UNIT 03

THE FINANCIAL MARKETS/ENVIRONMENT

LEARNING OBJECTIVES:

After studying this chapter one should be able to

 Describe how a financial system works?

 Define Financial Securities.
 Explain the function of financial intermediaries.
 Identify the different market places.
 Describe the securities traded in money and capital markets.

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A corporation has an advantage over other forms of business in its ability to generate
large amount of capital from the financial markets. Most businesses do not make millions
each time they go to the financial markets, but certainly would face difficulties if the
markets were not available for raising money and investing.
One of the central duties of a financial manager is to acquire capital, which is to raise
funds. Few companies are able to fund all their activities solely with funds from internal
sources. Most find it necessary to seek funding from outside sources. For this reason, all
business people need to know about financial markets.

THE FINANCIAL SYSTEM:

In an economy several types of individuals or entities generate and spend money. These
are called Economic Units. The main types of economic units include governments,
businesses and households.
There are two types of economic units;
1. Surplus Economic units: Economic Units that generate more income than they
spend and have funds left over are called surplus economic units.
2. Deficit Economic Unit: Economic Units that generate less income than they spend
and need to acquire additional funds in order to sustain their operations are called
deficit economic units.
For example if ICI needs Rs2 billion to purchase a manufacturing plant in a year when its
income is only Rs1.5 billion, ICI is a deficit unit that year. Likewise if a family earns
Rs40,000 in a year but spends only Rs36,000, it is a surplus economic unit for that year.

The purpose of financial system is to bring these two groups together for their mutual
benefit. The financial system also makes it possible for the participants to adjust their
holdings of financial assets as their needs change. This is the liquidity function of the
financial system, that is, the system allows the funds to flow with ease.
In considering any economy as a whole, the actual savings for a given period of time
must be equal to the actual investments. This phenomenon is called saving-investment
cycle. This cycle depends on the net savers (surplus economic units) and the net investors
(deficit economic units). The cycle is completed when the surplus economic units transfer
funds to the deficit economic units.
The two important components of the financial system are:
 Securities
 Financial Intermediaries

Securities:

Although money is the most obvious financial asset, there are others as well including
debt securities and equity securities. Debt and equity securities represent claims against
the assets and future earnings of the corporation1. These are the financial assets to the
investors who own them, and at the same time appear on the liabilities and equity side of
the issuing company’s balance sheet.
1
Moyer, McGuigan and Kretlow, “Contemporary Financial Management”

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Terminology related to Securities:

Securities are the documents that represent the right to receive funds in the future.2
The person or organization that holds a security is called a bearer. The security certifies
that the bearer has a claim to future funds. For example if you lend Rs.1000 to someone
and the person gives you an IOU, you have a security. The IOU represents your claim on
the Rs.1000 you owed.
The IOU may also state when you are to be paid the amount specified, which is referred
to as maturity date of the security. When the date of payment occurs, we say the security
matures.
Securities have value because the bearer has the right to be paid the amount specified. So
a bearer, who wants the money right away, could sell the security to someone else for
cash. The new bearer could sell the security too and so on down the line. When a security
is sold, it is being traded. Business firms, as well as local, state and national
governments, sell securities to the public to raise money. After the initial sale, investors
may sell the securities to other investors.
The price at which a security is purchased is called bid price. The price at which a
security is sold is called ask or offer price.

Common characteristics of Securities:

 Liquidity (or Marketability): It is the ease with which you can turn your investment
in securities quickly into cash, at or near the current market price.
 Expected Return: It is the overall profit that you might expect to receive from your
investment in securities- either as income, in the form of interest or dividend, or as
capital gains or losses resulting from changes in the market value of the security. In
ikktheory the higher the expected rate of return of a security, the greater the risk.
 Risk: It is the degree of uncertainty about your expected return from an investment in
securities, including the possibility that some or all of your investment may be lost.
With some securities (e.g., government treasury bills) there is very little risk that
investors will lose any of their initial investment. With some other securities, the risk
of loss can be very substantial.

