Financial Institution Module Handbook

Presented to BBA-8

Presented by

Muhammad Bilal (FA10-BBA-149)

Khizar Nawaz (FA10-BBA--___)

Submitted to

Sir wajid Shakeel

Dated: 04-03-2014

CHAPTER # 1

(WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS)

Financial markets: Any marketplace where buyers and sellers participate in the trade of

assets such as equities, bonds, currencies and derivatives. Financial markets are typically

defined by having transparent pricing, basic regulations on trading, costs and fees and market

forces determining the prices of securities that trade. Some financial markets only allow

participants that meet certain criteria, which can be based on factors like the amount of

money held, the investor's geographical location, knowledge of the markets or the profession

of the participant.

Debt and interest rate: A security (also referred to as a monetary instrument) may be a

claim on the issuer’s future income or assets (any monetary claim or piece of property that's

subject to ownership). A bond may be a debt security that guarantees to form payments

sporadically for a nominal amount of your time.1 Debt markets, additionally typically

brought up generically because the bond market, square erasure particularly necessary to

economic activity as a result of the permit companies and governments to borrow so as to

finance their activities; the bond market is additionally wherever interest rates square measure

determined. Associate degree charge per unit is that the price of borrowing or the value

procured the rental of funds (usually expressed as a proportion of the rental of $100 per year).

There square measure several interest rates within the economy—mortgage interest rates,

automobile loan rates, and interest rates on many alternative types of bonds. Interest rates

square measure necessary on variety of levels. On a private level, high interest rates might

deter you from shopping for a house or automobile as a result of the price of finance it would

be high. Conversely, high interest rates might encourage you to avoid wasting because you'll

earn a lot of interest financial gain by putt aside a number of your earnings as savings. On a

lot of general level, interest rates have a sway on the general health of the economy as a result

of they have an effect on not solely consumers’ disposition to pay or save however

additionally businesses’ investment choices. High interest rates, for instance, might cause a

company to put over building a replacement plant that may offer a lot of jobs.

Stock market: A common stock (typically simply referred to as a stock) represents a share of

possession in a corporation. It’s a security that's a claim on the earnings and assets of the

corporation. Issuing stock and merchandising it to the general public may be a manner for

companies to boost funds to finance their activities. The securities market, during which

claims on the earnings of companies (shares of stock) area unit listed, is that the most

generally followed monetary market in nearly each country that has one; that’s why it's

usually referred to as merely ―the market.‖ A big swing within the costs of shares within the

securities market is usually a significant story on the evening news. Folks usually speculate

on wherever the market is heading and obtain terribly excited once they will brag regarding

their latest ―big killing,‖ however they become depressed when they suffer a giant loss. The

eye the market receives will most likely be best explained by one straightforward fact: it's an

area wherever folks will get rich—or poor—quickly.

Foreign Exchange Market: The markets in which participants are able to buy, sell,

exchange and speculate on currencies. Foreign exchange markets are made up of banks,

commercial companies, central banks, investment management firms, hedge funds, and retail

forex brokers and investors. The forex market is considered to be the largest financial market

in the world

Financial Intermediary: An entity that acts as the middleman between two parties in a

financial transaction. While a commercial bank is a typical financial intermediary, this

category also includes other financial institutions such as investment banks, insurance

companies, broker-dealers, mutual funds and pension funds. Financial intermediaries offer a

number of benefits to the average consumer including safety, liquidity and economies of

scale.

Managing risk in financial institutions: In recent years, the economic environment has

become an increasingly risky place. Interest rates have fluctuated wildly, stock markets have

crashed both here and abroad, speculative crises have occurred in the foreign exchange

markets, and failures of financial institutions have reached levels unprecedented since the

Great Depression. To avoid wild swings in profitability (and even possibly failure) resulting

from this environment, financial institutions must be concerned with how to cope with

increased risk.

Conclusion: Activities in financial markets have direct effects on individuals’ wealth, the

behavior of businesses, and the efficiency of our economy. Three financial markets deserve

particular attention: the bond market (where interest rates are determined), the stock market

(which has a major effect on people’s wealth and on firms’ investment decisions), and the

foreign exchange market (because fluctuations in the foreign exchange rate have major

consequences for the U.S. economy). Because monetary policy affects interest rates,

inflation, and business cycles, all of which have an important impact on financial markets and

institutions, we need to understand how monetary policy is conducted by central banks in the

United States and abroad.

