Financial System and Markets

How is Value Created?

Learning from Economics: Learning from Finance:
Inputs produces output Efficient use of assets generate
surplus
Input Assets
 Labor  Human
 Raw materials  Physical
 Knowledge  Intangible
 Capital  Capital

Output: Output:
 Product & Services  Return on capital invested
 Cost price is less than sell should be more than cost of
price capital

Financial Institution and Markets Deals

with Capital
Understanding Financial Markets…

funds
Surplus Business Deficit Business
Unit (SBU) Unit (DBU)
(Households, (Government,
Corporate)
claim Corporate)

Create Assets for DBU Creates Liabilities for DBU

Claims of SBU can be debt claims or equity claims

Assets Liabilities
FUNDS CLAIMS
or
DEBT or borrowed capital
or
EQUITY or owners capital

Total Assets = Total Liabilities

Players in Financial Systems…
 Financial system channels surplus savings from savers to borrowers and
facilitates creation of real assets in the

Direct Finance: Borrower

DIRECT FINANCE gets fund directly from the
Financial market lenders in the financial
markets, by selling them
securities (also called
financial instruments). These
are assets who buys them
and liabilities to those who
sell (issue) them

SAVERS BORROWERS
Households INDIRECT FINANCE Government/PSU
Private Corporate Financial Private Corporate
Govt/ PSU Institutions & Households
Financial market

Indirect Finance: Intermediary borrows funds from the savers and then
using this fund makes loans to the borrower spenders

Intermediaries Facilitates the Channelization…

 Players in Financial Systems…
Funds Financial Institution
• Commercial Banks
Deposits/Shares • Insurance Companies
Funds • Mutual Funds
• Provident Funds
• Non Banking
Financial Companies

Supplier Of Funds Purchaser of Funds

• Individual Private
• Individual
• Business Placement
• Business
• Government • Government

Funds Financial Markets Funds

• Money Market
• Capital Market
Role of Intermediaries: Problem of Lemons
 How would you buy a old car
 Go to market where there are many old cars
 You do not know which is good old car
 Owner of the old cars know their conditions more than you would know
 How would quote a price for the old car?
 Suppose the good cars can sell at a min. price of 100k
 Bad cars at a min price of 40 k.
 Since you do not know you would be cautious and quote something in
between
 If you quote something in between what will happen?
 No good car seller will be present in the market
 One will be left with bad cars in the market, and these are call “Lemons”
 A buyer buying a bad car at 70k will feel cheated and in
future will be not come back to market
 This will result in break-down of the market
Problem of Lemons in Financial Market

 The borrower has more information about his ability or wiliness to

pay back the lender (net savers)
 Lender will not able to distinguish between good and bad
borrower
 Therefore, the lender will charge average rate of interest to
the borrower.
 Asymmetric information problem which is there before the
transaction occurs leads to adverse selection
 Potential bad credit risks are the ones who most actively seek out
loans
 Fear of ‘adverse selection’ prevents savers from lending, even
though there may be credit-worthy borrowers out there
 Markets break down
Problem of Lemons: Role of Intermediary
 What is the solution to problem of lemon ?
 In case of old car market get an expert who knows how
to distinguish between good old car from bad old car.
 The expert charges a fee to give you advise
 Once the expert exists the buyer will able to buy a good
car
 The seller will get the fair price
 The market will exist
 In case of financial markets the experts are called
intermediary.
 Examples of intermediary
 Credit rating agencies, which rates investable instruments so that
investor can distinguish between good investment instruments from bad
investment instruments
 Banks, which is able to identify a good borrower from a bad borrower
 Mutual funds, which is able to identify good investment opportunities
Role of Intermediaries: Basic Functions
1. Denomination Intermediation
 Small amount of savings from individuals and others are pooled so as to
give loans of varying size
2. Default Risk intermediation
 Willingness to give loans to risky borrowers without hurting the returns to
savers
3. Maturity intermediation
 Ability to create loans whose maturities may mismatch with the deposit
maturity profile
4. Liquidity intermediation
 Claims from savers that are highly liquid while loans to borrowers are
relatively less liquid
5. Information intermediation
 Ability to gather and process information from the financial marketplace far
more effectively than the individual saver
6. Currency intermediation
 Ability to lend cross-currency
 Role of Intermediaries …
 Financial Intermediaries through financial
markets and instruments coordinate between
borrower and lender and thereby help allocate
the economy’s scarce resources efficiently.
 Price discovery-process - is governed by the
forces of supply and demand of funds.
What is an Asset?
 An asset is any possession that has value when sold, exchanged, or
used

Real Assets vis-à-vis Financial Assets?

