The Financial environment

The Financial Markets:

In a general sense, the term financial market refers to a conceptual mechanism rather than a physical location or a specific type of organization or structure. The financial markets as being a system comprised of individuals and institutions and procedures that bring together borrowers and severs, no matter the location. Each market deals with different types of instruments in terms of the instruments maturity and the assets backing it.

Types of Financial Markets:

Here are some major type of market, based on1. Types of Investment: Debt Markets vs. Equity Market Debt Market: The markets where loans are traded. A debt instrument is a contract that specifies the amounts and schedule of when a borrower must repay funds provided by the lender Equity market: the markets where stocks of corporations are traded. Equity represent ownership in a corporation and entitles stock-holders to share in any cash distribution generated from income (dividends) and from liquidation of the firm. 2. Maturities of Investment: Money Markets vs. Capital Market Money Market: the markets for debt securities with maturities of one year or less. The primary function of the money markets is to provide liquidity to business, governments, and individuals to meet short-term needs for cash.

Capital markets: the markets for intermediate and long term debt and corporate stock. The primary function of the capital market is to provide the opportunity to transfer cash surpluses or deficits to future years. 3. Types of Borrowers and Lenders: Primary Markets vs. Secondary Market Primary Market: The markets in which corporation and (government) raise new funds of capital. IPO (initial public offering), whenever stock in a privately held corporation is offered to the public for the first time, the company is said to be going public. The market for corporations that go public is called the IPO market. Secondary Markets: the markets in which existing, previously issued securities are traded among investors. Secondary market also exist for mortgages, various others types of loans, and other financial assets.

4. Location of the Markets: Private Market vs. Public Market Private Markets: In private market transactions, stocks, bonds, or other types of debt are traded among sophisticated investors who generally are familiar with each others. Public Markets: Transactions in public markets are standardized, because securities traded in the public markets are traded among large numbers of investors who do not know each other and can not devote the time, effort, and cost necessary to ensure the validity of specialized, or non standardized, transactions such as those that occur in the private markets. 5. Types of Transactions: Spot Market vs. Future Market Spot Markets: in the spot markets the assets traded are brought or sold for on the spot delivery (immediately or within a few days). Future Markets: the markets for delivery of assets at some later date.
World, National, Regional and Local Markets: depending on an organizations size and scope of operations, it might be able to borrow all around the world, or it might be confined to a strictly local, even neighbourhood market.

Financial institutions
Funds are transferred between those who have funds to invest (savers) and those who need the funds (borrowers) by the three different process, such as: 1. A direct transfer of money and securities occurs when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. 2. A transfer also can go through an investments banking house. The company sells its stock or bonds to the investments bank, which in turn sells these same securities to investors. 3. Transfer can also be made through a financial intermediary such as bank or a mutual fund. In this case, here the intermediary obtain funds from savers, issuing its own securities or liabilities in exchange, and then it uses the money to lend out or to purchase another business securities.

Diagram of the Capital Formation Process 1. Direct transfer:

Business (Borrower)
Securities (Stocks and Bonds) Money

Investors (Savers)

2. Indirect transfer through an Investment Banker

Business (Borrower)
Securities Money

Investment Banking House

Securities Money

Investors (Savers)

3. Indirect transfer through a Financial Intermediary

Business (Borrower)
Securities Money

Financial Intermediaries

Intermediaries' Securities Money

Investors (Savers)

Investment Banker:
An organization that underwrites and distributes new issues of securities, helps business and other entities obtain needed financing. Investment banker acting as a middleman as funds are transferred from savers to business. Such organization 1. Help corporations design securities with the features that currently are most attractive to investors, 2. Buy these securities from the corporation, 3. Then resell them to savers.

Financial Intermediaries:
Specialized financial firms that facilitate the transfer of funds from savers to borrowers.

Types of Financial Intermediaries The major classes of financial intermediaries are as follows: 1. Commercial Banks: The traditional department stores of finance, serve a wide variety of customers. Commercial banks were the major institutions that handled checking account- receiving deposit and lending money, including trust operation, stock brokerage services and insurance. 2. Savings and Loans Associations: Traditionally served individual savers and residential and commercial mortgage borrowers. It collect the funds of many small savers and lend this money to home buyers and others types of borrowers. 3. Credit Unions:
Cooperative associations, whose members have common bonds. Members savings are loaned only to others members. Credit union are often cheapest source of funds available to individual borrowers.

4. Pension Funds: Retirement plans funded by corporation and government agencies for their workers and administrated primarily trust department of commercial banks or by insurance companies. 5. Life Insurance Companies: Take savings in the form of annual premiums, then invest these funds in stocks, bonds, real state and mortgages, and ultimately make payment to the beneficiary of the insured parties. 6. Mutual Funds: Investment companies that accept money from savers and use these funds to buy various types financial assets such as stocks, long-term bonds and short-term debt instruments.

