Financial Market and Institutions

182 Semester (6 Level)

Assignment -01

1. (a) What is financial market? How financial markets facilitate corporate finance and investment
Management?

Financial Markets
A financial market is a broad term describing any marketplace where trading of securities including equities,
bonds, currencies, and derivatives occur. Some financial markets are small with little activity, while some
financial markets like the New York Stock Exchange (NYSE) trade trillions of dollars of securities daily.
Financial market prices may not indicate the true intrinsic value of a stock due to macroeconomic forces like
taxes. In addition, the prices of securities are heavily reliant on informational transparency to ensure efficient
and appropriate prices are set by the market.
The stock market is a financial market that enables investors to buy and sell shares of publicly traded
companies. The primary stock market is where new issues of stocks are first offered. Any subsequent trading
of stock securities occurs in the secondary market.
1. It facilitates mobilization of savings and puts it to the most productive uses.
2. It helps in determining the price of the securities. The frequent interaction between investors helps in
fixing the price of securities, on the basis of their demand and supply in the market.
3. It provides liquidity to tradable assets, by facilitating the exchange, as the investors can readily sell
their securities and convert assets into cash.
4. It saves the time, money and efforts of the parties, as they don’t have to waste resources to find
probable buyers or sellers of securities. Further, it reduces cost by providing valuable information,
regarding the securities traded in the financial market.

The financial market may or may not have a physical location, i.e. the exchange of asset between the parties
can also take place over the internet or phone also.

1. (b) Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the
time?
Market Efficiency:
Market efficiency refers to the degree to which market prices reflect all available, relevant information. If
markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat"
the market because there are no under- or overvalued securities available. Market efficiency was developed in
1970 by economist Eugene Fama, whose theory of efficient market hypothesis (EMH) stated it is not possible
for an investor to outperform the market, and that market anomalies should not exist because they will
immediately be arbitraged away. Fama later won the Nobel Prize for his efforts. Investors who agree with this
theory tend to buy index funds that track overall market performance and are proponents of passive portfolio
management.
At its core, market efficiency measures the ability of markets to incorporate information that provides the
maximum amount of opportunities to purchasers and sellers of securities to effect transactions without
increasing transaction costs. Whether or not markets such as the U.S. stock market are efficient, or to what
degree, is a heated topic of debate among academics and practitioners.
We expect markets to be Efficient most of the time
First, the efficient market hypothesis assumes all investors perceive all available information in precisely the
same manner. ... Therefore, one argument against the EMH points out that, since investors value stocks
differently, it is impossible to determine what a stock should be worth under an efficient market.
When people talk about market efficiency, they are referring to the degree to which the aggregate decisions
of all market participants accurately reflect the value of public companies and their common shares at any
given moment in time. This requires determining a company's intrinsic value and constantly updating those
valuations as new information becomes known. The faster and more accurate the market is able to price
securities, the more efficient it is said to be. (See also: What Is Market Efficiency?)
This principle is called the efficient market hypothesis (EMH), which asserts that the market is able to correctly
price securities in a timely manner based on the latest information available. Based on this principle, there are
no undervalued stocks to be had since every stock is always trading at a price equal to its intrinsic value.
However, the theory has its detractors, who believe the market overreacts to economic changes, resulting in
stocks becoming overpriced or underpriced, and they have their own historical data to back it up. (See also:
Working Through The Efficient Market Hypothesis.)

2. (a) Explain what is meant by interest elasticity. Would you expect the federal Government’s demand for
loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

Answer
The proportional change in the quantity of money demanded divided by the proportional change in interest
rate. This is a measure of the responsiveness of the demand for money to changes in interest rates. A minus
sign is typically inserted into the definition to make the elasticity a positive number.

Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a
change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds
demanded in response to a change in interest rates.

On the demand side, there is the expected return on investments. If the expected return is a lot higher than
interest rates, then the elasticity will be low. This is because if investors expect a high return on their
investments then a small increase in the interest rate will not affect their demand for loans that much as the
return on their investments (minus the cost of interest) will still be high. Conversely, when interest rates are
close to the expected return, the elasticity will be high. Essentially, if the expected returns to investment are
close to the rate of interest and interest rates rise further then there will be even smaller (or maybe no) profits
from investments, so demand for investment funds will respond significantly.
On the supply side, consider the money supply. When money is scarce, the elasticity will be low. And,
conversely, when money is abundant, the elasticity will be high.

Federal government demand for loanable funds should be less interest elastic than the consumer demand for
loanable funds, because the government's planned borrowings will likely occur regardless of the interest rate.
Conversely, the quantity of loanable funds by consumers is more responsive to the interest rate level.
An expanded space program would (a) force the federal government to increase its budget deficit, (b) possibly
force any firms involved in facilitating the program to borrow more funds. Consequently, there is a greater
demand for loanable funds. The additional spending could cause higher income and additional saving. Yet, this
impact is not likely to be as great. The likely overall impact would therefore be upward pressure on interest
rates.
As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand for loanable funds, and therefore
reduce interest rates. ... In addition, foreign investors may invest more funds in the United States if they
expect the dollar to strengthen, because that could increase their return on investment.
2- (b) Explain why interest rates tend to decrease during recessionary periods. Review Historical interest
rates to determine how they reacted to recessionary periods.

