Course Name: Principles of Finance [BFB1313]

Chapter 2: The Financial Environment

TABLE OF CONTENTS
LEARNING OBJECTIVES ................................................................................... 2
ABSTRACT .......................................................................................................... 2
3.1 FINANCIAL ENVIRONMENT ......................................................................... 3
3.2 FINANCIAL MARKET .................................................................................... 5
3.2.1 Money Market .......................................................................................................... 5
3.2.2 Capital Market ......................................................................................................... 5
3.2.3 Primary Market ....................................................................................................... 6
3.2.4 Secondary Market .................................................................................................... 6
3.3 FINANCIAL INSTITUTIONS ........................................................................... 8
3.3.1 Categories of Financial Institutions ....................................................................... 9
3.4 COST OF MONEY ........................................................................................ 13
3.5 MARKET INTEREST RATE ......................................................................... 15
3.6 TERM STRUCTURE OF INTEREST RATE ................................................. 18
3.6.1 Factors for the Shape of the Yield Curve ............................................................ 19
ADDITIONAL MATERIALS ................................................................................ 22

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Chapter 2: The Financial Environment

LEARNING OBJECTIVES
At the end of this chapter, you will be able to:

• Introduce the different types of financial markets and financial institutions

• Write out two equations for nominal, or quoted interest rate, and briefly discuss each
component
• Define the term structure of interest rate or yield curve, and identify the factors that
determine the shape of yield curve.

ABSTRACT

It is critical that financial managers understand the environment and markets within which they
operate. In this chapter, the markets in which capital is raised and securities are traded are
examined. The financial institutions that operate in these markets will be discussed. In the
process, we shall see how cost of money is determined, and we shall explore the principal factors
that determine the general level of interest rates in economy.

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3.1 FINANCIAL ENVIRONMENT

Financial managers and investors make decisions within a large and complex financial
environment. Financial environment refers to financial market and institutions, tax and regulatory
policies, and the state of government. This financial environment may affect the decision made by
the decision-makers. Thus, it is crucial for financial managers to have a good understanding of
the environment in which they operate.

Financial market can be described as a meeting place of buyer and seller. The economists used
a better word such as a meeting place between those who supply and those that demands. In
finance we are going to be more specific that is a meeting place between those whom needs
financing (those who requires funds) and those who has funds (those who can provide the
financing).

Below is the graphic and explanation on the scenario in financial market.

Figure 1: An Overview of the Financial Market

Scenario
Business firms, individuals, and government units often need to raise capital. For example,
Tenaga Nasional forecasts an increase in the demand for electricity in Perak, and it decides to
build a new power plant. Because Tenaga almost certainly will not have such amount, they can
raise the capital in the financial markets.

On the other hand, the incomes of some individual or firms are greater than their current
expenditure, so they have funds available to invest. For instance, Mr. Chin has an income of RM
45,000 and his current expenses are only RM 40,000. People and organizations needing money
are brought together with those having surplus funds in the financial markets. They are many
different financial markets, each one consisting of many institutions. Each market deals with
different type of instruments in terms of the instrument's maturity and the assets backing it.

Furthermore, different markets serve different types of customers or operate in different parts of
the country.

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If you look at the figure above, we can see that there are various financial institutions in the
financial market offering various instruments. These institutions facilitate the movement of funds
between parties who need funds or capitals (deficit spending units) and parties with excess funds
(surplus spending units). In this case, Tenaga is the deficit spending unit because it needs funds
for the plant expansion. Adam and other investors such as Mr. Muthu and Aisys are surplus
spending units because they have more funds than needed. The blue and red arrows present the
movement of the funds.

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3.2 FINANCIAL MARKET

Financial market can be divided into two, which are the money market and the capital market.
Money market deals with short-term securities whilst long-term securities are traded on the
capital market.

Figure 2: Types of Financial Market

3.2.1 Money Market

Money market is the vehicle for economic units to adjust their balance sheets for temporary cash
surpluses and deficit. Therefore, if the company has extra cash than necessary, it will buy money
market securities. However, too much idle money will not give any return. Hence, it is wise for
investors to invest in securities that will give return. On the other hand, if the company has little
cash and needs extra cash, it will sell the money market securities in order to obtain the cash
needed. The term money market refers to the ease with which these securities can be bought or
sold. From a liquidity perspective, these instruments are the next best things to money. To qualify
as a money market instrument, a security must have maturity of one year or less. Only short-term
financial investments are traded in money market.

