unit 1: introduction

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FIN 252: Foundations of Financial Markets and Institutions

Facilitator:Ram Krishna Tiwari

BBS 4th Year

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Course Outline

Lecture Hours: 150 Full Marks: 100 Pass Marks: 35 Course Objective/s

Lay the foundation of students on financial institutions and markets by imparting the fundamentals concepts and theories of financial markets and institutions.

functioning of financial institutions such as depository and non-depository financial institutions, the role of the central bank, and the markets for government and corporate securities.

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Course Details Unit 1: Introduction - LH 10 Unit 2: Financial Institutions, Financial Intermediaries and Asset

Management Firms - LH 7 Unit 3: Depository Institutions- LH 8 Unit 4: The Central Bank and Monetary Policy - LH 10 Unit 5: Insurance Companies - LH 15 Unit 6: Investment Companies and Pension Funds - LH 15 Unit 7: Determinants of Asset Prices and Interest Rates - LH 15 Unit 8: Organization and Structure of Markets - LH 10 Unit 9: Market for Government Securities - LH 10 Unit 10: Markets for Common Stock - LH 10 Unit 11: Market for Corporate Senior Securities - LH 10 Unit 12: The Mortgage and Asset-backed Securities Markets - LH 10 Unit 13: Risks of Financial Institutions - LH 10 Project Work - LH 10

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Text and Reference Books

1-5About Financial Markets and Institutions

Important components of market economy. Fundamentals concepts and theories of;

Financial markets and assets, Depository and non-depository financial institutions, Central banking and monetary policy, Assets price and interest rates, Organization and structure of markets, Government securities markets, Markets for corporate securities, Mortgage and assets backed securities, and Risk in financial institutions.

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Unit 1: Introduction - LH 10

1.Overview of financial assets: concept of financial assets, debt versus equity instruments, the price of financial assets and risk, financial assets versus tangible assets, the role of financial assets;

2.Financial markets: concepts and role of financial markets, classification of financial markets, market participants, globalization of financial markets, classification of global financial markets, motivation for foreign market and Euromarkets;

3.The role of the government in financial markets: justification for regulation, forms of regulation; and

4.Financial innovation: categorization of financial innovations, and motivation for financial innovation.

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Concept of AssetsAn asset, broadly speaking, is any

possession that has value in an exchange, which can be classified as tangible or intangible.

Tangible Assets Value is based on physical properties Examples include buildings, land, machinery

Intangible Assets Claim to future income Examples include various types of financial

assets

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Real versus Financial Assets

• Real Assets• Used to produce goods and services: Property, plants and equipment, human capital, etc.

• Financial Assets• Claims on real assets or claims on real-asset income

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Real versus Financial Assets

• All financial assets (owner of the claim) are offset by a financial liability (issuer of the claim)

• When all balance sheets are aggregated, only real assets remain

• Net wealth of economy = Sum of real assets

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Real Assets vs. Financial Assets

Real assets: Possess productive capacity, hence are used to

produce goods and services Examples are property, plant & equipment, human

capital, etc.Financial assets:

Represents claims on income and other assets and define the allocation of income or wealth

Examples are shares of stocks, bonds, treasury securities, etc

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Financial Assets

1. Fixed-income (debt) securitiesa) Money market instruments

Bank certificates of deposit, T-bills, commercial paper, etc.

b) Bonds

c) Preferred stock

2. Common stock (equity) Ownership stake in entity, residual cash flow

3. Derivative securities Contract, value derived from underlying market condition

• Major Classes of Financial Assets or Securities

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Types of Financial Assets

Bank loansGovernment

bondsCorporate bondsMunicipal bondsForeign bond

Common stockPreferred stockForeign stock

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Identify the Type of Asset by Putting Cross (x)

Assets Real Financial

Plant and equipment X

Treasury bill

College education

A Rs 100 note

Patents

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Debt vs. Equity

Debt Instruments Fixed rupees payments Examples include loans, bonds

Equity Claims Rupees payment is based on earnings Residual claims Examples include common stock, partnership share

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Debt vs. Equity

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Debt vs. Equity

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Price of Financial Asset and Risk

The price or value of a financial asset is equal to the present value of all expected future cash flows. Expected rate of return Risk of expected cash flow

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Do you want to receive?

Option A Rs. 1000 After 3 years

Option B Rs. 875 today

Applicable Interest rate 5%

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Calculation

Option A Calculate PV

PV = FV / (1 + i)n= 1000/(1 + 0.05)3= Rs. 863.84 today

Option B Rs. 875 today

Option B shouldbe accepted

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Types of Investment Risks

Purchasing power risk or inflation risk

Default or credit risk

Exchange rate or currency risk

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Questions

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Role of Financial Assets

Transfer funds from surplus units to deficit units.

