Chapter Two

The Role of Financial Markets

Chapter Outline
2.1
2.2
2.3
2.4
2.5

An Overview of Financial System.

The Financial Market.
The Financial Institutions.
The Financial Instruments.
The Real VS The Nominal Interest Rates.

2.1 An Overview of Financial System.

Figure 2.1 Financial Systems.

In finance, the financial system is the system that allows the transfer of money between savers (and
investors) and borrowers. A financial system can operate on a global, regional or firm specific level.
Gurusamy, writing in Financial Services and Systems has described it as comprising "a set of complex and
closely interconnected financial institutions, markets, instruments, services, practices, and transactions."
According to Franklin Allen and Douglas Gale in Comparing Financial Systems:
"Financial systems are crucial to the allocation of resources in a modern economy. They channel household
savings to the corporate sector and allocate investment funds among firms; they allow intertemporal
smoothing of consumption by households and expenditures by firms; and they enable households and firms
to share risks. These functions are common to the financial systems of most developed economies. Yet the
form of these financial systems varies widely."

Figure 2.2 The Financial System.

Financial System of Bangladesh

The financial system of Bangladesh is comprised of three broad fragmented sectors:
1.
2.
3.

Formal Sector,
Semi-Formal Sector,
Informal Sector.

The sectors have been categorized in accordance with their degree of regulation.
1.
2.

3.

The formal sector includes all regulated institutions like Banks, Non-Bank Financial Institutions (FIs),
Insurance Companies, Capital Market Intermediaries like Brokerage Houses, Merchant Banks etc.;
Micro Finance Institutions (MFIs).
The semi formal sector includes those institutions which are regulated otherwise but do not fall
under the jurisdiction of Central Bank, Insurance Authority, Securities and Exchange Commission or
any other enacted financial regulator. This sector is mainly represented by Specialized Financial
Institutions like House Building Finance Corporation (HBFC), Palli Karma Sahayak Foundation
(PKSF), Samabay Bank, Grameen Bank etc., Non Governmental Organizations (NGOs and discrete
government programs.
The informal sector includes private intermediaries which are completely unregulated.

The financial market in Bangladesh is mainly of following types:

1. Money Market: The primary money market is comprised of banks, FIs and primary dealers as
intermediaries and savings & lending instruments, treasury bills as instruments. There are currently 15
primary dealers (12 banks and 3 FIs) in Bangladesh. The only active secondary market is overnight call
money market which is participated by the scheduled banks and FIs. The money market in Bangladesh is
regulated by Bangladesh Bank (BB), the Central Bank of Bangladesh.

2. Capital market: The primary segment of capital market is operated through private and public offering of
equity and bond instruments. The secondary segment of capital market is institutionalized by two (02)
stock exchanges-Dhaka Stock Exchange and Chittagong Stock Exchange. The instruments in these
exchanges are equity securities (shares), debentures, corporate bonds and treasury bonds. The capital
market in Bangladesh is governed by Securities and Commission (SEC).

3. Foreign Exchange Market: Towards liberalization of foreign exchange transactions, a number of

measures were adopted since 1990s. Bangladeshi currency, the taka, was declared convertible on
current account transactions (as on 24 March 1994), in terms of Article VIII of IMF Article of Agreement
(1994). As Taka is not convertible in capital account, resident owned capital is not freely transferable
abroad. Repatriation of profits or disinvestment proceeds on non-resident FDI and portfolio investment
inflows are permitted freely. Direct investments of non-residents in the industrial sector and portfolio
investments of non-residents through stock exchanges are repatriable abroad, as also are capital gains
and profits/dividends thereon. Investment abroad of resident-owned capital is subject to prior
Bangladesh Bank approval, which is allowed only sparingly. Bangladesh adopted Floating Exchange Rate
regime since 31 May 2003. Under the regime, BB does not interfere in the determination of exchange
rate, but operates the monetary policy prudently for minimizing extreme swings in exchange rate to
avoid adverse repercussion on the domestic economy. The exchange rate is being determined in the
market on the basis of market demand and supply forces of the respective currencies. In the forex
market banks are free to buy and sale foreign currency in the spot and also in the forward markets.
However, to avoid any unusual volatility in the exchange rate, Bangladesh Bank, the regulator of foreign
exchange market remains vigilant over the developments in the foreign exchange market and intervenes
by buying and selling foreign currencies whenever it deems necessary to maintain stability in the foreign
exchange market.

