Chapter

Role of Financial Markets and Institutions

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Chapter Objectives
Describe the types of financial markets that facilitate the flow of
funds,

Describe the role of financial institutions within financial

markets, and

Identify the types of financial institutions that facilitate

transactions in financial markets.

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Overview of Financial Markets

Financial Market:
A market in which financial assets (securities) such as stocks and
bonds can be purchased or sold. Funds are transferred in financial
markets when one party transfers funds in financial markets by
purchasing financial assets previously held by another party.
Financial markets facilitate the flow of funds and thereby allow
financing and investing by households, firms, and government
agencies.

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Overview of Financial Markets, cont..

The main participants in financial market transactions are
households, businesses and governments that purchase or sell
financial assets.
Surplus Units:
Those participants who receive more money than they spend are
referred to as surplus units. They provide their net savings to the
financial markets.
Deficit Units:
Those participants who spend more money than they receive are
referred to as deficit units. They access funds from financial markets
so that they can spend more money than they receive.
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Types of Financial Markets

We generally differentiate among financial markets based on-

1. The types of investments;

2. Maturities of investments;
3. Types of borrowers and lenders;
4. Location of the markets; and
5. The type of transactions.

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Types of Financial Markets, cont..

1. Types of Investment: Debt Markets vs. Equity Market
Debt Market: The markets where loans are traded. A debt instrument
is a contract that specifies the amounts and schedule of when a
borrower must repay funds provided by the lender. Debt markets are
generally described according to the characteristics of the debt that is
traded. Short-term debt instruments (Gov. Treasury), are traded in the
money market. Long-term debt instruments (bonds and mortgages),
are traded in the capital market.
Equity Market: The markets where stocks are traded. Equity
represent ownership in a corporation and entitles stock-holders to
share in any cash distribution generated from income (dividends) and
from liquidation of the firm. Equity markets which also are called
stock market.
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Types of Financial Markets, cont..

2. Maturities of Investment: Money Markets vs. Capital Market
Money Market: The market for short term financial instruments are
termed as money market. The money markets includes debt
instruments that have maturities equal to one year or less when
originally issued. The primary function of the money markets is to
provide liquidity to business, governments, and individuals to meet
short-term needs for cash.
Capital Markets: The markets for long term financial instruments are
termed as capital market. The capital market include instruments with
original maturities greater than one year- equity instruments and long
term debt instruments as mortgages, corporate bonds, and government
bonds. The primary function of the capital market is to provide the
opportunity to transfer cash surpluses or deficits to future years.
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Types of Financial Markets, cont..

3. Types of Borrowers and Lenders: Primary Markets vs.
Secondary Market
Primary Market: The primary markets are markets in which new
securities are traded. The markets in which corporation and
(government) raise new funds of capital. IPO (initial public offering),
whenever stock in a privately held corporation is offered to the public
for the first time, the company is said to be going public. The
market for corporations that go public is called the IPO market.
Secondary Markets: the secondary markets are markets in which
used securities are traded. The markets in which existing, previously
issued securities are traded among investors. Secondary market also
exist for mortgages, various others types of loans, and other financial
assets.
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Types of Financial Markets, cont..

4. Location of the Markets: Private Market vs. Public Market
Private Markets: In private market transactions, stocks, bonds,
or other types of debt are traded among sophisticated investors
who generally are familiar with each others.
Public Markets: Transactions in public markets are standardized,
because securities traded in the public markets are traded among
large numbers of investors who do not know each other and can
not devote the time, effort, and cost necessary to ensure the
validity of specialized, or non standardized, transactions such as
those that occur in the private markets.

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Types of Financial Markets, cont..

5. Types of Transactions: Spot Market vs. Future Market
Spot Markets: In the spot markets the assets traded are brought or
sold for on the spot delivery (immediately or within a few days).
Future Markets: The markets for delivery of assets at some later
date.
World, National, Regional and Local Markets:
Depending on an organizations size and scope of operations, it
might be able to borrow all around the world, or it might be
confined to a strictly local, even neighbourhood market.

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Types of Financial Markets, cont..

