financial institution 1st assignment

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Muhammad Danish | www.knowledgedep.blogspot.com Directorate of Distance Learning Education G.C University Faisalabad FORM FOR ASSESSMENT OF ASSIGNMENT (This part will be filled by Student) Name of student: MUHAMMAD DANISH Name of Tutor: Sir Muhammad Sajid SB Roll No. 119467 Address of Tutor: _________________________________ _________________________________ Contact No._______________________ Semester: 2 nd Year: 2015 To 2017 Address: H # P – 802 G M ABAD NO.1 FSD Name of course: Financial Market & Institutions Assignment No. 1 st Code No._____ Last date of submission of Assignment: 26-06-2016 Date of submission of Assignment: 23-06-2016 Signature of Student: _M. DANISH (This part will be filled by Tutors) Name of study Center: _____________________ District: ___________ Date of receiving Assignment: _______________ No. 1 2 3 4 5 6 7 8 9 10 Cumulative Obtained Marks Marks Obtained Total Marks Tutors’ comments: ______________________________________________________________________ ______________________________________________________________________

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Page 1: Financial institution 1st assignment

Muhammad Danish | www.knowledgedep.blogspot.com

Directorate of Distance Learning

Education

G.C University Faisalabad

FORM FOR ASSESSMENT OF ASSIGNMENT

(This part will be filled by Student)

Name of student: MUHAMMAD DANISH

Name of Tutor: Sir Muhammad Sajid SB

Roll No. 119467 Address of Tutor:

_________________________________

_________________________________

Contact No._______________________

Semester: 2nd

Year: 2015 To 2017

Address:

H # P – 802 G M ABAD NO.1 FSD

Name of course: Financial Market & Institutions Assignment No. 1st Code No._____

Last date of submission of Assignment: 26-06-2016

Date of submission of Assignment: 23-06-2016

Signature of Student: _M.

DANISH

(This part will be filled by Tutors) Name of study Center: _____________________ District: ___________ Date of receiving Assignment: _______________

No. 1 2 3 4 5 6 7 8 9 10

Cumulative Obtained

Marks

Marks Obtained

Total Marks

Tutors’ comments: ______________________________________________________________________

______________________________________________________________________

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Date of Assignment Return: _________ Signature of Tutor

Q1: Why are financial markets important to the health of the economy?

Explain financial system; write short notes on different components of

the financial system?

Answer:

Financial Markets:

A Financial market is a market in which people trade financial securities,

commodities, and other fungible items of value at low transaction costs and at

prices that reflect supply and demand. Securities include stocks and bonds, and

commodities include precious metals or agricultural products.

The importance of financial markets to the health of economy:

Financial markets are extremely important to the general health of an

economy. With effective markets for credit and capital, borrowing and investment

will be limited and the whole macro – economy can suffer.

Financial Crises

A financial crisis is a situation in which the value of financial

institutions or assets drops rapidly. A financial crisis is often associated with

a panic or a run on the banks, in which investors sell off assets or withdraw

money from savings accounts with the expectation that the value of those

assets will drop if they remain at a financial institution.

Debt Markets and Interest Rates

A security is a claim on the issuer’s future income or assets. A bond is

a debt security that promises to make payments periodically for a specified

period of time.1 Debt markets, also often referred to generically as the bond

market, are especially important to economic activity because they enable

corporations and governments to borrow in order to finance their activities;

the bond market is also where interest rates are determined. An interest rate

is the cost of borrowing or the price paid for the rental of funds (usually

expressed as a percentage of the rental of $100 per year). There are many

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interest rates in the economy—mortgage interest rates, car loan rates, and

interest rates on many different types of bonds.

Mortgage markets:

The mortgage market involves making long – term loans for buying

property. Once a loan is made, it can be traded on the second-hand mortgage

market. Like the stock exchange, the secondary mortgage market enables

the original lenders, the banks, and building societies, to regain lost

liquidity. The new owner of the mortgage debt is entitled to receive the

mortgage repayments.

Managing Risk in Financial Institutions

In recent years, the economic environment has become an

increasingly risky place. Interest rates have fluctuated wildly, stock markets

have crashed both here and abroad, speculative crises have occurred in the

foreign exchange markets, and failures of financial institutions have reached

levels unprecedented since the Great Depression. To avoid wild swings in

profitability (and even possibly failure) resulting from this environment,

financial institutions must be concerned with how to cope with increased

risk.

Financial system:

The processes and procedures used by an organization’s management

to exercise financial control and accountability. These measures include

recording, verification, and timely reporting of transactions that affect

revenues, expenditures, assets, and liabilities.

Basic components of financial system:

There are five basic components of financial system:

1. Financial institutions:

A financial institution (F1) is an establishment that focuses on dealing

with financial transactions, such as investment, loans and deposit.

Conventionally, financial institutions are composed of organizations such

as banks, trust companies, insurance companies and investment dealers.

