MGT411 Accounting , Banking & Finance Glossary And FAQ's Short Questions Answers | VULMS Help: Virtual University of Pakistan

TEXT AND REFERENCE MATERIAL &

FIVE PARTS OF THE FINANCIAL SYSTEM

The Primary textbook for the course will be

 “Money, Banking and Financial Markets” by Stephan G. Cecchetti

International Edition, McGraw Hill Publishers, ISBN 0-07-111565-X”

Reference books will be

 “The Economics of Money, Banking and Financial Markets”, by Fredrick S. Mishkin

7th Edition Addison Wesley Longman Publishers

 “Principles of Money, Banking and Financial Markets” by Lawrence S. Ritter, Willaim L. Silber and

Gregory F. Udell, Addison Wesley Longman Publishers

Course Contents

 Money and the Financial System

 Money and the Payments System

 Financial Instruments, Financial Markets, and Financial Institutions

 Interest rate, financial instruments and financial markets

 Future Value, Present Value and Interest Rates

 Understanding Risk

 Bonds, Pricing and Determination of Interest Rates

 The Risk and Term Structure of Interest Rates

 Stocks, Stock Markets and Market Efficiency

 Financial Institutions

 Economics of Financial Intermediation

 Depositary Institutions: Banks and bank Management

 Financial Industry Structure

 Regulating the financial system

 Central Banks, Monetary Policy and Financial stability

 Structure of central banks

 Balance sheet and Money Supply process

 Monetary policy

 Exchange rate policy

 Modern Monetary Economics

 Money growth and Money Demand

 Aggregate demand

 Business Cycle

 Output and inflation in the short run

 Money and Banking in Islam

 Monetary and financial policy and structure for an Interest-free economy

 Islamic Banking in the contemporary world

Five Parts of the Financial System

 Money

 Financial Instruments

 Financial Markets

 Financial Institutions

 Central Banks

1. Money

 To pay for purchases

 To store wealth

 Evolved from gold and silver coins to paper money to today’s electronic funds transfers

Money & Banking – MGT411 VU

 Traditional Paycheck system vs. ATM Withdrawals and Mailed transactions vs. E-banking

2. Financial Instruments

 To transfer wealth from savers to borrowers

 To transfer risk to those best equipped to bear it.

 Once investing was an activity reserved for the wealthy

 Costly individual stock transactions through stockbrokers

 Information collection was not so easy

 Now, small investors have the opportunity to purchase shares in “mutual funds.”

3. Financial Markets

 To buy and sell financial instruments quickly and cheaply

 Evolved from coffeehouses to trading places (Stock exchanges) to electronic networks

 Transactions are much more cheaper now

 Markets offer a broader array of financial instruments than were available even 50 years ago

4. Financial Institutions

 Provide access to financial markets

 Banks evolved from Vaults and developed into deposits- and loans-agency

 Today’s banks are more like financial supermarkets offering a huge assortment of financial

products and services for sale.

 Access to financial markets

 Insurance

 Home- and car-loans

 Consumer credit

 Investment advice

5. Central Banks

 Monitors financial Institutions

 Stabilizes the Economy

 Initiated by Monarchs to finance the wars

 The govt. treasuries have evolved into the modern central bank

 Control the availability of money and credit in such a way as to ensure

 Low inflation,

 High growth, and

 The stability of the financial system

 State Bank of Pakistanwww.sbp.org.pk

Summary

Five Parts of the Financial System

 Money

 Financial Instruments

 Financial Markets

 Financial Institutions

 Central Banks

Money & Banking – MGT411 VU

Lesson 2

FIVE CORE PRINCIPLES OF MONEY AND BANKING

1. Time has Value

 Time affects the value of financial instruments.

 Interest payments exist because of time properties of financial instruments

Example

 At 6% interest rate, 4 year loan of $10,000 for a car

 Requires 48 monthly installments of $235 each

 Total repayment = $235 x 48 = $11,280

 $11,280 > $10,000 (Total

repayment) (Amount of loan)

 Reason: you are compensating the lender for the time during which you use the funds

2. Risk Requires Compensation

 In a world of uncertainty, individuals will accept risk only if they are compensated in some form.

 The world is filled with uncertainty; some possibilities are welcome and some are not

 To deal effectively with risk we must consider the full range of possibilities:

 Eliminate some risks,

 Reduce others,

 Pay someone else to assume particularly onerous risks, and

 Just live with what’s left

 Investors must be paid to assume risk, and the higher the risk the higher the required payment

 Car insurance is an example of paying for someone else to shoulder a risk you don’t want to take.

Both parties to the transaction benefit

 Drivers are sure of compensation in the event of an accident

 The insurance companies make profit by pooling the insurance premiums and investing them

 Now we can understand the valuation of a broad set of financial instruments

 E.g., lenders charge higher rates if there is a chance the borrower will not repay.

3. Information is the basis for decisions

 We collect information before making decisions

 The more important the decision the more information we collect

 The collection and processing of information is the basis of foundation of the financial system.

 Some transactions are arranged so that information is NOT needed

 Stock exchanges are organized to eliminate the need for costly information gathering and thus

facilitate the exchange of securities

 One way or another, information is the key to the financial system

4. Markets set prices and allocate resources

 Markets are the core of the economic system; the place, physical or virtual,

 Where buyers and sellers meet

 Where firms go to issue stocks and bonds,

 Where individuals go to purchase assets

 Financial markets are essential to the economy,

 Channeling its resources

 Minimizing the cost of gathering information

 Making transactions

 Well-developed financial markets are a necessary precondition for healthy economic growth

 The role of setting prices and allocation of resources makes the markets vital sources of

information

 Markets provide the basis for the allocation of capital by attaching prices to different stocks or

bonds

Money & Banking – MGT411 VU

 Financial markets require rules to operate properly and authorities to police them

 The role of the govt. is to ensure investor protection

 Investor will only participate if they perceive the markets are fair

5. Stability improves welfare

 To reduce risk, the volatility must be reduced

 Govt. policymakers play pivotal role in reducing some risks

 A stable economy reduces risk and improves everyone's welfare.

