CHAPTER 8: UNDERSTANDING THE ROLE OF THE FINANCIAL MARKETS AND

INSTITUTIONS

LEARNING OBJECTIVES
After studying Chapter 8, you should be able to:
1. Define financial markets.
2. Identify the participants in the financial markets.
3. Appreciate the importance of financial markets as providers of funds to business
establishments.
4. Enumerate and distinguish the types of markets.
5. Familiar with the categories of financial institutions.
6. Understand the role of the stock market.
7. Know the kinds of stock market.
8. Explain the reasons for transactions in stock market.
9. Discuss the role and operation of a stock exchange.
10. Know how securities are listed on the stock exchange.

INTRODUCTION
One may wonder how a financial manager knows whether he or she is maximizing
shareholder value and ethical (unethical) behavior may affect the value of the company.
This information is provided daily to financial managers through price changes
determined in the financial markets. But what are the financial markets?
Financial markets are the meeting place for people, corporations and institutions that
either need money or have money to lend or invest. In a broad context, the financial
markets exist as a vast global network of individuals and financial institutions that may
be lenders, borrowers or owners of public companies worldwide. Participants in the
financial markets also include national, state and local governments that are primarily
borrowers of funds for highways, education, welfare and other public activities; their
markets are referred to as public financial markets. Large corporations raise funds in the
corporate financial markets.
Corporations rely on the financial markets to provide funds for short-term Operations
and for new plant and equipment. A firm may go to the markets and raise financial
capital by either borrowing money through a debt offering of corporate bonds or short-
term notes, or by selling ownership in the company through an issue of common stock.
When a corporation uses the financial markets to raise new funds, the sale of securities
is said to be made in the primary market by way of a new issue. After the securities are
sold to the public (institutions and individuals), they are traded in the secondary market
between investors. It is in the secondary market that prices are continually changing as
investors buy and sell securities based on their expectations of a corporation’s
prospects. It is also in the secondary market that financial managers are given feedback
about their firm’s performance. Those companies that perform are well and are
rewarded by the market with high priced securities have an easier time raising new
funds in the money and capital markets than their competitors. They are also able to
raise funds at a lower cost.

STRUCTURE AND FUNCTION OF THE FINANCIAL MARKETS

Different financial markets serve different types of customers or different parts of the
country. Financial markets also vary depending on the maturity of the securities being
traded and the ty pes of assets used to back the securities.

TYPES OF MARKETS
1. Physical asset markets versus financial asset markets. Physical asset markets
(also called tangible or real asset markets) are for products such as wheat,
autos, real estate, computers and machinery. Financial asset markets, on the
other hand, deal with stocks, bonds, notes and mortgages. Financial markets
also deal with derivative securities whose values are derived from changes in the
prices of other assets. A share of Meralco stock is a pure financial asset, while
an option to buy Meralco shares is a derivative security whose value depends on
the price of stock. Bonds backed by subprime mortgages are another type of
derivative, as the values of these bonds are derived from the values of the
underlying mortgages.

2. Spot markets versus future markets. Spot markets are markets in which assets
are bought or sold for "on-the-spot" delivery. Future markets are markets in
which participants agree today to buy or sell an asset at some future date.

3. Money markets versus capital markets. Money markets are financial in which
funds are borrowed or loaned for short periods (less than one year). Capital
markets are financial markets for stocks and for intermediate or long-term debt
(one year or longer).

4. Primary markets versus secondary markets. Primary are the markets in which
corporations raise capital by issuing new securities. Secondary markets are the
markets in which securities and other financial assets are traded among
investors after they have been issued by corporations.
 5. Private markets versus public markets. Private markets in which transactions are
worked out directly between two parties. Public markets are markets in which
standardized contracts are traded on organized exchanges.
FINANCIAL INSTITUTIONS
Direct funds transfers are common among individuals and small businesses and in
economies Where financial markets and institutions are less developed. But large
businesses in developed economies generally find it more efficient to enlist the services
of a financial institution when it comes time to raise capital.

