THE FINANCIAL ENVIRONMENT

MARKETS,
INSTITUTIONS
&
INTREST RATES
 Market ?

INTERACTION OF BUYERS &

SELLERS

How are they going to find each

other?
Problem: Search is expensive &
inefficient Solution: Need facilitator:
mechanisms & institutions
 WHAT IS A MARKET?
A mechanism by which investors (firms,
individuals, government) exchange assets
(real, financial)
 CLASSIFICATIONS OF FINANCIAL
MARKETS

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
Money Markets
T.Bs
Banks
 Negotiable Instruments
 Money Market Funds
Physical Goods Markets :
( Tangible or Real Assets)
Future and Forward Vs Spot Markets
Futures and forward contracts can be used to
reduce risk associated with unforeseen events by
looking into an agreement today for the future
delivery of a specific asset at a specific time, place,
quantity and quality.
Options:
The right, but not the obligation, to take a
specific action in the future. In finance,
the actions refer to: " the right to buy a
specific asset at a discount and to sell a
specific asset at an agreed upon price in
the future"
Why SECP
Markets do not always function perfectly.
To regulate these - Securities and
Exchange Commission (SEC).
 FINANCIAL INSTITUTIONS
Direct transfers of money and securities
Investment Banking House (Underwriters)
Financial intermediary
o Commercial Banks
o Savings and Loan Associations
o Credit Unions
o Pension Funds
o Life Insurance Companies
o Mutual Funds
 Capital Formation Process
• Direct Transfer Securities (Stocks or
Bonds)
Savers
Business
Dollars

8. Indirect Transfer through Investment Banks

(Underwriters) ?

Securities Securities
Investment (Same)
Banking Savers
Business
Houses
Dollars (AJD, JS) Dollars
1. Indirect Transfer Through a Financial
Intermediary

Business Intermediary's
Securities Securities
Financial
Business Intermediar Savers
y
Dollars Dollars
 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 & Computers
 Trading in unlisted securities
 THE STOCK MARKET

 Dealer Markets
Includes all facilities needed to conduct
Security transactions
Conducted on an unorganized Exchange
SECONDARY MARKET ROLE OF
A BROKER
 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 and
capital gains, whose sum is the cost of
equity money
Factors affecting the cost of Money
Production Opportunities
The returns available within an economy
from investments in productive ( Cash-
generating) assets- Effects?
Time Preference For Consumption
The preference of consumers for current
consumption as opposed to saving for future
consumption- Effects?
 Risk
In a financial market context the
chance that an investment will
provide low or negative return-
Effects?
 Inflation
The amount by which prices
increase over time- Effects?
EXPECTED RETURN (%) Allocation of Funds & Interest Rates

Spec. Common Stock

Conservative Common Stock

Preferred Stock

Long term Govt. Bonds

Govt. Bond

T-Bills

RISK
 Interest Rate levels
Market A: LOW - RISK Market B: High - RISK SECURITIES
Interest Rate (k) SECURITIES Interest Rate (k) (%)
(%)
S2 S1
S1

KB=12
KA = 10
D1
8
D1

D2

0 Dollars Dollars
0
 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
 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 if

Zero 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.
DRP= Default Risk Premium. This premium reflects the
possibility that the issuer will not pay interest or principal
at the stated time and in the stated amount.
LP= Liquidity, or Marketability Premium. This is a
premium charged by lenders to reflect the fact that
some securities cannot be converted to cash on short
notice at a “reasonable” price.
MRP= Maturity Risk Premium..
Since kRF = k* + IP, the Equation can be written as follows:

Nominal, or quoted, Rate = kRF + DRP + LP + MRP.

 The Real Risk-free Rate Of Interest (K*)

The rate of interest that would exist on default- free Treasury bills
if no inflation were expected.

It depends upon:
 The rate of return Corporations and other
borrowers expect to earn on productive assets
 People preference for current versus future
consumption

The Nominal, or Quoted, Risk Free Rate of Return(KRF)

The real risk-free rate plus a premium for expected inflation
KRF = K* + IP
• The risk-free is the rate free of any type of risk
• Risk –free interest used with out modifier “Real” or “Nominal”
generally means Quoted (Nominal ) rate, which includes IP and is
used for T-Bills
Inflation Premium (IP)
A premium equal to expected inflation that investors add to the real
Risk- Free rate of return

IP = K* - KRF
Default Risk Premium (DRP)
The difference between the interest rate on U.S treasury Bond(
Government Bonds) and a corporate bond of equal maturity and
marketability
Bond Rate DRP

U.S Treasury 6.6% -

AAA 7.6% 1.0%
AA 7.8% 1.2%
A 8.1% 1.5%
BBB 8.5% 1.9%
BB+ 10.3% 3.7%
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 close
to the”Fair 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
 With Increasing
Expected Inflation
Maturity K* IP MRP Yield

1 year 2.5% 3% 0% 5.50%

5 years 2.5% 3.4 0.18 6.08

10 years 2.5% 4.00 0.28 6.78

20 Years 2.5% 4.50 0.42 7.42

30 Years 2.5% 4.67 0.53 7.70

 With Decreasing Expected Inflation

Maturity K* IP MRP Yield

1 year 2.5% 5% 0% 7.50%

5 years 2.5% 4.60 0.18 7.28

10 years 2.5% 4.00 0.28 6.78

20 Years 2.5% 3.50 0.42 6.42

30 Years 2.5% 3.33 0.53 6.36

 Corporate and Treasury Yield Curves

INTEREST RATE

TERM TO TREASURY AA – RATED BBB –

MATURITY BOND BOND RATED
BOND
1 YEAR 5.5 % 6.7% 7.4%

5 YEARS 6.1% 7.4% 8.1%

10 YEARS 6.8% 8.2% 9.1%

20 YEARS 7.4% 9.2% 10.2%

30 YEARS 7.7% 9.8% 11.1%

 The Term Structure of Interest Rates
The relationship between short term and
long term interest rates
Important
o How ST and LT “IR” are related to each
other?
o What causes shift in their relative positions?
Interest Rate %
Abnormal Yield Curve

Normal Yield Curve

Maturity Period
 What Determines Shape of the
Yield Curve
Expectation Theory
A 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”
 Working……………
Expected Annual (1-Year) Expected Average Inflation
Inflation Rate Rate From 1998 to
Indicated Year

1999 3% 3%/1= 3.0%

2000 5% (3%+5%)/2= 4.00%

2001 7% (3%+5%+7%)/3
=5.0%
Liquidity Preference Theory
Investors prefers to hold short term
securities for reason of liquidity
Borrowers 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
 Investors Overseas
 Country Risk- The risk that arises from
investing 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
 Other Factors That Influence
Interest Rate Levels
 Federal Reserve Policy
o The money has a major effect on both the economic activity and
inflation rate;
o The SBP controls the money supply;
o Stimulation of Economy;
o Tightening of Economy
 Budget Deficit or Surplus
o More spending- Deficit – Borrowing or Printing more Notes –
What are the effects?
 International Factors
o Foreign Trade Deficit
o Foreign Trade Surplus
What are the effects of change of
interest rates upon the savers?