Interest rates rarely increase during a recession. Actually, the opposite tends to happen; as the economy
contracts, interest rates fall in tandem. Lowering the interest rates as an economy recedes is known as
quantities easing, and was widespread following the 2008 financial crisis.

When a recession hits, the Federal Reserve prefers rates to be low. The prevailing logic is low-interest rates
encourage borrowing and spending, which stimulates the economy.

A downside of this quantitative easing, or QE, is when countries keep interest rates too low—or even
negative—for too long and the economy goes into stagnation, similar to when a car battery doesn't receive an
adequate charge and bleeds power as a result. This is the most prevalent in some Eurozone countries in the
period between 2008-2018, when the European central bank kept interest rates low for far longer than their
bellwether, the United States Federal Reserve.

Interest rates affect all businesses, large and small, and interest rates typically fall during a recession. There
are several reasons for this. One is that the United States Federal Reserve uses its financial tools to nudge the
rates down. Theoretically, the basic law of supply and demand also kicks in. Ultimately, it is the consumers and
business borrowers who determine how much interest they are willing to pay to borrow money.
Setting Rates

One tool used to drop the interest rate is the Federal Funds Target Rate. This rate, referred to as the FFTR, is
set by a branch of the Federal Reserve called the Federal Open Market Committee. The FFTR is the rate that
financial institutions, such as banks, charge when lending to each other in the overnight market. When the
committee wants to increase spending and stimulate the economy, it lowers this rate. Conversely, the Fed
raises interest rates to cool down an overheated economy, says Chris Costanzo, a Houston-based chartered
financial analyst.

Buying Bonds
Another tool the Fed uses to drop interest rates is the buying of United States Treasury Securities, such as
bonds. By increasing its purchases of bonds and other securities, it drives up the demand for these products
and pushes up the price. Lee McPheters, a research professor and director of W.P. Carey School of Business at
Arizona State University has said that when the price of securities increases, the fixed return as a percent will
be lower.

Impact on Rates
Bond prices and interest rates tend to move in opposite directions because there is a fixed return on a bond.
In a 2011 article in "Dollars and Sense," Alejandro Ruess describes how this works. If a consumer pays $100 for
a bond that will pay $110 in a year, the interest rate on that bond is 10 percent. When the Federal Reserve
buys bonds it increases demand and pushes up the price. Even though the price of the bond goes to $105, it
will still pay $110 at the end of the term. Now, the interest rate has dropped from 10 percent to less than 5
percent. McPheters adds that any new securities that are issued will have lower interest rates that are
consistent with what is happening in the market at that time.
Supply and Demand
Although the Federal Reserve uses tools to adjust the interest rate, it doesn't control it. The laws of supply and
demand theoretically determine the interest rate. In a recession, consumers tend to save money rather than
spend it. There is more of a supply of money to lend than there is a demand to borrow it. Interest rates are a
reflection of the market's savings rate, said Albert Lu, managing director of Houston-based WB Wealth
Management. When consumers would rather save more than borrow and invest, there is less demand for
credit and interest rates drop.

3. (a) Describe the pricing framework for money market securities.

As money became a commodity, the money market became a component of the financial market for assets
involved in short-term borrowing, lending, buying and selling with original maturities of one year or less.
Trading in money markets is done over the counter and is wholesale.

There are several money market instruments in most Western countries, including treasury bills, commercial
paper, bankers' acceptances, deposits, certificates of deposit, bills of exchange, repurchase agreements,
federal funds, and short-lived mortgage- and asset-backed securities.[1] The instruments bear differing
maturities, currencies, credit risks, and structure and thus may be used to distribute exposure.[2]
Money markets, which provide liquidity for the global financial system including for capital markets, are part
of the broader system of financial markets.

Financial instruments are contracts that represent value. They come in many varieties. In fact, financial
managers and bankers have a lot of leeway in creating and issuing financial instruments. The Securities and
Exchange Commission (SEC) regulates publicly traded financial instruments; however, the SEC less stringently
regulates private placement instruments. Most financial instruments fall into one or more of the following five
categories: money market instruments, debt securities, equity securities, derivative instruments, and foreign
exchange instruments.

Money Market Instruments

Money market instruments are highly marketable short-term debt securities. Furthermore, money market
instruments are generally low-risk investments. Because of this, they offer yields that are lower than riskier
stocks and financial instruments.
Often, investors trade money market instruments in large denominations among institutional investors.
However, some money market instruments are available to individual investors via money market funds, or
mutual funds that pool money market instruments.

Debt Securities
Debt securities are longer-term debt instruments. With debt instruments, the issuer is essentially borrowing
money from the investor. The investor plays the role of a lender lending money to the issuing entity. Longer-
term debt securities often yield higher returns than money market instruments. Debt instruments also
represent a claim on the assets of the issuing entity.