 By stabilizing the economy as whole monetary policymakers eliminate risks that individuals can’t

and so improve everyone’s welfare in the process.

 Stabilizing the economy is the primary function of central banks

 A stable economy grows faster than an unstable one

Financial System Promotes Economic Efficiency

 The Financial System makes it Easier to Trade

 Facilitate Payments - bank checking accounts

 Channel Funds from Savers to Borrowers

 Enable Risk Sharing - Classic examples are insurance and forward markets

1. Facilitate Payments

 Cash transactions (Trade “value for value”). Could hold a lot of cash on hand to pay for things

 Financial intermediaries provide checking accounts, credit cards, debit cards, ATMs

 Make transactions easier.

2. Channel Funds from Savers to Borrowers

 Lending is a form of trade (Trade “value for a promise”)

 Give up purchasing power today in exchange for purchasing power in the future.

 Savers: have more funds than they currently need; would like to earn capital income

 Borrowers: need more funds than they currently have; willing and able to repay with interest in the

future.

 Why is this important?

A) Allows those without funds to exploit profitable investment opportunities.

 Commercial loans to growing businesses;

 Venture capital;

 Student loans (investment in human capital);

 Investment in physical capital and new products/processes to promote economic growth

B) Financial System allows the timing of income and expenditures to be decoupled.

 Household earning potential starts low, grows rapidly until the mid 50s, and then declines with age.

 Financial system allows households to borrow when young to prop up consumption (house loans,

car loans), repay and then accumulate wealth during middle age, then live off wealth during

retirement.

Money & Banking – MGT411 VU

Figure: Channel Funds from Savers to Borrowers

3. Enable Risk Sharing

 The world is an uncertain place. The financial system allows trade in risk. (Trade “value for a

promise”)

 Two principal forms of trade in risk are insurance and forward contracts.

 Suppose everyone has a 1/1000 chance of dying by age 40 and one would need $1 million to

replace lost income to provide for their family.

 What are your options to address this risk?

Summary

 Five Core Principles of Money and Banking

 Time has Value

 Risk Requires Compensation

 Information is the basis for decisions

 Markets set prices and allocate resources

 Stability improves welfare

 Financial System Promotes Economic Efficiency

 Facilitate Payments

 Channel Funds from Savers to Borrowers

 Enable Risk Sharing

Consumption

Income

TimRetirement e

Begins

Dissavings Dissavings

Savings

Money & Banking – MGT411 VU

Lesson 3

MONEY & THE PAYMENT SYSTEM

 Money

 Characteristics of Money

 Liquidity

 Payment system

 Commodity vs. Fiat Money

 Cheques

 Other forms of payments

 Future of Money

Money

 Money is an asset that is generally accepted as payment for goods and services or repayment of

debt.

 Not the same as wealth or income

 Money is a component of wealth that is held in a readily- spend able form

 Money is made up of

 Coin and currency

 Chequing account balances

 Other assets that can be turned into cash or demand deposits nearly instantaneously, without risk

or cost (liquid wealth)

Distinctions among Money, Wealth, and Income

 While money, income and wealth are all measured in some currency unit, they differ significantly in

their meaning.

 People have money if they have large amounts of currency or big bank accounts at a point in time.

(Stock variable)

 Someone earns income (not money) from work or investments over a period of time. (Flow

variable)

 People have wealth if they have assets that can be converted into more currency than is necessary

to pay their debts at a point in time. (Stock variable)

Characteristics of Money

 A means of payment

 A unit of Account

 A Store of Value

A means of payment

 The primary use of money is as a means of payment.

 Money is accepted in economic exchanges.

 Barter is an alternative to using money but it doesn’t work very well.

 Barter requires a “double coincidence of wants,” meaning that in order for trade to take place both

parties must want what the other has.

 Money finalizes payments so that buyers and sellers have no further claim on each other.

 As economies have become more complex and physically dispersed the need for money has grown.

 Just as the division of labor and specialization allow for efficient production, money allows for

efficient exchange.

A unit of Account

 We measure value using rupees and paisas.

 Money is the unit of account that we use to quote prices and record debts.

Money & Banking – MGT411 VU

 Money can be referred to as a standard of value.

 Using money makes comparisons of value easy

 Under barter the general formula for n goods, we will have n (n - 1) / 2 prices

 Two goods 1 price

 3 goods 3 prices

 100 goods 4,950 prices

 10,000 goods 50 million prices

A Store of Value

 For money to function as a means of payment it has to be a store of value too because it must

retain its worth from day to day.

 The means of payment has to be durable and capable of transferring purchasing power from one

day to the next.

 Money is not the only store of value; wealth can be held in a number of other forms.

 Other stores of value can be preferable to money because they pay interest or deliver other services.

 However, we hold money because it is liquid, meaning that we can use it to make purchases.

 Liquidity is a measure of the ease with which an asset can be turned into a means of payment

(namely money).

 The more costly an asset is to turn into money, the less liquid it is.

 Constantly transforming assets into money every time we wish to make a purchase would be

extremely costly; hence we hold money

Liquidity

 Liquidity is a measure of the ease an asset can be turned into a means of payment, namely money

 An asset is liquid if it can be easily converted into money and illiquid if it is costly to convert.

 Cash is perfectly liquid.

 Stocks and bonds are somewhat less liquid.

 Land is least liquid.

The Payments System

 The payment system is a web of arrangements that allows for the exchange of goods and services,

as well as assets among different people

 Money is at the heart of payment system!

Types of Money

 Commodity Money – Things that have intrinsic value

 Fiat Money – Value comes from government decree (or fiat)

Commodity Money

 The first means of payment were things with intrinsic value like silk or salt.

 Successful commodity monies had the following characteristics

 They were usable in some form by most people;

 They could be made into standardized quantities;

 They were durable;

 They had high value relative to their weight and size so that they were easily transportable; and

 They were divisible into small units so that they were easy to trade

 For most of human history, gold has been the most common commodity money

Fiat Money

 Today we use paper money that is fiat money, meaning that its value comes from government

decree (or fiat).

 A note costs about 0.04% its worth to produce.

 These notes are accepted as payment for goods or in settlement of debts for two reasons:

 We take them because we believe we can use them in the future.

