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Financial Institutions & Markets
Sohaib A. Butt
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Introduction
• Why do we need Finance?
• Economics talks about ‘scarcity’ and FoP
• Finance builds on Economics by:
– Creating wealth
– Minimizing the mismatch between people who have
wealth and who have productive opportunities

How are theories developed?
• Financial Economists model theories around average
behavior
– Behavior that represents the majority of the population
– Not possible to make a theory around behavior at the
tails as it does not hold on average
• Theories capture human aspect / human behavior
• The assumptions are relaxed to make the theory more
realistic in a step-wise manner

Example: Robinson Crusoe
• Shows anecdotal evidence of the benefit of financial
markets
• Can be replicated for any market
– 1 person world
– 2 person world (two-party transaction)
– Multiple borrowers and multiple lenders

Why Study Financial Markets?
1. Channel funds from savers to investors, promoting
economic efficiency.
– Economics metrics: GDP, GNP, Per capita income
– Financial Market metrics: trading volume, no. of IPOs, no. of listed
companies
2. Market activity affects: personal wealth, firm wealth, and
economic wealth.
3. Financial markets also improve the well-being of
consumers, allowing them to time their purchases better.

The role of capital markets in economic
growth
• “Recent literature on financial development and
growth identifies three fundamental channels
through which financial structure and growth are
linked:
– Financial development increases the proportion of
savings that is funneled to investments.
– Financial development may change the savings rate
and hence affect investments.
– Financial development increases the efficiency of
capital allocation.”
Garcia, M., Bekaert, G., & Harvey, C. R. (1995b). The role of capital markets in economic growth. Textos Para
Discussão. https://ideas.repec.org/p/rio/texdis/342.html

Linking Finance to Economics
Borrowing and Spending Aggregate

Lending money output/income

Financial Market Participants
Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

Making our example realistic
• Cheating is a humanistic trait which necessitates the need
of financial institutions – regulators and intermediaries
(types of financial institutions)
• The aspect of law: principal and agent
• Birth of the principal-agent problem, a realistic problem
• Necessitates a three-party transaction

Segments of Financial Markets
1. Direct Finance
– Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets
2. Indirect Finance
– Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrower’s future
income or assets

Figure 2.1 Flows of Funds Through the Financial System

Products of Financial Markets
1. Debt Markets
– Short-Term (maturity < 1 year)
– Long-Term (maturity > 10 year)
– Intermediate term (maturity in-between)
– Claim on assets in case the company is unable to
make interest payments
– Comes with monetary and business covenants
2. Equity Markets
– Pay dividends, in theory forever
– Shareholders are owners and management is agent
– Ownership comes with voting rights
Sources of External Funds for Nonfinancial Businesses: A
Comparison of the United States with Germany, Japan, and
Canada
Sources: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical
Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and
are gross flows as percentages of the total, not including trade and other credit data, which are not available.

Criteria to Evaluate Financial Instruments
(For Borrowers)
• Should it be strictly ‘money’ based?
• Should it consider other ‘risks’ which might not be
readily translatable into numbers?
• Should a firm pay more for protection against
risks?

Is Equity more expensive than Debt?
• Yes
– Debt markets are less heavily regulated than equity
markets. Regulations (such as transparency) always come
with an extra cost.
– Equity does not have a maturity while debt does. This
means the firm is infinitely responsible for cashflows to
investors. So, risk and return go hand in hand.
– Market for equity is dynamic and is almost always
unpredictable. The bond market is less dynamic and usually
in line with fundamentals such as interest rate (KIBOR).

Why do companies go public?
• For more transparency
– “Upon listing, a company must have its accounts
certified externally, which increases the cost of keeping
a parallel accounting system.”
• Cheaper access to credit
– “It enables companies to borrow more cheaply. Around
the IPO date the interest rate on their short-term credit
falls and the number of banks willing to lend rises.”
Pagano, M., Panetta, F., & Zingales, L. (1998b). Why Do Companies Go Public? An Empirical Analysis. The Journal of
Finance, 53(1), 27–64. https://doi.org/10.1111/0022-1082.25448
• For better performance - CEO compensation

– https://www.youtube.com/watch?v=8td1laTYvcM
Non-bank loans or Bank loans?
• “We find that bank regulation is a key driver. Unprofitable,
highly levered firms are more likely to borrow from
nonbanks than are other firms.”
• “Another natural question to ask is whether nonbanks are
able to offer more favorable loan terms. The answer is no
in terms of loan pricing. We find that nonbank loans carry
significantly higher interest rates.”
Chernenko, S., Erel, I., & Prilmeier, R. (2022). Why Do Firms Borrow Directly from Nonbanks? The Review of
Financial Studies, 35(11), 4902–4947. https://doi.org/10.1093/rfs/hhac016

Bank loans or Bonds?
• “This paper shows that credit spreads in the loan market are
significantly higher than implied by the capital market pricing of the risk
borne by lenders.”
• “The main implication of this finding is that firms are willing to pay a
high cost to borrow from a bank, offering the bank a senior claim at a
substantially higher yield than implied by the bond market.”
• “Therefore, firms must place a high value on bank services other than
the one-time provision of debt capital. The evidence in this sample
suggests the premium is related to ease of renegotiation”
• “While the financing choices of bond issuers in the broader universe
suggest that bank relationships are necessary to facilitate public debt
issuance.”
SCHWERT, M. (2019). Does Borrowing from Banks Cost More than Borrowing from the Market? The Journal of Finance,
75(2), 905–947. https://doi.org/10.1111/jofi.12849

Size of the US debt vs. equity market
Debt
Equity

Structure of Financial Markets
1. Primary Market
– New security issues sold to initial buyers
– Typically involves an investment bank who underwrites
the offering
2. Secondary Market
– Securities previously issued are bought and sold
– Examples include the NYSE and Nasdaq
– Involves both brokers and dealers (do you know the
difference?)

Why are secondary markets important?
Even though firms don’t get any money, per se, from the
secondary market, it serves four important functions:
• Provides liquidity, making it easy to buy and sell the
securities of the companies.
• Free-market determination of stock prices.
– Bad companies are rewarded with lower stock prices
– Good companies are rewarded with higher stock prices
• Establishes a price for the securities (useful for company
valuation – Takeovers / mergers).
• Establishes a floor price for a secondary public offering.
• CEOs are also compensated based on share performance.
Low liquidity vs. High liquidity

CEO compensation of S&P500 firms

Extras
• https://www.value.today/nyse-top-companies
• https://www.value.today/nasdaq-top-companies
• What is S&P500?
• What is DJIA?

Structure of Financial Markets
We can further classify secondary markets as follows:
1. Exchanges
– Trades conducted in central locations (e.g., New York
Stock Exchange, CBT)
http://www.samrohn.com/360-panorama/new-york-stock-
exchange/
2. Over-the-Counter Markets
– Dealers at different locations buy and sell
– Best example is the market for Treasury Securities

Links
• OTC and Exchange-based Markets
– https://www.youtube.com/watch?v=Mcc-GkjkOvE
• Why Are Most Bonds Traded on the Secondary

Market "Over the Counter"?
– https://www.investopedia.com/ask/answers/09/bond-
over-the-counter.asp

Classifications of Financial Markets
We can also classify markets by the maturity of the
securities:
1. Money Market: Short-Term debt instruments
(maturity < 1 year)
2. Capital Market: Long-Term debt instruments
(maturity > 1 year) plus equities (no maturity)

World stock markets according to market capitalization

Global Perspective: Relative Decline of
U.S. Capital Markets (1 of 2)
• The U.S. has lost its dominance in many industries:
automobiles and consumer electronics, to name a few.
• A similar trend appears at work for U.S. financial markets,
as London and Hong Kong compete. Indeed, many U.S.
firms use these markets over the U.S.
• https://fortune.com/2022/09/23/singapore-hong-kong-
place-asia-top-financial-center-new-partner-to-london-new-
york/

Global Perspective: Relative Decline of
U.S. Capital Markets (2 of 2)
Why?
1. Lower labor costs elsewhere
2. De-Dollarization
3. New technology and research in other countries
4. Shifts in consumer tastes and preferences
5. Tighter regulations
6. Greater risk of lawsuit in the U.S.
7. Sarbanes-Oxley has increased the cost of being a U.S.-
listed public company

Function of Financial
Intermediaries: Indirect Finance (1 of 8)
Instead of savers lending/investing directly with borrowers, a
financial intermediary (such as a bank) plays as the
middleman:
• the intermediary obtains funds from savers
• the intermediary then makes loans/investments with
borrowers

• This process, called financial intermediation, is actually the
primary means of moving funds from lenders to borrowers.
• Intermediaries needed because of transactions costs, risk
sharing, and asymmetric information.