The Financial System of

Bangladesh

Formal Sector

Semi Formal Sector

Financial Market

Regulators &
Institutions

Specialized Financial Institutions:

1.
2.
3.
4.

Money Market

Bangladesh Bank

(Banks, NBFIs, Primary Dealers)

(Central Bank)

Capital Market

Informal Sector

47 Scheduled & 4 Nonscheduled Banks.

(Stock Exchanges, Investment

Banks etc)

Foreign Exchange Market

31 NBFIs

(Authorized Dealer)

Insurance Development
Regulatory Authority
18 Life & 44 Non-life
Insurance Companies.

Securities & Exchange

Commission.

Stock Exchanges, Stock

Dealers & Brokers, Merchant
Banks etc.

Micro Credit Regulatory

Authority

Figure 2.3 The Financial System of Bangladesh

599 MFIs

House Building Finance Corporation.

Palli Karma Sahayak Foundation.
Samabay Bank.
Grameen Bank.

2.2 The Financial Market

A financial market is a market in which people and entities can trade financial securities, commodities, and
other fungible items of value at low transaction costs and at prices that reflect supply and demand. Securities
include stocks and bonds, and commodities include precious metals or agricultural goods. There are both
general markets (where many commodities are traded) and specialized markets (where only one commodity
is traded). Markets work by placing many interested buyers and sellers, including households, firms, and
government agencies, in one "place", thus making it easier for them to find each other. An economy which
relies primarily on interactions between buyers and sellers to allocate resources is known as a market
economy in contrast either to a command economy or to a non-market economy such as a gift economy.
In finance, financial markets facilitate:

The raising of capital (in the capital markets)

The transfer of risk (in the derivatives markets)
Price discovery
Global transactions with integration of financial markets
The transfer of liquidity (in the money markets)
International trade (in the currency markets)

And are used to match those who want capital to those who have it. Typically a borrower issues a receipt to
the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold.
In return for lending money to the borrower, the lender will expect some compensation in the form of
interest or dividends. This return on investment is a necessary part of markets to ensure that funds are
supplied to them.

Figure 2.4 The Financial Market.

Financial Market Slang

Poison Pill, when a company issues more shares to prevent being bought out by another company,
thereby increasing the number of outstanding shares to be bought by the hostile company making
the bid to establish majority.
Quant, a quantitative analyst with a PhD (and above) level of training in mathematics and statistical
methods.
Rocket Scientist, a financial consultant at the zenith of mathematical and computer programming
skill. They are able to invent derivatives of high complexity and construct sophisticated pricing
models. They generally handle the most advanced computing techniques adopted by the financial
markets since the early 1980s. Typically, they are physicists and engineers by training; rocket
scientists do not necessarily build rockets for a living.
White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one
organization to help prevent against a hostile takeover of that organization by another party.

Round Tripping, a form of barter that involves a company selling "an unused asset to another
company while at the same time agreeing to buy back the same or similar assets at about the same
price.
Smurfing, is a term used to describe inadvertently dyeing something blue. Sometimes used in the car
wash industry if too much blue foam polish is put on a white car, resulting in the car having a blue
tint.
Spread, the difference between the highest bid and the lowest offer.

Role of Financial Market (Financial System and the Economy)

One of the important requisite for the accelerated development of an economy is the existence of a dynamic
financial market. A financial market helps the economy in the following manner.

Saving mobilization: Obtaining funds from the savers or surplus units such as household
individuals, business firms, public sector units, central government, state governments etc. is an
important role played by financial markets.
Investment: Financial markets play a crucial role in arranging to invest funds thus collected in those
units which are in need of the same.
National Growth: An important role played by financial market is that, they contributed to a nations
growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for productive
purposed is also made possible.
Entrepreneurship growth: Financial market contributes to the development of the entrepreneurial
claw by making available the necessary financial resources.
Industrial development: The different components of financial markets help an accelerated growth
of industrial and economic development of a country, thus contributing to raising the standard of
living and the society of well-being.

