Directorate of Distance Learning
G.C University Faisalabad
FORM FOR ASSESSMENT OF ASSIGNMENT
(This part will be filled by Student)
Name of student: MUHAMMAD DANISH Name of Tutor: Sir Muhammad Sajid SB
Roll No. 119467 Address of Tutor:
Year: 2015 To 2017
H # P – 802 G M ABAD NO.1 FSD
Name of course: Financial Market & Institutions Assignment No. 1st Code No._____
Last date of submission of Assignment: 26-06-2016
Date of submission of Assignment: 23-06-2016
Signature of Student: _M.
(This part will be filled by Tutors)
Name of study Center: _____________________ District: ___________
Date of receiving Assignment: _______________
No. 1 2 3 4 5 6 7 8 9 10
Date of Assignment Return: _________ Signature of
Q1: Why are financial markets important to the health of the economy?
Explain financial system; write short notes on different components of
the financial system?
A Financial market is a market in which people trade financial securities,
commodities, and other fungible items of value at low transaction costs and at
prices that reflect supply and demand. Securities include stocks and bonds, and
commodities include precious metals or agricultural products.
The importance of financial markets to the health of economy:
Financial markets are extremely important to the general health of an
economy. With effective markets for credit and capital, borrowing and investment
will be limited and the whole macro – economy can suffer.
A financial crisis is a situation in which the value of financial
institutions or assets drops rapidly. A financial crisis is often associated with
a panic or a run on the banks, in which investors sell off assets or withdraw
money from savings accounts with the expectation that the value of those
assets will drop if they remain at a financial institution.
Debt Markets and Interest Rates
A security is a claim on the issuer’s future income or assets. A bond is
a debt security that promises to make payments periodically for a specified
period of time.1 Debt markets, also often referred to generically as the bond
market, are especially important to economic activity because they enable
corporations and governments to borrow in order to finance their activities;
the bond market is also where interest rates are determined. An interest rate
is the cost of borrowing or the price paid for the rental of funds (usually
expressed as a percentage of the rental of $100 per year). There are many
interest rates in the economy—mortgage interest rates, car loan rates, and
interest rates on many different types of bonds.
The mortgage market involves making long – term loans for buying
property. Once a loan is made, it can be traded on the second-hand mortgage
market. Like the stock exchange, the secondary mortgage market enables
the original lenders, the banks, and building societies, to regain lost
liquidity. The new owner of the mortgage debt is entitled to receive the
Managing Risk in FinancialInstitutions
In recent years, the economic environment has become an
increasingly risky place. Interest rates have fluctuated wildly, stock markets
have crashed both here and abroad, speculative crises have occurred in the
foreign exchange markets, and failures of financial institutions have reached
levels unprecedented since the Great Depression. To avoid wild swings in
profitability (and even possibly failure) resulting from this environment,
financial institutions must be concerned with how to cope with increased
The processes and procedures used by an organization’s management
to exercise financial control and accountability. These measures include
recording, verification, and timely reporting of transactions that affect
revenues, expenditures, assets, and liabilities.
Basic components of financial system:
There are five basic components of financial system:
A financial institution (F1) is an establishment that focuses on dealing
with financial transactions, such as investment, loans and deposit.
Conventionally, financial institutions are composed of organizations such
as banks, trust companies, insurance companies and investment dealers.
A financial market is the place where financial assets are creating. It can
be broadly categorized into money markets and capital markets. Money
market handles short – term financial assets (less than a year) whereas
capital markets take care of those financial assets that have maturity
period of more than a year. The key functions re:
1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth
4. Offer financial convenience.
One more classification is possible: primary markets and secondary markets.
Primary markets handle new issue of securities in contrast secondary
markets take care of securities that are presently available in the stock
This is an important component of financial system. The products,
which trade in a financial market, are financial assets, securities or other
type of financial instruments. There is a wide range of securities in the
markets since the needs of investors and credit seekers are different. They
indicate a claim on the settlement of principal down the road or payment
of a regular amount by means of interest or dividend. Equity shares,
debentures, bonds, etc. are some example.
Financial services consist of services provided by assets management
and liability management companies. They help to get the necessary
funds and make sure that they are efficiently deploying. They assist to
determine the financing combination and extend their professional
services up to the stage of servicing of lenders.
They help with borrowing, selling and purchasing securities, lending and
investing, making and allowing payments and settlements and taking care
of risk exposures in financial markets. These range from the leasing
companies, mutual fund house, merchant bankers, portfolio managers,
bill discounting and acceptance houses. The financial services sector
offers a merchant banking, depositoryservices, bookbuilding, etc.