• Transactions Costs
Financial intermediaries make profits by reducing
transactions costs by developing expertise and taking
advantage of economies of scale

Example of Transaction Costs
A lender lends out $1000 to the borrower on the promise that he
will pay back with $100 interest
How much better off will each party be in the future?
Without FI With FI
Contract cost = $50 Contract cost = $5
Lender Borrower Lender Borrower

Gets principal of $1000 Gets principal of $1000
Earns interest $100 Pays interest $100 Earns interest $100 Pays interest $100
Contract cost share $25 Contract cost share $25 Contract cost share $2.5 Contract cost share $2.5
Net profit $1075 Cost of borrowing $125 Net profit $1097.5 Cost of borrowing $102.5
The lender and borrower are better off when a Financial Intermediary exists
This is how FIs create incentives to lend/borrow

• A financial intermediary’s low transaction costs mean that it
can provide its customers with liquidity services, services
that make it easier for customers to conduct transactions
1. Banks provide depositors with checking accounts that
enable them to pay their bills easily
2. Depositors can earn interest on checking and savings
accounts
3. Yet they can still convert them into goods and services
whenever necessary
The facility of liquidity services enables households to keep money in banks
Households now become lenders (since money in bank is lent out)
• Another benefit made possible by the FI’s low transaction
costs is that they can help reduce the exposure of
investors to risk, through a process known as risk sharing
– FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from
another party
– This process is referred to as asset transformation,
because in a sense risky assets are turned into safer
assets for investors
Risk-averse investors can invest in safer assets


Asset Transformation in Banks
Portfolio return = 15%

Loans
Depositor A - $100
Depositor B - $100 Bank Bonds
Depositor C - $100 Invests the money in
Total deposits $300 a portfolio of assets Gold
Commodities
The benefit of this Bank earns = 10%

investment vehicle is that High risk = high return
it allows investors to invest
in safer assets Depositors earn = 5%
Low risk = low return

• Financial intermediaries also help by providing the means
for individuals and businesses to diversify their asset
holdings.
• Low transaction costs allow them to buy a range of assets,
pool them, and then sell rights to the diversified pool to
individuals.
• The best example for this is of a mutual fund.

Example of Diversification
How does a mutual fund work?

Equity
Financier A invests $1000
Financier B invests $1000 Manager Bonds
Financier C invests $1000 Invests the money in
Total investment $3000 a portfolio of assets Gold
+
Creates mutual
fund units to sell to
Commodities
public investors
The benefit of this

investment vehicle is that $3000 / 1000 units
it allows individual = $3/unit
investors to get benefits of The units are sold to public investors
diversification but with a promised return of 10%
Since financiers are the owners of the mutual
fund, they enjoy a return of the extra 5%
Manager gets a salary

• Another reason FIs exist is to reduce the impact of
asymmetric information.
• One party lacks crucial information about another party,
impacting decision-making.
– More specifically, borrowers have more information than the
lenders.
• We usually discuss this problem along two fronts: adverse
selection and moral hazard.

• Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse
outcome are ones most likely to seek a loan
3. Similar problems occur with insurance where unhealthy
people want their known medical problems covered
Fis reduce the incidence of adverse selection by screening out bad credit risks

Example of Adverse Selection
Gambling Borrower A is more
- Huge payoff with
small probability
likely to actively
seek loan
opportunities
Borrower A
Lender
OR
$1000
Borrower B
Business
- Can easily pay off
loan if he gets loan
Asymmetric Information: Adverse
Selection and Moral Hazard
• Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely
that won’t pay loan back
3. Again, with insurance, people may engage in risky
activities only after being insured
4. Another view is a conflict of interest
Fis reduce the incidence of moral hazard by monitoring borrowers


Example of Moral Hazard
Horse Betting Business Borrower A has
- Huge payoff with - Can easily pay off loan more incentives to
small probability if money is invested
engage in immoral
activities
Borrower A
Lender
OR
$1000
Borrower B
Business
- Can easily pay off
loan if he gets loan
Economies of Scope and Conflicts of
Interest
• FIs are able to lower the production cost of information by
using the information for multiple services: bank accounts,
loans, auto insurance, retirement savings, etc. This is
called economies of scope.
Reduced production cost of information translates to lower transaction costs for

borrowers/lenders

Conflict of Interest in Financial
Intermediaries
• Self-dealing describes the practice of mutual fund managers to
recommend stocks, while at the same time trading on their own behalf.
• Late trading refers to the practice of brokers, locking trades later than
requested by clients and hence materially causing financial harm.
• Spinning describes the practice of investment banks to distribute
highly sought after shares among preferential clients, to attract future
underwriting business.
• Connected lending refers to the practice of commercial banks to offer
services like monitoring of loans and advisory services to debtors at
the same time. This may create preferential treatment for rolling over
debts.
Palazzo, G., & Rethel, L. (2007). Conflicts of Interest in Financial Intermediation. Journal of Business Ethics, 81(1), 193–
207. https://doi.org/10.1007/s10551-007-9488-z

Financial Institutions in Pakistan
The banking sectors and non-banking sectors are regulated by the
central bank, State Bank of Pakistan. While rest of the market is
regulated by Securities and Exchange Commission of Pakistan.
SBP SECP
• Banking Sector • Insurance companies
• Stock exchanges
– Public banks • Leasing companies
– Private banks • Dealers
– Foreign banks • Brokers
• Mutual funds/Modarba trusts
• Non-banking Sector • Real Estate Investment trusts
– Investment banks • Corporate sector borrowing
– Development banks (DFIs)
– Microfinance banks
– Islamic banks
– Discount houses
Banking Sector
Commercial bank: A type of bank providing checking and saving
accounts, credit cards and business loans.
Such a bank induces general public to deposit their savings in the banks
and offers a wide range of services such as:
• Deposit Mobilization
• Money transfer
• Financing Working Capital
• Investing in government securities
• Call money operations (borrowing/lending for a day)

Investment Banks
Investment banks perform a variety of functions. Primarily, they assist
corporations to raise equity-capital by underwriting the public issues.
They also assist companies desiring of mergers and acquisition and
derivatives.
Such banks cannot take deposits. They manage their affairs by charging
fees such as
(i) retainer fee
(ii) advisory fees based on the transactions,
(iii) commission on underwriting
E.g. BMA Capital Management Limited, Invest Capital Investment Bank

Limited, IGI Investment Bank Limited

Development Banks (DFIs)
These banks provide guidance in selection of industrial units and extend
direct financial assistance to partly cover their financial requirements,
Such banks are responsible for speeding up the pace of economic
growth in the country in conformity with the national objectives, plans and
priorities.
Their core functions are:
• Direct financial assistance
• Mobilization of domestic savings
• Expanding entrepreneurial base by encouraging newcomers
E.g. Pak China Investment Company Limited, Islamabad, Pak Kuwait
Investment Company Limited, Karachi, Pak Libya Holding Company
Limited, Karachi, Pak Iran Joint Investment Company Limited, Karachi

Microfinance Banks
A microfinance bank would cater to the credit needs of poor households
and their small enterprises. Thus, microfinance bank provide credit to
those poor who are not considered creditworthy by the commercial banks
and other financial institutions. They provide basic training in start of a
small business, simple book-keeping and accounting.
The main aim of microfinance institutions is alleviation of poverty through
helping poor persons to earn, especially the women.
E.g. NRSP Micro Finance Bank Limited, The First Micro Finance Bank
Limited, Telenor Microfinance Bank.

Islamic Banks
In Islam, it is prohibited to charge interest on any loan. However, it is
acceptable to pass on funds to a needy person or corporation for trade
purpose in which case profit could be shared on an agreed basis
whereas loss should be shared according to the funds invested.
E.g. Al Baraka Bank Limited, Bank Islami Pakistan Limited, Dubai Islamic
Bank Pakistan limited, Meezan Bank Limited
• Islamic principles
– The deal is on the asset, not money
– Asset ownership
– Basis for charging rent

Discount Houses
These are firms which buys and discounts bills of exchange, banker'
acceptance, commercial paper, etc. Discount houses also tender for
treasury bills, deal in short-dated government bonds, and are an
important part of the short-term money markets.
• Commercial Banks are dealers of treasury securities in Pakistan.
• Government dealers (Defense Saving Certificates, Behbood
Certificates etc.)