Functions of Financial Markets

Intermediary Functions: The intermediary functions of a financial market include the following:

Transfer of Resources: Financial market facilitate the transfer of real economic resources from
lenders to ultimate borrowers.
Enhancing income: Financial markets allow lenders to earn internet or dividend on their surplus
invisible funds, thus contributing to the enhancement of the individual and the national income.
Productive usage: Financial market allow for the productive use of the funds borrowed. The
enhancing the income and the gross national production.
Capital Formation: Financial market provides a channel through which new savings flow to aid
capital formation of a country.
Price determination: Financial markets allow for the determination of price of the traded financial
assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in
the economy based on the demand and supply through the mechanism called price discovery
process.
Sale Mechanism: Financial markers provide a mechanism for selling of a financial asset by an
investor so as to offer the benefit of marketability and liquidity of such assets.
'Price determinants: Financial market allow for the determination of price of the traded financial
asset through the interaction of buyers and sellers. They provide a signal for the allocation of funds in
the economy, based on the demand and supply through the mechanism called price discovery
process.
Sale mechanism: Financial markets provide a mechanism for selling of a financial asset by an
investor so as to offer the benefits of marketability and liquidity, of such assets.
Information: The activities of the participants in the financial market result in the generation and the
consequent dissemination of information to the various segments of the market. So as to reduce the
cost of transaction of financial assets.

Financial Functions:

Providing the borrower with funds so as to enable them to carry out their investment plans.
Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets
in production debentures.
Providing liquidity in the market so as to facilitate trading of funds.

Who are the Major Players in Financial Markets?

By definition, financial institutions are institutions that participate in financial markets, i.e., in the creation
and/or exchange of financial assets. At present in the United States, financial institutions can be roughly
classified into the following four categories: "brokers;" "dealers;" "investment bankers;" and "financial
intermediaries."

Brokers: A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a
seller (or buyer) to complete the desired transaction. A broker does not take a position in the assets
he or she trades -- that is, the broker does not maintain inventories in these assets. The profits of
brokers are determined by the commissions they charge to the users of their services (the buyers,
the sellers, or both). Examples of brokers include real estate brokers and stock brokers.
Payment ----------------- Payment
------------>|
|------------->
Stock
|
|
Stock
Buyer
| Stock Broker |
Seller
<-------------|<----------------|<------------Stock | (Passed Thru) | Stock
Shares ----------------- Shares

Dealers: Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e.,
maintain inventories) in the assets he or she trades that permit the dealer to sell out of inventory
rather than always having to locate sellers to match every offer to buy. Also, unlike brokers, dealers
do not receive sales commissions. Rather, dealers make profits by buying assets at relatively low
prices and reselling them at relatively high prices (buy low - sell high). The price at which a dealer
offers to sell an asset (the "asked price") minus the price at which a dealer offers to buy an asset (the
"bid price") is called the bid-ask spread and represents the dealer's profit margin on the asset
exchange. Real-world examples of dealers include car dealers, dealers in U.S. government bonds, and
Nasdaq stock dealers.
Payment ----------------- Payment
------------>|
|------------->
Bond
| Dealer |
Bond
Buyer
|
|
Seller
<-------------| Bond Inventory |<------------Bonds |
| Bonds
-----------------

Investment Banks: An investment bank assists in the initial sale of newly issued securities (i.e., in
IPOs = Initial Public Offerings) by engaging in a number of different activities:

Advice: Advising corporations on whether they should issue bonds or stock, and, for bond
issues, on the particular types of payment schedules these securities should offer;

Underwriting: Guaranteeing corporations a price on the securities they offer, either

individually or by having several different investment banks form a syndicate to underwrite
the issue jointly;
Sales Assistance: Assisting in the sale of these securities to the public.

Some of the best-known U.S. investments banking firms are Morgan Stanley, Merrill Lynch, Salomon Brothers,
First Boston Corporation, and Goldman Sachs.