Financial Intermediaries:

Financial intermediaries act as grease that enables the machinery of the financial system
to work smoothly. These are specialized financial firms that facilitate the transfer of funds
from the savers to the demanders of capital 3. They specialize in certain services that
would be difficult for the individual to perform, such as matching buyers and sellers of
the securities. Three types of financial intermediaries are
 Investment bankers,
 Brokers and
 Dealers.

2
Eugene F. Brigham, “Fundamentals of Financial Management”
3
Timothy J. Gallagher, Joseph D. Andrew, Jr., “Financial Management”

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Investment Bankers
Investment banking firms are the institutions that exist to help businesses and state and
local government to sell their securities to the public.
Investment bankers arrange securities sale on either an underwriting basis or best effort
basis.

Underwriting refers to the process by which an investment banker (usually in cooperation

with other banking institutions) purchases all the new securities from the issuing
company and then resells them to the public. Investment bankers who underwrite
securities face some risk because occasionally an issue is overpriced and cannot be sold
to the public for the price anticipated by the investment banker. The investment banker
has already pad the issuing company its money upfront, and so must absorb the difference
between what is paid to the issuer and what the security actually sold for.
To alleviate this risk, investment bankers sell securities on a best effort basis. This means
that the investment banker will try its best to sell the securities for the desired price, but
there are no guarantees. If the securities must be sold for a lower price, the issuer collects
less money.

Brokers
Brokers-often account representatives for an investment banking firm-handle orders to
buy or sell securities. Brokers can be individuals or firms that act as agents and work on
the behalf of the investors.
When the investors call with an order, brokers work on their behalf to find someone to
take the other side of the proposed trade. If investors want to buy, brokers find sellers. If
investors want to sell, brokers find buyers. Brokers are compensated for their service
when the person whom they represent (the investor) pays them a commission on the sale
or purchase of securities.

Dealers
Dealers are the individuals or firms that buy or sell securities for their own account for
resale to other investors. They operate just like car dealers, who buy cars from the
manufacturers and resell them to others. A dealer differs from a broker/agent in that a
dealer acts as a principal in a transaction. That is, a dealer takes ownership of assets and
is exposed to inventory risk, while a broker only facilitates a transaction on behalf of a
client. Dealers make money by buying securities for a one price, the bid price and resell
them at a higher ask price. The difference or spread between the two prices represents the
dealer’s fee.

FINANCIAL MARKETS

The financial system allows surplus economic units to trade with the deficit economic
units. This trade is carried out in the financial markets. A financial market is a forum at
which the financial securities are traded. It may or may not have a physical location.
Related to financial markets are the financial institutions. A financial institution is an
organization that takes in funds from surplus economic units and makes them available to
the deficit ones.

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Financial Markets are categorized according to the characteristics of the participants
involved. The following are the main kinds of financial markets under this perspective
are:
 Primary market
 Secondary market

Financial Markets are also categorized according to the characteristics of the securities
involved-specially the maturity of the securities traded-such markets are:

 Money market
 Capital market

Besides these, a number of other markets also exit. An example of which is the Over the
Counter Market.

Primary Market:

In the primary market deficit economic units sell new securities directly to surplus
economic units and to financial institutions. For instance, on January 2006, The Bank of
Khyber issued its Initial Public Offering (IPO) in which it subscribed 500 ordinary shares
amounting to Rs7500.The issuing banks were First Dawood Investment Bank Limited,
Habib Bank Limited, MCB Bank Limited, Metropolitan Bank Limited, National Bank of
Pakistan, PICIC Commercial Bank Limited, The Bank of Khyber and United Bank
Limited.
When a security is created and sold for the first time in the financial marketplace, this
transaction takes place in the primary market. In this market the issuing business or entity
sells its securities to investors.