The money is anything that accepted for payment of product and
services or for the repayment of debt. It is a medium of exchange and
acts as a store of value.
Q2: What is money and its different functions? Briefly, explain how money
evolved in Pakistan?
The money is anything that accepted for payment of products and services or
for the repayment of debt. It is a medium of exchange and acts as a store of value.
Functions of money:
There are two types of functions of money.
1. Primary functions:
Primary functions include the most important of money, which it must
perform in every country, these are:
a) Medium of exchange:
Money, as a medium of exchange, means that it can be used to make
payments of all transactions of goods and services. It is the most essential
function of money. Money has the quality of general acceptability. So; all
exchanges take place in terms of money.
This function has removed the major difficulty of lack of double co –
incidence of wants and inconveniences associated with the barter
Use of money allow purchase and sale to be conducted independently
of one another.
This function of money facilitates trade and helps in conducting
transactions in an economy.
Money has no power to satisfy human wants, but it commands power
to purchase those things, which have utility to satisfy human wants.
b) Measure ofvalue (unit of value):
Money as measure of value means that money works as common
denomination, in which values of all goods and services are expressing.
By reducing the value of all goods and services to a single unit (i.e.
price), it becomes very easy to find out the exchange ratios between
them and comparing their prices.
This function facilitates maintenance of business accounts, which
would be otherwise impossible.
Money helps in calculating relative prices of goods and services. Due
to this reason, it is regarded as a unit of account’. For instance,
‘Rupee’ is the unit of account in India, ‘Pound’ in England and so on.
These refer to those functions of money, which are supplementary to the
primary functions. These functions derive from primary functions and,
therefore, they are known as ‘Derivative Functions’. The major secondary
1) Standard of deferred payments:
Money as a standard of deferred payments means that money acts as a
‘Standard’ for payments, which are to be made in future. Every day, millions
of transactions take place in which payments doses not made immediately.
Money encourages such transactions and helps in capital formation and
economic development of the economy. This function of money is
Money as a standard of deferred payments has simplified the
borrowing and lending operations.
It has led to the creation of financial institutions.
2) Store of value (Assetfunction of money):
Money as a store of value means that money can be used to transfer
purchasing power from present to future. Money is a way to store wealth.
Although wealth can be store in other forms also, but money is the most
economical and convenient way. It provides security to individuals to meet
contingencies, unpredictable emergencies and to pay future debts. Money as
store of value has the following advantages:
The money working in Pakistan
The money is working in Pakistan with different shapes, which are
1. Commodity money:
It is the simplest kind of money, which is use in barter system where
the valuable resources fulfill the functions of money. The value of this
kind of money comes from the value of resource use for the purpose. It is
only limited by the scarcity of the resources. Value of this kind of money
involves the parties associated with the exchange process.
2. Fiat money:
The word fiat means the” command of the sovereign”. Fiat currency is
the kind of money, which does not have any intrinsic value, and it cannot
converter into valuable resource. The value of fiat money determines by
government order, which makes it a legal instrument for all transaction
purposes. The fiat money need to be controller as it may affect entire
economy of a country if it is misused. Ex: Paper money, coins.
3. Fiduciary money:
Today’s monetary system is highly fiduciary. Whenever, any bank
assures the customers to pay in different types of money and when the
customer can sell the promise or transfer it to somebody else, it is called
the fiduciary money, fiduciary money generally paid in gold, silver or
paper money, there are cheques and bank notes, which are the examples
of fiduciary money because both are some kind of token, which are used
as money and carry the same value.
4. Commercialbank money:
Commercial bank money or demand deposits are claims against
financial institutions that can be used for the purchase of goods and
services. A demand deposit account is an account from which funds can
be withdrawn at any time by cheque or cash withdrawal without giving
the bank of financial institution any prior notice. Banks have the legal
obligation to return funds held in demand deposits immediately upon
demand (or ‘at call’). Demand deposit withdrawals can be performed in
person, via cheques or bank drafts, using automatic teller machines
(ATMs), or through online banking. There are also various other types of
money like the credit money, electronic money, coin and paper money,
fractional money and Representative money as discussed below:
It is a hybrid type of money, which is partly back by a
commodity and has fiat money transaction purpose. If the commodity
loses its value then fractional money converts into fiat money.
b) Representative money:
It represents a claim on commodity and it can be redeem for
that commodity at a bank. A token or paper money can be exchange
for a fixed quantity of commodity. Its value depends on the
commodity it backs.
