4th Session
CHAPTER 2: SAVINGS (FLOW OF FUNDS)
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Flow of funds (Transfer of Savings)
• Savings
– The portion of income not spent on consumption of
consumer goods.
• Transfer of savings
• A country’s economy can be divided into 3 sectors:
– Households (consumers)
– Businesses (producers)
– Government (both a consumer and a producer)
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• Each of these 3 sectors can have a:
– Balanced budget (I=E)
– Surplus budget (I>E)
– Deficit budget (I<E)
• Whenever a sector’s I>E, it will be a saving
surplus sector.
• Whenever a sector’s I<E, it will be a saving
deficit sector.
3
• At a group level, households comprise SSS while
businesses and governments are typically considered
to form the SDS.
• Why household is generally a SSS?
– As a group they save more than spending on current
consumption.
• Why governments and businesses considered SDS?
– They have to invest in growth opportunities that cannot be
financed by internally generated funds alone.
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• So, the households have surplus funds (SSS)
while governments & businesses need funds
(SDS).
• Thus, the funds flow from SSS to SDS. It can
occur in one of three ways:
1. Direct finance
2. Indirect finance (facilitated by investment bank)
3. Indirect finance (facilitated by financial
intermediaries)
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1. Direct Finance
• Security
– A claim on issuer’s future income.
• Direct finance
– Business selling its securities directly to savers (investor) in financial
market without going through any financial intermediary or financial
institution.
• Check to determine if a particular transaction is a
direct finance transaction or not?
– See if the investor directly holds claim against the borrower.
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1. Direct Finance
Examples
• A new business is formed, it goes to venture capitalist, V.C. will lend or
take an equity position in the business if it believes the project will be
successful.
•
APPLY THE CHECK: Here the investor (V.C.) directly holds claim against the borrower (buss.)
• Apple Computer building new facility funds it by selling a long-term 15
year old bond. A group of insurance companies buys it for $20 m.
Apple gets $20 m for 15 yrs. whereas bondholders get i-rates and $20
m at maturity.
•
APPLY THE CHECK: Here the investor (I.C.) directly holds claim against the borrower (Apple
Computer)
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2. Indirect Finance
(facilitated by investment bank)
•
Indirect money transfer generally takes place with the help of an investment bank.
•
What is an Investment bank?
–
–
–
Advisory role
Underwriting
Facilitating mergers and other corporate reorganizations
•
Investment bank serves as a middleman which facilitates transfer of funds between the
SSS and the SDS.
•
Why hire investment bank why not do we issue the securities on our own?
–
By committing to purchase bonds at a set price, investment banks underwrite any risks associated
with a new issue.
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2. Indirect Finance
(facilitated by investment bank)
• Underwriting
– Literally means ‘Assuming risk’.
– Name of the process in which I.B. buys new security issues from
issuing company and then resells them to the investors.
ABC corp. shares
ABC corp.
(SDS)
$30 per share
ABC corp. shares
Investment
Bank
$32 or 29 per share
Investor
(SSS)
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ILLUSTRATED EXAMPLE =>
•
•
•
A bank has agreed to underwrite an issue of 50 million shares by ABC
Corporation. In negotiations between the bank and the corporation the target
net price to be received by the corporation has been set at $30 per share. This
means that the corporation is expecting to raise 30 × 50 million dollars or $1.5
billion in total. The bank agrees to buy the shares from ABC Corporation for
$30 per share.
Two things may happen:
– Either stock sells below $30 or above $30
If banks the shares for $32 (above 32 case), it makes a profit of (32 − 30) × 50 =
$100 million because it has agreed to pay ABC Corporation $30 per share.
However, if it can only sell the shares for $29 per share (below 32 case), it
loses (30 − 29) × 50 = $50 million because it still has to pay ABC Corporation
$30 per share.
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2. Indirect Finance
(facilitated by investment bank)
ABC corp. shares
ABC corp.
(SDS)
$30 per share
ABC corp. shares
Investment
Bank
$32 or 29 per share
Investor
(SSS)
• Investment bank promises to buy ABC corp. security issue at a
fixed price, but it will offer to savers at a higher offering price.
This differential of ($32-$30=$2/share) is what is investment
bank’s compensation and is called the ‘underwriting spread’.
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2. Indirect Finance
(facilitated by financial intermediary)
• Funds can also transfer from SSS to SDS through a F.I.
• Here the F.I. obtains funds from investors issues them its own
(indirect) security and then uses the money to purchase
another company’s (direct)securities.
• Direct Securities
• Indirect Securities
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2. Indirect Finance
(facilitated by financial intermediary)
• Example of funds transfer through a F.I. (AMC)
• Funds transfer from SSS to SDS facilitated by AMC.
• Asset Management Company: Licensed by SECP to launch
mutual funds, AMC invests clients funds into securities that
meets its desired objectives.
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A
$2000
B
$2000
C
$2000
AMC
D
$2000
E
$2000
Blue arrow shows investors giving money to AMC
AMC investment into diff. securities
Red arrow shows AMC giving its own shares (indirect)
to investors
Return from securities (direct)
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5TH SESSION
15
Financial Asset
• Assets
– Resources owned by businesses or individuals
with the expectation that they will provide future
benefit.
16
• Assets can be classified into:
– Tangible assets
• Value depends on particular physical properties
– Intangible assets
• Represents legal claim to future benefit
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Financial Assets
• Intangible assets
• Value is the claim to the future cash flows of the issuer
• Issuer
– The entity that agrees to make future cash payments (or the one who
borrows the funds) is called the issuer or borrower of the financial
assets.
• Investor or Lender
– The owner of the financial assets (the one lending the money) is the
investor or lender.