Transfer funds so as to redistribute unavoidable risk associated with cash flows generated from both tangible and intangible assets. Redistribute risk among people or institutions

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Key Points You Should Understand

Difference between tangible and financial assets

Difference between debt and equity Cash flow of a financial asset Three types of risks associated with financial

asset Two principal economic functions of financial

assets

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Questions

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Overview of the financial markets

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Financial Markets

A financial market is a market where financial assets are exchanged (i.e. traded). not necessary for the creation and exchange of a financial asset.

The market in which a financial asset trades for immediate delivery is called the spot market or cash market.

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Classification of financial markets1. By nature of financial claim, e.g. Debt markets and

Equity markets.2. By maturity of claim, e.g. Money market (short-term debt

instruments), Capital market (longer-maturity financial assets).

3. By seasoning of claim: Primary market (dealing with financial claims that are newly issued), Secondary market (exchanging financial claims previously issued)

4. By immediate delivery or future delivery: Cash or Spot market, Derivative markets

5. By organizational structure: Auction market, OTC market or Intermediated market

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Primary markets versus secondary markets Primary market – Households which are in

financial surplus, exchange their savings for shares, debentures and securities of the financial deficit sectors such as the companies and governments

Public issue of securities are made through prospectus

New issues of equity and debt are arranged in the form of a new flotation, either publicly or privately or in form of a rights offer, to existing shareholders

The transactions in the primary market result in capital formation

1-29Primary markets versus secondary markets (contd.) Secondary market – securities which have

been issued in the past are traded Secondary market is called stock market or

stock exchange Owners of shares to sell their holdings readily

ensuring liquidity Secondary market enables investors to

continuously rearrange their assets if they so desire by divesting themselves of such assets while others can use their surplus funds to acquire them

Any trade of share subsequent to its primary offering is called a secondary transaction

1-30Primary markets versus secondary markets (contd.) Initial buyer in the primary market may re-offer the

securities to any interested buyer at whatever price is mutually satisfactory

The stock exchange provides a market where such mutually satisfactory prices may be determined

The stock exchange offer opportunities primarily for trading risk and boost liquidity

The presence of an active secondary market actually promotes the growth of the primary market and capital formation because investors in the primary market are assured that a continuous market exists and they can liquidate their investment in the stock exchange

The participants in the secondary market are linked by formal trading rules and communication networks for trading securities

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Money markets Vs capital markets Money markets

to meet the short term investment needs (1 year or less) to earn a small positive rate of return on cash Highly liquid, minimal risk of principle loss money markets consist of unsecured interbank trading, short

term debt issuance, short-term secured lending Use of a temporary surplus of funds by banks or businesses

Capital markets where borrowers raise cash for long-term investment needs generally riskier than money markets and capital market securities must promise to pay a higher rate of

return to attract funds savers willing to take the associated risk are attracted to these

markets

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Money markets Vs capital markets

Money markets• Interbank transaction

• Treasury bills: short-term debts of government• Commercial paper: short-term liabilities of prime business firms and finance

companies

Capital markets• Ordinary share• Preference share

• Debentures/Government securities

1-33Financial markets by type of claim

Fixed income market

Residual claim

Debt instrument Preferred stock Common stock

Fixed amount claim

Equity (stock) market

Debt Market Common stock market

Source: Fabozzi and Modigliani (2010)

1-34Financial markets by maturity of claim

Maturity 1 year or less

Debt instruments Common stock and preferred stock

Money Market Capital market

Maturity greater than 1 year

Source: Fabozzi and Modigliani (2010)

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Foreign exchange markets

The majority of the world’s business involves international business transactions

As corporations and institutions have increased their international transactions, foreign exchange risk has become a major source of risk for many firms today and much hedging with spot and forward foreign exchange trades occurs

International financial crisis effect domestic economy Remittance inflow effect due to foreign currency fluctuation Oil price effect the overall economy of the country

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Derivative security markets A derivative security is a contract which derives its value

from some underlying asset or market condition Main purpose of the derivatives markets is to transfer risk

between market participants. Hedgers

enter derivatives contracts to reduce their risk exposure in the underlying cash market (Eliminate the risk of price fluctuations)

Speculators use derivative contracts to bet on price movements speculators gamble on price fluctuations and hope to profit