 A real assets that has productive capacities,
 Land, labor, knowledge
 Factories
 Processes

 A financial asset is claims to income generated from real assets

 Stocks
 Bonds

Financial Institution and Markets Deals

with Financial Assets
Understanding Financial Asset?
 Any financial assets has two counterparties
 The issuer: The party which has agreed to make the payment
 The subscriber or investor: The owner of the financial asset

 The financial claims can be of two broad types

 The claim that is certain or known
 Debt instrument
 The claim that is uncertain and not known
 Equity instrument

 Price of the financial assets depends on counterparties involved and

types of financial claims

 Financial assets is risky

 Counter party risk: Default risk
 Risk associated with future value of claims: Inflation risk
 Risk associated with change in benchmark return: Interest rate risk
 Risk associated with currency: Foreign exchange risk

Pricing of Financial Assets is Complex

Where would One Find Financial Assets?
In Financial Markets…

What are the Functions of Financial Market?

 It enables price discovery of financial assets

 It provides liquidity to investors

 It reduces search costs

 It reduces information costs

 It reduces transaction costs: Both implicit and explicit costs

How can We Classify Financial Markets

 What are the types of financial claim?

 Certain
 Uncertain
 Maturity of instruments that carries financial claim
 Short-term
 Long-term
 Seasoning of the financial claims
 Primary market
 Secondary market
 Private deals
 Time of the delivery of instrument
 Cash or spot market
 Future market
How is Financial Assets Created: An
Example?
 Ram inherited Rs.10crs, and do not intent to use it. He is interested
in investing it in anticipation of future cash-flows
 Vimal sold his house and received Rs.2crs, and looking to invest in
other assets in anticipation of future cash-flows
 Raj wanted to start a factory, that need Rs.5crs, and he only has
Rs.1cr in his bank account
 Pritam is friend of Ram, Vimal and Raj
 Raj shared his business idea with Pritam, and wanted his help in
arranging for funds to start the business.

 Pritam convinced Ram to invest Rs.3crs in Raj’s business for a 30%

stake, and convinced Vimal to lend Rs.1cr to Raj at 15% rate of
interest for 5 years.

 Pritam created an equity instrument, and a debt instrument…

Pritam is the Intermediary…

Understanding Interest Rate
Introduction
 Most of us would have either paid and/or received
interest if…
 We have taken loans and have paid interest to the
lender.
 Student loan
 Auto loan
 Personal loan
 Mortgage loan
 We have invested have received interest from the
borrower.
 Saving account deposits
 Fixed deposits
 Infrastructure bonds
 Bonds Debentures of companies
Introduction (Cont…)
 What is interest?
 Compensation paid by the borrower of capital to the
lender
 Rent paid by the borrower of capital to the lender. The rent is
for permitting the borrower to use funds of lender
 How is interest rate determined?
 Depends on the market for capital
 In a free market it is determined by demand and supply of
capital
 In a controlled market, regulator can specify the interest rate
 In a regulated market, market can determine the interest rate
but regulator can intervene if it fills that market is not
functioning optimally
Real vis-à-vis Nominal Interest Rate…
 What is real interest rate?
 Compensation paid by the borrower of capital to the
lender when lender has zero risk and inflation rate is
zero
 Loans to government when there is no inflation
 What are the implication of no inflation?
 If one lends Rs. 100 at 10% for a year
 Assuming that the Rs. 100 can buy 100 mangoes
 Next year the Rs. 110 can buy 110 mangoes
 If there is positive inflation then next year Rs. 110 will able to
buy less that 110 mangoes
 This implies that in case of inflation the real interest rate
would be less than 10%
Real vis-à-vis Nominal Interest Rate…
 Most people who invest do so by acquiring financial assets such as
 Shares of stock
 Shares of a mutual fund
 Or bonds/debentures
 deposits with commercial bank
 Financial assets give returns in terms of money without any assurance
about the investor’s ability to acquire goods and services at the time
of repayment
 Financial assets therefore give a NOMINAL or MONEY rate of return.
 In the example, the GOI gave a 10% return on an investment of Rs 100.
 Let us say inflation rate is 5%
 The # of mangoes that can be bought is 110/1.05 = 104.74
 The real rate of return is 4.76% which is different from 10% nominal
return
 The relationship between the nominal and real rates of return is
expressed in the FISHER hypothesis;
 “Nominal Return” = “Real Return” + Inflation Rate (Approximate)
Interest Rate and Uncertainty…
 In FISHER equation it is assumed that the rate of inflation is known
with certainty.
 In real life inflation is uncertain and is random
 In the case of random variables exact outcome is not known in
advance
 Agents would have expected value of inflation
 Which is a probability weighted average of the values that the

variable can take.

