1. The Business, Tax and Financial Environment Chapter 2

2. Financial Markets All institutions and procedures for bringing buyers and sellers of financial instruments together. The purpose of financial markets in an economy is to allocate savings efficiently to ultimate users. It’s a “Mechanisms” by which borrower and lenders get together.

3. Financial Securities A financial security is a legal instrument that represents either an ownership or creditor claim on a company.

4. The Purpose of Financial Securities The time difference between the savings of various individuals, corporations and government from their investment in real assets. A financial asset is created only when the investment of an economic unit in real assets exceeds its savings and it finances this excess by borrowing or issuing stock. This exchange of fund is evidenced by investment instruments, or securities, representing financial assets to the holders and financial liabilities to the issuers.

5. Nature of Financial Securities It is not essential that a financial security, be it debt or equity security, has to be purchased directly from the issuing company. Once they are issued by the company, the securities are bought and sold in the market called the securities market.

6. Nature of Financial Securities Once financial securities are available for trade in the securities market, they may be bought and sold at a price higher or lower than their original issuing price. The market price of any security depends to a large extent on the financial performance of the issuing company, rising when the company’s performance improves and decreasing when the performance deteriorates.

7. Nature of Financial Securities Some of largest securities markets are situated in USA (the New York Stock Exchange), Britain (the London Stock Exchange), Germany (the Frankfurt Stock Exchange), and Japan (the Tokyo Stock Exchange). In Bangladesh, securities are traded in two stock exchanges, the Dhaka Stock Exchange (DSE), and the Chittagong Stock Exchange (CSE).

8. Types of Financial Securities A Debt Security represents money borrowed by the company. The firm incurs a liability to repay the money borrowed at some future date along with interest. An Equity Security represents ownership in the company. Whoever buys and holds an equity security of a company can claim partial ownership right in the company. The exact ownership rights are agreed to in advance and may be written in the organisational agreement.

9. Debt Security: Corporate Bonds A corporate bond is security representing a long-term promise to pay a certain sum of money at a certain time over the course of the loan, with a fixed rate of interest payable to the holder of the bond. The specific promises and details of the issue are written the agreement between the company and the bondholder, which is called the bond indenture.

10. Features of Corporate Bonds Fixed maturity First claim on earnings First claim on assets Non-participatory Call feature

11. Equity Securities: Preferred Stock Preferred stock is a form of equity security that offers preference claim or a more superior claim on the earnings and resources of the company over the other form of equity security, the common stock. The major features of preferred stock are as follows:

12. Features of Preferred Stock Preference in the receipt of dividend. Second claim on assets fixed dividend no stated maturity call feature non-participative cumulative dividend

13. Equity Securities: Common Stock Common stockholders provide the largest share of the company’s equity and enjoy least claim on the company’s earnings and resources. They may be called the true owners of the company as they take the maximum risk of the business.

14. Features of Common Stock Residual claim earnings Residual claim assets Participatory Inspection right Variable dividend Non-regular dividend Perpetual

15. Markets for Financial Securities Bonds, preferred stock, and common stock are traded in carefully regulated money and capital markets under the supervision and control of a federal authority called the “Securities and Exchange Commission (SEC)”

16. Debt Markets: The Markets where loans are traded. Equity Market: The markets where stocks of corporation are traded. Money Market: The financial markets in which funds are borrowed or loaned for short periods, generally one year or less. It’s a market for short-term government and corporate debt securities. Capital Market: The financial markets stocks and long- term debts.

17. Primary Markets: In the primary markets, corporate securities are made available to the public for the first time directly by the company issuing the securities. Secondary Markets: Securities that have already been issued previously are traded in the secondary markets. Secondary markets are the most brisk ones and these are the markets where the market values of the securities are determined through the market mechanism (demand and supply interaction).

18. Secondary markets like the NYSE, DSE etc. are highly organised and formal operating the tight regulations imposed by the SEC. Over-the-counter markets for trading securities are informal and less organised than the secondary markets. For example, stocks in the secondary markets have to be traded in lots (in bundles of say 50 or hundred shares). In the OTC market, shares may be traded in loose numbers. In the USA, most traders in the OTC market operate with the assistance of a computerised information system called the National Association of Securities Dealers Automated Quotation System (NASDAQ). Markets for Financial Securities

19. Investment sector Business Government Households Financial Brokers Investment Bankers Mortgage Bankers Secondary Market Security Exchanges OTC Market Financial Intermediaries Commercial Banks Saving Institutions Insurance Companies Pension Funds Finance Companies Mutual Funds Saving Sector Household Businesses Government Fig: Flow of funds in the economy and the mechanism that financial markets provide for channeling savings to the ultimate investors in real assets.

20. Major Classes of Financial Intermediaries 1.Commercial Banks: 2.Pension Funds: Retirement plans funded by corporations or government agencies for their workers. Primarily invests in long-term financial instruments. 3.Life insurance companies: Take savings in the form of annual premiums, then invest these funds in stocks, bonds, real estate, and mortgages, and finally make payments to the beneficiaries of insured parties. 4.Mutual Funds: Investment companies that accept money from savers and then use these funds to buy various types of financial assets such as stocks, long-term bonds, short- term debts instrument.

21. Fundamental factors affecting the cost of capital Production Opportunities: The returns available within an economy from investment in cash- generating asset. Time preferences for consumption: The preferences of consumers for current consumption as opposed to saving for future consumption. Risk: In a financial market context, the chance that a financial asset will not earn the return promised. Inflation: The tendency of prices to increase over time.

22. Interpreting Interest rates Equilibrium interest rates are the required rate of return for a particular investment. Interest rates are also referred to as a discount rates. We can also view interest rates as the opportunity cost of current consumption because future consumption could be i% higher.

23. Components of interest Rate Required (nominal) rate on a security = Real risk –free rate + expected inflation + default risk premium + liquidity premium + maturity risk premium

24. Inflation Premium: A rise in the average level of prices of goods and services. Default Risk Premium: The failure to meet the terms of a contract, such as failure to make interest or principal payments when due on a loan. The risk that a borrower will default on a loan. Liquidity Premium: The ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession. A premium added to the rate on a security if the security cannot be converted to cash on short notice and at close to the original cost..

25. Maturity Risk Premium: The life of a security the amount of time before the principal amount of a security becomes due. A premium reflects interest rate risk ( risk of capital losses because of changing interest risk); bonds with longer maturities have greater interest risk. Reinvestment Rate Risk: The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested.