Lecture 01 / Jan 29, 2009

System: A system consists of interrelated components that work together to perform a

specific objective.

Economic System: Economic system is a system that involves production, distribution,

and consumption of goods and services between entities (individuals, business firm, and
government) in a particular society. Economic system consists of people and institutions
including their relationship to productive resources.

Basic Functions of Economic System:

1. To allocate scarce resources
2. To produce goods and services needed by the society
3. To make possible the flow of production using resources and return for the flow
of payment

Flows of Activities within the Economic System:

Households provide labor, management skill, and natural resources to the business
firms and government; in return they receive income in the form of wages, and other
payments. Most part of this income is used to purchase goods and services produced by
the business firms and government. The remainder of the income is saved aside as
savings.
The spending by the households is a flow of funds back to the producing units as
income. This income stimulates producing units to produce more goods and services in
the future.
 Circular Flow of Production and Income

Function of Market in the Economic System:

1. Market carries out the task of allocating scarce resources and making possible
for producing and selling goods and services demanded by households and
businesses.
2. Market determines what goods and services to produce and in what quantity.
3. Market distributes income, it rewards superior producers with increased profits
and it determines income of individuals and business firms by the contribution they
make to produce goods and services.
4. If the price of an item increases the business firms will tend to produce more
goods and services to consumers. In the long run many firms may enter the market
to produce similar goods and services. A decline in price leads to reduce production
of goods and services. In the long run some less efficient firms may leave the market
place.

Types of Market in the Economic System:

1. Factor Market: Factor market allocates factors of production for producing goods
and services to producing units. And consuming units earn from the factor market by
factors of production.
2. Product Market: In the product market consuming units use most of their income
to purchase goods and services.
3. Financial Market: Financial market channels flow of payments between
consuming units and producing units. It attracts savings from the savers; it sets the
price and interest rates financial assets – stocks, bonds etc. It channels savings to
 those individuals and institutes needing additional funds in excess of their current
income for spending and investment.

Lecture 02 / Feb 02, 2009

Financial System: Financial system is a collection of financial institutions and markets

(money markets, capital markets) through which financial assets are traded. Interest
rates are determined in the financial system and particular financial services like
payment services, L/C services are produced and delivered around the world.
Primary task of financial system is to move scarce loanable funds from savers to
borrowers. These loanable funds are used to buy goods and services, and to make
investment.

Two Major Activities in the Financial System:

Savings: Savings are done by households, businesses, and government.
Household Savings: It is the savings left from current income after current expenditure
and payment of taxes.
Business Savings: It is the current retained earnings after payment of taxes and
shareholders’ dividends.
Government Savings: It is the surplus of current revenues over current expenditures in
a government budget.
Investment: Investments are also done by households, businesses, and government.
Business Investment: Business firm makes investment for acquisition of building,
equipment, and the purchase of inventories of materials for producing products, or the
purchase of inventories of finished goods for sale.
Government Investment: Government spends to build and maintain public facilities
(bridges, highways), and to meet the daily expenses to run the government organization.
Household Investment: Household investments are done mainly buy purchasing
financial assets.

Demanders raise funds by selling stocks and bonds to the households and businesses.
In return suppliers receive promises for their loan of their money in the form of dividends
on stocks, interest on bonds, deposit schemes, and claims on insurance policies.

Function of the Financial System:

1. Savings Function
2. Wealth Function
3. Liquidity Function
4. Credit Function
5. Payment Function
6. Risk Protection Function
7. Policy Function

Savings Function:
Financial system provides profitable and relatively low risk outlet for public savings. It
offers various types of deposit schemes and insurance policies; and these savings are
used to invest in financial instruments such as bonds, stocks, and other securities sold in
the financial market.

Wealth Function:
It is the accumulated savings built over time. Financial system preserves the value of
financial assets until funds are needed. For example, if the money is invested in things,
such as automobile, it is subject to depreciation and carries greater risk to loss. But
bond, stock, and other financial assets do not wire out over time and usually generate
income.

Liquidity Function:
Financial system provides liquidity for savers who hold financial instruments but are in
need of money. Holder of a financial asset can easily convert it into money through
financial market.

