Investment Environment

12/23/2021
Need for Investment
INVESTMENT ENVIRONMENT
• Cover Future Expenditure
• Excess disposable income at current time
• Possibility of higher income through certain
investment routes
Sankarshan Basu • Risk attitude of the investors
23 December 2021 Sankarshan Basu, IIM Bangalore 1 23 December 2021 Sankarshan Basu, IIM Bangalore 2
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Investments & Financial Assets Role of Financial Assets and Markets
• Essential nature of investment

– Reduced current consumption • Consumption Timing
– Planned later consumption • Allocation of Risk
• Real Assets • Separation of Ownership
– Assets used to produce goods and services
• Financial Assets
– Claims on real assets
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Why Study Financial Markets? Why Study Financial Markets?

Debt Markets & Interest The Stock Market The Foreign Exchange
Rates Market
• Financial markets are crucial to the economy – they • Facilitates borrowings by • Market where common • Market where currencies
channel funds from savers to investors, promoting individuals, governments,
and corporations.
stock (or just stock) are
traded.
trade and exchange rates
are set.
economic efficiency. • Borrowers issue a security
(bond), offering interest
• Companies initially sell
stock (in the primary
• Although most people
know little about this
• Market activity affects personal wealth, business and principal over time.
The cost of borrowing is
market) to raise money.
After that, the stock is
market, it has a daily
volume nearing $3 trillion!
firms, and economy. the interest rate. traded among investors. • These fluctuations matter!
• Many types of market • The stock market receives For example
• Well – functioning financial markets are key factors in interest rates: bank rate,
mortgage rates, auto loan
the most attention from
the media.
• Vacationing in
Europe can be
producing high economic growth. rates, credit card rates, • Companies, not just expensive, due to a
personal loan rates, etc. individuals, also watch the weakening USD
• The level of these rates are market, often seeking relative to the Euro.
important. additional funding • Strengthening of the
• Understanding the history • Success of SEOs is foreign currency
of interest rates is dependent on the leads to a fall in the
beneficial. company’s stock foreign purchase of
domestic goods.
5 6
Why Study Financial Institutions? Financial System Clients and Their Needs
1. Structure of the Financial System
2.
─ Helps funds move from savers to investors
Financial Crises
• Household Sector
─ The “Great Recession” of 2007–2009 was the worst financial crisis since the Great – Primary Need: Invest Funds
Depression. Why did it happen?
3. Central Banks and the Conduit of Monetary Policy • Business Sector
– The role of a central bank in the management of interest rates and the money supply
4. The International Financial System – Primary Need: Raise Funds
– Capital flows between countries impacts domestic economies
– Need to understand exchange rates, capital controls, and the role of agencies like the IMF • Government Sector
5. Banks and Other Financial Institutions
─ Includes the role of insurance companies, mutual funds, pension funds, etc. – Primary Need: Raise Funds
6. Financial Innovation
─ Focusing on improvements in technology and the impact on financial product delivery
7. Managing Risk in Financial Institutions
─ Focusing on risk management in financial institutions
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Meeting the Needs of Participants Investments and Innovation
• Financial Intermediation Technology and Service Delivery Globalization

• Investment Banking • Computer advancements • Domestic firms compete in
• On-line transactions global markets.
• Financial Innovation & Derivatives • More complete and timely • Performance in regions
information depends on other regions.
• Responding to Regulation & Taxes • Causes additional elements
of risk
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Key Trends
Globalization Securitization Financial Engineering
Developments in Global Securitization & Credit Services of Financial
Markets Enhancement Intermediaries
• Managing foreign • Offers opportunities for • Bundling and
exchange investors and unbundling of cash
• Diversification to
originators flows
Structure of Financial Markets
improve performance
• Instruments and • Changes in financial • Slicing and dicing of
vehicles continue to institutions and cash flows
develop. regulation • Examples: strips,
• Information and • Improvement in CMOs, dual
analysis improves. information capabilities purpose funds,
• Credit enhancement principal / interest
and its role splits
• Collateralized Loans
• Globalization and Securitization continues to develop and offer more opportunities.
• Continued development of derivatives and exotics.
• Strong fundamental foundation is critical.
• Integration of investments & corporate finance.
23 December 2021 Sankarshan Basu, IIM Bangalore 11
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Structure of Financial Markets Structure of Financial Markets
1. Debt Markets 1. Primary Market

