Financial Markets Introduction

Session #1
Introduction to
Financial System
Financial Assets
Asset
any possession that has value in an exchange
Tangible asset
The value depends on particular physical properties
(e.g. buildings, land, or machinery)
Intangible assets
Represent legal claims to some future benefit
Examples include financial assets, financial
instruments, or securities
Investor
The owner of the financial asset
FMS (Term IV) 2016-17
Dr. Kulbir Singh (IMTN)
Financial Assets
The Value of a Financial Asset
Valuation
The process of determining the fair value or price of
a financial asset
Fundamental principle of valuation

The value of any financial asset is the present value
of the cash flow expected
Process for
Valuing a
Financial Asset
Financial Assets
The Value of a Financial Asset
Various types of risk include:
Credit risk (Default risk)
the risk that the issuer or borrower will default on the
obligation
Purchasing power risk (Inflation risk)

the risk attached to the potential purchasing power of
the cash flow expected
Foreign exchange risk

the risk that the exchange rate will change adversely
Function of Financial Markets
Segments of Financial Markets

1. Direct Finance
Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrowers future income or assets
2. Indirect Finance
Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrowers future
income or assets
Direct Finance
Source: RBI Annual Report 2015
Direct Finance
Country Name
Australia
Bangladesh
Brazil
Bhutan
Canada
Switzerland
China
Germany
France
United Kingdom
Indonesia
India
Malaysia
Norway
Nepal
Pakistan
United States
South Africa
Congo, Dem. Rep.
Savings Rate (percent)

2010
22.57
38.46
19.26
33.79
19.30
39.35
50.60
25.24
20.19
13.56
32.65
34.16
33.47
36.47
37.75
21.55
15.18
18.02
10.66
2011
23.99
37.28
19.49
39.64
20.94
35.06
48.64
27.19
21.13
14.47
32.96
34.10
34.08
38.47
39.51
21.37
15.79
16.98
12.37
2012
25.03
39.85
16.91
47.61
21.08
35.56
49.86
26.26
19.84
12.96
32.22
32.34
30.92
38.95
40.28
20.50
17.75
15.14
15.15
2013
24.52
38.88
15.11
24.74
21.34
34.76
49.50
26.03
19.91
12.40
30.74
31.57
29.42
38.08
43.35
21.45
17.59
14.35
8.55
2014
23.93
37.72
16.23
34.75
21.45
31.50
49.31
26.94
20.04
12.39
31.35
31.26
29.29
37.88
41.33
22.82
18.43
14.89
9.98
Source: World Bank

10
Source: CNBC http://www.cnbc.com/2015/10/25/china-savings-rate-versus-the-world-in-a-chart.html

11
Direct Finance

12
Direct Finance
Source: Handbook of Statistics (SEBI) 2015
13
Direct Finance- Public Issue of NCDs
Source: SEBI
14
Direct Finance- Public Issue of NCDs
Source: SEBI
15
Direct Finance- Private Placement of Corporate Debt
Source:
SEBI
16
Structure of Financial Markets

1. Debt Markets
Short-Term (maturity < 1 year)

Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Total Debt Issues (Public & Private): Rs. 491,885.40
cr. (2015-16) & Rs. 102,779.27 cr. (2016-17)
2. Equity Markets
Pay dividends, in theory forever

Represents an ownership claim in the firm
Total Equity funds raised: Rs. 9,790.0 cr. (2014-15)
17

1. Primary Market
New security issues sold to initial buyers
Typically involves an investment bank who underwrites
the offering
2. Secondary Market
Securities previously issued are bought & sold
Examples include the BSE, NSE, NYSE and Nasdaq
Involves both brokers and dealers
18

Even though firms dont get any money,
per se, from the secondary market, it
serves two important functions:
Provide liquidity, making it easy to buy and
sell the securities of the companies
Establish a price for the securities
19

We can further classify secondary markets as
follows:
1. Exchanges
Trades conducted in central locations

(e.g., BSE, NSE, Tokyo Stock Exchange, Shanghai
Stock Exchange)
2. Over-the-Counter Markets
Dealers at different locations buy and sell
Best example is the market for Treasury securities
BSE home page http://www.bseindia.com/

20
Classifications of Financial Markets

We can also further classify markets by
the maturity of the securities:
1. Money Market: Short-Term (maturity < 1
year)
2. Capital Market : Long-Term (maturity > 1
year) plus equities
21
Internationalization of Financial Markets

The internationalization of markets is an important
trend.
International Bond Market
Foreign bonds
Denominated in a foreign currency
Targeted at a foreign market
Eurobonds
Denominated in one currency, but sold in a different market
ECB/FCCB (India)
April 2016: 46 firms raised $305.56m
March 2016 : 81 firms raised 1,502.46m
Feb 2016: 66 firms raised 1,353.28m
22
Internationalization of Financial Markets

Eurocurrency Market
Different from Forex Market. How?
Euro-Currency deposits and loans fall outside the
regulatory and supervisory control of the monitoring
authority in the country of origin.
World Stock Markets

