Chapter 1

An Overview of Financial Markets and Institutions

Mr. Al Mannaei
Introduction
Spending Unit : Any thing that spend
Money !

•Households (individuals).
•Governments.
•Corporations.
Introduction
Surplus Spending Unit (SSU)
•Income Expenditure
>>SSU will Invest OR borrow ?!

Which of following are most likely to be a

SSU ?
Households, Governments or Corporations.
Introduction
Deficit Spending Unit (DSU)
•Income Expenditure
>> DSU will Invest OR borrow ?!

Which of following are most likely to be a

DSU ?
Households, Governments or Corporations
Introduction
• What if the Income= Expenditure ?

Then its called ________.

 Introduction
DSU : Shortage in money (Need Money)
>> Income lower than expense.

SSU : Excess in money.

>> Income higher than expense.

Balanced position : income = expense.

SSU & DSU
• Which of the following represent SSU or
DSU :
– Borrower.
– Investor.
– Lender.
– Saver.
– Issuer of Financial Claims.
– Buyer of Financial Claims.
 Financial Claims
• Who issue financial claims ?! DSU or SSU
• Who buy financial claims ?! DSU SSU
• Is the financial claims assets or liability ?!
Financial Claims

• Day 1

CBB Bank
(DSU) (SSU)

• At Maturity

CBB Bank
 Financial Claims Features
Also know as “IOU” , Financial instruments or
Securities :
•Promise to pay in the future.
•Not a real asset !
•Involve two parties.
•Negotiable.
•Which of the following considered as FCs ? : Stocks ,
Bonds , House, Money ,Commodity ( Oil , Sugar , copper
…etc )
 What is Financial Market ?

Financial Markets : It’s a market where Sellers &

Buyers trades Financial claims (Bonds,
stocks ..etc) .

Example :
What is Financial Institutions ?
Financial institutions : Facilitate the flow of
funds (money) from SSU to DSU.

Examples :
Marketability
• The ease that financial claims can resold .

High marketability >> easy / hard to sell

Low marketability >> easy / hard to sell

 Direct Financing
Direct financing : Where the SSU & DSU
exchange money and financial claims using
Direct claims.

•Direct Financing can be made through :

– Private Placement.
– Dealers & Broker.
– Investment Bank (underwriting).
 Direct Financing

1.Private Placement : DSU sells whole security

issue to one investor or investor group.

DSU SSU

FC Preference
Amount : 30M
Maturity : 5 years
Currency : BD
 Direct Financing
2. Brokers & Dealers: Bring SSU & DSU
together .
Brokers :

CBB Broker Investors

Dealers : Dealer
CBB Investors
Direct Financing
3.Investment Bank : Buy entire issues of
securities from DSUs then find SSUs to buy
securities at higher price , Investment bank
profit from difference -“underwriting spread”
.

Investment
CBB Investor
Bank

FC Preference :
Amount : 30M
Maturity : 5 years
Currency : BD
Direct Financing
• Advantages :Speed & low cost of the
transaction as its one big transaction.

• Disadvantages:
• The amount of the direct financial claims is
very large.
• SSU & DSU should have the same
preference of maturity , risk , return &
liquidity.
Indirect Financing
The main deference between direct &
indirect financing is :
•Financial Intermediaries

Commercial Investor
CBB
Bank

FC Preference : FC Preference :
Denomination: 30 M Denomination: Flexible
Maturity : 5 years Maturity : Flexible
Currency : BD Currency : Flexible
Risk : lower risk
Liquidity : Higher
Financial intermediation
The financial intermediaries purchase direct
financial claims from DSU and transform
them into indirect claims with different set of
features.
 Services Provided by Financial Intermediary

Case 1 : BISB bought bond issued by CBB worth 10

million which mature after 5 years. Then BISB issue
new bonds and sell it to customers.
What shall we call the bond issued by CBB ?!
What shall we call the bond issued by BISB?!

CBB BISB Investor

 Services Provided by Financial Intermediary

Reem would like to buy bond from BISB worth 1M . Is she eligible to
do that?!
Nada would like to buy bond from BISB in U$ . Is she eligible to do
that?!
Fatima would like to buy a bond mature in 2 years Is she eligible to
do that?!
Jassim would like to take a loan for 3 years. Is he eligible to do
that?!

