CHAPTER TWO:

FINANCIAL ENVIRONMENT-
MARKETS AND INSTITUTIONS
Dr. Md. Saiful Alam FCMA
Associate Professor
Department of Accounting & Information Systems
University of Dhaka
s.alam@du.ac.bd
The Financial Environment

 The financial environment is an important part of an economy, where the major

participants are the business firms, investors, and the market.

 An important ingredient of the financial environment is the financial market.

 The financial environment in a country highlights the condition of the financial markets
as well as the economy of the country.

 Understanding the monetary and fiscal policies helps us in understanding the financial
system.
Financial Market

 Financial markets can be defined as those markets where buyers and sellers trade or

buy and sell various long terms and short terms securities such as equities, bonds,

currencies, and derivatives.

 Financial markets have their own rules and regulations for transactions.

 The financial market in the country is divided into two broad categories

 Capital Market

 Money Market
Capital Market

 The capital market is generally understood as the market for long-term funds. However, sometimes
the term is used in a very broad sense to include the market for short-term funds also.

 Capital markets are one in which individuals and institutions, generally buy and sell long-term equities
and securities to raise funds.

 Capital market deals in ordinary securities such as shares and debentures, bonds, and government
securities.

 The funds which flow into the capital market come from individuals, merchant banks, commercial
banks, and non-bank financial intermediaries, such as insurance companies, finance houses, unit
trusts, investment trusts, venture capital firms, leasing finance, and mutual funds, building societies,
etc.

 Capital markets are of two types:

 Primary market
 Secondary market
Primary Market

 Primary markets are ones in which new securities and issues are bought and sold.

 The types of issues in the primary market are listed below.

 Initial public offer (IPO) (in case of an unlisted company),

 Follow-on public offer (FPO),

 Rights offer such that securities are offered to existing shareholders,

 Preferential issue/ bonus issue

 The composite issue, that is, a mixture of rights and public offers, or offers for sale (offer of securities by

existing shareholders to the public for subscription).

Secondary Market

 A secondary market is one in which securities are bought and sold after being initially
offered to the public in the primary market and/or listed on the stock exchange.

 Organized Exchanges
 Dhaka Stock Exchange (DSE)

 Chittagong Stock Exchange (CSE)

 The over-the-counter (OTC) market serves as part of the secondary market for stocks and
bonds not listed on an exchange as well as for certain listed securities.
 It is composed of brokers and dealers who stand ready to buy and sell securities at quoted prices.

 Most corporate bonds, and a growing number of stocks, are traded OTC as opposed to being traded on an
organized exchange.
Money Market

 The money market is the market for short-term funds as distinct from Capital Market
which deals in long-term funds.

 In simple words, the money market is that segment of the financial market that deals in
short-term financial instruments having high liquidity.

 The participants of the money market purchase and sell financial securities of very
short-term maturity and the period varies from a few days to not more than a year.

 Money Market is a center for dealings, mainly of short-term monetary assets. It meets
the short-term requirements of the borrowers and provides liquidity or cash to the
lenders.
Financial Intermediaries

 Financial institutions that accept money from savers and use those funds to make
loans and other financial investments in their own name.

 They include
 commercial banks,
 savings institutions,
 insurance companies,
 pension funds,
 finance companies,
 mutual funds, and recently
 Mobile financial service providers (MFSP).
Financial Brokers

 Certain financial institutions perform a necessary brokerage function. When brokers

bring together parties who need funds with those who have savings, they are not
performing a direct lending function but rather are acting as matchmakers, or
middlemen.
 Investment banker: A financial institution that underwrites (purchases at a fixed price on a fixed date)
new securities for resale.

 Mortgage banker: A financial institution that originates (buys) mortgages primarily for resale.
Overview of Financial System of Bangladesh

 The financial system of Bangladesh is comprised of three broad fragmented sectors:

 Formal Sector
 Semi-Formal Sector
 Informal Sector

 The sectors have been categorized in accordance with their degree of regulation.

 The formal sector includes all regulated institutions like Banks, Non-Bank Financial Institutions (FIs),
Insurance Companies, Capital Market Intermediaries like Brokerage Houses, Merchant Banks etc.; Micro
Finance Institutions (MFIs).

 The semi formal sector includes those institutions which are regulated otherwise but do not fall under the
jurisdiction of Central Bank, Insurance Authority, Securities and Exchange Commission or any other enacted
financial regulator. This sector is mainly represented by Specialized Financial Institutions like House Building
Finance Corporation (HBFC), Palli Karma Sahayak Foundation (PKSF), Samabay Bank, Grameen Bank
etc., Non Governmental Organizations (NGOs and discrete government programs.

 The informal sector includes private intermediaries which are completely unregulated.
Financial Markets of Bangladesh

 The financial market in Bangladesh is mainly of following types:

 Money Market
 Taka Treasury Bond Market
 Capital Market
 Foreign Exchange Market
Capital Markets in Bangladesh

 After the independence, establishment of Dhaka Stock Exchange (formerly East

Pakistan Stock Exchange) initiated the pathway of capital market intermediaries in
Bangladesh. In 1976, formation of Investment Corporation of Bangladesh opened the
door of professional portfolio management in institutional form. In last two decades,
capital market witnessed number of institutional and regulatory advancements which
has resulted diversified capital market intermediaries. At present, capital market
intermediaries are of following types:
 Stock Exchanges
 Central Depository
 Stock Dealer/Stock Broker
 Merchant Banker & Portfolio Manager
 Asset Management Companies
 Credit Rating Companies
Risk-Return Trade-off

 Different financial instruments have different degrees of risk. In order for them to compete for funds, these

instruments must provide different expected returns, or yields.