3.2.2 Capital Market

The role of capital market is to facilitate long term financial arrangements between savers and
users of funds to allocate capital to its most productive uses. Due to the very temporary nature of
the funds transferred in the money market, the issuer of money market instruments does not
usually use the funds to acquire real assets. Capital market instruments on the other hand can
provide funds to finance acquisition of fixed assets. Any financial instruments with maturity
exceeding one year or long-term financial instruments qualify as capital market instruments.

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Financial market can be categorized further by looking at the issuance of the securities. In this
point of view, we will further categorize the market into primary market and secondary market.

Figure 3: Category of Financial Market

3.2.3 Primary Market

This is the market where the issuing company first issues the security. The capital raised from
issuance of the security will go to the issuing company. The issuing company for their business
expansion will then use this fund. Floatation costs are costs incurred when company issues new
security.

3.2.4 Secondary Market

This is the market where the security is already in circulation. Any proceed from selling and
buying the security will not go to the issuing company but will only be circulated among the
investors in the market. Examples of security in the secondary market are stocks traded on Kuala
Lumpur Stock Exchange (KLSE).

The most active secondary market is the stock market. KLSE is one of the examples of the most
active markets. Here, shares previously issued and in the hand of a shareholder are traded
between one shareholder and another. The shares will change hand, and so is the money from
the buyer to the seller but the company will not get any of it. This means that it is the present
shareholders that require the funds and not the company. The fund is obtained through selling
their shares to another shareholders through the stock exchange. Recent regulation posted by
the KLSE allows shareholders to sell their shares back to the issuing company.

There are basically two types of stock market:

• The organized stocks market

• The over-the-counter market

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The Organized Stocks Market

1. With designated members

2. Board of governors
3. Own trading building
4. Highly regulated
5. Equipped with the latest electronic equipment
6. Large number of dealers and agents
7. Example: KLSE

• Refer to www.klse.com.my for further reading on the KLSE.

The Over-the-Counter Market

1. Operates as an auction markets matching few seller and buyer

2. Trade securities of new and small firms
3. Few dealers but with agents
4. Equipped with latest electronic equipment but not as expensive as that in the organized
stock market
5. Example: Malaysian Exchange of Securities Dealing & Automated Quotation (MESDAQ)

• Refer to www.mesdaq.com.my for further reading on the MESDAQ.

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3.3 FINANCIAL INSTITUTIONS

Financial institutions are intermediaries that channel the savings of individuals, businesses, and
governments into loans or investments. Many financial institutions directly or indirectly pay savers
interest on deposited funds. Some financial institutions accept customer's savings deposits and
lend this money to other customers.

There are various financial institutions in the financial market offering various instruments.

Below is the information on movement of funds in financial institution.

Figure 4: Diagram on the Movement of Funds in Financial Institution

These institutions facilitate the movement of funds between parties who need funds or capitals
(deficit spending units) and parties with excess funds (surplus spending units). From the previous
examples, Tenaga is the deficit-spending unit because it needs funds for the plant expansion. Mr.
Chin and other investors are the surplus spending units because they have more funds that
needed.

These institutions can be generally grouped into four major categories. The categories are
investment companies, contractual intermediaries, depository institution, and finance companies.

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3.3.1 Categories of Financial Institutions

Figure 5: Categories of Financial Intermediaries

Investment Companies
Investment companies are companies that sell their own stock to small surplus units to raise
funds for the purchase of direct claims issued by larger deficit units. Examples of investment
companies are merchant banks and mutual fund companies. In our case, if Tenaga Nasional
would like to raise RM 6billion, it will approach Arab Malaysian Merchant Bank (AMMB). AMMB
will provide services such as underwriting service to Tenaga Nasional in which AMMB finds
buyers to buy the shares issued by Tenaga Nasional. When investors buy the securities, the fund
will be channeled to Tenaga Nasional. Another example of investment company is mutual funds.
Mutual funds are companies that accept money from savers and then pool their money to invest
in shares or bonds. The attraction of mutual fund companies to investors is that they offer the
benefits of substantial diversification and professional selection in the acquisition of large
portfolios.

