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Financial Markets
 
Hi everyone, welcome to our lecture on International Business. Today we will be continuingfrom the last lecture where we had stopped. So, in the last lecture we had discussed aboutforeign exposure, foreign market exposure and we talked about the FERA and FEMA, right.So, what is FERA and how it got converted into FEMA and what were the differencebetween the two acts basically, right.So, FERA was more stringent and it was like you know, a criminal offense and FEMA isslightly less you know stringent in comparison. And then we talked about the transactionexposure, translation exposure, which is basically an exposure which is explained on the onlybooks of accounts.So, today from there we will move into the Financial Markets, right. So, when I say thefinancial markets, I am sure you must be getting an idea that it is a huge market and therewere there is a lot of transactions going on, right.(Refer Slide Time: 01:33)So, what is this financial market? How it is defined? So, a financial market is defined as themechanism that facilitates the transfer of funds from a lender; who has surplus units to aborrower; who has deficit.So; that means, there is somebody who has got extra money and he does not have any let ussay, he wants to give it to somebody and there is somebody who wants the money, so that hecan use it for his business purposes or something.So, in these two cases, so this lender is has the surplus and he gives the money to theborrower and the borrower uses this money for it is advantage, right and then the borrowermaybe would pay an interest to the lender, right.So, the institutions and instruments are integral part of the financial market. So, what arethese institutions? For example, you can see the stock market, the bond markets, moneymarket, derivatives market, futures market, and insurance foreign exchange markets, they areall part of the financial markets, right. And we have several instruments for like for example,we have stocks, bonds, the commercial paper, the deposits, right; bank acceptances, etcetera.When funds flow across national boundaries and the transfer is between parties residing twodifferent countries; let us say, there comes into existence the international financial market.So, when you extend the financial market to more than two one country then it is a case ofinternational financial market; we say it is as an international financial market.The international financial market is a worldwide marketplace in which buyers and sellerstrade financial assets, such as stocks, bonds, currencies, commodities and derivatives, acrossthe national border. So, you can get an example idea from this figure, right.(Refer Slide Time: 03:24)So, why it is important? Let us see, let us go with a basic example. Suppose X, right supposeX, you are X and has you have rupees let us say, 1,00,000, but suppose there would havebeen no financial markets. What you would have done with this money? So, there is nooption, but to keep the money at home and get zero return. So, you are not getting any returnout of it.However, suppose there is a hotel owner, he wants this money to build more rooms, right;and so that he can earn more through; let us say rents. Now, in such a case this owner, hotelowner would be ready to pay some interest on the money he borrows from you.So, in this case the financial market exactly does that. It tries to connect the lender and theborrower. The financial markets are critical for producing an efficient allocation of thecapital, right. So, efficiently it helps in allocating the resources. Allowing funds to move frompeople who lack productive investment; as suppose you did not have a let us say, productiveinvestment you had the money, but you do not know what to do. So, there are lots of peoplealso they do not know what to do with the money.So, in that case it when they do not understand and they do not have a productive investmentopportunity, it goes to those people who now have them. Who have this, who want to use thismoney and have an opportunity to invest it, right. They are running short of funds, in thatcase, so they are looking after such money, right.So, what else? The financial markets also improve the well being of the consumers allowingthem to time their purchases better, right. So, the financial markets are very dynamic and itallows the you know the customers for example, the participants in the stock market to getbetter dividends or better returns on their money which is lying idle. So, this is the basicimportance. How does it function?(Refer Slide Time: 05:22)So, there are two ways; you can see, this side there are lenders, right. People who have savedsome money, so savers, lenders or savers. So, there are some, let us say household people,some housewives who are saving some money; business firms who have got some cashreserves; government; foreigners, right. Who have got some money saved with them, right?So, these funds, they can give it to the financial, through the financial market. They can giveit to the borrowers or the spenders. So, the borrower are the again the people who are thebusiness people, the government requires for, let us say to make bridge, schools, hospitalsetc. There could be people households, foreigners, again the same kind.So, there are two ways you can see the financial market funds; one is called the direct and theindirect