Metals of particular weight are stamp into coins. There are
various precious metals like gold, bronze, copper whose coins already
have used in human history. The minting of coins is control by the
Paper money don’t have any intrinsic value, as a fiat money. It
is approved by government order to be treat as legal tender through
which value exchange can happen. Government prints the paper
according to the requirements, which is tightly control as it can affect
the economy of the country.
Q3: What are different roles and functions of central bank to support
financial system of any country?
It every country, there is one bank, which acts as the leader of the money
market- supervising, controlling and regulating the activities of commercial banks
and other financial institutions. It acts as a banker of issue and is in close touch
with the government, as banker, agent and adviser to the latter. Such a bank is
known as the Central Bank of the country.
Roles & Functions of a central Bank
1. Bank of issue:
Central bank has the exclusive monopoly of note issue and the
currency notes issued by the central bank are declared unlimited legal tender
throughout the county. This monopoly brings about:
Uniformity of note issue which in turn facilitates trade and exchange
within the country
Enables the central bank to influence and control the credit creation of
Gives distinctive prestige to the currency notes
Enables govt to appropriate partly or fully the profits of note issue.
2. Banker, Agent and Adviser to the Government:
As banker and agent, RBI keeps the banking accounts of the central,
state governments, makes, and receives payments on behalf of the
government. It provides short – term advances to the govt. (ways and means
advances) to tide over temporary shortage of funds. It advises the govt. on
all monetary and banking matters.
3. Custodian of the cask reserves of commercialbank:
All commercial banks keep part of their deposits as reserves with the
central banks and hence the name Reserve bank of India. Centralized cash
reserves serve as the basis of a larger and more elastic credit structure and
helps commercial banks to meet crises and emergencies. Centralized cash
reserve aids the central bank to control credit creation and implement
4. Custodian of foreign balance of the country:
RBI holds the foreign exchange assets of all commercial and non –
commercial bank of the country. It is the responsibility of RBI to maintain
the rate exchange and manage exchange control and other restrictions
imposed by the state. It also maintains reserves with the IMF and obtains
normal drawing and special drawing rights.
5. Lender of the lastresort:
Central bank never refuses to accommodate any eligible commercial
bank experiencing cash shortage. In the absence of a central bank,
commercial banks will have to carry substantial cash reserves, which imply
restricted lending and responsibility of meeting directly or indirectly all
reasonable demands for accommodation by the commercial banks.
6. Central clearance,settlementtransfer:
As the central bank keeps cash reserves of commercial banks, it is
easier for member banks to settle their mutual claims in the books of the
central bank. These are the clearing house operations of RBI wherein
cheques are cleared, claims settled and funds transferred in the books of the
member banks. However, this function can also be performed by any leading
bank in a locality or area.
7. Controller of credit:
Central bank controls the level of credit in the economy by either
expanding or contracting bank deposits. In modern times, bank deposits
have become the most important source of money in the county. As
controller of credit, it seeks to influence and control the volume of bank
credit and to stabilize business conditions in the country.
8. Open market operations:
Deliberate and direct buying of securities and bills by the central bank
in the money market, on its own initiative, is called open market operations.
In periods of inflation, the central bank will sell in the market first calls bills
in its possession to buyers like commercial banks and others. This reduces
the cash reserves of the commercial banks, which in turn will reduce its
capability to give loans and advances. Thereby, business activity in the
country will be cut short. During recession, central banks buys bill from
commercial bank and thereby increases their cash reserves.
9. Cashreserve ratio:
According to the central bank, every scheduled bank has an obligation
to maintain a certain portion of their demand and time deposits as a reserve
with the central bank. This provision was fixed for three important reasons;
To ensure the liquidity and solvency of individual commercial bank and of
the banking system as a whole
To provide the central bank with supply of deposits for local operations
To influence and ultimately restrict commercial banks’ expansion of credit.
Hence, CRR is an additional instrument of credit controlof the central bank
The quantitative controls like bank rate, OMO and CRR affect
indiscriminately all sections of the economy which depend on bank credit.
Besides, there are some groups of borrowers who are engaged in important
spheres of economic activity and whom the central bank would like to
insulate from these quantitative effects. hence, central banks have been
adopting the tool of selective credit controls or qualitative controls whose
special features are:
They distinguish between essential and non – essential uses of bank
Only non – essential uses are brought under the scope of central bank
They affect not only the lenders but also the borrowers.