Contractual Intermediaries
Contractual intermediaries are companies that issue an indirect claim in the form of contract that
specifies the individual saver will make periodic fixed payments to the company in exchange for
the right to receive payments from the company in future. Examples of this kind of intermediaries
are insurance companies and pension funds. The contract issued by insurance companies, for
example, promise payments to the insured individual in the vent of financial losses suffered from
such hazard such as premature death, fire etc. The insurance company to make loans to
business and individuals and to acquire many varieties of securities uses premiums in excess of
insurance benefits paid out in a given year. The return will be used to pay any compensation to
savers.
Pension fund is another type of contractual intermediaries. The employers and employees have
obligation to contribute a sum of money to the pension funds every month. It is required by
Employees Provident Act 1991.

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Depository Institutions
These institutions raise funds by issuing indirect claims in the form of deposits, which can be
classified into two basic categories:

1. Transaction or demand deposits

Transaction deposit is the right of the depositors to withdraw the funds at any
time upon demand. Transaction deposits are popularly known as checking or
current account.

2. Savings and time deposits

It represents financial claims with no specific maturity. Time deposits have
specific maturity ranging from one month to several years. Examples of these
institutions are commercial banks and savings and loans association.

Finance Companies
Finance companies raise funds by selling their own debt instruments to surplus spending units
and by borrowing from other financial institutions, particularly commercial banks. An important
aspect of finance companies is that they specialize in lending to high-risk deficit units that find it
hard to borrow from commercial banks. For example, RHB finance and AMFB.

Transfers of capital between savers and those who need capital take place in the three different
ways:

• Direct transfer
• Indirect transfer through merchant/investment bankers
• Indirect transfer through financial intermediary

Direct Transfer

Figure 6: Direct Transfer

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Direct transfer of money and securities, as shown in Figure 6, occur when a business sells its
stock or bonds directly to savers, without going through any type of financial institutions. The
business delivers its securities to savers, who in turn give the firm the money it needs.

Indirect Transfer through Merchant/Investment Bankers

Figure 7: Indirect Transfer through Merchant/Investment Bankers

Transfer may also go through merchant bankers, such as AMMB, which serves as middlemen
and facilitates the issuance of securities. The company sells its stock or bonds to the investment
bank, which in turn sells the same securities to savers. The businesses' securities and the savers'
money merely pass through the investment-banking house. However, the investment bank does
not buy and hold the securities for a period of time, so it is taking a chance (to resell the securities
to savers for as much as it paid. As the new securities are involved and the corporation receives
money from the sale, it is a primary market transaction.

Indirect Transfer Through Financial Intermediary

Figure 8: Indirect Transfer Through Financial Intermediary

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Transfer can also be made through a financial intermediary such as bank or mutual fund. Here
the intermediary obtains funds from the savers, issuing its own securities in exchange, and it then
uses the money to purchase and then hold a business's securities. For example, a saver might
give dollars to a bank, receiving a certificate of deposits from the bank, and then the bank might
lend the money to a small business in the form of mortgage loan. Thus intermediary literally
creates new forms of capital. In this case, the certificates of deposits which are both safer and
more liquid than mortgages and thus are better securities for most savers to hold. The existence
of intermediaries greatly increases the efficiency of money and capital markets.

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3.4 COST OF MONEY

Capital is a free economy allocated through the price system. The interest rate is the price paid to
borrow debt capital. In the case of equity capital, investors expect to receive dividends and capital
gains, and these are the components, which determine the cost of equity money. The factors
which affect the supply of and the demand for investment capital, hence the cost of money.

The four most fundamental factors affecting the cost of money are:

• Production opportunities
The returns available within an economy from investments in productive (cash-
generating) assets.

• Time preferences for consumption

The preferences of consumers for current consumption as opposed to saving for future
consumption.

• Risk
In a financial market context, the chance that an investment will provide a low or negative
return.

• Inflation
The amount by which prices increase over time.

Below is the scenario relating to cost of money.

Figure 9: Cost of Money

Assuming that Omega Automation Sdn. Bhd. (OASB) is in need of money or fund for its
expansion plan. OASB approaches its other friends for the capital. Its friends, before parting with
the money, will look at the opportunities presented by the expansion plan. If the plan looks
profitable, its friend might be more willing to lend the money to OASB. If the plan is unprofitable,
its friend might be more wary and demand a higher return that the normal return because of the
unprofitable risk.