─ New security issues sold to initial buyers
─ Short-Term (maturity < 1 year) – Also called the ─ Typically involves an investment bank who underwrites
Money Market the offering
─ Long-Term (maturity > 1 year) – Also called the 2. Secondary Market
Capital Market ─ Securities previously issued are bought
and sold
2. Equity Markets ─ Involves both brokers and dealers
─ Pay dividends, in theory forever ─ Can be further classified as :
─ Exchanges
─ Represents an ownership claim in the firm ─ Trades conducted in central locations
─ Over-the-Counter Markets
─ Also called the Capital Market ─ Dealers at different locations buy and sell
13 14
Structure of Financial Markets Internationalization of Financial Markets

• International Bond Market & Eurobonds
Even though firms don’t get any money, per se, – Foreign bonds
• Denominated in a foreign currency
from the secondary market, it serves two • Targeted at a foreign market
─ Eurobonds
important functions: • 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
• Provides liquidity, making it easy to buy and • Eurocurrency Market
sell the securities of the companies ─ Foreign currency deposited outside of home country
─ Eurodollars are U.S. dollars deposited, say, London.
Gives USD borrowers an alternative source for dollars.
• Establishes a price for the securities (useful for ─
• World Stock Markets
company valuation) ─ U.S. stock markets are no longer always the largest—at one point, Japan’s was
larger
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Internationalization of Financial Markets
Functions of Financial Markets
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Function of Financial Markets Importance of Financial Markets

• Channels funds from person or business without investment
opportunities (i.e., “Lender-Savers”) to one who has them (i.e., • Financial markets are critical for producing an
“Borrower-Spenders”)
efficient allocation of capital, allowing funds
• Improves economic efficiency to move from people who lack productive
investment opportunities to people who have
Financial Markets Funds Transferees
them.
Lender-Savers Borrowers - Spenders
1. Households 1. Government • Financial markets also improve the well-being
2. Business firms 2. Business firms
3. Government 3. Households of consumers, allowing them to time their
4. Individuals 4. Individuals
purchases better.
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Segments of Financial Markets Function of Financial Intermediaries
Direct Finance Indirect Finance

Borrowers borrow directly Borrowers borrow indirectly
from lenders in financial from lenders via financial
markets by selling financial intermediaries (established to
instruments which are claims source both loanable funds
on the borrower’s future and loan opportunities) by
income or assets issuing financial instruments
which are claims on the
borrower’s future income or
assets
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Function of Financial Intermediaries: Indirect Finance Function of Financial Intermediaries: Indirect Finance
• Instead of savers lending/investing directly with borrowers, a

financial intermediary (such as a bank) plays as the middleman:
• Transactions Costs
• The intermediary obtains funds from savers 1. Financial intermediaries make profits by reducing
• The intermediary then makes loans/investments with
transactions costs
borrowers 2. Reduce transactions costs by developing
• This process, called financial intermediation, is actually the expertise and taking advantage of economies of
primary means of moving funds from lenders to borrowers. scale
• More important source of finance than securities markets
• Needed because of transactions costs, risk sharing, and
asymmetric information
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Function of Financial Intermediaries: Indirect Finance Function of Financial Intermediaries: Indirect Finance
• Another benefit made possible by the FI’s low transaction costs

• A financial intermediary’s low transaction is that they can help reduce the exposure of investors to risk,
costs mean that it can provide its customers through a process known as risk sharing
with liquidity services, services that make it ─ FIs create and sell assets with lesser risk to one party in order to buy
assets with greater risk from another party
easier for customers to conduct transactions ─ This process is referred to as asset transformation, because in a sense
1. Banks provide depositors with checking accounts risky assets are turned into safer assets for investors
that enable them to pay their bills easily • Financial intermediaries also help by providing the means for
individuals and businesses to diversify their asset holdings.
2. Depositors can earn interest on checking and
• Low transaction costs allow them to buy a range of assets, pool
savings accounts and yet still convert them into them, and then sell rights to the diversified pool to individuals.
goods and services whenever necessary
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Function of Financial Intermediaries: Indirect Finance Economies of Scope and Conflicts of Interest
• Another reason FIs exist is to reduce the impact of asymmetric information.
• One party lacks crucial information about another party, impacting decision- • FIs are able to lower the production cost of information by using
making.
• Can lead to adverse selection and / or moral hazard.
the information for multiple services: bank accounts, loans, auto
insurance, retirement savings, etc. This is called economies of
Adverse Selection Moral Hazard scope.
1. Before transaction occurs 1. After transaction occurs
2. Potential borrowers most likely to 2. Hazard that borrower has incentives to • But, providing multiple services may lead to conflicts of interest,
produce adverse outcome are ones engage in undesirable (immoral) perhaps causing one area of the FI to hide or conceal information
most likely to seek a loan activities making it more likely that
won’t pay loan back from another area (or the economy as a whole). This may
3. Similar problems occur with insurance
3. Again, with insurance, people may actually make financial markets less efficient!
where unhealthy people want their
known medical problems covered engage in risky activities only after being
insured
4. Another view is a conflict of interest
Financial intermediaries reduce adverse selection and moral