11.Working of bank rate policy:
Hence, rise in bank rate increases interest rates, curtails bank credit,
decreases demand for gods and services and finally reduces the price level.
Further, the most powerful influence of bank rate is psychological – bankers
and business men consider bank rate changes as authoritative
pronouncements of the central bank concerning the credit situations. at a
very important time. Radcliffe report states:” the rise in the bank rate is
symbolical; it is evident that authorities have the determination to take
unpleasant steps to check inflation”.
Q 4: Describe money market and briefly discus instruments of money
markets with examples from Pakistanimarkets?
The money market became a component of the financial markets for assets
involved in short – term borrowing, lending, buying and selling with original
maturities of one year or less. Trading in money markets is done over the counter
and is wholesale.
A segment of the financial market in which financial instruments with high
liquidity and very short maturities are trade. Participants use the money market as a
means for borrowing and lending loans in the short term, from several days to just
under a year.
Instruments of money markets:
1. Certificate of deposit:
A certificate of deposit (CD) is a savings certificate entitling the
bearer to receive interest. A CD bears a maturity date, a specified fixed
interest rate and can be issue in any denomination. CDs are generally issue
by commercial banks and are insure by the FDIC.
2. Repurchase agreements:
A repurchase agreement (repo) is a form of short – term borrowing for
dealers in government securities. The dealer sells the government securities
to investors, usually on an overnight basis, and buys them back the
Commercial paper is an unsecured, short - term debt instrument issued
by a corporation, typically for the financing of accounts receivable,
inventories and meeting short – term liabilities. Maturities on commercial
papers rarely range any longer than 270 days.
4. Federalagencyshort – term securities:
In the Pakistan, short – term securities issued by government
sponsored enterprises such as the farm credit system, the federal home loan
banks and the federal national mortgage association.
In the Pakistan, interest – bearing deposits held by banks and other
depository institutions at the federal reserve; these are immediately available
funds that institutions borrow or lend, usually on an overnight basis. They
are lent for the federal funds rate.
6. Municipal notes:
In the Pakistan, short – term notes issued by municipalities of tax
receipts of other revenues.
Short – term debt obligations of a national government that are issue
to mature in three to twelve months.
8. Money funds:
Pool short – maturity, high – quality investments that buy money
market securities on behalf of retail or institutional investors.
9. Foreignexchange swaps:
Exchanging a set of currencies in spot date and the reversal of the
exchange of currencies at a predetermined time in the future
An asset – backed security (ABS) is a security whose income
payments and hence value is derived from and collateralized (or “backed”)
by a specified pool of underlying assets. The pool of assets is typically a
group of small and illiquid assets, which are unable to be sold individually
Q5: Briefly explain different types of stock. What are different
intermediaries involved in stock markets?
Types of stock:
There are two types of stock:
a) Common stock
b) Preferred stock
a) Common stock:
A common stock is a security that represents ownership in a corporation.
Holders of common stock exercise control by electing a board of directors
and voting on corporate policy. Common stockholders are on the bottom of
the priority ladder for ownership structure.
A preferred stock is a class of ownership in a corporation that has a higher
claim on its assets and earnings than common stock. Preferred shares generally
have a dividend that must be paid out before dividends to common
shareholders, and the shares usually do not carry voting rights.
Intermediaries involved in stock market
1. Insurance companies
Insurance companies concentrate on fulfilling the insurance needs of the
community, both for life and non-life and non-life insurance. These companies
offer products that allow investors to select the kind of policies to suit their
financial planning needs. These companies also offer policies for funding a
child’s education and marriage, and providing a steady income for the aged
through annuities and pensions.
2. Mutual funs
Mutual funds (MFs) organizations satisfy the needs of individual’s investors
through pooling resources from a large number with similar investments goals
and risks appetite. The resource collected are invested in the capital and money
market securities. The returns are distributed to investors optimizing the return
for the investors.
3. Non-banking finance companies
NBFCs are commonly known as finance companies and are corporate
bodies, which concentrate mainly on lending activities in a well-defined area.
4. Investment brokers
The main duty of investment brokers is to transact the security sales. There
are discount brokers and full – service brokers. They provide an opportunity
online for some individuals to promote their trades. Aside from that, they can
also solicit valuable investment advice to some clients who may need it that
5. Investment bankers
The main duty of this financial intermediary is to increase monetary amounts
of companies through stocks and bonds. Since conducting stock offerings and
issuing bonds is so expensive, investment bankers focuses on how they can help
the firm to earn more capital.
