Why Study Financial Markets?

Financial markets, such as bond and

stock markets, are crucial in our economy.

1.These markets channel funds from savers to investors, thereby promoting economic
efficiency.
2.Market activity affects personal wealth, the behavior of business firms, and economy
as a whole
3.Poor financial markets is a reason behind poor economic conditions of countries

Financial Markets

Well functioning financial markets are key factors in producing high economic growth
bond market
stock market
foreign exchange market
Debt Markets & Interest Rates

Debt markets, or bond markets, allow governments, corporations, and individuals to

borrow to finance activities.
In this market, borrowers issue a security, called a bond, that promises
the timely payment of interest
and principal
over some specific time horizon.
The interest rate is the cost of borrowing.

Debt Markets & Interest Rates

There are many different types of market interest rates, including
mortgage rates
car loan rates
credit card rates, etc.
The levels of these rates are important.

Debt Markets & Interest Rates

Interest rates are important to individuals and business

Understanding the history of interest rates is beneficial
The Stock Market
The stock market is the market where common stocks (or just stocks) are traded
Stocks represent ownership in a company
Companies initially sell stock (in the primary market) to raise money
But after that, the stock is traded among investors (secondary market)
Of all the active markets, the stock market receives the most attention from the media,
probably because it is the place where people get rich (and poor) quickly

Pakistan Stock Market-Indexes

http://www.marketwatch.com/investing/index/kse100/charts?
countrycode=pk&charttype=interactive
http://www.bloomberg.com/quote/KSE100:IND

The Stock Market

Companies also watch the market.

Corporations dont typically invest in the market
They often seek additional funding in equity markets after going public.
The success of these seasoned-equity offerings (SEOs) is very dependent on the
current price of the companys stock.

The Foreign Exchange Market

The foreign exchange market is where international currencies trade and exchange
rates are set.
Although most people know little about this market, it has a daily volume around $1
trillion!

The Foreign Exchange Market

Exchange Rate fluctuations matter!
From U.S. Perspective:
In recent years, consumers have found that vacationing in Europe is expensive, due to
a weakening rupee relative to the Euro.
When the dollar strengthens, foreign purchase of domestic goods falls, and US
manufacturers experience a decreased demand for their goods.
Chapter # 2
Function of Financial Markets

Channels funds from person or business

without investment opportunities (i.e., Lender-Savers)
to one who has them (i.e., Borrower-Spenders)
Improves economic efficiency

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 by issuing financial
instruments which are claims on the borrowers future income or assets

Importance of Financial Markets

Financial markets are critical for producing an efficient allocation of capital
allowing funds to move from people who lack productive investment opportunities to
people who have them
improve the well-being of consumers, allowing them to time their purchases better

Structure of Financial Markets

1.Debt Markets
Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $41 trillion at the end of 2007.
2.Equity Markets
Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $18 trillion at the end of 2005.

Structure of Financial Markets

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 and sold
On exchanges like the NYSE and Nasdaq
Involves both brokers and dealers

Structure of Financial Markets 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

Structure of Financial Markets We can further classify secondary markets as follows:

1.Exchanges
Trades conducted in central locations (New York Stock Exchange, CBT)
2.Over-the-Counter Markets
Dealers at different locations buy and sell
Best example is the market for Treasury securities
Nasdaq

Classifications of Financial Markets We can also further classify markets by the

maturity of the securities:
1.Money Markets:
Short-Term (maturity < 1 year)
2.Capital Markets:
Long-Term (maturity > 1 year) plus equities
Internationalization of Financial Markets The internationalization of markets is an
important trend.
The U.S. no longer dominates the world stage.
International Bond Market
Foreign bonds
Sold in a foreign country
Denominated in that foreign countrys currency
Targeted at a foreign market

Eurobonds
Denominated in one currency, but sold in a different market
now larger than U.S. corporate bond market
Over 80% of new bonds are Eurobonds
Internationalization of Financial Markets
Eurocurrency Market
Foreign currency deposited outside of home country
Eurodollars are U.S. dollars deposited outside U.S.
Gives U.S. borrows an alternative source for dollars
World Stock Markets
U.S. stock markets are no longer always dominant
Brazil Bovespa
U.K. FTSE
Germany DAX
Hong Kong Hang Seng
India - Sensex

Global perspective Relative Decline of U.S. Capital Markets Why?

1.New technology in foreign exchanges
2.9-11 made U.S. regulations tighter
3.Greater risk of lawsuit in the U.S.
4.Sarbanes-Oxley has increased the cost of being a U.S.-listed public company

Function of Financial Intermediaries : Indirect Finance

Financial intermediation is 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

Function of Financial Intermediaries : Indirect Finance

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
Function of Financial Intermediaries : Indirect Finance
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

Function of Financial Intermediaries : Indirect Finance

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

Function of Financial Intermediaries : Indirect Finance

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.
Function of Financial Intermediaries : Indirect Finance
Another reason FIs exist is to reduce the impact of asymmetric information.

One party lacks crucial information about another party, impacting decision-making.