CBB BISB Customers

 Services Provided by Financial Intermediary

What if the Indirect financial claims defaulted ?!

What if the Direct financial claims defaulted ?!

What if one or more customer defaulted ?!

CBB BISB Customers

Services Provided by Financial Intermediary

1. Denomination (Amount).
2. Currency transfer.
3. Maturity (Time).
4. Credit Risk.
5. Liquidity.

DSUs Financial
SSUs
Intermediary
4 Major types of financial intermediaries*
transform claims to meet various needs
1. Deposit-type or “Depository” Institutions.
2. Contractual Savings Institutions.
3. Investment Funds
4. “Other” Institutions

*Note : All of the above provide indirect financing services.

4 Major types of financial intermediaries
transform claims to meet various needs

1.Deposit-type or “Depository” Institutions :

– Accept deposit (cash from customers).
– holds and facilitates the exchange of money.

Examples :
 Deposit-Type Institutions
1. Commercial bank ( Example :
)
- Obtain deposits in all denominations.
- Largest & Most diversified intermediaries.
- Provide loans in all amount to consumers, business &
governments

BISB
Investors Borrowers
 Deposit-Type Institutions
2. Thrift Institutions
- Obtain fund by issuing checking account , saving
accounts ( short-term).
-They use these funds to purchase real estate loans
(long term mortgages).
-Largest provider of mortgage loans..

Thrift Institution
SSUs DSUs
 Deposit-Type Institutions
3.Credit Unions
- Small non-profit organization.
- Owned & Managed by member.
- Member have to pay share of the capital called “
Common Bond”.
- Their investment are mainly in short-term loans.
- Exemption from Tax because of their cooperative
nature.
2.Contractual Savings Institutions

• They obtain funds under long term

contractual arrangements and Invest the
funds in capital market.
– SSU will pay installment to DSU on frequent
basis.
2.Contractual Savings Institutions

1. Life insurance company

•Obtain fund by selling insurance policies
that protect against loss of income from
death or retirement.
•Inflow is _______& outflow __________
•Invest in ________________.

Customer Takaful
2.Contractual Savings Institutions

2. Casualty Insurance Companies :

•Obtain fund by selling insurance policies
that protect against loss of property (home)
caused by almost anything.
•Inflow is _______ & outflow is __________.
•Invest in short-term asset & municipal
bonds
AON Customer
2.Contractual Savings Institutions

3.Pension Fund (retirement fund) :

- Obtain fund from employees & employers.
-Provide monthly payment.
-Inflow & Outflow is______.
-Invest in ________.investment.

Employees Retirement
Fund
3.Investment Funds
• Sell shares to investors and use these fund
to purchase direct financial claims
 3.Investment Funds

1. Mutual funds :
– Obtain funds by selling their own shares and
invest in stock & bonds.
– Help small investors to reduce risk through
diversification.
– Value of shares equal the value of their
investment

Investors Mutual
Fund
3.Investment Funds
2. Money Market Mutual Funds
•Like the mutual fund , the main difference is
that the MMMF invest in money market
( short-term investment ).
Financial Markets are classified in several ways.

Maybe you should go to the Black Market !

Financial Markets are classified in several ways.

1. Primary and Secondary.

2. Organized and Over-the-Counter (OTC).
3. Spot and Futures.
4. Options.
5. Foreign Exchange.
6. International and Domestic.
7. Money Market & Capital Market.
 1.Primary and Secondary
• Primary: issue of financial claims for the
first time.
• Secondary: are where financial claims
resold and reprised.

Corporation Investors Investors

 1.Primary and Secondary
Reem bought 10,000 shares from Vodafone IPO* in
Qatar, after listing the company in Doha Exchange,
Reem sell 5,000 shares.
The first transaction called ________, while the second
called ______.

After three years Vodafone decided to increase their

capital by selling shares ,this transaction illustrate
_________.

*IPO : Initial Public Offering.