hazard problems, enabling them to make profits.
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Major Types of Financial Products

• Debt
– Money market instruments
– Bonds
Financial Products • Equity
– Common stock
– Preferred stock
• Commodities
• Currency
• Derivative securities
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Money Market Instruments Bond Markets
• Treasury bills – Treasury Bonds and Notes

• Certificates of deposit
• Commercial Paper
– Government Bonds
• Bankers Acceptances – International Bonds
• Eurodollars – Municipal Bonds – specific to US
• Repurchase Agreements (RPs) and Reverse RPs – Corporate Bonds
• Federal Funds – basically central government funds
• Brokers’ Calls
– Mortgage-Backed Securities
• LIBOR Market
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Municipal Bond Yields Capital Market - Equity
• Interest income on most municipals is not • Common stock

subject to tax – Residual claim
• To compare the yields on municipals to other – Limited liability
bonds use equivalent taxable yield
• Preferred stock
(municipal return) / (1 – tax rate)
– Fixed dividends - limited
• Or solve for the tax rate that equates the two
– Priority over common
yields
– Tax treatment
Tax rate = 1 – (municipal rate/taxable rate)
33 34
Examples of Equity Indices

Market Indices
• Dow Jones Industrial Average (30 Stocks)
• Standard & Poor’s 500 Composite
• Uses • NASDAQ Composite
– Track average returns • NYSE Composite
– Comparing performance of managers • BSE Sensex
• NSE Nifty
– Base of derivatives
• Wilshire 5000
• Factors in constructing or using an Index • Nikkei 225 & Nikkei 300
– Representative? • FTSE (Financial Times of London)
• Dax
– Broad or narrow?
• Region and Country Indexes
– How is it constructed? – EAFE
– Far East
– United Kingdom
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Bond Indices Construction of Indices
• Global • How are stocks weighted?

– (Bank of America) Merrill Lynch Global Bond – Price weighted (DJIA)
Index. – Market-value weighted (S&P500, NASDAQ)
– Bloomberg Barclays Global Aggregate Bond Index. – Equally weighted (Value Line Index)
– Citi World Broad Investment-Grade Bond Index • How returns are averaged?
(WorldBIG)
– Arithmetic (DJIA and S&P500)
• Specialized Indexes – Geometric (Value Line Index)
– Merrill Lynch Mortgage
37 38
Averaging Methods Derivatives Securities
Component Return Options Futures

A=10% B= (-5%) C = 20% • Basic Positions • Basic Positions
– Call (Buy) – Long (Buy)
Arithmetic Average – Put (Sell) – Short (Sell)
[.10 + (-.05) + .2] / 3 = 8.33% • Terms • Terms
Geometric Average – Exercise Price – Delivery Date
– Expiration Date – Assets
[(1.1) (.95) (1.2)]1/3 - 1 = 7.84%
– Assets
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Primary vs. Secondary Market Sales
• Primary
– New issue
– Key factor: issuer receives the proceeds from the
Securities Trading sale.
• Secondary
– Existing owner sells to another party.
– Issuing firm doesn’t receive proceeds and is not
directly involved.
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Investment Banking Arrangements Public Offerings
• Underwritten vs. Best Efforts

