Financial Markets & Investment Strategies
1. Introduction to Financial Markets
Definition:
Financial markets are systems that allow people to buy and sell financial
instruments such as stocks, bonds, and derivatives. They are essential for
mobilizing savings, facilitating investment, and promoting economic growth.
Importance for Business Students:
- Helps
understand how businesses raise capital.
- Improves
decision-making in investment and financial planning.
- Essential
for careers in finance, banking, and entrepreneurship.
2. Stock Markets, Bond Markets & Alternative
Investments
A. Stock Markets
A stock market enables investors to buy ownership in
companies through shares.
Formulae:
- Market
Cap = Share Price × No. of Shares
- Dividend
Yield = (Annual Dividend ÷ Share Price) × 100
- P/E
Ratio = Price per Share ÷ EPS
Benefits for Business Students:
- Understanding
equity financing.
- Learning
how market valuation affects business reputation.
Solved Question 1:
A company has 2 million shares trading at PKR 50. Annual dividend = PKR
3/share.
Find: Market Capitalization and Dividend Yield.
Solution:
Market Cap = 2,000,000 × 50 = PKR 100,000,000
Dividend Yield = (3 ÷ 50) × 100 = 6%
Solved Question 2:
EPS = 10, Market Price = 120. Find: P/E Ratio.
Solution:
P/E = 120 ÷ 10 = 12 times
B. Bond Markets
Definition: A market where investors trade debt
instruments issued by corporations or governments.
Types:
- Government
Bonds
- Corporate
Bonds
- Municipal
Bonds
- Zero-Coupon
Bonds
Benefits for Business Students:
- Teaches
long-term financing and interest rate sensitivity.
Solved Question 1:
A PKR 1,000 bond with 8% coupon trades at PKR 950. Find Current Yield.
Solution:
(80 ÷ 950) × 100 = 8.42%
Solved Question 2:
If the bond matures in 5 years and pays annual interest, calculate total
interest income.
Solution: 80 × 5 = PKR 400
C. Alternative Investments
Definition: Non-traditional assets like real estate,
hedge funds, and crypto.
Importance: Diversifies portfolios, reducing overall risk.
Solved Question 1:
Investment in gold (return 12%) and property (return 9%) find average
return.
Solution: (12 + 9) ÷ 2 = 10.5%
Solved Question 2:
If investment in real estate increases 15%, find the new portfolio return.
Solution: New average = (12 + 15) ÷ 2 = 13.5%
3. Portfolio Management & Asset Allocation
A. Portfolio Management
The process of constructing and managing investments to meet
financial goals.
Portfolio Management & Asset Allocation in Strategic
Finance
1. Meaning of Portfolio Management
Portfolio Management refers to the art and science of
selecting and overseeing a group of investment assets such as stocks, bonds,
mutual funds, real estate, or cash equivalents so that the overall return
aligns with an investor’s risk tolerance, time horizon, and financial goals.
It involves:
- Continuous
monitoring of investments
- Rebalancing
of assets
- Risk
diversification to maximize return at an acceptable risk level
In Strategic Finance, portfolio management ensures
that financial resources are allocated efficiently to create sustainable
value for shareholders and support long-term corporate objectives.
2. Meaning of Asset Allocation
Asset Allocation is the process of dividing an
investment portfolio among different asset categories such as equities, fixed
income, and cash to balance risk and reward according to the organization’s or
investor’s financial strategy.
