FINANCIAL ENVIRONMENT

Financial Markets of Pakistan

Financial Markets

Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together.

Businesses interact continually with the financial markets. The purpose of financial markets is to efficiently allocate savings to ultimate users.

Financial Markets

Participants that provide funds are called surplus units (investors)

e.g., households

Participants that enter markets to obtain funds are deficit units (issuers)

e.g., the government

A major participant in financial markets is the SBP, because it controls the money supply

Segments of Financial Markets

1.

Direct Finance

Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrowers future income or assets
Borrowers borrow indirectly from lenders via financial intermediaries by issuing financial instruments which are claims on the borrowers future income or assets

2.

Indirect Finance

Financial Markets

Structure of Financial Markets

1.

Primary Market

New security issues sold to initial buyers Typically involves an investment bank who underwrites the offering

2.

Secondary Market

Securities previously issued are bought and sold Examples include the KSE, LSE, ISE Involves both brokers and dealers
e.g., the sale of new corporate stock or new Treasury securities e.g., the sale of existing stock

Primary markets facilitate the issuance of new securities

Secondary markets facilitate the trading of existing securities

Structure of Financial Markets

We can further classify secondary markets as follows: Exchanges

1.

Trades conducted in central locations (e.g., Stock Exchange) Dealers at different locations buy and sell

2.

Over-the-Counter Markets

A visible marketplace for secondary market transactions is an organized exchange Some transactions occur in the over-the-counter (OTC) market (a telecommunications network)

Classifications of Financial Markets

We can also further classify markets by the maturity of the securities:
1. 2.

Money Market: Short-Term (maturity < 1 year) Capital Market : Long-Term (maturity > 1 year)

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Securities Traded in Financial Markets

Money market securities

Money

market securities are debt securities with a maturity of one year or less Characteristics:
Liquid

& Marketable Low expected return Low degree of risk

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Securities Traded in Financial Markets (contd)

Capital market securities

Capital

market securities are those with a maturity of more than one year
Notes, Stocks

Bonds and mortgages

Capital

market securities have a higher expected return and more risk than money market securities

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Securities Traded in Financial Markets

Bonds and mortgages

Bonds

are long-term debt obligations issued by corporations and government agencies Mortgages are long-term debt obligations created to finance the purchase of real estate Bonds and mortgages specify the amount and timing of interest and principal payments

Securities Traded in Financial Markets

13

Stocks
Stocks

(equity) are certificates representing partial ownership in corporations Investors may earn a return by receiving dividends and capital gains Stocks have a higher expected return and higher risk than long-term debt securities

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Securities Traded in Financial Markets

Derivative securities
Derivative securities are financial contracts whose values are derived from the values of underlying assets Speculating with derivatives allow investors to benefit from increases or decreases in the underlying asset Risk management with derivatives generates gains if the value of the underlying security declines

Financial Intermediaries

Financial Intermediaries

These accept money from savers and use those funds to make loans and other financial investment in their own name. These include:
Commercial banks Saving institutions Insurance companies Pension funds Finance companies Mutual funds

Types of Financial Intermediaries

Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts. Commercial banks
Raise funds primarily by issuing current, savings, and time deposits which are used to make commercial, consumer and mortgage loans Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios

Types of Financial Intermediaries

Thrifts: S&Ls, Mutual Savings Banks and Credit Unions

Savings institutions

Include savings and loan associations (S&Ls) and savings banks (almost died in the 80s.) Are mostly owned by depositors (mutual)

Credit unions

Are nonprofit organizations Restrict their business to credit union members Tend to be much smaller than other depository institutions

Raise funds primarily by issuing savings, time, and current deposits which are most often used to make mortgage and consumer loans, with commercial loans Mutual savings banks and credit unions issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a companys workers

Insurance Companies
Provide insurance policies to individuals and firms for death, illness, and damage to property Charge premiums Invest in stocks or bonds issued by corporations

These acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.

Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict

Types of Financial Intermediaries

Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities Offered by most corporations and government agencies Manage funds until they are withdrawn from the retirement account Invest in stocks or bonds issued by corporations or in bonds issued by the government

Types of Financial Intermediaries

Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations Mutual Funds acquire funds by selling shares to individual investors and use the proceeds to purchase large, diversified portfolios of stocks and bonds

Types of Financial Intermediaries

Money Market Mutual Funds acquire funds use the proceeds to purchase highly liquid and safe short-term money market instruments Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.

Financial Brokers

Financial Brokers

They are matchmakers or middlemen.

Investment
It

banker

underwrites new securities for resale.

Mortgage
It

banker

buys mortgages for resale.

Broker vs Dealer

A broker is a person who executes the trade on behalf of others, whereas a dealer is a person who trades business on their own behalf. A dealer is a person who will buy and sell securities on their account. On the other hand, a broker is one who will buy and sell securities for their clients. While dealers have all the rights and freedom regarding the buying and selling of securities, brokers seldom have this freedom and these rights. A broker has only a little experience in the field compared to dealers. It has also been seen that brokers become dealers once they get experience. A broker is normally paid a commission for transacting the business. A dealer is not paid a commission, and he or she is a primary principal.

Types of Markets
Product markets

Financial markets Producing units (mainly business firms and governments)

Flow of funds (savings) Flow of financial services, income, and financial claims

Consuming units (mainly households)

Factor markets