U.S. stock markets are no longer always the largest
at one point
23
Function of Financial
Intermediaries: Indirect Finance
24
Intermediaries : Indirect Finance
Instead of savers lending/investing directly
with borrowers, a financial intermediary
(such as a bank) plays as the middleman:
the intermediary obtains funds from savers
the intermediary then makes

loans/investments with borrowers
Eg. Banks
25
26
This process, called financial
intermediation, is actually the primary
means of moving funds from lenders to
borrowers.
More important source of finance than
securities markets (such as stocks)
Needed because of transactions costs, risk
sharing, and asymmetric information
27
Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing
expertise and taking advantage of
economies of scale
28
A financial intermediarys low transaction costs

mean that it can provide its customers with
liquidity services, services that make it easier
for customers to conduct transactions
1.
Banks provide depositors with checking accounts

that enable them to pay their bills easily
2.
Depositors can earn interest on checking and

savings accounts and yet still convert them into
goods and services whenever necessary
29
Global Perspective
Studies show that firms in the U.S., Canada, the

U.K., and other developed nations usually
obtain funds from financial intermediaries, not
directly from capital markets.
In Germany and Japan, financing from financial

intermediaries exceeds capital market financing
10-fold.
However, the relative use of bonds versus equity

does differ by country.
30
Another benefit made possible by the FIs low
transaction costs is that they can help reduce the
exposure of investors to risk, through a process
known as risk sharing
FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from
another party
This process is referred to as asset transformation,
because in a sense risky assets are turned into safer
assets for investors
31
Financial intermediaries also help by
providing the means for individuals and
businesses to diversify their asset
holdings.
Low transaction costs allow them to buy a
range of assets, pool them, and then sell
rights to the diversified pool to individuals.
Eg.: Mutual Funds
32
Source: AMFI https://www.amfiindia.com/Themes/Theme1/downloads/home/Industry-Trends-May-2016.pdf

33
Source: AMFI https://www.amfiindia.com/Themes/Theme1/downloads/home/Industry-Trends-May-2016.pdf

34
Another reason FIs exist is to reduce the
impact of asymmetric information.
One party lacks crucial information about
another party, impacting decision-making.
We usually discuss this problem along two
fronts: adverse selection and moral hazard.
35
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek a loan
3. Similar problems occur with insurance where
unhealthy people want their known medical
problems covered
36
Asymmetric Information:
Adverse Selection and Moral Hazard
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to
engage in undesirable (immoral) activities
making it more likely that won't pay loan back
3. Again, with insurance, people may engage in
risky activities only after being insured
4. Another view is a conflict of interest
37
Asymmetric Information:
Adverse Selection and Moral Hazard
Financial intermediaries reduce adverse
selection and moral hazard problems,
enabling them to make profits.
38
Regulatory Agencies
39
Regulatory Agencies in India

RBI
SEBI
IRDA
FMC
PFRDA (pension fund regulatory &
development authority)
40
Regulation of Financial Markets

Main Reasons for Regulation
1. Increase Information to Investors
2. Ensure the Soundness of Financial
Intermediaries
41
Regulation Reason:
Increase Investor Information
Such government regulation can reduce adverse
selection and moral hazard problems in financial markets
and increase their efficiency by increasing the amount of
information available to investors. Indeed, the SEC has
been particularly active recently in pursuing illegal insider
trading.
42
Regulation Reason: Ensure Soundness

of Financial Intermediaries
Providers of funds to financial intermediaries may
not be able to assess whether the institutions
holding their funds are sound or not.
If they have doubts about the overall health of
financial intermediaries, they may want to pull
their funds out of both sound and unsound
institutions, with the possible outcome of a
financial panic.
Such panics produces large losses for the public
and causes serious damage to the economy.
43
Regulation Reason: Ensure Soundness

of Financial Intermediaries (cont.)
To protect the public and the economy from
financial panics, the government has
implemented six types of regulations:
Restrictions on Entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates
44

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Session #1

Dr. Kulbir Singh (IMTN)

Fundamental principle of valuation

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Purchasing power risk (Inflation risk)

Foreign exchange risk

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Function of Financial Markets

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Segments of Financial Markets

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Source: RBI Annual Report 2015

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Savings Rate (percent)

Source: World Bank

Dr. Kulbir Singh (IMTN)

Source: CNBC http://www.cnbc.com/2015/10/25/china-savings-rate-versus-the-world-in-a-chart.html

Dr. Kulbir Singh (IMTN)

Source: RBI Annual Report 2015

Dr. Kulbir Singh (IMTN)

Source: Handbook of Statistics (SEBI) 2015

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Direct Finance- Public Issue of NCDs

Dr. Kulbir Singh (IMTN)

Direct Finance- Public Issue of NCDs

Dr. Kulbir Singh (IMTN)

Direct Finance- Private Placement of Corporate Debt

Dr. Kulbir Singh (IMTN)

Structure of Financial Markets

Short-Term (maturity < 1 year)

Pay dividends, in theory forever

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Structure of Financial Markets

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Structure of Financial Markets

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Structure of Financial Markets

Trades conducted in central locations

Dealers at different locations buy and sell

Best example is the market for Treasury securities

BSE home page http://www.bseindia.com/

Dr. Kulbir Singh (IMTN)

Classifications of Financial Markets

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Internationalization of Financial Markets

FMS (Term IV) 2016-17

Dr. Kulbir Singh (IMTN)

Internationalization of Financial Markets

World Stock Markets

FMS (Term IV) 2016-17