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MBA 15th Batch

July, 2023 IB – 513: International
Financial Markets and
Investments
Dr. Muhammad Shahin Miah CPA

Compiled by
MD. TOWHIDUL ISLAM & MEHERAZ AL HASAN
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Contents

The Financial System ................................................................................................................. 1

Functions of financial system .................................................................................................... 2
1. Reducing information asymmetry and transaction cost ..................................................... 3
2. Facilitating trading, diversification and management of risk ............................................. 4
Role of government.................................................................................................................... 5
Bank based vs Market based financial system ........................................................................... 6
1. Providing financial functions .......................................................................................... 7
2. Corporate Governance........................................................................................................ 8
Loanable fund theory: ................................................................................................................ 9
Factors that affect interest rate: ................................................................................................ 11
1. Inflation ......................................................................................................................... 11
2. Monetary policy ............................................................................................................ 11
3. Budget deficit ................................................................................................................ 11
4. Foreign flow of funds.................................................................................................... 11
5. Political condition ......................................................................................................... 11
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Lecture – 01
The Financial System
The Financial System
Having a well-functioning financial system in place that direct funds to their most productive
uses is a crucial prerequisite for economic development. To understand the importance of
financial development, the essentials of a country’s financial system will first be outlined. The
financial system consists of the financial institutions, financial markets, and all financial
intermediaries and their relationship with respect to the flow of funds to and from households,
governments, business firms and foreigners.
Financial infrastructure is the set of institutions that enables the effective operation of
financial intermediaries and financial markets, including payment systems, credit information
bureaus, and collateral registries.

Figure – 1: Functioning of the financial system

Direct finance refers to the situation when one sector borrows funds from another sector
through/via financial markets.
Indirect finance refers to the situation when intermediaries obtain funds from saviors and uses
these saving to issue loan to sectors in need of finance.
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The main task of the financial system is to channel funds from sectors that have a surplus to
those with a shortage of funds. Figure – 1 explains the working of the financial system. Sectors
that have saved and are lending funds are on the left, and those that must borrow to finance
their spending are on the right. The bottom of the figure illustrates the process of direct finance,
when one sector borrows funds from another sector via a financial market – a market in which
participants issue and trade securities. The top of the figure depicts an indirect finance
transaction, in which a financial intermediary obtains funds from savers and uses these savings
to issue loans to a sector in need of finance. Financial intermediaries are the agents that provide
financial services, such as banks, insurance companies, finance companies, mutual funds, and
pension funds. In most countries, indirect finance is the main route for moving funds from
lenders to borrowers. These countries have a bank-based system, while those that rely more on
financial markets have a market-based system.
The financial system transforms household savings into funds that are available for investment
by firms. However, the importance of financial markets and financial intermediaries varies
across countries. The types of assets held by households also differ among countries.
The importance of internal finance: most investments by firms in industrial countries are
financed through retained earnings, regardless of the relative importance of financial markets
and intermediaries.
Question: Explain the functions of financial system (showing the role of financial market and
financial intermediaries).