Advantage of Money:
1. It is the only perfect liquid asset.
2. It can be spent as it is without converting it into some other forms.

Disadvantage of Money:
1. It generally earns the lowest rate of return.
2. Purchasing power of money is seriously eroded by inflation; that is why savers
generally minimize their holdings of money.

Lecture 03 / Feb 05, 2009

Credit Function:
Financial systems furnish credits to households, businesses, and government for
consumption and investment.

Payment Function:
Financial system provides mechanism for making payments for goods and services and
there are some other popular medium of payments; these are non-interest bearing
checking account, i.e. current account, interest bearing checking account, i.e. saving
account, credit card, and debit card. Consumer can pay immediately by debiting
electronically his or her account in a depository institution. Consumer can access to
short term credit for the purchase of goods and services.

Risk Protection Function:

The financial market around the world offer businesses, individuals, and the government
protection against life, health, and property. There are two types of insurance companies
– Life Insurance Company, and Property/Casualty Insurance Company. LIC offers
protection of possible loss of income following the death of the policy holder. PCIC
protects the policy holders against personal risk and property risk.

Policy Function:
Through financial market government can stabilize the economy and avoid inflation.
Government can control the borrowing and spending plans of the public by manipulating
interest rates and the availability of credits.

Lecture 04 / Feb 09, 2009

Financial system carries out its various roles through financial market, where vast
amount of loanable funds are continually being drawn upon by the demanders of funds,
and continually being replenished by the suppliers of funds.

Depending on the characteristics of financial assets traded, and needs of the different
savers and borrowers, financial market can be segmented into –
1. Money Market
2. Capital Market

Money Market: Short term market makes short term loans, less than one year maturity.
It meets the needs of the borrowers who have temporary shortage of funds.

Functions of Money Market:

 1. To finance the working capital needs of business firms
2. To provide government with short term funds as a substitute of tax collection;
government gets short term money by selling treasury bills
3. To supply funds to individuals for the purchase of securities and commodities

Capital Market: Capital market deals with financial instruments maturing more than one
year. In the capital market, funds float from savers to borrowers for long term
investment.

Functions of Capital Market:

1. Individuals need fund from capital market to purchase home and automobile.
2. Business firms use the fund from capital market for the construction of factory
building, and purchase of equipment.
3. Government takes fund from capital market to create public facilities

Money market can be sub-divided into different segments according to financial

securities traded in the market –
1. Treasury bill: Treasury bill is issued by the government.
2. Certificate of Deposits: These are issued by banks and other depository
institutions.
3. Banker’s Acceptance: Banks issue banker’s acceptance to facilitate the
overseas business.
4. Commercial Paper: This is issued by reputed large corporation to raise short
term funds.
5. Federal Fund: Reserved balances of the banks with the central bank. It is traded
daily, loans are paid back overnight.
6. Eurocurrency: Deposit of world’s major currencies (US Dollar, Pound, Euro, and
Yen)

Capital market can be sub-divided into different segments according to the securities
traded –
1. Mortgage Loan: It is the loan to support the building of homes, business
structure i.e. factories, and shopping centers which is issued by the financial
institution.
 2. Government Bond: This is issued by government
3. Consumer Loan: It is the loan for the consumer to purchase ranging from
automobile to home appliances.
4. Corporate Stock: This is issued by the corporate for indefinite life period.
5. Corporate Notes and Bonds: These are issued by the corporate. Notes are
issued for the maturity of less than five year, but more than one year. Bonds are
issued for the maturity of more than five year.

Financial market can be further sub-divided according to the nature of trading of financial
securities –
Open vs. Negotiated Market
Open Market: Open market is an institutional mechanism in which any individual or
institution can participate in the trade of securities. Financial securities are sold to the
highest bidder.
Negotiated Market: This is an institutional mechanism in which terms of trading are set
by direct bargaining between two parties. It is usually done under private contract.