 2. Organized & Over the Counter (OTC)

Mary ask her husband Sam to buy some

tomatoes!
Sam don’t have any idea about vegetables
prices!
Option1 : Local Grocery Option 2 : Vegetables market

Prices per kilo

Local tomato 0.200 BD
Imported tomato 0.300 BD
2. Organized & Over the Counter (OTC)

• Organized (Centralized)
– Trading from the regular financial market.
– Prices are disclosed on screens & trading
boards
– Central Trading Place (physical location) .
– Mostly for trading listed securities.
– No direct interact between buyer & seller
(identity is irrelevant).
 2. Organized & Over the Counter (OTC)

• Over the Counter (OTC) :

– Price not disclosed.
– Mostly for trading unlisted securities.
– No Central Trading Place.
– Direct contact between buyer and seller.
– Customized terms and conditions.
– Might be done through brokers and dealers.
– Less liquidity.
– Higher risk compared to organized market.
 2. Organized & Over the Counter (OTC)

Andy’s bought a small supermarket in his area,

this transaction illustrate _______.

Berkshire announces that it will by 5% from whole

mart, this transaction illustrate _______.

Mona bought a nice flat in Seef district from a real-

estate developer, this transaction illustrate _______.
3. Spot and Futures
• Spot market : ( Buy now – deliver now )

Investors Investors

• Future or forward market :immediate

pricing, promise of future delivery.

China Gov. Bapco

Futures and Forward
Farmer Juice Factory
“I will sell you 1 ton of
orange for 1000 $ after 3
Months”

What if the market price at maturity jump to $1500 ?

What if the market price at maturity dropped to $800 ?
 Futures and Forward
PepsiCo. made a forward contract for 20 years with
sugar factory in Brazil to buy ton of sugar for $350.
What is PepsiCo trying to do ?!
•Assure that it can afford the raw material for
reasonable prices >> commodity price risk.
•Try to hedge against currency risk.
Futures and Forward
Futures Forward

Listed on exchange ( Centralized ) OTC (Decentralized)

Term & conditions are Terms & conditions are

Standardized Customized
Identity is irrelevant Identity is relevant

Less costly More costly

No counterparty risk Counterparty risk

4.Option
• Option Market : Rights in underlying
securities or commodities—writer grants
owner some exclusive right for some
certain time.
o Buyer of
a. Call option : Right to buy
b. Put option : Right to sell
o Seller of
a. Call option : Must sell
b. Put option : Must Buy
Option
Hasan buy a call option from khalid stated that he
can buy apple stock at 90$ after 2 months . The call
option cost Hasan 2$. After 2 months the stock
jump to 100$ shall Hasan exercise the option ?!
What if the stock price dropped to 80 shall he
exercise the option ?

Day 0 Day 60
5.Foreign Exchange Markets
• Any currency is convertible to any other at
some exchange rate .
 6.International & Domestic Markets

• According to where they are located.

• International.
• Local.
John is a US citizen, form his point of view the following
market :
- Dubai Financial Market
- Bahrain stock exchange
- NYSE (New York stock exchange)
- LSE (London Stock Exchange)
6.International & Domestic Markets

• Eurodollars—US dollars deposited

outside U.S.
• Eurobonds—bonds issued outside US but
denominated in $US
• Examples
– Reem deposit 5000$ in Kuwait Finance House.
– Qatar Central Bank issue bonds in $US.
– US. Federal Reserve issue bonds worth 5 billion
$US.
7.Money market & Capital Market*

• Money market : Short-term maturity.

• Capital market : long-term maturity.

* Money market & Capital market will be discussed in details in

chapter 7 & 8.
Risks of Financial Institutions
• Credit or default risk: risk that a
borrower may not pay as agreed.

• Interest rate risk: fluctuations in a

security's price or reinvestment income
caused by changes in market interest
rates.

• Liquidity risk: risk that a financial

institution may be unable to transfer their
financial claims ( or assets) into cash .
Risks of Financial Institutions
• Foreign exchange risk: effect of
exchange rate fluctuations on profit of
financial institution.

• Political risk: risk of government or

regulatory action harmful to interests of
financial. institution
Examples: Default , IR , Liquidity, FX &
Political
• An investor bought bond issued by
government of India.
• Kuwait government impose foreign
companies to hire local citizens .
• Investors during the financial crisis
couldn’t sell their real-estate.
• BISB lost 15 BD million because a big
borrower fail to pay his obligation.
Examples: Default , IR , Liquidity, FX &
Political
• During the financial crisis the return for
bonds & stocks dropped dramatically.
• UK government has increase tax by 25%.
• Nakeel company ask bond holder to delay
the payment time.
• In 2009, due to the financial crisis , the
supply of houses was much higher than
demand.
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