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THE FINANCIAL ENVIRONMENTMARKETS,
INSTITUTIONS
&
INTREST RATES
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INTERACTION OF BUYERS &
SELLERS
How are they going to find eachother?
Problem:Search is expensive &
inefficientSolution:Need facilitator:
mechanisms & institutions
Market ?
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WHAT IS A MARKET?
A mechanism by which investors (firms,individuals, government) exchange assets
(real, financial)
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Capital Markets( Mortgages, Bonds, Leases & Stocks)
Primary Market New Capital Raised
Secondary Market Exchange of Ownership
(Brokerage services) Initial Public Offer Market
Mortgage & lease Market
Real Estate Market
CLASSIFICATIONS OF FINANCIAL
MARKETS
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Money MarketsT.Bs
Banks Negotiable Instruments Money Market Funds
Physical Goods Markets :( Tangible or Real Assets)
Future and Forward Vs Spot MarketsFutures and forward contracts can be used to
reduce risk associated with unforeseen events bylooking into an agreement today for the future
delivery of a specific asset at a specific time, place,
quantity and quality.
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Options:
The right, but not the obligation, to take aspecific action in the future. In finance,the actions refer to: " the right to buy aspecific asset at a discount and to sell a
specific asset at an agreed upon price inthe future"
Why SECP
Markets do not always function perfectly.To regulate these - Securities andExchange Commission (SEC).
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FINANCIAL INSTITUTIONS
Direct transfers of money and securities
Investment Banking House (Underwriters)
Financial intermediary
o Commercial Bankso Savings and Loan Associations
o Credit Unions
oPension Funds
o Life Insurance Companies
o Mutual Funds
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Capital Formation Process Direct Transfer
8. Indirect Transfer through Investment Banks(Underwriters) ?
Securities Securities
(Same)
Dollars Dollars
SaversBusiness
Dollars
Securities (Stocks orSecurities (Stocks or
Bonds)Bonds)
InvestmentBankingHouses(AJD, JS)
SaversBusinessBusiness
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1. Indirect Transfer Through a Financial
Intermediary
Business Intermediary's
Securities Securities
Dollars Dollars
BusinessFinancial
Intermediary
Savers
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THE STOCK MARKET
Physical Location Stock Exchanges
Formal Organisation
Tangible Physical Location
Conducts Auction Markets in designated (Listed)
Securities
KSE, LSE, ISE-NSE in the offing
Over the counter Markets (OTC)
Just a collection of brokers/ dealers
Connected electronically by Telephones & ComputersTrading in unlistedsecurities
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THE STOCK MARKET
Dealer MarketsIncludes all facilities needed to conduct
Security transactions
Conducted on an unorganized Exchange
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SECONDARY MARKET ROLE OF
A BROKER
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THE COST OF MONEY
Capital in free economy allocated
through the price system The interest rate is the price paid to
borrow debt capital. With equity capital,
investors expect to receive dividends andcapital gains, whose sum is the cost of
equity money
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RiskIn a financial market context thechance that an investment will
provide low or negative return-Effects?
Inflation
The amount by which pricesincrease over time- Effects?
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Allocation of Funds & Interest Rates
RISK
EXP
ECTEDRETU
RN(%)
T-Bills
Govt. Bond
Long term Govt. Bonds
Preferred Stock
Conservative Common Stock
Spec. Common Stock
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The Determinants of Market
Interest Rates
Real Risk-Free rate of Return( only T-Bills)Inflation Premium (IP)
Default Risk Premium (DRP)
Liquidity Premium (LP)
Maturity Risk Premium (MRP)
Reinvestment Rate Risk
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The Determinants of Market Interest Rates
Quoted Interest Rate = k = k*+IP+DRP+LP+MRP
where
K= The quoted, or nominal, rate of interest on a given security
K*=The real risk-free rate of interest on a risk less security ifZero inflation was expected
kRF = k* + IP=The quoted risk-free rate of interest on a security
such as a Govt. Treasury bill, which is very liquid
and also free of most risks.IP= Inflation Premium=The average expected inflation rate over
the life of the security.
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The Real Risk-free Rate Of Interest (K*)
The rate of interest that would exist on default- free Treasury billsif no inflation were expected.
It depends upon:
The rate of return Corporations and otherborrowers expect to earn on productive assets
People preference for current versus futureconsumption
The Nominal, or Quoted, Risk Free Rate of Return(KRF)
The real risk-free rate plus a premium for expected inflationKRF = K* + IP
The risk-free is the rate free of any type of risk
Risk free interest used with out modifier Real or Nominalgenerally means Quoted (Nominal ) rate, which includes IP and is
used for T-Bills
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Liquidity Premium (LP)
A Premium added to the equilibrium interest rate on a security if that
security can not be converted to cash on short notice and at closeto theFair Market Value
There is always some difference in the interest rates of least liquid
and most liquid financial assets provided all other risk elements are
the same
Maturity Risk Premium (MRP) The risk of capital losses to which investors are exposed because of
changing interest rates -The longer is the maturity period the higher
is this premium.
Reinvestment Rate Risk
The risk that a decline in interest rates will lead to lower income
when bonds mature and funds are reinvested
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7.700.534.672.5%30 Years
7.420.424.502.5%20 Years
6.780.284.002.5%10 years
6.080.183.42.5%5 years
5.50%0 %3 %2.5%1 year
YieldMRPIPK*Maturity
With Increasing
Expected Inflation
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6.360.533.332.5%30 Years
6.420.423.502.5%20 Years
6.780.284.002.5%10 years
7.280.184.602.5%5 years
7.50%0 %5%2.5%1 year
YieldMRPIPK*Maturity
With Decreasing Expected Inflation
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Corporate and Treasury Yield Curves
11.1%9.8%7.7%30 YEARS
10.2%9.2%7.4%20 YEARS
9.1%8.2%6.8%10 YEARS
8.1%7.4%6.1%5 YEARS
7.4%6.7%5.5 %
1 YEAR
BBB
RATED
BOND
AA RATED
BOND
TREASURY
BOND
TERM TO
MATURITY
INTEREST RATE
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Interest Rate %
Abnormal Yield Curve
Normal Yield Curve
Maturity Period
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What Determines Shape of the
Yield Curve
Expectation TheoryA theory which states that the shape of
the yield curve depends on the investors
expectations about future interest rates
Long term interest rates are the
weighted average of the current and
expected future short-term interest rates
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Working
(3%+5%+7%)/3
=5.0%
7%2001
(3%+5%)/2= 4.00%5%2000
3%/1= 3.0%3%1999
Expected Average Inflation
Rate From 1998 to
Indicated Year
Expected Annual (1-Year)
Inflation Rate
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Liquidity Preference TheoryInvestors prefers to hold short term
securities for reason of liquidityBorrowers prefer to long-term debt
because short term debt exposes them to
the risk of paying in adverse conditions Ready to pay higher interest for the long
term debts
Hence up sloping curve
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Investors Overseas
Country Risk-The risk that arises frominvesting or doing business in a particular
country
Exchange Rate Risk The risk that exchange
rate changes will reduce the number of dollars
provided by a given amount of a foreign
currency
Oth F t Th t I fl
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Other Factors That Influence
Interest Rate Levels
Federal Reserve Policyo The money has a major effect on both the economic activity andinflation rate;
o The SBP controls the money supply;
o Stimulation of Economy;
o Tightening of Economy
Budget Deficit or Surpluso More spending- Deficit Borrowing or Printing more Notes
What are the effects?
International Factorso Foreign Trade Deficit
o Foreign Trade Surplus
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