Financial Intermediaries: Unlike brokers, dealers, and investment banks, financial intermediaries
are financial institutions that engage in financial asset transformation. That is, financial
intermediaries purchase one kind of financial asset from borrowers -- generally some kind of longterm loan contract whose terms are adapted to the specific circumstances of the borrower (e.g., a
mortgage) -- and sell a different kind of financial asset to savers, generally some kind of relatively
liquid claim against the financial intermediary (e.g., a deposit account). In addition, unlike brokers
and dealers, financial intermediaries typically hold financial assets as part of an investment portfolio
rather than as an inventory for resale. In addition to making profits on their investment portfolios,
financial intermediaries make profits by charging relatively high interest rates to borrowers and
paying relatively low interest rates to savers.
Types of financial intermediaries include: Depository Institutions (commercial banks, savings and
loan associations, mutual savings banks, credit unions); Contractual Savings Institutions (life
insurance companies, fire and casualty insurance companies, pension funds, government retirement
funds); and Investment Intermediaries (finance companies, stock and bond mutual funds, money
market mutual funds).
Important Caution: These four types of financial institutions are simplified idealized classifications,
and many actual financial institutions in the fast-changing financial landscape today engage in
activities that overlap two or more of these classifications, or even to some extent fall outside these
classifications. A prime example is Merrill Lynch, which simultaneously acts as a broker, a dealer
(taking positions in certain stocks and bonds it sells), a financial intermediary (e.g., through its
provision of mutual funds and CMA checkable deposit accounts), and an investment banker.

What Types of Financial Market Structures Exist?

The costs of collecting and aggregating information determine, to a large extent, the types of financial market
structures that emerge. These structures take four basic forms:

Auction markets conducted through brokers;

Over-the-counter (OTC) markets conducted through dealers;
Organized Exchanges, such as the New York Stock Exchange, which combine auction and OTC
market features. Specifically, organized exchanges permit buyers and sellers to trade with
each other in a centralized location, like an auction. However, securities are traded on the
floor of the exchange with the help of specialist traders who combine broker and dealer
functions. The specialists broker trades but also stand ready to buy and sell stocks from
personal inventories if buy and sell orders do not match up.
Intermediation financial markets conducted through financial intermediaries;

Financial markets taking the first three forms are generally referred to as securities markets. Some financial
markets combine features from more than one of these categories, so the categories constitute only rough
guidelines.

Auction Markets: An auction market is some form of centralized facility (or clearing house) by which
buyers and sellers, through their commissioned agents (brokers), execute trades in an open and
competitive bidding process. The "centralized facility" is not necessarily a place where buyers and
sellers physically meet. Rather, it is any institution that provides buyers and sellers with a

centralized access to the bidding process. All of the needed information about offers to buy (bid
prices) and offers to sell (asked prices) is centralized in one location which is readily accessible to all
would-be buyers and sellers, e.g., through a computer network. No private exchanges between
individual buyers and sellers are made outside of the centralized facility.
An auction market is typically a public market in the sense that it open to all agents who wish to
participate. Auction markets can either be call markets -- such as art auctions -- for which bid and
asked prices are all posted at one time, or continuous markets -- such as stock exchanges and real
estate markets -- for which bid and asked prices can be posted at any time the market is open and
exchanges take place on a continual basis. Experimental economists have devoted a tremendous
amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury bills, notes, and bonds)
to cut down on information costs. Alternatively, some auction markets (e.g., in second-hand jewelry,
furniture, paintings etc.) allow would-be buyers to inspect the goods to be sold prior to the opening
of the actual bidding process. This inspection can take the form of a warehouse tour, a catalog issued
with pictures and descriptions of items to be sold, or (in televised auctions) a time during which
assets are simply displayed one by one to viewers prior to bidding.
Auction markets depend on participation for any one type of asset not being too "thin." The costs of
collecting information about any one type of asset are sunk costs independent of the volume of
trading in that asset. Consequently, auction markets depend on volume to spread these costs over a
wide number of participants.