6. Escrow companies
This is the type of financial intermediary that is built for the very purpose.
These companies’ acts like an unconcerned party that will hold instructions for
execution as well as the grounds agreed for it.
A pension fund is any plan, funds, or scheme which provides retirement
income. Pension funds are important to shareholders of listed and private
companies. They are especially important to the stock market where large
institutional investors dominate.
8. Collective investment scheme
A collective investment scheme is a way of investing money alongside other
investors in order to befit from the inherent advantages of working as part of a
group. These advantages include an ability to hire a professional investment
manage, which theoretically offer the prospects of better returns and / or risk
management. Benefit from economies of scale – cost sharing among others
diversifies more than would be feasible for most individual investors which,
theoretically, reduce risk.
Q 6: Explain functions of stock market and procedure of trading stock in
stock market also differentiates between KSF 100 – index and KSF 30
The stock is the market shares of publicly held companies are issue and trade
through exchange or over – the – counter market, the stock market also known as
the equity market.
Trading procedure on a stock market:
The trading procedure involves the following steps:
1. Selectionofa broker:
The buying and selling of securities can only be done through SEBI
registered brokers who are members of the stock exchange. The broker can
be an individual, partnership firm or corporate bodies. So, the first step is to
select a broker who will buy/sell securities on behalf of the investor or
2. Opening demat accountwith depository:
Demat (dematerialized) account refer to an account which a citizen
must open with the depository participant (bank or stockbrokers) to trade in
listed securities in electronic form. Second step in trading procedure is to
open a demat account. The securities are held in the electronic form by a
depository. Depository is an institution or an organization are which holds
securities (e.g. shares, debentures, bonds, mutual (National securities
depository Ltd.) and CDSL (central depository services Ltd.) there is no
direct contact between depository and investor. Depository participant will
maintain securities account balances of investor and intimate investor about
the status of their holdings from time to time.
3. Placing the order:
After opening the demat account, the investor can place the order. The
order can be placed to the broker either (DP) personally or through phone,
Investor must place the order very clearly specifying the range of price at
which securities can be bought or sold. E.g. “buy 100 equity shares of
reliance for not more than Rs 500 per share”.
4. Executing the order:
As per the instructions of the investor, the broker executes the order
i.e. the buys or sells the securities. Broker prepares a contract note for the
order executed. The contract note contains the name and the price of
securities, name of parties and brokerage (commission) charged by him.
Contract nonet is signed by the broker.
This means actual transfer of securities. This is the last stage in the
trading of securities done by the broker on behalf of their clients. There can
be two types of settlement.
a) On the spot settlement:
In means settlement is done immediately and on spot settlement
follow. T + 2 rolling settlement. This means any trade – trade – taking
place on Monday gets settled by Wednesday.
It means settlement will take place on some future date. It can be T+ 5
or T + 7, etc. All trading in stock exchanges takes place between 9.55 am
and 3.3. Pm. Monday to Friday.
Difference betweenKSF 100 & KSF 30:
The KSE 100 index was
introduced in 1991 and
comprises of 100 companies
selected on the basis of sector
representation and highest
market capitalization, which
captures over 80% of the total
market capitalization of the
companies listed on the
KSE 100 index is a stock
index acting as a benchmark
to compare prices on the
Karachi Stock Exchange over
The Karachi Stock Exchange is
maintaining two indices, which
are in place i.e. KSE 100 and
KSE all share index. Both the
said indices are market
capitalization based indices.
The Karachi Stock Exchange has
launched the KSE 30 index with
base value of 10,000 points,
formally implemented from
Friday, September 1, 2006.
KSE 30 index is based only on
the free float of shares, rather
than because of paid up capital.
When a company announces a
dividend, KSE 30 index is
adjusted for dividends and right
Q7: Explain in detail bonds, bonds market and different types of bonds; also
write a note on Pakistaninvestment bonds (PIB).
Bonds are a debt investment in which an investor loans money to an entity
(typically cooperate or government) which borrows the funds a defined period of
time at a variable or fixed interest rate.
The bond market (also debt market or credit market) is a financial market
where participants can issue new debt, known as the primary market, or buy and
sell debt securities, known as the secondary market. This is usually in the form of
bonds, butit may include notes, bills, and so on.
