. No makeup quizzes shall be allowed whatsoever.
-
8/3/2019 Financial Markets & Institutions-FAST
5/45
Course Evaluation and RewardsReport & Presentation 20% (A group project from a group size of 4-5 persons,). A report on comprehensive and critical analysis of a selected institution
or a topic shall be prepared and presented by each group. The groups
shall be finalized in the third week. The report must be submitted byApril 15th . The report shall not exceed 15 pages 1 space 12 Times NewRoman excluding title index and bibliography etc.
(Each group shall select a Financial Institution or a topic of interest forthe detailed analysis. Group members shall be asked to remain abreast
with the developments taking place in the marketplace, throughfinancial press. The impact of current developments taking place, whichare pertinent to their selection of study, shall be monitored andcompiled by the group. The group is expected to apprise the class withtheir observations through class participation)
-
8/3/2019 Financial Markets & Institutions-FAST
6/45
Course Evaluation and RewardsMid Term Exams
MCQs 25 %
Article presentation 5% Student will be given three articles from leading
financial press for reading and submitting their takeon the issue discussed. The purpose of this exercise is
to familiarize the students with the financial pressand develop understanding on the current issuespertaining to financial markets)
-
8/3/2019 Financial Markets & Institutions-FAST
7/45
Course Evaluation and RewardsFinal Comprehensive Examination 40%
-
8/3/2019 Financial Markets & Institutions-FAST
8/45
Lecture Objectives:Week 1, Lecture 1 & 2
Introduction to Financial Institution Market Course-
a course overview; Why Study Financial Markets andInstitution; Overview of Financial System;
Financial Markets; Financial Institutions; An overviewof Financial Institutions in Pakistan and in the
developed world.
-
8/3/2019 Financial Markets & Institutions-FAST
9/45
Questions1) What is main source of funds for firms?
Stock Market?
Banks?2) What are Mutual Funds?
3) What is the difference between Commercial Bankand Investment Bank?
-
8/3/2019 Financial Markets & Institutions-FAST
10/45
The Role of Financial System
Householders Firms
Consumption of outputs
Inputs of Land & Labor
Income (rent, wage, etc)
Payments for Outputs
Savings
Issuance offinancial Claims
-
8/3/2019 Financial Markets & Institutions-FAST
11/45
The Role of Financial System Barter Economy ( Double Coincidence of wants)
Considerable cost involved in searching party to trade
and reaching agreement on the terms will limit theamount of trade.
This will lead to adoption of single commodity ascurrency.(shells, cigarettes gold etc)
Criteria for development of money: Generalacceptance in exchange for other commodities.
Existence of money thus separates act of sale from actof purchase.
-
8/3/2019 Financial Markets & Institutions-FAST
12/45
The Role of Financial System Expenditure over income only possible if households
or firm has accumulated saving from previous periods.( Constraint on development)
As economy becomes more sophisticated firm requiremore funds than their accumulated saving or currentincome.
Firms then borrow from households with spendingless than income.
Firm issue financial claims in return.
-
8/3/2019 Financial Markets & Institutions-FAST
13/45
The Role of Financial SystemAbility to borrow encourages savings by households
and investment by firms.
Main Roles:
To provide a mechanism by which funds can betransferred from those with surplus funds to thosewho wish to borrow.(intermediary between surplusand deficit units)
Allocation of funds to their most efficient use by pricemechanism.
It enables the wealth holders to alter the compositionof their wealth.
-
8/3/2019 Financial Markets & Institutions-FAST
14/45
The Role of Financial System To provide payment mechanism.
Provision of special financial services such as pension
and insurance.