Primary vs. Secondary Market

Primary Market: It is the market for financial instruments issued for the first time. For
example, financial capital raised by issuing new stock of shares first time is in the
primary market.
Secondary Market: It is the market in which previously issued securities are traded
among the investors. This market provides liquidity for the investors. Activities in the
secondary market have strong influence on the issuance of the stocks in the primary
market.
Factors influencing issuance of stocks in the primary market:
1. Market price
2. Demand of the financial instruments
3. Tradability
4. Liquidity

Spot vs. Forward Market

Spot Market: Here the financial instruments are traded for immediate delivery. The
closing of contract and delivery of financial instruments take place on the spot, or within
a short period of time (usually two business days).
Forward Market: It is the market where contracts are made for future delivery of
financial instruments, but the delivery date and price are determined at the time of
contract, and delivery occurs at future. It has another name – future market.

Lecture 05 / Feb 12, 2009

Financial Asset: Financial asset is a claim against the income or wealth of an economic
unit. Financial assets are created usually by borrowing and lending of money. Stock of
shares, bonds, insurance policies, and deposits of money in banks are the examples of
financial assets.

Characteristics of Financial Assets:

1. It promises future return to the owner.
2. It serves as a store of value. It has the purchase power, holder can purchase
goods and services using the financial assets.
3. It doesn’t depreciate like physical assets.
4. The physical condition or form of financial asset is not relevant in determining its
market value.
5. Transportation cost of financial asset is very low.
6. Storage or holding cost of financial asset is low.
7. Financial asset has little or no value as commodity.
8. Financial asset can be substituted easily for other assets.

All financial assets can be divided into three principal categories –

1. Money
2. Equity security
3. Debt security
There is another category – Option.

Money: Money is the only financial asset that is generally accepted in payments for the
purchase of goods and services. Money has the following three forms –
  Currency
 Current chequing account
 Savings chequing account
Equity security: Equity security represents the ownership share in the business firm,
has claim against the firm’s profit and the proceeds from the sale of the firm’s asset; but
has the claim after the creditor. Equity security is of two forms – common stock, and
preferred stock.
Debt security: It entitles the holder to have priority claims over the equity holders, to the
assets and income of the business firm.

Preferred stock has both the equity feature and debt feature in a sense that principal has
not to be paid pack to the holders (equity feature), and holder is entitled to get a fixed
dividend at a fixed period (debt feature).

Two types of debt securities:

1. Negotiable debt securities: These securities can be transferred from one person
to another – bonds, notes, commercial paper, and banker’s acceptance.
2. Non-negotiable debt securities: These securities can’t be legally transferred from
one person to another – savings account.

Option: An option gives the holder the opportunity to buy from or sell to another party at
a pre-arranged date, at a pre-arranged price.

Volume of Financial Asset for All Lenders = Volume of Liability issued by the All
Borrowers
Total Asset in the Financial System = Total Financial Asset in the Financial System +
Total Real Asset in the Financial System
Total Financial Asset in the Financial System = Total Liability in the Financial System
Net Worth = Total Real Asset in the Financial System

In any financial system, any individual or firm can be either lender of funds, or borrower
of funds, or both.
Any individual, firm, or government in the financial system confirms the following
equation: R – E = ∆ FA - ∆ D
Where, R = Revenue
E = Expenditure
∆ FA = Change in Financial Asset
∆ D = Change in Debt and Equity Outstanding
This formula was developed by John Gurley and Edward Shaw, in 1960.

If E > R, an economic unit can

 Reduce the holdings of financial asset by withdrawing money from the savings
account, for example,
 Issue debt or equity securities
 Use the combination of both.

If R > E, an economic unit can

 Build up the holdings of financial asset by placing money in the savings account,
or purchase shares of stock
 Pay off some outstanding debt, or retire stocks previously issued by the business
firm
 Use the combination of both

Three groups in the financial system:

1. Deficit Budget Unit (DBU): Net borrower of fund, E > R; mainly business firm and
government
2. Surplus Budget Unit (SBU): Net lender of fund, R > E; mainly household
individuals and families
3. Balanced Budget Unit (BBU): Neither lender, nor borrower, R = E

Lecture 06 / Feb 19, 2009

Financial Transaction: It is the flow between savers and borrowers that can be
accomplished in three different ways –
1. Direct Finance
2. Semi-Direct Finance
 3. Indirect Finance
Methods are gradually evolved from direct finance to indirect finance; indirect finance is
the most reliable method of financial transaction.