Asset allocation decisions are strategic, as they
determine what proportion of total funds will be invested in various
asset classes, depending on:
- Risk
appetite
- Expected
rate of return
- Economic
outlook
- Liquidity
needs
3. Importance in Strategic Finance
|
Aspect |
Explanation |
Example |
|
1. Risk Diversification |
Strategic finance focuses on minimizing overall portfolio
risk by spreading investments across multiple asset classes. |
A company invests 40% in government bonds, 30% in
blue-chip stocks, and 30% in real estate to avoid dependence on one asset
class. |
|
2. Enhancing Returns |
Effective asset allocation ensures optimal use of
financial resources to achieve higher risk-adjusted returns. |
A pension fund adjusts its portfolio towards equities
during an economic boom to capture growth returns. |
|
3. Alignment with Strategic Goals |
Portfolio management aligns investment decisions with the
firm’s broader strategic financial objectives (e.g., expansion, liquidity,
stability). |
A corporation invests surplus cash in short-term bonds to
maintain liquidity for future acquisitions. |
|
4. Financial Stability |
Helps organizations maintain balance between risk and
return, reducing the impact of market fluctuations on capital structure. |
During a recession, the firm shifts from high-risk stocks
to stable bonds and cash equivalents. |
|
5. Long-term Value Creation |
Strategic asset allocation supports sustainable growth and
wealth maximization. |
A university endowment fund invests in a mix of equities
and real estate for long-term growth while maintaining liquidity for
scholarships. |
|
6. Capital Preservation |
Protects corporate or investor funds from excessive market
risk through balanced investments. |
A family office invests 25% in gold, 25% in fixed
deposits, and 50% in diversified mutual funds. |
4. Real-World Example
Example: Apple Inc.
Apple’s strategic finance team manages its massive cash reserves through portfolio
diversification:
- Investments
in U.S. Treasury securities, corporate bonds, and foreign
marketable securities
- Ensures
liquidity, capital safety, and steady returns
- Supports
Apple’s strategic goals such as R&D funding and share buybacks
Example: Pension Funds
Pension funds apply strategic asset allocation by investing in:
- Equities
(for long-term growth)
- Bonds
(for income stability)
- Real
assets (for inflation protection)
This diversification ensures stable returns to meet
future liabilities.
Formula:
Formula:
How to Read It (In Words):
“Sigma p equals the square root of
open bracket
w1 squared times sigma1 squared,
plus w2 squared times sigma2 squared,
plus two times w1 times w2 times the covariance of r1 and r2
close bracket.”
Meaning of Each Symbol:
|
Symbol |
Meaning |
|
σp |
Standard deviation (or risk) of the portfolio |
|
w₁, w₂ |
Weights (proportions) of total investment in asset
1 and asset 2 |
|
σ₁, σ₂ |
Standard deviations (individual risks) of asset 1
and asset 2 |
|
Cov(r₁, r₂) |
Covariance between the returns of asset 1 and asset
2 (shows how the two move together) |
|
√ |
Square root used to calculate the overall risk |
Conceptual Explanation:
This formula gives the total risk (standard deviation)
of a two-asset portfolio.
It considers:
- The individual
risks of each asset (σ₁ and σ₂),
- The weights
of each asset in the portfolio (w₁ and w₂),
- The relationship
between their returns (covariance).
Simplified Example:
Suppose:
- Asset
1 = 50% of portfolio → w₁ = 0.5
- Asset
2 = 50% of portfolio → w₂ = 0.5
- σ₁ =
10% (0.10)
- σ₂ =
20% (0.20)
- Cov(r₁,
r₂) = 0.01
Then:
So the portfolio’s overall risk = 13.2%.
Question 1
Find the portfolio risk (σₚ):
You have the following data for a two-asset portfolio:
|
Item |
Asset 1 |
Asset 2 |
|
Weight (w) |
0.6 |
0.4 |
|
Standard Deviation (σ) |
12% |
18% |
|
Covariance [Cov(r₁, r₂)] |
0.008 |
Solution:
✅ Answer: Portfolio risk =
11.92%
Explanation:
Although Asset 2 is riskier (18%), diversification reduces
total risk to 11.92%.
The covariance term accounts for how the two assets move together—positive
covariance increases risk; negative covariance would reduce it.
Question 2
Find σₚ when covariance is negative.
|
Item |
Asset 1 |
Asset 2 |
|
Weight (w) |
0.5 |
0.5 |
|
Standard Deviation (σ) |
10% |
16% |
|
Covariance [Cov(r₁, r₂)] |
–0.006 |
Solution:
✅ Answer: Portfolio risk =
7.68%
Explanation:
Because covariance is negative, the two assets move
in opposite directions, reducing the portfolio’s total risk
significantly — an excellent example of diversification benefit.
Question 3
Calculate portfolio risk when both assets move perfectly
together (ρ = +1).
