Question 1)

Briefly explain capital Allocation process with the help of diagram?

CAPITAL ALLOCATION PROCESS

Businesses often need capital to implement growth plans; governments require funds to finance building projects; and
individuals frequently want loans to purchase cars, homes, and education.

Fortunately, there are some individuals and firms with incomes greater than their expenditures.

In contrast to William Shakespeare’s advice, most individuals and firms are both borrowers and lenders. For example, an
individual might borrow money with a car loan or a home mortgage but might also lend money through a bank savings account.
In the aggregate, individuals are net savers and provide most of the funds ultimately used by nonfinancial corporations.
Although most nonfinancial corporations own some financial securities, such as short-term Treasury bills, nonfinancial
corporations are net borrowers in the aggregate.

In the United States federal, state, and local governments are also net borrowers in the aggregate (although many foreign
governments, such as those of China and oil-producing countries, are actually net lenders). Banks and other financial
corporations raise money with one hand and invest it with the other. For example, a bank might raise money from individuals in
the form of a savings account and then lend most of that money to business customers. In the aggregate, financial corporations
borrow slightly more than they lend.

Process for transfers of capital between savers and those who need capital take place in three different ways.

1. Direct transfers
2. Indirect transfers through investment bankers
3. Indirect transfers through an financial intermediary

Direct transfers:
Direct transfers of money and securities, occur when a business (or government) sells its securities directly to savers. The
business delivers its securities to savers, who in turn provide the firm with the money it needs. For example, a privately held
company might sell shares of stock directly to a new shareholder, or the government might sell a Treasury bond directly to an
individual investor.

Indirect transfers through investment bankers:

Indirect transfers may go through an investment banking house such as Goldman Sachs, which underwrites the issue. An
underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the
investment bank, which in turn sells these same securities to savers. Because new securities are involved and the corporation
receives the proceeds of the sale, this is a “primary” market transaction.
Indirect transfers through financial intermediary:
Transfers can also be made through a financial intermediary such as a bank or mutual fund, as shown in Panel 3. Here the
intermediary obtains funds from savers in exchange for its own securities. The intermediary then uses this money to purchase
and then hold businesses’ securities. For example, a saver might give dollars to a bank and receive a certificate of deposit, and
then the bank might lend the money to a small business, receiving in exchange a signed loan. Thus, intermediaries literally
create new types of securities.
Question 02)
Write Short note on the security?
1) Financial Institution
2) Financial Market

FINANCIAL INSTITUTIONS
When raising capital, direct transfers of funds from individuals to businesses are most common for small businesses or in
economies where financial markets and institutions are not well developed. Businesses in developed economies usually find it
more efficient to enlist the services of one or more financial institutions to raise capital most financial institutions don’t compete
in a single line of business but instead provide a wide variety of services and products, both domestically and globally. The
following sections describe the major types of financial institutions and services, but keep in mind that the dividing lines among
them are often blurred. Also, note that the global financial crisis we are now going through is changing the structure of our
financial institutions, and new regulations are certain to affect those that remain. Finance today is dynamic, to say the least!

Investment Banks and Brokerage Activities

Investment banking houses help companies raise capital. Such organizations underwrite security offerings, which means they (1)
advise corporations regarding the design and pricing of new securities, (2) buy these securities from the issuing corporation, and
(3) resell them to investors. Although the securities are sold twice, this process is really one primary market transaction.

Deposit-Taking Financial Intermediaries

Some financial institutions take deposits from savers and then lend most of the deposited money to borrowers. Following is a
brief description of such intermediaries

Savings and Loan Associations (S&Ls).

S&Ls originally accepted deposits from many small savers and then loaned this money to home buyers and consumers. Later,
they were allowed to make riskier investments, such as real estate development. Mutual savings banks (MSBs) are similar to
S&Ls, but they operate primarily in the northeastern states. Today, most S&Ls and MSBs have been acquired by banks.

Credit Unions.
Credit unions are cooperative associations whose members have a common bond, such as being employees of the same firm or
living in the same geographic area. Members’ savings are loaned only to other members, generally for auto purchases, home
improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual
borrowers.