finance, right. So, direct finance is when there is direct connection between the saveror the lender and the borrower, right. So, for example, you can trade it through the stockexchange. For example, let us say the stock exchange is a good example; where the shares ofthe companies are being traded and a person can directly buy, right; own or buy or sell it.But, indirect finance comes into play when the there is a financial intermediary comes intoplay. Who is this financial intermediary and why is he required, right? This financialintermediary has a lot of importance, we will see in the next slide. But who are when you gothrough this financial intermediary, when the fund comes, when the financial intermediarycollects the fund and through the market it gives it to the borrower, then there is anintermediary and because of this intermediary we are saying it is a case of a indirect finance,right.For example, the bank collects you know deposits from several large number of people,through savings account and other kinds of accounts, right; and it uses this money to give itas to as loan to, let us say industrialists and other people, who utilize this money in a moreproductive manner supposedly, right. So, this is where the such institutions like, the bankscome into play and this funding is called indirect finance, ok.(Refer Slide Time: 07:43)Now, look at the financial intermediaries. As we said, why they are important, first of all andwho were they are? Instead of the savers; the people like you and me who have saved somemoney, investing directly with borrowers; a financial intermediary such as the bank, placesthe middlemen, right.So, the intermediary obtains the funds from the savers. As I said, the banks does it from usand it then makes the loans and investments with the borrowers. It is needed because of fewthings, the transaction cost, risk sharing and asymmetric information.So, what it is doing? Why this intermediary is important? Because of three basic reasons;one, it has a good influence through the transaction cost; through the risk sharing mechanism;and because information is not in a symmetrically distributed across to all stakeholders, right.So, who are the basic financial intermediaries? You can see, Central Bank, the saving loanassociations insurance companies, mutual funds and brokerage firms, micro-financeinstitutions, right; commercial banks, pension funds, so many are there. It is actually theprimary means of moving funds from the lenders to the borrowers, ok.(Refer Slide Time: 09:02)So, what are these thing three things we talked about? One, we said transaction cost. Now, itrefers to the time and money spent in carrying out financial transactions, right. So, when youmake any transaction there is always a cost attached to it, right. You are spending money, youare collecting information, so, all these takes an you know, there is a resource spent on it.Financial intermediaries can substantially reduce transaction cost. These intermediaries like,banks; they can substantially reduce the transaction cost because they have developedexpertise in lowering them, and because their large size allows them to take advantage ofeconomies of scale.So, that is why it is always, you can understand, that when that is the, how the reason the youknow, the firms also came in to existence, right. Because there are firms and these firms canproduce in large bulk, that is why the when it is when the resources are given to them and theresources are utilized by a firm, is always more efficiently done, than when it is done by asmall player who may not achieve such high economies of scale, right. So, this is oneadvantage where the financial intermediaries help us.Second point is, it helps in risk sharing. Now, what does it mean? Financial intermediariessell assets with risk characteristics that people are comfortable with and then use the fund topurchase other assets that may have far more risk.This process of risk sharing is called asset transformation, that is, risky assets are turned intosafer assets for the investors. Another way of risk sharing provided was throughdiversification. Financial intermediaries invest in a collection of assets whose return do notalways move together, with the result that overall risk is lower than for the individual asset.So, many a times, the investor when it invests, let us say in an asset, one asset if I directly putit in a asset, let us say that asset could be a very risky asset, right. Suddenly, the market maycollapse and you know I may lose as an investor I may lose all the money. But suppose, I amgoing through a financial intermediary, like a for example, a bank, right; or a financialinstitution, then what happens? This financial institutions has have got the expertise, right.So, they know now, that what is best going to be done with this money. So, instead of me ifthey putting the money in a better asset which is more safer so then what happens, my risk ofmy risk of you know utilizing the money is lessened. So, that is how the financialintermediaries are very important because they help in sharing the distributing the risk, ok.Third thing is, the asymmetric information. So, this is risk sharing and asymmetricinformation also connected, if you can understand, you will see that. When one party hasmore or better information, right. In fact, most of the things in this world happens because ofasymmetric information. Financial