• Public offerings: registered with the
– Underwritten: firm commitment on proceeds
to the issuing firm. regulators and sale is made to the investing
– Best Efforts: no firm commitment. public.
• Negotiated vs. Competitive Bid
– Negotiated: issuing firm negotiates terms with • Initial Public Offerings (IPOs)
investment banker. – Evidence of underpricing
– Competitive bid: issuer structures the offering – Performance
and secures bids.
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Private Placements Organization of Secondary Markets
• Private placement: sale to a limited number Organized

exchanges
OTC market Subsidiary Markets
Third market Fourth market
of sophisticated investors not requiring the • Auction markets • Dealer market • Trading of listed • Institutions trading
with centralized without
protection of registration. order flow. centralized order
securities away
from the
directly with
institutions
• Dealership flow. exchange. • No middleman
• Dominated by institutions. function: can be
competitive or
• NASDAQ: largest
organized stock
• Institutional involved in the
assigned by the market for OTC market: to transaction
• Very active market for debt securities. exchange
(Specialists).
trading;
information
facilitate trades of
larger blocks of
• Organized
information and
• Securities: stock, system for securities. trading systems
• Not active for stock offerings. futures contracts, individuals, • Involves services • ECN Development
options, and to a brokers and of dealers and
lesser extent, dealers. brokers
bonds. • Securities: stocks,
• Examples: NYSE, bonds (secondary)
AMEX, Regionals, and some
CBOE. derivatives.
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International Market Structures Costs of Trading
• London Stock Exchange • Commission: fee paid to broker for making the
– Dealer market similar to NASDAQ transaction
– Stock Exchange Automated Quotation • Spread: cost of trading with dealer
– Greater Anonymity
– Bid: price dealer will buy from you
• Tokyo Stock Exchange
– No market making service – Ask: price dealer will sell to you
– Sartori provides bookkeeping service – Spread: ask - bid
– Feature a floor and electronic trading
• Combination: on some trades both are paid
• Global Market Alliances
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Types of Orders Margin Trading
• Instructions to the brokers on how to complete the • Using only a portion of the proceeds for an
order
– Market Orders : Execute at best available price
investment.
– Limit Orders: Sell above or buy below stated limits • Borrow remaining component.
– Stop-Loss Orders : Sell if price falls below a limit; buy if it rises above a
limit. Used to limit losses on existing positions • Margin arrangements differ for stocks and
– Market If Touched or MIT Orders: Become market orders if price
touches a trigger futures.
– Stop Limit Orders : Stop loss plus limit
– Time of Day Orders
– Day Orders
– Good Till Canceled
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Some Types of Margins System of Margins
• Regulators specify minimum margins between clearing

• Initial margin : When position is opened
members and clearinghouse.
• Maximum margin
• Margins at other levels negotiated
– In the US it is currently set at 50% by the Fed
• Variation Margin: Settlement of daily gains and losses • Margins can be deposited in cash or specified securities such
as T-bills. Interest on securities continues to accrue to owner.
• Maintenance Margin : Minimum balance in margin
account Margin is a performance bond.
• Margin Call: Call for more funds • Levels of margins may be changed if volatility increases.
– Position Liquidated if Margin Call not Honoured within Specified
Time.
– Protects clearing house; enhances financial integrity
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CLEARING Prices and the Margin Account

HOUSE
Security Price Margin

Account
CLEARING CLEARING
MEMBER A MEMBER B Initial
Margin
NON-CLEARING Maintenance
MEMBER CUSTOMER
Margin
CUSTOMER NON-CLEARING Margin Calls
MEMBER
CUSTOMER
Time
CUSTOMER
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Margin Trading - Initial Conditions Margin Trading - Maintenance Margin
X Corp $70 Stock price falls to $60 per share

50% Initial Margin New Position
40% Maintenance Margin Stock $60,000 Borrowed $35,000
1000 Shares Purchased Equity $25,000
Initial Position
Margin% = $(25,000/60,000) * 100 = 41.67%
Stock $70,000 Borrowed $35,000
Equity $35,000
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Margin Trading - Margin Call Short Sales
How far can the stock price fall before a margin • Purpose: to profit from a decline in the price of a
call? stock or security.
Mechanics
(1000P - $35,000)* / 1000P = 40% Borrow stock through a dealer.
Sell it and deposit proceeds and margin in an account.
P = $58.33 Closing out the position: buy the stock and return to
the party from which it was borrowed.
* 1000P - Amount Borrowed = Equity
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Short Sale - Initial Conditions Short Sale - Maintenance Margin
Z Corp 100 Shares Stock Price Rises to $110

