BBC406 Fundamentals of

Finance
Week 2 Malaysia Financial System

Overview of the Financial

Management

Part 1
Financial Markets and
Institutions

Learning Outcomes
describe the types of financial markets that
facilitate the flow of funds
describe the types of securities traded within
financial markets
describe the role of financial institutions within
financial markets
explain how financial institutions were exposed
to the credit crisis

Financial Market
A market in which financial assets (securities)
such as stocks and bonds can be purchased or
sold. Funds are transferred in financial markets
when one party purchases financial assets
previously held by another party.

Role of Financial Markets

Financial markets transfer funds from those who
have excess funds to those who need funds.
1. Surplus units: participants who receive more
money than they spend, such as investors.
2. Deficit units: participants who spend more
money than they receive, such as borrowers.
3. Securities: represent a claim on the issuers
a. Debt securities - debt (also called credit, or
borrowed funds) incurred by the issuer.
b. Equity securities - (also called stocks) represent
equity or ownership in the firm.

Role of Financial Markets

1. Accommodating Corporate Finance
Needs: The financial markets serves as the
mechanism whereby corporations (acting as
deficit units) can obtain funds from investors
(acting as surplus units).
2. Accommodating Investment Needs:
Financial institutions serve as intermediaries
to connect the investment management
activity with the corporate finance activity.

Comparison of Roles Among

Financial Institutions

Primary vs Secondary
Markets
1. Primary markets - facilitate the issuance of
new securities
2. Secondary markets facilitate - the trading of
existing securities, which allows for a change in
the ownership of the securities
a.Liquidity is the degree to which securities can
easily be liquidated (sold) without a loss of value.
b.If a security is illiquid, investors may not be able
to find a willing buyer for it in the secondary
market and may have to sell the security at a
large discount just to attract a buyer.

Securities Traded in
Financial Markets
Securities can be classified as money market
securities, capital market securities, or
derivative securities.
Money Market Securities
Money markets facilitate the sale of short-term
debt securities by deficit units to surplus units.
Debt securities that have a maturity of one year
or less.

Securities Traded in
Financial Markets
2.Capital Market Securities - facilitate the sale
of long-term securities by deficit units to surplus
units.
a. Bonds - long-term debt securities issued by the
Treasury, government agencies, and
corporations to finance their operations.
b. Mortgages - long-term debt obligations created
to finance the purchase of real estate.
c. Mortgage-backed securities - debt obligations
representing claims on a package of mortgages.
d. Stocks - represent partial ownership in the
corporations that issued them.

Securities Traded in
Financial Markets
3.Derivative Securities - financial contracts
whose values are derived from the values of
underlying assets
a.Speculation - allow an investor to speculate on
movements in the value of the underlying assets
without having to purchase those assets.
b.Risk management and hedging - financial
institutions and other firms can use derivative
securities to adjust the risk of their existing
investments in securities.

Valuation of Securities
1. Impact of information on valuations
a. Estimate future cash flows by obtaining
information that may influence a stocks future
cash flows. (Exhibit 1.2)
b. Use economic or industry information to value a
security
c. Use published opinions about the firms
management to value a security.

2. Impact of internet on the valuation process

a. More timely pricing
b. More accurate pricing
c. More informative pricing

Valuation of Securities
3.Impact of Behavioral Finance on Valuation
Various conditions can affect investor
psychology. Behavioral finance can sometimes
explain the movements of a securitys price.

4. Uncertainty Surrounding Valuation of

Securities
Limited information leads to uncertainty in the
valuation of securities.

Use of Information to Make

Investment Decisions

Securities Regulation
1. Required Disclosure
The Securities Act of 1933 was intended to ensure
complete disclosure of relevant financial

information on publicly offered securities and to

prevent fraudulent practices in selling these
securities.
The Securities Exchange Act of 1934 extended the
disclosure requirements to secondary market issues.

2. Regulatory Response to Financial Reporting Scandals

The Sarbanes-Oxley Act required that firms provide
more complete and accurate financial information.

International Securities
Transactions
1. Financial markets vary across the world in
terms of:
Degree of financial market development
Volume of funds transferred from surplus to
deficit units

2. Foreign Exchange Market - International

financial transactions normally require the
exchange of currencies. The foreign exchange
market facilitates this exchange.