Assignment

Financial Innovation

Introduction:

State Bank of Pakistan is implementing the Financial Inclusion Program (FIP), sponsored by

the UK Aid, with the aim to improve access to financial services in Pakistan. FIP has adopted

a multi-pronged approach towards tackling the problem of financial exclusion by combining

market forces and public sector principles. A notable tool of this approach is to accelerate on

innovations to widen the reach of financial services in Pakistan.

FIP has kept GBP 10 million pound in grants under the Financial Innovation Challenge Fund

(FICF) to help the financial sector reach the excluded with use of innovations. Specifically,

FICF will foster innovations to test new markets, lower cost of delivery, enable systems and

procedures to be more efficient and provide new ways of meeting the unmet demand for

financial services. The fund will hold specialized challenge rounds focusing on innovations

that market wishes to undertake to alter the scope and reach of financial services. Hence,

FICF will be open to both bank and non-bank financial institutions, telecoms, NGOs, and

academic organizations.

Objectives

The following are the objective of FICF:

a) Spur innovation and innovative practices that increase access to financial services by the

unbanked or the financially excluded. The fund will provide support for pilots and for up-

scaling financial services vis-à-vis seed capital and a platform for knowledge sharing.

b) Leverage FICF funds to attract private investment. Additional capital will help create a

bridge between pilot and roll-out of an innovation.

c) Create relations between successful projects with other funds under FIP and beyond to

ensure that pilots can be brought to scale through donor and private sector coordination.

Scope

The broad scope of the fund is to facilitate the spread of financial services through

innovation. Innovation may come in the following forms:

a) A product or service completely new and novel proposed by the applicant; or

b) A product or service that has been tested and proved successful somewhere in the world

but is new to Pakistan; or

c) An innovation that has been tested in Pakistan by organizations and has proved successful

and the applicant organization wishes to test it with a new partner or in a different territory.

CHAPTER # 2

(FINANCIAL CRISES)

Financial Crisis

A situation in which the value of financial institutions or assets drops rapidly. A financial

crisis is often associated with a panic or a run on the banks, in which investors sell off assets

or withdraw money from savings accounts with the expectation that the value of those assets

will drop if they remain at a financial institution. In the 19th and early 20th centuries, many

financial crises were associated with banking panics, and many recessions coincided with

these panics. Other situations that are often called financial crises include stock market

crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults.

Financial crises directly result in a loss of paper wealth but do not necessarily result in

changes in the real economy.

Types of financial crisis

Banking crisis: When a bank suffers a sudden rush of withdrawals by depositors, this is

called a bank run. Since banks lend out most of the cash they receive in deposits. it is difficult

for them to quickly pay back all deposits if these are suddenly demanded, so a run renders the

bank insolvent, causing customers to lose their deposits, to the extent that they are not

covered by deposit insurance. An event in which bank runs are widespread is called a

systemic banking crisis or banking panic. Examples of bank runs include the run on the Bank

of the United States in 1931 and the run on Northern Rock in 2007. Banking crises generally

occur after periods of risky lending and resulting loan defaults.

Speculative bubbles and crashes: A speculative bubble exists in the event of large,

sustained overpricing of some class of assets. One factor that frequently contributes to a

bubble is the presence of buyers who purchase an asset based solely on the expectation that

they can later resell it at a higher price, rather than calculating the income it will generate in

the future. If there is a bubble, there is also a risk of a crash in asset prices: market

participants will go on buying only as long as they expect others to buy, and when many

decide to sell the price will fall. However, it is difficult to predict whether an asset's price

actually equals its fundamental value, so it is hard to detect bubbles reliably. Some

economists insist that bubbles never or almost never occur. Black Friday, 9 May 1873,

Vienna Stock Exchange. The Panic of 1873 and Long Depression followed. Well-known

examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices

include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of

the 1980s, the crash of the dot-com bubble in 2000–2001, and the now-deflating United

States housing bubble. The 2000s sparked a real estate bubble where housing prices were

increasing significantly as an asset good.