-
8/3/2019 Financial Markets & Institutions-FAST
15/45
Saver- Lenders & Borrower- Spenders1) Households
2) Business Firms
3) Government4) Foreigners
Borrowers- Spenders
1) Business Firms
2) Government
3) Households
4) Foreigners
-
8/3/2019 Financial Markets & Institutions-FAST
16/45
Direct Finance
Savers-Lenders
Borrowers-
spenders
FinancialMarkets
Funds Funds
-
8/3/2019 Financial Markets & Institutions-FAST
17/45
Direct Finance Spenders borrows directly from Saver-Lenders in
Financial Markets by selling them financialinstruments ( securities).
Financial Instruments are claims on borrowers futurefinancial income.
Financial Instruments are assets for person who buys
them (lender) and liabilities for person who sell them(borrower).
Examples include Bonds, Stocks etc
-
8/3/2019 Financial Markets & Institutions-FAST
18/45
Importance of Direct Finance From a savers point of view: meeting place for lenders
and borrowers- win-win situation for both lender andborrow and for the economy.
Firms can raise money for the investment projects.
-
8/3/2019 Financial Markets & Institutions-FAST
19/45
Indirect Finance
Savers-Lenders
Borrowers-spenders
FinancialIntermediary FundsFunds
-
8/3/2019 Financial Markets & Institutions-FAST
20/45
Indirect Finance Saver lends funds to Financial Intermediary which in
turn lends to the borrow-spenders. This process iscalled Financial Intermediation.
Examples of Intermediaries:
Commercial Banks
Insurance Companies
Mutual Funds Pension Funds etc
-
8/3/2019 Financial Markets & Institutions-FAST
21/45
ComparisonAlthough Media focuses more on Financial Markets,
Indirect finance is the most important mode ofborrowing for most of the firms.
Reasons for importance of Indirect Finance:
Transaction Costs. (e.g. cost of drafting contract,economies of scale available to FI)
Risk Sharing. (Risk Sharing & Asset Transformationthrough Diversification)
Information Cost.
-
8/3/2019 Financial Markets & Institutions-FAST
22/45
Indirect Finance Allows choice of desired maturity
maturity intermediation
diversification w/ small amount of capital lower transactions costs
alternative payment mechanisms
-
8/3/2019 Financial Markets & Institutions-FAST
23/45
Transaction Cost Time & money spent in carrying out a transaction is
major consideration for people with excess money tolend.
For Example (writing up loan contract with a neighbor,cost of lawyer etc)
FI lowers transaction cost because of their expertise
and relying on economies of scale.(e.g Decreasing perRs. Cost as the size of transaction increases)
FI can also get a loan contract drafted and use it overand over again for countless customers.
-
8/3/2019 Financial Markets & Institutions-FAST
24/45
Risk Sharing FI reduces uncertainty of return a lender will earn on
asset(loan).
Risk sharing: create and sell asset that people arecomfortable buying and use the proceeds to buy riskyassets.
Asset Transformation: Converting risky illquid assets
to less risky liquid assets. Role of Diversification
-
8/3/2019 Financial Markets & Institutions-FAST
25/45
Information Cost In financial markets, one party does not know enough about the
other party to make an informed decision. This inequality iscalled Asymmetric Information.
Asymmetric information problem before the loan and after theloan.
Adverse Selection: Bad credit risks are the ones who are mostactively seeking loan and are most likely to be selected by lender.( before loan)
Examples: Least qualified tenants may be the ones most likely tobe seeking new housing, because their tenant history is so badand they have been evicted, so they may be selected.
IMF/World Bank offers development funds to countries withecon problems - the least creditworthy countries may apply.
-
8/3/2019 Financial Markets & Institutions-FAST
26/45
Information Cost Moral Hazard: Risk that borrower will engage in activities
that are considered undesirable from point of view ofborrower as they increase the chances of a bad
outcome.(after loan) Example: Company borrows Rs.100,000 at a fixed rate of
10%. They originally agreed to use money to finance aproject with an expected return of 15%. Suddenly a riskyproject becomes available with an expected return of 30%.
