CHAPTER 2: SAVINGS (FLOW OF FUNDS) 4 th Session 1

Flow of funds (Transfer of Savings) Savings – The portion of income not spent on consumption of consumer goods. Transfer of savings A country’s economy can be divided into 3 sectors: – Households (consumers) – Businesses (producers) – Government (both a consumer and a producer) 2

Each of these 3 sectors can have a: – Balanced budget (I=E) – Surplus budget (I>E) – Deficit budget (I<E) Whenever a sector’s I>E, it will be a saving surplus sector. Whenever a sector’s I<E, it will be a saving deficit sector. 3

At a group level, households comprise SSS while businesses and governments are typically considered to form the SDS. Why household is generally a SSS? – As a group they save more than spending on current consumption. Why governments and businesses considered SDS? – They have to invest in growth opportunities that cannot be financed by internally generated funds alone. 4

So, the households have surplus funds (SSS) while governments & businesses need funds (SDS). Thus, the funds flow from SSS to SDS. It can occur in one of three ways: 1.Direct finance 2.Indirect finance (facilitated by investment bank) 3.Indirect finance (facilitated by financial intermediaries) 5

1.Direct Finance Security – A claim on issuer’s future income. Direct finance – Business selling its securities directly to savers (investor) in financial market without going through any financial intermediary or financial institution. Check to determine if a particular transaction is a direct finance transaction or not? – See if the investor directly holds claim against the borrower. 6

1.Direct Finance Examples A new business is formed, it goes to venture capitalist, V.C. will lend or take an equity position in the business if it believes the project will be successful. APPLY THE CHECK: Here the investor (V.C.) directly holds claim against the borrower (buss.) Apple Computer building new facility funds it by selling a long-term 15 year old bond. A group of insurance companies buys it for $20 m. Apple gets $20 m for 15 yrs. whereas bondholders get i-rates and $20 m at maturity. APPLY THE CHECK: Here the investor (I.C.) directly holds claim against the borrower (Apple Computer) 7

2. Indirect Finance (facilitated by investment bank) Indirect money transfer generally takes place with the help of an investment bank. What is an Investment bank? – Advisory role – Underwriting – Facilitating mergers and other corporate reorganizations Investment bank serves as a middleman which facilitates transfer of funds between the SSS and the SDS. Why hire investment bank why not do we issue the securities on our own? – By committing to purchase bonds at a set price, investment banks underwrite any risks associated with a new issue. 8

2. Indirect Finance (facilitated by investment bank) Underwriting – Literally means ‘Assuming risk’. – Name of the process in which I.B. buys new security issues from issuing company and then resells them to the investors. 9 ABC corp. (SDS) Investment Bank Investor (SSS) ABC corp. shares $32 or 29 per share$30 per share

10 ILLUSTRATED EXAMPLE => A bank has agreed to underwrite an issue of 50 million shares by ABC Corporation. In negotiations between the bank and the corporation the target net price to be received by the corporation has been set at $30 per share. This means that the corporation is expecting to raise 30 × 50 million dollars or $1.5 billion in total. The bank agrees to buy the shares from ABC Corporation for $30 per share. Two things may happen: – Either stock sells below $30 or above $30 If banks the shares for $32 (above 32 case), it makes a profit of (32 − 30) × 50 = $100 million because it has agreed to pay ABC Corporation $30 per share. However, if it can only sell the shares for $29 per share (below 32 case), it loses (30 − 29) × 50 = $50 million because it still has to pay ABC Corporation $30 per share.

11 Investment bank promises to buy ABC corp. security issue at a fixed price, but it will offer to savers at a higher offering price. This differential of ($32-$30=$2/share) is what is investment bank’s compensation and is called the ‘underwriting spread’. 2. Indirect Finance (facilitated by investment bank) ABC corp. (SDS) Investment Bank Investor (SSS) ABC corp. shares $32 or 29 per share$30 per share

2. Indirect Finance (facilitated by financial intermediary) Funds can also transfer from SSS to SDS through a F.I. Here the F.I. obtains funds from investors issues them its own (indirect) security and then uses the money to purchase another company’s (direct)securities. Direct Securities Indirect Securities 12

2. Indirect Finance (facilitated by financial intermediary) Example of funds transfer through a F.I. (AMC) Funds transfer from SSS to SDS facilitated by AMC. Asset Management Company: Licensed by SECP to launch mutual funds, AMC invests clients funds into securities that meets its desired objectives. 13

14 A $2000 B $2000 C $2000 D $2000 E $2000 AMC Blue arrow shows investors giving money to AMC Red arrow shows AMC giving its own shares (indirect) to investors AMC investment into diff. securities Return from securities (direct)

5 TH SESSION 15

Financial Asset Assets – Resources owned by businesses or individuals with the expectation that they will provide future benefit. 16

Assets can be classified into: – Tangible assets Value depends on particular physical properties – Intangible assets Represents legal claim to future benefit 17

Financial Assets Intangible assets Value is the claim to the future cash flows of the issuer Issuer – The entity that agrees to make future cash payments (or the one who borrows the funds) is called the issuer or borrower of the financial assets. Investor or Lender – The owner of the financial assets (the one lending the money) is the investor or lender. 18