International financial crises: When a country that maintains a fixed exchange rate is

suddenly forced to devalue its currency because of a speculative attack, this is called a

currency crisis or balance of payments crisis. When a country fails to pay back its sovereign

debt, this is called a sovereign default. While devaluation and default could both be voluntary

decisions of the government, they are often perceived to be the involuntary results of a

change in investor sentiment that leads to a sudden stop in capital inflows or a sudden

increase in capital flight. Several currencies that formed part of the European Exchange Rate

Mechanism suffered crises in 1992–93 and were forced to devalue or withdraw from the

mechanism. Another round of currency crises took place in Asia in 1997–98. Many Latin

American countries defaulted on their debt in the early 1980s. The 1998 Russian financial

crisis resulted in a devaluation of the ruble and default on Russian government bonds.

Wider economic crisis: Negative GDP growth lasting two or more quarters is called a

recession. An especially prolonged or severe recession may be called a depression, while a

long period of slow but not necessarily negative growth is sometimes called economic

stagnation.

Declining consumer spending: Some economists argue that many recessions have been

caused in large part by financial crises. One important example is the Great Depression,

which was preceded in many countries by bank runs and stock market crashes. The subprime

mortgage crisis and the bursting of other real estate bubbles around the world also led to

recession in the U.S. and a number of other countries in late 2008 and 2009. Some

economists argue that financial crises are caused by recessions instead of the other way

around, and that even where a financial crisis is the initial shock that sets off a recession,

other factors may be more important in prolonging the recession. In particular, Milton

Friedman and Anna Schwartz argued that the initial economic decline associated with the

crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged

depression if it had not been reinforced by monetary policy mistakes on the part of the

Federal Reserve, a position supported by Ben Bernanke.

Causes and consequences of financial crisis

Strategic complementarities in financial markets: It is often observed that successful

investment requires each investor in a financial market to guess what other investors will do.

George Soros has called this need to guess the intentions of others 'reflexivity'. Similarly,

John Maynard Keynes compared financial markets to a beauty contest game in which each

participant tries to predict which model other participants will consider most beautiful.

Circularity and self-fulfilling prophecies may be exaggerated when reliable information is not

available because of opaque disclosures or a lack of disclosure. Furthermore, in many cases

investors have incentives to coordinate their choices. For example, someone who thinks other

investors want to buy lots of Japanese yen may expect the yen to rise in value, and therefore

has an incentive to buy yen too. Likewise, a depositor in IndyMac Bank who expects other

depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive

to withdraw too. Economists call an incentive to mimic the strategies of others strategic

complementarity. It has been argued that if people or firms have a sufficiently strong

incentive to do the same thing they expect others to do, then self-fulfilling prophecies may

occur. For example, if investors expect the value of the yen to rise, this may cause its value to

rise; if depositors expect a bank to fail this may cause it to fail. Therefore, financial crises are

sometimes viewed as a vicious circle in which investors shun some institution or asset

because they expect others to do so.

Leverage: Leverage, which means borrowing to finance investments, is frequently cited as a

contributor to financial crises. When a financial institution (or an individual) only invests its

own money, it can, in the very worst case, lose its own money. But when it borrows in order

to invest more, it can potentially earn more from its investment, but it can also lose more than

all it has. Therefore leverage magnifies the potential returns from investment, but also creates

a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised

payments to other firms, it may spread financial troubles from one firm to another. The

average degree of leverage in the economy often rises prior to a financial crisis. For example,

borrowing to finance investment in the stock market ("margin buying") became increasingly

common prior to the Wall Street Crash of 1929. In addition, some scholars have argued that

financial institutions can contribute to fragility by hiding leverage, and thereby contributing

to underpricing of risk.

