International Finance International Finance

Finance

1. The Financial System
and the Interest Rates
Dr. Amir Rafique
02/26/25

2. Topics for Today
Financial System
Components of the Financial System
Approaches to Investment Decision Making
Interest Rates and the Financial System

3. Financial System
An institutional framework
Three main parts:
Financial Instruments
Financial Markets
Financial Institutions
Regulations are another aspect of the
financial system (i.e. SBP, SECP)

4. The Financial System

5. Financial Instruments

6. Financial Instruments
A financial instrument is:
“the written legal obligation of one party to transfer
something of value usually money to another party
at some future date, under certain conditions”
Stocks, debts, or t-bills etc.

7. Assets
Assets are things that people own
Types of Assets
Financial Assets (Risky)
Non-Financial Assets/ Real Assets (Less Risky)

8. Financial Assets
Fixed Income Investments (Mandated Pay)
Non Marketable Financial Assets (NMFA)
Bank deposit, Post office deposit
Money Market Instruments
T. Bills, commercial paper, certificates of deposit
Bonds (Long Term Debt Instruments)
Govt. securities, corporate securities (Debentures,
Subordinated loans, Junk bonds, Convertible/ Callable
bonds)
Preferred stocks (hybrid security)

9. Financial Assets
Equity Shares (Ownership Capital)
Blue chip shares, growth shares, income shares
Mutual Funds
Money Market Funds
Equity and Bond Funds
Hybrid Funds
Financial Derivatives
Options, futures, forwards and swaps

10. Financial Markets

11. TIME PERIOD

12. Classification of Derivatives

13. Structure of Financial Markets
Primary vs. Secondary Markets
Centralized Exchanges vs. Over-The-Counter
(OTC) Markets
Spot vs. Future Markets

14. Financial Intermediaries/
Institutions

15. Financial Intermediaries
Companies obtain the financial resources in
two ways:
Directly (Financial Markets)
Indirectly (Financial Institutions/ Financial
Intermediaries)
Two broad categories
Depository Institutions
Non-Depository Institutions

16. 16

17. The Structure of the Financial
Industry
Individual
Surplus Units
Depository
Institutions
Mutual Funds Deficit Units
Deposits
Purchase Shares
Policyholders
Employers
Employees
Insurance
Companies
Pension Funds
Premiums
Employee
Contributions

18. Approaches to Investment
Decision Making

19. Approaches to Investment
Decision Making
Technical Analysis
Market data
Price trends
Technicians/ Chartists
Fundamental Approach
Fundamental analysis
Fundamental factors
Intrinsic value of a security
Fundamentalists

20. Technical Analysis
Measuring Risk and Return

21. Measuring Risk and Return for
Investments
To estimate/ evaluate the expected risk-return:
Historical rates of return
Average rates over time
Variance and standard deviation (Traditional)
Coefficient of Variation

22. Measures of Historical Rates of
Return (ex post)
%1010.0

$200
200 -$220

or
P
PP
SPR
0
01



 Where:
SPR = Single period return
P
0 = Beginning value
P
1 = Ending value
Single Period Yield/ Return

23. Measures of Historical Rates of
Return over the Period
High and low returns in different periods
So summary figures of returns required
The mean annual rate of returns for this
investment

24. Measures of Historical Rates
of Return over the Period
1 2 ...
NR R R
AM
N
  

The mean annual rate of returns for this investment over
some period of time is calculated
Arithmetic Mean
Where:
AM = Arithmetic Mean
R
i
= Holding Period Returns
N = Number of Periods

25. Problem
Year NBP (Rs.) MCB (Rs.)
2009 100 200
2010 119 216
2011 128 222
2012 113 202
2013 110 206
2014 127 214
• Compute arithmetic mean annual rate of return for each
stock. Which stock is better by this measure?

26. Actual Return/ Expected
Return/ Historical Return
NBP Returns (R) MCB Returns (R)
100 200
119 0.19 216 0.08
128 0.07563025 222 0.02777778
113 -0.1171875 202 -0.0900901
110 -0.0265487 206 0.01980198
127 0.15454545 214 0.03883495
Sum 0.27643953 Sum 0.07632462
E (R) 0.05528791 E (R) 0.01526492

27. Measures of Risk for a Single
Investment

28. Measures of Risk
Variance of rates of return
Standard deviation of rates of return
Coefficient of variation of rates of return

29. Measuring Risk: Variance of
Historical Returns
 
N
RE
i



n
1i
2
i
2
R

Where:
= Variance (of the pop)
R = Return i
E(R)
i
= Expected R*
N = Number of years
2

* The E(R) is equal to the arithmetic mean of the series of returns.