Functions of financial system

The structure of the world’s financial markets and institutions has experienced revolutionary
changes over the last 30 years. Some financial markets have become obsolete, while new ones
have emerged. Similarly, some financial institutions have gone bankrupt, while new entrants
have emerged. However, the functions of the financial system have been more stable than the
markets and institutions used to accomplish these functions.
Having a well-functioning financial system in place that directs funds to their most productive
uses is a crucial prerequisite for economic development. If sectors with surplus funds cannot
channel their money to sectors with good investment opportunities, many productive
investments will never take place. Indeed, cross-country, case-study, industry- and firm-level
analyses suggest that the functioning of financial systems is vitally linked to economic growth.
Countries with larger banks and more active stock markets have higher growth rates, even after
controlling for many other factors underlying economic growth.
However, others have questioned the importance of finance for economic growth. For instance,
Lucas (1988: 6) argues: “I believe that the importance of financial matters is very badly over-
stressed…”. Furthermore, several recent studies conclude that the relationship between
financial and economic development may be non-linear. For instance, Arcand et al. (2015)
report that at intermediate levels of financial depth, there is a positive relationship between the
size of the financial system and economic growth, but at high levels of financial depth, more
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finance is associated with less growth. In fact, the marginal effect of financial depth on output
growth becomes negative when credit to the private sector reaches 80–100 per cent of GDP.
This reflects the fact that higher levels of financing increase the likelihood of financial crises,
which may depress economic growth. In addition, a large financial sector may lead to a
misallocation of resources, as the financial sector may attract talent from more productive
sectors of the economy, which may be inefficient from society’s point of view. Finally, some
types of finance, like mortgage credit, are considerably less conducive to sustainable economic
development than other types, such as enterprise credit.
The main task of the financial system is to channel funds from those with a surplus to sectors
that have a shortage of funds. In doing so, the financial sector performs two main functions:
1. Reducing information asymmetry and transaction cost
The financial system overcomes information asymmetry between borrowers and lenders. Such
information asymmetry can occur ex ante and ex post (before and after a financial contract has
been agreed upon). Information asymmetry deals with the study of decisions in transactions
where one party has more or better information than the other. Sometimes, the lender doesn’t
well the borrower. When deciding to lending money, we should first asses the repay capacity
of the borrower. Sometimes the interest amount becomes 50/70% of principal amount. Even it
becomes equal to principal amount as the borrower delays to pay his debts.
Ex ante information asymmetry arises because borrowers generally know more about their
investment projects than lenders. The borrowers that are most eager to engage in a transaction
are the most likely ones to produce an undesirable outcome for the lender (adverse selection).
It is difficult and costly to evaluate potential borrowers. Individual savers may not have the
time, capacity, or means to collect and process information on a wide array of potential
borrowers. Thus, high information costs may prevent funds from flowing to their highest
productive use.
Financial intermediaries may reduce the costs of acquiring and processing information and
thereby improve resource allocation. Without intermediaries, each investor would face the
large fixed costs associated with evaluating investment projects.
Financial markets may also reduce information costs. Economizing on information acquisition
costs facilitates the gathering of information about investment opportunities and thereby
improves resource allocation. In addition to identifying the best investments, financial
intermediaries may also boost the rate of technological innovation by identifying entrepreneurs
with the best chances of successfully initiating new goods and production processes.
The information asymmetry problem occurs ex post when borrowers, but not investors, can
observe actual behavior. Once a loan has been granted, there is a risk that the borrower will
engage in activities that are undesirable from the perspective of the lender (moral hazard).
Financial markets and intermediaries also mitigate the information acquisition and enforcement
costs of monitoring borrowers. For example, equity holders and banks will create financial
arrangements that compel managers to manage the firm in their best interest.
Credit rating agencies (CRAs) play an important role in financial markets by producing
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information about credit risk and its distribution to market participants. CRAs assess the credit
risk of borrowers (governments, financial, and non-financial firms) by providing credit ratings.
A credit rating can be defined as an opinion regarding the creditworthiness of a financial
instrument, or the issuer of a financial instrument, using an established and defined ranking
system of rating categories. A rating only refers to the credit risk; other risks, like market risk
(the risk due to unfavorable movements in market prices) and liquidity risk (the risk that a
given security or asset cannot be traded quickly enough in the market to prevent a loss), are not
taken into account. Ratings play a crucial role in financial markets, as investors use them to
evaluate the credit risk of financial instruments. Since assessing these instruments requires
specific knowledge and is very time consuming, individual investors often rely on CPA ratings.
The ratings thus have an important influence on the interest rate that borrowers have to pay.
In addition to reducing information costs, the financial system reduces the time and money
required to carry out financial transactions (transaction costs), for example by pooling – the
process of agglomerating funds from disparate savers for investment. By pooling the funds of
various small savers, large investment projects can be financed.
Without pooling, savers would have to buy and sell entire firms. Mobilizing savings involves
(1) overcoming the transaction costs of collecting savings from different individuals, and (2)
overcoming the informational asymmetries associated with making savers feel comfortable
about relinquishing control of their savings.
Pooling can take place via either financial markets or financial intermediaries. Firms can raise
funds to finance large-scale projects by issuing securities (such as bonds and equities) in small
denominations on public markets (stock exchanges) to tap a larger pool of savers. Savers
generally prefer to invest in liquid instruments, i.e., instruments that can be converted into
purchasing power quickly and inexpensively to ensure easy access to their funds. If claims on
the firm can be traded in liquid secondary markets, savers will be more willing to relinquish
their funds to finance long-term projects. Financial intermediaries such as banks offer an
alternative way of pooling. They transform the funds collected from savers into short-term
(liquid) and relatively safe bank deposits andinvest these funds in portfolios of more profitable
long-term (illiquid) risky projects by granting loans to diverse firms.
By reducing information and transaction costs, financial systems lower the cost of channeling
funds between borrowers and lenders, which frees up resources for other uses, such as
investment and innovation. In addition, financial intermediation affectscapital accumulation by
allocating funds to their most productive uses.
2. Facilitating trading, diversification and management of risk
Financial system may mitigate associated risks associated with individual investment projects
by providing opportunities for trading and diversifying risks, which may affect long-run
economic growth. In general, high-return projects tend to be riskier than low-return projects.
Thus, financial systems that make it easier for people to diversify risk by offering a broad range
of high-risk (like equity) and low-risk (like government bonds) investment opportunities tend
to induce a portfolio shifttowards projects with higher expected returns. Likewise, the ability
to manage a diversified portfolio of innovative projects reduces risk and promotes investment
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in growth-enhancing innovative activities.