Money & Banking – MGT411 VU

 The law says we must accept them; that is what the words “legal tender” printed on the note

means.

 As long as the government stands behind its paper money, and doesn’t issue too much of it, we will

use it. In the end, money is about trust.

Fiat or Commodity Money?

 Does money need to be backed by a commodity at all?

 The logical answer to this question is no.

 If the monetary system is stable and functions effectively, “backing” is expensive, inconvenient, and

unnecessary.

 Today, money is only backed by confidence that government will responsibly limit the quantity of

money to ensure that money in circulation will hold its value.

Advantages of Fiat Money

 Fewer resources are used to produce money.

 The quantity of money in circulation can be determined by rational human judgment rather than by

discovering further mineral deposits—like gold or diamonds

Disadvantage

 A corrupt or pressured government might issue excessive amounts of money, thereby unleashing

severe inflation.

Cheques

 Cheques are another way of paying for things, but

 They are not legal tender

 They are not even money.

 Cheques are instructions to the bank to take funds from your account and transfer those funds to

the person or firm whose name is written in the “Pay to the Order of” line.

 When you give someone a Cheque in exchange for a good or service, it is not a final payment;

 A series of transactions must still take place that lead to the final payment

 Following are the steps in the process

1- You hand a paper cheque from your bank to a merchant in exchange for some good

2- The merchant deposits the cheque into merchant’s bank and merchant’s account is credited

3- The merchant’s bank sends the cheque to the local central bank

4- The Central Bank

(a) Credits the merchant’s bank’s reserve account

(b) Debits your bank’s reserve account

(This step involves money)

5- The Central Bank returns the cheque to your bank

6- Your bank debits your Chequing account by the amount of the cheque

 The whole process is time consuming and expensive;

 Though cheque volumes have begun to fall, paper Cheques are still with us because a cancelled

cheque is legal proof of payment

Other Forms of Payments

 Debit Cards

 Credit Cards

 Electronic Funds transfers

 Stored Value Cards

Money & Banking – MGT411 VU

Lesson 4

OTHER FORMS OF PAYMENTS

Debit Card

 The money in your account is used for payments

 Works like a cheque and there is usually a fee for the transaction

Credit card

 It is a promise by a bank to lend the cardholder money with which to make purchases.

 When the card is used to buy merchandise the seller receives payment immediately

 The money that is used for payment does not belong to the buyer

 Rather, the bank makes the payment, creating a loan that the buyer must repay.

 So, they do not represent money; rather, they represent access to someone else’s money

Electronic Funds Transfer

 Move funds directly from one account to another.

 Banks use these transfers to handle transactions among themselves

 Individuals may be familiar with such transfers through direct deposit of their paycheques and the

payment of their utility bills, etc

E-money

 Used for purchases on the Internet.

 You open an account by transferring funds to the issuer of the e-money

 When shopping online, instruct the issuer to send your e-money to the merchant

 It is really a form of private money.

Stored-value card

 Retail businesses are experimenting with new forms of electronic payment

 Prepaid cellular cards, Internet scratch cards, calling cards etc

The Future of Money

 The time is rapidly approaching when safe and secure systems for payment will use virtually no

money at all

 We will also likely see

 Fewer “varieties” of currency, (a sort of standardization of money) and

 A dramatic reduction in the number of units of account

 Money as a store of value is clearly on the way out as many financial instruments have become

highly liquid.

Measuring Money

 Different Definitions of money based upon degree of liquidity. Federal Reserve System defines

monetary aggregates.

 Changes in the amount of money in the economy are related to changes in interest rates, economic

growth, and most important, inflation.

 Inflation is a sustained rise in the general price level

 With inflation you need more money to buy the same basket of goods because it costs more.

 Inflation makes money less valuable

 The primary cause of inflation is the issuance of too much money

 Because money growth is related to inflation we need to be able to measure how much money is

circulating

 Money as a means of payments

 We measure the quantity of money as the quantity of currency in circulation – an unrealistically

limited measure, since there are other ways of payments

 Alternatively, broadly categorize financial assets and sort them by the degree of liquidity

 Sort them by the ease with which they can be converted into a means of payments

 Arrange them from most liquid to least liquid

 Draw a line and include everything on one side of the line in the measure of the money

Money & Banking – MGT411 VU

 Where to draw the line?

 In reality, we draw line at different places and compute several measures of money called the

monetary aggregates

 M1, M2, and M3

 M1 is the narrowest definition of money and includes only currency and various deposit accounts

on which people can write Cheques.

 Currency in the hands of the public,

 Traveler’s Cheques,

 Demand deposits and

 Other chequeable deposits

 M2 includes everything that is in M1 plus assets that cannot be used directly as a means of payment

and are difficult to turn into currency quickly,

 Small-denomination time deposits,

 Money market deposit accounts,

 Money market mutual fund shares

 M2 is the most commonly quoted monetary aggregate since its movements are most closely related

to interest rate and economic growth.

 M3 adds to M2 other assets that are important to large institutions

 Large-denomination time deposits,

 Institutional money market mutual fund shares,

 Repurchase agreements and

 Eurodollars

_ Symbol Assets included

C Currency

M1 C + demand deposits, travelers’ Cheques,

other chequeable deposits

M2 M1 + small time deposits, savings deposits,

money market mutual funds, money market deposit accounts

M3 M2 + large time deposits, repurchase agreements, institutional money market

mutual fund balances

Money & Banking – MGT411 VU

Monetary Aggregates Figures in millions as of March 2005

1. Currency issued 711,997

2. Currency held by SBP 3,188

3. Currency in tills of Scheduled Banks 43,914

4. Currency in circulation (1 – 2 – 3) 664,895

5. Scheduled Banks demand deposits 93,272

6. Other Deposits with SBP 4,826

7. M1 (4+5+6) 1,602,423

8. Scheduled Banks Time Deposits 1,037,678

9. Resident Foreign Currency Deposits 172,074

10. Total Monetary Assets (M2) 2,812,175

11. M3 3,833,686

Source: State Bank of Pakistan

Table : The Monetary Aggregates

Monetary Aggregates Value as of August 2004 (U.S.$ billion)

