financial markets & institutions-fast

8/3/2019 Financial Markets & Institutions-FAST

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Lecture 1 & 2


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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.


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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


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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.


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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)


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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)


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Course Evaluation and RewardsFinal Comprehensive Examination 40%


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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.


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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?


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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


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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.


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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.


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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.


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The Role of Financial System To provide payment mechanism.

Provision of special financial services such as pension

and insurance.


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Saver- Lenders & Borrower- Spenders1) Households

2) Business Firms

3) Government4) Foreigners

Borrowers- Spenders

1) Business Firms

2) Government

3) Households

4) Foreigners


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Direct Finance

Savers-Lenders

Borrowers-

spenders

FinancialMarkets

Funds Funds


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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


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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.


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Indirect Finance

Savers-Lenders

Borrowers-spenders

FinancialIntermediary FundsFunds


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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


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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.


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Indirect Finance Allows choice of desired maturity

maturity intermediation

diversification w/ small amount of capital lower transactions costs

alternative payment mechanisms


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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.


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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


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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.


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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.


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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


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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.


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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)


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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


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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


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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.


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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).


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Expected Return In the form of interest or dividend

Price appreciation

Ceteris paribus higher the return , greater will bedemand of the instrument.


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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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


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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).


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