Derivatives are highly leveraged instruments This allows hedgers to reduce risk with a low capital investment and

the leverage also allows speculators to attempt to earn high rates of return with low capital investments

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Derivative security markets The two main types of derivatives markets Market for exchange traded derivatives

Exchange traded derivatives are generally liquid and involve no counterparty risk

Over the counter (OTC) derivatives markets OTC contracts are custom contracts negotiated between two

counterparties and have default risk

Long—Buyer of the contract, receive commodity in the future Short—Seller of the contract, provide commodity in the future

Derivative security markets are the newest of the financial security markets in the context of Nepal

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Questions

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Economic Functions (Role) of Financial Markets

1. The interactions of buyers and sellers in a financial market determine the price of the traded asset. (Price discovery process), (Determine price or required rate of return of asset.)

2. Financial markets provide a mechanism for an investor to sell a financial asset. A financial market offers liquidity. The degree of liquidity is one of the factors that characterize different markets. (Provide liquidity.)

3. It reduces the cost of transaction. Search costs and information cost.(Reduce transactions costs, which consists of search costs and information costs.)

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Financial Market Participants

Households Business units (nonfinancial and financial

enterprises) National governments, federal, state, and local

governments Government agencies Supranational (such as the World Bank, the

European Investment Bank, and the Asian Development Bank)

Regulators

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Three economic functions of financial markets

Ways that financial markets can be classified

Market participants

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Globalization

Globalization is a process of interaction and integration among the people, companies, and governments of different nations, a process driven by international trade and investment and aided by information technology.

Globalization (or globalisation) is the process of international integration arising from the interchange of world views, products, ideas and other aspects of culture.

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Globalization of Financial Markets

Factors that have led to the integration of financial markets

1. Deregulation or liberalization of markets and the activities of market participants in key financial centers of the world.

2. Technological advances for monitoring world markets, executing orders, and analyzing financial opportunities

3. Increased institutionalization of financial markets.

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Questions

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Globalization of Financial Markets

Financial markets have shifted from domination by retail investors (individuals) to domination by financial institutions (institutional investors).

1-47Globalization of Financial Markets and Institutions Recent decades have witnessed the globalization of

financial markets to an unique degree The growth in foreign financial markets has 5 ongoing

causes:1. Greater pool of savings in foreign countries2. Better investment prospects outside of countries with large savings3. The Internet has improved information availability on foreign markets

and securities4. Low cost methods to invest in foreign securities have proliferated

(fast growth)5. Deregulation around the world has allowed investors to purchase

more foreign securities.

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Classification of Global Financial Markets

Internal Market(also called national

market)

External Market(also called internationalmarket, offshore market,

and Euro market)

Domestic Market Foreign Market

1-49Classification of Global Financial Markets National Market

The National Market System (NMS) is the national system for trading equities in the a Single Country. The System includes all the facilities and entities which are used by broker-dealers to fulfill trade orders for securities. This includes: major stock exchanges, such as NYSE and NEPSE. Domestic Market

A domestic market, also referred to as an internal market or domestic trading, is the supply and demand of goods, services, and securities within a single country. In domestic trading, a firm faces only one set of competitive, economic, and market issues and essentially must deal with only one set of customers, although the company may have several segments in a market.

South Korean Market Foreign Market

Part of a nation's internal market, representing the mechanisms for issuing and trading securities of entities domiciled outside that nation.

1-50Classification of Global Financial Markets Euromarket

The euromarket is the market that includes all of the European Union member countries - many of which use the same currency, the euro. All tariffs between Euromarket member countries have been abolished, and import duties from all non-member countries have been fixed for all of the member countries. The Euromarket also has one central bank for all of the member countries, the European Central Bank (ECB).

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Questions

Explain the differences between:

1. Domestic Market vs. Foreign Market2. National Market vs. Euromarket

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Motivation for Using Foreign Markets and Euromarkets1. The fund-seeking corporation’s domestic market is not fully developed

and cannot satisfy its demand for funds on globally competitive terms.

(Limited fund availability in internal market)

2. There may be opportunities for obtaining a lower cost of funding than

is available in the domestic market.(Reduced cost of funds)

3. Diversifying funding sources

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Derivatives Market

Futures/forward contracts are obligations that must be fulfilled at maturity.

Options contracts are rights, not obligations, to either buy (call) or sell (put) the underlying financial instrument.

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Role of Derivative Instruments

Protect against different types of investment risks, such as purchasing power risk, interest rate risk, exchange rate risk.