2. Financial markets:

A financial market is the place where financial assets are creating. It can

be broadly categorized into money markets and capital markets. Money

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market handles short – term financial assets (less than a year) whereas

capital markets take care of those financial assets that have maturity

period of more than a year. The key functions re:

1. Assist in creation and allocation of credit and liquidity.

2. Serve as intermediaries for mobilization of savings.

3. Help achieve balanced economic growth

4. Offer financial convenience.

One more classification is possible: primary markets and secondary markets.

Primary markets handle new issue of securities in contrast secondary

markets take care of securities that are presently available in the stock

markets.

3. Financial instruments:

This is an important component of financial system. The products,

which trade in a financial market, are financial assets, securities or other

type of financial instruments. There is a wide range of securities in the

markets since the needs of investors and credit seekers are different. They

indicate a claim on the settlement of principal down the road or payment

of a regular amount by means of interest or dividend. Equity shares,

debentures, bonds, etc. are some example.

4. Financial services:

Financial services consist of services provided by assets management

and liability management companies. They help to get the necessary

funds and make sure that they are efficiently deploying. They assist to

determine the financing combination and extend their professional

services up to the stage of servicing of lenders.

They help with borrowing, selling and purchasing securities, lending and

investing, making and allowing payments and settlements and taking care

of risk exposures in financial markets. These range from the leasing

companies, mutual fund house, merchant bankers, portfolio managers,

bill discounting and acceptance houses. The financial services sector

offers a merchant banking, depository services, book building, etc.

5. Money:

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The money is anything that accepted for payment of product and

services or for the repayment of debt. It is a medium of exchange and

acts as a store of value.

Q2: What is money and its different functions? Briefly, explain how money

evolved in Pakistan?

Answer:

Money:

The money is anything that accepted for payment of products and services or

for the repayment of debt. It is a medium of exchange and acts as a store of value.

Functions of money:

There are two types of functions of money.

1. Primary functions:

Primary functions include the most important of money, which it must

perform in every country, these are:

a) Medium of exchange:

Money, as a medium of exchange, means that it can be used to make

payments of all transactions of goods and services. It is the most essential

function of money. Money has the quality of general acceptability. So; all

exchanges take place in terms of money.

This function has removed the major difficulty of lack of double co –

incidence of wants and inconveniences associated with the barter

system.

Use of money allow purchase and sale to be conducted independently

of one another.

This function of money facilitates trade and helps in conducting

transactions in an economy.

Money has no power to satisfy human wants, but it commands power

to purchase those things, which have utility to satisfy human wants.

b) Measure of value (unit of value):

Money as measure of value means that money works as common

denomination, in which values of all goods and services are expressing.

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By reducing the value of all goods and services to a single unit (i.e.

price), it becomes very easy to find out the exchange ratios between

them and comparing their prices.

This function facilitates maintenance of business accounts, which

would be otherwise impossible.

Money helps in calculating relative prices of goods and services. Due

to this reason, it is regarded as a unit of account’. For instance,

‘Rupee’ is the unit of account in India, ‘Pound’ in England and so on.

2. Secondary Functions:

These refer to those functions of money, which are supplementary to the

primary functions. These functions derive from primary functions and,

therefore, they are known as ‘Derivative Functions’. The major secondary

functions are:

1) Standard of deferred payments:

Money as a standard of deferred payments means that money acts as a

‘Standard’ for payments, which are to be made in future. Every day, millions

of transactions take place in which payments doses not made immediately.

Money encourages such transactions and helps in capital formation and

economic development of the economy. This function of money is

significant because.

Money as a standard of deferred payments has simplified the

borrowing and lending operations.

It has led to the creation of financial institutions.

2) Store of value (Asset function of money):

Money as a store of value means that money can be used to transfer

purchasing power from present to future. Money is a way to store wealth.

Although wealth can be store in other forms also, but money is the most

economical and convenient way. It provides security to individuals to meet

contingencies, unpredictable emergencies and to pay future debts. Money as

store of value has the following advantages:

The money working in Pakistan

The money is working in Pakistan with different shapes, which are

following:

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1. Commodity money:

It is the simplest kind of money, which is use in barter system where

the valuable resources fulfill the functions of money. The value of this

kind of money comes from the value of resource use for the purpose. It is

only limited by the scarcity of the resources. Value of this kind of money

involves the parties associated with the exchange process.

2. Fiat money:

The word fiat means the” command of the sovereign”. Fiat currency is

the kind of money, which does not have any intrinsic value, and it cannot

converter into valuable resource. The value of fiat money determines by

government order, which makes it a legal instrument for all transaction

purposes. The fiat money need to be controller as it may affect entire

economy of a country if it is misused. Ex: Paper money, coins.