Direct Finance: In direct finance, borrower and lender meet each other, and exchange
funds in person, in return for the financial asset. These financial assets are the interest,
and securities.
Examples of Direct Finance:
 Borrowing money from a friend and giving him primary security
 Purchasing bond or stock from the issuing companies
Primary Security: It is the claim against the ultimate borrower, and this directly goes to
the ultimate lender.

Merits of Direct Finance:

 Simplest method for carrying out financial transaction
Limitations of Direct Finance:
 Borrower and lender, both, must desire to exchange same amount of fund at the
same time for the same period.
 The lender must be willing to accept borrower’s offered securities that may be
riskier.
 Both borrower and lender must incur substantial cost to find each other for
collecting information. The borrower may have to contract many lenders before
finding one with right amount of fund and willing to accept the securities.
 It is impractical for a large corporation who requires a large amount of fund to
deal with thousands of small lenders.
Semi-Direct Finance: It is the kind of direct finance with the help of market makers to
assist in making financial transaction between lenders and borrowers.

Types of Market Makers:

1. Broker: Broker provides information for possible purchase and sells of securities
and usually gets commissions.
2. Dealer: Dealer holds borrower’s securities for marketing at a later time, at a
favorable price. If the securities decline in price, dealers carry the risk.
3. Investment Bank: It is the financial institute that assists corporations and
government agencies in raising funds by underwriting their security offerings.
Advantages of Semi-Direct Finance:
 It lowers the information cost for the participants in the financial market
 Dealer makes split of large issue into smaller units so that these smaller
units can be affordable by buyers of various income levels
 It expands the flow of savings into investments
Disadvantage of Semi-Direct Finance:
 The lender must be willing to accept the borrower’s offered securities.

Indirect Finance: It carries out financial transactions with the help of financial
intermediaries (banks, insurance companies, leasing companies, insurance funds,
pension funds, credit unions, and savings and loans associations). Financial
intermediaries issue secondary securities to ultimate lenders, and accept primary
securities from ultimate borrowers.
Primary Security: It is the direct claim against the ultimate borrowers and are non-
acceptable to the ultimate lenders.
Secondary Security: This is the indirect claims against the ultimate borrowers, issued
by the financial intermediaries, in the form of savings deposits. Secondary securities are
liquid and can be converted into cash quickly.

Advantages of Indirect Finance:

 Financial intermediaries pull the resources of small savers in savings accounts,
and meet the credit needs of the borrowers.
 They satisfy the financial needs of both the borrowers and the lenders.
 They make savings and borrowings easier and safer.
 They permit small savings of individuals to finance a greater amount of
investment in the economy.

Lecture 07 / Feb 23, 2009

Definition of Money:
Money, M = M1 + M2 + M3
Where,
 M1 means the most liquid form – currency, current account, savings account
 M2 means short term deposits from households – Certificate of deposit
 M3 means loans from deposits – Institutional savings (Federal funds,
Eurocurrency)

Functions of Money:
1. It serves as the standard value for all goods and services, that is all
goods and services are valued in terms of money.
 2. It serves as the medium of exchange; it is the only financial asset that is
accepted by households, businesses, and governments in payment for purchase of
goods and services. Funds flow among economic units through money.
3. It serves as a store of value; it is the reserve of future purchasing power,
although the value of money is deteriorated by inflation.

Characteristics of Perfect Liquid Asset:

 Price stability: An asset is considered liquid if its price tends to be relatively
stable over time.
 Ready marketability: A liquid asset has active resell market.
 Reversibility: A liquid asset can be converted into any other form of asset without
loss.

Money is the only perfect liquid asset because it does not require converting into
any other form of asset to purchase goods and services.

Lecture 08 / Mar 02, 2009

Money Market: Money market arises because cash inflows and outflows of economic
units are rarely matched with each other. A cash surplus position brings an economic
unit into the money market as a lender; and cash deficit forces this unit onto the
borrowing side of money market.
Money market is a mechanism through which holders of temporary cash surplus meets
the needs of those who have temporary cash deficit.