If correlation (ρ) = +1, covariance = ρσ₁σ₂ =
(1)(0.08)(0.12) = 0.0096
|
Item |
Asset 1 |
Asset 2 |
|
Weight (w) |
0.7 |
0.3 |
|
Standard Deviation (σ) |
8% |
12% |
|
Covariance [Cov(r₁, r₂)] |
0.0096 |
Solution:
✅ Answer: Portfolio risk =
9.2%
Explanation:
When correlation is perfectly positive (+1), both
assets move together, so diversification gives no reduction in risk.
The portfolio’s risk is nearly a weighted average of individual risks.
Benefits for Business Students:
- Helps
in decision-making for company investment strategies.
- Useful
for entrepreneurship and personal finance.
B. Asset Allocation Strategies
Types:
- Strategic:
Fixed long-term mix.
- Tactical:
Short-term adjustments.
- Dynamic:
Continuous rebalancing.
Behavioral Finance and Investor Psychology
1. Introduction
In traditional finance theory, investors are assumed to be rational
meaning they make decisions based purely on logic, facts, and available
information.
However, in reality, human emotions and psychological biases strongly
influence investment decisions.
This leads us to the study of Behavioral Finance a modern field that combines psychology
and finance to explain why investors sometimes make irrational
financial decisions.
2. Definition of Behavioral Finance
Behavioral Finance is the study of how psychological
factors, such as emotions and cognitive biases, influence the financial
decisions of individuals and markets.
It challenges the traditional assumption that all investors
act rationally to maximize their wealth.
3. Key Concepts of Behavioral Finance
|
Concept |
Explanation |
Example |
|
Cognitive Biases |
Systematic errors in thinking that affect decisions. |
An investor keeps a losing stock, believing it will
recover soon (Overconfidence Bias). |
|
Emotions |
Feelings like fear and greed that affect decision-making. |
During market crashes, fear leads many investors to sell
at a loss. |
|
Heuristics |
Mental shortcuts or rules of thumb that simplify decisions
but can lead to mistakes. |
“If everyone is buying a stock, it must be good.” |
|
Herd Behavior |
Investors follow the crowd instead of analyzing facts. |
The 2008 housing bubble occurred as many bought homes
simply because others were doing so. |
|
Loss Aversion |
The pain of losing money is stronger than the joy of
gaining it. |
An investor avoids selling a losing stock to avoid
admitting loss. |
4. Definition of Investor Psychology
Investor Psychology refers to the emotions,
attitudes, and thought processes that shape how individuals make investment
and financial decisions.
It focuses on why investors behave the way they do
not just what decisions they make.
5. Importance of Behavioral Finance and Investor
Psychology
|
Importance |
Explanation |
|
1. Better Decision-Making |
Helps investors understand emotional triggers that lead to
poor financial choices. |
|
2. Risk Management |
By recognizing biases, investors can avoid overconfidence
or panic-driven decisions. |
|
3. Market Efficiency |
Explains anomalies like stock bubbles and crashes that
traditional finance cannot. |
|
4. Portfolio Optimization |
Behavioral insights help in balancing emotions and logic
when diversifying portfolios. |
|
5. Financial Education |
Teaches investors to be more disciplined and long-term
focused. |
6. Real-World Examples
Example 1: Dot-Com Bubble (1999–2000)
- Investors
overreacted to new internet companies, buying tech stocks without
analyzing fundamentals.
- Herd
behavior and overconfidence led to inflated prices.
- When
the bubble burst, markets crashed, causing massive losses.
Example 2: 2008 Global Financial Crisis
- Many
believed real estate prices would never fall.
- Banks
and investors ignored warning signs due to confirmation bias
(focusing only on positive data).
- Panic
selling (fear) deepened the crisis.
Example 3: Individual Investor Example
- A
student invests in cryptocurrency because all their friends are doing it.
- This
is an example of herd behavior and fear of missing out (FOMO).
- Without
research, such decisions are emotionally driven, not rational.