Asset-liability mismatch: Another factor believed to contribute to financial crises is asset-

liability mismatch, a situation in which the risks associated with an institution's debts and

assets are not appropriately aligned. For example, commercial banks offer deposit accounts

which can be withdrawn at any time and they use the proceeds to make long-term loans to

businesses and homeowners. The mismatch between the banks' short-term liabilities (its

deposits) and its long-term assets (its loans) is seen as one of the reasons bank runs occur

(when depositors panic and decide to withdraw their funds more quickly than the bank can

get back the proceeds of its loans). Likewise, Bear Stearns failed in 2007–08 because it was

unable to renew the short-term debt it used to finance long-term investments in mortgage

securities. In an international context, many emerging market governments are unable to sell

bonds denominated in their own currencies, and therefore sell bonds denominated in US

dollars instead. This generates a mismatch between the currency denomination of their

liabilities (their bonds) and their assets (their local tax revenues), so that they run a risk of

sovereign default due to fluctuations in exchange rates.

Regulatory failures: Governments have attempted to eliminate or mitigate financial crises

by regulating the financial sector. One major goal of regulation is transparency: making

institutions' financial situations publicly known by requiring regular reporting under

standardized accounting procedures. Another goal of regulation is making sure institutions

have sufficient assets to meet their contractual obligations, through reserve requirements,

capital requirements, and other limits on leverage. Some financial crises have been blamed on

insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For

example, the former Managing Director of the International Monetary Fund, Dominique

Strauss-Kahn, has blamed the financial crisis of 2008 on 'regulatory failure to guard against

excessive risk-taking in the financial system, especially in the US'. Likewise, the New York

Times singled out the deregulation of credit default swaps as a cause of the crisis. However,

excessive regulation has also been cited as a possible cause of financial crises. In particular,

the Basel II Accord has been criticized for requiring banks to increase their capital when risks

rise, which might cause them to decrease lending precisely when capital is scarce, potentially

aggravating a financial crisis. International regulatory convergence has been interpreted in

terms of regulatory herding, deepening market herding (discussed above) and so increasing

systemic risk. From this perspective, maintaining diverse regulatory regimes would be a

safeguard. Fraud has played a role in the collapse of some financial institutions, when

companies have attracted depositors with misleading claims about their investment strategies,

or have embezzled the resulting income. Examples include Charles Ponzi's scam in early 20th

century Boston, the collapse of the MMM investment fund in Russia in 1994, the scams that

led to the Albanian Lottery Uprising of 1997, and the collapse of Madoff Investment

Securities in 2008.

Many rogue traders that have caused large losses at financial institutions have been accused

of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been

cited as one possible cause of the 2008 subprime mortgage crisis; government officials stated

on September 23, 2008 that the FBI was looking into possible fraud by mortgage financing

companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American

International Group. Likewise it has been argued that many financial companies failed in the

recent crisis because their managers failed to carry out their fiduciary duties.

Contagion: Contagion refers to the idea that financial crises may spread from one institution

to another, as when a bank run spreads from a few banks to many others, or from one country

to another, as when currency crises, sovereign defaults, or stock market crashes spread across

countries. When the failure of one particular financial institution threatens the stability of

many other institutions, this is called systemic risk. One widely cited example of contagion

was the spread of the Thai crisis in 1997 to other countries like South Korea. However,

economists often debate whether observing crises in many countries around the same time is

truly caused by contagion from one market to another, or whether it is instead caused by

similar underlying problems that would have affected each country individually even in the

absence of international linkages.

CHAPTER # 3

(OVER VIEW OF THE FINANCIAL SYSTEM)

Function of Financial Markets

They perform very important function by acting as a medium of exchange from funds. Some

people who save their income can lend it to others who have good opportunities to invest

them and produce more return. Financial market is the place where this can be done. For this

purpose there are two ways:

Direct finance:

In this borrowers borrow funds directly from lenders in financial markets by selling them

securities (also called financial instruments), which are claims on the borrower’s future

income or assets. Securities are assets for the person, who buys them, but they are liabilities

(IOUs or debts) for the individual or firm that sells (issues) them.

Indirect finance:

In this a third party called financial intermediaries is responsible for transfer of funds between

borrower and lenders. These include banks, mutual funds, insurance companies etc. these

take money from savers and then give it to investors.

