McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Money and Banking Lecture 6

3-2 Review of the Previous Lecture Financial Intermediaries Financial Instruments Uses Characteristics Value

3-3 Topics under Discussion Financial Instruments Examples Financial Markets Roles Structure Financial Institutions

3-4 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

3-5 Examples of Financial Instruments Primarily Stores of Value 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.

3-6 Examples of Financial Instruments 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

3-7 Examples of Financial Instruments Primarily to transfer risk 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.

3-8 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

3-9 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

3-10 Structure of Financial Markets Centralized Exchanges vs. Over-the- counter Markets. In the centralized exchange (e.g. Karachi Stock Exchange ), the trading is done “on the floor” Over-the-counter (or OTC) market are electronic networks of dealers who trade with one another from wherever they are located

3-11 Structure of Financial Markets 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

3-12 Financial Markets Characteristics of a well-run financial market 1.Low transaction costs. 2.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 3.Investors must be protected. A lack of proper safeguards dampens people’s willingness to invest

3-13 Market Size and Investor Protection

3-14 Summary Financial Instruments Examples Financial Markets Roles Structure

3-15 Upcoming Topics Financial Institutions Time Value of Money Future value, Compound Interest Present Value Interest Rates