7. Behavioral Biases Common Among Investors
|
Bias |
Meaning |
Effect on Investment |
|
Overconfidence Bias |
Overestimating one’s knowledge or prediction ability |
Taking excessive risks |
|
Anchoring Bias |
Relying too heavily on the first piece of information |
Holding a stock because of its past high price |
|
Confirmation Bias |
Paying attention only to information that supports
existing beliefs |
Ignoring warning signals about a bad investment |
|
Herding Behavior |
Following others without analysis |
Buying/selling because “everyone else is” |
|
Loss Aversion |
Fear of losses stronger than desire for gains |
Selling winners too early, holding losers too long |
8. Practical Strategies to Reduce Behavioral Mistakes
✅ Set clear investment goals
and stick to them.
✅
Use data and research instead of emotions when deciding.
✅
Diversify to reduce risk exposure.
✅
Keep a long-term perspective — avoid reacting to short-term market
noise.
✅
Maintain an investment diary to reflect on past decisions and biases.
Financial Technology (FinTech) & Sustainable
Investing
1. Introduction
In today’s fast-changing financial world, technology
and sustainability are reshaping how we invest, save, and manage money.
Two key trends defining modern finance are:
- Financial
Technology (FinTech)the digital transformation of financial services.
- Sustainable
Investing investing with the goal of achieving both financial
returns and positive social or environmental impact.
2. Definition of Financial Technology (FinTech)
FinTech refers to the use of technology and
innovation to deliver financial services more efficiently, securely,
and accessibly.
It combines finance and technology to improve
banking, payments, investing, lending, and financial management.
3. Importance of FinTech in Modern Finance
|
Importance |
Explanation |
Example |
|
1. Financial Inclusion |
Provides access to banking and payments for people without
traditional bank accounts. |
Mobile money services like Easypaisa and JazzCash
in Pakistan. |
|
2. Convenience & Speed |
Online platforms allow 24/7 transactions, instant
payments, and digital investments. |
Internet banking and digital wallets (PayPal, Apple Pay). |
|
3. Cost Efficiency |
Reduces operational costs for banks and customers through
automation. |
Robo-advisors providing low-cost investment advice. |
|
4. Innovation in Payments |
Enables cashless transactions and contactless
technologies. |
QR code payments and mobile wallets. |
|
5. Transparency & Security |
Blockchain and AI enhance trust, recordkeeping, and fraud
detection. |
Blockchain-based systems in cryptocurrency like
Bitcoin and Ethereum. |
|
6. Growth of Startups |
Encourages entrepreneurship and innovation in financial
services. |
FinTech startups like Revolut, NayaPay, and Stripe. |
4. Examples of FinTech Applications
|
Area |
FinTech Example |
Explanation |
|
Payments |
Easypaisa, PayPal |
Instant money transfer using smartphones. |
|
Investment Platforms |
Robinhood, Sarmayacar |
Mobile apps for stock and startup investments. |
|
Blockchain & Crypto |
Bitcoin, Ethereum |
Decentralized digital currencies for secure transactions. |
|
Lending |
Finja, Qarz.pk |
Online peer-to-peer (P2P) loan platforms. |
|
Insurance (InsurTech) |
TPL Insurance digital services |
Online claim processing and AI-based premium setting. |
|
Wealth Management |
Betterment, Wahed Invest |
Robo-advisors providing automated investment guidance. |
5. Definition of Sustainable Investing
Sustainable Investing means making investment
decisions that consider both financial returns and environmental,
social, and governance (ESG) factors.
It aligns investments with ethical values, climate
goals, and social responsibility.