Financial intermediaries and markets can reduce risk by providing liquidity, which refers to the
ease and speed with which agents can convert assets into purchasing power at agreed prices.
Savers are generally unwilling to delegate control over their savings to investors for long
periods, so less investment is likely to occur in high-return projects that require a long-term
commitment of capital. However, the financial system makes it possible for savers to hold
liquid assets – like equity, bonds, or demand deposits – that they can sell quickly and easily if
they need access to their savings.
Without a financial system, all investors would be locked into illiquid long-term investments
that yield high payoffs only for those who consume at the end of the investment.
Liquidity is created by financial intermediaries as well as financial markets. For instance, a
bank transforms short-term liquid deposits into long-term illiquid loans, therefore making it
possible for households to withdraw deposits without interrupting industrial production.
Similarly, stock markets reduce liquidity risks by allowing stock holders to trade their shares,
while firms still have access to long-term capital.
Question: Explain the main functions of financial system.

Role of government
A well-functioning financial system requires four types of government actions.
1) Government regulation is needed to protect property rights and to enforce contracts.
Each and every should have right to use their own property. Property rights refer to
control over the use of the property, the right to any benefit from the property, the right
to transfer or sell the property, and the right to exclude others from the property. The
absence of secure property rights and enforcement of contracts severely restricts
financial transactions and investment, thereby hampering financial development. If it
is not clear who is entitled to perform a transaction, an exchange will be unlikely. As
the financial system allocates capital across time and space, contracts are needed to
connect the providers and users of funds. If one of the parties does not adhere to the
content of a contract, an independent enforcement agency (for instance, a court) is
needed; otherwise, contracts would be useless.