Roles of Financial
Institutions
Financial institutions are needed to resolve the
limitations caused by market imperfections such as
limited information regarding the creditworthiness of
borrowers.
1. Role of depository institutions - Depository
institutions accept deposits from surplus units and
provide credit to deficit units through loans and
purchases of securities.
a. Offer liquid deposit accounts to surplus units
b. Provide loans of the size and maturity desired by deficit
units
c. Accept the risk on loans provided
d. Have more expertise in evaluating creditworthiness
e. Diversify their loans among numerous deficit units

Role of Financial
Institutions
Depository Institutions include:
Commercial Banks
The most dominant type of depository institution
Transfer deposit funds to deficit units through loans or purchase of
debt securities

Savings Institutions
Also called thrift institutions and include Savings and Loans (S&Ls)
and Savings Banks
Concentrate on residential mortgage loans

Credit Unions
Nonprofit organizations
Restrict business to CU members with a common bond

Role of Financial
Institutions
2.Role of nondepository institutions
a. Finance companies - obtain funds by issuing securities
and lend the funds to individuals and small businesses.
b. Mutual funds - sell shares to surplus units and use the
funds received to purchase a portfolio of securities.
c. Securities firms - provide a wide variety of functions in
financial markets. (Broker, Underwriter, Dealer, Advisory)
d. Insurance companies - provide insurance policies that
reduce the financial burden associated with death,
illness, and damage to property. Charge premiums and
invest in financial markets.
e. Pension funds manage funds until they are
withdrawn for retirement

Comparison of Roles among

Financial Institutions

Comparison of Roles among

Financial Institutions
1. Financial institutions facilitate the flow of
funds from individual surplus units (investors)
to deficit units.
2. Financial institutions also serve as monitors
of publicly traded firms.
1. By serving as activist shareholders, they
can help ensure that managers of publicly
held corporations are making decisions that
are in the best interests of the
shareholders.

How the Internet Facilitates

Roles of Financial Institutions
The Internet has enabled financial institutions to
perform their roles more efficiently.
1. Allows for lower costs and fees.
2. Makes firm more competitive forcing other
firms to price their services competitively

Relative Importance of
Financial Institutions
1. Households with savings are served by
depository institutions.
2. Households with deficient funds are served by
depository institutions and finance companies.
3. Several agencies regulate the various types of
financial institutions, and the various
regulations may give some financial
institutions a comparative advantage over
others.

Summary of Institutional
Sources and Uses of Funds

Consolidation of Financial
Institutions
1. Typical Structure of a Financial
Conglomerate - In recent years, the barriers to
entry have been reduced, allowing firms that had
specialized in one service to expand more easily
into other financial services. (Exhibit 1.5)
2. Impact of Consolidation on Competition provided more convenience. Individual customers
can rely on the financial conglomerate for
convenient access to multiple services.
3. Global Consolidation of Financial Institutions
- Many financial institutions have expanded
internationally to capitalize on their expertise.

Organizational Structure of a
Financial Conglomerate

Credit Risk for Financial

Institutions
1. Following the abrupt increase in home prices
in the 2004-2006 period, many financial
institutions increased their holdings of
mortgages and mortgage-backed securities.
2. In 2007-2008 period, mortgage defaults
increased and home values declined
substantially.

Systemic Risk during the

Credit Crisis
1. Systemic Risk is the spread of financial problems,
among financial institutions and across financial markets,
that could cause a collapse in the financial system.
2. Mortgage defaults affected financial firms in several
ways:
Mortgage originators sold mortgages to other financial
institutions shortly before the crisis.
Many other financial institutions invested in derivatives and
were exposed to the crisis.
Some financial institutions relied on short-term funding and
used MBS as collateral.
Decline in home building activity caused a decrease in the
demand for many related businesses leading to a weak
economy.

Government Response to
the Credit Crisis
1. Emergency Economic Stabilization Act
Intended to resolve the liquidity problems of
financial institutions and to restore the confidence
of the investors who invest in them.

2. Federal Reserve Actions - Fed provided

emergency loans to many securities firms that
were not subject to its regulation.
3. Financial Reform Act of 2010
a. Also referred to as Wall Street Reform Act or
Consumer Protection Act
b. Mortgage lenders must verify the income, job
status, and credit history of mortgage applicants
before approving mortgage applications.