Functions of Money Market:

1. To finance the working capital needs of business firms
2. To provide government with short term funds as a substitute of tax
collection; government gets short term money by selling treasury bills
3. To supply funds to individuals for the purchase of securities and
commodities
4. to provide investment layout for the economic unit that holds surplus cash
for a short period, and wish to earn some return on temporary idle money
Characteristics of Money Market:
1. Money market is extremely broad, because a large volume of transaction takes
place in the money market with small change in security prices and interest rates. It
is broad because investors can sell their securities easily in the money market on
short notice.
2. Money market is a very efficient market. Security dealers, brokers, and some
banks can maintain their contact with each other over a vast telephone and computer
network, and make decision on purchasing and selling securities.
3. Money market is the wholesale market for funds. Most trading occurs in the
money market in multiple of million dollars.
4. Money market is dominated by small number of large financial institutions
through which bulk of federal funds are traded in the money market.

“Money market investors seek safety and liquidity for their funds plus opportunity
to earn some interest income. They are very much sensitive to risk, because
funds invested in the money market are only temporary cash surplus, and funds
are usually needed in the near future.”
Types of Maturity Period:
1. Original Maturity: It is the interval between the issue date and the date on which
the borrower promises to redeem the security.
2. Actual Maturity: It is the interval between the issue date and the date on which
the security actually retires.
 If actual maturity is shorter than the original maturity, it is subject to loss
to the investors.
 Original maturity for money market instruments range from one day to
one year.

Risks in the Money Market:

1. Market Risk: This risk arises when the value of value of an asset declines and
results in a capital loss when sold. Market risk occurs when the investor’s holding
period is shorter than the original maturity of the asset.
2. Reinvestment Risk: It arises when earnings from an investment will have to
invest in a lower yielding asset in the future.
 3. Default Risk: It is the risk when the borrower fails to pay principal, or to meet one
or more promotional interest payment on a security.
4. Inflation Risk: The risk that arises due to increases in general price levels of
goods and services will reduce the purchasing power of earnings from the
investment.
5. Currency Risk: It arises due to unfavorable changes in the value of foreign
currencies.
6. Political Risk: It is the risk due to changes in the government rules and
regulations that can reduce the expected return from investment.

Money market instrument offers more protection against risk than any other instrument,
that is, capital market instruments because the price of money market instruments tend
to be more stable compare to bonds, stocks (capital market instruments), commodities,
real estates. So market risk is expected to be minimal in the money market.

Role of the Government in Money Market:

1. Government serves as the regulator in money market.
2. Government is the largest borrower in money market.

Lecture 09 / Mar 05, 2009

Treasury bill (T-bill): Most popular money market financial instrument in the world is
Treasury bill, of which maturity period is one year or less. T-bill was first issued by the
US government in 1929. Now it is issued by all governments throughout the world to
raise short term funds and to meet the expenses. It is a direct obligation of the
government. Tax revenues and any other sources of fund are used to repay the holders
of the t-bills.

Importance of T-Bill in the Financial System:

1. There is no default risk of t-bill.
2. T-bill has the ready marketability; it has a secondary market where holders can
sell t-bills before maturity.
3. T-bill has high liquidity; holders can convert t-bills into cash before maturity.
Types of T-bills:
1. Regular series bill: It is issued routinely every week or month in the competitive
tender. Original maturity of regular series bill is three months, six months, or one
year.
2. Irregular series bill: It is issued when the treasury has special cash need. It is a
package offering of t-bill that requires an investor to bid for entire series bill, of
different maturity periods. Successful bidder must accept the bid at bid price.

Sales of T-bill:
T-bills are sold using the auction technique. So market decides the price and all bids for
t-bill must be expressed as a discount rate. A new regular t-bill is usually announced by
the treasury on a particular day of each week. It requires the investors to bid on the
following day of announcement.
Participating in auction can be done in two ways –
1. Investor may appear in person to fill out the tender form to make an offer to the
treasury.
2. Investor may place an offer through security dealer for a specific bill at a specific
price.