Types of bonds:
Treasuries are issued by the federal government to finance its gadget
deficits. Because they’re backed by Uncle Sam’s awesome taxing authority,
they’re considered credit – risk free. The downside: their yields are always
going to be lowest (except for tax – free munis). But in economic downturns
they perform better than higher – yielding bonds, and the interest is exempt
from state income taxes.
2. Agency bonds:
These bonds are issued by federal agencies, they’re different from the
mortgage – backed securities issued by those same agencies, and by Freddie
Mac (FRF) (the Federal home loan mortgage cop.) agency yields are higher
than treasury yields because they are not full – faith - and – credit
obligations of the U.S. government, but the credit risk is considered
minimal. Interest on the bonds is taxable at both the federal and state levels,
3. Investment – grade corporate bonds:
Investment – grade corporate is issued by companies or financing
vehicles with relatively strong balance sheets. The carry ratings of at least
triple – B from standard & poor’s, Moody’s investors service or both. (The
scale is triple – A as the highest, followed by double – A, single – A, then
triple – B, and so on.) for investment – grade bonds, the risk of default is
considered pretty remote. Still, their yields are higher than either Treasury or
agency bonds, though like most agencies they are fully taxable. In economic
downturns, these bonds tend to underperform Treasuries and agencies.
4. High – yield bonds
These bonds are issue by companies or financing vehicles with
relatively weak balance sheets. They carry ratings below triple – B. default
is a distinct possibility. As a result, high – yield bond prices are more closely
tie to the health of corporate balance sheets. They track stock prices more
closely than investment – grade bond prices. “High – yield doesn’t provide
the same asset – allocation benefits you get by mixing high – grade bonds
and stock, “observes Charles Schwab chief investment officer Steve ward.
These securities are something else altogether. Some are dollar –
denominated, but the average foreign bond fund has about a third of its
assets in foreign – currency – denominated debt, according to Lipper. With
foreign – currency – denominated bond, the issuer promises to make fixed
interest payments – and to return the principal – in another currency. The
size of those payments when they are converted into dollars depends on
6. Mortgage – backedbonds
Mortgage – backed, which have a face value of $25,000 compared to
&1,000 or &5,000 for other types of bonds, involve “prepayment risk.”
Because their value drops when the rate of mortgage prepayments rises, they
don’tbenefit from declining interest rates like most other bonds do.
7. Municipal bonds:
Municipal bonds are issued by governments or their agencies, and
they come in both the investment – grade and high – yield varieties. The
interest is tax – free, but that doesn’t mean everyone can benefit from them.
Taxable yields are higher than muni yield to compensate investors for the
taxes, so depending on your bracket; you might still come out ahead with
Pakistan investment bonds:
Pakistan investment bonds are issued by SBP on the behalf of federal
government. These are long – term securities and benchmark for long tenure debt.
These are risk free debts. Interbank/ NBFIs transfer of PIBs is permissible. PIBs
issued in five tenures: 3 years, 5 years, 10-year, 15 years, 20years, 30 years
maturity. SBP, SECP & ministry of finance announce the coupon retest and the
target consulting each other and profit is paid semiannually. SBP is acting as an
agent on behalf of the government for raising short term and long – term funds
from the market. Primary dealer maintains a subsidiary general ledger account
(SGLA) with SBP for the settlement pure – pose. The PIBs are sold by SBP to ten
approved primary dealers through multiple prices sealed bids auction. The
commission is paid to primary dealers on sale proceeds of Pakistan investment
bonds (PIBs) @ 0.5% on amount of bid accepted or 3.5% of the target amount
whichever is less. The commission is paid to primary dealers by debiting the
government non – food account and credit the amount to the respective bank’s
Q8: What are different determinants of interest rates and its impact on
valuation of securities?
Determinants of interest rates:
1) Inflation rate:
The result is that consumers have more money to spend, causing the
economy to grow and inflation to increase. The opposite holds true for rising
interest rates. As interest rates are increased, consumers tend to have less
money to spend. With less spending, the economy slows and inflation
2) The real interestrates:
The real interest rate is the rate of interest an investor, saver or lender
receives (or expects to receive) after allowing for inflation. It can be described
more formally by the fisher equation, which states that the real interest rate is
approximately the nominal interest rate minus the inflation rate.
One-year T – bill rate in 2015 was 4.53% and inflation for the year was
2.80%. if investors expected the same inflation rate, the according to the
fisher effect the real interest rate for 2015; 4.53% - 2.80% = 1.73%
If one – year T – bill rate was 1.89% while the inflation rate was 3.30%. the
real rate; 1.89% - 3.30% = -1.41%
3) Default (credit) risk:
A credit risk is the risk of default on a debt that may arise from a borrower
failing to make required payments. In the first resort, the risk is that of the
lender and includes lost principal and interest, disruption to cash flow, and
increased collection costs. Bond rating agencies.