6. Importance of Sustainable Investing
|
Importance |
Explanation |
Example |
|
1. Long-Term Value Creation |
Focuses on companies with sustainable growth and good
governance. |
Investing in renewable energy firms like Tesla or ENGRO
Energy. |
|
2. Environmental Protection |
Encourages eco-friendly business practices. |
Investment funds that avoid fossil fuels and support green
energy. |
|
3. Social Responsibility |
Promotes fair labor, diversity, and human rights. |
Impact funds investing in women-led businesses or
education startups. |
|
4. Risk Management |
Companies with strong ESG performance are less exposed to
scandals and regulations. |
Investors prefer firms with transparent sustainability
reports. |
|
5. Investor Demand |
Increasing interest from millennials and institutions in
ethical investments. |
ESG-based mutual funds are growing rapidly worldwide. |
|
6. Policy Support |
Governments and regulators promote green finance and
sustainable bonds. |
Green Bonds issued by the World Bank or Pakistan’s
State Bank. |
7. Examples of Sustainable Investing
|
Type |
Description |
Example |
|
ESG Investing |
Screening companies based on Environmental, Social, and
Governance criteria. |
Excluding tobacco or coal companies from portfolios. |
|
Impact Investing |
Directly investing in projects that generate measurable
social or environmental impact. |
Investing in solar energy startups in rural areas. |
|
Green Bonds |
Bonds used to finance environmentally sustainable
projects. |
Pakistan’s Green Eurobond (2021) to fund clean
energy. |
|
Socially Responsible Funds (SRFs) |
Mutual funds that invest in ethically responsible
companies. |
Dow Jones Sustainability Index (DJSI) includes such
firms. |
8. Relationship Between FinTech and Sustainable Investing
FinTech and Sustainable Investing increasingly support each
other:
|
FinTech Role |
Impact on Sustainable Investing |
|
Digital Platforms |
Make ESG investment opportunities accessible to small
investors. |
|
Blockchain |
Improves transparency and tracking of sustainable
projects. |
|
Data Analytics |
Helps investors measure a company’s ESG performance. |
|
Crowdfunding |
Supports small green or social projects by collecting
funds online. |
Example:
Platforms like Trine allow individuals to invest small amounts in
renewable energy projects in developing countries using FinTech tools.
9. Real-World Case Examples
Example 1: Wahed Invest (Islamic FinTech)
- Offers
Shariah-compliant online investment services.
- Promotes
ethical finance and transparency — blending FinTech with
sustainability.
Example 2: Tesla & ESG Funds
- ESG
investors prefer companies like Tesla, which focus on electric
vehicles and renewable energy.
- Represents
the environmental aspect of sustainable investing.
Example 3: Pakistan’s Green Bonds (2021)
- Government
issued USD 500 million Green Eurobonds to fund hydroelectric and
clean energy projects.
- Example
of sustainable finance initiative.
Derivatives & OTC Markets
1. Derivatives
Definition:
A derivative is a financial contract whose value is
derived from the performance of an underlying asset such as stocks, bonds,
commodities, interest rates, or market indexes.
Common types include futures, options, forwards, and swaps.
Explanation:
- The
value of a derivative depends on another asset.
- For
example, a gold futures contract derives its value from the current
and expected price of gold.
- Derivatives
are widely used for hedging risk or speculative purposes.
Types of Derivatives
1. Futures Contracts
Definition:
A futures contract is a standardized agreement
to buy or sell an asset (such as commodities, currencies, or financial
instruments) at a fixed price on a specific future date, traded through
an organized exchange (like the Pakistan Mercantile Exchange or CME).
✅
Purpose: Used for hedging price risk.
2. Forward Contracts
Definition:
A forward contract is a customized agreement
between two parties to buy or sell an asset at a specific future date
for a price agreed upon today.
It is not traded on an exchange, but rather in the OTC
(Over-the-Counter) market.
✅
Purpose: Used for hedging exchange rate risk.
3. Options Contracts
Definition:
An option is a financial contract that gives the buyer
the right (but not the obligation) to buy or sell an asset at a predetermined
price within a certain period.
- Call
Option: Right to buy
- Put
Option: Right to sell
✅ Purpose: Used for speculation and limited-risk hedging.
4. Swaps
Definition:
A swap is a private agreement between two
parties to exchange cash flows or financial obligations over a period of
time.
Common types include:
- Interest
Rate Swaps
- Currency
Swaps
- Commodity
Swaps
Example:
A company with a variable-rate loan enters into an interest
rate swap with a bank.
The company agrees to pay a fixed rate and receive a floating rate
from the bank.
This helps the company stabilize interest payments even if market rates
rise.
✅
Purpose: Used for managing interest rate or currency risk.
