BBA Program
FIN201 Financial Environment & Banking
Lecturer: Alavi Khondoker
Chapter 1:
Role of Financial Markets and Institutions
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Topics of Discussion
■ Overview and Importance of Financial System /
Environment
■ Securities Traded in Financial Markets
■ Role of Financial Markets
■ Role of Financial Institutions
■ Regulations in the Financial System
■ Globalization, Innovations and Technological
Transformations
■ Why Study Financial Securities, Markets and
Institutions?
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Basic
Terminologies
Investment
The commitment of funds to one or more assets that will be
held over some future time period is called investment.
Investments
The study of the investment process is called investments.
Financial Assets
■Pieces of paper evidencing a claim on some issuer is
called financial assets.
■A paper (or electronic) claim on some issuer is called
financial assets.
Real Assets
The physical/tangible assets such as gold, silver, diamond
and real estate etc are called real assets.
Basic
Terminologies
Marketable Securities:
■Financial assets that are easily traded in
organized market is called marketable
securities.
Liquidity:
The ease with in which an asset can be bought or
sold with relatively low price change is called
liquidity. There are two conditions for the liquid
assts:
1. Easily convertible into cash
2. With relatively low price change
An Overview of Financial System
■ A well-functioning financial system is essential for
stable economic growth.
■ A system in which funds/capital flow from
savers/lenders to users/borrowers efficiently for the
most productive uses.
■ Major components of the financial system
◻ Financial securities/ instruments /assets
◻ Financial markets
◻ Financial institutions
■ Surplus & Deficit Units: Household/Individual,
Business and Government
■ Financing and Investment needs/decisions 5
Transfer of Capital from Savers to Borrowers
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Transfer of Capital from Savers to Borrowers
■ Direct transfer (e.g., corporation issues shares
commercial papers to insurance companies).
■ Indirect transfer through an investment banking house
(e.g., IPO, seasoned equity offering, or debt placement).
Investment banks merely transfer securities (claims) for a
margin/fees.
■ Indirect transfer through a financial intermediary (e.g.,
individual deposits money in bank, bank makes
commercial loan to a company). Financial intermediaries
create their own securities (claims).
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Securities Traded in Financial
Markets
■Money market securities
◻Money market securities are debt securities
with a maturity of one year or less
E.g. T-bill
◻Characteristics:
■Liquid - easily sellable or convertible into cash
■Low expected return
■Low degree of risk
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Securities Traded in Financial
Markets (cont’d)
■Capital market securities
◻Capital market securities are those with a
maturity of more than one year
■Bonds and mortgages
■Stocks
◻Capital market securities have a higher
expected return and more risk than money
market securities
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Securities Traded in Financial
Markets (cont’d)
■Bonds and mortgages
◻Bonds are long-term debt obligations issued
by corporations and government agencies
◻Mortgages are long-term debt obligations
created to finance the purchase of real estate
◻Bonds and mortgages specify the amount and
timing of interest and principal payments
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Securities Traded in Financial
Markets (cont’d)
■Stocks
◻Stocks (equity) are certificates representing
partial ownership in corporations
◻Investors may earn a return by receiving
dividends and capital gains
◻Stocks have a higher expected return and
higher risk than long-term debt securities
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Securities Traded in Financial
Markets (cont’d)
■Derivative securities
◻ Derivative securities are financial contracts whose
values are derived from the values of underlying
assets
◻ Speculating with derivatives allow investors to
benefit from increases or decreases in the underlying
asset
◻ Risk management with derivatives generates gains if
the value of the underlying security declines
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Overview of Financial Markets
■ A financial market is a market in which financial assets
(securities) can be purchased or sold
■ Financial markets facilitate financing and investing by
households, firms, and government agencies
◻ Participants that provide funds are called surplus units
■ e.g., households, businesses, the government
◻ Participants that enter markets to obtain funds are
deficit units
■ e.g., households, businesses, the government
■ A major participant in financial markets is the Fed, because
it controls the money supply
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Types of Financial Markets
■ Financial markets can be distinguished by the maturity
structure and trading structure of its securities
■ Money versus capital markets
◻ The flow of short-term funds is facilitated by money markets
◻ The flow of long-term funds is facilitated by capital markets
■ Primary versus secondary markets
◻ Primary markets facilitate the issuance of new securities
■ e.g., the sale of new corporate stock or new Treasury securities
◻ Secondary markets facilitate the trading of existing securities
■ e.g., the sale of existing stock
■ Securities traded in secondary markets should be liquid
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Types of Financial Markets (cont’d)
■Organized versus over-the-counter markets
◻ A visible marketplace for secondary market
transactions is an organized exchange
◻ Some transactions occur in the over-the-counter
(OTC) market (a telecommunications network)
■Knowledge of financial markets is power
◻ Decide which markets to use to achieve our
investment goals or financing needs
◻ Decide which markets to use as part of your job
◻ Avoid common mistakes in investing and borrowing
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Valuation of Securities in Financial
Markets
■ Securities are valued as the present value of their
expected cash flows, discounted at a rate that reflects
their uncertainty
■ Market pricing of securities
◻ Different investors may value the same security differently based
on their interpretation of information
■ Impact of valuations on pricing
◻ Every security has an equilibrium market price at which demand
and supply for the security are equal
■ Favorable information results in upward valuation revisions;
unfavorable information results in downward revisions
◻ Securities reach a new equilibrium price as new information
becomes available
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Valuation of Securities in Financial
Markets (cont’d)
■Impact of the Internet on the valuation process
◻ The valuation of securities is improved as a result of
the internet because of
■Online price quotations
■Increased information about firms issuing securities
■Online orders to buy or sell securities
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Market Efficiency
■Markets are efficient when security prices
fully reflect all available information
■In an efficient market, different investors
may still prefer different securities because
of differences in:
◻Risk preference
◻Desired liquidity
◻Tax status
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Market Efficiency (cont’d)
■ Impact of asymmetric information
◻ Asymmetric information is information a firm’s managers
have that is not available to investors
◻ The valuation process is influenced by the financial
statements that are used to derive cash flow estimates
◻ Securities may be mispriced because of
■Flexibility in accounting guidelines
■Overestimation of earnings
◻ The asymmetric information problem can be reduced if
managers frequently disclose financial data and
information to the public or through increased regulation
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