CHAPTER 1

Overview of Financial System

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Finance

 Finance is simply money management.

 Finance is the science of management of

money- how to get it, spend it or use it.

 CFO is a person who deals with financial

management. S/he is responsible for
financial decision in an organization.

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Areas of Finance
 Financial Management
 Financial Economics
 Investments
Security analysis
Portfolio theory
Market Analysis
Behavioral Finance
 Personal Finance
 Public Finance
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What is “Behavioral Finance”?

 Incorporates elements of cognitive psychology to better

understand how individuals and markets respond to
different situations.

 Example: “bubbles” perpetuate themselves. Your

friend tells you how much they are making in real
estate, so you get on board. You tell your friend, etc.
Price get bid up. At some point, everyone’s on board.
Bubble pops. Example: Holland’s tulip bulb bubble
400 years ago.

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Investments

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The Capital Allocation Process

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How is capital transferred between savers and
borrowers?
 Direct transfers ($ go directly from saver to borrower)
 Example:
 Your small business borrows money from a wealthy individual in exchange
for a part ownership

 Indirect transfer using investment banker

 Example:
 Investment banker Goldman Sachs helps a company with its initial public
offering (“IPO”) --- the company issues stock; the investors get the stock

 Indirect transfer using investment banker financial intermediary

 Example:
 Sallie Mae issues bonds to raise money to lend to students as home loans
-- the bond investors get bonds; the students receive individual loans

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Transfer of capital

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What is a market?

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How important are financial markets?

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Summary of Classification of
Financial Markets

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Financial Instruments and
Markets
 Primary Markets
 Market for issuing a new security and distributing to
saver-lenders.
 Investment Banks—Information and marketing
specialists for newly issued securities.
 Secondary Markets
 Market where existing securities can be exchanged
 New York Stock Exchange
 American Stock Exchange
 Over-the-counter (OTC) markets

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Stock Market Transactions

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What is an IPO?

 An initial public offering (IPO) is where a company issues

stock in the public market for the first time.

 “Going public” enables a company’s owners to raise capital

from a wide variety of outside investors. Once issued, the
stock trades in the secondary market.

 Public companies are subject to additional regulations and

reporting requirements.

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Stock Represents Ownership

 Stockholders
 Owns part of the corporation and receives
dividends from the issuer.
 Capital Gains
 Difference between price initially paid and amount
received when stock is sold.

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Types of Corporate Stock

 Preferred Stock
 Fixed dividends, priority over common stock
 Common Stock
 Variable dividends, based on company’s profits.
 Convertible
 Preferred stock that can be converted into
common stock at a stated price

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Common stock

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Preferred Stock

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Measures of Trends in Common
Stock Prices
 Standard & Poor’s 500 Stock Index
 Based on prices of 500 individual stocks
 NASDAQ Composite Index
 Based on all stocks listed in NASDAQ
 Dow Jones Industrial Average
 Based on price of 30 “blue-chip” stocks

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S&P 500 Index, Total Returns: Dividend Yield +
Capital Gain or Loss, 1968-2007
What was the total return for 2008? - 57% 
What was the total return for 2009? + 26% 

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Where can you find a stock quote, and what does
one look like?
 Stock quotes can be found in a variety of print sources (Wall
Street Journal or the local newspaper) and online sources
(Yahoo!Finance, CNNMoney, or MSN MoneyCentral).
 This one is from finance.yahoo.com

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What is “Market Efficiency”?

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What is “Market Efficiency”? (continued)

Another implication of market efficiency:

 A small investor has been reading about a “hot” IPO that is scheduled to
go public later this week. She wants to buy as many shares as she can get
her hands on, and is planning on buying a lot of shares the first day once
the stock begins trading. Would you advise her to do this?
 Probably not. The long-run track record of hot IPOs is not that great,
unless you are able to get in on the ground floor and receive an
allocation of shares before the stock begins trading. It is usually hard
for small investors to receive shares of hot IPOs before the stock
begins trading.
 The “hot” IPOs usually go to big institutional traders (hedge fund
managers, investment banks, and mutual fund managers).

