Fall 2013 ADVANCED FINANCIAL INSTRUMENTS AND MARKETS

LectureNo.01 Financial Institutions and Role of Go ernment Government

Hammad Hassan Mirza AssistantProfessor(Finance) p of o BusinessAdministration o Department UniversityofSargodha

CourseIntroduction
Simultaneously Philosophical and Practical underpinnings Banking, B ki I Insurance, S Securities, iti D i ti Derivatives, Fi Financial i l Crisis. International Bias but will try best to relate. Course is more theoretical but cannot avoid mathematics/statistics completely. Problem Sets/case studies/Quiz etc.

PropertyofDepartmentofBusinessAdministration,UniversityofSargodha

CourseObjectives
Onsuccessfulcompletionofthismodule,youare expectedto:
1. 2. 3. 4 4. 5. Gainsomeknowledgeofthemainfunctionsoffinancial markets k and di institutions i i Developanunderstandingoftheworkingsofequity capital p marketsandInstrumentsofRiskManagement g Understandthenatureoffinancialinstrumentsandthe reasonsforinnovatingsuchinstruments Beawareoftherelevantempiricalcapitalmarkets research Becomefamiliarwiththekeyresearchmethodsusedin thefinancial f marketsliterature
3

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

TeachingMethodology

Lecturefordisseminatingkeyconcepts Discussiononpracticalissues Assignments andPresentations/Projects g / j Quiz/CaseStudies

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

Evaluation

IndividualClassPresentations/Projects RegularClassPresentations/Participation(7%) TermPaper/Assignment(8%) ClassQuiz/CaseStudies(5%) MidTermTest(45Minutes) Fi lExamination Final E i ti (2 ( hours) h )

20%

20% 6 % 60% 100%

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

RecommendedText
1. Fabozzi, Frank J., Franco Modigliani, Frank J. Jones, and Michael G. Ferri. Foundations of Financial Markets and Institutions, 4th ed. Prentice Hall, 2010. FS S Mishkin, s , SG Eakins a s. Financial a c a Markets a ets a and d Institutions st tut o s 5th Edition. dto Pearson Publications John C. Hull, Options, Futures and Other Derivatives, 6th Edition, Prentice Hall. Frank J. Fabozzi: Bond Market Analysis and Strategies, Prentice Hall. Szymon Borak Wolfgang Karl Hrdle Brenda Lpez Cabrera, Statistics of Financial Markets, Springer Heidelberg Dordrecht London New York Robert Dubil, An Arbitrage Guide to Financial Markets, 2004 , John Wiley & Sons Ltd Relevant Research Articles (Downloadable D l d bl from f www.financecottage.com fi )
6

2. 3. 4. 5. 6. 7 7.

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

CourseContents (MidTerm)
FinancialInstitutionsandRoleofGovt. RiskandFinancialcrisis TechnologyandInventioninFinance PortfolioDiversificationandSupportingFinancial I t Inst. 5. DeterminantsofAssetPricesandInterestRates 6 OrganizationandStructureofMarkets 6. 7. MarketforGovernmentandCorporateSecurities g g andSecuritizedAssetMarkets 8. Mortgage 9. MarketDerivativeSecurities PropertyofDepartmentofBusinessAdministration,Universityof
Sargodha 7

1. 2. 3. 4.

CourseContents (FinalTerm)
1. 2. 3. 4. 5. 6. 7. CollateralPresentValueandVocabularyofFinance MechanicsofFutureMarkets HedgingStrategiesusingfutures InterestratesandDeterminantsofForwardandFutureprices MechanicsofOptionMarkets Insurance:ThearchetypicalRiskManagementInstitution Financial lInstrumentsand dMajorWorld ldFinancial lCrisis

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

TodaysSession
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 9

Session I

WhyFinance WallStreetCrash1929 Japanese AssetPriceBubble p AsianFinancialCrisis ImportanceofFinancialMarkets BasicFinancialInstruments

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

10

WallStreetCrashof1929
ll S h of f 1929, also l k Th The W Wall Street C Crash known as the Black Tuesday and the Stock Market Crash of 1929, began in late October 1929 and was the most devastating stock market crash in the history of the United States, when taking into consideration the full extent and duration of its fallout. The crash signaled the beginning of the 10year Great Depression that affected all Western industrialized countries and did not end in the United States until the onset of American mobilization for World War II at the end of 1941. 15 million people had unemployment coming to them after the banks crashed.
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 11