They could switch projects and increase the riskiness to thebank. If the new project pays off, all profits go to theowners, none to the bank. If the project fails, and the loadgoes bad, the bank suffers.
-
8/3/2019 Financial Markets & Institutions-FAST
27/45
Information Cost FI reduced information cost or asymmetric
information problem because they have developedexpertise in screening out good from bad credit risk
(minimize losses due to adverse selection) andmonitoring the borrowers through their dedicatedstaff for this purpose and because of various othermeans.
Explains why we don't see a credit market ofindividuals dealing directly with each other - too risky.Adverse selection and moral hazard would cause thosecredit markets to break down, disappear
-
8/3/2019 Financial Markets & Institutions-FAST
28/45
Characteristics of Financial
Instruments Claim to the sum of money at some future date or
dates.
Characteristics:
1) Risk,
2) Liquidity,
3) Real value certainty,
4) Expected return,5) Term to maturity,
6) Currency denomination and divisibility.
-
8/3/2019 Financial Markets & Institutions-FAST
29/45
Risk In finance risk is referred to the fact that some of the
future outcome regarding a financial instrument is notknown with certainty.
E.g change in price, default with respect to income orprinciple.
Distribution of return around mean.( Standard
Deviation)
-
8/3/2019 Financial Markets & Institutions-FAST
30/45
Liquidity how easy is it to sell?
how cheap is it to sell?
is asset a medium of exchange?
or easily converted to one?
checking account--YES
Tbills--easily converted
real estate--NO
-
8/3/2019 Financial Markets & Institutions-FAST
31/45
Currency & Divisibility Currency
is cash flow in domestic or foreign currency?
exchange rates impact value of cash flows
Divisibility/denomination
minimum amount to buy/sell asset
money, bank deposits Rs.1
Mutual Funds- Rs.5000
-
8/3/2019 Financial Markets & Institutions-FAST
32/45
Real Value Certainty Susceptibility to loss due to rise in general level of prices
(Inflation). More important characteristic to consider when lending for
long term. Importance of preservation of purchasing power when
saving for retirment. Fixed value instrument more prone to loss in real value
over time (e.d fixed deposit at bank when inflation exceedsdeposit rate)
Stocks have tendency to increase in value over time in linewith or over the rate of general price levels.
Best inflation protection is provided by physical assets ofproperty rather than financial assets.
-
8/3/2019 Financial Markets & Institutions-FAST
33/45
Term to Maturity maturity
time until last cash flow
may be uncertain
Sight deposit at banks have zero maturity.
Equity have infinite term to maturity.
Term to marurity is linked with liquidity and return(premium for expectations for change in interest rates).
-
8/3/2019 Financial Markets & Institutions-FAST
34/45
Expected Return In the form of interest or dividend
Price appreciation
Ceteris paribus higher the return , greater will bedemand of the instrument.
-
8/3/2019 Financial Markets & Institutions-FAST
35/45
PRIMARY VS. SECONDARY MARKETS Primary market - newly issued securities, bonds/stocks,
being sold to initial purchasers by corporation or govtagency through an investment bank, which underwrites
the securities. Underwriting - guaranteed price. Secondary market - trading of previously issued stocks and
bonds. Secondhand market. You buy MCB Bank sharesfrom another individual who is selling. MCB Bank hasnothing to do with the transaction.
NYSE and the AMEX (organized exchanges/physicallocation) and NASDAQ (over-the-counter, computerlinked dealers all over the country) are the three nationalsecondary stock markets in US.
-
8/3/2019 Financial Markets & Institutions-FAST
36/45
MONEY VS. CAPITAL MARKETS
Money markets - debt securities with less than one year tomaturity. Safe, liquid.
Capital markets - Equity and debt with more than one
year to maturity. Riskier. Tbills- Discount instruments (3, 6 and 12 month
maturities). Risk-free securities of government. Sold at adiscount and pay no int. Ex. Buy @ Rs.9000 with aRs.10,000 maturity in one year. (Int = 11.11%).
