Financial Markets, Institutions

and Interest Rates

Introduction to Business Finance (Fall 2016)

 Firms operate in a financial system
Financial Institutions
Commercial Banks
Funds supplied through Insurance Companies
investments in Mutual Funds
Pension Funds

Suppliers Of Funds Demanders of funds

Businesses Businesses
Government Government
Individuals Individuals

Funds supplied Financial Markets

directly through Money Market
Capital market
Introduction to Business Finance (Fall 2016) 2
 Capital formation process

Introduction to Business Finance (Fall 2016)

 Financial markets bring
together the buyers and sellers
of debt and equity securities

Introduction to Business Finance (Fall 2016)

 Types of financial markets
Money versus Capital Market
The money market refers to debt instruments
with maturity of one year or less.
Examples: Treasury bills (T-bills), Commercial
paper (CP).
The capital market refers to long-term debt
and equity instruments.
Examples: Common stock, Preferred stock,
Corporate bond, Treasury bond, Municipal bond.

Introduction to Business Finance (Fall 2016)

 Types of Financial Markets
Debt Markets
treasury, corporate, mortgage-backed, money
market, municipal, etc...
Equity Markets
stock markets

Introduction to Business Finance (Fall 2016)

 Equity Markets
Primary
corporations raise funds by issuing new securities
Secondary
securities are traded among investors after they
have been issued

Introduction to Business Finance (Fall 2016)

 Derivatives Markets
Options, futures and swaps are securities
whose value is determined, or derived directly
from other assets
These can be used to manage risk or to
speculate

Introduction to Business Finance (Fall 2016)

 Organized Investment NetworksThe
Over-the-Counter Market (OTC)
Collection of brokers and dealers connected
electronically
Provides for trading in securities not listed on
the organized exchanges

Introduction to Business Finance (Fall 2016)

 Over-the-Counter Market (OTC)
1. Dealers hold inventory and make a market
2. Brokers act as agents in bringing together
dealers with investors
3. Electronic network provides
communications link

Introduction to Business Finance (Fall 2016)

 Types of Stock Market Transactions

1. Secondary market
trading existing stocks
2. Primary market
existing firm issues additional shares
3. Initial Public Offering (IPO)
privately held company offers stock to the
public for the first time
called going public
Introduction to Business Finance (Fall 2016)
IPOs keep the primary markets alive

Year No. of IPOs Amount Raised

(USD million)
2007 10 85
2008 9 66
2009 3 17
2010 6 62
2011 4 35

Source: AKD Securities

Introduction to Business Finance (Fall 2016)

 Debt Securities
Firms borrow money by selling debt securities
in the debt market.
If the debt has a maturity of less than one
year, it is typically called notes, and is traded
in the money market.
If the debt has a maturity of more than one
year, it is called bond and is traded in the
capital market.

Introduction to Business Finance (Fall 2016)

Basic Debt Instruments in Pakistan
Include

Government Debt Instruments:

Treasury Bills (Short-term)
National Saving Certificates (redeemable any time at
par)
PIBs (Long-term)
Corporate Debt Instruments:
Term Deposits in Banks (Short-term)
TFCs (Conventional)
Commercial Paper
Sukuks (Islamic)
Introduction to Business Finance (Fall 2016)
Recent trends observed in the Debt
Market of Pakistan include

Government Borrowing On a rising trend

Government borrowing shifting from Short-term
to Long term. Short term debt came down to
42% from 55%.
Corporate Demand Falling trend but has
increased in the past year. (Bank lending)
Banks shifting from corporate lending to T-bills,
and now again to corporate lending but slightly.

Introduction to Business Finance (Fall 2016)

 Equity securities
Represent ownership of the corporation.

There are two major types of equity securities:

common stock
preferred stock

Introduction to Business Finance (Fall 2016)

Stocks were previously listed and
traded in three stock exchanges
(secondary markets) in Pakistan

Karachi Stock Exchange

Lahore Stock Exchange
Islamabad Stock Exchange

Introduction to Business Finance (Fall 2016)

 Merger of stock exchanges
On 11 January 2016, the three individual stock
exchange's of Karachi, Lahore and Islamabad were
merged to form PSX.
The Pakistan Stock Exchange (PSX) is now the main stock
exchange of Pakistan with trading offices
in Karachi, Islamabad and Lahore.

Articles:
http://www.dawn.com/news/1232383
http://www.pakistantoday.com.pk/2016/01/10/business
/three-stock-exchanges-to-merge-to-form-pse-today/

Introduction to Business Finance (Fall 2016)

 Some key facts and figures from PSX

Listed Companies 577

Market Capitalization Rs. 7655.410 billion
The investors on the exchanges include 1,886 foreign
institutional investors and 883 domestic institutional investors
along with about 0.22 million retail investors.
There are also about 400 brokerage houses which are members
of the PSX as well as 21 asset management companies.

As of June 15, 2016.

Introduction to Business Finance (Fall 2016)

Recent trends observed in the Equity
Market of Pakistan include
PSX has been reclassified in MSCI under Emerging markets
from Frontier markets.
Due to the reclassification, the index recorded its biggest
single-day gain since March 31, 2015, and is one of Asia's best
performers this year.

Articles:
Pre-classification
https://www.thenews.com.pk/print/127569-PSX-likely-to-be-
upgraded-to-MSCI-EM-Index
Post-classification
http://www.dawn.com/news/1264977

Introduction to Business Finance (Fall 2016)

Recent trends observed in the Equity
Market of Pakistan include
State Bank of Pakistan (SBP) cut the policy rate by 25
basis points in the outgoing quarter, to 5.75 percent
with chances of further 25 basis point cut likely
during remainder of calendar year.
Budget 2016-17 introduced measures for real estate
sector to bridge the gap between declared value of
properties and market value of properties.
Investors are now pulling their money out of real
estate and thus equity markets are enjoying huge
inflows.
Introduction to Business Finance (Fall 2016)
 PSX-100 Index historical returns

Pakistan KSE100 Index increased 135 points or 0.34% to 39927 on Friday August 26 from 39792 in
the previous trading session. Pakistan KSE100 Index changed +1.08% during the last week, +1.25%
during the last month and +17.57% during the last year. Historically, the Pakistan Stock
Market (KSE100) reached an all time high of 40057.52 in August of 2016 and a record low of 538.89 in
June of 1990.

Source: http://www.tradingeconomics.com/
Introduction to Business Finance (Fall 2016)
 Sector wise performance

Source: https://dps.psx.com.pk/

Introduction to Business Finance (Fall 2016)

 Interest Rates are determined
through the interaction of
demand and supply forces

Introduction to Business Finance (Fall 2016)

The nominal interest rate comprises
of

Interest Rate = RRIR + IP + DRP +

LRP + MP
Real Risk-free interest rate (RRIR)
Inflation premium (IP)
Default risk premium (DRP)
Liquidity risk premium (LRP)
Maturity premium (MP)

Introduction to Business Finance (Fall 2016)

 Term Structure of Interest Rates is
the relationship between the
interest rates and the time to
maturity

Introduction to Business Finance (Fall 2016)

There are 3 theories describing the
Term Structure of Interest Rates

Unbiased expectation theory

Only risk factor existing is inflation
Forward rate can be easily calculated
Long-term rate = Average of short-term rates
Different maturities are perfect substitutes
Liquidity premium theory
Market segmentation theory

Introduction to Business Finance (Fall 2016)

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Introduction to Business Finance (Fall 2016)