The Domestic and Global Financial Marketplace

Chapter 2:

2004 by Nelson, a division of Thomson Pakistan Limited

Introduction
This chapter looks at the domestic and

international financial marketplaces within which business firms operate.

2004 by Nelson, a division of Thomson Pakistan Limited

Central Banking
The State Bank (Pakistans Central Bank) was
created to:
Manage the growth of the money supply Act as banker for Government of Pakistan Act as banker for Pakistani chartered banks Act as lender of last resort Administer the Bank Act Administer and regulate the orderly buying and selling of Pakistani Rupee in foreign exchange markets

2004 by Nelson, a division of Thomson Pakistan Limited

Monetary Policy
Monetary Policy refers to the different tools and
actions that the State Bank can use to manage price stability (inflation) and Pakistani interest rates.

2004 by Nelson, a division of Thomson Pakistan Limited

Interest Rates
Pakistani interest rates affect domestic economic
activity Low interest rates stimulate economic activity High interest rates dampen economic activity

The value of the Pakistani dollar in foreign

exchange markets Low interest rates Pakistani rupee falls High interest rates Pakistani rupee rises

2004 by Nelson, a division of Thomson Pakistan Limited

Important Interest Rates

Bank Rate: interest rate charged to borrow
from the State Bank of Pakistan. Set at upper bound of the Operating Band.

Overnight Rate: interest rate charged on

short-term loans between chartered banks The State Bank of Pakistan will attempt to keep this rate within the Operating Band.

Prime Rate: lowest published rate banks

charge on loans to large, creditworthy business customers

2004 by Nelson, a division of Thomson Pakistan Limited

The Financial System

Primary function is to facilitate the flow of
savings from savers to borrowers

This occurs through two primary channels:

Financial intermediaries (such as Chartered Banks, Trust Companies & Credit Unions) Direct (but facilitated by Investment Banks)

2004 by Nelson, a division of Thomson Pakistan Limited

Financial System

Cash Securities

Intermediated: Banks & Near Banks

Cash Securities

Direct: Investment Banks Cash

Securities

2004 by Nelson, a division of Thomson Pakistan Limited

Borrowers

Savers

Types of Financial Institutions

Chartered Banks
Trust Companies (A legal entity that acts as
fiduciary, agent or trustee on behalf of a person or business entity for the purpose of administration, management and the eventual transfer of assets to a beneficial party).

Credit Unions Investment Companies Pension Funds Insurance Companies

9 2004 by Nelson, a division of Thomson Pakistan Limited

Financial Assets
Debt securities: represent evidence of the
indebtedness of Party A to Party B

Equity securities: represent evidence of

ownership

Derivative securities: contracts deriving

value from another underlying asset Note: every financial asset is offset by an identical financial liability somewhere in the financial system.

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2004 by Nelson, a division of Thomson Pakistan Limited

Financial Markets
The vehicles through which financial assets are
bought, sold, and traded.

Financial markets may be classified as:

Money or capital markets Primary or secondary markets

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2004 by Nelson, a division of Thomson Pakistan Limited

Money and Capital Markets

Money markets: market for short-term, highquality debt securities with maturities of 1-year or less

Capital markets: market for long-term

securities (both debt & equity) having maturities greater than 1-year

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2004 by Nelson, a division of Thomson Pakistan Limited

Primary and Secondary Markets

Primary market: refers to the process

whereby issuers sell new securities to investors

Secondary market: refers to the process

whereby investors sell existing securities to other investors

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2004 by Nelson, a division of Thomson Pakistan Limited

Secondary Markets
Security Exchanges (Example: TSX)
Formal marketplace with specific requirements for listing and trading securities Often are associated with a market index (i.e. TSX, Dow Jones, S&P 500, NASDAQ)

Over-the-counter (OTC) Market

Public stock issues not traded on any domestic stock exchange A virtual, negotiated market. Dealers act as market makers

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2004 by Nelson, a division of Thomson Pakistan Limited

Services of Investment Dealers

Creation of offer documents (such as a
Prospectus)

Providing long-range financial planning

assistance

Providing guidance concerning the timing of

security issues

Marketing securities to potential investors

Arranging private loans and leases Negotiating mergers
15 2004 by Nelson, a division of Thomson Pakistan Limited

How Securities are sold

Public cash offering: securities are sold to
the public through an investment dealer

Private, or direct placement: securities are

sold to one or more large investors

Rights offering: a new issue of common

stock is sold to existing shareholders at an offer price below the current market price

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2004 by Nelson, a division of Thomson Pakistan Limited

International Finance
Global Financial Transaction Decisions
Import
Export Open a Foreign Branch Licensing Arrangements Joint Ventures Become a Multinational Corporation

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2004 by Nelson, a division of Thomson Pakistan Limited

Global Risks
Fluctuating exchange rates Changing government regulations Changing tax laws Unfamiliar business practices Shifting political environments

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2004 by Nelson, a division of Thomson Pakistan Limited

Some Important Terms

Exchange rate: rate that one currency can be
bought or sold for another

Direct quote: home currency price for one unit

of foreign currency Example: $1.4230 CAD per $1.00 US

Indirect quote: foreign currency price of one

unit of domestic currency Example: $0.7027 US per $1.00 CAD

Spot rate: current exchange rate

Forward exchange rate: exchange rate for a
transaction to take place in the future
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Futures & Forward Contracts

Both futures and forward contracts allow one to
agree today to an exchange to take place in the future, at a price agreed upon today. speculate (assume additional risk with the hope of making a profit)
Example: An exporter has a US $100,000 receivable coming due in 30 days. To reduce exchange rate risk, the exporter can sell the US dollars today for delivery in 30 days time, at a price agreed upon today
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May be used to either hedge (reduce risk) or

2004 by Nelson, a division of Thomson Pakistan Limited

Futures versus Forward Contracts

Futures
Exchange traded Standardized Marked-to-Market daily (profits & losses flow through margin account) Requires margin account

Forwards
Trade OTC Customized Profits/losses realized only at contract expiry No margin required

No default risk (due to Clearinghouse)

Default risk exists (no Clearinghouse)

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2004 by Nelson, a division of Thomson Pakistan Limited

Foreign Currency Options

Call Option
buyer has the right, but not the obligation, to buy at a specified price for a specified period of time

Put Option
buyer has the right, but not the obligation, to sell at a specified price for a specified period of time

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2004 by Nelson, a division of Thomson Pakistan Limited

Effect of Income Taxes

Taxes affect most financial transactions:
Capital budgeting: after-tax cash flows, depreciation, net present value (NPV)
Capital structure policy: tax advantage of debt financing Dividend policy: capital gains versus dividend policy Leasing: motivated by tax effects

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2004 by Nelson, a division of Thomson Pakistan Limited

Major Points
The State Bank plays a significant role in the
management of the money supply.

Securities trade on exchanges or over-the-

counter markets which may be classified as primary or secondary. and territory.

Market regulation is carried out by each province

Taxes affect all financial transactions and

business decisions.

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2004 by Nelson, a division of Thomson Pakistan Limited