30. Measuring Risk: Standard
Deviation
Standard Deviation is the square root of the variance
Standard Deviation is a measure of dispersion around
the mean. The higher the standard deviation, the
greater the dispersion, the greater the risk
deviation Standard
2
Variance

31. Problems
•Compute variance and the standard deviation of the annual
rate of return for each stock. Which is preferable by these
measures?
•How you interpret the results of the two measures?
Year NBP (Rs.) MCB (Rs.)
2009 100 200
2010 119 216
2011 128 222
2012 113 202
2013 110 206
2014 127 214

32. Variance and Standard
Deviation
NBP Returns (R) E (R) R- E(R) [R- E(R)]²
100
119 0.19 0.055288 0.134712 0.0181473
128 0.07563025 0.055288 0.020342 0.0004138
113 -0.1171875 0.055288 -0.17248 0.0297478
110 -0.0265487 0.055288 -0.08184 0.0066972
127 0.15454545 0.055288 0.099257 0.009852
Sum 0.27643953 Sum 0.0648582
E (R) 0.05528791 Var 0.0129716
S.D. 0.114
MCB Returns (R) E (R) R- E(R) [R- E(R)]²
200
216 0.08 0.015265 0.064735 0.0041906
222 0.02777778 0.015265 0.012513 0.0001566
202 -0.0900901 0.015265 -0.10536 0.0110997
206 0.01980198 0.015265 0.004537 2.058E-05
214 0.03883495 0.015265 0.02357 0.0005555
Sum 0.07632462 Sum 0.016023
E (R) 0.01526492 Var 0.0032046
S.D. 0.057

33. Coefficient of Variation: Relative
Measure of Risk
Coefficient of variation (CV) is a measure of relative
variability
CV indicates risk per unit of return, thus making
comparisons easier
i
E(R)
Standard Deviation of Returns
CV
Expected Rate of Return



The risk per unit of return

34. Problems
•Compute the coefficient of variation for each stock. Which
stock is better by this relative measure of risk?
Year NBP (Rs.) MCB (Rs.)
2009 100 200
2010 119 216
2011 128 222
2012 113 202
2013 110 206
2014 127 214

35. Coefficient of Variation
NBP Returns (R) E (R) R- E(R) [R- E(R)]²
100
119 0.19 0.055288 0.134712 0.0181473
128 0.07563025 0.055288 0.020342 0.0004138
113 -0.1171875 0.055288 -0.17248 0.0297478
110 -0.0265487 0.055288 -0.08184 0.0066972
127 0.15454545 0.055288 0.099257 0.009852
Sum 0.27643953 Sum 0.0648582
E (R) 0.05528791 Var 0.0129716
S.D. 0.114
C.V. 2.0619337
MCB Returns (R) E (R) R- E(R) [R- E(R)]²
200
216 0.08 0.015265 0.064735 0.0041906
222 0.02777778 0.015265 0.012513 0.0001566
202 -0.0900901 0.015265 -0.10536 0.0110997
206 0.01980198 0.015265 0.004537 2.058E-05
214 0.03883495 0.015265 0.02357 0.0005555
Sum 0.07632462 Sum 0.016023
E (R) 0.01526492 Var 0.0032046
S.D. 0.057
C.V. 3.7340507

36. Interest Rates

37. Interest Rates
Definition of Interest Rate
The price of funds
Types of Interest Rates
Determination of Interest Rates

38. Types of Interest Rates
Types of Interest Rates
Nominal Interest Rates
Real Interest Rates

39. Real and Nominal Interest
Rates
The nominal interest rate is equal to the real
interest rate plus the expected rate of inflation
Also called Fisher Equation:
i = r + π
e

The nominal interest rate, i, equals the real
interest rate, r, plus expected inflation, π
e

40. Determination of Interest Rates
The market interest rate is determined by the
factors that affect the supply and demand of the
loanable funds

41. Loanable Funds Theory
S
Quantity of Lending/ Borrowing in the Economy (s)
D
i
Equilibrium Interest Rate
S=D

42. Issues