Stock Markets
Most active and important secondary market is the stock market. Traditionally stock markets are divided into two basic types, (1) organized exchanges and (2) over-the counter market (OTC). Today it is more appropriate to classify stock markets as either1. 2. Physical stock exchanges, and Organized investment networks

Physical Stock Exchanges: Physical stock exchanges are tangible entities. Each of the larger exchanges occupies its own building, has specially designated members, and has an elected governing body. Members are said to have seats on the exchange. These seats, which are brought and sold, give the holder the right to trade on the exchange. Most of the larger investment banking houses operate brokerage departments that own seats on the exchanges and designate one or more of their officers as members. The exchange members with sell order offer the shares for sale, which in turn are bid for by the members with buy orders. Thus, the exchanges operate as auction markets. Example- NYSE, AMEX and DSE.

Organized Investment Networks: If a security is not traded on a physical stock exchange, it has been customary to say it is traded in Over-The Counter (OTC) market. OTC Market: A intangible trading system that consist of a network of brokers and dealers around the country. If a stock is traded less frequently, perhaps it is the stock of a new or a small firm, few buy and sell order come in, and matching them within a reasonable length of time would be difficult. To avoid this problem, some brokerage firm maintain inventories of such stocks. These firms buy when individual investors want to sell and sell when investors want to buy. At one time the inventory of securities was kept in a safe, and the stocks, when brought and sold, literally passed over the computer.

The cost of Money

In a free economy, excess funds are allocated to borrowers in the financial markets through a pricing system that is based on the supply of, and the demand for, fund. The pricing system is represented by rates of return. Four fundamental factors affect the cost of money: (1) Production opportunities: The returns available within an economy from investment in productive (cash-generating) assets. (2) Time preferences for consumption: The preferences of customers for current consumption as opposed to saving for future consumption. (3) Risk: In a financial market context, the chance that a financial assets will not earn the return promised. (4) Inflation: The tendency of price to increase over time.

Interest Rate Levels

Funds are allocated among borrowers by interest rates. Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so the tend to attract it away from less efficient firms or from those whose products are not demand. So interest rate is determined by supply and demand of fund. The determinants of Market Interest Rates: In general, the quoted or nominal interest rate on debt security, K, is composed of a real risk free rate of interest, K*, plus several premiums that reflect inflation, the riskiness of the security and the securitys marketability. This relationship can be expressed as follows:

Quoted Interest Rate= K= K*+IP+DRP+LP+MRP Here, K= The quoted or nominal rate of interest on a given security K*= The real risk free rate of interest IP= Inflation premium DRP= Default risk premium LP= Liquidity risk premium MRP= Maturity risk premium The Real Risk Free Rate of Interest, K*: The real risk free rate of interest is define as the interest rate that would exist on a security with a guaranteed payoff if inflation was expected to be zero during the investment period. The real risk free rate changes over time depending on economic conditions, especially-

(1) On the rate of return corporations and other borrowers are willing to pay to borrow funds, and (2) On peoples time preference for current versus future consumption Inflation Premium (IP): A premium for expected inflation that investors add to the real risk-free rate of return. The Nominal, or Quoted, Risk free rate of interest, KRF: The interest rate on a security that has absolutely no risk at all, that is, one that has a guaranteed outcome in the future, regardless of the market conditions. KRF=K*+IP So earlier equation can be write asK= KRF+DRP+LP+MRP

Default Risk Premium (DRP): The difference between the quoted interest rate on Government bond and on a corporate bond with similar maturity, liquidity and other features. The default risk premium (DRP) would beDRP=K-KRF Liquidity Premium (LP): Liquidity risk premium is a premium added to the rate on a security if the security can not be converted to cash on short notice and at close to the original cost. Because liquidity is important, investors evaluate and include liquidity premium when interest rates are established.

Maturity Risk Premium (MRP): A premium that reflects interest rate risk, bonds with longer maturities have greater interest rate risk. Interest rate risk: the risk of capital losses to which investors are exposed because of changing interest rates. Reinvestment rate risk: the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested.

The Term Structure of Interest Rates

The relationship between the long-tern and short-term rates, which is known as the term structure of interest rates. It is important to understand (1) How long-term and short-term rates are related to each other and (2) What causes shift in their relative positions. Yield Curve: A graph showing the relationship between yields and maturities of securities. Normal Yield Curve: an up-word sloping yield curve. Inverted Yield Curve: a downward sloping yield curve.

Expectation Theory: This theory states that the yield curve depends on expectations concerning future inflation rates. That means, K= K* + IP, under this theory, MRP is assumed to be zero, and for Government bonds, DRP and LP also are zero. Liquidity Premium Theory: This theory states that long term bonds normally yield more than short term bonds for two reasons: (1) All else equal inventors generally prefer to hold short term securities, because such securities are more liquid, (2) Borrowers on the other hand generally prefer long term debt because short term debt exposes them to the risk. Lender and borrower preferences both operate to cause short term rates to be lower than long term rates.

Market Segmentation Theory: This theory sates that each borrower and lender has a preferred maturity. An upward sloping yield curve would occur when there was a large supply of short term funds relative to demand, but a shortage of long term funds. A downward sloping yield curve would indicate relatively strong demand for funds in the short term market compared to that in the long term market. A flat yield curve would indicate balance between the two markets.