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If OASB's friends have the need for the money now, they might only be willing to part with the
money if there is a higher return compared to the normal return. If OASB's friends have no urgent
use of the money now, they are more willing to invest in the expansion plan at the normal rate.

The higher the risk, the higher the return that OASB's friend wants. This means that the cost of
capital will also increase. The lower the risk, the lower the rate of return.

Lastly, when OASB's friends take into consideration the inflation factor, things are different again.
If there is an indication that inflation is going to increase, OASB's friends would want a higher
return to protect them from the effect of inflation. If inflation is projected to be low, then he would
not mind to accept a lower rate of return.

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3.5 MARKET INTEREST RATE

If we are to assume that money is as similar as another commodity to trade then the law of
demand and supply is applicable. The amount of money in circulation that is supply of money and
the level of demand for the money will determine the cost of money. Just like other commodity,
where the commodity is distributed to buyers in relation to selling price, money (or capital) is
allocated to borrower by the use of interest rate.

However, note that capital is allocated to borrower not only on the basis of interest rates. There
are other factors that will ensure the supply of capital to certain borrower or sector, such as:

• Government regulation for allocation of funds on promoted industry - tourism,

construction, high technology industry etc.
• Bank Negara regulations on the portfolios of loans - whereby total loan must be spread to
various industry on a predetermined percentage, allocation of funds to Small Medium
Industry (SMI), availability of funds to finance low cost houses etc.

The market risk free interest rate is being determine by two main factors: (1) Real risk free rate of
interest and (2) Inflation Premium.

Figure 10: Determinants of Market Risk Free Interest Rate

• kRF = the quoted or market rate on riskless securities in a world where inflation exists.
This is the quoted interest rate on a security such as the Malaysian Government's
treasury bill, which is very liquid and free of most risk.

• k* = the real free rate of interest is the rate that would exist on a riskless security in a zero
inflation world.

In addition, the quoted (or nominal) interest rate on a debt security, k, is composed of a real risk-
free rate return, k*, plus several premiums that reflect inflation, the riskiness of the security and
the security's marketability (or liquidity).

Below is the scenario of market interest rate for a better understanding.

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Figure 11: Scenario of Market Interest Rate

For example, Gammapro Industries is in a low risk bracket, and then investors will be happy to
receive a normal return. Assuming that the normal return is 10%, the company can borrow money
and pay only the normal rate of 10%.

If Deltacom Corporation Berhad, a riskier company wants to borrow money from the market, the
investors will demand a risk premium because of the additional risk. Now, the investors are
demanding a 12% return, higher than normal market return. The additional 2% are the
compensation for the extra risk. Deltacom Corporation Berhad can only borrow at 12% and not
10%.

Determinants of market interest rate are further explained below.

Figure 12: Determinants of Market Interest Rate

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If the market is riskless, the only market interest rate that exists is the KRF, that is market risk
free interest rate.

K = the quoted (or nominal) market interest rate on a given security. There are many different
securities, hence many different quoted interest rates, that is different k's.

DRP = default risk premium. This premium reflects the possibility that the issuer will not pay the
promised interest or principal on a security. DRP is generally thought to be zero for treasury
securities. For example, treasury bills issued by the Malaysian Government. DRP rises as the
riskiness of issuers’ increases.

LP = liquidity or marketability premium. This is a premium charged by lenders on securities that

cannot be converted to cash on a short notice at a reasonable price. LP is very low for treasury
securities but is relatively high on securities issued by very small firms.

MRP = maturity risk premium. Longer-term bonds are highly exposed to the maturity risk. A slight
change interest will cause a significant change in the price of long-term bonds. To protect from
the risk, investors demand a premium.

With the following data, we will look at the calculation on market interest rate using the above
formula.

Real risk free rate of interest = 2%

Market risk free interest rate = 5%
Inflation premium = 3%
Default risk premium = 2%
Maturity risk premium = 3%
Liquidity premium = 1%

K = k* + IP + DRP + LP + MRP

= 2% + 3% + 2% + 1% + 3%

= 11%

2% + 3% = KRF = 5%

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3.6 TERM STRUCTURE OF INTEREST RATE

The term structure of interest rate is the relationship between long and short-term rates. It is
important to corporate treasurers, who must decide whether to borrow by issuing long-or short-
term debt. In other word, the term structure of interest rate is the relationship between bond yield
and maturity. The relationship can be showed through the yield curve diagram.