Financial markets play very important role for economy, this can be understood by an

example. Let’s suppose there was a person A, who has saved Rs.100. if he gives it to person

B on interest of 10% who want to buy new equipment which will reduce his cost and increase

his income. At the end return to A will be Rs.110 and it will help to increase productivity.

Without the financial markets it could not be possible.

Financial markets are critical for producing an efficient allocation of capital (wealth, either

financial or physical, that is employed to produce more wealth), which contributes to higher

production and efficiency for the overall economy

Structure of Financial Markets

Debt and Equity Markets

Most common method used to get fund is to issue bonds or mortgages. By this borrower is

bound to pay fixed periodic payments until the maturity date when he loan is returned totally.

A debt instrument is short-term if its maturity is less than a year and long-term if its

maturity is 10 years or longer. Debt instruments with a maturity between one and 10 years are

said to be intermediate-term.

Another way is to issue equities, like common stock, it is claim over income of organization

and on assets. For example a firm issue 100 shares and you have bought 30 share then you

have 30% ownership of that organization. Some of these shares pay periodically in form of

dividends and are considered long term securities as they don’t mature. The main

disadvantage of owning a corporation’s equities rather than its debt is that the corporation

must pay its equity holders after it pays to all its debt holders. The advantage of holding

equities is that equity holders benefit directly from any increases in the corporation’s

profitability or asset. Debt holders do not share in this benefit, because their dollar payments

are fixed. Equity holders also have voting rights to choose directors for organization.

Size of the debt market is often substantially larger than the size of the equities market.

Primary and Secondary Markets

In primary market new securities are issued, such as a bond or a stock and are sold to initial

buyers by the corporation or government agency for raising funds.

In secondary market previously issued securities can be resold.

Exchanges and Over-the-Counter Markets

Secondary markets can work in two ways. One method is through exchanges, where buyers

and sellers of securities meet in one central location to conduct trades e.g. Stock Exchanges.

The other way is to have an over-the counter (OTC) market, in which dealers at different

locations who have an inventory of securities stand ready to buy and sell securities ―over the

counter‖ to anyone who comes to them and is willing to accept their prices. This is not very

much different from stock exchanges but it has high competition.

Money and Capital Markets

We can distinguish financial markets on the basis of the maturity of the securities traded in

each market. The money market is a financial market in which only short-term debt

instruments (generally those with original maturity of less than one year) are traded. The

capital market is the market in which long term debt (generally with original maturity of one

year or greater) and equity instruments are traded. Money market securities are usually more

widely traded than longer-term securities and so tend to be more liquid.

Conclusion

The basic function of financial markets is to channel funds from savers who have an excess

of funds to spenders who have a shortage of funds. Financial markets can do this either

through direct finance, in which borrowers borrow funds directly from lenders by selling

them securities, or through indirect finance, which involves a financial intermediary that

stands between the lender-savers and the borrower-spenders and helps transfer funds from

one to the other. This channeling of funds improves the economic welfare of everyone in the

society. Because they allow funds to move from people who have no productive investment

opportunities to those who have such opportunities, financial markets contribute to economic

efficiency. In addition, channeling of funds directly benefits consumers by allowing them to

make purchases when they need them most. Financial markets can be classified as debt and

equity markets, primary and secondary markets, exchanges and over-the-counter markets,

and money and capital markets.

Assignment

Eurobond: a bond denominated in a currency other than that of the country in which it is

sold for example, a bond denominated in U.S. dollars sold in London.

Eurocurrencies: these are foreign currencies deposited in banks outside the home country.

Eurodollars: which are U.S. dollars deposited in foreign banks outside the United States or

in foreign branches of U.S. banks. Because these short-term deposits earn interest, they are

similar to short-term Eurobonds.

CHAPTER # 4

(WHAT DO INTEREST RATES MEAN AND WHAT IS THEIR

ROLE IN VALUATION)

INTRODUCTION:

Interest rates are among the most closely watched variables in the economy. Their

movements are reported almost daily by the news media because they directly affect our

everyday lives and have important consequences for the health of the economy. They affect

personal decisions such as whether to consume or save, whether to buy a house, and whether

to purchase bonds or put funds into a savings account. Interest rates also affect the economic

decisions of businesses and households, such as whether to use their funds to invest in new

equipment for factories or to save their money in a bank.