M1= Currency in the hands of the public

+ Traveler’s checks

+ Demand deposits

+ Other checkable deposits

Total M1

686.2

7.6

315.3

328.5

1,337.6

M2=M1

+ Small-denomination time deposits

+ Savings deposits including money market deposit

accounts

+ Retail money market mutual fund shares

Total M2

794.7

3415.3

735.5

6,283.1

M3=M2

+ Large-denomination time deposits

+ Institutional money market mutual fund shares

+ Repurchase agreements

+ Eurodollars

Total M3

1,036.3

1,104.7

516.6

344.5

9,285.2

Money & Banking – MGT411 VU

Figure: Growth Rates in Monetary Aggregates

-5

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

1990-91

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

Years

Measures of Inflation

 Fixed-weight Index - CPI

 Deflator – GDP or Personal Consumption Expenditure Deflator

Consumer Price Index (CPI)

 Measure of the overall level of prices used to

 Track changes in the typical household’s cost of living

 Allow comparisons of dollar figures from different years

 Survey consumers to determine composition of the typical consumer’s “basket” of goods.

 Every month, collect data on prices of all items in the basket; compute cost of basket

 CPI in any month equals

Figure: Money Growth and Inflation

Cost of basket in that month

100

Cost of basket in base period

Money & Banking – MGT411 VU

Example:

The basket contains 20 pizzas and 10 compact discs.

Prices

Years Pizza CDs

2002 $10 $15

2003 $11 $15

2004 $12 $16

2005 $13 $15

From this table, we can calculate the inflation rate as:

Years Cost of Basket CPI Inflation rate

2002 $350 100.0 n.a.

2003 370 105.7 5.7%

2004 400 114.3 8.1%

2005 410 117.1 2.5%

GDP Deflator

The GDP deflator, also called the implicit price deflator for GDP, measures the price of output relative to

its price in the base year. It reflects what’s happening to the overall level of prices in the economy

GDP Deflator = (Nominal GDP / Real GDP) ×100

Years Nom. GDP Real GDP GDP Deflator Inflation Rate

2001 Rs46, 200 Rs46, 200 100.0 n.a.

2002 51,400 50,000 102.8 2.8%

2003 58,300 52,000 112.1 9.1%

Money & Banking – MGT411 VU

Lesson 5

FINANCIAL INTERMEDIARIES

 Financial Intermediaries

 Financial Instruments

 Uses

 Characteristics

 Value

 Examples

Financial Intermediaries

 The informal arrangements that were the mainstay of the financial system centuries ago have since

given way to the formal financial instruments of the modern world

 Today, the international financial system exists to facilitate the design, sale, and exchange of a broad

set of contracts with a very specific set of characteristics.

 We obtain the financial resources we need from this system in two ways:

 Directly from lenders and

 Indirectly from financial institutions called financial intermediaries.

Indirect Finance

 A financial institution (like a bank) borrows from the lender and then provides funds to the

borrower.

 If someone borrows money to buy a car, the car becomes his or her asset and the loan a liability.

Direct Finance

 Borrowers sell securities directly to lenders in the financial markets.

 Governments and corporations finance their activities this way

 The securities become assets to the lenders who buy them and liabilities to the borrower who sells

them

Financial and Economic Development

 Financial development is inextricably linked to economic growth

o There aren’t any rich countries that have very low levels of financial development.

Money & Banking – MGT411 VU

Figure: Financial and Economic Development

Financial Instruments

 A financial instrument is the written legal obligation of one party to transfer something of value –

usually money – to another party at some future date, under certain conditions, such as stocks,

loans, or insurance.

 Written legal obligation means that it is subject to government enforcement;

 The enforceability of the obligation is an important feature of a financial instrument.

 The “party” referred to can be a person, company, or government

 The future date can be specified or can be when some event occurs

 Financial instruments generally specify a number of possible contingencies under which one party

is required to make a payment to another

 Stocks, loans, and insurance are all examples of financial instruments

Uses of Financial Instruments

1. Means of Payment Purchase of Goods or Services

2. Store of Value Transfer of Purchasing Power into the future

3. Transfer of Risk Transfer of risk from one person or company to another

Characteristics of Financial Instruments

 Standardization

 Standardized agreements are used in order to overcome the potential costs of complexity

 Because of standardization, most of the financial instruments that we encounter on a day-to-day

basis are very homogeneous

 Communicate Information

 Summarize certain essential information about the issuer

 Designed to handle the problem of “asymmetric information”,

 Borrowers have some information that they don’t disclose to lenders

Classes of Financial Instruments

 Underlying Instruments (Primary or Primitive Securities)

 E.g. Stocks and bonds

Financial Development is

measured by the commonly

used ratio of broadly defined

money to GDP. Economic

development is measured by

the real GDP per capita.

0 50 100 150 200 250

5000

10000

15000

20000

Financial Market Development

25000

Per Capita Real GDP

Korea

Malaysia

Correlation=0.62

Hong Kong

China

••

•

•••

•

••

•

Money & Banking – MGT411 VU

 Derivative Instruments

 Value and payoffs are “derived from” the behavior of the underlying instruments

 Futures and options

Value of Financial Instruments

 Size of the promised payment

 People will pay more for an instrument that obligates the issuer to pay the holder a greater sum.

 The bigger the size of the promised payment, the more valuable the financial instrument

 When the payment will be received

 The sooner the payment is made the more valuable is the promise to make it

 The likelihood the payment will be made (risk).

 The more likely it is that the payment will be made, the more valuable the financial instrument

 The conditions under which the payment will be made

 Payments that are made when we need them most are more valuable than other payments

Value of Financial Instruments

1. Size Payments that are larger are more valuable

2. Timing Payments that are made sooner are more valuable

3. Likelihood Payments that are more likely to be made are more valuable

4. Circumstances Payments that are made when we need them most are more valuable

Money & Banking – MGT411 VU

Lesson 6

FINANCIAL INSTRUMENTS & FINANCIAL MARKETS

 Financial Instruments

 Examples

 Financial Markets

 Roles

 Structure

 Financial Institutions

Examples of Financial Instruments

Primarily Stores of Value

 Bank Loans

 A borrower obtains resources from a lender immediately in exchange for a promised set of

payments in the future

 Bonds

 A form of a loan, whereby in exchange for obtaining funds today a government or corporation

promises to make payments in the future

 Home Mortgages

 A loan that is used to purchase real estate

 The real estate is collateral for the loan,

 It is a specific asset pledged by the borrower in order to protect the interests of the lender in the

event of nonpayment.