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What is the Efficient Market Hypothesis
(EMH)?
 Securities are normally in equilibrium and are “fairly priced.”
 Investors cannot “beat the market” except through good luck or
better information.
 Efficiency continuum

Highly Highly
Inefficient Efficient

Small companies not Large companies followed

followed by many analysts. by many analysts. Good
Not much contact with communications with
investors. investors.

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Bonds Represent Borrowing
 Agreement by issuer to pay interest on specified
dates and redeem the bond upon maturity.
 Consol
 Bond with no maturity date, pay interest forever
 Coupon Securities
 Make interest payments – usually semiannually.
 Zero-coupon
 Make no interest payments.
 Sold at price well below face value.
 Tax Exempt
 Interest earned is not taxed.

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Bond

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 Both stocks and bonds represent a claim
to a stream of payments in the future.
 Bonds—Interest payment and face value at
maturity
 Stocks—Dividends and sales price when sold

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Mortgages
 Debt incurred in order to buy land or building
 Amortized—principal and interest is gradually
repaid over the life of loan
 Fixed Rate—Rate of interest is fixed
 Variable-Rate—Rate of interest varies
depending on financial environment
 Cash flow for lender is uncertain
 Interest payments may vary - variable rate mortgages
 Home owner may prepay
 Refinance a fixed mortgage if interest rates decline

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Mortgages

 Securitization—Individual mortgages may

be “pooled” and sold as a unit to reduce
uncertainty.
 Mortgages may be insured by government
agencies
 Federal Housing Authority (FHA)
 Veterans Administration (VA)

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What are derivatives?
How can they be used to reduce or increase risk?

 A derivative security’s value is “derived” from the price of another

security (e.g., options and futures).

 Can be used to “hedge” or reduce risk. For example, an importer, whose

profit falls when the dollar loses value, could purchase currency futures
that do well when the dollar weakens.

 Also, speculators can use derivatives to bet on the direction of future

stock prices, interest rates, exchange rates, and commodity prices. In
many cases, these transactions produce high returns if you guess right, but
large losses if you guess wrong. Here, derivatives can increase risk.

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Options and Futures Contracts
 Contractual agreement between two parties to
exchange an asset in the future at a stated price
 Derivative financial instruments
 Derive value from underlying assets
 Long
 Buyer of the contract, receive commodity in the future
 Short
 Seller of the contract, provide commodity in the future
 Speculators
 Gamble on price fluctuations and hope to profit
 Hedgers
 Eliminate the risk of price fluctuations
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The Money Market
 Exchange of short-term instruments—less than one
year
 Highly liquid, minimal risk
 Use of a temporary surplus of funds by banks or
businesses
 U.S. Treasury bills—short-term debts of US government
 Bank Certificates of Deposits—liabilities of issuing bank,
interest bearing to corporations that hold them
 Commercial paper—short-term liabilities of prime business firms
and finance companies
 Federal Funds—Exchange of excess/deficient reserves between
banks on an overnight basis.

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Pakistani MM T-Bills

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The Capital Market
 Exchange of long-term securities—in excess
of one year
 Generally used to secure long-term financing for
capital investment
 Stock market—Largest part of capital market and
held by private and institutional investors
 Corporate bond market—Held by insurance
companies, pension and retirement funds
 Local and state government bonds—Primarily held
for tax-exempt feature
 Government securities—Held by commercial banks,
the Fed, individual Americans/foreigners, and dealers

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Role of Financial Intermediaries

 Act as agents in transferring funds from savers-

lenders to borrowers-spenders.
 Acquire funds by issuing their liabilities to public
and use money to purchase financial assets
 Earn profits on difference between interest paid and
earned
 Diversify portfolios and minimize risk
 Lower transaction costs
 Competition lowers interest rates—beneficial to
economic growth

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Types of financial Institutions

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Types of financial Institutions
 Deposit-taking institutions that accept and manage
deposits and make loans, including banks, building
societies, credit unions, trust companies, and mortgage
loan companies.

 Non-depository Institutions are financial intermediaries

that do not accept deposits but do pool the payments of
many people in the form of premiums or contributions
and either invest it or provide credit to others.
Insurance companies and pension funds;
Brokers, underwriters and investment funds.