There are two types of tenders –

1. Competitive tender: This is submitted by the large investors including banks,
security dealers, and any other depository institutions (insurance company, leasing
company).
2. Non-competitive tender: This is submitted by the small investors and they do
agree accept whatever the bid price is determined at the auction. In this case
investor must pay the full par value of the issue for which he or she bids at the time
the tender is made. Treasury gives the investor a refund cheque if the price of the
issue is less than the amount paid. The refund cheque represents the difference
between the amount paid and the actual auction price. The highest bid becomes the
common price of the t-bills.

Calculation of Yield on T-bill:

Bank discount method (360 days a year):
DR = ((Par Value – Purchase Price) / Par Value)*(360 / Days to Maturity)
Investment Rate Method (365 days a year):
IR = ((Par Value – Purchase Price) / Par Value)*(365 / Days to Maturity)

** An individual purchases a t-bill for $97 on a $100 par value, and the maturity is 180
days. Calculate both DR and IR.
Answer:
DR = (($100 - $97) / $100) * (360 / 180) = 6%
IR = (($100 - $97) / $100) * (365 / 180) = 6.27%

Yield before Maturity: If the investor sells the t-bill before maturity then yield before
maturity is to be calculated.

Yield before Maturity = Original DR + Change in Discount Rate over the Holding Period

Change in Discount Rate over the Holding Period =

((Original Maturity Period – Holding Period) / Holding Period) * Change in Discount Rate

** An investor buys a t-bill with 180 days maturity at a price that result in DR of 6%; after
30 days the investor needs immediate cash and is forced to sell at a price that result in
DR of 5.8%. What is investor’s holding period yield?
Answer:
YBM = 6% + ((180-30)/30) * (6% - 5.8%) = 7%

Role of T-bill in the Money Market:

1. Government raises short term fund by issuing t-bills.
2. Government implements monetary policy through t-bill. Government increases
the money supply by returning back the t-bills and it stimulates the economic
activities. Government decreases money supply by selling the t-bills, and decreases
the overall demands of goods and services.
Lecture 10 / Mar 09, 2009

Certificate of Deposit: CD is issued by the depository institutions, and they are interest
bearing deposits for a set period of time.
 There are many types of CD issued by the depository institutions. True money
market CDs are negotiable CD, which may be sold in the money market before
maturity, means there is a secondary market. Negotiable CDs may be of two
types –
1. Registered with the issuing company
2. Issued in a bearer form to the investors
 Negotiable CDs in bearer form are more convenient for resell in the
secondary market because they are in the hands of the investors who
own those.
 Interest rates on large CDs are set by negotiating between issuing
institutions and investors.
 When loanable funds are scarce, the issuing institutions offer high interest
rate; and when loanable funds are more abundant, the interest rates fall.
 Interest from CD = (Term in Days / 360) * Principal * Yield to Maturity
(YTM)
YTM → Promised interest rate by the issuing institutions at maturity

Advantage of CD:
1. Readily marketable at low risk
2. May be purchased at any desired maturity
3. Carries somewhat higher yield than that on t-bills.

Types of CDs:
1. Variable Rate CD: It carries maturities up to five years and interest rate is
adjusted every three months, or six months.
 2. Roll over CD: It is composed of three months, or six months CDs and extended
for further period.
3. Installment CD: It allows customer to make a small initial deposit in the account
and then gradually build up the balance in the account to some target level.
4. Special CD: It provides the investors with penalty free withdrawals on some
selected anniversary dates.

** If a business firm purchases negotiable CD of tk. 100,000 for 6 months at 7.5%

interest rate, then what will be the interest amount?
Answer:
Interest Amount = (Term in Days/360) * Principal Amount * Yield to Maturity
= (180/360) * 100,000 * 7.5% = tk. 3,750

** A 6 months tk. 100,000 worth CD, bearing 7.5% interest rate at maturity. If the
investor sells the CD 3 months prior to the maturity for tk 115,000, then what would be
the investment rate?
Answer:
IR = ((Selling Price – Par Value) / Par Value)* (365 / Days to maturity)
= ((115,000 – 100,000) / 100,000) * (365/(180-90)) = 60.83%