Financial Markets and

institutions
Lecture 1: Introduction
Relevance of the course
Much of the financial crisis of 2008-
09 has roots in financial markets and
institutions
What happened on the financial
markets in 2008-09?
 What happened on the financial markets in 2008-
09 ?
Federal National Mortgage Association and
Federal Home Loan Mortgage Corporation,
commonly known as Fannie Mae and Freddie Mac
were bought by their regulator
A week later: A bust of one of the biggest players
on the market: a record-breaking bankruptcy of
Lehman Brothers
A day later: US government takeover of a
desperately illiquid American International Group
(AIG)
A day later: Bank of America bought Merrill Lynch
in US; Lloyds bought HBOS in UK
Central banks desperately throw liquidity on the
markets
 TOTAL 2008 2008 2008 2007 2007
Firm ($bn) Q3 Q2 Q1 Q4 Q3
Citigroup -61.00 -6.20 -12.00 -19.00 -18.20 -5.60

Wachovia -52.70 -30.30 -13.00 -4.40 -3.20 -1.90

Merrill Lynch -52.20 -6.10 -9.00 -9.70 -18.00 -9.40

Washington
Mutual -45.60 -30.90 -5.50 -4.10 -3.50 -1.20
UBS AG -44.20 0.00 -6.00 -19.20 -14.40 -4.70

HSBC -27.40 0.00 -9.50 -4.20 -10.00 -0.90

Bank of America -27.40 0.00 -5.20 -6.70 -6.70 -2.50

J P Morgan
Chase -18.80 -6.00 -3.60 -4.70 -1.90 -2.00
Morgan Stanley -15.70 -1.30 -1.80 -2.30 -9.40 -0.90
IKB -14.00 0.00 0.00 -14.00 0.00 0.00
What are we going to study in this
course
As the name of the course suggests,
we shall focus mainly on three areas:
Financial Markets
Financial Institutions
Money and monetary Policy

Why to study these three areas?

Why to study Financial
Markets
Financial Markets: Markets in which funds are
transferred from people who have an excess of
available funds to people who have a shortage of
funds
Financial markets promote efficiency in
economic system
Taking funds from those who do not have
productive use of funds and
Giving to those who can best utilize the funds
Affect wealth and behavior of business firms
and individuals
 SEBI regulates the stock markets
Controller of Capital Issues abolished
Several developments:
National Stock Exchange (1994) initiated
screen based trading.
Depositories (NSDL and SHCL) have resulted
in dematerialisation of shares
Internet trading
Take-over code
Derivatives - futures and options introduced
kinds of financial markets
Debt v. Equity
Primary v. Secondary
Exchanges v. Over-the-counter
markets
Money v. Capital market
 Financial Markets interest
rates
Some definitions
Interest rates: An interest rate is the cost of
borrowing or the price paid for the rental of
funds (usually expressed as a percentage of
the rental of 100 per year)
Interest rates affect both individuals and
corporations decisions to spend or save
A stock: A share of ownership in a
corporation. It is a security, that is a claim on
the earnings and assets of the corporation.
 The stock market is where stocks are
traded:
Can it affect wealth and spending
behavior of investors? How is it
important for individuals and
corporations?
BSE in Last 5years
Bond Market
Definition: A bond is a debt security
that promises to make payments
periodically for a specified period of
time.
The bond market is where bonds are
traded. Why is the bond market
important?
it enables corporations or governments
to borrow to finance their activities
it is where interest rates are determined
The Foreign Exchange
Market
A foreign exchange market is a market
where funds are converted from one
currency to another
Why do firms and citizen need this
conversion?
To transfer funds from one country to
another for trade
For safety reasons
Historical Rupee-Dollar
parity
Why this market is important?
What happens when rupee becomes
cheaper against dollar?
For individuals
For firms?
B- Banks and Other Financial
Institutions
Banks are financial institutions that accept
deposits and make loans.
FIs work like intermediaries, i.e no one can
directly lend to corporations
We shall study aspects of FIs like
Why are financial intermediaries so crucial to well-
functioning financial markets?
Why do they extend credit to one party but not to
another?
Why do they usually write complicated legal documents
when they extend loans?
Why are they the most heavily regulated businesses in
the economy?
Major Financial Institutions and Market

Commercial Banks
Development Financial Institutions
Mutual Funds
Insurance Companies
 Commercial Banks
The most important and largest part of
the financial system ~ 40% of financial
savings is with banks
Prior to 1991, Indian banking was highly
regulated. Also, profitability and financial
strength of banks were not considered
important, but now profitability of banks
have improved significantly.
About 80% of the banking deposits and
assets are in the public sector.
 Development Financial
Institutions
All India DFIs - IDBI, ICICI, IFCI,
SIDBI
State DFIs - example: KIDC and
KFC
DFIs had access to low cost SLR
funds, cost of which has increased
to market levels since
liberalisation.
Problem of high NPAs - lending at
the most risky stage of the
Development Financial Institutions

