CHAPTER 4

FINANCIAL MARKETS

 Introduction

Financial markets ( bond and stock markets ) and financial intermediaries ( banks, insurance

companies, pension funds) have the basic function of getting people like Inez and Walter

together by moving funds from those who have a surplus of funds ( Walter ) to those who have a

shortage of funds ( Inez). More realistically, when Apple invents a better ipod, it may need funds

to bring its new product to market. Similarly, when a local government needs to build a road or a

school, it may need more funds than local property taxes provide. Well functioning financial

muskets and financial intermediaries are crucial to economic health.

To study the effects of financial markets and financial intermediaries on the economy, we need

to acquire an understanding of their general structure and operation

4.1 Function of Financial Markets

Financial markets perform the essential economic function of channeling funds from households,

firms and governments that have saved strophes funds by spending less than their income to

those that have a shortage of funds because they wish to spend more than their income. This

function is shown schematically in figure 1. Those who have saved and are lending funds, the

lender savers, are at the left, and those who must borrow funds to finance theirs spending, the

borrower spenders, are at the right.

The principal lender savers are house holds, but business enterprises and the government

(particularly state and local government) as well as foreigners and their governments sometimes

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also find themselves north excess funds and so lend them out. The most important borrower

spenders are businesses and the government (particularly the federal government), but house

holds and foreigners also borrow to finance their purchases of cars. From lenders -savers to

borrower-spenders via two routes.

INDIRECT FINANCE

Figure I Flow of funds through the financial System

Indirect finance ( the route at the bottom of figure 1) , borrowers borrow funds directly from

lenders in financial markets by selling them securities ( also called financial instruments) which

are claims on the borrower’s future income or assets securities are assets for the person who buys

them but liabilities ( ious or debts) for the individual or firms that sells ( issues ) them.

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Example. If general motors needs to borrow funds to pay for anew factory to manufacture

electric cars, it might borrow the funds from savers by selling them bonds, debt securities that

promise to make payments periodically for a specified period of lime.

 Financial markets are thus essential to promoting economic efficiency without financial

markets, it is hard to transfer funds from person who has no investment opportunities to

one who has them . Therefore the existence of financial markets is beneficial even if

some over borrows for a purpose other than in creasing production in a business.

 If a financial market were set up so that people who had built up savings could lend you the

funds to buy some else.

Now we can see why financial markets have such an important function in the economy they

allow funds to more from people from people who lack productive investment. Opportunities to

people who have such opportunities.

Financial markets are critical for producing an efficient allocation of capital, which contributes to

higher production and efficiency for the overall economy.

Well- functioning financial markets also directly improve the well being of consumers by

allowing them to time their purchases better. They provide funds to young people. To buy what

they need and can eventually afford without forcing them to wait until they have saved up the

entire purchase price. Financial markets that are operating efficiently improve the economic

welfare of everyone in the society.

4.2. The Organization and Structure of Markets

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Now that we understand the basic function of financial markets, let’s look at their structure. The

following deceptions of several categorizations of financial markets illustrate essential features

of these markets.

4.2.1 Debt and Equity Markets

A firm or an individual can obtain funds in a financial market in two ways. The most Common

method is to issue a debt instrument, such as a bond or a mortgage, which is a contractual

agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular

intervals ( interest and principal payments ) until a specified date ( the maturity date )

when a final payment is made. The maturity of a debt instrument is the number of the years

(term) until that instrument’s expiration date. A debt instrument is short term if its maturity is

less than a year and long term if its maturity is ten years or longer. Debt instruments with a

maturity between one and ten years are said to be intermediate-term.

The second method of raising funds is by issuing equities such as common stock, which are

claims to share in the net in come (income after expenses and taxes) and the assets of a business.

If you own one share of common shares, you are entitled to 1 one millionth of the firm’s net in

come and 1 one millionth of the firm’s assets. Equities often make periodic payments (dividends

) to their holders and are considered long-term securities because they have no maturity date. In

addition, owning stock means that you own a portion of the firm and thus have the right to vote

on issues import hat to the firm and to elect its directors.

The main advantage of owning a corporation’s equities rather than its debt is that an equity

holder is a residual claimant that is the corporation must pay all its debt holders equity holders.

The advantage of holding equities is that equity holders benefit directly from any increases in the

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corporation’s profitability or asset value because equities confer ownership rights on the equity

holders. Debt holders do not share in this benefit, because their dollar payments are fixed.

4.2.2 Primary and Secondary Markets

A primary market is a financial market in which new is sues of a security, such as a bond or a

stock, are sold. to initial buyers by the corporation or government agency borrowing the funds. A

secondary market is a financial market in which securities that have been previously issued can

be sold.

The primary markets for securities are not well known to the public be cause the selling of

securities. To initial buyers often takes place behind closed doors. An important financial

institution that assists in the initial sale of securities in the primary market is the investment bank.

It does this by underwriting securities: it guarantees a price for a corporation’s securities and

then sells them to the public.

The New York and American stock exchanges and NASDAQ (National Association of

Securities Dealers Automated Quotation System) , in which previously issued stocks are traded,

are the best known examples of secondary markets, although the bond markets, in which

previously issued bonds of major corporations and the U.S government are bought and sold,

actually have a larger trading volume. Other examples of secondary markets are foreign-

exchange markets, futures markets, and options markets. Securities brokers and dealers are

crucial to a well-functioning secondary market. Brokers are agents of investors who match

buyers with sellers of securities: dealers link buyers and sellers by buying and selling securities

at stated prices.

