The Financial Environment

Markets, Institutions, Interest Rates

and Taxes
 The Financial Markets
 Financial Markets: “Mechanisms” by which
borrowers and lenders get together.
 Debt Markets: The financial markets where
loans are traded.
 Equity Markets: The financial markets where
stocks of corporation are traded.
 Money Markets: The financial markets in
which funds are borrowed or loaned for short
periods (generally one year or less)
 Cont…..
 Capital Markets: The financial markets for stocks
and long-term debt (generally longer than one year).
 Primary Markets: Markets in which corporations
raise funds by issuing new securities.
 Secondary Markets: Markets in which securities and
other financial assets are traded among investors
after they have been issued by corporations and
public agencies such as municipalities .
 Cont…..
 Mortgage Markets: The markets deal with loans
on residential, commercial and industrial real
estate and on farmland.
 Consumer Credit Markets: The markets involve
loans on autos and appliances as well as loans
for education, vacations and so forth.
 Spot Markets: The term that refer to whether
the assets are being bought or sold for “on the
spot” delivery.
 Cont…..
 Future Markets: The term that refer to whether
the assets are being bought or sold for delivery
at some later date, such as six months or a year
in to the future.
World, National, Regional and local markets also
exists. Thus, depending on an organization’s size and
scope of operation, it might be able to borrow all
around the world or might be confined to a strictly
local oe even neighborhood market.
 Financial Institutions (Fund Transfer
Mechanism)
Funds are transferred between those who have funds to
invest (savers) and those who need the funds
(borrowers) by the three different Process:
 A direct transfer of money or securities occurs when

a business sells its stocks or bond directly to savers

(investors) without going through any type of
financial institution. The business delivers its
securities to savers who in turn give the firm the
money it needs.
 Financial Institutions (Fund Transfer
Mechanism) Cont……
 A transfer also can go through an investment banking
house which serves as a middleman and facilitates the
issuance of securities. The company sells its stocks or
bonds to the investment bank, which in turn sells these
same securities to investors.
 Transfers can also be made through a financial
intermediary such as a bank or a mutual fund. The
intermediary obtains 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’s
securities.
 Financial Institutions (Fund Transfer
Mechanism) Cont……
 Investment Bankers: An organization that underwrites and
distributes new issues of securities; helps businesses and
other entities obtain needed financing.
 Direct transfer of funds from savers to businesses are
possible and do occur on occasion, but it is generally more
efficient for a business to enlist the service of an investment
banker.
 Investment bankers
 Help corporations design securities with the features that
currently are most attractive to investors
 Buy these securities from the corporations, and
 Then resell them to savers
 Financial Institutions (Fund Transfer
Mechanism) Cont……
 Financial Intermediaries: Specialized financial firms that
facilitate the transfer of funds from savers to borrowers.
 The financial intermediaries do more than simply transfer
money and securities between and savers- they literally create
new financial products. Because the intermediaries generally
are large, they gain economics of scale in analyzing the
creditworthiness of potential borrowers, in processing and
collecting loans, in pooling risks, and thus helps individual
savers diversify- that is, “not put all their financial eggs in one
basket.”
 A system of specialized intermediaries can enable savings to
do more than just draw interest.
 Financial Institutions (Financial
Intermediaries)
 Commercial Banks: are the traditional “department stores of
finance”, serve a wide variety of customers. Commercial banking
organization provide an ever-widening range of services,
including trust operations, stock brokerage services and
insurance.
 Commercial banking organizations are quite different from
investment banks. Commercial banks lend money, whereas
investment banks help companies raise capital from other parties.

 Savings and Loan Association (S&Ls): have traditionally served

individual savers and residential and commercial mortgage
borrowers, take the funds of many small savers and then lend
these money to home buyers and other types of borrower.
 Most significant economic function of S&L is to “create liquidity.”
 Financial Institutions (Financial
Intermediaries) Cont……

 Credit Unions: are cooperative associations whose members

have a common bond, such as being employees of the same
occupation or firm. Members’ savings are loaned only to other
members, generally for auto purchase, home improvements
and the like.

 Pension Funds: are retirement plans funded by corporations or

government agencies for their workers and administered
primarily by the trust departments of commercial banks or by
life insurance companies. Pension fund invest primarily in
long-term financial instruments, such as, bonds, stocks,
mortgages and real estate.
 Financial Institutions (Financial
Intermediaries) Cont……

 Life Insurance Companies: take savings in the form of annual

premiums, then invest these fund in the stocks, bonds, real
estate, and mortgages.