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Functions of Financial Assets
• Two principal economic functions
– Transfer of funds (SSS TO SDS)
– Redistribute the unavoidable risk from the issuer’s
of the security (person needing funds) to those
supplying the funds (investors).
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Illustration of the two functions of financial assets
with the help of an example
• Joe needs $300,000 to setup a wristwatch manufacturing
plant.
• Joe has $200,000 in life savings – not willing to take risk.
• Susan has inherited $130,000, plans to invest 100,000 (excess
funds)
• Larry earned $100,000 in bonus, plans to invest all of it
(excess funds)
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• Suppose the three (Joe, Susan and Larry) meet.
Reduction of owner’s risk
(meets second goal).
JOE
Personal funds of $100,000
SUSAN
Gives $100,000 and gets 30%
share in company
Wristwatch
business needs
$300,000
i
LARRY
Lends $100,000
Equity
Meets the
first goal.
Debt
These two financial assets allow funds
to be transferred from Susan and
Larry to Joe who needs funds.
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Financial Markets and their Functions
• Financial Markets
– Markets (bond and stock market for instance)
where financial securities are bought and sold.
• Two main functions
1. Moving funds from people having surplus funds to those
in need of funds.
2. Financial markets promote greater economic efficiency.
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Structure of Financial Markets
• Several basis for classification of Financial
Markets:
A. Classification of financial market on basis of the
nature of claim
Claim is to ‘demand anything as a right’. If I hold
– Debt market
a debt instrument it means I hold the right to
demand periodic interest payments and
principal upon maturity, similarly if I hold a stock
– Equity market
I can demand dividend as my right.
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1. Debt Market
• The debt market is the market where debt
instruments are traded.
• Debt instruments are assets that require a
fixed payment to the holder, usually in the
form of interest payments.
• Examples of debt instruments include
government bonds and corporate bonds.
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• The most common method for a firm or an individual
to raise funds in the financial markets is to issue a debt
instrument, such as a bond.
• The maturity of a debt instrument is the number of
years (term) until that instrument’s expiration date.
– A debt instrument is short-term if its maturity is less than
a year (T-bills).
– Debt instruments are called long-term if their maturity is
ten years or longer (T-bonds).
– Debt instruments with a maturity between one and ten
years are said to be intermediate-term (T-Notes).
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2. Equity Market
• The equity market (often referred to as the
stock market) is the market for trading equity
instruments.
• The second method of raising funds is by
issuing equities, such as common stock, which
are claims to share in the net income (income
after expenses and taxes) of a business.
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Characteristics of Equity Securities
• Variable return
• Capital gains
• Unlimited life of the security
– Equities are considered long-term securities because they
have no maturity date.
• Equities often make periodic payments (dividends) to
their holders.
• Equity holder (owns a portion of the firm) and has the
right to vote on issues important to the firm.
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Advantages versus disadvantage of owning a
corporation’s equities rather than its debt
ADVANTAGES
DISADVANTAGES
DEBT
1. A corporation has to pay all its
debt holders before it pays its
equity holders.
- Less risky (paid first)
1. Debt holders interest payments are
fixed, they do not benefit directly
from any increases in the
corporation’s profitability.
EQUITIES
1. Equity holders benefit directly
from any increase in the
corporation’s profitability as
they are owners of the
corporation.
1. An equity holder is a residual
claimant.
- More risky.
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6th Session
B. Classification of financial market on the basis
of the security issue
– Primary market (new issues of security)
– Secondary market (previously issued)
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1. Primary Market
• New issues of a security.
• Role of Investment Bank in primary market.
– A market offering where investment bank purchases
securities from issuers and sells them to investors is a
primary market offering.
• Not well known to public.
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2. Secondary Market
• Previously issued securities are bought and sold.
• New York Stock Exchange (NYSE), Karachi Stock
Exchange (KSE) and NASDAQ etc.
• A market offering where the proceeds from the
sale of securities do not go the issuer of the
security, but to the current holder is a secondary
market offering.
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Secondary
Market
Broker
Market
Dealer
Market
Stock
Exchange
OTC
• Broker Market
– The two sides of the transaction are brought
together and trade takes place at that point.
– Broker
• Broker matches ‘buy order’ of person A with ‘sell order’
of person B and charges a commission for that.
– Example: Stock Exchanges
• Dealer Market
– Markets in which buyers and sellers are never brought together.
– Dealer
• Dealer trades for himself acting as a principal not an agent.
• 2 separate trades are made.
• Dealer buys securities from person A (at ‘bid price’ - low) and sells to person B
(at ‘ask price’ - high).
• Bid Ask Spread – Difference between ask price and bid price (dealer’s profit).
• Example: Dealer will offer $599 bid price for 100 shares of Google’s stock and
will sell them at an ask price of $600 keeping the $1.
– Example: OTC and NASDAQ
B. Classification of financial market on the basis
of maturities of securities traded
– Money market
– Capital market
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1. Money Market
• Short term (maturity of less than one year)
• Debt instruments
• Characteristic
– Highly liquid.
2. Capital Market
• Long term (maturity of greater than one year)
• Debt and Equity instruments
• Characteristic
– Riskier than money market (Price fluctuation)
Money Market Instruments
1. T-bills:
–
–
–
Short term financial instruments
Issued by government at a ‘discount’
Discount from principal represents interest to investors
•
–
–
–
For example, a 52-week T-Bill with a $1,000 face value might be sold initially for $990.
When it matures, the investor will receive the full $1,000. The extra $10 the investor
receives is their investment return for purchasing the T-Bill.
Default free
Liquid Instrument
Balance Sheet (Cash and Cash Equivalent)
2. Fed Funds
– A deposit at the central bank
– Cash Reserve Requirement (RR)
Fed Fund Transaction
– Loans of reserve deposits (at the Fed) between
the depository institutions
– Federal Fund Rate