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Function of Financial Markets - Docfinal

Financial markets perform three main functions: 1) channeling funds from savers to borrowers, 2) promoting economic efficiency through capital allocation, and 3) allowing consumers to time purchases better. They operate through direct and indirect finance. Direct finance involves direct transfers between lenders and borrowers, while indirect finance involves financial intermediaries receiving funds from savers and lending them to borrowers. Financial markets are composed of debt markets, equity markets, primary markets where new securities are issued, and secondary markets where existing securities are traded. They also include money markets for short-term instruments and capital markets for longer-term debt and equity. Financial intermediaries exist to lower transaction costs, reduce risk, and address information asymmetries between l

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64 views

Function of Financial Markets - Docfinal

Financial markets perform three main functions: 1) channeling funds from savers to borrowers, 2) promoting economic efficiency through capital allocation, and 3) allowing consumers to time purchases better. They operate through direct and indirect finance. Direct finance involves direct transfers between lenders and borrowers, while indirect finance involves financial intermediaries receiving funds from savers and lending them to borrowers. Financial markets are composed of debt markets, equity markets, primary markets where new securities are issued, and secondary markets where existing securities are traded. They also include money markets for short-term instruments and capital markets for longer-term debt and equity. Financial intermediaries exist to lower transaction costs, reduce risk, and address information asymmetries between l

Uploaded by

Rabie Haroun
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Function of Financial Markets

• Perform the essential function of channeling funds from economic


players that have saved surplus funds to those that have a shortage of
funds
• Promotes economic efficiency by producing
an efficient allocation of capital, which increases production
• Directly improve the well-being of consumers by allowing them to time
purchases better
Direct finance and Indirect finance
• Direct finance – funds are directly transferred from lenders to
borrowers
• Indirect finance – financial intermediaries receive funds from savers
and lend them to borrowers
 Securities are assets for the holder and liabilities for the issuer
1- Allows transfers of funds from person or business without investment
opportunities to one who has them
2. Improves economic efficiency

Structure of Financial Markets


• Debt and Equity Markets

1
 Debt instruments – contractual obligation to pay the holder fixed
payments at specified dates (e.g., mortgages, bonds, car loans,
student loans)
 Short-term debt instruments have a maturity of less than one
year
 Intermediate-term debt instruments have a maturity between 1
and 10 years
 Long-term debt instruments have a maturity of ten or more
years
 Equity – sale of ownership share (owners are residual
claimants).
 Owners of stock may receive dividends

• Primary and Secondary Markets


 Primary market = financial market in which newly issued
securities are sold.
 Secondary market = financial market in which previously owned
securities are sold.
 Investment Banks underwrite securities in primary markets
 Brokers and dealers work in secondary markets
• Broker – match buyers and sellers
• Dealers – buy and sell securities

• Roles of Secondary Markets


 Increase liquidity of financial assets
 Determine security prices that help determine the price of
securities in primary markets
• Exchanges and Over-the-Counter (OTC) Markets
 Exchange – buyers and sellers meet in one central location (e.g.,
NYSE or Chicago Board of Trade)
 Over-the-counter market – transactions take place in multiple
locations through dealers
• Money and Capital Markets
 Money markets deal in short-term debt instruments
 Capital markets deal in intermediate and longer-term debt and
equity instruments

2
Financial Market Instruments
• Money Market Instruments
 US treasury bills: 1-, 3-, 6-month maturities, discounted; no default
risk
 Negotiable bank certificates of deposit (NCD): transferable in the
secondary markets, large denominations
 Commercial paper (CP): issued by large banks or well-known
corporations, growing fast, direct finance; largest instrument
 Banker’s Acceptances: can be resold in the secondary markets,
use abroad in international trade
 Repurchase Agreements (repos): treasury bills are used to serve
as collateral, <2 weeks
 Federal (Fed) funds: overnight loan b/w banks of their deposits at
Fed
• Capital Market Instruments
 Stocks: largest instruments, hold by individuals (1/2), pensions,
mutual funds, and insurance companies
 Mortgages: 3 government agencies, FNMA (Fannie Mae), GNMA
(Ginnie Mae), FHLMC (Freddie Mac)
 Corporate bonds: convertible or non-convertible
 US government securities: issued by US Treasury, most liquid
security
 US government agency securities: issued by other US gov’t
agencies, e.g., FNMA, GNMA…
 State and local government bonds: also called municipal bonds,
interest-exemption
 Consumer and bank commercial loans

Function of Financial Intermediaries: Indirect Finance


• Lower transaction costs
 Economies of scale
 Liquidity services
• Reduce Risk
 Risk Sharing (Asset Transformation)
 Diversification
• Asymmetric Information

3
 Adverse Selection (before the transaction)—more likely to select
risky borrower
 Moral Hazard (after the transaction)—less likely borrower will
repay loan

Adverse Selection: Individuals who are willing to accept a financial (or


other) contract are of lower ―quality‖ than a typical individual in the
population
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones
most likely to seek loans and be selected
Moral Hazard: The existence of a contract causes one party to alter their
behavior in a manner detrimental to the other party
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard
problems, enabling them to make profits

Types of financial intermediaries


• Depository institutions
 Commercial banks
 Savings and Loan Associations
 Mutual savings banks
 Credit unions
• Contractual savings institutions
 Life insurance companies
 Fire and casualty insurance companies
 Pension funds and government retirement funds
• Investment intermediaries
 Finance companies
 Mutual funds
 Money market mutual funds
 Investment banks

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