Interest rates are important to understand because due to the fluctuation of interest rate, we

make our decisions about personal decisions or business decisions. Personal decisions in term

of like if I want to buy a house and want some money borrow, so if interest rate is low that

I’d be supposed to pay at the end of the time, then I’d go for borrowing. Same is the case with

business decisions, like if a business intends to extend its operations and want some money

but due to fluctuation in interest rate it is not possible.

Also due to fluctuation in interest rate, the value of your assets decrease and you’d try to sell

it out. Here is another concept that when money comes with anyone, different ideas come in

mind to rock the world. Investment bankers and brokers need such type of idea to tell to the

potential investors that their money won’t be lost. There are different ways to measure the

interest rate given below.

Present value: present value tells that cash flow paid to you after specific time is less worthy

than it’s paid to you today. Through present value, interest rate could be determined. For

example, if you made your friend Ali a simple loan of PKR 1000 for one year, you would

require him to repay the principal of PKR 1000 in one year’s time along with an additional

payment for interest; like PKR 100. In the case of a simple loan, the interest payment divided

by the amount of the loan. So simple interest rate, i, is: 100/1000=10%

Yield to maturity: it’s most accurate measure of interest rate because it calculates the

present value of cash flow received from any debt instrument with its value today. Lets

suppose I want to borrow PKR 1000 from Rizwan today and he wants me to give him back

PKR 1100 after one month. So here the difference that is of PKR 100 would be calculated by

yield to maturity.

1000=1100/(1+i)

(1+i) 1000=1100

i=1.10-1=0.10=10%

Real and nominal interest rate: nominal interest rate is that interest rate that makes no

allowance for inflation. It is different from real interest rate because real interest rate has

included inflation with it. The interest rate makes no allowance for inflation, and it is more

precisely referred to as the nominal interest rate. We distinguish it from the real interest rate,

the interest rate that is adjusted by subtracting expected changes in the price level (inflation)

so that it more accurately reflects the true cost of borrowing. This interest rate is more

precisely referred to as the ex-ante real interest rate because it is adjusted for expected

changes in the price level. The ex-ante real interest rate is most important to economic

decisions, and typically it is what financial economists mean when they make reference to the

―real‖ interest rate. The interest rate that is adjusted for actual changes in the price level is

called the ex post real interest rate. It describes how well a lender has done in real terms after

the fact. The real interest rate is more accurately defined by the Fisher equation, named for

Irving Fisher, one of the great monetary economists of the twentieth century. The Fisher

equation states that the nominal interest rate i equals the real interest rate is plus the expected

rate of inflation.

Real interest rate=nominal interest rate + inflation.

Credit Market Instruments: A simple loan, in which the lender gives to the borrower with

an amount of funds, which must be repaid to the lender at the maturity date along with an

additional payment for the interest. A fixed-payment loan in which the lender gives to the

borrower with an amount of funds, which must be repaid by making the same payment every

period (such as a month), consisting of part of the principal and interest for a set number of

years. A coupon bond pays the owner of the bond a fixed interest payment (coupon

payment) every year until the maturity date, when a specified final amount face value is

repaid. A discount bond also called a zero-coupon bond is bought at a price below its face

value called as at a discount, and the face value is repaid at the maturity date. For example, a

discount bond with a face value of $1,000 might be bought for $900; in a year’s time the

owner would be repaid the face value of $1,000.

Interest rate risk: prices of longer-maturity bonds respond more dramatically to changes in

interest rates helps explain an important fact about the behavior of bond markets: Prices and

returns for long-term bonds are more volatile than those for shorter-term bonds.

Reinvestment Risk: Up to now, we have been assuming that all holding periods are short

and equal to the maturity on short-term bonds and are thus not subject to interest-rate risk.

However, if an investor’s holding period is longer than the term to maturity of the bond, the

investor is exposed to a type of interest-rate risk called reinvestment risk. Reinvestment risk

occurs because the proceeds from the short-term bond need to be reinvested at a future

interest rate that is uncertain.

CHAPTER # 5

(WHY DO INTEREST RATE CHANGE)

Determinants of Asset Demand: An asset is a piece of property that is a store of value.