Secondary Market:

Secondary market is a market where an investor purchases a security from another

investor rather than the issuing company.
Once a security has been issued, it may be traded from one investor to another. Many of
the investors who originally bought Pakistan Petroleum Limited (PPL) stock, for
example, have since traded their shares to other investors in the Stock Exchange. The
shares were originally sold for Rs55 per share during 2004-05, however it was traded on
an average market price of Rs220 during January 2006. Thus the secondary market is a
place where previously issued or used securities are traded among investors. Suppose an
investor calls his broker to buy 100 shares of stock, these shares would usually be
purchased form another investor in the secondary market. These purchase and sale
transactions occur thousands of times daily as investors trade securities among
themselves.

Money Market:

Short-term securities (having maturity of one year or less) are traded in the money
market. Network of dealers operate in this market. They use phones and computers to
make trade rapidly among themselves and the issuing corporations. The specific
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securities traded in the money market include Treasury Bills, negotiable certificate of
deposit, commercial paper and other short-term debt instruments.

Capital Market:

Long-term securities (maturing over one year) trade in the capital market. Federal State,
local governments and corporations raise long-term funds in the capital markets. Firms
usually invest proceeds from the capital market securities sale in long-term assets like
buildings, production equipment, and so on. Initial offerings of securities in the capital
markets are usually large deals put together by investment banker, although after the
initial issue, the securities may be traded quickly and easily among investors. The two
most widely recognized securities in the capital market are the bonds and stocks.

Security Exchanges:

Security or Stock Exchanges are the organizations that facilitate the trade of stocks and
bonds among investors. Corporations arrange for their stocks or bonds to be listed on a
stock exchange so that the investors may trade the company’s stocks and bonds at an
organized trading location. Listing of securities generally results in their easy trade and
boost of prices. Exchanges earn fee for listing and other services.
In Pakistan three stock exchanges are operating, namely: Karachi Stock Exchange (KSE),
Lahore Stock Exchange (LSE) and Islamabad Stock Exchange (ISE). Almost ninety
percent of the whole trade is done through KSE. Prominent international security
exchanges are New York Stock Exchange (NYSE), American Stock Exchange (AMEX)
and major exchanges at Tokyo, London, Paris and Mexico.

Over-the-Counter Market (OTC):

OTC is a market of securities not listed on an exchange, where the market participants
trade over the telephone or electronic network instead of physical trading floor. Thus
there is no central exchange or meeting place for this market.
In the OTC market, trading occurs via a network of middlemen, called dealers, who carry
inventories of securities to facilitate the buy and sell orders of investors, rather than
providing the order matchmaking service seen in a stock exchange such as the KSE.
Say an investor wanted to buy a security that is traded OTC. The investor will call a
broker, who will then shop among competing dealers who have securities in their
inventories. After locating the dealer with best price, the broker would buy the security on
the investor’s behalf.
In USA the electronic/computer network through which the dealers in OTC are connected
to is called NASDAQ (the National Association of Securities Dealers Automated Quote
system). Many others especially those dealing in securities issued by very small
companies, simply buy or sell over the telephone.

Market Efficiency:

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The term market efficiency refers to the ease, speed and cost of the trading securities. In
an efficient market, securities can be traded easily, quickly and at a low cost. Markets
lacking these qualities are considered inefficient.
The major stock markets are generally efficient because the investors can trade thousands
of dollar worth of shares in minutes simply by making phone call and paying a relatively
small commission. In contrast, the real estate market is relatively inefficient because it
might take you months to sell a house you would probably have to pay the real estate
agent a large commission to handle the deal.
The more efficient the market, the easier it is for excess funds in the hands of surplus
economic units to make their way into the hands of deficit economic units. In an
inefficient market, the surplus economic units may end up with excess funds that are idle.
When this happens, economic activity and job creation will be lower than it could be, and
deficit economic units may not be able to achieve their goals because they could not
obtain needed funds.

SECURITIES IN FINANCIAL MARKETPLACE

To understand how the financial markets perform the important role of channeling funds
from lenders (savers) to borrowers (spenders), we need to examine the securities
(instruments) traded in financial markets. Securities are traded in both the money and the
capital markets.

