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Lecture 1 & 2

Course Outline
Required Text Financial Markets and Institutions By Frederic S. Mishkin and Stanley G. Eakins (Pearson International) 5th Edition Text for Derivatives section shall be specified later. Methodology Primarily Lecture method based on assigned readings. Class discussions on assigned topics. Various reports and; current developments.

Course Objectives Expected outcome & Policy


The course is designed to equip students with knowledge

of a financial system and its regulatory framework and environments in Pakistan, and as it exists in developed economies. On completion of the course the students shall be able to demonstrate an understanding of the subject matter and financial markets in Pakistan. Course is fairly lengthy covering all types of financial institutions and markets; therefore focus of this course is on breadth rather than depth of analysis of the subject. The course policy envisages positive learning environments in the class. A productive participation conditional on attendance shall be rewarded. Tardiness and casual attitude shall be strongly discouraged

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.

Course Evaluation and Rewards


Report & 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 by April 15th . The report shall not exceed 15 pages 1 space 12 Times New Roman excluding title index and bibliography etc.
(Each group shall select a Financial Institution or a topic of interest for

the detailed analysis. Group members shall be asked to remain abreast with the developments taking place in the marketplace, through financial press. The impact of current developments taking place, which are pertinent to their selection of study, shall be monitored and compiled by the group. The group is expected to apprise the class with their observations through class participation)

Course Evaluation and Rewards


Mid Term Exams MCQs 25 % Article presentation 5% Student will be given three articles from leading financial press for reading and submitting their take on the issue discussed. The purpose of this exercise is to familiarize the students with the financial press and develop understanding on the current issues pertaining to financial markets)

Course Evaluation and Rewards


Final Comprehensive Examination 40%

Lecture Objectives:
Week 1, Lecture 1 & 2
Introduction to Financial Institution Market Course-

a course overview; Why Study Financial Markets and Institution; Overview of Financial System; Financial Markets; Financial Institutions; An overview of Financial Institutions in Pakistan and in the developed world.

Questions
1) What is main source of funds for firms? Stock Market? Banks? 2) What are Mutual Funds? 3) What is the difference between Commercial Bank and Investment Bank?

The Role of Financial System


Savings Income (rent, wage, etc)

Inputs of Land & Labor

Householders

Firms

Consumption of outputs
Payments for Outputs Issuance of financial Claims

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 the amount of trade. This will lead to adoption of single commodity as currency.(shells, cigarettes gold etc) Criteria for development of money: General acceptance in exchange for other commodities. Existence of money thus separates act of sale from act of purchase.

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 require more funds than their accumulated saving or current income. Firms then borrow from households with spending less than income. Firm issue financial claims in return.

The Role of Financial System


Ability to borrow encourages savings by households

and investment by firms. Main Roles: To provide a mechanism by which funds can be transferred from those with surplus funds to those who wish to borrow.(intermediary between surplus and deficit units) Allocation of funds to their most efficient use by price mechanism. It enables the wealth holders to alter the composition of their wealth.

The Role of Financial System


To provide payment mechanism.
Provision of special financial services such as pension

and insurance.

Saver- Lenders & Borrower- Spenders


1) Households
2) Business Firms 3) Government

4) Foreigners
Borrowers- Spenders 1) Business Firms 2) Government 3) Households 4) Foreigners

Direct Finance

SaversLenders

Funds

Financial Markets

Funds

Borrower sspenders

Direct Finance
Spenders borrows directly from Saver-Lenders in

Financial Markets by selling them financial instruments ( securities). Financial Instruments are claims on borrowers future financial income. Financial Instruments are assets for person who buys them (lender) and liabilities for person who sell them (borrower). Examples include Bonds, Stocks etc

Importance of Direct Finance


From a savers point of view: meeting place for lenders

and borrowers- win-win situation for both lender and borrow and for the economy. Firms can raise money for the investment projects.

Indirect Finance

SaversLenders

Funds

Financial Intermediary

Funds

Borrowersspenders

Indirect Finance
Saver lends funds to Financial Intermediary which in

turn lends to the borrow-spenders. This process is called Financial Intermediation. Examples of Intermediaries: Commercial Banks Insurance Companies Mutual Funds Pension Funds etc

Comparison
Although Media focuses more on Financial Markets,

Indirect finance is the most important mode of borrowing 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 Transformation through Diversification) Information Cost.

Indirect Finance Allows


choice of desired maturity maturity intermediation diversification w/ small amount of capital
lower transactions costs alternative payment mechanisms

Transaction Cost
Time & money spent in carrying out a transaction is

major consideration for people with excess money to lend. 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 per Rs. Cost as the size of transaction increases) FI can also get a loan contract drafted and use it over and over again for countless customers.