Derivatives Markets: Financial markets in which options, future
and
swaps securities are traded. These securities are called derivatives
because their values are determined, or derived directly from other
assets.
Future contracts, which is a contract for the future delivery of an
item where the price, amount, delivery date, place of delivery, and so
forth are specified.
Options contracts, are contracts that allows the option buyer to
purchase or sell a certain number of securities to the option seller at a
pre-specified price, for a particular period of time. Option contracts
are two types call option and put option.
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Types of Financial Markets, cont..

Stock Markets:
Most active and important secondary market is the stock market.
Traditionally stock markets are divided into two basic types,
(1) organized exchanges and (2) over-the counter market (OTC).
Today it is more appropriate to classify stock markets as either-

1. Physical stock exchanges, and

2. Organized investment networks
General Stock Market Activities:
. Trading in the outstanding, previously issued shares of
established, publicly owned companies: the secondary marker.
. Additional shares sold by established, publicly owned
companies: the primary market.
. New public offering by privately held firms: the initial public
offering (IPO) market; the primary market.
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Types of Financial Markets, cont..

Physical Stock Exchanges:
Physical stock exchanges are tangible entities. Each of the larger
exchanges occupies its own building, has specially designated
members, and has an elected governing body. Members are said to
have seats on the exchange. These seats, which are brought and
sold, give the holder the right to trade on the exchange. Most of the
larger investment banking houses operate brokerage departments that
own seats on the exchanges and designate one or more of their
officers as members. The exchange members with sell order offer the
shares for sale, which in turn are bid for by the members with buy
orders. Thus, the exchanges operate as auction markets. ExampleNYSE, AMEX and DSE.

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Types of Financial Markets, cont..

Organized Investment Networks:
If a security is not traded on a physical stock exchange, it has been
customary to say it is traded in Over-The Counter (OTC) market.
OTC Market: An intangible trading system that consist of a network
of brokers and dealers around the country. If a stock is traded less
frequently, perhaps it is the stock of a new or a small firm, few buy
and sell order come in, and matching them within a reasonable length
of time would be difficult. To avoid this problem, some brokerage
firm maintain inventories of such stocks. These firms buy when
individual investors want to sell and sell when investors want to buy.
At one time the inventory of securities was kept in a safe, and the
stocks, when brought and sold, literally passed over the computer.
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Securities Traded in Financial Markets

Money Market Securities:
Money market securities are debt securities that have maturity of one
year or less. They generally gave a relatively high degree of liquidity,
a low expected return and also a low degree of risk. Common types
of money market securities are
1. Treasury Bills: T-bills are discounted securities issued by the
government to finance operations. T-bills prices are determined by an
auction process: interested investors and investing organization
submit competitive bids for the T-bills offered.

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Money Market Securities, cont..

2. Repurchase Agreement (Repo): A Repo is an agreement in
which one firm sells some of its financial assets to another firm with
a promise to repurchase the securities at a higher price at a later date.
The price at which the securities will be repurchased is agreed to at
the time the repo is arranged.
3. Bankers Acceptance: A bankers acceptance is a time draft- an
instrument issued by a bank that obligates the bank to a specified
amount to the owner of the bankers acceptance at some future date.
A bankers acceptance is generally sold by the original owner before
its maturity to raise immediate cash. Bankers acceptance sold at a
discount, because it does not pay interest.
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Money Market Securities, cont..

4. Federal Funds: Fed Fund represent overnight loans from one
bank to another bank. Banks that needs additional funds to meet the
reserve requirements of the Central Reserve borrow from banks with
access reserves.
5. Commercial Paper: Commercial paper is a type of promissory
note, or legal IOU, issued by large, financially sound firms.
Commercial paper does not pay interest, so it must be sold at a
discount. Commercial paper primarily sold to other business,
insurance companies, pension funds, money market mutual funds,
and banks.

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Money Market Securities, cont..

6. Certificates of Deposit (CD): CD is an interest-earning time
deposit at a bank or other financial intermediary and must kept for
specified time period. Negotiable CDs, can be traded to other
investors prior to maturity because they can be redeemed by whoever
owns them at maturity.
7. Money Market Mutual Funds: Money market mutual funds are
investment funds that are pooled and managed by the firms that
specialized in investing money for others (called investment
companies) for the purpose of investing in short-term financial
assets.
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Securities Traded in Financial Markets, cont..