Insurance Companies
Insurance is a hedge against the risk of a contingent and uncertain loss.
In other words, it is the equitable transfer of the risk of a loss, from one
entity to another, in exchange for payment. For this service, the insurer
charges a fee called premium depending upon the risk involved.
E.g. IGI Insurance Limited, East West Life Assurance Company, New
Jubilee Life Insurance Company Limited, East West Life Assurance
Company, Data Bank International

Stock Exchanges
Stock exchange is a place where securities are bought and sold. Such
securities include shares, derivative, unit trusts and bonds. It also
provides facilities for the issue and redemption of securities. Prices of
shares and bonds are influenced by their demand and supply like in
other commodities.
The national stock exchange is Pakistan Stock Exchange (PSX) and the
national index is KSE All-Share Index.

Leasing Companies
Leasing: It is a contract where owner of an asset agrees to allow
someone to use it for a fixed rental. It can be for fixed or indefinite period
of time. It is a binding contract which sets out terms of lease agreement
between the owner and the user.
E.g. Orix Leasing, Askari Leasing Limited, Commercial Banks.

Mutual Fund/Modarba
Acquire funds by selling shares to individual investors (many of whose
shares are held in retirement accounts) and use the proceeds to
purchase large, diversified portfolios of stocks and bonds.
It is a form of partnership which has two distinct parties:
(i) the financier
(ii) the manager.
The financer takes no part of management of the business. The profits
are distributed among the subscriber while the manager is paid the
usual salary.
Modarba is one the modes of Islamic finance. It is like mutual fund minus
its un-Islamic features.
https://www.mufap.com.pk/nav_returns_performance.php?tab=01

Mutual Fund Example
How does a mutual fund work?

Equity
Financier A invests $1000
Financier B invests $1000 Manager Bonds
Financier C invests $1000 Invests the money in
Total investment $3000 a portfolio of assets Gold
+
Creates mutual
fund units to sell to
Commodities
public investors
The benefit of this

investment vehicle is that $3000 / 1000 units
it allows individual = $3/unit
investors to get benefits of The units are sold to public investors
diversification but with a promised return of 10%
Since financiers are the owners of the mutual
fund, they enjoy a return of the extra 5%
Manager gets a salary

Real Estate Investment Trust (REIT)
REIT is a fund-based trust that owns income-producing real estate, buys
real estate, develops, manage/ operates and sells real estate assets.
REITs are modelled after mutual funds where all taxable income is paid
out as dividends to shareholders.
They are traded on the stock exchange like other securities.
E.g. Arif Habib Dolmen REIT

REIT Example
Arif Habib
Total investment needed Raise money by selling
for construction: $1000 REIT securities to the
public
Construction ✔
Income from rent = 15% $1000 / 1000 REITS

REIT-holders = 10% = $1/REIT
Arif Habib = 5%
Generates rent from

offices and shops

Exchange Traded Fund (ETF)
An exchange traded fund (ETF) is a type of security that tracks an index,
sector, commodity, or other asset, but which can be purchased or sold on
a stock exchange the same way a regular stock can.
An ETF can be structured to track anything from the price of an individual
commodity to a large and diverse collection of securities. ETFs can even
be structured to track specific investment strategies.
As the underlying stock prices change, so does the price of the ETF
E.g. UBL Pakistan Enterprise ETF, NIT Pakistan Gateway ETF, NBP
Pakistan Growth ETF, Meezan Pakistan ETF
https://www.psx.com.pk/psx/product-and-services/products/exchange-
traded-funds-etfs

ETF Example
Share price Weight ETF price
Apple $100 x 1/4 = $25.00
Microsoft $125 x 1/4 = $31.25
Tesla $90 x 1/4 = $22.50
Google $115 x 1/4 = $28.75
$107.5

Term Finance Certificate (TFC)
Corporate Bond is a debt security which is issued by company and sold
to investors to meet its financial requirements.
In Pakistan this is commonly known as Term Finance Certificate (TFC).
Corporate Bonds are normally issued for a specified time period with an
assurance to return the principal amount of the bond money including
interest to the bondholder.
Sukuk bonds are Shariah compliant (Islamic) versions of TFC.

Regulation of Financial Markets
Main reason for regulation is that even financial
intermediaries can develop conflicts of interest
– Unable to minimize asymmetric information
– Unable to minimize the mismatch between lenders and borrowers
– Ultimately leads to financial markets stagnating/freezing
The role of a regulator is to:

1. Increase information to investors
2. Ensure the soundness of financial intermediaries

Regulator
Lender Intermediary Borrower

Regulation Reason: Increase Investor
Information (1 of 2)
• Asymmetric information in financial markets means that
investors may be subject to adverse selection and moral
hazard problems that may hinder the efficient operation of
financial markets and may also keep investors away from
financial markets.
• The Securities and Exchange Commission (SEC) requires
corporations issuing securities to disclose certain
information about their sales, assets, and earnings to the
public and restricts trading by the largest stockholders
(known as insiders) in the corporation.

Regulation Reason: Increase Investor
Information (2 of 2)
• Such government regulation can reduce adverse selection
and moral hazard problems in financial markets and
increase their efficiency by increasing the amount of
information available to investors. Indeed, the SEC has
been particularly active recently in pursuing illegal insider
trading.
• More on inside trading:
https://www.youtube.com/watch?v=2BtawLeS5fM&t=77s

Regulation Reason: Ensure Soundness of
Financial Intermediaries (1 of 2)
• Providers of funds (depositors, like you) to financial
intermediaries may not be able to assess whether the
institutions holding their funds are sound or not.
• If they have doubts about the overall health of financial
intermediaries, they may want to pull their funds out of
both sound and unsound institutions (trust broken), which
can lead to a financial panic.
• Such panics produces large losses for the public and
causes serious damage to the economy in the form of
recessions.

Regulation Reason: Ensure Soundness of
Financial Intermediaries (2 of 2)
• To protect the public and the economy from financial
panics, the government has implemented six types of
regulations:
– Restrictions on Entry
– Disclosure Requirements
– Restrictions on Assets and Activities

Regulation: Restriction on Entry
• Restrictions on Entry
– Regulators have created tight regulations as to who is
allowed to set up a financial intermediary
– Individuals or groups that want to establish a
financial intermediary, such as a bank or an insurance
company, must obtain a charter from the state or the
federal government
▪ In Pakistan, financial intermediaries need to purchase licenses
from the regulator.

Regulation: Disclosure
• There are stringent reporting requirements for financial
intermediaries
– Their bookkeeping must follow certain strict principles
– Their books are subject to periodic inspection
– They must make certain information available to
the public

Regulation: Restriction on Assets and
Activities
• There are restrictions on what financial intermediaries are
allowed to do and what assets they can hold
• One way of doing this is to restrict the financial
intermediary from engaging in certain risky activities
• Another way is to restrict financial intermediaries from
holding certain risky assets, or at least from holding a
greater quantity of these risky assets than is prudent.

Regulation Reason: Improve Monetary
Control
• Because banks play a very important role in determining
the supply of money (which in turn affects many aspects of
the economy), regulation of these financial intermediaries
is intended to improve control over the money supply
• One example is reserve requirements, which make it
obligatory for all depository institutions to keep a certain
fraction of their deposits in accounts with the central bank.
• Reserve requirements help the Fed exercise more precise
control over the money supply

Other Financial Regulatory Bodies
Central Depository Company (CDC)
Custodian of capital markets which handles the electronic settlement of
shares
Competition Commission Pakistan (CCP)
Promotes competition and establishes fair trade
National Clearing Company of Pakistan (NCCPL)
Clearing and settlement services between brokers and stock exchange
Pakistan Mercantile Exchange (PMEX)
Commodity futures regulator

Decision-making in Debt Markets
• Concept of cost of borrowing/return on lending
1. Invest where?
– Different instruments
– Different return mechanisms
2. Hold to maturity or sell early?