 If payment is not made the lender can foreclose on the property.

 Stocks

 An owner of a share owns a piece of the firm and is entitled to part of its profits.

Primarily to transfer risk

 Insurance Contracts

 The primary purpose is to assure that payments will be made under particular (and often rare)

circumstances

 Futures Contracts

 An agreement to exchange a fixed quantity of a commodity, such as wheat or corn, or an asset,

such as a bond, at a fixed price on a set future date

 It is a derivative instrument since its value is based on the price of some other asset.

 It is used to transfer the risk of price fluctuations from one party to another

 Options

 Derivative instruments whose prices are based on the value of some underlying asset;

 They give the holder the right (but not the obligation) to purchase a fixed quantity of the

underlying asset at a predetermined price at any time during a specified period.

Financial Markets

 Financial Markets are the places where financial instruments are bought and sold.

 Enable both firms and individuals to find financing for their activities.

 Promote economic efficiency by ensuring that resources are placed at the disposal of those who can

put them to best use.

 When they fail to function properly, resources are no longer channeled to their best possible use

and the society suffers at large

Money & Banking – MGT411 VU

Role of Financial Markets

Liquidity Ensure that owners of financial instruments can buy and sell them cheaply and easily

Information Pool and communicate information about the issuer of a financial instrument

Risk Sharing Provide individuals with a place to buy and sell risk, sharing them with individuals

Financial markets need to be designed in a way that keeps transactions costs low

Structure of Financial Markets

Primary vs. Secondary Markets

 In a primary market a borrower obtains funds from a lender by selling newly issued securities.

 Most companies use an investment bank, which will determine a price and then purchase the

company’s securities in preparation for resale to clients; this is called underwriting.

 In the secondary markets people can buy and sell existing securities

Centralized Exchanges vs. Over-the-counter Markets

 In the centralized exchange (e.g. Karachi Stock Exchange www.kse.com.pk ), the trading is done

“on the floor”

Over-the-counter (or OTC)

 OTC market are electronic networks of dealers who trade with one another from wherever they are

located

Debt and Equity vs. Derivative Markets

 Equity markets are the markets for stocks, which are usually traded in the countries where the

companies are based.

 Debt instruments can be categorized as

 Money market (maturity of less than one year) or Bond markets (maturity of more than one year)

Characteristics of a well-run financial market

 Low transaction costs.

 Information communicated must be accurate and widely available

 If not, the prices will not be correct

 Prices are the link between the financial markets and the real economy

 Investors must be protected.

 A lack of proper safeguards dampens people’s willingness to invest

Money & Banking – MGT411 VU

Figure: Market size and investors protection

-2.5 -1.5 -0.5 0.5 1.5

0.5

1.0

1.5

2.0

Measure of investor protection

2.5

Stock market relative to GDP

Greece

•Portugal

•

Norway

•

••

••••

•

••

•

-3.5

3.0

3.5

•

Less More

Money & Banking – MGT411 VU

Lesson 7

FINANCIAL INSTITUTIONS

 Financial Institutions

 Structure of Financial Industry

 Time Value of Money

Financial Institutions

 Financial institutions are the firms that provide access to the financial markets;

 They sit between savers and borrowers and so are known as financial intermediaries.

 Banks, insurance companies, securities firms and pension funds

 A system without financial institutions would not work very well for three reasons

 Individual transactions between saver-lenders and borrower-spenders would be extremely

expensive.

 Lenders need to evaluate the creditworthiness of borrowers and then monitor them, and

individuals are not equipped to do this.

 Most borrowers want to borrow long term, while lenders favor short-term loans

Role of Financial Institutions

 Reduce transactions cost by specializing in the issuance of standardized securities

 Reduce information costs of screening and monitoring borrowers.

 Curb information asymmetries, helping to ensure that resources flow into their most productive

uses

 Make long-term loans but allow savers ready access to their funds.

 Provide savers with financial instruments (more liquid and less risky than the individual stocks and

bonds) that savers would purchase directly in financial markets

Figure: Flow of funds through Financial Institutions: Access to Financial Markets

Lenders/Savers

(Primarily Households)

Borrowers/Spenders

(Primarily Governments

and Firms)

Financial Institutions that

act as Brokers

Financial Institutions that

transform assets

Bonds & Stocks

Funds

Lenders/Savers

(Primarily Households)

Borrowers/Spenders

(Primarily Governments

and Firms)

Financial Institutions

that act as Brokers

Financial Institutions

that transform assets

Bonds & Stocks

Funds Funds

Bonds & Stocks

Loans, Bonds,

Stocks and Real

Estate

Funds

Deposits & Insurance

Policies

Funds

Indirect Finance

Money & Banking – MGT411 VU

The simplified Balance Sheet of a Financial Institution

Assets Liabilities

Bonds

Stocks

Loans

Real estate

Deposits

Insurance policies

The structure of the financial industry

The structure of the financial industry:

 Financial institutions or intermediaries can be divided into two broad categories

Depository institutions - take deposits and make loans.

 (Commercial banks, savings banks, and credit unions)

Nondepository institutions

 Insurance companies, securities firms, mutual fund companies, finance companies, and pension

funds

Insurance companies

 Accept premiums, which they invest in securities and real estate in return for promising

compensation to policyholders should certain events occurs (like death, property losses, etc.)

Pension funds

 Invest individual and company contributions into stocks, bonds and real estate in order to provide

payments to retired workers.

Securities firms

 They include brokers, investment banks, and mutual fund companies

 Brokers and investment banks issue stocks and bonds to corporate customers, trade them, and

advise clients.

 Mutual fund companies pool the resources of individuals and companies and invest them in

portfolios of bonds, stocks, and real estate.

