2. Overview
◦ The Capital Allocation Process
◦ Financial Markets
◦ Financial Institutions
◦ Stock Markets and Returns
◦ Stock Market Efficiency
3. Financial Markets and Institutions
◦ The Economy Depends on a Strong Financial System
◦ Well-functioning financial markets facilitate the flow of capital from
investors to the users of capital.
◦ Well-functioning markets promote economic growth.
◦ Economies with well-developed markets perform better than
economies with poorly-functioning markets.
4. How is Capital Transferred Between Savers
and Borrowers
Direct transfers
Investment banks
Financial intermediaries
5. The Capital Allocation Process
Transfer of Funds between:
• lenders to borrowers
• from those who are in surplus to those in need
oFunds Transfer ways
• Direct transfer—financial institutions are not used; funds loaned
directly to borrowers.
• usually used by individuals in small firms
• little capital raised
6. The Capital Allocation Process
Transfers through an investment bank (IB)
◦ Investment bank underwrites and facilitates the issuance of securities.
◦ The company sells its stocks or bonds to the investment bank, which
then sells these same securities to savers.
◦ Risk for investment bank
◦ It may not be able to resell the securities to savers for as much as it
paid
7. The Capital Allocation Process
Transfers through a financial intermediary
◦ The intermediary obtains funds from savers in exchange for its
securities.
◦ Intermediaries create new form of capital
◦ Like certificate of deposits
8. Key terms
◦ Investment banker—an organization that specializes in issuing
stocks and bonds; serves as an agent that gets borrowers and lenders
together; gets a commission/fee for services rendered.
◦ Financial intermediary—a firm that issues its own securities (either
stocks or bonds) to get funds from savers, and then lends the funds to
borrowers; earns the difference between the rate that is charged on
the loans and the rate that is paid to attract funds.
◦ Today, many financial intermediaries offer a variety of services, including
taking deposits, lending funds to individuals and businesses, and other
financial services, such as investments and related services.
9.
10. Financial Institutions
Commercial Banks
Insurance Companies
Mutual Funds
Pension Funds
Suppliers Of Funds Demanders of funds
Businesses Businesses
Government Government
Individuals Individuals
Financial Markets
Money Market
Capital market
Funds supplied through
investments in…
Funds supplied
directly through…
Firms operate in a financial system…
10
11. Financial Markets
◦ People and organizations wanting to borrow money are brought
together with those who have surplus funds in the financial markets.
12. Types of markets
Physical asset markets
◦ tangible” or “real” asset markets
◦ for products like wheat, autos, real estate, computers and machinery
Financial asset market
◦ stocks, bonds, notes, and mortgages
◦ financial markets also deal with derivative securities
◦ Derivatives: Any financial asset whose value is derived from the value of some
other ‘underlying’ asset
◦ Forwards, futures, Options, and swaps are securities whose value is determined,
or derived directly from other assets
◦ These can be used to manage risk or to speculate.
13. Types of Markets
Spot markets
◦ Markets in which assets are bought or sold for “on-the-spot” delivery (literally,
within a few days).
Futures markets
◦ Markets in which participants agree today to buy or sell an asset at some future
date.
◦ In Pakistan, futures are traded on Pakistan Mercantile Exchange (PMEX)
14. Types of Markets
◦ Debt Markets bond market or credit market
◦ buying and selling of debt securities.
◦ Usually, fixed income securities are traded in debt market.
◦ treasury, corporate, municipal bonds, mortgage-backed securities, etc...
◦ Equity Markets
◦ stock market or share market.
◦ trading of equity /shares/stocks
◦ Equity represents ownership in the corporation.
15. Equity Markets
◦ Primary market
◦ corporations raise funds by issuing new securities (shares/stocks).
◦ Initial public Offerings (IPOs), Private placement, Right issue
◦ Secondary market
◦ securities are traded among investors after they have been issued
◦ Provides liquidity
◦ Lowers transaction costs due to high volume of transactions
◦ Encourages new investment
◦ The corporation whose securities are being traded is not involved in a secondary
market transaction and thus does not receive funds from such a sale.
16. Types of Markets
Money markets
◦ Markets for short-term, highly liquid debt securities.
Maturity of one year or less.
Examples: Treasury bills (T-bills); Commercial papers
The New York, London, and Tokyo money markets are among the world’s largest.
Capital market
◦ Markets for intermediate- or long-term debt and corporate stocks
Examples: Common stock, Preferred stock, Corporate bond, Treasury bond, Municipal bond.
oShort-term generally less than 1-year, intermediate term means 1 to 10 years, and
long-term means more than 10 years.