– Interest rate risk
– Reinvestment risk

Present Value
• If you are promised $1 in 10 years time from now, this
dollar would not be as valuable to you as $1 today.
• Reason: If you had $1 today, you could simply invest it and
end up with more than $1 in 10 years.
• The term present value (PV) can be extended to mean the
PV of a single cash flow or the sum of a sequence or
group of cash flows.

Present Value Applications
There are four basic types of credit instruments which
incorporate present value concepts:
1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond

Yield to Maturity: Simple Loans
Yield to maturity = interest rate that equates today’s value
with present value of all future payments
1. Simple Loan Interest Rate (i = 10%)
$100 = $110 / (1 + i), or I = 10%

Yield to Maturity: Fixed-payment Loans
2. Fixed Payment Loan (i = 12%)
$126 $126 $126 $126

$1000 = + + +⋯ +
(1 + 𝑖) 1+𝑖 2 1+𝑖 3 1 + 𝑖 25
𝐹𝑃 𝐹𝑃 𝐹𝑃 𝐹𝑃
𝐿𝑉 = + 2
+ 3
+⋯ + 𝑛
(1 + 𝑖) 1+𝑖 1+𝑖 1+𝑖

Yield to Maturity: Coupon Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
$100 $100 $100 $100 $1000

𝑃= + + + ⋯+ +
(1 + 𝑖) 1+𝑖 2 1+𝑖 3 1 + 𝑖 10 1 + 𝑖 10
𝐶 𝐶 𝐶 𝐶 𝐹
𝑃= + 2
+ 3
+ ⋯+ 𝑛
+ 𝑛
(1 + 𝑖) 1+𝑖 1+𝑖 1+𝑖 1+𝑖
Formula serves two purposes:

1. Fair value of a bond when KIBOR fluctuates
2. Calculating YTM of a bond

Yield to Maturity: ZCB Bonds
4. One-Year Discount Bond
(P = $900, F = $1000)
$900 = $1,000 / (1 + i), or i = 11.11%

KIBOR Rates (Market Interest Rate)
Determine:
1. The price at which new bonds will be issued at
2. The price at which already existing bonds will sell at
Example 1/6
You visit a bond dealer and want to buy a 10% Coupon Rate Bond
Maturing in 10 Years (Face Value = $1,000)
The KIBOR (market interest rate) is 10%.

If you hold the bond to maturity, your return will be 10%.
You discount the cashflows and find that the fair value of the bond is
1000.
Now you know what price a dealer should be charging.
https://www.omnicalculator.com/finance/bond-price
In this example, we assume that KIBOR and bond yield are equivalent.

Example 2/6
In the first year, you receive your $100 coupon.
At the end of the first year, SBP announces to increase the KIBOR to
15%
How will this impact the price of your bond?

At 9 years to maturity, your bond is now worth 761.42.
You bought the bond at 1000.

If in case, you decide the sell the bond, what will be the return?
(761.42 – 1000) / 1000 + 10% = - 13.85%

Example 3/6
In the two years, you receive your $100 x 2 coupon.
At the end of the second year, SBP announces to decrease the KIBOR
to 5%

You bought the bond at 1000.

(1323.16 – 1000) / 1000 + 10% = 42.31%

Example 4/6
In the seven years, you receive your $100 x 7 coupons.
At the end of the seventh year, SBP announces to increase the KIBOR
to 15%.

You bought the bond at 1000

(885.84 – 1000) / 1000 + 10% = - 1.41%
What if you want to buy a new bond right now?

What would be its YTM?

Example 5/6
In the eight years, you receive your $100 x 8 coupons.
At the end of the eighth year, SBP announces to decrease the KIBOR
to 5%

At 2 year to maturity, your bond is now worth 1092.97.
You bought the bond at 1000

(1092.97 – 1000) / 1000 + 10% = 19.29%

Example 6/6
At the end of the tenth year, your bond is now at its fair value of $1000.
The borrower will repay this money to you.
How much return did you generate over this 10-year investment?
(1000 – 1000) / 1000 + 10% = 10%

Lessons from the example
• Increases in KIBOR lead to fall in prices and hence fall in
returns.
• Decreases in KIBOR lead to rise in prices and hence rise
in returns.
• As the bond matures, it becomes less sensitive to rises in
interest rates.
• As the bond matures, it becomes less sensitive to falls in
interest rates.
• Only at maturity does the YTM equal the return.
• At maturity, the bond value equals its par value.

Federal Funds Rate and Treasury Bill Yields
Federal Funds Rate = U.S. equivalent to KIBOR
Source: http://www.federalreserve.gov/releases/h15/data.htm.

Why is there a difference?
• Federal Funds Rate / KIBOR is the market interest
rate at which new bills are issued at.
• Treasury yields, on the other hand, are
determined by buying and selling of bills.
– When buying pressure is high, bill prices rise while bill
yields fall.
– This means that while KIBOR might be 10%, investors
have bid up the prices and something which might
ordinarily cost $909 is now costing $915.
▪ See the example in the next slide.

The formula in action (T-Bills)
Scenario 1: Investors have not bid up prices
KIBOR = 10%
909 = 1000 / (1+YTM) Kibor = Yield = 10%
YTM = 10%
Scenario 2: Investors have bid up prices
time
KIBOR = 10%
915 = 1000 / (1+YTM)
Kibor = 10%
YTM = 9.28% Yield = 9.28%
time

Why can’t bond issuers issue bonds lower
than the KIBOR rate?
• As we have discussed in earlier examples, the coupon rate
is always determined by the market interest rate (KIBOR).
• If an issuer tries to offer a lower coupon rate, do you think
investors will be attracted to buy those bonds? Of course
not.
• Investors will simply not buy the issuer’s bonds. Ultimately,
it will be the issuer/borrower who loses out because they
will be unable to raise financing.

Can Nominal T-Bill Yields go negative?
• Why does it happen? A dearth of investment opportunities
and very low inflation can drive market interest rates to
near-zero levels.
• When this happens, the central bank taxes commercial
banks for money not lent out.
• In such a scenario, depositors pay to keep money in the
bank since the bank itself is bearing a high cost to hold
funds.
• This is when investors tend to buy T-Bills rather than
keeping money in the bank. Hence as they drive up prices,
nominal yields can go negative.
• What this means is that borrowers get more money to
borrow money.
Why might investors buy treasury bills
when yields are negative?
• Safety: Treasury bills are considered to be a very safe
investment, as they are backed by the full faith and credit
of the US government.
• Liquidity: Treasury bills are highly liquid and can be easily
bought and sold in the secondary market.
• Diversification: Buying Treasury bills can help investors
diversify their portfolios, reducing overall risk.

Distinction Between Real and Nominal
Interest Rates (1 of 3)
• Real interest rate
Interest rate that is adjusted for expected changes in the
price level
ir = i − e
Real interest rate more accurately reflects true cost of
borrowing

If i = 8% and e = 10% then
8% − 10% = − 2%
This means that although you would be receiving 8% more
dollars at the end of the year, you will be paying 10% more
for goods. The result is that you will be able to buy 2% fewer
goods at the end of the year, and you will be 2% worse off in
real terms.
By contrast, at the end of the year, the borrower will have to
pay back 2% less in terms of good and services – so the
borrower will be ahead by 2% in real terms.
When the real rate is low, there are greater incentives to
borrow and less to lend
Let’s take the example of wallets as a good:
• If a lender gives $1000 at the nominal interest rate, he is
promised $1080 tomorrow. If he did not lend the money, he can
purchase $1000/$100, 10 wallets today.
• If he lends the money, he can purchase $1080/$110, 9.8 wallets
tomorrow.
• This is a disincentive to lend out money, because in real terms
his purchasing power has reduced.
• On the other hand, the borrower would benefit because he can
purchase 10 wallets today and only has to repay money
equivalent to 9.8 wallets in the next time period.
• The alternative holds when inflation rate is lower than the
nominal .
Figure 3.1 Real and Nominal Interest Rates (Three-Month
Treasury Bill), 1953–2016
Sources: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3MS and
https://fred.stlouisfed.org/series/CPIAUCSL. The real rate is constructed using the procedure outlined in Frederic S.
Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie–Rochester Conference Series on Public Policy 15
(1981): 151–200. This involves estimating expected inflation as a function of past interest rates, inflation, and time trends
and then subtracting the expected inflation measure from the nominal interest rate.