intermediaries are usually better at credit risk screeningthan individuals, right because they have more expertise.Therefore reducing losses due to wrong investment decision making. So, suppose I do notknow for example, I would have put my money in suppose, buying some stock, let us say. So,I suppose or let us say putting in some real estate, now let us say the government is comingup with taxes in the real estate sector. So, now, this effect could be negative for example, forsuddenly the you know real estate demand may go down.Let us say, assume. So, this information is always not distributed equally. So, the people whoare involved; for example, there is banks and the financial institutions and the real estateagencies and all, they are better equipped than an individual.So, in that case, this helps. They have developed the expertise in monitoring the parties theylend to. Suppose, you are instead of you buying directly through the you know an asset if youbuy routed through the bank it is much better, because the bank knows how to analyze andcalculate the assets safety, ok. Thus, reducing losses due to moral hazard.Now, what is moral hazard? The tendency to take on more risk, because of the perception thatone is protected from the consequences of doing so. So, these kind of things, it helps youhelps an individual. So, the financial intermediaries have a very important role to play.(Refer Slide Time: 13:48)Then we come from the, as we said, when it the transaction happens across the border it iscalled international financial market, right. Why international financial markets? Why usethem? So, the investors and the borrowers. So, the investors invest in foreign markets to takeadvantage of the favorable economic conditions.So, suppose as we have learnt in some other classes, because the there is a continuouslydynamic market, right. So, and the currencies are changing, traders are doing business and thecurrencies are one is going against the other and it is going up, some is going down. So, incertain such situations the investor finds that his money could be better utilized would givebetter returns if it is put in another market, right. So, to take advantage of favorable economicconditions is one reason.Second, when they expect foreign currencies to appreciate against their own. So, if they feelthat the foreign currencies are going to appreciate, so that would give them better return. Sothey would go for it. To reap the benefits of international diversification. So, diversificationalways reduces the risk, that is the biggest advantage. To capitalize on higher foreign interestrates. So, this is related, right.Now, what do the borrowers gain? To capitalize on lower foreign interest rates. So, supposemy domestic interest rates are very high so if I am getting money from other markets at alower interest, why not utilize it.When they expect foreign currencies depreciate against their own. So, in such conditions theboth investor and the borrower tend to use the international financial market, right. How arethe financial markets classified?(Refer Slide Time: 15:30)This is, I can show you, on terms of several ways nature of claim, seasoning of claim,maturity, timing and organizational structure, five ways I have mentioned here. So, on termsof nature of claim, the financial markets are divided into debt markets and equity markets. So,debt market, as you can see I have written here, short term it could be, a long term.When any instruments matures or the time of maturity is less than 1 year, it is called a shortterm, right. When the instrument, the maturity time for the instrument is more than a 10years, it is almost 10 years or more than that, so that is long term. Similarly, in the debt isalways we can you know, debt is loan, basically borrowings, right.And equity market is the market where the one individual becomes an owner in the firm,right. So, suppose, let us say you have, let us say you are a participant in the equity market.You own certain shares of or equity of TATA. So, you are a partial owner of TATA; thatmeans, the true meaning of it is the same and you get regular dividends, right.So, in terms of seasoning; there is a primary market primary market and secondary market.Primary market is where the you know the securities are often the securities are first time aretraded for the first time, for the first time, right; first time.So, when the suppose, for an example, an IPO as I have said, initial public offering. So, thewhen the first for the first time it is done, it is creating for the first time it is called a primary.When it is then regularly traded, for example, in the National Stock Exchange or the BSEstock exchange, it is called a secondary market. In terms of claim also, basically, when weunderstand financial markets, generally financial markets are shown like this. So, one is themoney market and the other being the capital market. So, this is different way ofunderstanding, that is all.And then capital market is again primary and this is secondary it goes on, right. In terms ofmaturity of claim, this is again, timing of delivery in terms of delivery also on the timing youcan classify the market as a cash market or spot market which is on the spot, right; immediateor a futures market or derivative market, right.Finally in terms of structure, either it is an exchange, traded structure which is morecentralized and all the routings are done through the centralized manner. For example, theBSE, NSE, New York Stock Exchange etcetera. Or an over the counter market, which is adecentralized market, right and for example, the forex market, right.