Functions of Financial Assets Two principal economic functions – Transfer of funds (SSS TO SDS) – Redistribute the unavoidable risk from the issuer’s of the security (person needing funds) to those supplying the funds (investors). 19

Illustration of the two functions of financial assets with the help of an example Joe needs $300,000 to setup a wristwatch manufacturing plant. Joe has $200,000 in life savings – not willing to take risk. Susan has inherited $130,000, plans to invest 100,000 (excess funds) Larry earned $100,000 in bonus, plans to invest all of it (excess funds) 20

Suppose the three (Joe, Susan and Larry) meet. 21 JOE Wristwatch business needs $300,000 LARRY SUSAN Personal funds of $100,000 Lends $100,000 i Gives $100,000 and gets 30% share in company DebtEquity These two financial assets allow funds to be transferred from Susan and Larry to Joe who needs funds. Meets the first goal. Reduction of owner’s risk (meets second goal).

Financial Markets and their Functions Financial Markets – Markets (bond and stock market for instance) where financial securities are bought and sold. Two main functions 1.Moving funds from people having surplus funds to those in need of funds. 2.Financial markets promote greater economic efficiency. 22

Structure of Financial Markets Several basis for classification of Financial Markets: A. Classification of financial market on basis of the nature of claim – Debt market – Equity market 23 Claim is to ‘demand anything as a right’. If I hold a debt instrument it means I hold the right to demand periodic interest payments and principal upon maturity, similarly if I hold a stock I can demand dividend as my right.

1. Debt Market The debt market is the market where debt instruments are traded. Debt instruments are assets that require a fixed payment to the holder, usually in the form of interest payments. Examples of debt instruments include government bonds and corporate bonds. 24

The most common method for a firm or an individual to raise funds in the financial markets is to issue a debt instrument, such as a bond. The maturity of a debt instrument is the number of years (term) until that instrument’s expiration date. – A debt instrument is short-term if its maturity is less than a year (T-bills). – Debt instruments are called long-term if their maturity is ten years or longer (T-bonds). – Debt instruments with a maturity between one and ten years are said to be intermediate-term (T-Notes). 25

2. Equity Market The equity market (often referred to as the stock market) is the market for trading equity instruments. The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) of a business. 26

Characteristics of Equity Securities 27 Variable return Capital gains Unlimited life of the security – Equities are considered long-term securities because they have no maturity date. Equities often make periodic payments (dividends) to their holders. Equity holder (owns a portion of the firm) and has the right to vote on issues important to the firm.

Advantages versus disadvantage of owning a corporation’s equities rather than its debt 28 ADVANTAGESDISADVANTAGES DEBT1.A corporation has to pay all its debt holders before it pays its equity holders. - Less risky (paid first) 1.Debt holders interest payments are fixed, they do not benefit directly from any increases in the corporation’s profitability. EQUITIES1.Equity holders benefit directly from any increase in the corporation’s profitability as they are owners of the corporation. 1.An equity holder is a residual claimant. - More risky.

6 th Session

B. Classification of financial market on the basis of the security issue – Primary market (new issues of security) – Secondary market (previously issued) 30

1. Primary Market New issues of a security. Role of Investment Bank in primary market. – A market offering where investment bank purchases securities from issuers and sells them to investors is a primary market offering. Not well known to public. 31

2. Secondary Market Previously issued securities are bought and sold. New York Stock Exchange (NYSE), Karachi Stock Exchange (KSE) and NASDAQ etc. A market offering where the proceeds from the sale of securities do not go the issuer of the security, but to the current holder is a secondary market offering. 32

Secondary Market Broker Market Stock Exchange Dealer Market OTC

Broker Market – The two sides of the transaction are brought together and trade takes place at that point. – Broker Broker matches ‘buy order’ of person A with ‘sell order’ of person B and charges a commission for that. – Example: Stock Exchanges

Dealer Market – Markets in which buyers and sellers are never brought together. – Dealer Dealer trades for himself acting as a principal not an agent. 2 separate trades are made. Dealer buys securities from person A (at ‘bid price’ - low) and sells to person B (at ‘ask price’ - high). Bid Ask Spread – Difference between ask price and bid price (dealer’s profit). Example: Dealer will offer $599 bid price for 100 shares of Google’s stock and will sell them at an ask price of $600 keeping the $1. – Example: OTC and NASDAQ

B. Classification of financial market on the basis of maturities of securities traded – Money market – Capital market 36

1. Money Market Short term (maturity of less than one year) Debt instruments Characteristic – Highly liquid.

2. Capital Market Long term (maturity of greater than one year) Debt and Equity instruments Characteristic – Riskier than money market (Price fluctuation)

Money Market Instruments 1.T-bills: – Short term financial instruments – Issued by government at a ‘discount’ – Discount from principal represents interest to investors For example, a 52-week T-Bill with a $1,000 face value might be sold initially for $990. When it matures, the investor will receive the full $1,000. The extra $10 the investor receives is their investment return for purchasing the T-Bill. – Default free – Liquid Instrument – Balance Sheet (Cash and Cash Equivalent)

2. Fed Funds – A deposit at the central bank – Cash Reserve Requirement (RR) Fed Fund Transaction – Loans of reserve deposits (at the Fed) between the depository institutions – Federal Fund Rate