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When an individual buys a security in the secondary market, the person who has sold the security

receives money in exchange for the security, but the corporation that issued the security acquires

no new funds.

A corporation acquires new funds only when its securities are first sold in the primary market.

Nonetheless, secondary markets serve two important functions. First, they make it easier and

quicker to sell these financial in strumpets to raise cash; that is they make the financial

instruments more liquid. The increased liquidity of these instruments then makes them more

desirable and thus easier for the issuing firm to sell in the primary market. Second, they

determine the price of the security that the issuing firm sells in the primary market. The investors

who buy securities in the primary market will set for this security. The higher the security’s price

in the secondary market, the higher the price that the issuing firm will receive for a new security

in the primary market, and hence the greater the amount of financial capital it can raise.

Conditions in the secondary market are therefore the most relevant to corporations issuing

securities.

It is for this reason that books like this one, which deal with financial markets, focus on behavior

of secondary markets rather than primary markets.

4.2.3 Exchanges and Over-The-Counter Markets

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Secondary markets can be organized in two ways- one method is to organize exchanges, where

buyers and sellers of securities (or their agents or brokers) meet in one central location to

conduct traders. The new York and American stock exchange for stocks and the Chicago board

of trade for Commodities (wheat, corn, silver, and other raw materials ) are examples of

organized exchanges.

Many common stocks are traded over-the-counter, although a majority of the largest

corporations have their shares traded at organized stock exchanges. The U.S government bond

market, with a larger trading volume than the new York stock exchange, by contrast, is set up as

an over the counter market . Forty or so dealers establish a “market “in these securities by

standing ready to buy, and sell U.S government bonds. Others over the counter markets include

those that trade other types of financial instruments such as negotiable certificates of deposit,

federal funds, banker’s acceptances and foreign exchange.

4.2.4 Money and Capital Markets

Another way of distinguishing between markets is on the basis of the maturity of the securities

traded in each market. Thus, money market is a financial in which only short term debt

instruments (generally those with original maturity of less than one year) are traded. On the other

hand, the money market is designed for the making of short term loans it is the institution

through which individuals and institutions with temporary surpluses of funds meet the needs of

borrowers who have temporary funds shortages (deficits). Thus, the money market enables

economic units to manage their liquidity positions. By convention, a security or loan maturing

with in one year or less is considered to be a money market instrument. One of the principal

functions of the money market is to finance the working capital needs of corporations and to

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provide governments with short term funds in live of tax collections.

The money market also supplies funds for speculative buying of securities and commodities. In

contrast, the capital market id designed to finance to finance long term investments by Business

governments, and households. Trading of funds in the capital market makes possible the

construction of factories of factories highways, schools and homes. Financial instruments in the

capital market have original maturities of more than one year and range in size from small loans

to multimillion dollar credits.

Who are the principal suppliers and demanders of funds in the money market and the capital

market? in the money market, commercial banks are the most important institutional supplier of

funds ( lender ) to both business firms and governments.

Additionally, The capital market is the market in which longer term debt ( generally those with

original maturity of one year or greater ) and equity instrument sane traded.

When compare the money market and capital market money market securities are usually more

widely traded than longer term securities and sutend to be more liquid non financial business

corporations with temporary cash surpluses also provide substantial short term funds to the

money market. On the demand for funds side, the largest borrower in the U.S money market is

the treasury department, which borrows billions of dollars weekly.

Other governments around the world are after among the leading borrowers in their own

domestic money markets.

The largest and best-known corporations and securities dealers are also active borrowers in

money markets around the world. Due to the large size and strong financial standing of these

well-known money markets and lenders, money market instruments are considered to be high-

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quality,” near money” IOU.

In contrast, the principal suppliers and demanders of funds in the capital market are more varied

than those in the money market. Families and individuals, for example, tap the capital market

when they borrow to finance a new home. Governments rely on the capital market for funds to

build schools and highways and provide essential services to the public.

The most important borrowers in the capital market are businesses of all sizes that issue long-

term debt instruments representing claims against their future revenues in order to cover the

purchase of equipment and the construction of new facilities. Ranged against these many

borrowers in the capital market are financial institutions such as insurance Companies, mutual

funds, security dealers and pension funds, which supply the bulk of capital market funds.

4.2.5 Open versus negotiated Markets

Another distinction between market in the global financial system focuses on open market versus

negotiated markets, for example, some corporate bonds are sold in the open market to the highest

bidder and are bought and sold any number of times before they mature and are paid off. In

contrast, in the negotiated market for corporate bonds, securities generally oversold to one or a

few buyers under private contract.

An individual who goes to his or her local banker to secure a loan for new furniture enters the

negotiated market for personal loans. In the market for corporate stocks there are the major stock

exchanges, which represents the open market. Operating at the same time, however, is the

negotiated market for stock, in which a corporation may sell its entire stock issue to one or a

handful of buyers.

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Review Questions

1. Can you distinguish the differences between the following institutions?

Money market versus Capital market?

Open market versus negotiated market ?

Primary market versus secondary market ?

Summary

The financial system produces and distributes financial services to the public The markets that

serve the financial system may be classified in several different ways, in chiding money market,

supplying short term loans ( credit ) of less than a year and capital markets, supplying long-term

loans ( credit ) lasting longer than a year . There are also open markets where any one may

participate as buyer or seller versus negotiated markets where only a few bidders seek to trade

assets. There are primary versus secondary markets in the former, new financial instruments are

traded in contrasts to the latter where existing instruments are exchanged.

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