Summary Table
|
Derivative Type |
Traded On |
Obligation |
Customizable |
Main Use |
Example |
|
Futures |
Exchange |
Yes |
No |
Hedge or Speculate |
Wheat futures contract |
|
Forwards |
OTC |
Yes |
Yes |
Hedge risk |
Exporter fixes exchange rate |
|
Options |
Exchange or OTC |
No (Right, not obligation) |
Partly |
Speculate or Hedge |
Call option on stock |
|
Swaps |
OTC |
Yes |
Yes |
Manage interest/currency risk |
Interest rate swap with bank |
Importance:
- Risk
Management:
Businesses and investors use derivatives to hedge against fluctuations in prices, interest rates, or exchange rates.
Example: An airline company may buy fuel futures to lock in fuel prices. - Price
Discovery:
Derivative markets help in determining the future price expectations of assets.
Example: Wheat futures prices help farmers estimate future crop prices. - Market
Efficiency:
Derivatives link different financial markets, promoting liquidity and improving efficiency.
Example: Investors use stock index futures to quickly adjust portfolio risk.
Question:
An investor buys a call option on 100 shares of XYZ
Ltd. at a strike price of PKR 50 per share.
The investor pays a premium of PKR 5 per share.
At expiration, the stock price rises to PKR 65 per share.
Tasks:
- Calculate
the profit the investor makes.
- What
would be the loss if the stock price falls to PKR 45 per share?
Solution:
Step 1: Understand the problem
- Call
option gives the right to buy at PKR 50.
- Premium
= PKR 5 per share.
- Number
of shares = 100.
Step 2: Profit if stock price rises to PKR 65
Step 3: Loss if stock price falls to PKR 45
Since the option is not exercised, the loss is limited to the premium
paid:
Answer:
- Profit
if stock rises to 65: PKR 1,000
- Loss
if stock falls to 45: PKR 500
This example clearly demonstrates the limited-risk,
leveraged nature of options — a key concept in derivatives.
2. OTC (Over-the-Counter) Markets
Definition:
The Over-the-Counter (OTC) market is a decentralized
market where financial instruments like derivatives, bonds, currencies, and
small-cap stocks are traded directly between two parties without going
through an exchange.
Explanation:
- OTC
markets operate through a network of dealers or brokers.
- Transactions
are private and less regulated compared to exchange-traded
markets.
- Examples
include forward contracts, swap agreements, and corporate
bonds.
Importance:
- Flexibility:
OTC contracts can be customized according to the needs of the buyer and seller.
Example: A bank and a company can design a currency swap matching their specific currencies and rates. - Access
to Unique Instruments:
Investors can trade assets not listed on formal exchanges.
Example: Small technology firms’ shares are often traded OTC before being listed. - Global
Financial Integration:
OTC markets enable international firms to manage exposure across countries.
Example: Multinational corporations use OTC derivatives to manage exchange rate risks.
Example:
A Pakistani exporter expecting USD payments in three months
enters an OTC forward contract with a bank to fix the exchange rate.
This helps avoid losses if the dollar weakens in the future.
Question:
A Pakistani exporter expects to receive USD 200,000
in 3 months. The current exchange rate is PKR 280/USD, but the exporter
is worried that the PKR may strengthen in the future, reducing the PKR value of
the payment.
The exporter enters into an OTC forward contract with
a bank to sell USD 200,000 at a forward rate of PKR 282/USD after 3
months.
Tasks:
- Calculate
the PKR amount the exporter will receive after 3 months under the
forward contract.
- Explain
how the forward contract hedges the currency risk.
Solution:
Step 1: Calculate PKR amount under the forward contract
✅ The exporter will receive PKR
56,400,000 after 3 months.
Step 2: Explain risk hedging
- Without
the forward contract, the exporter would receive PKR 56,000,000 if
the rate remained at 280, but if PKR strengthens to 275/USD, the payment
would fall to:
- By
entering the OTC forward contract at PKR 282/USD, the exporter locks
in the rate, eliminating the exchange rate risk.
- Even
if the PKR strengthens or weakens, the exporter is guaranteed PKR
56,400,000.
Answer:
- PKR
amount received under forward contract: PKR 56,400,000
- Hedging
Explanation: The forward contract eliminates exchange rate risk by
locking in a guaranteed rate, protecting the exporter from currency
fluctuations.
