MGT411 Accounting , Banking & Finance Glossary And FAQ's Short Questions Answers


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
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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 Pakistan www.sbp.org.pk
Summary
Five Parts of the Financial System
Money
Financial Instruments
Financial Markets
Financial Institutions
Central Banks
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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
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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.
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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
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Consumption
Income
$
TimRetirement e
Begins
Dissavings Dissavings
Savings
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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.
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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.
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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
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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
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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
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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
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Figure: Growth Rates in Monetary Aggregates
-5
0
5
10
15
20
25
30
35
40
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
M1
M2
M3
0
5
10
15
20
25
30
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
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Figure: Money Growth and Inflation
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Cost of basket in that month
100
Cost of basket in base period
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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%
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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.
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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
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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
••
•••
••
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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
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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
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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
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Figure: Market size and investors protection
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-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
UK
Norway
••
••••
••••
••
-3.5
0
3.0
3.5
US
Less More
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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
© Copyright Virtual University of Pakistan 20
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.
© Copyright Virtual University of Pakistan 21
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)
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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
© Copyright Virtual University of Pakistan 23
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
© Copyright Virtual University of Pakistan 24
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.
© Copyright Virtual University of Pakistan 25
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?
© Copyright Virtual University of Pakistan 26
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
© Copyright Virtual University of Pakistan 27
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
© Copyright Virtual University of Pakistan 28
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
C
i
C
i
C
i
P C
(1 )
......
(1 )1 (1 )2 (1 )3 +
+ +
+
+
+
+
+
=
© Copyright Virtual University of Pakistan 29
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
F
i
C
i
C
i
C
i
P P P C
(1 ) (1 )
......
(1 )1 (1 )2 (1 )3 +
+ ú
û
ù
êë
é
+
+ +
+
+
+
+
+
= + =
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
Or
r = i - πe
Figure: Nominal Interest rates, Inflation, and real interest rates
© Copyright Virtual University of Pakistan
1 1985 1 1 1994
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0
5
10
-10
15
20
1979 1997 2000 2003
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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.
© Copyright Virtual University of Pakistan
5 10 15 20 25
5
10
15
20
25
30
0 30
Turkey 45º line
Brazil
Russia
South Africa
UK US
Inflation (%)
Nominal Interest Rate (%)
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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
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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.
© Copyright Virtual University of Pakistan 33
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;

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