Money Market Securities:

Governments, corporations and financial institutions that want to raise money for short
time issue money market securities. Buyers of money market securities include
government, corporations and financial institutions that want to park surplus cash for a
short time, and other investors who want the ability to alter or cash in their investments
quickly.

Characteristics of Money Market Securities

There are two main characteristics of money market securities. These are:
1. High Liquidity:
Money market securities are very liquid, that is, they mature quickly and can be sold
for cash quickly and easily. These securities have maturity of less than a year.
2. Low Risk:
Because of their short terms of maturity, the instruments traded in money market
undergo the least price fluctuations and so are the least risky investments. They have
a low degree of risk also because purchasers will only buy them from large, reputable
issuers.
These two characteristics make money market securities the ideal parking place for
temporary excess cash.

The typical money market instruments are as follows:

1. Treasury Bills:

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Treasury bills are the money market securities issued by the government to finance the
federal budget deficit and to refinance the billions of dollars of previously issued
government securities that come due each week. After the government initially sells T-
Bills, they are traded actively in the secondary market.
These securities pay a set amount at maturity and have no interest payments, but they
effectively pay interest by initially selling at a discount. For instance, one may buy a one-
year treasury bill in May 2005 for Rs9000 that can be redeemed for Rs10000 in May
2006.
Treasury bills are the most liquid of all the money market securities because these are the
most actively traded. They are considered as the benchmark of safety because the have
essentially no risk. This is due to the fact that there is no possibility of default as the
government is always able to meet its obligations as it can raise taxes or issue currency.
Treasury Bills are held mainly by banks and financial intermediaries.

2. Negotiable Bank Certificates of Deposit:

A certificate of deposit (CD) is a debt instrument sold by a bank that pays annual interest
of a given amount and at maturity pays back the original purchase price. They are simply
pieces of paper that certify that you have deposited a certain amount of money in the
bank, to be paid back on a certain date with interest.
Small-denomination CDs are very safe investments and they tend to have low interest
rates. Large denomination CDs (of Rs100,000 to Rs1 million or more), with maturities of
two weeks to a year are negotiable CDs because they can be traded in secondary markets
after they are initially issued by a financial institution. Large corporations and other
institutions buy negotiable CDs when the have cash they wish to invest for a short period
of time and sell these CDs when they want to raise cash quickly.

3. Commercial Paper:
Commercial paper is a type of short-term promissory note similar to an IOU-issued by
large corporations with strong credit ratings. Commercial paper is unsecured, meaning
that the issuing corporation does not provide any property as collateral that the lender (the
one who buys the commercial paper note) can take instead of payment if the issuing
corporation defaults on the note. That is why only financially strong, reliable firms issue
commercial papers.
Commercial paper is considered a safe place to put money for short period of time. The
notes themselves are issued and traded through a network of commercial paper dealers.
Most of the buyers are large institutions.

4. Eurodollars:
U.S. dollars deposited in foreign banks outside the United States or in foreign branches of
US banks are called Eurodollars. American banks can borrow these deposits from other
banks or foreign branches of their own banks when they need funds.
Eurodollars are interest-paying deposits. Although Eurodollars originated in Europe –thus
the name-Eurodollars now can be housed in banks throughout the world, form Asia to
South America but Euro is still in the name.
These are deposited and borrowed by large institutions with good credit ratings. Because
of the solid credit ratings of the players and because the foreign bank regulations are less
strict than the US bank regulations, Eurodollars often generate a high rate of return and

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may be borrowed at often lower interest rates than the dollar-denominated deposits in the
US banks.

5. Banker’s Acceptances:

A bankers’ acceptance is a bank draft (a promise of payment similar to a cheque), issued

by a firm, payable at some future date, and guaranteed for a fee by the bank that stamps it
“accepted”. These money market instruments are created in the course of carrying out
international trade and have been in use for hundred of years.
The firm issuing the instrument is required to deposit the required funds into its account
to cover the draft. If the firm fails to do so, the bank’s guarantee means that it is obligated
to make good on the draft. The advantage to the firm is that the draft is more likely to be
accepted when purchasing goods abroad because the foreign exporter knows that even if
the company purchasing the goods goes bankrupt, the bank draft will still be paid off.
These accepted drafts are also resold in the secondary market at a discount and so are
familiar to the Treasury Bills. Typically, they are held by many of the same parties that
hold the Treasury Bills.