10 – year Treasury interest rate was 4.70%. Danish rated corporate debt interest
was 5.58% and Ijaz rated corporatedebt interest rate was 6.70%.
DRP Danish = 5.58% - 4.70% = 0.88%
DRP Ijaz = 6.70% - 4.70% = 2%
4) Liquidity risk:
Liquidity risk is the risk that a company or bank may be unable to meet short
term financial demands. This usually occurs due to the inability to convert a
security or hard asset to cash without a loss of capital and/or income in the
5) Specialprevisions and covenants:
Such as taxability, convertibility and culpability affect the interest rates. As
special provisions that provide benefits to the security holder increases, interest
6) Term to maturity:
Term structure of interest rates (yield curve) maturity premium (MP) is the
difference between the long and short – term securities of the same
characteristics except maturity.
Yield curve: relationship btw YTM and time to maturity.
Yield may rise with maturity (up – ward sloping yield curve: the most
common yield curve) Yields may fall with maturity (Inverted or
downward sloping yield curve) Flat yield curve: Yields are unaffected
by the time to maturity
Ij = (IP, RIR, DRPj, LRPj, SCPj, MPj)
Q9: Explain foreign exchange marketand its participants?
The foreign exchange market (forex, FX, or currency market) is a global
decentralized market for the trading of currencies. This includes all aspects of
buying, selling and exchanging currencies at current or determined prices. In terms
of volume of trading, it is by far the largest market in the world.
Types of participants:
1) The interbank or wholesalemarket:
Major Forex Trading in the wholesale forex market is undertaken by banks –
popularly known as interbank market. In this market, banks and non – bank
financial institutions transact with each other. They undertake trading on behalf
of customers, but majority of trading is undertaken for their own account by
2) Foreignexchange dealers and brokers:
Dealers: banks and some non – blank financial institutions act as foreign
exchange dealer. These dealers quote both “bid” and “ask” for a particular
currency pair (for spot, forward and swap contracts) and take opposite side to
either buyer or sellers of currency. They make profit from the spreads between
buying and selling prices i.e. Bid and ask rate. Brokers are agents, which merely
match buyers and sellers and get a brokerage fee.
Brokers: brokers on the other hand, help clients to get a better rate on the
currency trade by making available different quotes offered by dealers. Traders
can compare rats accordingly take a decision. Brokers charge a commission for
providing these services.
3) Hedger, speculators and arbitrageurs:
Traders buying and selling foreign exchange can take the role of hedgers, or
speculators or arbitrageurs.
Hedgers are traders who undertake forex trading because they have assists or
liability in foreign currency. For example, when an importer requiring foreign
currency, sells domestic currency to buy foreign currency, he is termed as a
hedger. The importer has a foreign currency liability. Similarly, an exporter
sells foreign currency and buys domestic currency is hedger.
Speculators are traders who essentially buy and sell foreign currency to make
profit from the expected futures movement of the currency. These traders do not
have any genuine requirement for trading foreign currency. They do not hold
any cashposition in the currency.
Arbitrageurs buy and sell the same currency at two different markets
whenever there is prices discrepancy. The principal of “law of one price”
governs the arbitrage principle. Arbitrageurs ensure that market prices move to
rational or normal levels. With the proliferation on internet, cross currency,
cross currency arbitrage possibility has increased significantly.
4) Central banks and treasuries:
All most all central bank and treasuries participate in the forex market.
Central banks play very important role in foreign exchange market. However,
these banks do not undertake significant volume of trading. Each central bank
has official/unofficial target of the forex rate of its home currency. If the actual
price deviates from the target rate, the central banks intervene in the market to
set a time.
In the retail market, individuals (tourists, foreign students, patients traveling
to other countries for medical treatment) small companies, small exporters and
importers operate. Money transfer companies/remittance companies (for
example like western union) are also major players in the retail market. Retail
traders buy/sell currency for their genuine business/personal requirements. For
example, an exporter enters into forward contract to convert foreign currency to
domestic currency. A tourist buys foreign currency in the spot market before
undertaking the journey. A UK patient visiting India to undertake an operation
that would have costhim a fortune at UK
Q10: Explain determinants of exchange rate and financial instruments of
foreign exchange market?