Over-the-Counter Markets: An over-the-counter market has no centralized mechanism or facility for

trading. Instead, the market is a public market consisting of a number of dealers spread across a
region, a country, or indeed the world, who make the market in some type of asset. That is, the
dealers themselves post bid and asked prices for this asset and then stand ready to buy or sell units
of this asset with anyone who chooses to trade at these posted prices. The dealers provide customers
more flexibility in trading than brokers, because dealers can offset imbalances in the demand and
supply of assets by trading out of their own accounts. Many well-known common stocks are traded
over-the-counter in the United States through NASDAQ (National Association of Securies Dealers'
Automated Quotation System).
Intermediation Financial Markets: An intermediation financial market is a financial market in which
financial intermediaries help transfer funds from savers to borrowers by issuing certain types of
financial assets to savers and receiving other types of financial assets from borrowers. The financial
assets issued to savers are claims against the financial intermediaries, hence liabilities of the financial
intermediaries, whereas the financial assets received from borrowers are claims against the
borrowers, hence assets of the financial intermediaries. (See the diagrammatic illustration of a
financial intermediary presented earlier in these notes.)

The Structure of Financial Market

Primary market: Primary market is a market for new issues or new financial claims. Hence its also
called new issue market. The primary market deals with those securities which are issued to the public
for the first time.
Secondary market: Its a market for secondary sale of securities. In other words, securities which have
already passed through the new issue market are traded in this market. Generally, such securities are
quoted in the stock exchange and it provides a continuous and regular market for buying and selling of
securities.
Money market: Money market is a market for dealing with financial assets and securities which have a
maturity period of up to one year. In other words its a market for purely short term funds.
Capital market: A capital market is a market for financial assets which have a long or indefinite maturity.
Generally it deals with long term securities which have a maturity period of above one year. Capital
market may be further divided in to: (a) industrial securities market (b) Govt. securities market and (c)
long term loans market.

Debt market: The market where funds are borrowed and lend is known as debt market. Arrangements
are made in such a way that the borrowers are agree to pay the lender the original amount of the loan
plus some specified amount of interest.
Euro Bond market: A market where bonds are denominated in currency other than that of the country
in which they are issued is called euro bond market. Euro- Bond market is international in character. A
striking characteristic of euro-bond market is that bulk if these bonds are denominated in dollars.
Equity markets: A market where ownership of securities are issued and subscribed is known as equity
market. An example of a secondary equity market for shares is the Bombay stock exchange.
Financial service market: A market that comprises participants such as commercial banks that provide
various financial services like ATM. Credit cards. Credit rating, stock broking etc. is known as financial
service market. Individuals and firms use financial services markets, to purchase services that enhance
the working of debt and equity markets.
Depository markets: A depository market consist of depository institutions that accept deposit from
individuals and firms and uses these funds to participate in the debt market, by gibing loans or
purchasing other debt instruments such as treasure bills.
Non-Depository market: Non-depository market carry out various functions in financial markets ranging
from financial intermediary to selling, insurance etc. The various constituencies in non-depositary
markets are mutual funds, insurance companies, pension funds, brokerage firms etc.

Asymmetric Information in Financial Markets

Asymmetric information in a market for goods, services, or assets refers to differences ("asymmetries")
between the information available to buyers and the information available to sellers. For example, in markets
for financial assets, asymmetric information may arise between lenders (buyers of financial assets) and
borrowers (sellers of financial assets). Problems arising in markets due to asymmetric information are
typically divided into two basic types: "adverse selection;" and "moral hazard." This section explains these
two types of problems, using financial markets for concrete illustration.
1.

Adverse Selection: Adverse selection is a problem that arises for a buyer of goods, services, or assets
when the buyer has difficulty assessing the quality of these items in advance of purchase. Consequently,
adverse selection is a problem that arises because of different ("asymmetric") information between a
buyer and a seller before any purchase agreement takes place.
An Illustration of Adverse Selection in Loan Markets:
In the context of a loan market, an adverse selection problem arises if the contractual terms that a lender
sets in advance in an attempt to protect himself against the consequences of inadvertently lending to high
risk borrowers have the perverse effect of encouraging high risk borrowers to self-select into the lender's
loan applicant pool while at the same time encouraging low risk borrowers to self-select out of this pool.
In this case, the lender's pool of loan applicants is adversely affected in the sense that the average quality
of borrowers in the pool decreases.

