Financial Environment

LEARNING OBJECTIVES

This topic provides a look at the financial system, its components and domestic marketplace
in which the Sri Lankan firms operate. It discusses international marketplaces in brief. The
chapter provides an overview of financial system and how funds (scarce resources) are
transferred between savers and investors. The major financial intermediaries and the
operation and structure of secondary security markets are reviewed. Also, some aspects of
international financial markets are covered.

1. Financial System

The role of financial system in an economy is:

• To provide the mechanism by which funds can be transferred from those with surplus
funds to those who wish to borrow.

For the economy as a whole, the savings for a given period of time must equal the
investments in that period of time. This phenomenon is called the savings-investment
cycle.
• To establish fair prices for securities
• To provide liquidity in the market
• To reduce transaction cost

The financial system acts as an intermediary between surplus and deficits;

1. Financial middlemen include brokers (who buy securities for investors), dealers (who
sell securities to investors from their own inventory of securities), and investment
bankers (who help corporations sell their securities).
2. Financial intermediaries sell claims against themselves (called secondary claims) to
surplus spending units in order to get the funds to buy the obligations of the deficit
spending units (called primary claims). Secondary claims frequently possess more
liquidity, safety, and divisibility than primary claims.

A variety of financial intermediaries exist to facilitate the flow of funds between spending
surplus units and deficit spending units.

1. Commercial Banks. They are major suppliers of short-term and intermediate-term

loans to businesses for a variety of purposes. Commercial Banks accept time deposits
and demand deposits. These funds are loaned to individuals, businesses and
governments.
2. Investment companies—mutual funds and real estate investment trusts (REITs).
They pool funds from many savers and invest the funds in a various types of assets.
3. Investment Bankers
• Firms specializing in the sale of new securities to public
• Issuers of securities often rely on an investment banker because - issues of
securities do not raise long-term capital frequently and they usually lack of

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 expertise needed to do the best job possible. - They act as intermediaries between
issuer and investor.
• Investment banker helps companies in their mergers and acquisitions.
4. Pension funds. They pool pension contributions from employers and their employees
and invest the funds in a variety of financial assets.
5. Insurance companies—life insurance and property and casualty companies. The
premiums received by insurance companies are invested in variety of assets. The
proceeds from these assets are used to pay claims against insured events/losses such
as death, disability, accident, fire, etc.
6. Finance companies. They obtain funds by issuing their own debt or by borrowing
from commercial banks. These funds are loaned out to individuals and businesses.

The primary suppliers of capital in Sri Lankan market are mainly financial institutions (i.e.
commercial banks and other primary dealers).

• To allocate funds to their most efficient use amongst competing demands;

• To provide the mechanism for the inner money (the payment mechanism);
• The provision of special financial services such as insurance and pension services.

Flow of Funds through the Financial System

___________________________________________________________________________
Indirect Finance

Financial
Intermediaries
Funds Funds
Funds

Lenders (Savers) Borrowers

1. Households (Spenders)
2. Business Firms 1. Business Firms
3. Government Funds Financial Funds 2. Government
4. Foreigners Markets
3. Households
4. Foreigners
Direct Finance
___________________________________________________________________________

The above figure explains the circular flow of funds in financial system. Business and
government have been net demanders of funds and the household sector the major supplier of
funds in financial system. As the business firms become more sophisticated, investment
requires larger amount of accumulated funds. Therefore, those investors or lenders that did
not spend all their current income on consumption, that is, saved some of their income, could
lend these funds to borrowers, which could use these funds to finance investment. These

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household sector savings are usually channeled to demanders of funds through financial
institutions such as commercial banks, savings and loans, mutual funds, credit unions. Other
intermediaries in the flow-of-funds process include mutual funds, pension plans, and
insurance firms. International investors are also a very important supplier of capital.
However, the business firms involve in this process specially in raising funds for their
required investment. Eventually, in exchange for these funds, firms would issue claims (for
example, share certificates, Treasury bills, Treasury bond, corporate bonds etc). These are
refereed to as financial instruments.

2. Financial Markets and Types of Markets

2.2.1 Market

Any organized system for connecting buyers and sellers. Markets may have a physical
location or may reside only in computer memories.

There are number of ways to classify markets:

1 Money/Capital

Money Market: Short-term market comprised of securities maturing in a year or less.