6. Repurchase Agreements (Repos):

These are effectively short-term loans (usually with a maturity of less than two weeks) in
which Treasury Bills serve as collateral, an asset that the lender receives if the borrower
does not pay back the loan.
Repos are made as follows: A large corporation such as ICI may have some idle funds in
its bank account, say Rs1 million which it would like to lend overnight. ICI uses this
excess Rs1 million to buy Treasury Bills from a bank, which agrees to repurchase them
the next morning at a price slightly above ICI’s purchase price. The effect of this
agreement is that ICI makes a loan of Rs1 million and holds Rs1 million of the bank’s
Treasury Bills until the bank repurchases the bills to pay off the loan.
Repos are an important source of bank funds and the most important lenders in this
market are large corporations.

7. Federal (Fed) Funds:

These are typically overnight loans between banks of their deposits at the Federal
Reserve. These loans are not made by the federal government or by the Federal Reserve
but rather by banks to other banks.
One reason why a bank might borrow in the federal funds market is that it might find that
the deposits it has at the Fed do not meet the amount required by the regulations. It can
then borrow these deposits from another bank, which transfers them to the borrowing
bank using the Fed’s wire transfer system. This market is very sensitive to the credit
needs of the banks, so the interest rates on these loans, called Federal Funds Rate, is
closely watched barometer of the tightness of credit market conditions in the banking
system and the stance of monetary policy; when its high, it indicates that the banks are
strapped for funds, whereas when it is low, bank’s credit needs are low.

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Capital Market Securities:

When governments, corporations, and financial institutions want to raise money for a
long period of time, they issue capital market securities.
In contrast to money market instruments, the capital market instruments may not be very
liquid. They are not generally suitable for short-term investments. They also have far
wider price fluctuations than money market instruments and are considered to be fairly
risky. There are two most prominent capital market securities, bonds and stocks.

Bonds:
Bonds are essentially IOUs that promise to pay their owner a certain amount of money on
some specified date in the future-and in most cases an interest payments at regular
intervals until maturity.
When companies want to borrow money (usually a fairly large amount for a long period
of time), they arrange for their investment bankers to print up the IOUs and sell them to
public at whatever price they can get. In essence, a firm that issues the bond is borrowing
the amount that the bond sells for on the market.

Bond Terminology:
Although many types of bonds exist, most bonds have three special features that are as
under:
a. Face Value:
The amount that the bond promises to pay to its owner at some date in the future is
called bond’s face value or par value or principal. Bond face values range in multiples
of Rs1000 all the way up to more than Rs1 million.
b. Maturity Date:
The date on which the issuer is obligated to pay the bondholder the bond’s face value
is called the maturity date.
c. Coupon Interest:
The interest payments made to the bond owner during the life of a bond is the coupon
interest on the bond.
Some bonds pay coupon interest once a year; others pay it twice a year. Some bonds
do not pay any interest at all. These bonds are called zero coupon bonds.
The percentage of the face value that the coupon interest represents is called the
coupon interest rate. For example, assuming the face value of a bond was Rs1000, a
bond owner who received Rs80 interest payments each year would own a bond
paying a coupon interest rate of 8 percent.

80/1000 = 0.08 or 8%

Types of Bonds:

The major types of bonds include treasury bonds and notes issued by federal government;
municipal bonds issued by state or local governments; and corporate bonds issued by
corporations.