Japaneseassetpricebubble1986
The Japanese asset price bubble was an economic b bbl in bubble i Japan from f 1986 86 to 1991, in i which hi h real l estate and stock prices were greatly inflated. The bubble's collapse subsequent q p lasted for more than a decade with stock prices initially bottoming in 2003, although they would descend even further amidst the global crisis in 2008. The Japanese asset price bubble contributed to what some refer to as the Lost Decade. Some economists, such as Paul Krugman, have argued that Japan fell into a liquidity trap during d i these h years.
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 12

AsianFinancialCrisis1997
The Asian financial crisis was a period of financial crisis that g gripped pp much of Asia beginning g g in July y 1997, and raised fears of a worldwide economic meltdown due to financial contagion. The crisis started in Thailand with the financial collapse of the Thai baht after the Thai government was forced to float the baht (due to lack of foreign currency to support its fixed f d exchange h rate), ) cutting its peg to the U.S. dollar, after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven.
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 13

USSubprimeMortgage
The U.S. U S subprime mortgage crisis was a set of events and conditions that led to the late2000s financial crisis, characterized by a rise in subprime mortgage d li i and df l d the h resulting li d li delinquencies foreclosures, and decline of securities backed by said mortgages. Several major p in September p 2008, with financial institutions collapsed significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 14

ImportanceofFinancialMarkets
Financial markets, such as bond and stock markets, are crucial in our economy. y These markets channel funds from savers to investors, thereby promoting economic efficiency. Market activity affects personal wealth wealth, the behavior of business firms, and economy as a whole Debt markets, or bond markets, allow governments, corporations, and individuals to borrow to finance activities.

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

15

ImportanceofFinancialMarkets
The stock market is the market where common stock (or just stock), representing ownership in a company, are e traded. ded Companies initially sell stock (in the primary market) to raise money. But after that, the stock is traded among investors (secondary market) market). The foreign exchange market is where international currencies trade and exchange rates are set. Although most people know little about this market, it has a daily volume around $1 trillion!
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

16

PakistanMarketIndicators 20072013

1. 2. 3. 4. 5.

PKR/USD KSE100Index InterestRate(SBOP) InflationRate PakGovt.BondYeild

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

17

DesignofFinancialMarkets

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

18

BasicFinancialInstruments
ItsyourTurn.. Turn

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

19

Session II
Introduction
FinancialAssets FinancialMarkets GlobalizationandFinancialMarkets D i ti M k t Derivative Markets

RoleofFinancialIntermediaries OverviewofAsset/LiabilityManagementforFIs RoleofGovernment

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

20

Introduction
ProductVSFactorMarket FinancialMarketandFinancialAssets FinancialAssets,FinancialInstruments,Securities DebtVSEquityInstruments PricingPrinciplesofFinancialAssets RoleofFinancialAsset
Transfer T f of fF Funds d from f S Surplus l toD Deficit fi i units i Redistributionofunavoidablerisk

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

21

FinancialMarkets
RoleofFinancialMarkets
PriceDiscoveryProcess OfferingLiquidity ReductionofSearch/InformationCost

ClassificationofFinancialMarkets
PrimaryVsSecondary(SeasoningofClaim) MoneyVsCapital(Maturity) DebtVsEquity(NatureofClaim) CashVsDerivative(Delivery/SettlementofClaim) OrganizedVsOTC(Structure)
22

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

GlobalizationofFinancialMarkets
Thefactorsthathaveledtotheintegrationof FinancialMarkets
Deregulation/Liberalization TechnologicalAdvancesformonitoring/executing. IncreasedInstitutionalizationofFinancialMarkets

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

23

FinancialInstitutions
FunctionsperformedbyFinancialInstitutions
FinancialIntermediation Exchangeoffinancialassetsonbehalfofcustomers Exchangeoffinancialassetsontheirownaccount Assistingincreationoffinancialassets Providinginvestmentadvice Managementofportfolios

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

24

FinancialIntermediaries

CommercialBanks Savingandloanassociation Saving gBanks Insurancecompanies Pensionfunds CaptiveFinanceCompanies??