Inflation-hedging Assets
https://www.nber.org/digest/202209/which-asset-classes-provide-inflation-hedges
Hedging Interest-Rate Risk
1. By investing in shorter-term bonds since with a longer
term, there are more chances of market interest rate
changing.
2. By measuring duration
– A tool to manage interest-rate risk.
– E.g. A 10-year coupon bond does not have equal interest-rate
risk as a 10-year zero-coupon bond
– Reason: In a coupon, cashflows are periodic while in a zero-
coupon bond, cashflows are only at maturity.
– https://www.youtube.com/watch?v=S3lEAQDjmM8

Immunization
• Immunization helps banks protect their portfolios from
exposure to interest rate fluctuations. Using this strategy,
they can nearly guarantee that movements in interest rates
will have virtually no impact on the value of their portfolios.
• Asset-liability matching duration so that
– Healthy returns can be generated on investments
– While withdrawal services are provided to depositors
– And liquidity levels are maintained
• Banks try to invest in such a way that they do not have to
sell bonds before maturity (to avoid huge capital losses).

Reinvestment Risk
• (1) Occurs when the investor’s holding period is more than
the maturity of the bond.
• (2) When coupon payments have to be reinvested at a
lower rate of interest.
• (3) When a bond is called prematurely called (because of
staggering interest rates), so now the investor is forced to
reinvest at a lower interest rate.
• Gain from i ↑, lose when i ↓

Hedging Reinvestment Risk
1. By investing in longer-maturity bonds at high rates.
2. By investing in what is called a Bond Ladder.
– A bond ladder is a portfolio of fixed-income securities in which
each security has a significantly different maturity date.
– Mix of short- and long-term securities works best.
– Bonds maturing when interest rates are low may be offset by
bonds maturing when rates are high.

What determines bond demand?
• An asset is a piece of property that is a store of value. Facing the
question of whether to buy and hold an asset or whether to buy one
asset rather than another, an individual must consider the following
factors:
1. Wealth, the total resources owned by the individual, including all
assets
2. Expected return (the return expected over the next period) on
one asset relative to alternative assets
3. Risk (the degree of uncertainty associated with the return) on one
asset relative to alternative assets
4. Liquidity (the ease and speed with which an asset can be turned
into cash) relative to alternative assets

Theory of Portfolio Choice
The quantity demanded of an asset differs by factor.
1. Wealth: Holding everything else constant, an increase in wealth
raises the quantity demanded of an asset
2. Expected return: An increase in an asset’s expected return relative
to that of an alternative asset, holding everything else unchanged,
raises the quantity demanded of the asset
3. Risk: Holding everything else constant, if an asset’s risk rises relative
to that of alternative assets, its quantity demanded will fall
4. Liquidity: The more liquid an asset is relative to alternative assets,
holding everything else unchanged, the more desirable it is, and the
greater will be the quantity demanded
Markowitz, H. (1952). PORTFOLIO SELECTION*. The Journal of Finance, 7(1), 77–91. https://doi.org/10.1111/j.1540-
6261.1952.tb01525.x

Demand Curve
• Think from the perspective of a lender.
• Because at lower interest rates the return on
investment is lower, individuals/firms will be willing
to invest less through bond issues, and the
quantity of bonds demanded is at the lower level.

Supply Curve
• Think from the perspective of a borrower.
• Because at lower interest rates it is now less
costly to borrow by issuing bonds, firms/govts will
be willing to borrow more through bond issues,
and the quantity of bonds supplied is at the higher
level.

Supply and Demand for Bonds

Market Conditions
Market equilibrium occurs when the amount that people
are willing to buy (demand) equals the amount that people
are willing to sell (supply) at a given price
Excess supply occurs when the amount that people are
willing to sell (supply) is greater than the amount people are
willing to buy (demand) at a given price
Excess demand occurs when the amount that people are
willing to buy (demand) is greater than the amount that
people are willing to sell (supply) at a given price

Changes in Equilibrium Interest Rates
We now turn our attention to changes in interest rate. We
focus on actual shifts in the curves.
Remember: movements along the curve will be due to price
changes alone.
First, we examine shifts in the demand for bonds. Then we
will turn to the supply side.

How Factors Shift the Demand Curve
(1 of 4)
• Wealth/saving
– When wealth rises (falls) in an economy, investors are
able to purchase more (less) bonds – the demand
curve shifts outward (inwards).

(2 of 4)
• Expected Returns on bonds

– When interest rates are expected to go fall (rise), it
means returns on long-term bonds will rise (fall). –
demand curve shifts outwards (inwards).
– When inflation is expected to fall (rise), on relative
terms financial assets give a better (worse) return than
physical assets – demand curve shifts outwards
(inwards).
– When expected return on other assets falls (rises),
bonds may become more (less) attractive – demand
curve shifts outwards (inwards).

(3 of 4)
• Risk
– When bonds become less (more) risky, investors would
demand more (less) bonds – demand curve shifts
outwards (inwards).
– When other assets become more (less) risky compared
to bonds, investors would demand more (less) bonds –
demand curve shifts outwards (inwards).

(4 of 4)
• Liquidity
– When bonds become more (less) liquid, investors
would demand more (less) bonds – demand curve
shifts outward (inward).
– When other assets become less (more) liquid
compared to bonds, investors would demand more
(less) bonds – demand curve shifts outward (inward).

Summary Factors That Shift the Demand Curve for Bonds (1 of 2)

Summary Factors That Shift the Demand Curve for Bonds (2 of 2)

Shift in the Demand Curve for Bonds

Shifts in the Supply Curve (1 of 3)
• Profitability of Investment Opportunities
– In a business cycle expansion (contraction), there are
more (less) investment opportunities, and hence more
(less) funds are raised through bonds – supply curve

• Expected Inflation
– When inflation is expected to rise (fall), there is an
incentive (disincentive) to borrow as real cost of
borrowing is low (high). Hence more (less) funds are
raised through bonds – supply curve shifts outward
(inward).

• Government Activities
– When there are government deficits (surpluses), more
(less) funds are raised through bonds – supply curve

Factors That Shift Supply Curve of Bonds

Shift in the Supply Curve for Bonds

Case 1: Fisher Effect
We’ve done the hard work. Now we turn to some special
cases. The first is the Fisher Effect. Recall that rates are
composed of several components: a real rate, an inflation
premium, and various risk premiums.
What if there is only a change in expected inflation?

Changes in e: The Fisher Effect
As seen in the next slide, if expected inflation goes up:
1. Relative return of bonds falls; demand curve shifts inward
2. With greater incentives to borrow as the real cost of
borrowing is less, supply curve shifts outward
3. When the demand for bonds falls and the quantity of
bonds supplied increases, the equilibrium bond
price falls.
4. Since the bond price is negatively related to the bond
yield, this means that the bond yield will rise.

Response to a Change in Expected Inflation

Expected Inflation and Interest Rates (Three-Month Treasury
Bills), 1953–2016
Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An
Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These procedures
involve estimating expected inflation as a function of past interest rates, inflation, and time trends. Nominal three-month
Treasury bill rates from Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3MS and
https://fred.stlouisfed.org/series/CPIAUCSL

Case 2: Business Cycle Expansion
Another good thing to examine is an expansionary business
cycle. Here, the amount of goods and services for the
country is increasing, so national income is increasing.
What is the expected effect on interest rates?

Business Cycle Expansion
As the next slide shows, in a Business Cycle Expansion:
1. There are many profitable opportunities so the supply for
bonds shifts outwards.
2. Over time, wealth accumulates and the demand for bonds
shifts outward (but by a lesser degree).
3. Ultimately, it leads to bond prices falling and bond yields
rising.

Response to a Business Cycle Expansion

Business Cycle and Interest Rates (Three-Month Treasury
Bills), 1951–2016
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS.

