Business Finance 1

Lecture 2:
Financial Markets, Institutions and
Interest Rates
Muslim Reza Mooman

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 Firms operate in a financial system…
Financial Institutions
Commercial Banks
Funds supplied Insurance Companies
through investments Mutual Funds
Pension Funds

Rates
Financial Markets, Institutions and Interest
in…

Suppliers Of Funds Demanders

of funds
Businesses Businesses
Government Government
Individuals Individuals

Financial Markets
Funds supplied Money Market
directly through… Capital market
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 Rates
Financial Markets, Institutions and Interest
FINANCIAL MARKETS BRING TOGETHER THE
BUYERS AND SELLERS OF DEBT AND EQUITY
SECURITIES…

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TYPES OF FINANCIAL MARKETS INCLUDE…

 Money Markets versus Capital Markets

Rates
Financial Markets, Institutions and Interest
 Debt Markets versus Equity Markets

 Primary Markets versus Secondary Markets

 Spot Markets versus Derivatives Markets

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BASIC DEBT INSTRUMENTS IN PAKISTAN
INCLUDE…
Government Debt Instruments:

Rates
Financial Markets, Institutions and Interest
 Treasury Bills (Short-term)
 National Saving Certificates (redeemable any time at
par)
 PIBs (Long-term)

Corporate Debt Instruments:

 Term Deposits in Banks (Short-term)
 TFCs (Conventional)
 Sukuks (Islamic) 5
FIGURES FOR SOME BORROWING RATES IN
PAKISTAN…
Discount Rate 5.75%

Rates
Financial Markets, Institutions and Interest
T-Bill Rate (3 month)* 5.99%
T-Bill Rate (6-month)* 6.01%
KIBOR (3-month)** 6.14%
PIB (3-year)* 6.41%
PIB (10-year)* 7.94%
*Based on the most recent auctions as of August 23, 2017
** As of August 18, 2017

Source: State Bank of Pakistan

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STOCK EXCHANGES (SECONDARY MARKETS) IN
PAKISTAN…

 Karachi Stock Exchange

Rates
Financial Markets, Institutions and Interest
 Lahore Stock Exchange

 Islamabad Stock Exchange

In January 2016, the three exchanges were merged into a

single exchange, Pakistan Stock Exchange (PSX).

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SOME KEY FACTS AND FIGURES FROM KSE…

Listed Companies 560

Rates
Financial Markets, Institutions and Interest
Listed TFCs 14
Market Capitalization PKR 9,595 bn
Leading stock market Indicator PSX-100

Source: Pakistan Economic Survey 2016-17

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KSE-100 INDEX HISTORICAL RETURNS…
140.00%

120.00% 112.20%

Rates
Financial Markets, Institutions and Interest
100.00%

80.00%
65.53%
60.05%
60.00% 53.68%
48.98% 49.43% 45.68%
39.06% 40.20%
40.00% 28.08% 27.20%
20.00% 7.00%
5.06% 2.13%
0.00%
-5.61%
-20.00% -15.56% -12.18%

-40.00%

-60.00%
-58.34%
-80.00%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

* Return for 2017 is from January 1 to August 22.

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RECENT TRENDS OBSERVED IN THE EQUITY
MARKET OF PAKISTAN INCLUDE…
 PSX was ranked best market in Asia and fifth best
performing market in the world in the year 2016 by

Rates
Financial Markets, Institutions and Interest
Bloomberg.
 Following the announcement about Pakistan’s
reclassification in MSCI EM Index from FM index in June
2016, trading volume witnessed three-fold increase.
 Stable macroeconomic environment, stable exchange rate,
and not so-high inflationary pressures are also some factors
behind the good performance of stock market.
 Performance has dropped recently due to the pressures and
uncertainties on political front. 10
IPOS KEEP THE PRIMARY MARKETS ALIVE…

Year New Companies Listed

Rates
Financial Markets, Institutions and Interest
2010-11 1
2011-12 3
2012-13 4
2013-14 5
2014-15 9
2015-16 6
2016-17 4

Source: Pakistan Economic Survey 2016-17 11

 INTEREST RATES ARE DETERMINED
THROUGH THE INTERACTION OF DEMAND
AND SUPPLY FORCES…

Rates
Financial Markets, Institutions and Interest
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THE NOMINAL INTEREST RATE COMPRISES OF…
Interest Rate = RRIR + IP + DRP + LRP + MP

Rates
Financial Markets, Institutions and Interest
 Real Risk-free interest rate (RRIR)
 Inflation premium (IP)

 Default risk premium (DRP)

 Liquidity risk premium (LRP)

 Maturity premium (MP)

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 Rates
Financial Markets, Institutions and Interest
TERM STRUCTURE OF INTEREST RATES IS
THE RELATIONSHIP BETWEEN THE INTEREST
RATES AND THE TIME TO MATURITY…

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THERE ARE 3 THEORIES DESCRIBING THE TERM
STRUCTURE OF INTEREST RATES…

 Unbiased expectation theory

Rates
Financial Markets, Institutions and Interest
 Only risk factor existing is inflation
 Forward rate can be easily calculated
 Long-term rate = Average of short-term rates
 Different maturities are perfect substitutes

 Liquiditypremium theory
 Market segmentation theory

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REFERENCES

 Chapter 3, Essentials of Managerial Finance.

Scott Besley & Eugene F. Brigham. 14th Edition.

Rates
Financial Markets, Institutions and Interest
 Chapter 5, Essentials of Managerial Finance.
Scott Besley & Eugene F. Brigham. 14th Edition.
 Chapter 6, Economic Survey of Pakistan 2016-17.

 State Bank of Pakistan

 Pakistan Stock Exchange

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