3. Fiduciary money:

Today’s monetary system is highly fiduciary. Whenever, any bank

assures the customers to pay in different types of money and when the

customer can sell the promise or transfer it to somebody else, it is called

the fiduciary money, fiduciary money generally paid in gold, silver or

paper money, there are cheques and bank notes, which are the examples

of fiduciary money because both are some kind of token, which are used

as money and carry the same value.

4. Commercial bank money:

Commercial bank money or demand deposits are claims against

financial institutions that can be used for the purchase of goods and

services. A demand deposit account is an account from which funds can

be withdrawn at any time by cheque or cash withdrawal without giving

the bank of financial institution any prior notice. Banks have the legal

obligation to return funds held in demand deposits immediately upon

demand (or ‘at call’). Demand deposit withdrawals can be performed in

person, via cheques or bank drafts, using automatic teller machines

(ATMs), or through online banking. There are also various other types of

money like the credit money, electronic money, coin and paper money,

fractional money and Representative money as discussed below:

a) Fractional money:

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It is a hybrid type of money, which is partly back by a

commodity and has fiat money transaction purpose. If the commodity

loses its value then fractional money converts into fiat money.

b) Representative money:

It represents a claim on commodity and it can be redeem for

that commodity at a bank. A token or paper money can be exchange

for a fixed quantity of commodity. Its value depends on the

commodity it backs.

c) Coins:

Metals of particular weight are stamp into coins. There are

various precious metals like gold, bronze, copper whose coins already

have used in human history. The minting of coins is control by the

state.

d) Paper money:

Paper money don’t have any intrinsic value, as a fiat money. It

is approved by government order to be treat as legal tender through

which value exchange can happen. Government prints the paper

according to the requirements, which is tightly control as it can affect

the economy of the country.

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Q3: What are different roles and functions of central bank to support

financial system of any country?

Answer:

Central bank:

It every country, there is one bank, which acts as the leader of the money

market- supervising, controlling and regulating the activities of commercial banks

and other financial institutions. It acts as a banker of issue and is in close touch

with the government, as banker, agent and adviser to the latter. Such a bank is

known as the Central Bank of the country.

Roles & Functions of a central Bank

1. Bank of issue:

Central bank has the exclusive monopoly of note issue and the

currency notes issued by the central bank are declared unlimited legal tender

throughout the county. This monopoly brings about:

Uniformity of note issue which in turn facilitates trade and exchange

within the country

Enables the central bank to influence and control the credit creation of

commercial banks

Gives distinctive prestige to the currency notes

Enables govt to appropriate partly or fully the profits of note issue.

2. Banker, Agent and Adviser to the Government:

As banker and agent, RBI keeps the banking accounts of the central,

state governments, makes, and receives payments on behalf of the

government. It provides short – term advances to the govt. (ways and means

advances) to tide over temporary shortage of funds. It advises the govt. on

all monetary and banking matters.

3. Custodian of the cask reserves of commercial bank:

All commercial banks keep part of their deposits as reserves with the

central banks and hence the name Reserve bank of India. Centralized cash

reserves serve as the basis of a larger and more elastic credit structure and

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helps commercial banks to meet crises and emergencies. Centralized cash

reserve aids the central bank to control credit creation and implement

monetary policy.

4. Custodian of foreign balance of the country:

RBI holds the foreign exchange assets of all commercial and non –

commercial bank of the country. It is the responsibility of RBI to maintain

the rate exchange and manage exchange control and other restrictions

imposed by the state. It also maintains reserves with the IMF and obtains

normal drawing and special drawing rights.

5. Lender of the last resort:

Central bank never refuses to accommodate any eligible commercial

bank experiencing cash shortage. In the absence of a central bank,

commercial banks will have to carry substantial cash reserves, which imply

restricted lending and responsibility of meeting directly or indirectly all

reasonable demands for accommodation by the commercial banks.

6. Central clearance, settlement transfer:

As the central bank keeps cash reserves of commercial banks, it is

easier for member banks to settle their mutual claims in the books of the

central bank. These are the clearing house operations of RBI wherein

cheques are cleared, claims settled and funds transferred in the books of the

member banks. However, this function can also be performed by any leading

bank in a locality or area.

7. Controller of credit:

Central bank controls the level of credit in the economy by either

expanding or contracting bank deposits. In modern times, bank deposits

have become the most important source of money in the county. As

controller of credit, it seeks to influence and control the volume of bank

credit and to stabilize business conditions in the country.

8. Open market operations:

Deliberate and direct buying of securities and bills by the central bank

in the money market, on its own initiative, is called open market operations.

In periods of inflation, the central bank will sell in the market first calls bills

in its possession to buyers like commercial banks and others. This reduces

the cash reserves of the commercial banks, which in turn will reduce its

capability to give loans and advances. Thereby, business activity in the

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country will be cut short. During recession, central banks buys bill from

commercial bank and thereby increases their cash reserves.