Government Sponsored Enterprises:

 Federal credit agencies that provide loans directly for farmers and home mortgages, as well as

guarantee programs that insure the loans made by private lenders.

 HBFC, ZTBL, Khushhali bank, SME Bank

 The government also provides retirement income and medical care to the elderly (and disabled)

through Social Security and Medicare.

Finance Companies:

 Raise funds directly in the financial markets in order to make loans to individuals and firms.

 The monetary aggregates are made up of liabilities of commercial banks, so clearly the financial

structure is tied to the availability of money and credit.

Money & Banking – MGT411 VU

Lesson 8

TIME VALUE OF MONEY

 Time Value of Money

 Future Value Concepts

 Present value

 Application in financial environment

Time Value of Money

 Credit is one of the critical mechanisms we have for allocating resources.

 Even the simplest financial transaction, like saving some of your paycheck each month to buy a

car, would be impossible.

 Corporations, most of which survive from day to day by borrowing to finance their activities,

would not be able to function.

 Yet even so, most people still take a dim view of the fact that lenders charge interest.

 The main reason for the enduring unpopularity of interest comes from the failure to appreciate the

fact that lending has an opportunity cost.

 Think of it from the point of view of the lender.

 Extending a loan means giving up the alternatives. While lenders can eventually recoup the sum

they lend, neither the time that the loan was outstanding nor the opportunities missed during that

time can be gotten back.

 So interest isn't really "the breeding of money from money,'' as Aristotle put it; it's more like a

rental fee that borrowers must pay lenders to compensate them for lost opportunities.

 It's no surprise that in today's world, interest rates are of enormous importance to virtually

everyone

 Individuals, businesses, and governments

 They link the present to the future, allowing us to compare payments made on different dates.

 Interest rates also tell us the future reward for lending today, as well as the cost of borrowing now

and repaying later.

 To make sound financial decisions, we must learn how to calculate and compare different rates on

various financial instruments

Future Value

 Future Value is the value on some future date of an investment made today.

 To calculate future value we multiply the present value by the interest rate and add that amount of

interest to the present value.

PV + Interest = FV

PV + PV*i = FV

$100 + $100(0.05) = $105

PV = Present Value

FV = Future Value

i = interest rate (as a percentage)

 The higher the interest rate (or the amount invested) the higher the future value.

Future Value in one year

FV = PV*(1+i)

Money & Banking – MGT411 VU

 Now we need to figure out what happens when the time to repayment varies

 When we consider investments with interest payments made for more than one year we need to

consider compound interest, or the fact that interest will be paid on interest

Future Value in two years

$100+$100(0.05) +$100(0.05) + $5(0.05) =$110.25

Present Value of the Initial Investment + Interest on the initial investment in the 1st Year + Interest on the

initial investment in the 2nd Year+ Interest on the Interest from the 1stYear in the 2nd Year

= Future Value in Two Years

General Formula for compound interest – Future value of an investment of PV in n years at interest rate i

(measured as a decimal, or 5% = .05)

FVn = PV*(1+i) n

Table: Computing the Future Value of $100 at 5% annual interest rate

Years into future Computation Future value

1 $100(0.5) $105.00

2 $100(0.5)2 $110.25

3 $100(0.5)3 $115.76

4 $100(0.5)4 $121.55

5 $100(0.5)5 $127.63

10 $100(0.5)10 $162.89

Note:

Both n and i must be measured in same time units—if i is annual, then n must be in years, so future value of

$100 in 18 months at 5% is

FV = 100 *(1+.05)1.5

 How useful it is?

 If you put $1,000 per year into bank at 4% interest, how much would you have saved after 40

years?

 Taking help of future value concept, the accumulated amount through the saving will be $98,826 –

more than twice the $40,000 you invested

 How does it work?

 The first $1,000 is deposited for 40 years so its future value is

 $1,000 x (1.04)40 = 4,801.02

 The 2nd $1,000 is deposited for 39 years so its future value is

 $1,000 x (1.04)39 = 4,616.37

 And so on…..up to the $1,000 deposited in the 40th year

 Adding up all the future values gives you the amount of $98,826

Present Value

 Present Value (PV) is the value today (in the present) of a payment that is promised to be made in

the future. OR

 Present Value is the amount that must be invested today in order to realize a specific amount on a

given future date.

 To calculate present value we invert the future value calculation;

 We divide future value by one plus the interest rate (to find the present value of a payment to be

made one year from now).

 Solving the Future Value Equation

Money & Banking – MGT411 VU

FV = PV*(1+i)

 Present Value of an amount received in one year.

Example:

 $100 received in one year, i=5%

 PV=$100/ (1+.05) = $95.24

 Note:

 FV = PV*(1+i) = $95.24*(1.05) = $100

 For payments to be made more than one year from now we divide future value by one plus the

interest rate raised to the nth power where n is the number of years

 Present Value of $100 received n years in the future:

Example

Present Value of $100 received in 2 ½ years and an interest rate of 8%.

PV = $100 / (1.08)2.5 = $82.50

Note:

FV =$82.50 * (1.08)2.5 = $100

Money & Banking – MGT411 VU

Lesson 9

APPLICATION OF PRESENT VALUE CONCEPTS

 Application of Present Value Concept

 Compound Annual Rate

 Interest Rates vs. Discount Rate

 Internal Rate of Return

 Bond Pricing

Important Properties of Present Value

Present Value is higher:

 The higher the future value (FV) of the payment

 The shorter the time period until payment (n)

 The lower the interest rate (i)

The size of the payment (FVn)

 Doubling the future value of the payment (without changing time of the payment or interest rate),

doubles the present value

 At 5% interest rate, $100 payment has a PV of $90.70

 Doubling it to $200, doubles the PV to $181.40

 Increasing or decreasing FVn by any percentage will change PV by the same percentage in the same

direction

The time until the payment is made (n)

 Continuing with the previous example of $100 at 5%, we allow the time to go from 0 to 30 years.