(Refer Slide Time: 18:31)So, the different ways of classifying the financial market. So, this is a diagrammaticalrepresentation, ok.(Refer Slide Time: 18:36)Money market, as we said, so there are two; when you divide the financial market basically itdivide into two types; one the money market, the other is the capital market. So, let us startwith the first part, the money market. So, what is this money market? Money market is amechanism facilitating and promoting transactions in short term funds. So, this is the keyword or financial instruments. So, the funds are for a short term purpose, used for a shortterm purpose. It is also known as cash investments, because of the short maturities.Efficient source of credit for, it generate sufficient source of credit for large financialinstitutions, non financial corporations, government bodies who use this money for differentpurposes. They are large, generally issued in large denominations usually 1 million or morekind of it, right. Money market instruments have short maturities as the first line itself says. Itis less than three months or it ranges from 1 day to 1 year.Money market can be defined as a market where lending and borrowing of short term fundsare arranged and it comprises the short term credit instruments and the institutions andindividuals who participate in the lending and borrowing business. So, what are the shortterm credit instruments? Some of the instruments are like treasury bills, commercial paper,bankers acceptances, deposit, bill of exchange, etcetera.(Refer Slide Time: 20:10)Now, the constituents of the money market. So, who, what constitutes? The central bank, thecommercial bank, the cooperative banks, saving bank discount houses, acceptance houses,etcetera are the main constituents of a well developed money market. The central bank isregarded as the “presiding deity”, so it is like a god, ok; of the money market. For example, inour case our RBI and can influence the condition and activities of the market.So, the money market is largely is controlled by the RBI, who is as per this line, it is thepresiding deity or the god, right. So, this deity will influence the condition and activities ofthe market.Certain specialized organizations like information bureaus, chamber of commerce, tradeassociation, etcetera help the smooth and efficient functioning of the money market byhelping the collection and dissemination of information. So, these other organizations are alsoimportant because they help in the circulation of the or dissemination of the information.(Refer Slide Time: 21:18)What is the function of this money market? A money market augments an equilibratingmechanism for demand and supply of short term funds. So, somebody require short termfunds for a short term nature. So, here the money market comes into play, ok.Helps to minimize the excess and shortages due to the seasonal variations in the flow offunds. So, what it is lets us see, let us go with the most popular one, the LIBOR is an acronym forLondon interbank offered rate, right. Is the benchmark interest rate that banks charge eachother, that the banks charge each other for overnight, 1 month, 3 months, 6 month or 1 yearloans, right.So, this is something that many people are not aware. How the banks get money from outsidesome other banks outside, right. On basis of maybe the London interbank offered rate. So,what is this? It is the benchmark for bank rates all over the world, right. It is a very standardpractice. The banks use the LIBOR interest rates as the base rate, right; when setting theinterest rates for loans savings and mortgages.So, when the banks would like to give you know loans to others, on what basis would theygive? So, they have a base rate; this base rate is the LIBOR interest rate, right. Because if it isless than that, then they are making losses simple, right.Thomson Reuters publishes the rate each day at 11:55 a.m. London time in five currencies.Which five currencies? The Swiss franc, the euro, the pound sterling, the Japanese yen, andthe U.S. dollar.On August 4, 2014, the Intercontinental Exchange Benchmark Administration took overadministration of LIBOR from the British Bankers Association. Earlier, it was there with theBBA, but in 2014 the ICE took it over. The ICE calculates the rates based on submissionsfrom individual contributor banks.Now, what how it is calculated? We will see; a panel of 11 to 18 contributor banks are usedfor calculating the LIBOR, right. So, there are 11 to 18 contributory banks, right. So, all thebanks which are part of the exchange system, the of the trading system, right.