50% Initial Margin
30% Maintenance Margin Sale Proceeds $10,000
$100 Initial Price
Initial Margin 5,000
Sale Proceeds $10,000 Stock Owed 11,000
Margin & Equity 5,000 Net Equity 4,000
Stock Owed 10,000 Margin % (4000/11000) = 36%
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Short Sale - Margin Call
How much can the stock price rise before a margin call?
($15,000* - 100P) / (100P) = 30%

Set-up of Financial Markets
P = $115.38
* Initial margin plus sale proceeds
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Role of Central Banks

Various Players / Intermediaries
• Autonomous vs. Government controlled – most are semi-autonomous
• Central Bank
• Basic objectives:
• Depositories – Any institution that accepts deposits
– Creation of money in the system through printing, auctioning of government
– Banks securities as well as open market operations
– Savings & Loans Associations – Managing the monetary policy of the country
– Credit Unions – Be a banker to the government
• Investment Companies – Control the financial system in the country – ensure stability and
– Mutual Funds sustainability of financial institutions as well as offer mechanisms to protect
investors
• Insurance Companies
– Control the interest rate in the market – the most important arsenal in the
• Pension Funds armoury of any central bank
• Corporate entities – Control the kind of instruments to be traded in the market
• Retail investors – Act as a banker of the last resort
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Depositories
Investment Companies
• A depository is any institution that accepts any form of deposits – in
this case financial deposits • Types of investment companies:
• Role of the depositories is to accept deposits (liabilities) from – Mutual funds – open and closed ended
investors and then lend the amount collected in the markets as loans – Unit trusts
(assets) to earn profits basically as spread income – Pure investment funds / Exchange traded funds
• Problems faced by depositories:
• Need and growth of investment companies
– Interest Rate Risk
– Liquidity Risk • Charges levied by insurance companies:
– Credit Risk – Shareholder fee
– Regulatory Risk – Sales (transaction) charges
– Operational Risk
• Types of funds:
• Funding sources for depositories:
– Central bank for banks – Conservative – primarily a fixed income fund
– Markets and investors for most others – could be of savings account – Growth – primarily an equity fund
(demand deposits) types or time deposits type – Balanced – mix of fixed income and equity funds
• Regulation of depositories • Regulation of investment funds
65 66
Insurance Companies Pension Funds

• Fundamental concept in insurance: risk reduction through risk • Objectives of a pension plan: provide long term super-annuation
aggregation for a cost (premium) benefits for money collected during the working life
• Types of Insurance Companies: • Types of plans:
– Life Insurance Companies
– Defined Benefits (DB)
– Non-life insurance companies
– Defined Contribution (DC)
– Reinsurance companies
– Hybrid
• Types of products:
– Term products • Investments of pension funds: Risk taking ability is capped to meet
– Investment linked products social sector obligations
– Annuity – Significant part of their investments (in excess of 75% of the fund value)
is necessarily in government securities
• Forms of Insurance Companies:
– Stock • Regulation of pension plans – may or may not be independent of
– Mutual insurance regulators
• Investment norms for insurance companies • Pension plan managers – may or may not be insurance companies
• Regulation of the insurance industry – deregulation in recent years
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Role of Regulators
• Most regulators are government controlled or semi-

autonomous with certain conditions laid down by the
Regulations in Financial Markets respective governments
• The basic idea of regulation is to ensure

– Increase Information to Investors
– Ensure the Soundness of Financial Intermediaries
• Competitive markets with sustained competition – This is because absence of
competition will lead to inefficiencies in the production processes and all.
• Ensure that there is no market failure – A market is supposed to fail if it cannot, by
itself, maintain all requirements for a competitive situation
69 70
Regulators
Regulation of Securities Markets • Central Bank
– Regulates the banking sphere in any economy. In some cases, the Central Bank also
• Government Regulation regulates parts of the capital markets
– Typically, the fixed income markets are regulated by them
• Self-Regulation – Examples are: US Fed, Bank of England, ECB, RBI, BOJ
• Circuit Breakers • Equity Market Regulator

– Mainly concerned with regulation of the equity markets
• Insider Trading – Examples are SEC, SEBI
• ECNs and Fragmentation • Commodity Regulator