2) Government regulation is needed to encourage proper information provision

(transparency) so that providers of funds can take better decisions on how to allocate
their money. Government regulation can reduce adverse selection and moral hazard
problems in financial systems and enhance their efficiency by increasing the amount of
information available to investors, for instance, by setting and enforcing accounting
standards. However, borrowers have strong incentives to cheat, so government
regulation may not always be sufficient, as various corporate scandals, such as
WorldCom, Parmalat, and Ahold, illustrate.
Question: A well functioning financial system requires a transparent government.
Explain the statement.
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3) Government should arrange proper regulation and supervision for financial institutions
in order to ensure their soundness. Because, saviors are often unable to properly
evaluate the financial soundness of a financial intermediary, as that requires extensive
effort and technical knowledge.
Financial intermediaries have an incentive to take too many risks because high-risk
investments generally bring in more revenues that accrue to the intermediary, while if
the intermediary fails the depositors bear a substantial part of the costs. Government
regulation may prevent financial intermediaries from taking too many risks.
Depositors may also be protected by a deposit guarantee system, but this may provide
the intermediary with an even stronger incentive to engage in risky behavior.
Finally, there is a risk that a sound financial intermediary may fail when another
intermediary goes bankrupt due to taking too many risks. Since the public cannot
distinguish between sound and unsound financial institutions, they may withdraw their
money once one financial intermediary fails, thereby perhaps destroying a sound
institution.

4) Government is responsible for competition policy to ensure competition. There are

many ways such competition may be hampered. For example, competitors may agree
together to sell a specific product or service at a fixed price, leading to profit for all the
sellers. Or banks may receive support from the government (state aid), leading to an
unfair advantage over their competitors.