Items such as money, bonds, stocks, art, land, houses, farm equipment, and manufacturing

machinery are all assets. Asset demand can be considered with the help of following factors:

1. Wealth, the total resources owned by the individual, including all assets. When wealth

increases then ability to demand assets also increases.

2. Expected return (the return expected over the next period) on one asset relative to

alternative assets. If there are two companies from which company A’s return was previously

20% but now it is increased to 25% so people will buy its securities more than company B

return stayed on 20%.

3. Risk (the degree of uncertainty associated with the return) on one asset relative to

alternative assets. For example if company B gives return of 10% for half of life and 5% for

other half-life then there is a risk in it as its return is fluctuating. But if company A provides

return at constant rate of 10% people will demand its securities more because it has no

uncertainty on rate of return.

4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to

alternative assets. People prefer short term securities because they are highly liquid i.e. they

can be resold easily and quickly then long term securities.

Supply and Demand in the Bond Market: Demand Curve: It shows the relationship

between the quantity demanded and the price when all other economic variables are held

constant. We can analyse it with the help of a example through following formula:

I =Re= F-P/P

Where I = interest rate = yield to maturity

Re = expected return

F = face value of the discount bond

P = initial purchase price of the discount bond

If the bond sells for $950, the interest rate and expected return are

1000-950/950= 5.3%

But At a price of $900, the interest rate and expected return are

1000-900/900= 11.1%

So definitely people will buy more at a price of RS.900 as it is giving more return. Demand

increases from $100 billion to $200 billion, when price fall from $950- $900.

But opposite is the case with supply organizations will supply more when prices are high

because it helps them to raise more funds at lower cost of borrowing (interest). So when price

increases from 900 to 950, supply goes up by $100 billion.

Equilibrium between supply and demand is gained at price of $850 with interest rate of

17.6%. Equilibrium satisfies both buyers and sellers of securities.

Market always move toward equilibrium i.e. when prices are lower than $850 people will

demand more as security is cheaper to purchase and provides more return while organizations

will supply less as its cost is high and funds are also less, due to more demand and less supply

(excess demand) prices will rise until they reach $850. Vice versa in the case when prices are

above equilibrium.

Shifts in the Demand for Bonds

Some factors cause the demand curve for bonds to shift. These factors include changes in

four parameters:

1. Wealth:

In a business cycle expansion with growing wealth, the demand for bonds rises and the

demand curve for bonds shifts to the right. Using the same reasoning, in a recession, when

income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the

left.

Bond price

Quantity demand

2. Expected returns on bonds relative to alternative assets:

Higher expected interest rates in the future lower the expected return for long-term bonds,

decrease the demand, and shift the demand curve to the left. (Higher interest means lower

prices in future which can reduce gain on sale of these securities).

3. Risk of bonds relative to alternative assets:

If prices in the bond market become more volatile, the risk associated with bonds increases,

and bonds become a less attractive asset. An increase in the riskiness of bonds causes the

demand for bonds to fall and the demand curve to shift to the left.

BD1

111

BD2

Bond price &

Interest rate

Quantity demand

4. Liquidity of bonds relative to alternative assets:

Increased liquidity of bonds results in an increased demand for bonds, and the demand curve

shifts to the right.

Bond price

Quantity demand

Shifts in the Supply of Bonds

Certain factors can cause the supply curve for bonds to shift, among them these:

1. Expected profitability of investment opportunities:

The more profitable plant and equipment investments that a firm expects it can make, the

more willing it will be to borrow to finance these investments. When the economy is growing

rapidly, as in a business cycle expansion, investment are expected to be profitable, and the

quantity of bonds supplied at any given bond price will increase.

BD1

111

BD2

BD1

111

BD2

Bond price

Quantity supply

2. Expected inflation

The more profitable plant and equipment investments that a firm expects it can make, the

more willing it will be to borrow to finance these investments. When the economy is growing

rapidly, as in a business cycle expansion, investment opportunities that are expected to be

profitable abound, and the quantity of bonds supplied at any given bond price will increase.

Bond price

Quantity supply

BS1

111

BS2

BS1

111

BS2