The role of Self-Regulating Markets
• Classical Economics stresses that free markets have an
in-built self-regulating mechanism. This is exactly what we
see in Case 1 and 2.
• Notice how a rise (fall) in Expected Inflation automatically
leads to increasing (decreasing) short-term bond yields.
• Notice how a business cycle expansion (contraction)
automatically leads to increasing (decreasing) short-term
bond yields.
• Simply put, the demand and supply forces regulate the
short-term bond prices and hence yields.
• This is not to be confused with KIBOR which is set by the
Central Bank.
How markets signal increases in KIBOR
Higher expected
inflation
+
Higher risk
premiums
3m T-bill Yield 18.75% Market determined

KIBOR (overnight) 17% Central bank determined
Differential 1.75% Market is signaling to take necessary action

Bond Valuation: Investors bid up prices
You visit a bond dealer and want to buy a 10% Coupon Rate Bond
Maturing in 10 Years (Face Value = $1,000).
The KIBOR (market interest rate) is 10%. Coupon rate = central bank determined
The yield of the bond = 12%. Discount factor = market determined
100/(1+12%)^1 + 100/(1+12%)^2 + ……… + 1100/(1+12%)^10

Buying price of bond today = 887
If you hold the bond to maturity, your return will be 12%.

10% (coupons) + 2% (capital gains)
Current yield Because you bought the bond at a cheap price =
represents the PREMIUM earned for holding risky
bonds

Why are there different interest rates?
• In previous chapters, we assumed a one-interest-rate economy.
• But realistically speaking, there exist numerous interest rates in
an economy.
• Understanding why these differences exist from bond to bond
helps businesses, banks, insurance companies, and private
investors decide which bonds to buy as investments and which
ones to sell.
• Investor’s risk appetite is dynamic in nature. During a crisis, we
want to take cover, while during growth spurts, we might want to
hold riskier assets.
• The average investor is predominantly risk-averse.

Risk Structure of Interest Rates
• The relationship among interest rates of similar maturity
bonds is called risk structure.
• For example, why does a 1-year corporate bond not have
the same yield as a 1-year treasury bill?
• What are the underlying risks involved?

Figure 5.1 Long-Term Bond Yields, 1919–2016
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal
Reserve Bank of St. Louis FRED database, https://fred.stlouisfed.org/series/GS10, https://fred.stlouisfed.org/series/AAA,
https://fred.stlouisfed.org/series/BAA.

Insight To Investor Psychology
• Investors are risk-averse on average and that is reflected
in this graph as well.
• The yields for govt bonds are low – bond prices are high
which means they are more in demand (most investors
invest in safer assets).
• The yields for corporate bonds are high – bond prices are
low which means they are less in demand (only some
investors have the risk appetite to invest in risky bonds).

Risk Structure of Long Bonds in the U.S.
The figure shows two important features of the interest-rate
behavior of bonds.
• Rates (yields) on different bond categories change from
one year to the next.
• Spreads (difference between yields) on different bond
categories change from one year to the next.

Factors Affecting Risk Structure of
Interest Rates
To further examine these features, we will look at three
specific risk factors.
• Default Risk
• Liquidity Risk
• Information Costs

Default Risk
One attribute of a bond that influences its interest rate is its
risk of default, which occurs when the issuer of the bond is
unable or unwilling to make interest payments when
promised.

Default-free Bonds
U.S. Treasury bonds have usually been considered to have
no default risk because the federal government can always
increase taxes to pay off its obligations (or just print money).
Bonds like these with no default risk are called default-free
bonds.

Default Risk Premium
• The spread between the interest rates on bonds with
default risk and default-free bonds, called the risk
premium, indicates how much additional interest people
must earn in order to be willing to hold that risky bond.
• In other words, risk premium is the compensation that
investors demand to hold that asset.
• A bond with default risk will always have a positive risk
premium, and an increase in its default risk will raise the
risk premium.

Credit Ratings
• Default risk is an important component of the size of the
risk premium.
• Because of this, bond investors would like to know as
much as possible about the default probability of a bond.
• One way to do this is to use the measures provided by
credit-rating agencies: Moody’s, Fitch, S&P, VIS Credit
Rating Co. Ltd, PACRA.
• Credit rating agencies are independent financial
institutions which have the responsibility of providing
transparent bond ratings to the general public.

Table 5.1 Bond Ratings by Moody’s and Standard and
Poor’s
Moody’s S&P Rating Description Examples of Corporations with

Rating Bonds Outstanding in 2016
Aaa AAA Highest quality (lowest Microsoft, J&J
default risk)
Aa AA High quality Apple, General Electric
A A Upper-medium grade MetLife, Intel, Harley-Davidson
Baa BBB Medium grade McDonalds, BofA, HP, FedEx,
Southwest Airlines
Ba BB Lower-medium grade Best Buy, American Airlines, Delta
Airlines, United Airlines
B B Speculative Netflix, Rite Aid, J.C. Penney
Caa CCC,CC Poor (high default risk) Sears, Elizabeth Arden
C D Highly speculative Halcon Resources, Seventy-Seven
Energy

PACRA
https://www.pacra.com/

Country Risk Premium
• Countries are also assigned credit ratings based on their
ability to repay outstanding loans.
• As the name suggests, country risk premium is the
additional return demanded by investors to compensate
them for the higher risk associated with investing in a
foreign country, compared with investing in the domestic
market.
• Currently Pakistan has a ‘Caa1’ with negative outlook.
• Caa1 stands for “rated as poor quality and very high credit
risk.”

The Impact of Ratings on Yields
• Bond ratings are designed to reflect default risk.
• The lower the rating, the higher the risk of default.
• The lower its price and the higher its yield.

Liquidity Risk
• Another attribute of a bond that influences its interest rate
is its liquidity; a liquid asset is one that can be quickly and
cheaply converted into cash if the need arises. The more
liquid an asset is, the more desirable it is (higher demand),
holding everything else constant.

Information Cost Risk
• Financial markets are characterized by information
asymmetry: the borrower has more information than the
investor.
• Gathering information requires resources and reduces the
expected return on a financial asset. Government bonds
such as Treasury bills have the lowest information costs
because all savers know with certainty that the principal
and interest will be repaid.
• Information costs increase if the borrowers are not that
well known, and research needs to be conducted before
potential lenders are willing to buy bonds from such
borrowers. In short, the higher the information costs, the
higher the interest rate.
Information in Risk Structure: Recession
• The immediate impact of a pending recession is to raise
the risk premium on privately issued bonds.
• Note that an economic slowdown or recession does not
affect the risk of holding government bonds.
• The impact of a recession on companies with high bond
ratings is also usually quite small.
• The lower the initial grade of the bond, the more the
default-risk premium rises as general economic conditions
deteriorate.

Information in Risk Structure: Crisis
• During financial crises, people take cover.
• They sell risky investments & buy safe ones.
• An increase in the demand for government bonds coupled
with a decrease in the demand for virtually everything else
is called a flight to quality.
• This leads to an increase in the risk spread.

Long-Term Bond Yields, 1919–2016
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal
Reserve Bank of St. Louis FRED database, https://fred.stlouisfed.org/series/GS10, https://fred.stlouisfed.org/series/AAA,
https://fred.stlouisfed.org/series/BAA.
https://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States
Term Structure of Interest Rates
• The relationship among interest rates of different terms to
maturity bonds (and same risks) is called term structure.
• For example, why does the yield for a 1-year bond differ
from a 30-year bond, provided that the risk characteristics
are the same?
• Here we assume default, liquidity, tax, and information risk
is the same (for an equal comparison).

A Stylized Figure of the Yield Curve
2.8% Term spread = LT yield – ST yield

= 2.8% - 0.2%
= 2%
Which bonds
are more in
demand?
0.2%

Movements over Time of Interest Rates on U.S. Government
Bonds with Different Maturities
Source: Federal Reserve Bank of St. Louis, FRED database, https://fred.stlouisfed.org/series/TB3MS;

https://fred.stlouisfed.org/series/GS3; https://fred.stlouisfed.org/series/GS5; https://fred.stlouisfed.org/series/GS20: Yield
curve, http://finance.yahoo.com/bonds.

Term Structure Facts
1. Interest rates for different maturities move together.
2. Yield curves tend to have steep upward slope when
short-term rates are low and a downward slope when
short-term rates are high.
3. Yield curve is typically upward sloping.
4. Yields on short-term bonds are more volatile than yields
on long-term bonds.
5. Long-term yields tend to be higher than short-term yields.