 Mutual Funds: A mutual fund that invests in short-term, low-

risk securities and allows investors to write checks against
their accounts.
 The Stock Market (Stock Exchanges)
 Organized Security Exchanges: Formal organizations with
physical locations where auction markets are constructed in
designated (“listed”) securities.
 Example: The two major U.S. stock exchanges are the New York
Stock Exchange (NYSE) and the American Stock Exchange (AMEX).
Stock exchanges of Bangladesh are Dhaka Stock Exchange (DSE) and
Chittagong Stock Exchange (CSE).

 Most of the large investment banking houses operate

brokerage departments that own seats on the exchanges and
designate one or more of their officers as members. Exchange
members meet in the large room equipped with telephones and
other electronic equipment that enable each member to
communicate with his or her firm’s offices throughout the
country.
 The Stock Market (Stock Exchanges)
 Over-the-Counter Market (OTC): A large collection of brokers
and dealers, connected electronically by telephones and
computers, that provides for trading in securities not listed on
the organized exchanges.
 Traditionally, the over-the-counter market has been defined to
include all facilities that are needed to conduct security
transactions not conducted on the organized exchanges. These
facilities consist of
1. The relatively few dealers who hold inventories of over-the-
counter securities and who are said to “make a market” in these
securities
2. The thousands of brokers who act as agents in bring these dealers
together with investors
3. The computers, terminals and electronic networks that provide a
communication link between dealers and brokers.
 The Stock Market (Stock Exchanges)
 Over-the-counter market- cont…..
 Most of the brokers and dealers who make up the over-the-
counter market are members of a self-regulating body known as
the National Association of Security Dealers (NASD), which
licenses brokers and oversees trading practices. The
computerized trading network used by NASD is known as the
NASD Automated Quotation System (NASDAQ) and the Wall
Street Journal and other newspapers contain information on
NASDAQ transactions.
 The NASDAQ, the AMEX and the Philadelphia Stock Exchange
merged in 1998 to form the Nasdaq-Amex Market group, which
might best be referred to as an organized investment network.
 The Cost of Money
 The interest rate is the price paid to borrow funds, whereas
in the case of equity capital, investors expect to receive
dividends and capital gains. The factors that affect the
supply of and demand for investment capital and hence the
cost of money are-
1. Production Opportunities: The return available within
an economy from investment in productive (cash-
generating) Assets.
2. Time Preferences for consumption: The preferences of
consumers for current consumption as opposed to saving
for future consumption.
 The Cost of Money

1. Risk: In a financial market context, the chance

that a financial asset will not earn the return
promised.

2. Inflation: The tendency of prices to increase over

time.
The Determinants of Market Interest Rates
 In general, the quoted (or nominal) interest rate on a debt security,
k, composed of a real risk-free rate of interest, k *, plus several
premiums that reflect inflation, the riskiness of the security, and
the security’s marketability (or liquidity). 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 or marketability premium
MRP = maturity risk premium
The Determinants of Market Interest Rates
 Real Risk-Free Rate of Interest (k*): The rate of interest that
would exist on a security with a guaranteed payoff (termed
a riskless or risk-free security) if no inflation were expected.

The real risk-free rate changes over time depending on economic

conditions Specially
1. On the rate of return corporations and other borrowers are
willing to pay to borrow funds, and
2. On people’s time preferences for current verses future
consumption
The Determinants of Market Interest Rates
 Nominal (Quoted) Risk-Free Rate (KRF): The rate of interest
on a security that is free of all risk; is proxied by the T-bill rate
or T-bond rate. KRF includes an inflation premium.
KRF = k* + IP
 Inflation Premium (IP): A premium for expected inflation that
investors add to the real risk-free rate of return.
 Default Risk Premium (DRP): The difference between the
quoted interest rate on a T-bond and a corporate bond of equal
maturity and marketability.
 Liquidity Premium (LP): A premium added to the rate on a
security if the security cannot be converted to cash on short
notice and at close to the original cost.
The Determinants of Market Interest Rates

 Interest Rate Risk: The risk of capital losses to which

investors are exposed because of changing interest rates.

 Maturity Risk Premium (MRP): A premium that reflects

interest rate risk; bonds with longer maturities have greater
interest rate risk.

 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
 Term Structure of Interest Rates: The relationship between
yields and maturities of securities.
 Yield Curve: A graph showing the relationship between yields
and maturities of securities.
 “Normal” Yield Curve: An upward sloping yield curve.
 Inverted (“ Abnormal”) Yield Curve: A downward-sloping
yield curve.
 Expectations Theory: The theory that the shape of the yield
curve depends on investors’ expectation about future inflation
rates.