Summary
Financial markets facilitate the transfer of funds from
surplus units to deficit units. Because funding needs vary
among deficit units, various financial markets have been
established. The primary market allows for the issuance
of new securities, and the secondary market allows for
the sale of existing securities.
Securities can be classified as money market (shortterm)
securities or capital market (long-term) securities.
Common capital market securities include bonds,
mortgages, mortgage-backed securities, and stocks. The
valuation of a security represents the present value of
future cash flows that it is expected to generate. New
information that indicates a change in expected cash
flows or degree of uncertainty affects prices of securities
in financial markets.

Summary
Depository and nondepository institutions help to finance
the needs of deficit units. The main depository institutions
are commercial banks, savings institutions, and credit
unions. The main nondepository institutions are finance
companies, mutual funds, pension funds, and insurance
companies. Many financial institutions have been
consolidated (due to mergers) into financial conglomerates,
where they serve as subsidiaries of the conglomerate while
conducting their specialized services. Thus, some financial
conglomerates are able to provide all types of financial
services. Consolidation allows for economies of scale and
scope, which can enhance cash flows and increase the
financial institutions value. In addition, consolidation can
diversify the institutions services and increase its value
through the reduction in risk.

Summary
The credit crisis in 2008 and 2009 had a
profound effect on financial institutions. Those
institutions that were heavily involved in
originating or investing in mortgages suffered
major losses. Many investors were concerned
that the institutions might fail and therefore
avoided them, which disrupted the ability of
financial institutions to facilitate the flow of
funds. The credit crisis led to concerns about
systemic risk, as financial problems spread
among financial institutions that were heavily
exposed to mortgages.

Part 2
Interest Rates determination

Learning Outcomes
apply the loanable funds theory to explain why
interest rates change
identify the most relevant factors that affect
interest rate movements
explain how to forecast interest rates

Loanable Funds Theory

1. The Loanable Funds Theory suggests that
the market interest rate is determined by the
factors that control supply of and demand for
loanable funds.
2. Can be used to explain:

Movements in the general level of interest

rates in a particular country

Why interest rates among debt securities of a

given country vary.

Demand for Loanable

Funds
1. Household demand for loanable funds
2. Business demand for loanable funds
3. Government demand for loanable funds
4. Foreign demand for loanable funds
5. Aggregate demand for loanable funds

Household demand

Households demand loanable funds to finance

housing expenditures as well as the purchase of
automobiles and household items.

Inverse relationship between the interest rate and

the quantity of loanable funds demanded.

Relationship between Interest Rates and

Houshold Demand (Dh) for Loanable Funds
at at Given Point in Time

Business Demand
Depends on number of business projects to be
implemented. More demand at lower interest
rates.
n

CFt
NPV INV
t
(
1

k
)
t 1
NPV net present va lue of project
INV initial investment
CFt cash flow in period t
k required rate of return on project

Relationship between Interest Rates and

Business Demand (Db) for Loanable Funds
at a Given Point in Time

Government Demand

Governments demand loanable funds when

planned expenditures are not covered by incoming
revenues.

Government demand is said to be interest

inelastic: insensitive to interest rates.
Expenditures and tax policies are independent of
the level of interest rates.

Impact of Increased Government Deficit on

the Government Demand for Loanable
Funds

Foreign Demand

A countrys demand for foreign funds depends on

the interest rate differential between the two.

The greater the differential, the greater the

demand for foreign funds.

The quantity of U.S. loanable funds demanded by

foreign governments will be inversely related to
U.S. interest rates.

Impact of Increased Foreign Interest Rates on

the Foreign Demand for U.S. Loanable Funds

Aggregate Demand
The sum of the quantities demanded by the
separate sectors at any given interest rate.

Determination of the Aggregate Demand

Curve for Loanable Funds

Supply of Loanable Funds

1. Households are largest supplier, but some
supplied by government units.

More supply at higher interest rates.

Supply by buying securities.

2. Effects of the Fed - By affecting the supply

of loanable funds, the Feds monetary policy
affects interest rates.
3. Aggregate supply of funds Is the
combination of all sector supply schedules
along with the supply of funds provided by the
Feds monetary policy.