Capital Market: Long-term market consisting of securities having maturities greater
than one year.
Some assets, such as most bonds, have a fixed lifespan. Others, such as common stock,
have an indefinite life.

2 Primary/Secondary

Primary markets:
A smoothly functioning secondary market aids the primary market, improves liquidity,
and lowers the cost of capital to the firm.

• Primary markets are markets that involve new issues of securities and hence,
provide a direct flow of cash to the issuing entity.
• If a firm is issuing equity to the public for the first time, it is making an Initial
Public Offering (IPO).
• If a firm is already publicly traded and is simply selling more stocks, it is making
Seasoned Offering (SEO).
• Both IPO's and SEO's include both primary and secondary issues.

Secondary Market:

Secondary market exists for the trading of common and preferred stock, warrants,
bonds, and put and calls.
Equity Markets

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 • Common stocks, preferred stocks, and warrants are traded in the equity market.
• Some secondary equity markets are auction markets involving an auction
process in a specific physical location.
• Investors are represented by brokers.
• Other type of secondary market is negotiated market involving a network of
dealers who make a market by standing ready to buy and sell securities at
specific prices. Negotiate market involves the over-the-counter market.

3. Negotiated Market/Over-the-counter (OTC) Market

• Transactions not handled on an organized exchange are handled in this market, that is,
this market essentially handles unlisted securities, or securities not listed on a stock
exchange.

In the US market, OTC trading includes trading in the stocks of small and relatively
unknown companies, many bank and insurance company stocks, most corporate bonds
and preferred stocks, and most U.S. Treasury and municipal bonds.

Price quotations on OTC stocks are available from NASDAQ, the automated quotation
system of the National Association of Security Dealers.

• Unlike organized stock exchanges, the OTC market does not have a specific location.
Rather it is a way of doing business. It consists of a network of dealers linked together
by communications devices, including latest equipment. These dealers conduct
transactions directly with each other and with customers.

4 Call/Continuous

In a call market trading takes place at a specified time intervals. Some call markets
have a provision that limits movement from the prior price. This is to prevent a
temporary order imbalance from dramatically moving the price.

In a continuous market there is trading at all times the market is open.

5 Private Placement

The sale of issue of securities to institutional investors. Firms do not need to register with
SEC, thereby saving both time and money. Investment banker's service is not required. The
underwriting spread is saved. High interest cost and a lack of marketability are some of the
disadvantages.

6 Broker

A broker is a representative appointed by individual investor. Brokers are rewarded through

commission and have an incentive to encourage trade.

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 An advisor: a broker can offer investment advice and information.

Full-service broker: offer a full range of services including information and advice.

Discount broker: offer a restricted range of services at a lower price.

Floor broker: located on the floor of the exchange and does the actual buying and
selling.

Specialist: holds inventory of stock and posts prices.

3. International Financial Markets

An increasing international demand for capital has resulted in the rapid growth and
development of capital markets worldwide. Important events have significantly impacted
international capital markets in recent past. After implementing European Union (EU), it led
to a more competitive and tariff-free Europe. Further, the initiation of the European Monetary
Union (EMU) in January 1999 created a new economic order for Europe. The new European
Central Bank will be responsible for monetary policy throughout the Euro Zone. Securities
markets in Europe may eventually rival Wall Street.

Companies search international markets for borrowing opportunities at the lowest cost and
list their common stock on international exchanges. However, all firms engaged in
international business transactions face unique problems and risks not encountered by firms
that operate in only one country.

Business enterprises participate in the global marketplace in a wide variety of ways.

1. The simplest case would be firms that only import or export finished products or raw
materials.

2. At the other extreme are multinational corporations, which have direct investments in
manufacturing and/or distribution facilities in more than one country.

Firms that are engaged in international financial transactions face the following problems:

1. Firms doing business in different currencies are concerned with fluctuations in the
exchange rates between currencies.

2. Firms doing business in foreign countries face different governmental regulations, tax
laws, business practices, and political environments.

4. Financial Instruments

A financial claim can be defined as a claim to the payment of a sum of money at some future
dates. These are a wide variety of financial instruments in developed financial markets. Each
of those has different characteristics, the most important are: risk, liquidity, real value
certainty, expected return, term to maturity, currency denomination, and divisibility.