Equity Securities
Equity securities represent shares of ownership in a company. In addition, equity securities often come with
voting rights. They represent the shareholders’ interest in the issuing company and a residual claim on the
company’s assets. This means if the issuing company goes bankrupt and has its assets liquidated, then the
equity holders only get their money back after all other relevant claimants have been paid what they are
owed.
Financial Derivative Instruments
A financial derivative instrument is a contract that derives its value from an underlying asset or factor. In short,
the value of a derivative depends on the value of something else. When the value of the underlying factor
changes, the value of the derivative instrument also changes. Derivatives are often used for speculation, for
leveraging a position, or for hedging risk.

Foreign Exchange Instruments

Another category of financial instruments is foreign exchange instruments. These are contracts involving
different currencies. There are many currencies in the world, and there are several different instruments
commonly used to trade in currencies.

3-(b)- Assume an investor purchased six-month T-bill with a $10,000 for $9,000 and sold it 90 days later for
$9,100. What is the yield?

ANSWER:
SP  PP 365
Yt  
SP n

$9,100  $9,000 365

 
$9, 000 90

 4.51%

3- (c) A U.S. investor obtains British pounds when the pound is worth $1.50 and invests in a one-year money
market security that provides a yield of 5 percent (in pounds). At the end of one year, the investor converts
the proceeds from the investment back to dollars at the prevailing spot rate of $1.52 per pound.
Calculate the effective yield.

ANSWER: $8,816.6 = 10,000/(1 + r ) 2 $8,816.6 (1 + r ) 2 = 10,000 (1 + r ) 2 = 1.1342 (1 + r ) = 1.0649 r = 0.0649

= 6.49%

4. What is corporate bond? Describe the characteristics of corporate bond.

Corporate bond
Corporate bonds are debt instruments created by companies for the purpose of raising capital. They are called
fixed-income securities because they pay a specified amount of interest on a regular basis.
Corporate bonds are issued by companies to raise more capital. Companies use the money to reinvest in their
operations; buy other companies; or even pay off older, more expensive loans.
In January 2018, there was $37 billion in corporate debt traded per day. Companies want to issue debt before
the Federal Reserve raises interest rates further.
The alternative for companies is to engage in an initial public offering and raise equity by selling stocks. This is
a long and expensive procedure. Selling bonds, while still complicated, is easier. It's a quicker way to raise
capital for corporate expansion.

Characteristics of corporate bond

Like the US government, corporations issue bonds to raise money. The bond buyer receives regular interest
payments, then gets the principal back when the bond matures. Corporate bonds offer a higher rate of return
than federal or municipal bonds because they're a riskier investment. They're considered a safer investment
than stocks, however, because if a corporation goes bankrupt, bond-holders are in line to be paid ahead of
stockholders.
Size of Market. The corporate bond market is generally large and liquid; in 2009 daily trading volume was an
estimated $16.8 billion and total issuance was over $900 billion. The total market value of outstanding
corporate bonds in the United States at the end of 2009 was approximately $6.9 trillion. A variety of investors
participate in the corporate bond market, including individuals who invest in corporate bonds through direct
ownership and/or through mutual funds; insurance companies; pension funds and other institutional
investors.
Trading Venues. The vast majority of corporate bond transactions, even those involving exchangelisted issues,
take place in the over-the-counter (OTC) market. This market does not have a central location, but rather is
made up of brokers and dealers from around the country who trade debt securities over the phone or
electronically. Market participants are increasingly using electronic transaction systems to assist in the trade
execution process. Some bonds trade in the centralized environments of the New York Stock Exchange (NYSE)
and American Stock Exchange (AMEX), but the bond trading volume on the exchanges is relatively small.
Bonds are traded on both a principal and agency basis. When a broker buys or sells bonds from their firms’
inventory – or on a principal basis – clients do not pay an outright commission, but instead pay a markup that
is built into the price quoted for the bond. If a broker has to go out into the market to find a particular bond
for a customer, a commission may be charged. Commission rates and markups vary based on the type of bond
and size of the transaction.
Corporate Bond Advantages: Corporate bonds have advantages in addition to the higher yields, according to
the Pimco investment company. One such advantage is that they're a liquid investment: They can be and are
sold before maturity and there's a thriving secondary market in corporate bonds. Another benefit is that the
interest payments—typically semiannual—provide a steady income stream.

Ratings :Bond rating services such as Moody's or Stand and Poors rate corporate bonds from triple-A for the
most secure investment down to a C or D for corporations that have defaulted on their bond debt. The better
ranked bonds are grouped together as "investment grade," while everything below that is classified as
"speculative grade," which has a higher rate of risk, but offers larger returns. Bonds may move up or down the
rating scale depending on the financial fortunes of their issuers.

Bond Pricing
Corporate bond prices are influenced not only by the issuer's credit rating but the general level of interest
rates and the length of maturity, according to Pimco. Short-term bonds mature in five years or less; medium-
term bonds mature in five to 12 years; long-term bonds take more than 12 years. Another factor in pricing is
the "credit spread" between the yields and risk of a particular bond issue compared to safer, but lower-yield
Treasury bond.

Sajib Roy