Commercial Banks.
Commercial banks raise funds from depositors and by issuing stock and bonds to investors. For example, someone might deposit
money in a checking account. In return, that person can write checks, use a debit card, and even receive interest on the
deposits. Those who buy the banks’ stocks expect to receive dividends and interest payments. Unlike nonfinancial corporations,
most commercial banks are highly leveraged in the sense that they owe much more to their depositors and creditors than they
raised from stockholders.

Investment Funds
At some financial institutions, savers have an ownership interest in a pool of funds rather than owning a deposit account.
Examples include mutual funds, hedge funds, and private equity funds.

Mutual Funds.
Mutual funds are corporations that accept money from savers and then use these funds to buy financial instruments. These
organizations pool funds, which allows them to reduce risks by diversification and achieve economies of scale in analyzing
securities, managing portfolios, and buying/selling securities Different funds are designed to meet the objectives of different
types of savers. Hence, there are bond funds for those who desire safety and stock funds for savers who are willing to accept
risks in the hope of higher returns. There are literally thousands of different mutual funds with dozens of different goals and
purposes. Some funds are actively managed, with their managers trying to find undervalued securities, while other funds are
passively managed and simply try to minimize expenses by matching the returns on a particular market index.
Money market funds invest in short-term, low-risk securities, such as Treasury bills and commercial paper. Many of these funds
offer interest-bearing checking accounts with rates that are greater than those offered by banks, so many people invest in
mutual funds as an alternative to depositing money in a bank. Note, though, that money market funds are not required to be
insured by the FDIC and so are riskier than bank deposits. Most traditional mutual funds allow investors to redeem their share of
the fund only at the close of business. A special type of mutual fund, the exchange traded fund (ETF), allows investors to sell
their share at any time during normal trading hours. ETFs usually have very low management expenses and are rapidly gaining in
popularity.

Hedge Funds.
Hedge funds raise money from investors and engage in a variety of investment activities. Unlike typical mutual funds, which can
have thousands of investors, hedge funds are limited to institutional investors and a relatively small

Private Equity Funds.

Private equity funds are similar to hedge funds in that they are limited to a relatively small number of large investors, but they
differ in that they own stock (equity) in other companies and often control those companies, whereas hedge funds usually own
many different types of securities. In contrast to a mutual fund, which might own a small percentage of a publicly traded
company’s stock, a private equity fund typically owns virtually all of a company’s stock. Because the company’s stock is not
traded in the public markets, it is called “private equity.”

Life Insurance Companies and Pension Funds

Life insurance companies take premiums, invest these funds in stocks, bonds, real estate, and mortgages, and then make
payments to beneficiaries. Life insurance companies also offer a variety of tax-deferred savings plans designed to provide
retirement benefits.

Traditional pension funds are retirement plans funded by corporations or government agencies. Pension funds invest primarily
in bonds, stocks, mortgages, hedge funds, private equity, and real estate. Most companies now offer self- directed retirement
plans, such as 401(k) plans, as an addition to or substitute for traditional pension plans. In traditional plans, the plan
administrators determine how to invest the funds; in self-directed plans, all individual participants must decide how to invest
their own funds. Many companies are switching from traditional plans to self-directed plans, partly because this shifts the risk
from the company to the employee.

Regulation of Financial Institutions

With the notable exception of investment banks, hedge funds, and private equity funds, financial institutions have been heavily
regulated to ensure their safety and thus protect investors and depositors. Historically, many of these regulations—which have
included a prohibition on nationwide branch banking, restrictions on the types of assets the institutions could buy, ceilings on
the interest rates they could pay, and limitations on the types of services they could provide—tended to impede the free flow of
capital and thus hurt the efficiency of our capital markets. Recognizing this fact, policymakers took several steps from the 1970s
to the 1990s to deregulate financial services companies. For example, the barriers that restricted banks from expanding
nationwide were eliminated. Likewise, regulations that once forced a strict separation of commercial and investment banking
were relaxed.

The result of the ongoing regulatory changes has been a blurring of the distinctions between the different types of institutions.
Indeed, the trend in the United

States was toward huge financial services corporations, which own banks, S&Ls, investment banking houses, insurance
companies, pension plan operations, and mutual funds and which have branches across the country and around the world.
 FINANCIAL MARKETS

Financial markets bring together people and organizations needing money with those having surplus funds. There are many
different financial markets in a developed economy. Each market deals with a somewhat different type of instrument, customer,
or geographic location. Here are some ways to classify markets:

1. Physical asset markets (also called “tangible” or “real” asset markets) are those for such products as wheat, autos, real estate,
computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, derivatives,
and other financial instruments.

