Financial and Economic

Environment

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 Financial Environment
• Businesses interact continually with the
financial markets.
• Financial Markets are composed of all
institutions and procedures for bringing buyers
and sellers of financial instruments together.
• The purpose of financial markets is to
efficiently allocate savings to ultimate users.

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 Flow of Funds in the Economy

INVESTMENT SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS

SECONDARY MARKET

SAVINGS SECTOR

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 Flow of Funds in the Economy

INVESTMENT SECTOR
INVESTMENT
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Businesses

SECONDARY MARKET Government

Households
SAVINGS SECTOR

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 Flow of Funds in the Economy

INVESTMENT SECTOR
SAVINGS
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Households

SECONDARY MARKET Businesses

Government
SAVINGS SECTOR

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 Flow of Funds in the Economy

INVESTMENT SECTOR
FINANCIAL
BROKERS

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Investment
Bankers
SECONDARY MARKET
Mortgage
Bankers
SAVINGS SECTOR

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 Flow of Funds in the Economy

INVESTMENT SECTOR
FINANCIAL

INTERMEDIARIES
INTERMEDIARIES

FINANCIAL
FINANCIAL BROKERS
Commercial Banks
Savings Institutions
SECONDARY MARKET Insurance Cos.
Pension Funds
Finance Companies
SAVINGS SECTOR
Mutual Funds

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 Flow of Funds in the Economy

INVESTMENT SECTOR
SECONDARY
MARKET

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Security
Exchanges
SECONDARY MARKET
OTC
Market
SAVINGS SECTOR

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 Allocation of Funds
• Funds will flow to economic units that are willing
to provide the greatest expected return (holding
risk constant).
• In a rational world, the highest expected returns will be
offered only by those economic units with the most
promising investment opportunities.
• Result: Savings tend to be allocated to the most efficient
uses.

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 Risk-Expected Return
Profile
Speculative Common Stocks
EXPECTED RETURN (%)

Conservative Common Stocks

Preferred Stocks
Medium-grade Corporate Bonds
Investment-grade Corporate Bonds
Long-term Government Bonds
Prime-grade Commercial Paper
US Treasury Bills (risk-free securities)

RISK
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 What Influences Security
Expected Returns?
• Default Risk is the failure to meet
the terms of a contract.
• Marketability is the ability to sell a
significant volume of securities in a short
period of time in the secondary market
without significant price concession.

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 Ratings by Investment
Agencies on Default Risk
MOODY’S INV SERVICE STANDARD & POOR’S
Aaa Best Quality AAA Highest Grade
Aa High Quality AA High Grade
A Upper Med Grade A Higher Med Grade
Baa Medium Grade BBB Medium Grade
Ba Possess Speculative BB Speculative
Elements

C Lowest Grade D In Payment Default

Investment grade represents the top four categories.

Below investment grade represents all other categories.
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 What Influences Expected
Security Returns?
• Maturity is concerned with the life
of the security; the amount of time
before the principal amount of a
security becomes due.
• Taxability considers the expected tax
consequences of the security.

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 Term Structure of Interest
Rates
Upward Sloping Yield Curve
0 2 4 6 8 10

(Usual)
YIELD (%)

Downward Sloping Yield Curve

(Unusual)
0 5 10 15 20 25 30
YEARS TO MATURITY

A yield curve is a graph of the relationship between yields and term to

maturity for particular securities.
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 Economic Environment
• Economic Environment refers to all forces which have an economic impact
on Business.
• The economic environment consists of the demand dynamics, supply
situation, pricing factors, degree of competitiveness, and impact of
profitability. It includes the fiscal policy, monetary policy and the taxation
policy, the FDI norms, the investment criterion and financing decisions.
Economic environment includes:

• Growth strategy
• Industry
• Agriculture
• Infrastructure
• Money and Capital Markets
• Per capita and national income
• Population
• New Economic Policy

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