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Risk: The future outcome affecting the instruments is not known with certainty. The
uncertainty outcome may be changes in the price of the security, or the default with respect to
repayment of capital or income stream. Although such outcomes are uncertain, an individual
may have some view about the likelihood of particular outcome occurring. As a consequence,
we can assign subjective probabilities to the different outcomes that may occur. The measure
of risk is the standard deviation of the probability distribution.

Liquidity: It refers to the ease and speed at which a financial instrument can be turned into
cash without any loss. A bank sight deposit can be withdrawn or redeemed on demand and is
therefore very liquid. Listed shares can be sold on a stock exchange but the amount of cash
obtained depends on the market valuation at the time of sale. Hence, these are less liquid.
Life policies and pension rights are very illiquid.

Real Value certainty: It refers to the susceptibility to loss due to a rise in the general level of
prices. Share price tends to increase in line or above the rise in the general price level.

Terms of maturity: Financial instruments vary widely according to their characteristics

terms of maturity. Sight deposits at bank have zero term to maturity, as they can be
withdrawn on demand.

Currency denomination: This adds a further component to the return on non-domestic

instruments in the form of the appreciation or depreciation of the relevant exchange rate.

Divisibility: It reflects the degree to which the instruments can be subdivided into small units
for transaction purposes. A saving deposit is fully divisible. Treasury bills are sold in
minimum denomination and hence are not divisible.

1. Corporate Securities

Security: "A legal contract representing the right to receive future benefits under a stated set
of conditions."

The piece of paper defining the property rights is the security.

New issues of corporate securities have been predominantly common stock in Sri Lanka.
Since 1987 firms have been financed with about 60 percent equity and 40 percent debt.
Though very similar to debt, the lack of the tax deductibility of preferred stock dividends has
constrained preferred stock issue to very small percentage. Among the debt financing
corporate bonds also accounted for very smaller percentage, because of our debt market is
also in its infant stage.

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 Major Financial Instruments Available in Sri Lanka

Instrument Issuer Principle features

MONEY MARKET
Treasury Bills Government Treated as the market risk free rate

Repurchase (Repo) Licensed Commercial Banks Investment in TB on the basis of repurchase

(LCBs) and primary dealers agreement (SB sells TBs out of its own holdings
and absorbs liquidity), Short-term maturities

Rev-repurchase agreement Central Bank CBSL purchase TBs from LCBs and primary
dealers at a discount price with an agreement to
sell back on an agreed date, at an agreed price

Commercial paper, Non-financial Corporations Fixed payment on maturity, up to 270 days

Banker Acceptances Bankers Letter of credit (a bank promise to pay) that has
been stamped "guranteed" by another bank. Like
post dated cheque. Used widely in international
finance.

Eurodollar US commercial banks US dollar denominated deposits of US

commercial banks with banks in foreign
countries. These IOUs are actively traded in all
international exchanges based on current
exchange rates.
CAPITAL MARKET

Common stock Public Companies Holder takes ownership position. Expects cash
flows in form of dividends and capital gain
indefinite maturity

Preferred stocks Public Companies An unlimited maturity quasi-debt instrument

with a fixed dividend.

Corporate Bonds Public Companies No ownership, fixed payments of principal and

interest,

Treasury Bonds Government 2 to 6 years maturities

Sri Lanka Dev. Bonds Government Fixed payments on maturity, US Dollar

denominated

Rupee Loans Government A fixed rate of interest. Medium and long term
borrowing from 2 to 8 years maturities

Mutual funds Different fund mgmt Portfolio of stocks, bonds or other instruments.
Deposits companies Funds companies are owned by investors (there
are no shareholders). Shares are offered by the
fund company in the primary market.
Redeemable at market value, fixed periodic
payment of interest

Whole-life insurance policy Insurance companies Life insurance with savings element

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5. Capital market Regulation
Securities Exchanges

Securities and Exchange Commission of Sri Lanka (SEC)

The government regulates the securities business.

1. Because of many abuses such as incomplete and fraudulent information,

government enacted the Registered Stock and Securities Amendments Act No 27
of 1985.

2. Following the experience 1929 stock market crash in the US, the Sri Lankan
government enacted its regulation, the Securities Exchange Commission Act No
36 of 1987. Federal legislation has been aimed primarily at ensuring full
disclosure of security information.