Liquidity Premium Theory
• The liquidity premium theory asserts that investors
demand higher compensation to invest in long-term bonds.
Interest rate risk premium
Inflation risk premium
Liquidity risk premium
Default risk premium
Average of short-term yields

• Interest rate risk premium: Long-term bonds are exposed to expected
market interest rates (KIBOR), which is the risk that the value of the bond will
decline if interest rates rise. To compensate investors for this risk, long-term
bonds typically offer a higher yield than short-term bonds.
• Inflation risk premium: Long-term bonds are also exposed to expected
inflation, which is the risk that inflation will erode the purchasing power of the
bond's future cash flows. To compensate investors for this risk, long-term
bonds typically offer a higher yield than short-term bonds.
• Liquidity risk premium: Long-term bonds may also be less liquid than short-
term bonds, meaning that they may be more difficult to sell quickly without
incurring significant transaction costs. To compensate investors for this risk,
long-term bonds may offer a higher yield than more liquid short-term bonds.
• Default risk premium: Long-term bonds issued by companies or
governments with lower credit ratings may also compensate investors for the
higher risk of default by offering a higher yield. This is because there is a
greater risk that the issuer may default on its debt obligations and be unable to
make interest payments or repay the principal amount of the bond.

Information in Term Structure: Recession
• As expectations get priced in the long-term yields, it can be
inferred that the yield curve predicts economic conditions.
• A steep upward-sloping yield curve predicts a future
increase in inflation – because the economy is going
through a boom right now and it expects inflationary
pressure in the future AND higher interest rate in the
future.
• While a flat or downward-sloping yield curve predicts a
future decline in inflation – because the economy is going
through a recession right now and it expects deflationary
pressure AND lower interest rate in the future.

Key Facts
• When the term spread falls, GDP growth tends to fall one
year later.
• This shows that the yield curve is a valuable forecasting
tool, at least it forecasts the direction accurately
(exceptions are always there).
• The ability of the yield curve to forecast business cycles
and inflation is one reason why the slope of the yield curve
is part of the toolkit of many economic forecasters and is
often viewed as a useful indicator of the stance of
monetary policy.

Information in Term Structure: Crisis
• The term structure did not predict the 2007 crisis
accurately.
– Notice how the term spread goes negative for a while,
but then becomes positive.
– The positive term spread indicates that investors were
buying more short-term bonds than long-term bonds.
– One reason for this is because Federal Funds Rate
(Pakistan equivalent of KIBOR) was reduced to almost
zero. Taxes on deposit policy was implemented and
hence investors chose to put money in T-bills than in
bank accounts.

Implication of an Inverted Yield Curve
• An inverted yield curve is not a healthy sign for a

developed economy.
• Lower long-term yields than short-term yields suggest that
investors want to invest long-term and not short-term.
• The implied meaning behind this is that the economy is
doing poorly or will perform poorly within a year.
• Investors are betting on economic improvements in the
long-term that is why they are willing to invest for a longer
time period (to avoid the bad times within shorter
maturities).

Pakistan Bonds Yield Curve

Background of Market Efficiency
• The stock market is a central institution of capitalism.
• A core principle of capitalism is the free-market mechanism
whereby the market forces of demand and supply
determine equilibrium price.
• The fluctuations of stock market price quotations reflect
current expectations about company profits.
• According to the free-market mechanism, market forces
determine whether a company’s stock has value. If
investors don’t feel the stock has value, the stock will
become worthless.

Efficient Market Hypothesis
• The Efficient Market Hypothesis (EMH) is the idea that
financial markets are "efficient" in processing and reflecting
all available information about a particular asset (such as a
stock or bond) into its current market price.
• EMH suggests that all relevant information about an asset
is already reflected in its market price, and therefore it is
difficult or impossible to consistently achieve returns that
beat the overall market average through active trading or
investment strategies.

The Role of Expectations
• Just like expectations can be about inflation or interest
rates, there can also be about returns of stocks.
• Expectations are built upon information available in the
market.
• This information includes historical information and
publicly available information.
• There are various sources of information: news, financial
reports, press releases, social media.

Expected / Optimal Forecast Return
• The best forecast made using all available information.
• This forecast incorporates the market expectations which
hold on average.
• This forecast yields an optimal forecast return: RE

Realized / Equilibrium Return
• Realized return is formed with the interaction of demand
and supply forces.
• This can be denoted as: RR

Expected return
before Buying pressure
announcement increases prices
Thus, expected
Return 78%
return falls to
realized return
Realized return Realized return

12.5% 12.5%
before after
announcement announcement
Days
Price Day of profit
announcement
22.5
20
11.25
10
Days
Rationale Behind the Hypothesis
• When an unexploited profit opportunity arises on a
security, investors will rush to buy until the price rises to
the point that the returns are normal again.
• If RE > RR → Pt ↑ → RE ↓
If RE < RR → Pt ↓ → RE ↑
Until RE = RR
• All unexploited profit opportunities eliminated
• Efficient market condition holds even if there are
uninformed, irrational participants in market – because it
only requires a few ‘smart’ investors to avail the profit
opportunity.

Efficient Market Hypothesis
RE = RR
• This equation tells us that current prices in a financial market will be
set so that the expected return using all available information equals
the security’s realized return.
• Financial economists state it more simply: Security prices
instantaneously reflect all available public information in an efficient
market.
• The average investor cannot ‘beat the market’ because smart investors
arbitrage the profitable opportunities away.
• These smart investors possess private information which is why they
are able to buy cheaper (before everyone starts buying) and sell
expensive, generating overall higher return.

Evidence on Efficient Market Hypothesis
• Favorable Evidence
1. Investment analysts and mutual funds don't beat
the market
2. Stock prices reflect publicly available info:
anticipated announcements don't affect stock price
3. Arguments for random walk of prices
4. Technical analysis does not outperform market

Can Investment Analysts and Mutual
Funds Outperform the Market?
• The “Investment Dartboard” often beats investment
managers – humans aren’t outperforming computers.
• Mutual funds not only do not outperform the market on
average, but when they are separated into groups
according to whether they had the highest or lowest profits
in a chosen period, the mutual funds that did well in the
first period do not beat the market in the second period –
you could associate it to mere luck.
• Investment strategies using inside information is the only
“proven method” to beat the market. In the U.S., it is illegal
to trade on such information, but that is not true in all
countries – only possible to beat the market using private
information.
Do Stock Prices Reflect Publicly Available
Information?
• If information is already publicly available, a positive
announcement about a company will not, on average,
raise the price of its stock because this information is
already reflected in the stock price.
• This is called Event Study Analysis in Finance.
• Empirical evidence confirms favorable earnings
announcements do not, on average, cause stock prices to
rise.

Are Stock Prices a Random-Walk?
• A random-walk is a variable which cannot be forecasted
with accuracy because movements are random.
• This can be checked by asking a simple question: Is
yesterday’s price impacting today’s price? – because this
will show that movements are not random but have some
dependency.
• Econometric models confirm that historical price does not
impact future price and thus – prices are random in nature.

Can Technical Analysis Predict Price
Accurately?
• Technical Analysis is the study past stock price data,
searching for patterns such as trends and regular cycles,
suggesting rules for when to buy and sell stocks.
• Technical analysis is not a magic bullet that will enable a
person to make money for sure. It is a tool which needs to
be sharpened in combination with other analyses. Maybe
some people are just good poker players. Maybe it is a
self-fulfilling prophecy.
• Bottomline, the average investor is not equipped enough to
use technical analysis and for sure not 100% accurately.
Book: https://www.academia.edu/35414068/Robert_Edwards_Technical_Analysis_of_Stock_Trends_9th_Ed
Comic video: https://www.youtube.com/watch?v=ZN6P9ErUcOg

Evidence on Efficient Market Hypothesis
• Unfavorable Evidence
1.Small-firm effect
2.Neglected-firm effect
3.January effect
4.Market overreaction effect
5.Excessive volatility effect
6.Mean reversion effect
7.Post announcement earnings drift

Small-Firm Effect
• The small firm effect theory posits that smaller firms with
lower market capitalizations tend to outperform larger
companies.
– The argument is that smaller firms typically are more
nimble and able to grow much faster than larger
companies.
– Greater amount of growth opportunities than larger
companies.
– Tend to have lower stock prices, and these lower prices
mean that price appreciations tend to be larger than
those found among large-cap stocks.

Neglected-Firm Effect
• The neglected firm effect predicts that the stocks of lesser-
known companies may outperform their more well-known
peers in the market.
– The theory goes that neglected stocks have greater
information inefficiencies that remain unexploited.
– This is because they are less likely to be analyzed and
scrutinized by market analysts.
Cornell University Library. "Giraffes, Institutions and Neglected Firms." Accessed Feb. 11, 2021.

