CHAPTER 2:The Financial

Environment: Markets,
Institutions, and Interest Rates
 Importance & Functions of Financial
Markets
 Classification of Financial Markets
 Financial Institutions
 Determinants of Interest rates
 Yield Curves
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 Financial market:
The mechanism/process/technique/
method through which financial
assets are issued by the issuer to
the investor and traded
between/among investors is called
financial market.
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 Functions/Role of Financial
Markets
 Bridging the gap between net borrowers and net savers. Net
borrowers or investors are the deficit sector. They demand loan. Net
savers are surplus sector. They supply loan. The two groups do not know
each other, financial market brings them together.
 Providing the equilibrium interest rate. Net savers like to get more
interest and net borrowers like to pay less interest. Financial market
provides the equilibrium rate.
 Separation principle: Financial institutions separate the pattern of
current consumption from the pattern of current income by means of
inter-temporal consumption function. People in need of more current
consumption than current income borrow money. People who like to defer
consumption lend money.
 Facilitating liquidity: Financial markets provides liquidity of financial
assets by facilitating trading of these whenever required by investors.
 Discovering market prices of financial assets: Through interaction of
demand and supply financial market sets of price of financial assets at
which these will be traded among investors.
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 Types of Financial Markets
 Debt vs. Equity Markets. Financial market deals with debt
instruments like bond, debenture, bank loan, mortgage,
commercial and consumer credit is known as debt market.
Equity market deals with equity securities like preferred stock
and common stock. Interest on debt is a compulsory payment
but dividend is not. Cost of debt is usually less than cost of
equity.
 Money vs. Capital Markets. Money market deals with short
term financial instruments. Capital market deals long term
financial instruments like preferred stock and ordinary stock .
 Primary vs. Secondary Markets. In the primary market, the
firm directly issues financial assets to the applicant. In the
secondary market, existing financial assets are traded among
investors. 2-4
 Types of Financial Markets

 Public vs. Private Markets. Securities traded in the

public markets are traded among large number of
investors’ who do not know each other and cannot
devote time, effort and cost necessary to ensure the
validity of specialized transaction. In the private
market transactions, securities are traded among
investors who are generally familiar with each other.
 Spot vs. Future Markets. In spot market transactions
are settled down at available price immediately,
whereas in future market transactions would be
executed at a some later date.

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 Market Efficiency
An efficient market is one in which security
prices adjust rapidly to the arrival of new
information and therefore, the current prices
of securities reflect all information about the
security. In broader sense if the market price
of a particular security can reflect all relevant
information and the market can settle
transactions with minimum cost then the
market is considered as efficient.
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 Market Efficiency
Operational efficiency: If the market can
settle the transactions within minimum cost
easily and quickly then this is called
operationally efficient market. A
market condition that exists when
participants can execute transactions and
receive services at a price that equates fairly
to the actual costs required to provide them.

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 Market Efficiency
Informational/Pricing efficiency: If the
determined price in the market can reflect all
relevant and available information about a
particular financial asset then this is called pricing
efficiency. Followers of the efficient markets theory
hold that the market efficiently deals with all
information on a given security and reflects it in the
price immediately, and that technical analysis,
fundamental analysis, and/or any speculative
investing based on those methods are useless.
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 Market Efficiency
Economic efficiency: If the market can allocate
funds in optimal way at the lowest costs i.e.
businesses and individuals invest their funds in
assets that provide the highest returns and the
costs of searching for such opportunities are lower.

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Efficient Market Hypothesis (EMH)

1. Weak form efficient market

hypothesis
2. Semi-strong form efficient
market hypothesis
3. Strong form efficient market
hypothesis

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Financial Institutions and Intermediary

 Commercial banks
 Savings and loan associations

 Credit unions

 Pension funds

 Life insurance companies

 Mutual funds

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 The cost of money
It means the extra rate of payment made by the
user to the supplier of fund for a specific time
period.
 In case of debt capital, cost of money refers to
the interest rate.
 In case of equity capital, cost of money is the
required return. This is the return expected by
the shareholders to leave the share price
unchanged.
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 Factors Affecting Cost of Money
 Production opportunities-return available within
an economy from investment in productive assets.
 Time preference for consumption-the
preferences of consumers for current consumption
as opposed to saving for future consumption.
 Risk-the chance that a financial asset will not earn
the return promised.
 Inflation-the tendency of prices to increase over
time.
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 Cost of Money (interest rate
level): Loanable Fund Theory
Interest rate(%)

S (Savings)

D (Investment)
Quantity of Loanable Fund

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Determinants of interest rates
k = k* + IRP + DRP + LRP + MRP
k = required return on a debt security
k* = real risk-free rate of interest
IRP = expected inflation premium
DRP = default risk premium
LRP = liquidity premium
MRP= maturity risk premium
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 Concepts of risk premium
 Inflation Premium refers to the additional interest to
cover the loss due to inflation.
 Default risk premium is the addition in the interest
rate to compensate the possibility that the borrower
may fail to pay interest and principal.
 Liquidity risk premium is the addition to compensate
the possibility that the security may not be sold with
in a short notice.
 Maturity risk premium covers the possibility of price
fluctuation of bond. The price depends on market
interest rate. Bonds of longer maturity assumes more
maturity risk premium.
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Term Structure of Interest Rates &
Yield Curve: Relationship between interest
rate/yields and time period/maturities.

 Normal k
 Abnormal
 Flat

Maturity
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 Why Do Yield Curves Differ?
(Theories of Yield Curves)
 Liquidity Preference Theory: Lenders prefer to
make short term loan than long term loan. Yield
curve should be positive.
 Expectations Theory: Yield curve depends on the
expectation about inflation. If inflation is expected
to rise in future, then yield curve should be
positive and vice-versa.
 Market Segmentation Theory: The short term
market and the long term market are different
from one another. Yield curve should not have a
definite pattern.
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 Other Factors That Influence
Interest Rate Levels:
 Government reserve policy i.e. to control level of
money supply.
 Government deficit i.e. to borrow or print new money for
meeting up the shortage drives up interest rate.
 Foreign trade balance i.e. larger trade deficit, larger
borrowing that drives up interest rate and vice-versa.
 Business activity/cycle i.e. in case of recession there is
higher inflation and higher interest rate.

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