 Therefore in real life a default free security will not give an assured
real rate.
 It will give an assured nominal rate
 The real rate will depend on the actual rate of inflation

There
There is
is Uncertainty
Uncertainty (Risk)
(Risk) over
over the
the Real
Real Rate
Rate of
of Return
Return even
even ifif the
the Nominal
Nominal
Return
Return is
is Certain
Certain due
due to
to Uncertainty
Uncertainty over
over Inflation…
Inflation…
Uncertainty and Risk Aversion…
 Majority of investors are characterized by Risk Aversion.
 What is risk aversion?
 It does not mean that investor would not take risk
 It means that investor would expect higher return to take higher risk.
 Given a choice between two investments with the same expected rate
of return the investor will choose the less risky option
 In the case of existence of positive inflation
 The investor will not accept the expected inflation as compensation
 To tolerate the inflation risk the investor will demand a POSITIVE risk
premium
 Compensation over and above the expected rate of inflation
 Why?
 The actual inflation could be higher than anticipated resulting in
actual real rate lower than anticipated.
 The Fisher equation need to be modified to take into risk aversion nature
of the investor
 The Fisher equation may be restated as
 Nominal Return = Real Return + Expected Inflation + Risk Premium
 What Drives Interest Rate…
 From the discussion so far with zero default the interest rate would depends on
 The real rate
 The expected inflation
 The risk premium of the investor

When we relax the assumption of zero default risk the interest rate would depends
 Credit risk involved with the borrower, which would vary from individual to
individual
 The risk of non-payment of interest rate
 The risk of non-payment of principal
 Higher the risk of default higher would be expected interest rate

 Tenure of the investment

 Higher the tenure higher could be credit risk
 The lender would prefer to lend for short-term and borrower would prefer to borrow for
long-term for a given rate of interest rate
 Lender would demand higher interest rate to lend for long tenure
Nuances of Calculating Interest Income…
 Simple interest rate vis-à-vis compound interest rate
 When interest is calculated on interest income generated during
the previous period
 They will differ when the interest conversion period is different
from the measurement period
 What is interest conversion period?
 The unit of time over which interest is paid once and is reinvested to
earn additional interest is called interest conversion period
 What is measurement period?
 The unit on which the time is measured is called measurement
period
 The interest conversion period is typically less than or equal to the
measurement period.
 Nominal interest rate vis-à-vis effective interest rate
 The quoted interest rate per measurement period is called the
nominal interest rate
 The interest that a unit of currency invested at the beginning of a
measurement period would have earned by the end of the period
is called the effective rate
Calculative Effective Interest Rate…
The effective rate i can be calculated by using the formula when the
Nominal rate is r and m # of interest conversion periods per
measurement period.

Conversely the nominal rate r can be calculated if we know i and m

And N=1

Two
Two Nominal
Nominal Rates
Rates Compounded
Compounded at at Different
Different Intervals
Intervals are
are Equivalent
Equivalent ifif they
they
Yield
Yield the
the Same
Same Effective Rate …
Effective Rate
Using the Right Rate for Measurement…
 Effective rate is what one gets and nominal rate is what one sees
 Compounding yields greater benefits than simple interest
 The larger the value of N the greater is the impact of compounding. Thus,
the earlier one starts investing the greater are the returns.
 If the length of the interest conversion period is equal to the measurement
period
 The effective rate will be equal to the nominal rate
 If the interest conversion period is shorter than the measurement period
 The effective rate will be greater than the nominal rate
 If the interest conversion period is longer than the measurement period
 The effective rate will be lower than the nominal rate
 If we are comparing two alternative investment opportunity, first thing we need
to do is convert the rate of return into effective rate of return

Effective
Effective Rate
Rate is
is Appropriate
Appropriate Rate
Rate to
to Measure…
Measure…
Thank You