This problem is usually discussed along two fronts:

adverse selection

and moral hazard

Function of Financial Intermediaries : Indirect Finance

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

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

Types of Financial Intermediaries

Commercial banks
Raise funds primarily by issuing checkable, savings, and time deposits which are used
to make commercial, consumer and mortgage loans
Collectively, these banks comprise the largest financial intermediary and have the
most diversified asset portfolios

Types of Financial Intermediaries

Thrifts: S&Ls, Mutual Savings Banks and Credit Unions
Raise funds primarily by issuing savings, time, and checkable deposits which are most
often used to make mortgage and consumer loans
Mutual savings banks and credit unions issue deposits as shares and are owned
collectively by their depositors
Contractual Savings Institutions (Insurance Companies)
Acquire funds from clients at periodic intervals on a contractual basis and have fairly
predictable future payout requirements.
Life Insurance Companies
receive funds from policy premiums
can invest in less liquid corporate securities and mortgages
Loses are easier to predict through actuarial tables
Fire and Casualty Insurance Companies
receive funds from policy premiums
must invest most in liquid government and corporate securities
Losses are harder to predict

Contractual Savings Institutions (CSIs)

Pension and Government Retirement Funds
hosted by corporations and state and local governments
acquire funds through employee and employer payroll contributions
invest in corporate securities
provide retirement income via annuities
Contractual Savings Institutions (CSIs)
Pension and Government Retirement Funds
hosted by corporations and state and local governments
acquire funds through employee and employer payroll contributions
invest in corporate securities
provide retirement income via annuities

Types of Financial Intermediaries

Money Market Mutual Funds
acquire funds by selling checkable deposit-like shares to individual investors
use the proceeds to purchase highly liquid and safe short-term money market
instruments
Investment Banks
advise companies on securities to issue
underwriting security offerings
offer M&A assistance
and act as dealers in security markets

Regulation of Financial Markets

Main Reasons for Regulation
1.Increase Information to Investors

2.Ensure the Soundness of Financial Intermediaries

Regulation Reason
To protect the public and the economy from financial panics, the government
implements various types of restrictions:
Restrictions on Entry

Disclosure

Restrictions on Assets and Activities

Deposit Insurance
Limits on Competition

Restrictions on Interest Rates

Chapter 3
Chapter Preview
Interest rates are among the most closely watched variables in the economy.

It is imperative that what exactly is meant by the phrase interest rates is understood.

In this chapter, we will see that a concept known as yield to maturity (YTM) is the most
accurate measure of interest rates.

Chapter Preview
We examine the terminology and calculation of various rates, and we show the
importance of these rates in our lives and the general economy. Topics include:
Measuring Interest Rates

The Distinction Between Real and Nominal Interest Rates

The Distinction Between Interest Rates and Returns

Present Value
Different debt instruments have very different streams of cash payments to the holder
known as cash flows
with very different timing
All else being equal, debt instruments are evaluated against one another based on
the amount of each cash flow and
the timing of each cash flow
A dollar of cash flow paid one year from now is less valuable than a dollar paid to you
today

Present Value
The analysis of the amount and timing of a debt instruments cash flows which leads to
its yield to maturity or interest rate is called
Present Value Analysis
The term present value (PV) can be extended to mean the PV of a single cash flow or
the sum of a sequence of cash flows

Present Value Applications

There are four basic types of credit instruments which incorporate present value
concepts:
1.Simple Loan
2.Fixed Payment Loan
3.Coupon Bond
4.Discount Bond

Present Value Concept: Simple Loan Terms

Loan Principal:
the amount of funds the lender provides to the borrower.
Maturity Date:
the date the loan must be repaid
the Loan Term is from initiation to maturity date
Interest Payment:
the cash amount that the borrower must pay the lender for the use of the loan principal
Simple Interest Rate:
the interest payment divided by the loan principal
the percentage of principal that must be paid as interest to the lender
convention is to express on an annual basis, irrespective of the loan term

Loan Types
Simple Loans
require payment of one amount which equals the loan principal plus the interest.
Fixed-Payment Loans
loans where the loan principal and interest are repaid in several payments, often
monthly, in equal dollar amounts over the loan term

Installment Loans, such as auto loans and home mortgages are frequently of the fixed-
payment type.
Distinction Between Real and Nominal Interest Rates
Real interest rate
Interest rate that is adjusted for expected changes in the price level
3-18 ir i e

Real interest rate more accurately reflects true cost of borrowing

usually referred as the ex ante real rate of interest because it is adjusted for the
expected level of inflation
ex post real rate based on after the fact observed level of inflation
When the real rate is low, there are
greater incentives to borrow and
less incentive to lend
Maturity and the Volatility of Bond Returns
Key findings
1.Only bond whose return equals yield is one where maturity equals holding period

2.For bonds with maturity > holding period, i P implying capital loss

3.Longer the maturity, greater is price change associated with interest rate change

Maturity and the Volatility of Bond Returns

Conclusion
1.Prices and returns are more volatile for long-term bonds because they have higher
interest-rate risk
2.No interest-rate risk for any bond whose maturity equals holding period

Reinvestment Risk Occurs if one holds a series of short bonds over long holding period
i at which reinvestment is uncertain
Gain when i , loss when i
3-25
Duration
It is a measurement of how long, in years, it takes for the price of a bond to be repaid
by its internal cash flows.
Duration is a weighted measure of the length of time the bond will pay out.
It is the weighted average of the effective maturities of a series of zero coupon bonds.
It is an important measure for investors to consider as
bonds with higher durations carry more risk and
have higher price volatility than bonds with lower durations
Duration of a zero coupon bond equals its maturity
3-26
Formula for Duration
Duration is additive
the duration of a portfolio of securities is the weighted-average of the durations of the
individual securities, with the weights equaling the proportion of the portfolio invested in
each
What is the duration of a portfolio that holds 25% of its assets in a bond with duration
of 5 years and the remaining in a bond with a duration of 10 years?
3-30

Duration and Interest-Rate Risk

The greater is the duration of a security, the greater is the percentage change in the
market value of the security for a given change in interest rates

Therefore, the greater is the duration of a security, the greater is its interest-rate risk
3-33