9. Cash reserve ratio:

According to the central bank, every scheduled bank has an obligation

to maintain a certain portion of their demand and time deposits as a reserve

with the central bank. This provision was fixed for three important reasons;

To ensure the liquidity and solvency of individual commercial bank and of

the banking system as a whole

To provide the central bank with supply of deposits for local operations

To influence and ultimately restrict commercial banks’ expansion of credit.

Hence, CRR is an additional instrument of credit control of the central bank

10. Selective credit controls:

The quantitative controls like bank rate, OMO and CRR affect

indiscriminately all sections of the economy which depend on bank credit.

Besides, there are some groups of borrowers who are engaged in important

spheres of economic activity and whom the central bank would like to

insulate from these quantitative effects. hence, central banks have been

adopting the tool of selective credit controls or qualitative controls whose

special features are:

They distinguish between essential and non – essential uses of bank

credit

Only non – essential uses are brought under the scope of central bank

controls

They affect not only the lenders but also the borrowers.

11. Working of bank rate policy:

Hence, rise in bank rate increases interest rates, curtails bank credit,

decreases demand for gods and services and finally reduces the price level.

Further, the most powerful influence of bank rate is psychological – bankers

and business men consider bank rate changes as authoritative

pronouncements of the central bank concerning the credit situations. at a

very important time. Radcliffe report states:” the rise in the bank rate is

symbolical; it is evident that authorities have the determination to take

unpleasant steps to check inflation”.

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Q 4: Describe money market and briefly discus instruments of money

markets with examples from Pakistani markets?

Answer:

Money market:

The money market became a component of the financial markets for assets

involved in short – term borrowing, lending, buying and selling with original

maturities of one year or less. Trading in money markets is done over the counter

and is wholesale.

A segment of the financial market in which financial instruments with high

liquidity and very short maturities are trade. Participants use the money market as a

means for borrowing and lending loans in the short term, from several days to just

under a year.

Instruments of money markets:

1. Certificate of deposit:

A certificate of deposit (CD) is a savings certificate entitling the

bearer to receive interest. A CD bears a maturity date, a specified fixed

interest rate and can be issue in any denomination. CDs are generally issue

by commercial banks and are insure by the FDIC.

2. Repurchase agreements:

A repurchase agreement (repo) is a form of short – term borrowing for

dealers in government securities. The dealer sells the government securities

to investors, usually on an overnight basis, and buys them back the

following day.

3. Commercial paper:

Commercial paper is an unsecured, short - term debt instrument issued

by a corporation, typically for the financing of accounts receivable,

inventories and meeting short – term liabilities. Maturities on commercial

papers rarely range any longer than 270 days.

4. Federal agency short – term securities:

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In the Pakistan, short – term securities issued by government

sponsored enterprises such as the farm credit system, the federal home loan

banks and the federal national mortgage association.

5. Federal funds:

In the Pakistan, interest – bearing deposits held by banks and other

depository institutions at the federal reserve; these are immediately available

funds that institutions borrow or lend, usually on an overnight basis. They

are lent for the federal funds rate.

6. Municipal notes:

In the Pakistan, short – term notes issued by municipalities of tax

receipts of other revenues.

7. Treasury bills:

Short – term debt obligations of a national government that are issue

to mature in three to twelve months.

8. Money funds:

Pool short – maturity, high – quality investments that buy money

market securities on behalf of retail or institutional investors.

9. Foreign exchange swaps:

Exchanging a set of currencies in spot date and the reversal of the

exchange of currencies at a predetermined time in the future

10. Asset – backed securities:

An asset – backed security (ABS) is a security whose income

payments and hence value is derived from and collateralized (or “backed”)

by a specified pool of underlying assets. The pool of assets is typically a

group of small and illiquid assets, which are unable to be sold individually

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Q5: Briefly explain different types of stock. What are different

intermediaries involved in stock markets?

Answer:

Types of stock:

There are two types of stock:

a) Common stock

b) Preferred stock

a) Common stock:

A common stock is a security that represents ownership in a corporation.

Holders of common stock exercise control by electing a board of directors

and voting on corporate policy. Common stockholders are on the bottom of

the priority ladder for ownership structure.

b) Preferred stock:

A preferred stock is a class of ownership in a corporation that has a higher

claim on its assets and earnings than common stock. Preferred shares generally

have a dividend that must be paid out before dividends to common

shareholders, and the shares usually do not carry voting rights.

Intermediaries involved in stock market

1. Insurance companies

Insurance companies concentrate on fulfilling the insurance needs of the

community, both for life and non-life and non-life insurance. These companies

offer products that allow investors to select the kind of policies to suit their

financial planning needs. These companies also offer policies for funding a

child’s education and marriage, and providing a steady income for the aged

through annuities and pensions.