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

25

RoleofFinancialIntermediaries

DirectandIndirectInvestments MaturityIntermediation RiskDiversification CostReduction PaymentMechanism

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

26

AssetLiabilityManagementof FinancialInstitutions
NatureofLiabilities
Theamountandtimingofthecashoutlaysthatmustbe madetosatisfy f thecontractualtermsof ftheobligation issued.(LiquidityConcerns)
TYPE OFLIABILITY AMOUNTOFCASH OUTLAY Type I Type yp II Type III Type IV Known Known Uncertain Uncertain TIMINGOFCASH OUTLAY Known Uncertain Known Uncertain

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

27

PrimaryAssetsandLiabilitiesofFIs

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

28

RoleofGovernmentinFinancial Markets
StopMarketFailure?
MainReasonsforRegulation 1 IncreaseInformationtoInvestors 1.
Decreasesadverseselectionandmoralhazardproblems SECforcescorporationstodiscloseinformation Preventsfinancialpanics Chartering,reportingrequirements,restrictionsonassets andactivities,depositinsurance,andanticompetitive measures Reserverequirements

2. Ensuring gtheSoundnessofFinancialIntermediaries

3. ImprovingMonetaryControl

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

29

RegulationReason:EnsureSoundness ofFinancialIntermediaries(cont.)
T Toprotect t tthe th public bli and dthe th economyfrom f fi financial i l panics,thegovernmenthasimplementedsixtypesof regulations: RestrictionsonEntry Disclosure RestrictionsonAssetsandActivities DepositInsurance LimitsonCompetition RestrictionsonInterestRates
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 30

Regulation: RestrictiononEntry
RestrictionsonEntry
Regulatorshavecreatedverytightregulationsastowho i allowed is ll dto t set tupafinancial fi i lintermediary i t di Individualsorgroupsthatwanttoestablisha financialintermediary, y,suchasabankoraninsurance company,mustobtainacharterfromthestateorthe federalgovernment Only O l ifthey th areupstanding t di citizens iti with ithimpeccable i bl credentialsandalargeamountofinitialfundswillthey givenacharter. beg
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 31

Regulation:Disclosure
DisclosureRequirements Th Therearestringent t i g treporting ti grequirements i t f for financialintermediaries
Theirbookkeepingmustfollowcertainstrictprinciples principles, Theirbooksaresubjecttoperiodicinspection, They ymustmakecertaininformationavailableto thepublic.

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

32

Regulation:Restrictionon AssetsandActivities
Restrictionsontheactivitiesandassetsofintermediaries helpstoensuredepositorsthattheirfundsaresafeand th tthe that th b bank korother th fi financial i lintermediary i t di will illb beable bl t to meetitsobligations. Intermediaryarerestrictedfromcertainriskyactivities Andfromholdingcertainriskyassets,oratleastfrom holdingagreaterquantityoftheseriskyassetsthanis prudent d

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

33

Regulation:DepositInsurance
The government can insure people depositors to a fi financial i l intermediary i di f from any financial fi i l loss l if the h financial intermediary should fail

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

34

Regulation: LimitsonCompetition
Althoughtheevidencethatunbridledcompetition amongfinancialintermediariespromotesfailuresthat willharmthepublicisextremelyweak,ithasnot stoppedthestateandfederalgovernmentsfrom imposingmanyrestrictiveregulations Inthepast,bankswerenotallowedtoopenup branchesinotherstates,andinsomestatesbanks wererestrictedfromopening additional add t o a locations ocat o s
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 35

Regulation:Restrictions onInterestRates
Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on d deposits it These regulations were instituted because of the widespread belief that unrestricted interestrate competition helped encourage bank failures during the Great Depression Later evidence does not seem to support this view, and restrictions on interest rates have been abolished

PropertyofDepartmentofBusinessAdministration,Universityof Sargodha

36

RegulationReason: ImproveMonetaryControl
Because banks play a very important role in determining the supply of money (which in turn affects many aspects of the economy) much regulation of these financial intermediaries economy), is intended to improve control over the money supply One such regulation is reserve requirements, which make it bli t f ll d it i tit ti t t i obligatory for all depository institutions to k keep a certain fraction of their deposits in accounts with the Federal Reserve System (the Fed), the central bank in the United States Reserve requirements help the Fed exercise more precise y supply pp y control over the money
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 37

ThankYou!
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 38