Determinants of exchange rate:
1. Inflation rates
Changes in market inflation cause changes in currency
exchange rates. A country with a lower inflation rate than another is will
see an appreciation in the value of its currency. The prices of goods and
services increase at a slower rate where the inflation is low. A country with
a consistently lower inflation rate exhibits a rising currency value while a
country with higher inflation typically sees depreciation in its currency and
is usually accompanied by higher interest rates.
2. Interest rates
Changes in interest affect currency value and dollar exchange
rate. Forex rates, interest rates, and inflation are all correlated. Increases in
interest rates cause a country’s currency to appreciate because higher
interest rates provide higher rates to lenders, thereby attracting more foreign
capital, which causes a rise in exchange rates.
3. Country’s current account/balance ofpayments
A country’s current account reflects balance of trade and
earnings on foreign investment. It consists of total number of transactions
including its exports, imports, debt, etc. a deficit in current account due to
spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments fluctuates
exchange rate of its domestic currency.
4. Government debt
Government debt is public debt or national debt owned by the
central government. A country with government debt is less likely to
acquire foreign capital, leading to inflation. Foreign investors will sell their
bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate will
5. Terms of trade
Related to current account and balance of payments, the terms
of trade are the ratio of export prices to import prices. A country’s terms of
trade improve if its exports prices rise at a greater rate than its imports
prices. This results in higher revenue, which causes a higher demand for the
country’s currency and an increase in its currency’s value. This results in an
appreciation of exchange rate.
6. Politicalstability & performance
A country’s political state and economic performance can affect
its currency strength. A country with less risk for political turmoil is more
attractive to foreign investors, as a result, drawing investment away from
other countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of its domestic
currency. A country with sound financial and trade policy does not give any
room for uncertainty in value of its currency. But, a county prone to
political confusions may see depreciation in exchange rates
When a country experiences a recession, its interest rates are
likely to fall, decreasing its chances to acquire foreign capital. As a result,
its currency weakens in comparison to that of other countries, therefore
lowering the exchange rate.
If a county’s currency value is expected to rise, investors will
demand more of that currency in order to make a profit in the near future.
As a result, the value of the currency will rise due to the increase in
demand. With this increase in currency value comes a rise in the exchange
rate as well.
Financialinstruments of foreignexchange market?
There are six instruments of foreign exchange market?
1) Exchange – traded fund
If referred to as ETF’s. These are open – ended investment companies that
have the characteristic of being traded at any time throughout the day. These will
oftentimes attempt duplicating stock market indices such as the S&P 500. The
ETF’s gain strength as the United States dollar (USD) weakens against a different
currency and therefore replicate currency market investment. Certain funds can
track the price fluctuations of the various world currencies as they compare to the
USD, and will oftentimes increase in value to counter the direction that the USD
moves in. this crease increased interest in the USD for investors and speculators.
The agreement established between two parties wherein they purchase, sell,
or trade an asset at a pre – agreed upon price is called a forward or a forward
contract. Normally, there is no exchange of money until a pre – established future
date has been arrived at. Forwards are normally performed as a hedging instrument
used to either deter or alleviate risk in the investment activity.
A forward transaction that contains standard contract sizes and maturity
dates are considered futures. Futures are traded on exchanges that have been
created for that purpose exclusively. Just like with commodity markets, a future in
the forex market normally designates a contract length of 3 months in duration.
Interest amounts are also included in a futures contract.
Commonly shortened to FX option from foreign exchange option. Options
are derivatives (financial instruments whose values fluctuate based on underlying
variable) wherein the owner has the right to, but is not necessarily obligated to,
exchange on currency for another at a pre – agreed upon rate and a specified date.
When you talk about options in any form (stock market, forex, or any other
market), the forex market is the deepest and largest, as well as the liquid market of
any options in the world
Where futures normally employ a 3 – month timeframe, spot transactions
encompass a 48 – hour delivery transaction period. There are four characteristics
that all spottransactions have in common, namely:
a) A direct exchange between two currencies
b) Involves only cash, never contracts
c) No interest is included in the agreed upon transaction
d) Shortest of all transaction timeframes
Currency swaps are the most common type of forward transactions. A swap
is a trade between two parties wherein they exchange currencies for a pre –
determined length of time. The transaction then is reversed at a pre – agreed upon
future date. Currency swaps can be negotiated to mature up to 30 years in the
future, and involve the swapping of the principle amount. Interest rates are no
“netted” since they are denominated in different currencies.