Bank based vs Market based financial system

While there is considerable evidence that financial development up to some point is good for
economic growth, there is no clear evidence that one type of financial system is better for
growth than another. However, various recent studies suggest that differences in financial
systems may influence the type of activity in which a country specializes because certain
systems may more easily facilitate particular types of economic activity than others. In
addition, some evidence suggests that the economies of market-based systems are less affected
by financial crisis.
There are important differences among the financial systems of the EU Member States. For
instance, the size of financial markets and the importance of bank and non-bank financial
intermediaries (such as mutual funds, private pension funds, and insurance companies) differ
substantially across countries. Based on the ratio of bank credit to market capitalization, three
groups of countries can be distinguished:
1. Belgium, Finland, France, Ireland, Luxembourg, the Netherlands, Sweden, and theUnited
Kingdom (market-based countries);
2. Austria, Bulgaria, Croatia, the Czech Republic, Denmark, Estonia, Germany, Greece,
Hungary, Italy, Latvia, Lithuania, Malta, Poland, Portugal, Romania, Slovakia, Slovenia,
and Spain (bank-based countries);
3. Cyprus (outlier).
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Countries in the first group are closer to the US than other EU Member States. The second
group consists of EU countries that resemble China more closely and includes the Eastern
European countries that joined the EU more recently. Recent entrants generally have smaller
financial systems than those in the old Member States, where firms rely more on financing by
banks than on market finance. Finally, Cyprus is classified as an outlier since it has a very large
banking sector that extends a large amount of credit relative to the size of its economy.
Arguably, it could also be classified as bank based,given the size of its banking sector.
However, there are sometimes important differences even within each group. For instance,
among bank-based countries the importance of bank credit for financing non- financial firms
differs substantially. For instance, bank credit to non-financial firms was higher in Spain than
in Germany or Italy.
A key question is how these differences in financial systems affect macro-economic outcomes.
For instance, do bank-based financial systems (like that of Germany) lead tohigher rates of
economic growth than market-based systems (like that of the UK)?
1. Providing financial functions
The case for a bank-based system refers to the role of markets in fulfilling financial roles. As
discussed above, atomistic markets face a free-rider problem: when an investor acquires
information about an investment project and behaves accordingly, he reveals this information
to all investors, thereby dissuading others from devoting resources to acquiring information.
Thus, investors lack strong incentives to properly acquire information, as they cannot keep the
benefits of this information for themselves.
Consequently, innovative projects with the potential to foster growth may not be identified.
Banks, however, may exclusively benefit from the information they acquire, often by
maintaining long-term relationships with firms, and use it in a profitable way. Since banks can
make investments without revealing their decisions immediately in public markets, they have
an incentive to research potential investment projects.
Furthermore, banks with close ties to firms may be more effective than atomistic markets at
exerting pressure on firms to repay their loans. Often, firms obtain a variety of financial
services from their bank and also maintain checking accounts with it, thereby increasing the
bank’s information about the borrower. For example, the bank can learn about the firm’s sales
by monitoring the cash flowing through its checking account or by keeping track of the firm’s
accounts receivables. Firms may profit from these long-term relationships in the form of access
to credit at lower prices.
However, banks’ informational advantage may induce them to appropriate a sizeable share of
their borrowers’ profits, thus thwarting borrowers’ incentives to perform. This hold-up problem
can be mitigated if a borrower also has access to market-based funding. However, many firms,
especially small and medium-sized enterprises, have no access to market-based funding, and
therefore remain vulnerable to the hold-up problem.
The problem of free riding in financial markets that occurs due to diffuse shareholders may be
less severe in the case of large, concentrated ownership. However, concentrated owners may
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maximize the private benefits of control at the expense of minority shareholders. Furthermore,
large equity owners may stimulate the firm to undertake higher-risk activities since
shareholders benefit on the upside, while debt holders share the costs of failure. Finally, the
concentrated control of corporate assets produces market power that may distort public policies
(Levine, 2005). The available empirical evidence does not suggest that international differences
in concentrated ownership are associated with disciplining firms’ management.
Question: Differentiate between bank-based vs market based financial system.
2. Corporate Governance
A second element of this debate about the merits and demerits of bank-based vs market based
systems refers to corporate governance. It refers to the set of mechanisms that arrange the
relationship between stakeholders of a firm, notably equity holders and the management of the
firm. Corporate governance systems differ across countries.
Principal agent theory predicts that the managers (agents) may not always act in the best interest
of the general shareholders. Investors (the outsiders) cannot perfectly monitor managers acting
on their behalf, since managers (the insiders) have superior information about the performance
of the company. Therefore, mechanisms or tools are needed to prevent company insiders from
using the firm’s profit for their own benefit rather than transferring the profit to outside
investors.
Investors can use several tools to ensure that firm managers act in their interest. The most
important of these are the appointment of the board of directors, executive compensation, the
market for corporate control, concentrated holdings, and monitoring by financial
intermediaries. Besides, they can use different sub-committee such as audit committee or
nomination committee, etc.
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Lecture – 02
Interest Rates
Loanable fund theory:
This theory explains interest rate movements and other factors that control the supply and
demand for loanable funds.
Interest rate is the price to paid borrow debt capital or in other words it is the cost of money.
Nominal interest rate refers to the interest rate without adjusting inflation.
Calculation formula: 1 + Real interest rate) * (1 + Inflation rate)] – 1
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation.
Calculation Formula: interest rate - rate of inflation (expected or actual).
Criticisms of Loanable Funds Theory: The loanable funds theory is not a new theory, but
only a modified version of the classical theory; in essence, it is the classical saving and
investment theory. As such, it is open to the same criticism as the classical theory is. Though
the loanable funds theory has improved upon the classical theory in some respects, it has its
own defects too. The main drawbacks of the theory are discussed below:
1. Misspecifications of Factors: The loanable funds theory mis-specifies various sources of
supply and demand for loanable funds: (a) Not all savings come to the loanable market; some
are invested directly by the households and the business firms. (b) All dishoarding is not lent
to others; some is spent by the dishoards. (c) All investment or hoarding is not financed by
borrowed funds; some part of it is financed by own funds. (d) Funds are borrowed for many
purposes other than investment, hoarding and consumption.
2. Unrealistic Integration of Real and Monetary Factors: The neoclassical economists
attempted to combine the monetary factors with the real factors in the loanable fund theory.
But they did not succeed in this attempt. The two sets of factors are completely different in
their origin, nature and impact and cannot be combined directly. How can the real factors like
saving and investment be combined with the monetary factors like bank money and holding of
cash balances. A proper integration of the real and the monetary factors is possible through
considering changes in the income level as attempted by Hicks and Hansen.
3. Unrealistic Assumption of Full Employment: The theory is based on the unrealistic
assumption of full employment. According to Keynes, less-than-full employment, and not full
employment, is a normal feature of a capitalist economy. Thus, the theory fails to apply in the
real world.
4. Unrealistic Assumption of Constant Income: The loanable funds theory assumes that the
income level of the community remains constant and the changes in investment have no effect
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on it. But the reality is that when the volume of investment increases as a result of a fall in the
rate of interest, it leads to an increase in the income level.
5. Interest-Elasticity of Saving Over-Emphasized: The loanable funds theory exaggerates the
effect of the rate of interest on saving. Saving may not be so much affected by the rate of
interest as suggested by the theory. Sometimes people start saving without any increase in the
rate of interest. Sometimes people do not stop saving even if the rate of interest falls to zero.
6. Saving and Investment Equality: The loanable funds theory implies that saving-investment
equality (and also monetary equilibrium) is established through changes in the rate of interest.
When market rate of interest is less than the natural rate of interest, investment exceeds saving.
As a result, the market rate of interest increases which causes saving to increase and investment
to fall. Thus, equality between saving and investment as well as between the natural rate and
the market rate is established. Keynes criticized this view and believed that it is the changes in
income, and not the rate of interest, that brings about equality between saving and investment.
When investment exceeds saving, income increases which leads to an increase in saving and
thus making it equal to investment.
7. Indeterminate Theory: Like the classical theory, the loanable funds theory is also
indeterminate. According to Hansen, it does not tell clearly how the rate of interest is
determined. In this theory, the rate of interest depends upon the loanable funds and the loanable
funds depend upon savings. But savings depend upon the income level. Income level depends
upon the level of investment and the volume of investment depends upon the rate of interest.
In this way we are caught in a vicious circle. The rate of interest cannot be determined with the
help of this theory.
Demand for loanable fund comes from:
1. Households
2. Business
3. Foreign
4. Governments
5. Others
Supply of loanable fund comes from:
1. Households
2. Business
3. Governments
4. Foreign sources
In equation form:
Aggregate demand for loanable funds, DA = DH + DB + DG + DF
Where,
DA = Aggregate demand
DH = Demand from Households
DB = Demand from Business
DG = Demand from Governments
DF = Demand from Foreigners
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Aggregate supply of loanable funds, SA = SH + SB + SG + SF