RBI committee has recommended

that DFIs convert to commercial
banks or NBFCs
DFIs earlier would give only term
loans. Now can give working capital
loans also.
ICICI that started as a term lending
DFI has now merged with ICICI Bank
C - Money supply and Inflation and
Interest Rates
Money (also referred to as the money
supply), is anything that is generally
accepted in payment for goods or services
or in the repayment of debts.
Why study of money is important?
Money creates business cycles and inflation
(M. Friedman).
Evidence suggests that money plays an
important role in generating business
cycles
The shaded areas representing
recessions, periods of declining
aggregate output
The graph shows that the rate of
money growth has declined before
every recession
The graph indicates that changes in
money might be a driving force
behind business cycle fluctuations.
Money and Inflation
Inflation is a continual increase in the
price level
What causes inflation?
the price level and the money supply
generally move closely together
For example, the next two diagrams
show the relationships of price level
and inflation for a number of
countries
Inflation and Money Supply
in US
Further evidence on Inflation and
Money supply
Money and Interest
Rates
In addition to other factors, money plays an
important role in interest-rate fluctuations,
Increased money supply should lower
interest rates, but the historical relationship
is not clear-cut
Monetary Policy?
Monetary policy is the management of
money and interest rates
RBI conducts monetary policy
 Business Structure

Sole Proprietorships
Unlimited Liability
Personal tax on profits

Partnerships

Limited Liability
Corporate tax on profits +
Corporations
Personal tax on dividends
Corporate form of
business
Most large firms are organised as a company or
corporation
Corporation is a separate legal entity from its
owners. Owners enjoy limited liability. (First limited
liability co. Verenigde Oostindische Compagnie or VOC was
Netherlands biggest trading company during the 17th and 18th
centuries. It was the worlds first joint-stock limited liability company
with freely transferable shares. Shares issues in 1602) Source:
http://www.worldsoldestshare.com /. In India, limited liability companies enabled
by Act in 1857.
The purpose of the corporation is set in the articles
of incorporation.
Closely held/private corporation few shareholders
with no public share ownership
Public listed companies are those where the public
hold shares of the firm and the shares are traded on
an exchange.
Assets
Real assets
Tangible, eg. Plant and machinery
Intangible, eg. Technical expertise,
brands, patents
Financial assets
Stocks, bonds, etc.
 Two basic questions
1. What real assets should the firm
invest in?
Capital Budgeting

2. How should the real assets be finance

Financing Decisions
 Recent examples of investment and
financing decisions
Company (Revenue) Investment Decision
Boeing ($61 billion) Began production of 787
Dreamliner at cost of
~$10 billion
GlaxoSmithKline (24 3.7 billion in 2008 on Finances R&D expenditure
billion) R&D of new drugs
Wells Fargo ($52 billion) Acquired Wachovia Bank
in 2008 for $15.1 billion
LVMH (17 billion) Acquired the Spanish Issued a six year bond in
winery Bodega Numanthia
Termes
Lenova ($16 billion) Expanded its chain of
retail stores to cover over
2,000 cities
Indigo (Rs. 26 billion) In 2011, placed order for
180 Airbus A320 aircraft
Financing Decision
The cash flows from
Boeings operations; repay
some of its debt and
repurchase $2.8billion of
stock.
largely through internal
cash flows
Financed the acquisition
by an exchange of shares
2007, raising 300 million
Swiss francs
Borrowed $400 million for
5 years from a group of
banks
Plans to finance
acquisition with an IPO
and a sales and lease
 Role of The Financial
Manager
(2) (1)

Firm's Financial Financial

manager (4a)
operations Markets
and
Institutions
(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
 Who is The Financial
Manager?

Chief Financial Officer

Financial policy
Corporate planning

Treasurer Controller
Cash management Preparation of financial
Raising capital statements
Banking relationship Accounting
Tax
 Fundamental Objective
Maximizing the value of the cash
invested in the firm.
Logic:
a. Shareholders want to be as rich as
possible, that is maximize his or her
wealth.
b. Transform the wealth into most
desirable time pattern of
consumption
c. Manage the risk characteristics of
that consumption
 Shareholder Value
Ethics is an important issue and is
not to be forgotten while maximizing
value.

Examples of not following good

ethics:
Enron
Worldcom
Satyam
 What is the value of the
firm?
Take example of Infosys:
BSE NSE
2581.5 2583.9
Last (-51.30) (-48.20)
Previous 2632.8 2632.1
Open 2647 2649
Today's High 2648 2649
Today's Low 2555 2553.8
17/09/2012 17/09/2012
Traded Date 10:48:00 AM 10:49:59 AM
Volume 38211 465076
52 W High 2990 2994
52 W Low 2102 2101.25

Full Year Mar'12

FV BV Market Price Div(%) MCap Mcap Net Profit EPS P/E
Unit Unit (USD, Unit
Curr. Curr. Rs. (Rs. Cr) billion) (Rs. Cr) Curr.

5 518.2 2583.9 940 151185.9 28.5 7986 131.4 20

 Financial System:
Primary Function
Mobilize (collect) resources from savers and allocate
(invest or lend) to users of funds such as firms and
government.

The Users
Savers Financial of
System funds
Financial system: the
institution link
Cash Cash

Financial
Savers Users
Intermediary

IOU IOU

I Owe (yo)U
IOU:

Financial intermediary: commercial

banks, insurance co.,mutual funds,
pension funds
Financial system: the market
link
Cash

Markets:
Savers facilitate Users
the
process

IOU
 Financial Instruments
Common stock
Ownership
Voting rights
Preferred stock
 Financial Instruments
Debt
Maturity
Fixed vs floating
Denominated in INR or foreign currency
Seniority junior or senior
Secured or unsecured
Straight bonds or convertible bonds