(Refer Slide Time: 29:58)So, LIBOR calculation, how it is done? So, the LIBOR interest rates are not based on actualtransactions. What it is saying? The LIBOR interest rates are not based on the actualtransaction. So, then what it is based? On every working day at 11:55 the panel banks informThomson Reuters for each maturity at what interest rate they would expect to be able to raisea substantial loan in the interbank money market at that moment.What it is saying? At a particular time 11:55 when the information comes, right. So, the panelbanks; the panel banks means the banks which are involved, right or paneled or basically,they are part of this contributory banks basically. So, they would inform that at what interestrate they would expect to be able to raise a substantial loan, right. The reason, that themeasurement is not based on actual transactions is because not every bank borrowssubstantial amounts for each maturity every day, right.So, it is not same, right. So, do not borrow a substantial amount each of our each day. LIBORrate is calculated using a trimmed arithmetic mean. Now, I will solve a problem, next.Once, Thomson Reuters has collected all the rates, right, of these banks or which they can getthe loan, right; at which they will be able to raise a loan, right. So, they are ranked indescending order, they are ranked in a descending; the most or the highest, then secondhighest, third highest, goes on till the lowest. And then the highest and lowest and 25 percentof value are eliminated.What it does? They are ranked in descending order and then the highest and lowest 25percent. So, the highest 25 percent and the lowest 25 percent are eliminated, right. Anaverage is calculated of the 50 percent remaining ‘mid values’ in order to produce an officialLIBOR rate. Why it is done? Why they are eliminating 25 percent of the top and bottom?Simply, just they want to get rid of any effect of outliers. Any extreme value should not getaffect should not affect them, right.(Refer Slide Time: 32:17)Let us see this; this trimming at the top and bottom quarters allows for the exclusion ofoutliers from the final calculation. Number of contributors; suppose, there are 18contributors, 17 contributors, 16 contributors, 15, 14, 13, 12, and 11.What is the methodology? To find the outliers and remove them. So, when there are 18contributors, the top 4 and the tail 4; that means, the lowest 4 are removed. So, how many isremaining? Number of contributor rates average this now 10, right.17 contributors, right. So, 4 and 4. So, it is not exactly 25. Do not get into the calculation ofyou know, because I had said 25 percent top, 25 percent at the bottom, so do not get into thatexact calculation.But generally what they do is, they take the first 4 and the last 4, right. If it is 16, 17, or 18 oreven 15 contributors, but once it is low than less than 15 contributors banks, then forexample, 14 contributors. What they do? The 3 and 3. So, 3, 3, 6 is almost what percentage of14? 6 would be 14 14 fours are 56. 40 some percentage, right. Almost close to 50 percent thatis, right. So, this is what they do, right. So, this is the number of contributor rates averaged.(Refer Slide Time: 33:36)Now, say this is the bank 1, who says they can get raise a loan on 3.9 percent interest rate.Bank 2 says 3.5, bank 3 says, 3.1 the se are the lending, the loan raising interest rates, right.So, say group of 14 member banks propose the following as 1 year LIBOR rates, ok. So,what is the average 3.9, 3.5 goes on till 2.8 divided by 14. So, this is my average.Now, in this case, let us say that to calculate the LIBOR a 10 percent trimmed mean iscalculate taken. So, the data are arranged like this and instead of now, 25 4 4 what we I willdo? 10 percent of 14. So, trimmed 5 percent of the data from the upper and lower end. Thisdecision has to be taken. So, 10 percent of 14 is how much? 1.4 which is actually almost 1.We cannot, because it had not been 1.5 and above we are taken to 2.So, the new data set will now remove one from the top and one from the bottom. So, this isnow you see. So, if you go to this one when they were all arranged. So, this one is cut andthis one is cut. So, this, now the new mean is equal to this divided by 12, because two banksare gone. So, the new interest rate is the new LIBOR rate is how much? 3.175. So, the current1 year LIBOR rate will be 3.175 percent in this case.(Refer Slide Time: 35:19)Now, any bank would or any the anybody, who wants to do any transaction, now they wouldtake this rate as the base rate and then they would maybe add another percentage on that andthen they will make the loans, right.Another interbank rate is the Mumbai Interbank Offer Rate. Now, what is this? It is the rate atwhich the unsecured funds are borrowed by banks from one another in the interbank market.It is an indicator of lending rates for loans, ok. And used for calculating interest rates forsecuring interbank loans in the Indian market. So, we for to do any you know transaction inthe Indian market, this is used for calculation.MIBOR is used by different Indian banks either for interbank lending of the surplus funds orfor interbank borrowing for meeting the short term liquidity requirements. So, if there is aextra excess or there is a shortage, in both case there is an interbank lending or interbankborrowing.MIBOR is calculated every day by the NSE, right. As a weighted average of lending rates ofa group of banks or funds lend to first class borrowers, right. First class borrowers meanborrowerswho have a very high credit rating. So, in this case the credit rating of becomes avery important parameter, right.MIBOR is fixed for overnight to 3 months, right, long funds and these rates are publishedevery day at a designated time. The rate is announced at 10:45 am every day, okthis calculation methods. LIBOR or MIBOR or for Paris interbank rate or anything, right.So, this is all we have for today. So, we will continue from here in the next lecture, right.So, thank you very much.