Where,
SA = Aggregate supply
SH = Households supply of loanable funds
SB = Business supply of loanable funds
SG = Government supply of loanable funds
SF = Foreign supply of loanable funds
Question: How to determine the equilibrium interest rate or how interest rate is determined?

Study in details
Financial Markets & Institutions (13th Edition)
Chapter – 02: Determination of Interest Rates (Page: 25 – 32)

Factors that affect interest rate:

1. Inflation
Inflation affects interest rate by affecting the amount of households’ expenditure or business
expenditure. Real interest rate is determined by deducting inflation rate from nominal interest
rate. According to Bangladesh Bank, the average inflation rate was 8.39% in March, 2023
which was 5.75% in the same period last year (SPLY).
2. Monetary policy
It depends on government. Bangladesh Bank significantly control money market on behalf of
government. Government’s expansion policy causes for interest rate deduction.
3. Budget deficit
When government enact fiscal policies that results in more expenditure than tax revenue,
budget deficit will arise. Such budget deficit will increase demand for loanable funds, thereby
results in higher interest rate.
4. Foreign flow of funds
5. Political condition
Political Stability and Interest Rate
• Less Risky
• Lower Interest Rate
• More Confident Investment
Political Changes and Interest Rates
• Uncertainty
• Interest Rate may rise
• More Cautious Investment
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Political Stability and Central Bank Independence

• Decisions based on economic fundamentals
• Interest Rate are stable & predictable
• More Confident Investors

Study in details
Financial Markets & Institutions (13th Edition)
Chapter – 02: Determination of Interest Rates (Page: 32 – 37)

The End for 1st In-course Examination