Chapter 2:

Financial Environment

1
 Financial System

Financial System

Financial Financial Financial Financial

Institutions Markets Instruments Services

Intermediaries Primary Secondary Primary Secondary

Banking Non-Banking
Capital Money Long Medium Short
Market Market Term Term Term
2
 Securities
• Are documents that represent the right to receive
funds in the future.
• The person or organization that holds a security is
called a bearer.
• A security certifies that the bearer has a claim to
future funds.
• Maturity date
• Interest rate

3
 Financial Instruments
• Equity
– Ownership interest in an asset
– Residual claim on earnings and assets
• Dividend
• Liquidation
– Types
• Ordinary share
• Preference shares

12/06/23 4
 Financial Instruments
• Debt
– Contractual claim
• Periodic interest payments
• Repayment of principal
– Non-government debt instruments
• Debentures, unsecured notes, mortgage loans
– Government debt instruments
• Treasury Bonds, treasury notes
– Secured or unsecured
– Negotiable & Non-negotiable Debt instruments

12/06/23 5
 Financial Institutions & Markets
• Firms that require funds from external sources
can obtain them in three ways:
– through a bank or other financial institution
– through financial markets
– through private placements

1-6
Financial Institutions & Markets: Financial
Institutions
• Financial institutions are intermediaries that channel
the savings of individuals, businesses, and
governments into loans or investments.
• The key suppliers and demanders of funds are
individuals, businesses, and governments.
• In general, individuals are net suppliers of funds,
while businesses and governments are net
demanders of funds.

1-7
Financial Institutions and Markets: An Overview
Financial Markets
Flow of funds for financial institutions and market

Funds Funds
Deposits/Shares Financial Loans
Institutions

Securities
Funds

Suppliers of Funds Demanders of

Private
Funds Funds
Placement
Securities

Funds Funds
Financial
Markets
Securities Securities
 Financial Intermediaries
• Acts as grease that enables the machinery of
the financial system to work smoothly.
• Specialize in certain services that would be
difficult for individual participants to perform,
such as matching buyers and sellers of
securities.
• Investment banks, brokers, dealers.

9
 Investment Banks
• Exists to help business and state and local
government sell their securities to the public.
• Arrange securities sales on either an underwriting
basis or a best efforts basis.
• Underwriting
– A process by which a investment banker purchases all
the new securities from the issuing company then resell
them to the public.
• Best efforts
– The bank will try its best to sell the securities for the
desired price, but there are no guarantees.

10
 Brokers
• Often account representatives for an investment
banking firm-handle orders to buy or sell securities.
• Agents work on behalf of an investor
• When investor call with an order, brokers work on
their behalf to find someone to take the other side of
the proposed trade.
• Brokers are compensated for their services

11
 Dealers
• “Dealers” keep an inventory of the stock (or other financial
asset) and place bid and ask “advertisements,” which are prices
at which they are willing to buy and sell.
• Computerized quotation system keeps track of bid and ask
prices,but does not automatically match buyers and sellers.
• Bid Price
– Dealers make money by buying securities for one price
• Offer Price (Ask Price)
– Selling them for a higher
• Dealer’s Fee
– The difference between the bid price and the ask price

12
 Financial Institutions
• Institutions that perform the essential function of
channeling funds from those with surplus funds to
those with shortages of funds
• Business organizations that act as mobiliser and
depositor of savings and purveyors of credit.
• Example: banks, thrifts, insurance companies,
securities firms and investment banks, finance
companies, mutual funds, pension funds

13
 Financial Institutions
• Financial institutes are different form non-
financial institutions.
• Financial institutions deal in financial assets
i.e. deposits, loans, securities & etc.
• Non-financial institutions deal in real assets
i.e. machinery, stocks of goods, real estate, etc.

14
 Types of Financial Institutions
• Commercial banks
– depository institutions whose major assets are
loans and major liabilities are deposits
• Thrifts
– depository institutions in the form of savings and
loans, credit unions
• Insurance companies
– financial institutions that protect individuals and
corporations from adverse events. State life,
Adamjee Insurance

15
 Types of Financial Institutions
• Securities firms and investment banks
– financial institutions that underwrite securities and
engage in securities brokerage and trading. IGI
investment bank, JS bank
• Finance companies
– financial institutions that make loans to individuals
and businesses. HBFCL,ORIX Leasing company
• Mutual Funds
– financial institutions that pool financial resources and
invest in diversified portfolios i.e. Mutual fund
association of Pakistan, NIT
• Pension Funds
– financial institutions that offer savings plans for
retirement. i.e. Mutual fund association of Pakistan

16
 What is a market?
• A market is a venue where goods and services
are exchanged.
• A financial market is a mechanism that allow
individuals and organizations to buy and sell
financial securities.