Risk Sharing
FI reduces uncertainty of return a lender will earn on

asset(loan). Risk sharing: create and sell asset that people are comfortable buying and use the proceeds to buy risky assets. Asset Transformation: Converting risky illquid assets to less risky liquid assets. Role of Diversification

Information Cost
In financial markets, one party does not know enough about the

other party to make an informed decision. This inequality is called Asymmetric Information. Asymmetric information problem before the loan and after the loan. Adverse Selection: Bad credit risks are the ones who are most actively seeking loan and are most likely to be selected by lender. ( before loan) Examples: Least qualified tenants may be the ones most likely to be seeking new housing, because their tenant history is so bad and they have been evicted, so they may be selected. IMF/World Bank offers development funds to countries with econ problems - the least creditworthy countries may apply.

Information Cost
Moral Hazard: Risk that borrower will engage in activities

that are considered undesirable from point of view of borrower 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 a project with an expected return of 15%. Suddenly a risky project becomes available with an expected return of 30%. They could switch projects and increase the riskiness to the bank. If the new project pays off, all profits go to the owners, none to the bank. If the project fails, and the load goes bad, the bank suffers.

Information Cost
FI

reduced information cost or asymmetric information problem because they have developed expertise in screening out good from bad credit risk (minimize losses due to adverse selection) and monitoring the borrowers through their dedicated staff for this purpose and because of various other means. Explains why we don't see a credit market of individuals dealing directly with each other - too risky. Adverse selection and moral hazard would cause those credit markets to break down, disappear

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.

Risk
In finance risk is referred to the fact that some of the

future outcome regarding a financial instrument is not known with certainty. E.g change in price, default with respect to income or principle. Distribution of return around mean.( Standard Deviation)

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

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

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 exceeds deposit rate) Stocks have tendency to increase in value over time in line with or over the rate of general price levels. Best inflation protection is provided by physical assets of property rather than financial assets.

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).

Expected Return
In the form of interest or dividend
Price appreciation Ceteris paribus higher the return , greater will be

demand of the instrument.

PRIMARY VS. SECONDARY MARKETS


Primary market - newly issued securities, bonds/stocks,

being sold to initial purchasers by corporation or govt agency 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 shares from another individual who is selling. MCB Bank has nothing to do with the transaction. NYSE and the AMEX (organized exchanges/physical location) and NASDAQ (over-the-counter, computer linked dealers all over the country) are the three national secondary stock markets in US.

MONEY VS. CAPITAL MARKETS


Money markets - debt securities with less than one year to

maturity. 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 a discount and pay no int. Ex. Buy @ Rs.9000 with a Rs.10,000 maturity in one year. (Int = 11.11%). Commercial paper - short term debt issued by large corporations in direct finance to other large corporations or banks. Example of financial disintermediation. Maturity of 270 days or less.

Money Market Instruments


Banker's Acceptances - letter of credit from a bank

to facilitate international trade. Bank guarantees payment, usually of an import order. Example: local food company wants to purchase beer/wine from Germany. Banker's acceptance is used to guarantee payment. Eurodollars - dollar denominated deposits in foreign banks. Or Yen denominated deposits outside Japan.

CAPITAL MARKET INSTRUMENTS


Stocks equity
Corporate Bonds - 10-50 year long term debt instruments

to finance expansion of firm. Unsecured debt. Int payable twice a year. Convertible bond - convertible to common stock at a fixed rate. Example = one bond convertible to 40 shares of common stock until maturity. Advantage to bondholder - share in profits of successful company. Advantage to company = can reduce interest payments after conversion. T-notes and T-bonds. State and local govt bonds. Municipal bonds. Tax-exempt.

Foreign Exchange Markets

Largest single financial market ($1Trillion daily), where foreign currency is traded Over The Counter. MNCs operate globally and are exposed to currency fluctuations and currency risk (or foreign exchange risk). Cash flows from foreign sales or investments denominated in foreign currency expose a firm or investor to currency risk.

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 sell BP forward at the forward rate (F90), a Pakistani importer can buy BP forward at F90 to eliminate foreign exchange risk.

FINANCIAL INTERMEDIARIES
Three categories of financial intermediaries:

1. Banks (depository institutions) 2. Contractual savings institutions (insurance companies and pension 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 to maturity, 1 or 5 year CD). These deposits are liabilities for the bank and provide the source of funds.

Banks (depository institutions)


The banks then lend the money out in the form of

business loans, consumer loans (auto, student, home improvement, etc.), mortgages. These are assets of the bank. Banks also invest in treasury securities and municipal bonds.. Profits: pay 3-4% to attract deposits, lend out at 8-12%, banks make money.

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

Investment Intermediaries
Finance companies - Ford Credit, Toyota Credit. Issue

commercial paper, bonds and stocks to attract funds. Lend out commercial 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 pooling large sums of money and 2) provides excellent diversification most mutual funds own 100s of companies. Money market mutual funds - same as above, but investment is in short-term money market, credit instruments (commercial paper, t-bills, etc.), not capital markets. Often shareholders have checking privileges, so it is an alternative to a checking account with restrictions ($500 minimum). (Not so in Pakistan).

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