Aggregate Supply Curve for

Loanable Funds

Equilibrium Interest Rate

1. Aggregate Demand for funds (DA)
DA = D h + D b + D g + D m + D f
Dh = household demand for loanable funds
Db = business demand for loanable funds
Dg = federal government demand for loanable funds
Dm = municipal government demand for loanable funds
Df = foreign demand for loanable funds

2. Aggregate Supply of funds (SA)

SA = Sh + Sb + Sg + Sm + Sf
Sh = household supply for loanable funds
Sb = business supply for loanable funds
Sg = federal government supply for loanable funds
Sm = municipal government supply for loanable funds
Sf = foreign supply for loanable funds

Interest Rate Equilibrium

Factors that affect Interest

Rates
1. Impact of economic growth on interest rates:
a. Puts upward pressure on interest rates by
shifting demand for loanable funds outward.

2. Impact of inflation on interest rates:

a. Puts upward pressure on interest rates by
shifting supply of funds inward and demand for
funds outward. (Exhibit 2.10)
b. Fisher effect: i = E(INF) + iR

where i = nominal or quoted rate of interest

E(INF) = expected inflation rate
iR = real interest rate

Impact of Increased
Expansion by Firms

Impact of an Economic
Slowdown

Impact of an Increase in Inflationary

Expectations on Interest Rates

Factors that Affect Interest

Rates
3. Impact of Monetary Policy on Interest Rates
When the Fed reduces (increases) the money supply, it
reduces (increases) the supply of loanable funds, putting
upward (downward) pressure on interest rates.

4. Impact of the Budget Deficit on Interest Rates

Crowding-out Effect: Given a certain amount of loanable
funds supplied to the market, excessive government
demand for funds tends to crowd out the private demand
for funds.

5. Impact of Foreign Flows of Funds on Interest Rates

Interest rate for a certain currency is determined by the
demand for funds in that currency and the supply of funds
available in that currency.

Flow of Funds between the Federal

Government and the Private Sector

Demand and Supply Curves for Loanable

Funds Denominated in U.S. Dollars and
Brazilian Real

Summary of Forces that

Affect Interest Rates
1. Economic conditions are the primary
forces behind a change in the supply of
savings provided by households or a change
in the demand for funds by households,
businesses, or the government.
2.

The demand for funds in the United States is

indirectly affected by U.S. monetary and
fiscal policies because these policies
influence economic growth and inflation,
which in turn affect business demand for
funds. Fiscal policy determines the budget
deficit and therefore determines the federal
government demand for funds.

Interest Rate Movements

over time

Forecasting Interest Rates

1. Net Demand (ND) should be forecast:
ND = DA SA
ND = (Dh + Db + D,m + Dr) (Sh + Sb + Sm + Sf)

2. Future Demand for Loanable Funds depends on future

a. Foreign demand for U.S. funds
b. Household demand for funds
c. Business demand for funds
d. Government demand for funds

3. Future Supply of Loanable Funds depends on:

a. Future supply by households and others
b. Future foreign supply of loanable funds in the U.S.

Framework for Forecasting

Interest Rates

Summary
The loanable funds framework shows how the
equilibrium interest rate depends on the aggregate
supply of available funds and the aggregate demand
for funds. As conditions cause the aggregate supply
or demand schedules to change, interest rates
gravitate toward a new equilibrium.
Given that the equilibrium interest rate is determined
by supply and demand conditions, changes in the
interest rate can be forecasted by forecasting
changes in the supply of and the demand for
loanable funds. Thus, the factors that influence the
supply of funds and the demand for funds must be
forecast in order to forecast interest rates.

Summary
The relevant factors that affect interest rate
movements include changes in economic
growth, inflation, the budget deficit, foreign
interest rates, and the money supply. These
factors can have a strong impact on the
aggregate supply of funds and/or the
aggregate demand for funds and can thereby
affect the equilibrium interest rate. In
particular, economic growth has a strong
influence on the demand for loanable funds,
and changes in the money supply have a
strong impact on the supply of loanable funds.