Capital Market Securities:
Securities with a maturity of more than one year are called capital
market securities. These are as follows:
1. Term Loans: A loan, generally obtained from a bank or
insurance company, on which the borrower agrees to make a series of
payments consisting of interest and principal.
2. Bonds: Bond is a long-term contract under which a borrower
agrees to make payments of interest and principal on specific dates to
the bondholder (investor).

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Capital Market Securities, cont..

2.1. Government Bonds: Bond issued by federal state, or local
government. Treasury Notes and Treasury Bond are most common
form of Gov. bond.
2.2. Municipal Bond: Bond issued by state or local government. The
two principal types of municipal bonds are(i) Revenue Bonds- issued to raise funds for projects that generate
revenues and revenues used to payment of interest and principal.
(ii) General Obligation Bond- bonds are backed by the
governments ability to tax its citizens; special taxes or tax increases
are used to generate the funds needed to service such bonds.
2.3. Corporate Bond: Long-term debt instruments issued by
corporations.
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Capital Market Securities, cont..

2.4. Mortgage Bonds: The corporation pledges certain assets as
security, or collateral, for the bond.
2.5. Debenture: An unsecured bond; it provides no lien, or claim,
against specific property as security for the obligation. Therefore,
debenture holders are general creditors whose claims are protected by
property not otherwise pledge as collateral.
2.6. Subordinated Debenture: A bond that has a claim on assets only
after the senior debt has been paid off in the event of liquidation.
2.7. Zero Coupon Bond: A bond that pays no annual interest but is
sold at a discount below par.
2.8. Junk-Bond: A high-risk, high-yield bond used to finance
mergers, leveraged buyouts, and troubled companies.
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Capital Market Securities, cont..

3. Stocks: Stocks (also known as equity securities) are certificates
representing partial ownership in the corporations that issued them.
They are classified as capital market securities because they have no
maturity and therefore serve as a long term source of fund. Stocks are
two type:
3.1. Preferred Stock:
Preferred shareholder have preference over common shareholders
when a firm distributes funds (dividend) among shareholders, also
they will get preference in liquidation process resulting from
bankruptcy, are paid before common stockholders.

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Capital Market Securities, cont..

3.2. Common Stock:
Common stockholders as the owners of the firm because investors in
common stock have certain rights and privileges generally associated
with property ownership. Common stockholders are entitled to any
earnings that remain after interest and preferred dividend.
4. Derivative Securities:
Derivative securities are financial contracts whose values are derived
from the values of underlying assets.
Speculation: Derivative securities allow an investor to speculate on
movements in the underlying assets without having to purchase those
assets.
Hedging: Derivative securities can be used to generate gains if the
value of the underlying assets declines.
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Role of Depository Institutions

Types of Financial Intermediaries:
The major classes of financial intermediaries are as follows:

1. Commercial Banks: The traditional department stores of

finance, serve a wide variety of customers. Commercial banks were
the major institutions that handled checking account- receiving
deposit and lending money, including trust operation, stock brokerage
services and insurance.
2. Savings and Loans Associations: Traditionally served individual
savers and residential and commercial mortgage borrowers. It collect
the funds of many small savers and lend this money to home buyers
and others types of borrowers.
3. Mutual Funds: Investment companies that accept money from
savers and use these funds to buy various types financial assets such
as
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Role of Depository Institutions, cont..

3. Mutual Funds: Investment companies that accept money from
savers and use these funds to buy various types financial assets such
as stocks, long-term bonds and short-term debt instruments.
4. Credit Unions:
Cooperative associations, whose members have common bonds
Members savings are loaned only to others members. Credit union
are often cheapest source of funds available to individual borrowers.
5. Pension Funds:
Retirement plans funded by corporation and government agencies for
their workers and administrated primarily trust department of
commercial banks or by insurance companies.
6. Life Insurance Companies:
Take savings in the form of annual premiums, then invest these funds
in stocks, bonds, real state and mortgages, and ultimately make
payment to the beneficiary of the insured parties.
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