 This process shows us that the PV payment is worth $100 if it is made immediately, but gradually

declines to $23 for a payment made in 30 years

Figure: Present value of $100 at 5% interest rate

The rule of 72

 For reasonable rates of return, the time it takes to double the money, is given approximately by

t = 72 / i%

 If we have an interest rate of 10%, the time it takes for investment to double is:

t = 72 / 10 = 7.2 years

 This rule is fairly applicable to discount rates in 5% to 20% range.

Money & Banking – MGT411 VU

The Interest rate (i)

 Higher interest rates are associated with lower present values, no matter what size or timing of the

payment

 At any fixed interest rate, an increase in the time until a payment is made reduces its present value

Table: Present Value of a $100 payment

Payment due in

Interest rate 1 Year 5 Years 10 Years 20 Years

1% $99.01 $95.15 $90.53 $81.95

2% $3.77 $98.04 $90.57 $29.14 $82.03 $67.30

3% 4% $97.09 $86.26 32% $74.41 $55.37

4% $96.15 $82.19 $67.56 $45.64

5% $95.24 $78.35 $61.39 $37.69

6% $94.34 $74.73 $55.84 $31.18

7% $93.46 $71.30 $50.83 $25.84

8% $92.59 $68.06 $46.32 $21.45

9% $91.74 $64.99 $42.24 $17.84

10% $90.91 $62.09 $38.55 $14.86

11% $90.09 $59.35 $35.22 $12.40

12% $89.29 $56.74 $32.20 $10.37

13% $88.50 $54.28 $29.46 $8.68

14% $87.72 $51.94 $26.97 $7.28

15% $86.96 $49.72 $24.72 $6.11

Figure: The relationship between Present value and Interest Rates

Compound Annual Rates

 Comparing changes over days, months, years and decades can be very difficult.

 The way to deal with such problems is to turn the monthly growth rate into compound-annual rate.

 An investment whose value grows 0.5% per month goes from 100 at the beginning of the month to

100.5 at the end of the month:

We can verify this as following

100 (100.5 - 100) = [(100.5/100) – 1] = 0.5%

100

 What if the investment’s value continued to grow at 0.5% per month for next 12 months?

Money & Banking – MGT411 VU

 We cant simply multiply 0.5 by 12

 Instead we need to compute a 12 month compound rate

 So the future value of 100 at 0.5 %( 0.005) per month compounded for 12 months will be:

FVn = PV (1+i) n = 100(1.005)12 = 106.17

 An increase of 6.17% which is greater than 6%, had we multiplied 0.5% by 12

 The difference between the two answers grows as the interest rate grows

 At 1% monthly rate, 12 month compounded rate is12.68%

 Another use for compounding is to compute the percentage change per year when we know how

much an investment has grown over a number of years

 This rate is called average annual rate

 If an investment has increased 20%, from 100 to 120 over 5 years

 Is average annual rate is simply dividing 20% by 5?

 This way we ignore compounding effect

 Increase in 2nd year must be calculated as percentage of the investment worth at the end of 1st year

 To calculate the average annual rate, we revert to the same equation:

FVn = PV (1+i) n

120 = 100(1 + i) 5

Solving for i

i = [(120/100)1/5 - 1] = 0.0371

 5 consecutive annual increases of 3.71% will result in an overall increase of 20%

Interest Rate and Discount Rate

 The interest rate used in the present value calculation is often referred to as the discount rate

because the calculation involves discounting or reducing future payments to their equivalent value

today.

 Another term that is used for the interest rate is yield

 Saving behavior can be considered in terms of a personal discount rate;

 People with a low rate are more likely to save, while people with a high rate are more likely to

borrow

 We all have a discount rate that describes the rate at which we need to be compensated for

postponing consumption and saving our income

 If the market offers an interest rate higher than the individual’s personal discount rate, we would

expect that person to save (and vice versa)

 Higher interest rates mean higher saving

Applying Present Value

 To use present value in practice we need to look at a sequence or stream of payments whose

present values must be summed. Present value is additive.

 To see how this is applied we will look at internal rate of return and the valuation of bonds

Internal Rate of Return

 The Internal Rate of Return is the interest rate that equates the present value of an investment with

it cost.

 It is the interest rate at which the present value of the revenue stream equals the cost of the

investment project.

 In the calculation we solve for the interest rate

A machine with a price of $1,000,000 that generates $150,000/year for 10 years

1 2 3 (1 )10

...... $150,000

(1 )

$150,000

(1 )

$150,000

(1 )

$1,000,000 $150,000

i i i + i

+ +

Money & Banking – MGT411 VU

Solving for i, i=.0814 or 8.14%

 The internal rate of return must be compared to a rate of interest that represents the cost of funds

to make the investment.

 These funds could be obtained from retained earnings or borrowing. In either case there is an

interest cost

 An investment will be profitable if its internal rate of return exceeds the cost of borrowing

Money & Banking – MGT411 VU

Lesson 10

BOND PRICING & RISK

 Bond Pricing

 Real Vs Nominal Interest Rates

 Risk

 Characteristics

 Measurement

Bond Pricing

 A bond is a promise to make a series of payments on specific future date.

 It is a legal contract issued as part of an arrangement to borrow

 The most common type is a coupon bond, which makes annual payments called coupon payments

 The percentage rate is called the coupon rate

 The bond also specifies a maturity date (n) and has a final payment (F), which is the principal, face

value, or par value of the bond

 The price of a bond is the present value of its payments

 To value a bond we need to value the repayment of principal and the payments of interest

Valuing the Principal Payment

 A straightforward application of present value where n represents the maturity of the bond

 Valuing the Coupon Payments:

 Requires calculating the present value of the payments and then adding them; remember, present

value is additive

 Valuing the Coupon Payments plus Principal

 Means combining the above

Payment stops at the maturity date. (n)

A payment is for the face value (F) or principle of the bond

Coupon Bonds make annual payments called, Coupon Payments (C), based upon an interest rate,

the coupon rate (ic), C=ic*F

A bond that has a $100 principle payment in n years. The present

Value (PBP) of this is now:

BP n n i i

P F

(1 )

$100

(1 ) +

If the bond has n coupon payments (C), where C= ic * F, the Present Value (PCP) of the coupon

payments is:

CP n i

P C

(1 )

......