Part 3
Interest rates Structure

Learning Outcomes
describe how characteristics of debt securities
cause their yields to vary
demonstrate how to estimate the appropriate
yield for any particular debt security
explain the theories behind the term structure
of interest rates (relationship between the term
to maturity and the yield of securities)

Why Debt Security Yields

Vary
The yields on debt securities are affected:
Credit (default) risk
Liquidity
Tax status
Term to maturity

Why Debt Security Yields

Vary
1. Credit (Default) Risk securities with a higher
degree of default risk offer higher yields.
Rating Agencies - Rating agencies charge the issuers
of debt securities a fee for assessing default risk.
Accuracy of Credit Ratings - The ratings issued by
the agencies are useful indicators of default risk but
they are opinions, not guarantees.
Oversight of Credit Rating Agencies - The Financial
Reform Act of 2010 established an Office of Credit
Ratings within the Securities and Exchange
Commission in order to regulate credit rating agencies.
Rating agencies must establish internal controls.

Rating Classification by
Rating Agencies

Why Debt Securities Yields

Vary
2. Liquidity - The lower a securitys liquidity, the
higher the yield preferred by an investor.
3.Tax Status
Investors are more concerned with after-tax income.
Taxable securities must offer a higher before-tax
yield.

4.Term to Maturity
Maturity dates will differ between debt securities.
The term structure of interest rates defines the
relationship between term to maturity and the
annualized yield.

Why Debt Securities Yields

Vary
Computing the Equivalent After-Tax Yield:

at bt (1 T )
Computing the Equivalent Before-Tax Yield:

at
bt
(1 T )

Example
Consider a taxable security that offers a before
tax yield of 8 percent. When converted into
after tax term, the yield will reduced by the tax
percentage. The precise after tax yield is
dependent on the tax rate, T. If the tax rate of
the investor is 20%, then the after tax yield will
be

After-Tax Yields Based on Various

Tax Rates and Before-Tax Yields

Terms to Maturity

Explaining Actual Yield

Differentials
Small yield differentials can be relevant
The yield differential is the difference between
the yield offered on a security and the yield on
the risk-free rate.
They are sometimes measured in basis points
where 1bp = 0.01%

Yield Differentials on Money

Market Securities
Yields on commercial paper and negotiable
CDs are only slightly higher than T-bill rates to
compensate for lower liquidity and higher
default risk.
Market forces cause the yields on all securities
to move in the same direction.

Yield Differentials on Capital

Market Securities
Municipal bonds have the lowest before-tax
yield but their after-tax yields are typically
higher than Treasury bonds.
Treasury bonds have the lowest yield because
of their low default risk and high liquidity.

Yield Differentials of
Corporate Bonds

Estimating the Appropriate

Yield
Yn = Rf,n + DP + LP + TA
where:

Yn

= yield of an n-day debt security

Rf,n

= yield of an n-day Treasury (risk-free)

security

DP

= default premium to compensate for

credit risk

LP

= liquidity premium to compensate for

less liquidity

TA

= adjustment due to difference

in tax status

Example
Suppose that the three-month T-bills annualized rate is 8
percent and that Company Ali plans to issue 90-day
commercial paper. Ali must determine the default
premium (DP) and liquidity premium (LP) to offer on its
commercial paper in order to make it as attractive to
investors as three month (13 weeks) T-bill. The federal tax
status of commercial paper is subject to state taxes
whereas income earned from investing in T-bills is not.
Investors may require a premium for this reason alone if
they reside in a location where state and income tax apply.
Assume Ali believes that an 0.7% DP, an 0.2% LP, and and
0.3% tax adjustment are necessary to sell its commercial
paper to investors. What is the appropriate yield ?

A closer look at the Term

Structure
Pure Expectations Theory: Term structure
reflected in the shape of the yield curve is
determined solely by the expectations of interest
rates.

An expected increase in rates

leads to an upward sloping yield
curve
An expected decrease in rates
leads to a downward sloping yield
curve.