Commercial paper - short term debt issued by largecorporations in direct finance to other large corporations orbanks. Example of financial disintermediation. Maturity of270 days or less.
-
8/3/2019 Financial Markets & Institutions-FAST
37/45
-
8/3/2019 Financial Markets & Institutions-FAST
38/45
CAPITAL MARKET INSTRUMENTS Stocks equity
Corporate Bonds - 10-50 year long term debt instrumentsto finance expansion of firm. Unsecured debt. Int payable
twice a year. Convertible bond - convertible to commonstock at a fixed rate. Example = one bond convertible to 40shares of common stock until maturity. Advantage tobondholder - share in profits of successful company.
Advantage to company = can reduce interest paymentsafter conversion.
T-notes and T-bonds.
State and local govt bonds. Municipal bonds. Tax-exempt.
-
8/3/2019 Financial Markets & Institutions-FAST
39/45
Foreign Exchange Markets Largest single financial market ($1Trillion daily),
where foreign currency is traded Over TheCounter. MNCs operate globally and are exposed to
currency fluctuations and currency risk (or foreignexchange risk). Cash flows from foreign sales orinvestments denominated in foreign currency expose afirm or investor to currency risk.
-
8/3/2019 Financial Markets & Institutions-FAST
40/45
Two types of currency markets 1. Spot Market for immediate delivery, e.g. e =
Rs. 140/.
2. Forward Market for delivery in 1, 3, or 6 months,e.g. F90 = Rs.142/. Allows investors, MNCs,exporters/importers to lock in ex-rates now for future
transactions. Example, a Pakistani exporter can sellBP forward at the forward rate (F90), a Pakistaniimporter can buy BP forward at F90 to eliminateforeign exchange risk.
-
8/3/2019 Financial Markets & Institutions-FAST
41/45
FINANCIAL INTERMEDIARIES Three categories of financial intermediaries:
1. Banks (depository institutions)
2. Contractual savings institutions (insurance companies andpension funds)
3. Investment intermediaries (finance companies, mutual funds,money market funds)
Banks accept deposits in the form of checking deposits/accounts,savings deposits/accounts and time deposits (CDs, fixed term tomaturity, 1 or 5 year CD). These deposits are liabilities for thebank and provide the source of funds.
-
8/3/2019 Financial Markets & Institutions-FAST
42/45
Banks (depository institutions) The banks then lend the money out in the form of
business loans, consumer loans (auto, student, homeimprovement, etc.), mortgages. These are assets of the
bank. Banks also invest in treasury securities andmunicipal bonds..
Profits: pay 3-4% to attract deposits, lend out at 8-12%,banks make money.
-
8/3/2019 Financial Markets & Institutions-FAST
43/45
Contractual Savings Institutions 1. Insurance Companies - source of funds:
premiums. Assets: stocks, bonds, mortgages, T-bonds.Mostly long-term assets based on actuarial
projections. 2. Pension funds - employer/employee contributions
provide source of funds. Assets are bonds and stocks,usually through mutual funds
-
8/3/2019 Financial Markets & Institutions-FAST
44/45
Investment Intermediaries Finance companies - Ford Credit, Toyota Credit. Issue
commercial paper, bonds and stocks to attract funds. Lend outcommercial loans.
Mutual funds - source of funds: savers/investors buying shares.Assets: portfolios of stocks and bonds (capital markets).Advantages: 1) lowers transactions costs for investors by poolinglarge sums of money and 2) provides excellent diversification -most mutual funds own 100s of companies.
Money market mutual funds - same as above, but investmentis in short-term money market, credit instruments (commercialpaper, t-bills, etc.), not capital markets. Often shareholders havechecking privileges, so it is an alternative to a checking account
with restrictions ($500 minimum). (Not so in Pakistan).
-
8/3/2019 Financial Markets & Institutions-FAST
45/45
THE END