2. The Securities and Exchange Commission (SEC) regulates the disclosure of

information in new security offerings and sets disclosure requirements for
nearly all firms trading publicly.
3. The SEC also regulates "insider" trading, which includes trading done by
directors, officers, and major shareholders of a corporation. All trading by
insiders must be reported to the SEC. In addition, the SEC attempts to
prevent insiders from secretly trading securities on the basis of private
information that outside shareholders do not possess.

Colombo Stock Exchange (CSE)

Share trading in Sri Lanka dates back to 1896 when the Colombo Brokers Association
commenced the share trading in limited liability companies which were involved in
opening plantations in the country. The establishment of a formal stock exchange in
1985 and the incorporation of the Colombo Stock Exchange marked a milestone in the
history of share trading in Sri Lanka.

The Colombo Stock Exchange (CSE) is a company limited by guarantee, and

established under the Companies Act No. 17 of 1982. The CSE took over the Stock
Market in 1985 from the Colombo Share Brokers Association. It currently has a
membership of 15 institutions, all of which are licensed to operate as stockbrokers.

The policy making body of the Stock Exchange is its Board of Directors - consisting of
9 Directors. The members elect five Directors and the Minister of Finance appoints four
Directors. Currently, the Board has appointed five sub-committees to administer the
operations of the Exchange. The Exchange Secretariat, headed by the Director General,
is responsible for the operations of the Exchange and is accountable to the Board of
Directors.

Since it commenced operations the CSE has initiated a number of measures to improve
the market's infrastructure and regulatory framework to facilitate an orderly and fair
market. To date (by the end of 2002), the exchange has 242 listed companies,

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representing 20 business sectors with a market capitalisation of over 145 billion rupees
(over US $ 1.5 billion), which correspond to approximately 8% of the country's GDP.

The CSE is aware of the fact that technology and infrastructure alone does not build a
dynamic stock market. Therefore, the Exchange has formulated strategies focusing
specifically on its future direction. Capitalising on its strengths in systems, infrastructure
and regulation, the CSE is currently moving towards market development and
diversification.

Organization Structure of the CSE

Board of Directors

Director General

Senior Management

♦ Finance & Administration

♦ Information Technology
♦ Marketing & Public Relations
♦ Clearing & Settlement
♦ Listing & Surveillance
♦ Operations

Central Depository System

The Central Depository Systems (CDS) provides depository facilities and clearing
services for securities traded on the Colombo Stock Exchange. The CDS is a 100%
owned subsidiary of the Colombo Stock Exchange (CSE). The Board of Directors
constitutes the CDS's policy-making body. The Board consists of nine Directors. Five
directors are elected to office by the members of the CSE and four directors are
nominated by the Ministry of Finance.

6. Market Indices

Stock market indexes give an indication of how the stock market, or some segment of it, is
performing. The Colombo Stock Exchange has two main Price Indices and twenty Sector
Price Indices based on the business activities of companies.
Sector Price Indices
The market has been divided into 20 sectors and the price indices for each sector are
calculated on a daily basis. Each index indicates the direction of the price movement of
the sector.
The two main Price Indices are:

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• All Share Price Index (ASPI), which comprises all listed companies on the
market.
• Milanka Price Index (MPI), which is based on 25 selected companies.
These Price Indices are capital weighted indices. The weight of any company is taken as
the number of ordinary shares listed on the market. This weighting system allows the
price movements of larger companies to have a greater impact on the index. Such a
weighting system was adopted on the assumption that the general economic situation
has a greater influence on larger companies than on smaller ones.

The daily trading activity results in market price changes and this in turn changes
market capitalisation, which affects price indices. There are, however, exceptions other
than market price changes. Sometimes the number of listed shares will increase or
decrease and this will affect the market capitalisation of companies. In order to avoid
the fluctuation of Price Indices, the Base Market Capitalisation and Market
Capitalisation are adjusted in such instances.

All Share Price Index

The All Share Price Index (ASPI) is based on the share movements of all companies on
the stock market. Calculations for the ASPI use 1985 as a base year.