2.

Moral Hazard: Moral hazard is said to exist in a market if, after the signing of a purchase agreement
between the buyer and seller of a good, service, or asset:

The seller changes his or her behavior in such a way that the probabilities (risk calculations) used by
the buyer to determine the terms of the purchase agreement are no longer accurate;
The buyer is only imperfectly able to monitor (observe) this change in the seller's behavior.
For example, a moral hazard problem arises if, after a lender purchases a loan contract from a
borrower, the borrower increases the risks originally associated with the loan contract by investing
his borrowed funds in more risky projects than he originally reported to the lender.

2.3 The Financial Institutions.

In financial economics, a financial institution is an institution that provides financial services for its clients or
members. Probably the most important financial service provided by financial institutions is acting as
financial intermediaries. Most financial institutions are regulated by the government.

Broadly speaking, there are three major types of financial institutions:

Depositary Institutions : Deposit-taking institutions that accept and manage deposits and make loans,
including banks, building societies, credit unions, trust companies, and mortgage loan companies
Contractual Institutions : Insurance companies and pension funds; and
Investment Institutes: [Investment Banks - Underwriting underwriters], [Security Firms -Broker].

Role of Financial Institutions

Reduce transactions cost by specializing in the issuance of standardized securities

Reduce information costs of screening and monitoring borrowers.
Issue short term liabilities and purchase long-term loans.

Figure 2.5 The Financial Institutions.

2.4 The Financial Instruments.

A financial instrument is the written legal obligation of one party to transfer something of value usually
money to another party at some future date, under certain conditions, such as stocks, loans, or insurance.
According to IAS 32 and 39, it is defined as 'any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity'.

Characteristics of Financial Instruments

Standardization
Communicate Information

Classes of Financial Instruments

Financial instruments can be categorized by form depending on whether they are cash instruments or
derivative instruments:
Cash instruments are financial instruments whose value is determined directly by markets. They can be
divided into securities, which are readily transferable, and other cash instruments such as loans and
deposits, where both borrower and lender have to agree on a transfer.

Derivative instruments are financial instruments which derive their value from the value and
characteristics of one or more underlying entities such as an asset, index, or interest rate. They can be
divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.

Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity
based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the
issuing entity). If it is debt, it can be further categorized into short term (less than one year) or long term.
Combining the above methods for categorization, the main instruments can be organized into a table as
follows:
Instrument Type
Asset Class
Securities

Other cash

Exchange-traded
derivatives

OTC derivatives

Debt (Long
Term)
>1 year

Bonds

Loans

Bond futures
Options on bond futures

Interest rate swaps

Interest rate caps and
floors
Interest rate options
Exotic instruments

Debt (Short
Term)
<=1 year

Bills, e.g. T-Bills

Commercial
paper

Deposits
Certificates of
deposit

Short term interest rate

futures

Forward rate
agreements

Stock

N/A

Stock options
Equity futures

Stock options
Exotic instruments

Currency futures

Foreign exchange
options
Outright forwards
Foreign exchange
swaps
Currency swaps

Equity

Foreign
Exchange

Spot foreign
exchange

N/A

Measuring Financial Instrument's Gain or Loss

Instrument
Type

Categories

Measurement

Gains and losses

Assets

Loans and
receivables

Amortized costs

Net income when asset is derecognized or impaired

(foreign exchange and impairment recognized in net
income immediately)

Assets

Available for sale

financial assets

Deposit account Fair value

Other
comprehensive
income
(impairment
recognized in net income immediately)

Value of Financial Instruments:

1)
2)
3)
4)

Size the promised payment. (Face Value)

When the payment will be received. (Maturity)
The likelihood the payment will be made (risk).
The conditions under which the payment will be made. (Prerogatives)

Examples of Financial Instruments

Primarily Stores of Value:

i. Bank Loans
ii. Bonds
iii. Home Mortgages
iv. Stocks
v. Asset-backed securities
Primarily to transfer risk
i. Insurance
ii. Futures Contracts
iii. Options

Figure 2.6 The Financial Instruments.