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 Treasury Notes and Bonds:
When the federal government wants to borrow money for periods of more than a year,
it issues treasury notes and treasury bonds.
T-notes and T-bonds are identical except for their maturities. T-notes have maturity
from one to ten years, and T-bonds have maturity of more than ten years. Both pay
interest semi-annually, in addition to the principal, which is paid at maturity.
T-notes and T-bonds are auctioned every three months to pay off old maturing
securities and to raise additional funds to finance the federal government’s new deficit
spending.
Although Treasury securities such as T-notes and T-bonds are extremely low risk,
they are not risk free. They are the most liquid securities traded in capital market.
They are held by Federal Reserve, banks, and other investors.

 Municipal Bonds:
The bonds issued by state and local governments (provinces in case of Pakistan) are
known as municipal bonds or munis.
Many investors like municipal bonds because their coupon interest payments are free
of federal income tax. Municipal bonds come in two types:
 General Obligation Bonds (GO) and
 Revenue Bonds
They differ in where the money is expected to come from to pay them off. General
Obligation bonds are supposed to be paid off from the money raised by the issuer
from a variety of tax revenue sources. Revenue Bonds are supposed to be paid off
from the money generated by the project the bond was issued to finance-such as using
toll plaza fees to pay off the bonds to finance the toll plaza.

 Corporate Bonds:
Corporate bonds are similar to the T-bonds and the T-notes except they are issued by
the corporations. Like T-bonds and the T-notes, they pay their owner interest during
the life of the bond and repay principal at maturity.
Unlike T-bonds and the T-notes, the corporate bonds sometimes carry substantial risk
of default. As a last resort the government can print money to pay off its treasury
bills, notes and bond obligations; but when private companies run into trouble, they
have no such latitude. Corporation’s creditors may get paid late or not at all.
Relatively safe bonds are the Investment Grade Bonds-that is-medium to high quality
bonds. Many financial institutions and money management firms are required to
invest only in those corporate bonds that are investment grade.
Relatively risky bonds are called Junk Bonds-that is-the low quality bonds with high
default risk. Junk bonds are generally issued by the troubled companies, but may be
issued by financially strong companies that later run into trouble.

 Consumer and Bank Commercial Loans:

These are loans to consumers and businesses made principally by banks, however, in
the case of consumer loans, also by finance companies. There are often no secondary
markets in these loans, which makes them the least liquid of the capital market
instruments.
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 Mortgage Bonds:
Mortgage bonds are the source of loan to the individuals or firms to purchase
housing, land or other real structures, where the structure, or land, then in turn serves
as collateral for the loans. If the housing market and economic outlook are not good,
then housing/mortgage bonds have a higher risk of default.

Corporate Stock:
Rather than borrowing money by issuing bonds, a corporation may choose to raise money
by selling shares of ownership interest in the corporation. The shares of ownership are
called stocks. Stocks are the equity claims on the net income and assets of the
corporation. Investors who buy stock are called stockholders.
As a source of funds, stock has an advantage over the bonds: The money raised by the
sale of stock does not ever have to be paid back, and the company does not have to make
interest payments to the stockholders.
A corporation may issue two types of corporate stock, common stock and preferred stock.

 Common Stock:
The holders of a company’s common stock are the owners of the company. Their
ownership entitles them to the firm’s earnings that remain after all other groups
having a claim on the firm (such as bondholders) have been paid.
Each common stockholder owns a portion of the company represented by the fraction
of the whole that stockholder’s shares represent. Thus if a company issued 1 million
shares of common stock, a person who owns one share owns one millionth of the
company.
Common stockholders receive the return on their investment in the form of

 Common stock dividends, distributed from the firm’s profit, and

 Capital gains, realized upon the sale of shares.

 Preferred Stock:
Preferred stock is so called because if the board of directors of the business declares
the dividends, they are paid to preferred stockholders first. If any funds are left over,
they may be paid to common stockholders.
In contrast to common stock that normally provides a slightly higher expected return
because it is a more risky investment-that is dividends are not guaranteed, the return
on preferred stock is fixed. However, common stockholder-as owners-are entitled to
all the residual income of the firm, and there is no upper limit as to how great the
residual income of the firm might be. Also the preferred stockholders normally don’t
get to vote on how the firm is run.

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