Let us look at the relationship between bond yield and maturity. The relationship can be showed
through the yield curve. Yield curve has different shapes depending on expected inflation rates
and perceptions about the relative riskiness of securities with different maturities.

The figure below shows the relationship between yield and maturity.

Figure 13: Relationship Between Yield and Maturity

A yield curve is upward sloping when short-term rates are lower than long-term rates. It is also
known as 'normal' yield curve because long term rates have been above short-term rates
historically and yield curve usually slope upward.

On the other hand, a yield curve will slope downward when short-term rates are higher that long
term rates. A yield curve, which slopes downward, is also known as inverted or 'abnormal' yield
curve.

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The shape of the yield curve depends on 2 key factors:

• Expectation about future inflation or expectation theory

• Perception about the relative riskiness of securities with different maturities or liquidity
preference theory.

3.6.1 Factors for the Shape of the Yield Curve

There are two factors that shape the yield curve, which are, the expectation theory and liquidity
preference theory.

Expectation Theory
The expectation theory sometimes referred to as the pure expectation theory, states that the yield
curve depends on expectations about future interest rates. To begin, the expectation theory holds
that long-term interest rates are a weighted average of current and expected future short-term
interest rate.

Example 1
If one-year treasury bills currently yield 7%, and one-year bills are expected to yield 7.5% a year
from now, investors will expect to earn an average of 7.25% over the next two years:

7% + 7.25% = 7.25%
2

According to the expectation theory, this implies that a two-year treasury note purchased today
should also yield 7.25%.

Example 2
1-year treasury bills yield 7% and 2-year treasury bills yield 8%, what do you expect the yield of
1-year treasury bills one year from now?

Assume that X% represents the yield of 1-year treasury bills one year from now.

2-year yield = (7% + X%)/2 = 8%

X% = 9%

(The yield of 1-year treasury bills is 9%)

The pure expectation theory assumes that investors establish bond prices and interest rates
strictly on the basis of expectations for interest rates. This means that they are indifferent with
respect to maturity in the sense that they do not view long-term bonds as being riskier than short-
term bonds. Therefore, according to the pure expectation theory, the maturity risk premium
(MRP) is equal to zero.

In addition, according to expectation theory, kRF, or the yield of treasury securities, is determined
as the sum of the real risk free rate, k*, plus an inflation premium, IP.

kRF = k* + IPt

Here IPt is found as the average inflation rate over the t years until the bond matures. For
example, if 1-year treasury bills yield 7%, and K* = 3%, how much is the IP?

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Yield = kRF = K* + IP
7% = 3% + IP
IP = 4%

If 2-year treasury bills yield 8%, and K* = 3%, how much is the IP?

kRF = k* + IP
8% = 3% + IP
IP = 5%

However, inflation rate is an average inflation rate for two years, therefore, expected inflation rate
one year from now:

(4% + X%)/2 = 5%
X = 6%

Figure 14: Term Structure of Interest Rate

According to expectation theory, an upward sloping yield curve occurs when interest rates are
expected to increase in the future. This increase could be due to an increase in expected inflation
or to an increase in the expected real risk-free rate. By contrast, a downward sloping yield curve
occurs when interest rates are expected to decline.

Liquidity Preference Theory

According to this theory, long-term bonds normally yield more than short-term bonds for two
reasons:

1. Investors generally prefer to hold short-term securities because such activities are more
liquid in the sense that they can be converted to cash with little danger of losing the
principal. Therefore, investors will generally accept lower yields on short-term securities
and this lead to relatively low short-term rates.

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2. Borrowers generally prefer long-term debt because short-term debt exposes them to the
risk of having to repay the debt under adverse conditions. As a result, borrowers are
willing to pay a higher rate; other things remain constant, for long-term funds than short-
term funds, and this lead to relatively low short-term rates.
Thus, lender and borrower preferences both operate to cause short-term rates to be
lower than long-term rates. With this situation and under normal condition where MRP is
positive, MRP increases with years to maturity will lead to an upward sloping of the yield
curve.

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ADDITIONAL MATERIALS
Hyperlinks

• Money Market: Introduction

http://www.investopedia.com/university/moneymarket/

• Invest Wisely: An Introduction to Mutual Funds

http://www.sec.gov/investor/pubs/inwsmf.htm

QUESTIONS
Refer to the EQ.

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