2.5 The Real VS Nominal Interest Rates.

The "Real Interest Rate" is the rate of interest an investor expects to receive after allowing for inflation. It
can be described more formally by the Fisher equation, which states that the real interest rate is
approximately the nominal interest rate minus the inflation rate. If, for example, an investor were able to lock
in a 5% interest rate for the coming year and anticipated a 2% rise in prices, he would expect to earn a real
interest rate of 3%. This is not a single number, as different investors have different expectations of future
inflation. Since the inflation rate over the course of a loan is not known initially, volatility in inflation
represents a risk to both the lender and the borrower.
In finance and economics, Nominal Interest Rate or nominal rate of interest refers to two distinct things: the
rate of interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates
"as stated" without adjustment for the full effect of compounding (also referred to as the nominal annual
rate). An interest rate is called nominal if the frequency of compounding (e.g. a month) is not identical to the
basic time unit (normally a year).

In economics and finance, an individual who lends money for repayment at a later point in time expects to be
compensated for the time value of money, or not having the use of that money while it is lent. In addition, they
will want to be compensated for the risks of having less purchasing power when the loan is repaid. These
risks are systematic risks, regulatory risks and inflation risks. The first includes the possibility that the
borrower will default or be unable to pay on the originally agreed upon terms, or that collateral backing the
loan will prove to be less valuable than estimated. The second includes taxation and changes in the law which
would prevent the lender from collecting on a loan or having to pay more in taxes on the amount repaid than
originally estimated. The third takes into account that the money repaid may not have as much buying power
from the perspective of the lender as the money originally lent that is inflation, and may include fluctuations
in the value of the currencies involved.
Nominal interest rates include all three risk factors, plus the time value of the money itself.
Real interest rates include only the systematic and regulatory risks and are meant to measure the time value
of money.
Real rates = Nominal rates minus Inflation and Currency adjustment.
The "real interest rate" in an economy is often the rate of return on a risk free investment, such as US
Treasury notes, minus an index of inflation, such as the CPI, or GDP deflator.
Fisher Equation
The relation between real and nominal interest rates and the expected inflation rate is given by the Fisher
equation

Where
= nominal interest rate;
= real interest rate;
= expected inflation rate.

Variations in Inflation
The inflation rate will not be known in advance. People often base their expectation of future inflation on an
average of inflation rates in the past, but this gives rise to errors. The real interest rate ex post may turn out to
be quite different from the real interest rate that was expected in advance. Borrowers hope to repay in
cheaper money in the future, while lenders hope to collect on more expensive money. When inflation and
currency risks are underestimated by lenders, then they will suffer a net reduction in buying power The
complexity increases for bonds issued for a long term, where the average inflation rate over the term of the
loan may be subject to a great deal of uncertainty. In response to this, many governments have issued real
return bonds, also known as inflation-indexed bonds, in which the principle value and coupon rises each year
with the rate of inflation, with the result that the interest rate on the bond is a real interest rate. In the US,
Treasury Inflation Protected Securities (TIPS) are issued by the US Treasury.
The expected real interest rate can vary considerably from year to year. The real interest rate on short term
loans is strongly influenced by the monetary policy of central banks. The real interest rate on longer term
bonds tends to be more market driven, and in recent decades, with globalized financial markets, the real
interest rates in the industrialized countries have become increasingly correlated. Real interest rates have
been low by historical standards since 2000, due to a combination of factors, including relatively weak
demand for loans by corporations, plus strong savings in newly industrializing countries in Asia. The latter
has offset the large borrowing demands by the US Federal Government, which might otherwise have put
more upward pressure on real interest rates.

Related is the concept of "risk return", which is the rate of return minus the risks as measured against the
safest (least-risky) investment available. Thus if a loan is made at 15% with an inflation rate of 5% and 10%
in risks associated with default or problems repaying, then the "risk adjusted" rate of return on the
investment is 0%.