17
 Financial Markets

• Financial Market: a market in which financial assets

(securities) such as stocks and bonds can be purchased or
sold
• They are the cornerstones of the overall financial system in
which financial managers operate
• Financial markets provide for financial intermediation--
financial savings (Surplus Units) to investment (Deficit Units)
• Financial markets provide payments system
• Financial markets provide means to manage risk

18
 Financial Markets

19
 Financial Markets
• Primary versus Secondary markets
• Money Markets versus Capital
Markets
• Foreign Exchange Markets
• Stock market

20
 Primary versus Secondary markets

• Primary Market
– When a security is created and sold for the first
time in the financial market place
• Secondary Markets
– A market where previously issued securities are
traded

21
 Primary and secondary market
transactions
• Primary market transaction
– The issue of a new financial instrument to raise
funds to purchase goods, services or assets by
• Businesses
– Company shares or debentures
• Governments
– Treasury notes or bonds
• Individuals
– Mortgage
 Primary Markets
• Example: when a corporation issue new shares
to raise money for an investment project.

Suppliers of Give Rs. Users of Funds

Funds
(Deficit Unit)
(Surplus Unit)

Issue new Financial

Instruments
23
 Primary and secondary market
transactions (cont.)
• Secondary market transaction
– The buying and selling of existing financial
instruments
• No direct impact on original issuer of security
• Transfer of ownership from one saver to another saver
• Provides liquidity which facilitates restructuring of
portfolios of security owners
– Secondary markets provide a centralized
marketplace where economic agents know they
can transact quickly and efficiently.
 Secondary Markets

Surplus Entity 1
Sell
Holders of Marketable
previously issued Instruments
financial Surplus Entity 2
instruments

Surplus Entity 3

Receive $
25
 The Money Market
A financial relationship created between
suppliers and demanders of short-term
funds, which have maturities of one year or
less

Certain individuals, businesses, Other individuals, businesses,

governments, and financial institution Money government, and financial
Market
have temporary idle funds that they institution find themselves in
exists
wish to place in some type of liquid need of seasonal or
asset or short-term, interest earning temporary financing
instrument
Most money market transactions are made
in marketable securities

Short-term debt instruments, such as US

Treasury Bill, Commercial Papers, and
Negotiable Certificate of Deposits issued by
government, business, and financial
institution

Operates both as primary markets &

secondary markets
 The Capital Market
A financial relationship created by
institutions and arrangements that allows
suppliers and demanders of long-term
funds- funds with maturiry of more than Bond
one year- to make transactions. Long-term debt instrument used by business
and governments to raise large sums of
The backbone of the capital market is money
formed by the various securities exchange
that provide a forum for debt and equity Common stock
transaction
Units of ownership interest, or equity. In a
corporation
Key Securities
Common stockholders expect to earn a return
by receiving Dividend

Periodic distribution of earnings to the owners

of stock in a firm

Preferred stock
A special form of ownership having a fixed
periodic dividend that must be paid prior
to payment of any common stock dividends
 Capital Market
• Markets in which longer-term securities are issued
and traded
– Equity markets
– Corporate debt markets
– Government debt markets
– Foreign exchange markets
– Derivatives markets
• Term to maturity of more than one year
• Major suppliers are corporations & Government

28
 Capital Market
• Capital market Instruments
– Corporate Stocks
– Residential Mortgages
– Corporate Bonds
– Treasury Securities
– Government Bonds
– Bank & consumer loans
• These instruments experience wide price fluctuations
in the Secondary Markets

29
 Foreign Exchange Market
• “FX” markets deal in trading one currency for another
(e.g. dollar for yen) at current exchange rate.
• Foreign currency exchange rate are flexible.
• They vary day to day with the demand & supply of foreign
currency.
• “spot” FX transaction involves the immediate exchange of
currencies at the current exchange rate
• “forward” FX transaction involves the exchange of
currencies at a specified date in the future and at a specified
exchange rate. Typically for one two or three months

30
 Stock Market
• A market in which shares of stock are bought
and sold.
• An organized way for
– 1) people to buy and sell stocks and
– 2) corporations to raise money.
• A stock market can be an actual place, but with
the growth of electronic transactions a large
fraction of stock market transactions are not
centrally located in a particular location.

31
 Stock Exchange
• It is an organized and regulated security market .
• Only listed securities (stocks) are traded.
• Helps to mobilize financial resources.
• Trends of stock market reflect the true picture of
economic condition of a country.
• Exchanges are the physical locations where stocks are
bought and sold.
• The Securities and Exchange Commission (SEC)
regulates stock trading and exchanges
• Stock markets allow suppliers of funds to efficiently and
cheaply get equity funds
32
 Stock Market
• In exchange, the fund users (firms) give the fund
suppliers ownership rights in the firm as well as cash
flows in form of dividends
• The stock market is driven by supply & demand
• The number of shares of stock dictates the supply
• The number of shares that investors want to buy dictates
the demand
• The main players in the stock market are the exchanges
• Exchanges are where the sellers are matched with buyers
to both facilitate trading and to help set the price of the
shares

33
 Major Securities Exchanges:
Over-the-Counter Exchange
• The over-the-counter (OTC) market is an
intangible market for securities transactions.
• Unlike organized exchanges, the OTC is both a
primary market and a secondary market.
• The OTC is a computer-based market where dealers
make a market in selected securities and are linked to
buyers and sellers through the stock exchange
System.
• Dealers also make money on the “spread.”
 Over-the-Counter Market
• Not an organization, but an intangible market for the
purchase and sale of securities not listed by the
organized exchange
• No fixed location or it is every where
• Network of dealers around the world who maintain
inventories of securities for sale.
• Bid price
• Ask price
• Deals both in Primary and Secondary Market
transactions

35