2. Mutual funs

Mutual funds (MFs) organizations satisfy the needs of individual’s investors

through pooling resources from a large number with similar investments goals

and risks appetite. The resource collected are invested in the capital and money

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market securities. The returns are distributed to investors optimizing the return

for the investors.

3. Non-banking finance companies

NBFCs are commonly known as finance companies and are corporate

bodies, which concentrate mainly on lending activities in a well-defined area.

4. Investment brokers

The main duty of investment brokers is to transact the security sales. There

are discount brokers and full – service brokers. They provide an opportunity

online for some individuals to promote their trades. Aside from that, they can

also solicit valuable investment advice to some clients who may need it that

time.

5. Investment bankers

The main duty of this financial intermediary is to increase monetary amounts

of companies through stocks and bonds. Since conducting stock offerings and

issuing bonds is so expensive, investment bankers focuses on how they can help

the firm to earn more capital.

6. Escrow companies

This is the type of financial intermediary that is built for the very purpose.

These companies’ acts like an unconcerned party that will hold instructions for

execution as well as the grounds agreed for it.

7. Pension fund

A pension fund is any plan, funds, or scheme which provides retirement

income. Pension funds are important to shareholders of listed and private

companies. They are especially important to the stock market where large

institutional investors dominate.

8. Collective investment scheme

A collective investment scheme is a way of investing money alongside other

investors in order to befit from the inherent advantages of working as part of a

group. These advantages include an ability to hire a professional investment

manage, which theoretically offer the prospects of better returns and / or risk

management. Benefit from economies of scale – cost sharing among others

diversifies more than would be feasible for most individual investors which,

theoretically, reduce risk.

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Q 6: Explain functions of stock market and procedure of trading stock in

stock market also differentiates between KSF 100 – index and KSF 30

indexes.

Answer:

Stock market:

The stock is the market shares of publicly held companies are issue and trade

through exchange or over – the – counter market, the stock market also known as

the equity market.

Trading procedure on a stock market:

The trading procedure involves the following steps:

1. Selection of a broker:

The buying and selling of securities can only be done through SEBI

registered brokers who are members of the stock exchange. The broker can

be an individual, partnership firm or corporate bodies. So, the first step is to

select a broker who will buy/sell securities on behalf of the investor or

speculator.

2. Opening demat account with depository:

Demat (dematerialized) account refer to an account which a citizen

must open with the depository participant (bank or stockbrokers) to trade in

listed securities in electronic form. Second step in trading procedure is to

open a demat account. The securities are held in the electronic form by a

depository. Depository is an institution or an organization are which holds

securities (e.g. shares, debentures, bonds, mutual (National securities

depository Ltd.) and CDSL (central depository services Ltd.) there is no

direct contact between depository and investor. Depository participant will

maintain securities account balances of investor and intimate investor about

the status of their holdings from time to time.

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3. Placing the order:

After opening the demat account, the investor can place the order. The

order can be placed to the broker either (DP) personally or through phone,

email, etc.

Investor must place the order very clearly specifying the range of price at

which securities can be bought or sold. E.g. “buy 100 equity shares of

reliance for not more than Rs 500 per share”.

4. Executing the order:

As per the instructions of the investor, the broker executes the order

i.e. the buys or sells the securities. Broker prepares a contract note for the

order executed. The contract note contains the name and the price of

securities, name of parties and brokerage (commission) charged by him.

Contract nonet is signed by the broker.

5. Settlement:

This means actual transfer of securities. This is the last stage in the

trading of securities done by the broker on behalf of their clients. There can

be two types of settlement.

a) On the spot settlement:

In means settlement is done immediately and on spot settlement

follow. T + 2 rolling settlement. This means any trade – trade – taking

place on Monday gets settled by Wednesday.

b) Forward settlement:

It means settlement will take place on some future date. It can be T+ 5

or T + 7, etc. All trading in stock exchanges takes place between 9.55 am

and 3.3. Pm. Monday to Friday.

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Difference between KSF 100 & KSF 30:

KSE 100 The KSE 100 index was

introduced in 1991 and comprises of 100 companies

selected on the basis of sector representation and highest

market capitalization, which captures over 80% of the total

market capitalization of the companies listed on the Exchange.

KSE 100 index is a stock

index acting as a benchmark to compare prices on the

Karachi Stock Exchange over a period.

KSE 30 The Karachi Stock Exchange is

maintaining two indices, which are in place i.e. KSE 100 and

KSE all share index. Both the said indices are market

capitalization based indices.

The Karachi Stock Exchange has

launched the KSE 30 index with base value of 10,000 points,

formally implemented from Friday, September 1, 2006.

KSE 30 index is based only on

the free float of shares, rather than because of paid up capital.

When a company announces a

dividend, KSE 30 index is

adjusted for dividends and right shares.

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Q7: Explain in detail bonds, bonds market and different types of bonds; also

write a note on Pakistan investment bonds (PIB).