17. Types of Markets
◦ Money Market
◦ Short term Securities
◦ Only debt securities
◦ Low risk
◦ Low return
◦ High liquidity
◦ Low price volatility
◦ Capital markets
◦ Long term securities
◦ Both debt and equity
◦ Higher risk
◦ Higher return
◦ Higher price volatility
18. Types of Markets
Private markets
◦ Markets where transactions are negotiated directly between two or more parties
◦ Bank loans and private debt placements with insurance companies.
◦ Features – Customized, negotiation
Public markets
◦ Securities that are traded in public markets like common stocks and corporate
bonds are example of public markets.
◦ Features — Broad ownership, standardization, liquid
19. Financial Institutions
◦ Financial services corporations – large conglomerates that combine
many different services (investment banking, brokerage operations,
insurance, and commercial banking) within a single corporation.
◦ Investment banks – Also called underwriters, traditionally help
companies obtain financing/ raise capital.
◦ Commercial banks — serving a variety of savers and borrowers.
20. Financial Institutions
◦ Credit unions— provide range of banking services to their
members, who are also the owners of the credit union.
◦cooperative associations in which members have a common
bond, such as the same type of employment.
◦ Life insurance companies – take savings in the form of annual
premiums; invest these funds in stocks, bonds, real estate, and
mortgages; and make payments to the beneficiaries of the insured
parties
21. Financial Institutions
◦ Mutual funds—investment companies that collect (pool) funds from
savers and reinvest the funds in financial assets, such as stocks and
bonds.
◦ Money Market Funds —Mutual funds that invest in short-term,
low-risk securities and allow investors to write checks against their
accounts.
◦ Actively managed funds – Try to outperform the overall markets.
◦ Indexed funds – are designed to simply replicate the performance of
a specific market index.
22. Financial Institutions
◦ Hedge funds
◦ similar to mutual funds because they accept money from savers and
use the funds to buy various securities, but there are largely
unregulated. typically have large minimum investments (often
exceeding $1 million) and are marketed primarily to institutions and
individuals with high net worth.
◦ Private equity companies
◦ organizations that operate much like hedge funds, but rather than
purchasing some of the stock of a firm, private equity players buy and
then manage entire firms. Most of the money used to buy the target
companies is borrowed.
23. The Stock Market
Physical Stock Exchanges—organized physical stock exchanges are
physical locations where stocks are traded;
◦ the New York Stock Exchange (NYSE) is the largest organized
exchange
◦ The Over-the-Counter Market (OTC)
◦ Collection of brokers and dealers connected electronically
◦ Provides for trading in securities not listed on the organized
exchanges
24. The Market for Common Stock
Closely Held Corporations
◦ A corporation that is owned by a few individuals who are typically
associated with the firm’s management.
Publicly owned Corporation
◦ A corporation that is owned by a relatively large number of
individuals who are not actively involved in the firm’s
management.
25. Stock Market Transactions
1. Secondary market
◦ trading existing stocks
2. Primary market
◦ existing firm issues/sell additional shares
3. Initial Public Offering (IPO)
◦ privately held company offers stock to the public for the first
time called “going public”
◦ Going public” enables a company’s owners to raise capital from
a wide variety of outside investors.
◦ Public companies are subject to additional regulations and
reporting requirements.
26. Stock Market Transactions
◦ Apple decides to issue additional stock with the assistance of its
investment banker. An investor purchases some of the newly issued
shares. Is this a primary market transaction or a secondary market
transaction?
◦ Since new shares of stock are being issued, this is a primary market
transaction.
◦ What if instead an investor buys existing shares of Apple stock in the
open market. Is this a primary or secondary market transaction?
◦ Since no new shares are created, this is a secondary market transaction.
27. Stock Market Efficiency
• Securities are normally in equilibrium and are “fairly priced.”
• It implies that, on average, asset/stock prices are about equal to their intrinsic
values.
Example:
• You hear in the news that a medical research company received FDA approval for
one of its products. If the market is highly efficient, can you expect to take
advantage of this information by purchasing the stock?
• No. If the market is efficient, this information will already have been incorporated
into the company’s stock price. So, it’s probably too late for you to “capitalize” on the
information.
28. Behavioral Finance
Although the logic behind the EMH is compelling, many events in the
real world seem inconsistent with the hypothesis, which has spurred a
growing field called behavioral finance.
◦ Rather than assuming that investors are rational, behavioral finance
theorists borrow insights from psychology to better understand how
irrational behavior can be sustained over time.
◦ Cognitive biases cause investors to make systematic mistakes that lead
to inefficiencies
◦ Overconfidence—self-attribution bias and hindsight bias
30. Some key facts and figures from PSX
◦ Listed Companies 540
◦ Market Capitalization Rs. 8398.456 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 February 7, 2021.