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Types of financial institutions
 Commercial banks
 Investment banks
 Financial services corporations
 Credit unions
 Pension funds
 Life insurance companies
 Mutual funds
 Hedge funds
 Private equity companies

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Commercial Banks
 Most prominent financial institution
 Range in size from huge (BankAmerica) to small (local
banks)
 Major sources of funds
 used to be demand deposits of public
 now rely more on “other liabilities”
 also accept savings and time deposits
 Uses of funds
 short-term government securities
 long-term business loans
 home mortgages

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Commercial Banks in Pakistan
 Commercial banks
 Allied Bank Limited Allied Bank of Pakistan
 Bank Alfalah Limited
 Habib Bank Limited
 Bank Al-Habib Limited
 Standard Chartered Bank Limited
 City Bank Limited
 United Bank Limited
 Askari Bank Limited.
 MCB Bank Limited.

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Investment Banks
 In the primary market, investment banks assist a
business in selling a new issue to the public.
 Investment banks underwrite new securities,
meaning that they buy the new issue from the
business and sell it to the public.
 Investment banks charge fees for this service,
along with any profits from reselling the issue at a
higher price.
 Underwriting is big business. The largest
underwriters of new equity securities include Merril
Lynch, Salomon Smith Barney, and Goldman
Sachs.
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Investment banks in Pakistan

 BMA Capital Management Limited

 Invest Capital Investment Bank Limited
 IGI Investment Bank Limited
 AMZ Securities
 Orix Leasing (Pakistan) Limited
 Trust Investment Bank Limited
 Arif Habib Investment and Mutual Funds Co.

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Life Insurance Companies

 Insure against death

 Receive funds in form of premiums
 Use of funds is based on mortality statistics—
predict when funds will be needed
 Invest in long-term securities—high yield
 Long-term corporate bonds
 Long-term commercial mortgages

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 Pension and Retirement Funds
(Superannuation Funds)
 Concerned with long run
 Receive funds from working
individuals building “nest-egg”
 Accurate prediction of future use of
funds
 Invest mainly in long-term corporate
bonds and high-grade stock

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Mutual Funds

 Stock or bond market related

institutions
 Pool funds from many people

 Invest in wide variety of securities—

minimize risk

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Money Market Mutual Funds

 Individuals purchase shares in the fund

 Fund invests in highly liquid short-term
money market instruments
 Large-size negotiable CD’s
 Treasury bills
 High-grade commercial paper

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Savings and Loan Associations
(S&L’s)
 Traditionally acquired funds through savings
deposits
 Used funds to make home mortgage loans
 Now perform same functions as commercial
banks
 issue checking accounts
 make consumer and business loans

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Commercial and Consumer Finance
Companies
 Acquire funds primarily by selling short term
loans (commercial paper)
 Lend money for consumer purchases or
business firms to finance inventories

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Property and Casualty Insurance
Companies
 Insure homeowners and businesses against
losses
 Receive premiums
 Need to be fairly liquid due to uncertainty of
claims
 Purchase a variety of securities
 high-grade stocks and bonds
 short-term money market instruments for liquidity

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Credit Unions

 Organized as cooperatives for people with

common interest
 Members buy shares [deposits] and can
borrow
 Changes in the law in 1980 broadened their
powers
 checking [share] accounts
 make long-term mortgage loans

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 Hedge funds
 Hedge funds—financial institutions that pool funds from a limited number
(e.g., less than 100) of wealthy (e.g., annual incomes of more than
$200,000 or net worth exceeding $1 million) individuals and other investors
(e.g., commercial banks) and invest these funds on their behalf, usually
keeping a large proportion (commonly 20 percent) of any upside return and
charging a fee (2%) on the amount invested.
 Unregulated ( with few regulations. They can do whatever they want
 Hedge funds managers are smarter
 Exotic instrument = having special feature/common
 Very rare instrument
 High risk
 High return

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Private Equity firms

Venture capital and private equity firms, which

pool money from individual investors and other
FIs (e.g., insurance companies) to fund
relatively small and new businesses (e.g.,
biotechnology).

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The End

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