– In charge of regulating the dealings with respect to commodities in markets where they
are allowed
– Examples are CFTC, FMC
• Insurance Regulator
– Looks after regulations in the insurance sector. In some cases, the Pensions funds are also
regulated by them
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Objectives of regulations
Issues in Regulation – 1
1. To prevent issuers of securities from defrauding • Statutory Regulation vs. Voluntary Regulation
investors by concealing relevant information
• Disclosure regulation:
2. To promote competition and fairness in the trading of – Requires issuers of securities to make public large amount of
financial securities financial information to actual and potential investors
– Market failure, if at all it occurs despite this regulation is due to
3. To promote the stability of financial institutions Asymmetric Information.
– This is also referred to as the Agency Problem – the firms
4. To restrict the activities of foreign concerns in domestic managers who act as agents for the investors may act in their own
interests to the disadvantage of the investors
markets and institutions
• Illegality if Insider Trading
5. To control the level of economic activity • Costs of regulation, rather costs of incorrect regulation
73 74
Some Regulators
Issues in Regulation – 2
• US Federal Reserve
• Non – compliance with statutory disclosure could lead to • Securities Exchange Commission
• Commodities Futures Trading Commission (CFTC)
legal issues – depending on the legal set up it could be
• National Futures Association (NFA)
either civil or criminal liability
• National Association of Securities Dealers (NASD)
• Stock Exchanges (NYSE, NASDAQ, PHLX, CBOT, CME, etc.)
• Bailouts by governments • Bank of England
– To protect small investors • Bank for International Settlements (BIS)
• European Central Bank
– To protect the confidence of investors in the system
• Ministry of Finance (in various countries)
– Issues about costs
• Securities Exchange Board of India
– Some examples
• Reserve Bank of India
• National Stock Exchange of India (NSE)
• Regulation is a continually changing framework with new • National Commodities and Derivatives exchange of India (NCDEX)
and new issues coming up on a regular basis Note some of them are statutory bodies with legal powers while
others are advisory bodies
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Regulation Reason: Ensure Soundness of Financial

Regulation Reason: Increase Investor Information Intermediaries
• Investors to financial intermediaries may not be able to assess whether
• Asymmetric information in financial markets means that investors
the institutions holding their funds are sound or not.
may be subject to adverse selection and moral hazard problems that
• In case of doubts about the soundness of the financial health of the
may hinder the efficient operation of financial markets and may also
keep investors away from financial markets. intermediaries, investors may want to pull their funds out of both sound
and unsound institutions, leading to a financial panic and causing large
• Regulators requires corporations issuing securities to disclose losses for the public and serious damage to the economy.
certain information about their sales, assets, and earnings to the • Protection of the public and the economy from financial panics is
public and restricts trading by the largest stockholders (known as addressed though the six types of regulations are considered:
insiders) in the corporation. ─ Restrictions on Entry
─ Disclosure
• Such regulation can reduce adverse selection and moral hazard
─ Restrictions on Assets and Activities
problems in financial markets and increase their efficiency by ─ Deposit Insurance
increasing the amount of information available to investors. ─ Limits on Competition
─ Restrictions on Interest Rates
77 78
Regulation: Restriction on Entry Regulation: Disclosure
• Restrictions on Entry • There are stringent reporting requirements for

─Regulators have created tight regulations as to financial intermediaries
who is allowed to set up a financial intermediary
─Accounting processes must follow certain strict
─Individuals or groups that want to establish a principles
financial intermediary, such as a bank or an
insurance company, must obtain a charter from ─Accounts are subject to periodic inspection
the relevant regulator ─They must make certain information available to
─Only if they are upstanding citizens with the public
impeccable credentials and a large amount of
initial funds will they be given a charter
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Regulation: Restriction on Assets and Activities Regulation: Deposit Insurance
• There are restrictions on what financial intermediaries are • The government can insure people’s deposits to a
allowed to do and what assets they can hold financial intermediary from any financial loss if
• Before one puts funds into a bank or some other similar the financial intermediary should fail
institution, one would want to know that the funds are safe • The Federal Deposit Insurance Corporation (FDIC)
and that the financial intermediary will be able to meet its insures each depositor at a commercial bank or
obligations mutual savings bank up to a loss of $250,000 per
• One way of doing this is to restrict the financial intermediary account
from engaging in certain risky activities • Similar government agencies exist for other
• Another way is to restrict financial intermediaries from depository institutions:
holding certain risky assets, or at least from holding a greater ─ The National Credit Union Share Insurance Fund
quantity of these risky assets than is prudent (NCUSIF) provides insurance for credit unions
81 82
Regulation: Limits on Competition Regulation: Restrictions on Interest Rates
• Evidence is weak showing that competition among financial • Competition has also been inhibited by regulations that
intermediaries promotes failures that will harm the public. impose restrictions on interest rates that can be paid on
However, such evidence has not stopped the regulators from deposits
imposing many restrictive regulations. • These regulations were instituted because of the widespread
belief that unrestricted interest-rate competition helped
encourage bank failures during the Great Depression of 1929
– 1936.
• Later evidence did not support this view, and restrictions on
interest rates have been abolished
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Regulation Reason: Improve Monetary Control Views about Regulation
• Because banks play a very important role in determining the • Investors:

supply of money (which in turn affects many aspects of the
economy), regulation of these financial intermediaries is – Necessary and absolutely must – provides
intended to improve control over the money supply protection and confidence in the system
• One example is reserve requirements, which make it
obligatory for all depository institutions to keep a certain
fraction of their deposits in accounts with the Central Bank • Corporates:
• Reserve requirements help the Central Bank exercise more
precise control over the money supply – Unnecessary requirement leading to no major
improvement and blocking up of resources
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Investment Environment

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12/23/2021

Need for Investment

Investments & Financial Assets Role of Financial Assets and Markets

• Essential nature of investment

Why Study Financial Markets? Why Study Financial Markets?

Meeting the Needs of Participants Investments and Innovation

• Financial Intermediation Technology and Service Delivery Globalization

Structure of Financial Markets Structure of Financial Markets

1. Debt Markets 1. Primary Market

Structure of Financial Markets Internationalization of Financial Markets

Internationalization of Financial Markets

Functions of Financial Markets

23 December 2021 Sankarshan Basu, IIM Bangalore 18

Function of Financial Markets Importance of Financial Markets

Segments of Financial Markets Function of Financial Intermediaries

Direct Finance Indirect Finance

23 December 2021 Sankarshan Basu, IIM Bangalore 21

• Instead of savers lending/investing directly with borrowers, a

• Another benefit made possible by the FI’s low transaction costs

Financial intermediaries reduce adverse selection and moral

Major Types of Financial Products

Money Market Instruments Bond Markets

• Treasury bills – Treasury Bonds and Notes

Municipal Bond Yields Capital Market - Equity

• Interest income on most municipals is not • Common stock

Examples of Equity Indices

Bond Indices Construction of Indices

• Global • How are stocks weighted?

Averaging Methods Derivatives Securities

Component Return Options Futures

Primary vs. Secondary Market Sales

Investment Banking Arrangements Public Offerings

• Underwritten vs. Best Efforts

Private Placements Organization of Secondary Markets

• Private placement: sale to a limited number Organized

International Market Structures Costs of Trading

Types of Orders Margin Trading

Some Types of Margins System of Margins

• Regulators specify minimum margins between clearing

CLEARING Prices and the Margin Account

Security Price Margin

Margin Trading - Initial Conditions Margin Trading - Maintenance Margin

X Corp $70 Stock price falls to $60 per share

Margin Trading - Margin Call Short Sales

Short Sale - Initial Conditions Short Sale - Maintenance Margin

Z Corp 100 Shares Stock Price Rises to $110

Short Sale - Margin Call

($15,000* - 100P) / (100P) = 30%

* Initial margin plus sale proceeds

Role of Central Banks

Insurance Companies Pension Funds

• Most regulators are government controlled or semi-

• The basic idea of regulation is to ensure

• Circuit Breakers • Equity Market Regulator

• ECNs and Fragmentation • Commodity Regulator

Regulation Reason: Ensure Soundness of Financial

Regulation: Restriction on Entry Regulation: Disclosure

• Restrictions on Entry • There are stringent reporting requirements for

Regulation: Restriction on Assets and Activities Regulation: Deposit Insurance

Regulation: Limits on Competition Regulation: Restrictions on Interest Rates

Regulation Reason: Improve Monetary Control Views about Regulation

• Because banks play a very important role in determining the • Investors:

23 December 2021 Sankarshan Basu, IIM Bangalore 86