Market Capitalization of All Listed Companies

ASPI = x 100
Base Market Capitaliztion
Where:
Market Capitalisation = Number of Issued Shares of a Company x Market Price
Base Market Capitalisation = Number of Issued Shares at Base Year (1985) x Base Market Price

Milanka Price Index

The Milanka Price Index (MPI) was introduced in January 1999. The criteria taken into
account in the construction of the Milanka Price Index are:

The size of the companies (measured by market capitalisation)

The liquidity of the companies (measured by the number of trades executed, and
the trading value as a percentage of the average market capitalisation)

The MPI comprises 25 companies representing 8 sectors. The Index represents over
10% of all listed companies and accounts for over 50% of the total market capitalisation
of the CSE.

Calculations for the MPI use 1998 as a base year.

Market Capitalization of 25 Selected Companies
MPI = x 100
Base Market Capitaliztion of those Selected 25 Companies as at 31st December1998

The Milanka Price Index (MPI) is revised annually.

Total Return Index (TRI)

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Total Return Index series reflect returns due to both price changes and dividend income,
whereas the price indices reflect only the price movements of the underlying shares. In
computing the TRI, it is assumed that dividends earned from a share are re-invested in
the market.
Commencing from 2nd January 2004, the ASPI, MPI, and Sector Indices are being
published daily, using both price and total return bases. The ASPI computed on total
returns is known as ASTRI and the MPI computed on total return is known as MTRI.

Computation methodology
Adjustment for Cash Dividend

Where:
Dividend per share of the i the component security
Weighting of the i the component security (equal to the number of ordinary
shares issued by the company)
B Base market capitalization of the relevant price index

Computation of TRI

The formula used for calculating TRI is given below:

Where:
Total Returns Index value today
Total Returns Index value previous day
Underlying Price Index today
Underlying Price Index previous day
XDJ Ex-dividend adjustment as computed above

Total Return Indices: As at 02-Mar-2006 02:30

Change %
ASTRI 2,395.20 3.95 0.17%
MTRI 3,044.00 9.26 0.31%

New Listings 2006

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 ATL Amana Takaful Limited November27, 2006
VPEL Vallibel Power Erathna Ltd May16, 2006

List of Stock Brokering Firms The industrial sectors as classified by the

CSE
1. Asha Phillip Securities. Ltd
1. Banks, Finance and Insurance
2. Asia Securities (Pvt) Ltd.
2. Beverage, Food and Tobacco
3. Bartleet Mallory Stockbrokers(Pvt) Ltd.
3. Chemicals and Pharmaceuticals
4. CT Smith Stockbrokers (Pvt) Ltd.
4. Construction and Engineering
5. Ceylinco Stockbrokers (Pvt) Ltd.
5. Diversified Holdings
6. DFCC Stockbrokers (Pvt) Ltd
6. Footwear and Textiles
7. DP Global Securities (Pvt) Ltd.
7. Healthcare
8. HNB Stockbrokers (Pvt) Ltd
8. Hotels and Travels
9. JB Securities (Pvt) Ltd..
9. Information Technology
10. John Keells Stockbrokers (Pvt) Ltd.
10. Investment Trusts
11. Lanka Orix Securities (Pvt) Ltd.
11. Land and Property
12. Lanka Securities (Pvt) Ltd.
12. Manufacturing
13. NDBS Stockbrokers (Pvt) Ltd.
13. Motors
14. SC Securities (Pvt) Ltd.
14. Oil Palms
15. Somerville Stockbrokers (Pvt) Ltd
15. Plantations
16. Power and Energy
17. Services
18. Stores and Supplies
19. Telecommunication
20. Trading

More Frequently Quoted International Stock Indexes

The Dow Jones Industrial Average (DJIA), which is based on the prices of 30,
large, well-established stocks. The DJIA is based on the prices of these 30 stocks,
which are divided by a number reflecting prior stock dividends and splits.

The Dow Jones Transportation Average is based on 20 major railroad, airline, and
trucking stocks, and the Dow Jones Utility Average is derived from the prices of 15
major utility stocks. The DJIA Composite Average is based on a combination of the
DJIA, Dow Jones Transportation Average, and the Dow Jones Utility Average.

The Standard and Poor's 500 Stock Price Index (S&P 500) is a broader index than
the DJIA. It is derived from the prices of 400 leading industrial firms, 20
transportation firms, 40 utilities, and 40 financial institutions. The S&P 500 is a
market value-weighted index, which means that a stock whose total market value is
$100 million influences the index twice as much as a stock whose total market value
is $50 million.

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