Answer:

Bonds:

Bonds are a debt investment in which an investor loans money to an entity

(typically cooperate or government) which borrows the funds a defined period of

time at a variable or fixed interest rate.

Bonds markets:

The bond market (also debt market or credit market) is a financial market

where participants can issue new debt, known as the primary market, or buy and

sell debt securities, known as the secondary market. This is usually in the form of

bonds, but it may include notes, bills, and so on.

Types of bonds:

1. Treasury bonds:

Treasuries are issued by the federal government to finance its gadget

deficits. Because they’re backed by Uncle Sam’s awesome taxing authority,

they’re considered credit – risk free. The downside: their yields are always

going to be lowest (except for tax – free munis). But in economic downturns

they perform better than higher – yielding bonds, and the interest is exempt

from state income taxes.

2. Agency bonds:

These bonds are issued by federal agencies, they’re different from the

mortgage – backed securities issued by those same agencies, and by Freddie

Mac (FRF) (the Federal home loan mortgage cop.) agency yields are higher

than treasury yields because they are not full – faith - and – credit

obligations of the U.S. government, but the credit risk is considered

minimal. Interest on the bonds is taxable at both the federal and state levels,

however.

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3. Investment – grade corporate bonds:

Investment – grade corporate is issued by companies or financing

vehicles with relatively strong balance sheets. The carry ratings of at least

triple – B from standard & poor’s, Moody’s investors service or both. (The

scale is triple – A as the highest, followed by double – A, single – A, then

triple – B, and so on.) for investment – grade bonds, the risk of default is

considered pretty remote. Still, their yields are higher than either Treasury or

agency bonds, though like most agencies they are fully taxable. In economic

downturns, these bonds tend to underperform Treasuries and agencies.

4. High – yield bonds

These bonds are issue by companies or financing vehicles with

relatively weak balance sheets. They carry ratings below triple – B. default

is a distinct possibility. As a result, high – yield bond prices are more closely

tie to the health of corporate balance sheets. They track stock prices more

closely than investment – grade bond prices. “High – yield doesn’t provide

the same asset – allocation benefits you get by mixing high – grade bonds

and stock, “observes Charles Schwab chief investment officer Steve ward.

5. Foreign bonds:

These securities are something else altogether. Some are dollar –

denominated, but the average foreign bond fund has about a third of its

assets in foreign – currency – denominated debt, according to Lipper. With

foreign – currency – denominated bond, the issuer promises to make fixed

interest payments – and to return the principal – in another currency. The

size of those payments when they are converted into dollars depends on

exchange rates.

6. Mortgage – backed bonds

Mortgage – backed, which have a face value of $25,000 compared to

&1,000 or &5,000 for other types of bonds, involve “prepayment risk.”

Because their value drops when the rate of mortgage prepayments rises, they

don’t benefit from declining interest rates like most other bonds do.

7. Municipal bonds:

Municipal bonds are issued by governments or their agencies, and

they come in both the investment – grade and high – yield varieties. The

interest is tax – free, but that doesn’t mean everyone can benefit from them.

Taxable yields are higher than muni yield to compensate investors for the

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taxes, so depending on your bracket; you might still come out ahead with

taxable bonds.

Pakistan investment bonds:

Pakistan investment bonds are issued by SBP on the behalf of federal

government. These are long – term securities and benchmark for long tenure debt.

These are risk free debts. Interbank/ NBFIs transfer of PIBs is permissible. PIBs

issued in five tenures: 3 years, 5 years, 10-year, 15 years, 20years, 30 years

maturity. SBP, SECP & ministry of finance announce the coupon retest and the

target consulting each other and profit is paid semiannually. SBP is acting as an

agent on behalf of the government for raising short term and long – term funds

from the market. Primary dealer maintains a subsidiary general ledger account

(SGLA) with SBP for the settlement pure – pose. The PIBs are sold by SBP to ten

approved primary dealers through multiple prices sealed bids auction. The

commission is paid to primary dealers on sale proceeds of Pakistan investment

bonds (PIBs) @ 0.5% on amount of bid accepted or 3.5% of the target amount

whichever is less. The commission is paid to primary dealers by debiting the

government non – food account and credit the amount to the respective bank’s

account.

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Q8: What are different determinants of interest rates and its impact on

valuation of securities?

Answer:

Determinants of interest rates:

1) Inflation rate:

The result is that consumers have more money to spend, causing the

economy to grow and inflation to increase. The opposite holds true for rising

interest rates. As interest rates are increased, consumers tend to have less

money to spend. With less spending, the economy slows and inflation

decreases.

2) The real interest rates:

The real interest rate is the rate of interest an investor, saver or lender

receives (or expects to receive) after allowing for inflation. It can be described

more formally by the fisher equation, which states that the real interest rate is

approximately the nominal interest rate minus the inflation rate.