Advantages: Lower transactions costs Faster to carry out transaction Greater liquidity

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Three major factors that have integrated financial markets

Institutionalization of financial markets Internal and external markets Motive to raise money outside of domestic

market Two basic types of derivatives Principal economic role of derivatives Potential uses of derivatives

1-56The RegulationRegulations are legal restrictions circulated by government authority. Financial system is among the most heavily regulated sectors of the economy.

Banks are among the most heavily regulated of financial institutions.However, Regulations sometimes can’t prevent financial crisis.The time and energy spent on regulatory compliance activities are costly.

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Justification for Regulation

Create competitive market and fairnessPrevent market failurePrevent fraudPromote stability of financial institutionsControl level of economic activityRestrict the activities of foreign concerns in

domestic markets and institutions

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Types of Regulation

Disclosure regulation Financial activity regulation Regulation of financial institution Regulation of foreign participation

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Regulation in Nepal

Reasons for regulation Stock market crash of 1929, Great Depression

of 1930s, Asian Crisis of 1997, and Financial Crisis of 2008

Regulation primarily by Nepal Rastra Bank, Government, SEBON, Insurance Board, and Regulatory Institutions

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Financial market regulation Financial markets are regulated by the Security Board of

Nepal (SEBO/N) in Nepal The primary purposes of regulations are

to prevent fraud, to ensure performance as promised, and to ensure that the public has enough information to evaluate

the riskiness of an investment. the regulators do not attempt to ensure investors earn a

minimum rate of return to ensure full and fair disclosure of information on securities

issues to actual and potential investors (new issue legal document “Prospectus”)

monitors trading on the exchanges

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Financial market regulation (contd.) The primary purposes of regulations are…………………

To ensure that stockholders and managers do not trade on the basis of insider information

An effort to reduce excessive price fluctuations

Current Regulations1. NRB Act, 20582. BAFIA, 20633. Unified Directives4. Foreign Currency related Act and Circulars

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Financial market regulation (contd.) Securities Allotment Guidelines, 2068 Securities Exchange Act, 2006 Membership of stock exchange and transaction bye-laws

1993 Securities listing bye-laws 1996 New issue management guidelines 1997 Securities allotment guidelines 1997 Compliance guidelines for securities brokers Securities registration and issue approval guidelines 2057 Bonus share guidelines 2058 Government securities transaction bylaws of SEBO 2062. Securities Registration and Issue Regulation, 2065 Securities Registration and Issue Regulation, 2065 (First Amendment) Securities Issue Guidelines, 2065

See (http://sebon.gov.np/)

http://sebon.gov.np/

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Overview of the financial institutions

1-64Financial institutions

Institution that perform the essential function of channeling funds from those with surplus funds to those with shortages of fund

Savers typically desire a different type of claim than the ultimate borrower wishes to offer

Asset transformers, such as banks, offer low risk claims to savers while granting higher risk, more illiquid investments (e.g., loans) to the funds demanders.

Other types of institutions have evolved to meet special needs of savers such as life insurance firms to eliminate certain risks, pension funds to transfer wealth through time, mutual funds to pool investors’ savings, etc.

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Financial Institutions

A. Depositary Financial Institutions1. Commercial Banks2. Development Banks3. Finance Companies (in Nepal only) 4. Micro-credit Development Banks5. Saving Credit Cooperatives6. NGOs (Financial Intermediaries)

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Financial Institutions

B. Non-Depositary Financial Institutions1. Insurance Companies

- Life insurance companies- Non-life insurance companies

2. Investment Companies3. Employees Provident Fund4. Citizen Investment Trust5. Mutual Funds

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Flow of Funds in Financial Markets

1-69Categorization of financial innovations Financial system/institutional innovations.

Such innovations can effect the financial sector as a whole, relate to changes in business structures, to the establishment of new types of financial intermediaries, or to changes in the legal and supervisory framework. Important examples include the use of the group mechanism to retail financial services, formalizing informal finance systems, reducing the access barriers for women, or setting up a completely new service structure. For e.g. - Bancassurance

1-70Categorization of financial innovationsProcess innovations

Such innovations cover the introduction of new business processes leading to increased efficiency, market expansion, etc. Examples include office automation and use of computers with accounting and client data management software.

1-71Categorization of financial innovationsProduct innovations.

Such innovations include the introduction of new credit, deposit, insurance, leasing, hire purchase, and other financial products. Product innovations are introduced to respond better to changes in market demand or to improve the efficiency.

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Explanation for the existence of regulation Goals sought in regulation Major forms of regulation financial innovationCategorization of financial innovationsMotivation for financial innovation

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Thank You

unit 1: introduction

Education