2. Spot markets and futures markets are markets where assets are being bought or sold for “on-the-spot” delivery (literally,
within a few days) or for delivery at some future date, such as 6 months or a year into the future.

3. Money markets are the markets for short-term, highly liquid debt securities, while capital markets are the markets for
corporate stocks and debt maturing more than a year in the future. The New York Stock Exchange is an example of

a capital markets. When describing debt markets, “short term” generally means less than 1 year, “intermediate term” means 1
to 5 years, and “long term” means more than 5 years.

4. Mortgage markets deal with loans on residential, agricultural, commercial, and industrial real estate, while consumer credit
markets involve loans for autos, appliances, education, vacations, and so on.

5. World, national, regional, and local markets also exist. Thus, depending on an organization’s size and scope of operations, it
may be able to borrow or lend all around the world, or it may be confined to a strictly local, even neighborhood, market.

6. Primary markets are the markets in which corporations raise new capital. If a company were to sell a new issue of common
stock to raise capital, this would be a primary market transaction. The corporation selling the newly created stock receives the
proceeds from such a transaction. The initial public offering (IPO) market is a subset of the primary market. Here firms “go
public” by offering shares to the public for the first time.

Secondary markets are markets in which existing, already outstanding securities are traded among investors. Thus, if you
decided to buy 1,000 shares of AT&T stock, the purchase would occur in the secondary market. The New York Stock Exchange is
a secondary market, since it deals in outstanding (as opposed to newly issued) stocks. Secondary markets also exist for bonds,
mortgages, and other financial assets. The corporation whose securities are being traded is not involved in a secondary market
transaction and, thus, does not receive any funds from such a sale.

7. Private markets, where transactions are worked out directly between two parties, are differentiated from public markets,
where standardized contracts are traded on organized exchanges. Bank loans and private placements of debt with insurance
companies are examples of private market transactions. Since these transactions are private, they may be structured in any
manner that appeals to the two parties. By contrast, securities that are issued in public markets (for example, common stock
and corporate bonds) are ultimately held by a large number of individuals. Public securities must have fairly standardized
contractual features because public investors cannot afford the time to study unique, non-standardized contracts. Hence private
market securities are more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater
standardization.
Question # 03)

Explain different types of securities?

FINANCIAL SECURITIES
The variety of financial securities is limited only by human creativity, ingenuity, and governmental regulations. At the risk of
oversimplification, we can classify most financial securities by the type of claim and the time until maturity. In addition, some
securities actually are created from packages of other securities.

Type of Claim: Debt, Equity, or Derivatives

Financial securities are simply pieces of paper with contractual provisions that entitle their owners to specific rights and claims
on specific cash flows or values.

Debt Instruments:
Debt instruments typically have specified payments and a specified maturity.
1. Capital market security
If debt matures in more than a year, it is called a capital market security. For example, an Alcoa bond might promise to
pay 10% interest for 30 years, at which time it promises to make a $1,000 principal payment. Thus, the Alcoa bond in this
example is a capital market security.
2. Money market security
If the debt matures in less than a year, it is a money market security. For example, Home Depot might expect to receive
$300,000 in 75 days, but it needs cash now. Home Depot might issue commercial paper, which is essentially an IOU. In this
example, Home Depot might agree to pay $300,000 in 75 days in exchange for $297,000 today. Thus, commercial paper is a
money market security

Equity instruments:
Equity instruments are a claim upon a residual value. For example, Alcoa’s stockholders are entitled to the cash flows generated
by Alcoa after its bondholders, creditors, and other claimants have been satisfied. Because stock has no maturity date, it is a
capital market security.

Derivatives:
Derivatives are securities whose values depend on, or are derived from, the values of some other traded assets. For example,
options and futures are two important types of derivatives, and their values depend on the prices of other assets. An option on
Alcoa stock or a futures contract to buy pork bellies are examples of derivatives.

Some securities are a mix of debt, equity, and derivatives. For example, preferred stock has some features like debt and some
like equity, while convertible debt has both debt-like and option-like features.

A summary of the most important conventional financial securities provided in below table.