Example:

One-year T – bill rate in 2015 was 4.53% and inflation for the year was

2.80%. if investors expected the same inflation rate, the according to the

fisher effect the real interest rate for 2015; 4.53% - 2.80% = 1.73%

If one – year T – bill rate was 1.89% while the inflation rate was 3.30%. the

real rate; 1.89% - 3.30% = -1.41%

3) Default (credit) risk:

A credit risk is the risk of default on a debt that may arise from a borrower

failing to make required payments. In the first resort, the risk is that of the

lender and includes lost principal and interest, disruption to cash flow, and

increased collection costs. Bond rating agencies.

Example:

10 – year Treasury interest rate was 4.70%. Danish rated corporate debt interest

was 5.58% and Ijaz rated corporate debt interest rate was 6.70%.

Average DRP:

DRP Danish = 5.58% - 4.70% = 0.88%

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DRP Ijaz = 6.70% - 4.70% = 2%

4) Liquidity risk:

Liquidity risk is the risk that a company or bank may be unable to meet short

term financial demands. This usually occurs due to the inability to convert a

security or hard asset to cash without a loss of capital and/or income in the

process.

5) Special previsions and covenants:

Such as taxability, convertibility and culpability affect the interest rates. As

special provisions that provide benefits to the security holder increases, interest

rate decreases.

6) Term to maturity:

Term structure of interest rates (yield curve) maturity premium (MP) is the

difference between the long and short – term securities of the same

characteristics except maturity.

Yield curve: relationship btw YTM and time to maturity.

Yield may rise with maturity (up – ward sloping yield curve: the most

common yield curve) Yields may fall with maturity (Inverted or

downward sloping yield curve) Flat yield curve: Yields are unaffected

by the time to maturity

Ij = (IP, RIR, DRPj, LRPj, SCPj, MPj)

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Q9: Explain foreign exchange market and its participants?

Answer:

Foreign exchange market:

The foreign exchange market (forex, FX, or currency market) is a global

decentralized market for the trading of currencies. This includes all aspects of

buying, selling and exchanging currencies at current or determined prices. In terms

of volume of trading, it is by far the largest market in the world.

Types of participants:

1) The interbank or wholesale market:

Major Forex Trading in the wholesale forex market is undertaken by banks –

popularly known as interbank market. In this market, banks and non – bank

financial institutions transact with each other. They undertake trading on behalf

of customers, but majority of trading is undertaken for their own account by

proprietary desks.

2) Foreign exchange dealers and brokers:

Dealers: banks and some non – blank financial institutions act as foreign

exchange dealer. These dealers quote both “bid” and “ask” for a particular

currency pair (for spot, forward and swap contracts) and take opposite side to

either buyer or sellers of currency. They make profit from the spreads between

buying and selling prices i.e. Bid and ask rate. Brokers are agents, which merely

match buyers and sellers and get a brokerage fee.

Brokers: brokers on the other hand, help clients to get a better rate on the

currency trade by making available different quotes offered by dealers. Traders

can compare rats accordingly take a decision. Brokers charge a commission for

providing these services.

3) Hedger, speculators and arbitrageurs:

Traders buying and selling foreign exchange can take the role of hedgers, or

speculators or arbitrageurs.

Hedgers are traders who undertake forex trading because they have assists or

liability in foreign currency. For example, when an importer requiring foreign

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currency, sells domestic currency to buy foreign currency, he is termed as a

hedger. The importer has a foreign currency liability. Similarly, an exporter

sells foreign currency and buys domestic currency is hedger.

Speculators are traders who essentially buy and sell foreign currency to make

profit from the expected futures movement of the currency. These traders do not

have any genuine requirement for trading foreign currency. They do not hold

any cash position in the currency.

Arbitrageurs buy and sell the same currency at two different markets

whenever there is prices discrepancy. The principal of “law of one price”

governs the arbitrage principle. Arbitrageurs ensure that market prices move to

rational or normal levels. With the proliferation on internet, cross currency,

cross currency arbitrage possibility has increased significantly.

4) Central banks and treasuries:

All most all central bank and treasuries participate in the forex market.

Central banks play very important role in foreign exchange market. However,

these banks do not undertake significant volume of trading. Each central bank

has official/unofficial target of the forex rate of its home currency. If the actual

price deviates from the target rate, the central banks intervene in the market to

set a time.

5) Retail market:

In the retail market, individuals (tourists, foreign students, patients traveling

to other countries for medical treatment) small companies, small exporters and

importers operate. Money transfer companies/remittance companies (for

example like western union) are also major players in the retail market. Retail

traders buy/sell currency for their genuine business/personal requirements. For

example, an exporter enters into forward contract to convert foreign currency to

domestic currency. A tourist buys foreign currency in the spot market before

undertaking the journey. A UK patient visiting India to undertake an operation

that would have cost him a fortune at UK

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Q10: Explain determinants of exchange rate and financial instruments of

foreign exchange market?