January Effect
• The January Effect is the tendency of stock prices to
experience an abnormal positive return in the month of
January that is predictable.
– Investors have an incentive to sell stocks in December
to reduce their tax liability.
– Investors use year-end cash bonuses to purchase
investments in January.
– Some investors believe that January is the best month
to begin an investment program (like a New Year
Resolution).
College of William & Mary. "Yes, Wall Street, There Is a January Effect!," Page 1. Accessed Feb. 2, 2022

Market Overreaction Effect
• Expectations not only have a rational explanation, but a
behavioral explanation as well: An emotional response out
of greed or fear.
– Bubbles and crashes are examples of overreactions to
the upside and downside, respectively.
– When corporations announce a major change in
earnings, say, a large decline, the stock price may
overshoot, and after an initial large decline, it may rise
back to more normal levels over a period of several
week – price correction takes time.
Werner F. M. De Bondt, and Richard Thaler. “Does the Stock Market Overreact?” The Journal of Finance, vol. 40,
.
no. 3, [American Finance Association, Wiley], 1985, pp. 793–805, https://doi.org/10.2307/2327804
Excessive Volatility Effect
• The stock market appears to display excessive volatility;
that is, fluctuations in stock prices may be much greater
than is warranted by fluctuations in their fundamental
value.
– Researchers have found that fluctuations in the S&P
500 stock index could not be justified by the
subsequent fluctuations in the dividends of the stocks
making up this index.
– Investors can invest based on relative risk measures
(Investing in low-risk stocks and skipping high risk
stocks)
Shiller, Robert J. “Market Volatility and Investor Behavior.” The American Economic Review, vol. 80, no. 2,
American Economic Association, 1990, pp. 58–62, http://www.jstor.org/stable/2006543.

Mean Reversion Effect
• Some researchers have found that stocks with low returns
today tend to have high returns in the future, and vice
versa. This is called the Contrarian Effect.
– Long-term (more than 1 year)
• Some researchers have found that stocks with high returns

today tend to have high returns in the future, and vice
versa. This is called the Momentum Effect.
– Short-term (less than 1 year)

Stock price
150
140
130
135
120
125
110
100
Time

Post Announcement Earnings Drift Effect
• New information is not always immediately incorporated
into stock prices.
– Although generally true, recent evidence suggests that,
inconsistent with the efficient market hypothesis, stock
prices do not instantaneously adjust to profit
announcements.
– Instead, on average stock prices continue to rise for
some time after the announcement of unexpectedly
high profits, and they continue to fall after surprisingly
low profit announcements.
Bernard, Victor L., and Jacob K. Thomas. “Post-Earnings-Announcement Drift: Delayed Price Response or Risk
Premium?” Journal of Accounting Research, vol. 27, [Accounting Research Center, Booth School of Business,
University of Chicago, Wiley], 1989, pp. 1–36, https://doi.org/10.2307/2491062.
Are Financial Markets Efficient?
• NO
– Saying that financial markets are efficient would mean that
▪ (1) Expectations are rational: meaning that investors always
act rationally. [market over-reaction exists]
▪ (2) Market prices are a true depiction of asset fundamentals:
meaning that market value should not be too inflated beyond
book value. [bubbles and crashes exist]
▪ (3) One investment is just as good as any other (so stock
picking is pointless). [different portfolios perform differently]
▪ (4) Prices reflect historical, public and private information.
[insider trading exists]
• Saying that financial markets follow EMH just means that
prices are unpredictable, which is TRUE
The Internal Contradiction
• There is an internal contradiction in claiming that there is
“no possibility of beating the market” in an efficient market
and then requiring profit-maximizing (read: rational)
investors to constantly seek out ways of beating the
market and thus making it efficient.
• If markets were, in fact, efficient, investors would stop
looking for inefficiencies, which would lead to markets
becoming inefficient again.
• The correct view: It makes sense to think about an
efficient market as a self-correcting mechanism, where
inefficiencies appear at regular intervals but disappear
almost instantaneously as investors find them and trade on
them. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Should You Track The Market Everyday?
• NO
– “Mr. Market” is an allegory by Benjamin Graham.
– Graham is the founder of Value Investing and mentor to Warren
Buffet.
▪ Mr. Market is an investor prone to erratic swings of pessimism and optimism.
Since the stock market is comprised of these types of investors, the market
takes on these characteristics.
▪ Graham's take is that a prudent investor can enter stocks at a favorable price
when Mr. Market is too pessimistic. When Mr. Market is overly optimistic,
investors may choose to look for an exit.
▪ Mr. Market creates ups and downs in stock prices all the time, and prudent
fundamental investors are unfazed by them since they are looking at the
larger, long-term picture.
https://www.investopedia.com/terms/m/mr-market.asp
https://www.investopedia.com/articles/07/ben_graham.asp

Should You Be Skeptical Of Stock Tips?
• YES
– As soon as the information hits the street, the
unexploited profit opportunity it creates will be quickly
eliminated.
– The stock’s price will already reflect the information,
and you should expect to realize only the equilibrium
return.

Should You Use Technical Analysis?
• YES, BUT
– As an aid in combination with fundamental analysis,
rather than a standalone tool.
▪ Using a number of technical indicators can prove to
be more useful – only buy/sell when all the
indicators are giving the green signal.

Should You Use Fundamental Analysis?
• YES
– Should be used (in combination with Technical
Analysis) to aid in stock picking.
▪ For example, investing where both analyses give a green signal. But more
weightage should be given to fundamental analysis than technical analysis.
– Should be updated regularly to incorporate latest

events and indications about the future.
▪ For example, if a factory is being constructed, investor can see that historically
factories complete in 3 years and incorporate this in model.
– Investor should buy stocks with a margin of safety

(MoS) and sell stocks where the MoS has been
breached.

What Valuation Models Should Be Used?
• Popular models
– Dividend Discount Model
▪ Considers expected returns to investors (future dividends)
– Discounted Cash Flow Model
▪ Considers expected cash to company (future cashflows)
– Relative Stock Valuation
▪ Considers current market scenario
– Graham’s Value
▪ Considers EPS and BV
▪ Determines the highest price an investor should pay for a stock
– Sum-Of-The-Parts Valuation
▪ Separately assessing business units
▪ Useful where company has multiple revenue streams

What Is the Ideal Investment Horizon?
• Short-term horizon
– Riskier because of higher volatility
– Plagued with investor over/under reactions
• Long-term horizon
– Growth Investing
▪ Buying growth stocks, which are stocks from companies that
are projected to outperform the overall market.
▪ Startups and small companies growing faster than the industry.
– Value Investing
▪ Buying stocks that appear to be trading for less than their
intrinsic or book value.
▪ Big, mature companies with consistent history of dividends.

Do stock prices always rise when there is
good news?
• NO
– In an efficient market, stock prices will respond to
announcements only when the information being
announced is new and unexpected.
– So, if good news was expected (or as good as
expected), there will be no stock price response.
– And, if good news was unexpected (or not as good as
expected), there will be a stock price response.

Should You Trade Very Often?
• NO
– Investor should not try to outguess the market by
constantly buying and selling securities. This process
does nothing but incur commissions costs on each
trade. Transaction costs can cause substantial dent to
short-term profits.
– Investor should pursue a “buy and hold” strategy—
purchase stocks and hold them for long periods of
time.
▪ Fewer brokerage commissions will have to be paid.

Is it Rational to Invest in Mutual Funds?
• MAYBE
– It is frequently a sensible strategy for a small investor,
whose costs of managing a portfolio may be high
relative to its size, to buy into a mutual fund rather than
individual stocks.
– An investor should not buy into one that has high
management fees or that pays sales commissions to
brokers but rather should purchase a no-load
(commission-free) mutual fund that has low
management fees.
– Mutual fund investing also has tax benefits (reducing
tax liability).
What Do Stock Market Crashes Tell Us
About the Efficient Market Hypothesis?
• To answer this question, we can ask: Does any version of
Efficient Markets Hypothesis (EMH) hold in light of sudden
or dramatic market declines?
• A bubble is a situation in which the price of an asset differs
from its fundamental market value.
– Can bubbles be rational?
• Role of behavioral finance
– Herd behavior: is the behavior of individuals in a group
acting collectively without centralized direction.

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