(1 )1 (1 )2 (1 )3 +

+ +

Money & Banking – MGT411 VU

Present Value of Coupon Bond (PCB) = Present value of Yearly Coupon Payments (PCP) + Present Value of

the Principal Payment (PBP)

CB CP BP n n i

P P P C

(1 ) (1 )

......

(1 )1 (1 )2 (1 )3 +

+ ú

êë

+ +

= + =

Note:

 The value of the coupon bond rises when the yearly coupon payments rise and when the interest

rate falls

 Lower interest rates mean higher bond prices and vice versa.

 The value of a bond varies inversely with the interest rate used to discount the promised payments

Real and Nominal Interest Rates

 So far we have been computing the present value using nominal interest rates (i), or interest rates

expressed in current-dollar terms

 But inflation affects the purchasing power of a dollar, so we need to consider the real interest rate

(r), which is the inflation-adjusted interest rate.

 The Fisher equation tells us that the nominal interest rate is equal to the real interest rate plus the

expected rate of inflation

Fisher Equation:

i = r + e

r = i - πe

Figure: Nominal Interest rates, Inflation, and real interest rates

1 1985 1 1 1994

-5

-10

1979 1997 2000 2003

Money & Banking – MGT411 VU

Figure: Inflation and Nominal Interest Rates, April 2004

Risk

 Every day we make decisions that involve financial and economic risk.

 How much car insurance should we buy?

 Should we refinance the home loan now or a year from now?

 Should we save more for retirement, or spend the extra money on a new car?

 Interestingly enough, the tools we use today to measure and analyze risk were first developed to

help players analyze games of chance.

 For thousands of years, people have played games based on a throw of the dice, but they had little

understanding of how those games actually worked

 Since the invention of probability theory, we have come to realize that many everyday events,

including those in economics, finance, and even weather forecasting, are best thought of as

analogous to the flip of a coin or the throw of a die

 Still, while experts can make educated guesses about the future path of interest rates, inflation, or

the stock market, their predictions are really only that—guess.

 And while meteorologists are fairly good at forecasting the weather a day or two ahead, economists,

financial advisors, and business gurus have dismal records.

 So understanding the possibility of various occurrences should allow everyone to make better

choices. While risk cannot be eliminated, it can often be managed effectively.

 Finally, while most people view risk as a curse to be avoided whenever possible, risk also creates

opportunities.

 The payoff from a winning bet on one hand of cards can often erase the losses on a losing hand.

 Thus the importance of probability theory to the development of modern financial markets is hard

to overemphasize.

 People require compensation for taking risks. Without the capacity to measure risk, we could not

calculate a fair price for transferring risk from one person to another, nor could we price stocks and

bonds, much less sell insurance.

 The market for options didn't exist until economists learned how to compute the price of an option

using probability theory

 We need a definition of risk that focuses on the fact that the outcomes of financial and economic

decisions are almost always unknown at the time the decisions are made.

 Risk is a measure of uncertainty about the future payoff of an investment, measured over some

time horizon and relative to a benchmark.

5 10 15 20 25

0 30

Turkey

45º line

•

Brazil

• Russia

•

South Africa

Inflation (%)

Nominal Interest Rate (%)

Money & Banking – MGT411 VU

Characteristics of risk

 Risk can be quantified.

 Risk arises from uncertainty about the future.

 Risk has to do with the future payoff to an investment, which is unknown.

 Our definition of risk refers to an investment or group of investments.

 Risk must be measured over some time horizon.

 Risk must be measured relative to some benchmark, not in isolation.

 If you want to know the risk associated with a specific investment strategy, the most appropriate

benchmark would be the risk associated with other investing strategies

Measuring Risk

Measuring Risk requires:

 List of all possible outcomes

 Chance of each one occurring

 The tossing of a coin

 What are possible outcomes?

 What is the chance of each one occurring?

 Is coin fair?

 Probability is a measure of likelihood that an even will occur

 Its value is between zero and one

 The closer probability is to zero, less likely it is that an event will occur.

 No chance of occurring if probability is exactly zero

 The closer probability is to one, more likely it is that an event will occur.

 The event will definitely occur if probability is exactly one

 Probabilities can also be expressed as frequencies

Table: A Simple Example: All Possible Outcomes of a Single Coin Toss

Possibilities Probability Outcome

#1 1/2 Heads

#2 1/2 Tails

 We must include all possible outcomes when constructing such a table

 The sum of the probabilities of all the possible outcomes must be 1, since one of the possible

outcomes must occur (we just don’t know which one)

 To calculate the expected value of an investment, multiply each possible payoff by its probability

and then sum all the results. This is also known as the mean.

Case 1

An Investment can rise or fall in value. Assume that an asset purchased for $1000 is equally likely to fall to

$700 or rise to $1400

Table: Investing $1,000: Case 1

Possibilities Probability Payoff Payoff ×Probability

#1 1/2 $700 $350

#2 1/2 $1,400 $700

Expected Value = Sum of (Probability times Payoff) = $1,050

Money & Banking – MGT411 VU

Expected Value = ½ ($700) + ½ ($1400) = $1050

Case 2

The $1,000 investment might pay off

 $100 (prob=.1) or

 $2000 (prob=.1) or

 $700 (prob=.4) or

 $1400 (prob=.4)

Table: Investing $1,000: Case 2

Possibilities Probability Payoff Payoff ×Probability

#1 0.1 $100 $10

#2 0.4 $700 $280

#3 0.4 $1,400 $560

#4 0.1 $2,000 $200

Expected Value = Sum of (Probability times Payoff) = $1,050

 Investment payoffs are usually discussed in percentage returns instead of in dollar amounts; this

allows investors to compute the gain or loss on the investment regardless of its size

 Though both cases have the same expected return, $50 on a $1000 investment, or 5%, the two

investments have different levels or risk.

 A wider payoff range indicates more risk.

Money & Banking – MGT411 VU

Lesson 11

MEASURING RISK

 Measuring Risk

 Variance and Standard Deviation

 Value at Risk (VAR)

 Risk Aversion & Risk Premium

Measuring Risk

 Most of us have an intuitive sense for risk and its measurement;

 The wider the range of outcomes the greater the risk

VU Subjects