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Role of Financial Markets and InstitutionsRole of Financial Markets and Institutions

11 Chapter Chapter

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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 instrumentis a contract that specifies the amounts and schedule of when aborrower must repay funds provided by the lender. Debt markets aregenerally described according to the characteristics of the debt that istraded. Short-term debt instruments (Gov. Treasury), are traded in themoney market. Long-term debt instruments (bonds and mortgages),are traded in the capital market.

Equity Market: The markets where stocks are traded. Equityrepresent ownership in a corporation and entitles stock-holders to share in any cash distribution generated from income (dividends) andfrom liquidation of the firm. Equity markets which also are calledstock 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 aretermed 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 toprovide liquidity to business, governments, and individuals to meetshort-term needs for cash.

Capital Markets: The markets for long term financial instruments aretermed as capital market. The capital market include instruments withoriginal maturities greater than one year- equity instruments and longterm debt instruments as mortgages, corporate bonds, and governmentbonds. The primary function of the capital market is to provide theopportunity 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 newsecurities 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 publicfor the first time, the company is said to be ‘going public’. Themarket for corporations that go public is called the IPO market.

Secondary Markets: the secondary markets are markets in whichused securities are traded. The markets in which existing, previouslyissued securities are traded among investors. Secondary market alsoexist for mortgages, various others types of loans, and other financialassets.

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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 investorswho generally are familiar with each others.

Public Markets: Transactions in public markets are standardized,because securities traded in the public markets are traded amonglarge numbers of investors who do not know each other and cannot devote the time, effort, and cost necessary to ensure thevalidity of specialized, or non standardized, transactions such asthose 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 orsold for ‘on the spot’ delivery (immediately or within a few days).

Future Markets: The markets for delivery of assets at some laterdate.

World, National, Regional and Local Markets:

Depending on an organization’s 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 derivativesbecause their values are determined, or derived directly from otherassets.

Future contracts, which is a contract for the “future” delivery of anitem where the price, amount, delivery date, place of delivery, and soforth are specified.

Options contracts, are contracts that allows the option buyer topurchase or sell a certain number of securities to the option seller at apre-specified price, for a particular period of time. Option contractsare 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, and2. 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 largerexchanges occupies its own building, has specially designatedmembers, and has an elected governing body. Members are said tohave ‘seats’ on the exchange. These seats, which are brought andsold, give the holder the right to trade on the exchange. Most of thelarger investment banking houses operate brokerage departments thatown seats on the exchanges and designate one or more of theirofficers as members. The exchange members with sell order offer theshares for sale, which in turn are bid for by the members with buyorders. Thus, the exchanges operate as auction markets. Example-NYSE, 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 beencustomary to say it is traded in Over-The Counter (OTC) market.

OTC Market: An intangible trading system that consist of a networkof brokers and dealers around the country. If a stock is traded lessfrequently, perhaps it is the stock of a new or a small firm, few buyand sell order come in, and matching them within a reasonable lengthof time would be difficult. To avoid this problem, some brokeragefirm maintain inventories of such stocks. These firms buy whenindividual investors want to sell and sell when investors want to buy.At one time the inventory of securities was kept in a safe, and thestocks, 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. Banker’s Acceptance: A banker’s acceptance is a time draft- an

instrument issued by a bank that obligates the bank to a specified

amount to the owner of the banker’s acceptance at some future date.

A banker’s acceptance is generally sold by the original owner before

its maturity to raise immediate cash. Banker’s 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

government’s 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 derivedfrom the values of underlying assets.Speculation: Derivative securities allow an investor to speculate onmovements in the underlying assets without having to purchase thoseassets.Hedging: Derivative securities can be used to generate gains if thevalue of the underlying assets declines.

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Role of Depository InstitutionsTypes of Financial Intermediaries:

The major classes of financial intermediaries are as follows:

1. Commercial Banks: The traditional ‘department stores offinance’, serve a wide variety of customers. Commercial banks werethe major institutions that handled checking account- receivingdeposit and lending money, including trust operation, stock brokerageservices and insurance.

2. Savings and Loans Associations: Traditionally served individualsavers and residential and commercial mortgage borrowers. It collectthe funds of many small savers and lend this money to home buyersand others types of borrowers.3. Mutual Funds: Investment companies that accept money fromsavers and use these funds to buy various types financial assets such

asstocks, long-term bonds and short-term debt instruments

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Role of Depository Institutions, cont..3. Mutual Funds: Investment companies that accept money fromsavers and use these funds to buy various types financial assets suchas stocks, long-term bonds and short-term debt instruments.

4. Credit Unions: Cooperative associations, whose members have common bondsMembers’ savings are loaned only to others members. Credit unionare often cheapest source of funds available to individual borrowers.

5. Pension Funds:Retirement plans funded by corporation and government agencies fortheir workers and administrated primarily trust department ofcommercial banks or by insurance companies.

6. Life Insurance Companies:Take savings in the form of annual premiums, then invest these fundsin stocks, bonds, real state and mortgages, and ultimately makepayment to the beneficiary of the insured parties.