A closer look at the Term

Structure
Algebraic Presentation

(1 t i2 ) 2 (1 t i1 )(1 t 1 F1 )
i known annualized interest rate of a two - year security at time t

t 2

i known annualized interest rate of a one - year security at time t

t 1

t 1

F1 one - year interest rate that is anticipate d as of time t 1

Example
Assume that, as of today (time t), the
annualized two-year interest rate is 10 percent
and the one-year interest rate is 8 percent. The
forward rate is then:

How Interest Rate Expectations

Affect the Yield Curve

A Closer Look at the Term

Structure
Liquidity Premium Theory: Investors prefer
short-term liquid securities but will be willing to
invest in long-term securities if compensated
with a premium for lower liquidity.
Estimation of Forward Rates Based on
Liquidity Premium

(1 + ti2)2 = (1 + ti1)(1 + t+1r1) + LP2

Example
Reconsider the example where i1 = 8% and i2
= 10%, and assume that the liquidity premium
on a two year security is 0.5 %. The one year
forward rate can be derived as:

Impact of Liquidity Premium on the Yield

Curve under Three Different Scenarios

A Closer Look at the Term

Structure
Segmented Markets Theory: Investors choose
securities with maturities that satisfy their forecasted
cash needs.

Limitations of the theory :

Some borrowers and savers have the flexibility to choose
among various maturities

Implications: Preferred Habitat

Theory
Although investors and borrowers may normally
concentrate on a particular maturity market, certain
events may cause them to wander from their natural or
preferred market.

Research on the Term

Structure Theories
Interest rate expectations have a strong
influence on the term structure of interest rates.
However, the forward rate derived from a yield
curve does not accurately predict future interest
rates, and this suggests that other factors may
be relevant.
General Research Implications - Although the
results differ, there is evidence that
expectations, liquidity premium, and segmented
markets theories all have some validity.

Integrating the Theories of

the Term Structure
If we assume the following conditions:
Investors and borrowers currently expect interest
rates to rise.
Most borrowers need long-term funds, while most
investors have only short-term funds to invest.
Investors prefer more liquidity to less.

Then all three conditions place upward

pressure on long-term yields relative to short
term yields leading to upward sloping yield
curve.

Effect of Conditions in
Example of Yield Curve

Use of the Term Structure

Forecasting Interest Rates
The shape of the yield curve can be used to
assess the general expectations of investors
and borrowers about future interest rates.
The curves shape should provide a
reasonable indication (especially once the
liquidity premium effect is accounted for) of
the markets expectations about future
interest rates.

Forecasting Recessions - Some analysts

believe that flat or inverted yield curves
indicate a recession in the near future.

Use of the Term Structure

Making Investment Decisions - If the yield
curve is upward sloping, some investors may
attempt to benefit from the higher yields on
longer-term securities even though they have
funds to invest for only a short period of time.
Making Decisions about Financing - Firms
can estimate the rates to be paid on bonds
with different maturities. This may enable them
to determine the maturity of the bonds they
issue.

Use of the Term Structure

Why the slope of the Yield Curve changes
Conditions may caused short-term yields to
change in a manner that differs from the
change in long-term yields.

Potential Impact of Treasury Shift from

Long-Term to Short-Term Financing

Use of the Term Structure

How the Yield Curve has Changed over time

Yield Curves at Various Points in

Time

Use of the Term Structure

International Structure of Interest Rates - The
yield curves shape at any given time also
varies among countries

Yield Curves among Foreign

Countries (as of May 2011)

Summary
Quoted yields of debt securities at any given time may
vary for the following reasons. First, securities with
higher credit (default) risk must offer a higher yield.
Second, securities that are less liquid must offer a higher
yield. Third, taxable securities must offer a higher beforetax yield than do tax-exempt securities. Fourth, securities
with longer maturities offer a different yield (not
consistently higher or lower) than securities with shorter
maturities.
The appropriate yield for any particular debt security can
be estimated by first determining the risk-free yield that
is currently offered by a Treasury security with a similar
maturity. Then adjustments are made that account for
credit risk, liquidity, tax status, and other provisions.

Summary
The pure expectations theory suggests that the
shape of the yield curve is dictated by interest rate
expectations. The liquidity premium theory suggests
that securities with shorter maturities have greater
liquidity and therefore should not have to offer as
high a yield as securities with longer terms to
maturity. The segmented markets theory suggests
that investors and borrowers have different needs
that cause the demand and supply conditions to vary
across different maturities. Consolidating the theories
suggests that the term structure of interest rates
depends on interest rate expectations, investor
preferences for liquidity, and the unique needs of
investors and borrowers in each maturity market.