Importance in Economic Theory

Economics relies on measurable variables, chiefly price and objectively measurable production. Since
production is "real", while prices are relative to the general price level, in order to compare an economy at
two points in time, nominal price variables must be converted into "real" variables. For example, the number
of people on payrolls represents a "real" variable, as does the number of hours worked. But in order to
measure productivity, the nominal prices of the goods and services that labor produces must be converted to
the "real" purchasing power. To do this requires adjusting prices for inflation.
The same is true of investment. Investment produces real gains in efficiency, and purchases productive
capacity - factories, machines and so on - which is also real. To find the return on this capital, it is necessary to
subtract the increases in its nominal value that are the result of increases in the general level of prices. To do
this means subtracting the inflation rate from the nominal rate of return. For example, a portfolio of stocks
that returns 10%, when inflation is running at 4% has a 6% real rate of return. The real interest rate is used
in various economic theories to explain such phenomena as the capital flight, business cycle and economic
bubbles. When the real rate of interest is high, that is, demand for credit is high, then money will, all other
things being equal, move from consumption to savings. Conversely, when the real rate of interest is low,
demand will move from savings to investment and consumption. Different economic theories, beginning with
the work of Knut Wicksell have had different explanations of the effect of rising and falling real interest rates.
Thus, international capital moves to markets that offer higher real rates of interest from markets that offer
low or negative real rates of interest triggering speculation in equities, estates and exchange rates. Related to
this concept is the idea of a "natural rate of interest", that is, the expected return on savings and capital
invested.

Negative Real Interest Rates

The real interest rate solved from the Fisher equation is

If there is a negative real interest rate, it means that the inflation rate is greater than the interest rate. If the
Federal funds rate is 2% and the inflation rate is 10%, then the borrower would gain 7.27% of every dollar
borrowed per year.

Calculating Real Interest Rates using Change in Value

Bearing in mind that a real interest rate is simply the proportion of return or proportion of loss of a changed
revenue stream after inflation has been factored in, we could use a simple change formula to calculate the real
rate of change in income based on the new living costs.
Using the example above, for negative real rates of interest, where the standard bank loan rate is at 2% and
the rate of inflation is 10%, we can use the following formula.

RIR =
Where:
RIR= Real Interest Rate
NIR= Nominal Interest Rate effect on initial investment
I= Inflationary effect on initial investment
So lets assume a consumer borrows 200,000 from this bank. Calculating the nominal change on initial value
or "NIR" is simply 200,000 + 2% = 204,000
The inflationary effect on the initial value or "I" is calculated as 200,000 + 10%= 220,000. We calculate this
value because we want to find the amount of money which is required to buy the same volume of goods and
services in the following time period as 200,000 did in the preceding period.
So NIR - I = 204,000 - 220,000 = - 16,000.
This difference is the top line of the equation and shows that the real debt is negative since the price of the
debt rose at a lower rate than the money supply rate. So in effect, the creditor is losing 16,000 at prices in
the latest time period. This is because the 204,000 return doesnt reflect the same purchasing power in the
current time period as 200,000 did in the preceding one. Assuming the borrowers annual income is
200,000, if this rose in line with inflation, he/she would gain 16,000 in latest money terms. If this income
grew at 2%, he would find his loan no less easy or harder to pay but would find other items which grew at a
higher rate of inflation more expensive. This change represents the inflationary adjusted change in value and
so by dividing it by this by the inflationary effect on the initial value and then multiplying by 100, we can get
the percentage change on value based on the inflated value.
Therefore: RIR = (-16,000/220,000) X 100 = -0.07272 X 100 = -7.27%
This means that assuming a persons valued income or wealth rose by the same level of inflation, the loan is
around 7.3% lower in real value and would therefore represent a transfer of wealth from the bank to the
repaying individual. Obviously, this would lead to commodity speculation and business cycles, as the
borrower can profit from a negative real interest rate.

Self-Test Questions
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10

What is Financial System? Briefly explain the financial system of Bangladesh.

What are the roles & functions of Financial Market in an economy?
Who are the major players in financial markets?
What types of financial market structure exist?
What are the uses of asymmetric information in financial market?
What roles financial institutions play in facilitating the flow of funds in the entire economy?
What are the characteristics of Financial Instruments?
What are the factors to be considered in valuing a financial instrument?
Briefly explain the different types of financial instruments.
Differentiate between Real rate of interest & Nominal rate of interest.