 The idea of the market-imposed “trade-off ” between risk and return for securities – that is, the higher the

risk of a security, the higher the expected return that must be offered to the investor.

 If all securities had exactly the same risk characteristics, they would provide the same expected returns if

markets were in balance.

 Because of differences in default risk, marketability, maturity, taxability, and embedded options, however,

different instruments pose different degrees of risk and provide different expected returns to the investor.
Default Risk

 When we speak of default risk, we mean the danger that the borrower may not meet
payments due on principal or interest.

 Investors demand a risk premium (or extra expected return) to invest in securities that
are not default free.

 The greater the possibility that the borrower will default, the greater the default risk and
the premium demanded by the marketplace.

 Because Treasury securities are usually regarded as default free, risk and return are
judged in relation to them.

 The greater the default risk of a security issuer, the greater the expected return or yield
of the security, all other things the same.
Marketability

 The marketability (or liquidity) of a security relates to the owner’s ability to convert it into cash.

 There are two dimensions to marketability: the price realized and the amount of time required to sell the
asset.

 The two are interrelated in that it is often possible to sell an asset in a short period if enough price
concession is given.

 For financial instruments, marketability is judged in relation to the ability to sell a significant volume of
securities in a short period of time without significant price concession.

 The more marketable the security, the greater the ability to execute a large transaction near the quoted
price.

 In general, the lower the marketability of a security, the greater the yield necessary to attract investors.

 Thus the yield differential between different securities of the same maturity is caused not by differences in
default risk alone, but also by differences in marketability.
Maturity

 The maturity of a security can often have a powerful effect on expected return, or yield.

 The relationship between yield and maturity for securities differing only in the length of

time (or term) to maturity is called the term structure of interest rates.

 The graphical representation of this relationship at a moment in time is called a yield

curve.
Inflation

 In addition to the preceding factors, which affect the yield of one security relative to that of another, inflation expectations
have a substantial influence on interest rates overall.

 It is generally agreed that the nominal (observed) rate of interest on a security embodies a premium for inflation.

 The higher the expected inflation, the higher the nominal yield on the security; and the lower the expected inflation, the lower
the nominal yield.

 Many years ago Irving Fisher expressed the nominal rate of interest on a bond as the sum of the real rate of interest (i.e.,
the interest rate in the absence of price level changes) and the rate of price change expected to occur over the life of the
instrument.

 If the annual real rate of interest in the economy was 4 percent for low-risk securities and inflation of 6 percent per annum
was expected over the next 10 years, this would imply a yield of 10 percent for 10-year, high-grade bonds. (Note: It is the
expected rate of inflation, not the observed or reported rate of inflation, that is added to the real rate of interest.)

 This states merely that lenders require a nominal rate of interest high enough for them to earn the real rate of interest after
being compensated for the expected decrease in the buying power of money caused by inflation.
Inflation

 Many years ago Irving Fisher expressed the nominal rate of

interest on a bond as the sum of the real rate of interest
(i.e., the interest rate in the absence of price level changes)
and the rate of price change expected to occur over the life
of the instrument.

 If the annual real rate of interest in the economy was 4

percent for low-risk securities and inflation of 6 percent per
annum was expected over the next 10 years, this would
imply a yield of 10 percent for 10-year, high-grade bonds.
(Note: It is the expected rate of inflation, not the observed
or reported rate of inflation, that is added to the real rate of
interest.)

 This states merely that lenders require a nominal rate of

interest high enough for them to earn the real rate of
interest after being compensated for the expected decrease
in the buying power of money caused by inflation.
Exercise
 John Henry has a small housecleaning business that currently is a sole proprietorship.
The business has nine employees, annual sales of $480,000, total liabilities of
$90,000, and total assets of $263,000. Including the business, Henry has a personal
net worth of $467,000 and non-business liabilities of $42,000, represented by a
mortgage on his home. He would like to give one of his employees, Tori Kobayashi, an
equity interest in the business. Henry is considering either the partnership form or the
corporate form, where Kobayashi would be given some stock. Kobayashi has a
personal net worth of $36,000.

a. What is the extent of Henry’s exposure under the sole proprietorship in the case of a
large lawsuit (say, $600,000)?

b. What is his exposure under a partnership form? Do the partners share the risk?

c. What is his exposure under the corporate form?

Exercise

 Loquat Foods Company is able to borrow at an interest rate of 9 percent for one year.
For the year, market participants expect 4 percent inflation.

a. What approximate real rate of return does the lender expect? What is the inflation
premium embodied in the nominal interest rate?

b. If inflation proves to be 2 percent for the year, does the lender suffer? Does the
borrower suffer? Why?

c. If inflation proves to be 6 percent, who gains and who loses?