Answer:

Determinants of exchange rate:

1. Inflation rates

Changes in market inflation cause changes in currency

exchange rates. A country with a lower inflation rate than another is will

see an appreciation in the value of its currency. The prices of goods and

services increase at a slower rate where the inflation is low. A country with

a consistently lower inflation rate exhibits a rising currency value while a

country with higher inflation typically sees depreciation in its currency and

is usually accompanied by higher interest rates.

2. Interest rates Changes in interest affect currency value and dollar exchange

rate. Forex rates, interest rates, and inflation are all correlated. Increases in

interest rates cause a country’s currency to appreciate because higher

interest rates provide higher rates to lenders, thereby attracting more foreign

capital, which causes a rise in exchange rates.

3. Country’s current account/balance of payments

A country’s current account reflects balance of trade and

earnings on foreign investment. It consists of total number of transactions

including its exports, imports, debt, etc. a deficit in current account due to

spending more of its currency on importing products than it is earning

through sale of exports causes depreciation. Balance of payments fluctuates

exchange rate of its domestic currency.

4. Government debt

Government debt is public debt or national debt owned by the

central government. A country with government debt is less likely to

acquire foreign capital, leading to inflation. Foreign investors will sell their

bonds in the open market if the market predicts government debt within a

certain country. As a result, a decrease in the value of its exchange rate will

follow.

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5. Terms of trade

Related to current account and balance of payments, the terms

of trade are the ratio of export prices to import prices. A country’s terms of

trade improve if its exports prices rise at a greater rate than its imports

prices. This results in higher revenue, which causes a higher demand for the

country’s currency and an increase in its currency’s value. This results in an

appreciation of exchange rate.

6. Political stability & performance

A country’s political state and economic performance can affect

its currency strength. A country with less risk for political turmoil is more

attractive to foreign investors, as a result, drawing investment away from

other countries with more political and economic stability. Increase in

foreign capital, in turn, leads to an appreciation in the value of its domestic

currency. A country with sound financial and trade policy does not give any

room for uncertainty in value of its currency. But, a county prone to

political confusions may see depreciation in exchange rates

7. Recession

When a country experiences a recession, its interest rates are

likely to fall, decreasing its chances to acquire foreign capital. As a result,

its currency weakens in comparison to that of other countries, therefore

lowering the exchange rate.

8. Speculation

If a county’s currency value is expected to rise, investors will

demand more of that currency in order to make a profit in the near future.

As a result, the value of the currency will rise due to the increase in

demand. With this increase in currency value comes a rise in the exchange

rate as well.

Financial instruments of foreign exchange market?

There are six instruments of foreign exchange market?

1) Exchange – traded fund

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If referred to as ETF’s. These are open – ended investment companies that

have the characteristic of being traded at any time throughout the day. These will

oftentimes attempt duplicating stock market indices such as the S&P 500. The

ETF’s gain strength as the United States dollar (USD) weakens against a different

currency and therefore replicate currency market investment. Certain funds can

track the price fluctuations of the various world currencies as they compare to the

USD, and will oftentimes increase in value to counter the direction that the USD

moves in. this crease increased interest in the USD for investors and speculators.

2) Forward:

The agreement established between two parties wherein they purchase, sell,

or trade an asset at a pre – agreed upon price is called a forward or a forward

contract. Normally, there is no exchange of money until a pre – established future

date has been arrived at. Forwards are normally performed as a hedging instrument

used to either deter or alleviate risk in the investment activity.

3) Future:

A forward transaction that contains standard contract sizes and maturity

dates are considered futures. Futures are traded on exchanges that have been

created for that purpose exclusively. Just like with commodity markets, a future in

the forex market normally designates a contract length of 3 months in duration.

Interest amounts are also included in a futures contract.

4) Option

Commonly shortened to FX option from foreign exchange option. Options

are derivatives (financial instruments whose values fluctuate based on underlying

variable) wherein the owner has the right to, but is not necessarily obligated to,

exchange on currency for another at a pre – agreed upon rate and a specified date.

When you talk about options in any form (stock market, forex, or any other

market), the forex market is the deepest and largest, as well as the liquid market of

any options in the world

5) Spot:

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Where futures normally employ a 3 – month timeframe, spot transactions

encompass a 48 – hour delivery transaction period. There are four characteristics

that all spot transactions have in common, namely:

a) A direct exchange between two currencies

b) Involves only cash, never contracts

c) No interest is included in the agreed upon transaction

d) Shortest of all transaction timeframes

6) Swaps

Currency swaps are the most common type of forward transactions. A swap

is a trade between two parties wherein they exchange currencies for a pre –

determined length of time. The transaction then is reversed at a pre – agreed upon

future date. Currency swaps can be negotiated to mature up to 30 years in the

future, and involve the swapping of the principle amount. Interest rates are no

“netted” since they are denominated in different currencies.

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