CATEGORIES OF FINANCIAL INSTITUTIONS

1. Investment banks. An organization that underwrites and distributes new
investment securities and helps business obtain financing.
2. Commercial banks. The traditional department store of finance serving a variety
of savers and borrowers.
3. Financial services corporations. A firm that offers a wide range of financial
services, including investment banking, brokerage operations, insurance and
commercial banking.
4. Credit unions. Cooperative associations whose members are supposed to have a
common bond, such as being employees of the same firm. Credit unions are
often the cheapest source of funds available to individual borrowers.
5. Pension funds. Retirement plans funded by corporations or government agencies
for their workers and administered primarily by the trust departments of
commercial banks or by life insurance companies.
6. Life insurance companies. Savings in the form of annual premiums; invest these
funds in stocks, bonds, real estate and mortgages; and make payments to the
beneficiaries of the insured parties.
7. Mutual funds. Organizations that pool investor funds to purchase financial
instruments and thus reduce risks through diversification. Money market funds
are mutual funds that invest in short-term, low-risk securities and allow investors
to write checks against their accounts.
8. Exchange trade funds (ETF). Similar to regular mutual funds and are often
operated by mutual fund companies. ET F buy a portfolio of stocks of a certain
type and then sell their own shares to the public.
9. Hedge funds. Similar to mutual funds because they accept money and use the
funds to buy various securities, but there are some important differences
10. Private equity companies. Organizations that operate much like hedge funds, but
rather than purchasing some of the stock of firm, private equity players buy and
then manage entire firms.
THE STOCK MARKETS
Business finance is concerned with the provision of funds for investment in business
enterprise, whatever is invested in (his way must be provided by an investor and this
Incans that the investor must forgo consumption and save to provide the funds. Savers
and the users of their funds come together in the market for finance, where the normal
rules of supply and demand apply unless there is government interference with interest
rates. The price of money is the rate of interest paid for the use. If the demand for
investment funds is greater than the funds offered for investment by savers, then the
rate of interest will rise until people in the economy are induced to forgo consumption
and make their savings available for investment. The new issues of securities are made
available in the primary market. The securities that are already outstanding and owned
by the investors are usually bought and sold through the secondary market, which is
popularly known as stock market.
In a stock market, purchases and sales of securities whether or government or semi-
government bodies or other public bodies and also shares and debentures issued by
joint stock companies are affected. The securities of government are traded in the
stock market as a separate component called gilt edged market. Government securities
are traded outside the trading wing in the form of over-the-counter sales or purchases.
Another component of stock market deals with trading in shares and debentures of
limited companies.
In the stock market, the outstanding issues are permitted to trade. In this market, a
stock or bond issue has already been sold to the public and it is traded between current
and potential owners. The proceeds from sale in the stock market do not go to the
issuing organization but to the current owner of the security. Once issues have been
purchased by investors. they change hands in the stock market. The primary
middlemen in the stock market are brokers and dealers. The distinction between them is
the broker acts as an agent, whereas the dealer acts as a principal in the transaction.
Stock markets are said to reflect the health of the country's economy. On the other
hand, major economic indicators determine stock market movements to a large extent.
From a thorough analysis of the various economic indicators and its implications on the
stock markets, it is known that stock market movements are largely influenced by broad
money supply, deficit apart from political instability. Besides, fundamental factors like
corporate performance, industrial growth and so forth always exert a certain amount of
markets. The derivatives are most modern financial instruments influence in on hedging
the risk. The individuals and firms who wish to as avoid or reduce risk can deal with
others who are willing to accept the risk for a price. The common place where such
transactions take place is called the derivative market. futures. options, swaps, caps
and floor are some of the commonly traded derivatives in the derivatives market.

KINDS OF STOCK MARKET

There are two broad segments of the stock markets:
1. The Organized Stock Exchange. The stock exchanges ill a physical location
where stocks buying and selling transactions take in the stock exchange floor
(e.g., New York Stock Exchanges, Japan Nikkei, Shanghai Components,
NASDAC, Philippine Stock Exchange etc.).
2. The Over-the-Counter (OTC) Exchange. Where shares, money market
instruments are traded using a system of computer screens and telephones.

REASONS FOR TRANSACTIONS IN STOCK MARKET

There are two main reasons individuals transact in the or stock market:
1. Information Motivated Reasons. Information motivated investors believe that they
have superior information about than other market participants. The information
leads that the security is not being correctly priced by the information is good, this
suggests that the underpriced and investors access to such buy the security. On the
other hand, if they will be currently overpriced and such holdings of the security.
2. Liquidity Motivated Reasons. Liquidity motivated investors, on the other hand,
transact in the secondary market because they are currently in a position of either
excess or insufficient liquidity. Investors with surplus cash holdings (e.g., as a result
of inheritance) will buy securities, where as investors with sufficient cash (e.g., to
purchase a car) will sell securities.

MEANING OF STOCK EXCHANGE

Stock exchange is an organized secondary market where securities like shares,
debentures of public companies, government securities and bonds issued by
municipalities, public corporations, utility undertakings, port trusts and such other local
authorities are purchased and sold. In order to bring liquidity, the stocks are traded
systematically in a stock exchange.
The stock exchange is an entity (a corporation or mutual organization) which is in the
business of bringing buyers and sellers of stocks and securities together. The purpose
of stock exchange is to facilitate the exchange of securities between buyers and sellers,
thus providing a market place, virtual or real. The stock market does not have a
physical presence, it is a virtual market. Gone are the days when share brokers
assembled in a place called the "trading ring" and bought and sold shares, it was
known as the outcry method. Technology has enabled the ring to be located on a
central computer, which has millions of buyers and sellers attached to it through a
telecommunication network. These buyers and sellers indicate their intentions through
a computer at home or the office, their own or their broker's. Buyers' and sellers' orders
are matched by the central computer, and if quantities and prices correspond, then a
trade is set to be executed. The entire process of sending the order to the stock
exchange computer, confirmation of order and execution, if any, is communicated
within a fraction of a second.
The stock exchange supplies a platform from which to buy and sell shares in certain
listed companies. It regulates the company's behavior through requirements agreed
upon by the company in order to be listed. This is called a listing agreement which
ensures that the company provides all the information pertaining to its working from
time to time, including events that affect its valuation, such as mergers, amalgamations
and such other sensitive matters. Large volumes are possible in these markets
because of two things. one is the ease or settlements. The shares that are traded in are
received and delivered through an electronic entry in the books of buyers and sellers.
The second reason is guarantee of trades. Sellers get their money; buyers get their
shares. The stock market is known as barometer of the company's economy. The
companies listed on stock exchanges collectively contribute to the country's GDP.

LISTING OF SECURITIES ON STOCK EXCHANGE

Listing means admission of securities to dealings on a recognized stock exchange of
any incorporated company, central and state governments, quasi-governmental and
other financial institutions/corporations, municipalities, electricity boards, housing
boards and so forth. The principal objective of listing is to provide liquidity and
marketability to listed securities and ensure effective monitoring of trading for the
benefit of all participants in the market. A company desiring to get listing has to enter
into listing agreement with the concerned stock exchange and is required to pay the
specified listing fees. Thereafter, the company is required to comply with all clauses of
the listing agreement and to send details of book closure, record dates, copies of
annual report, quarterly and half-yearly reports and cash flow statements to the
respective stock exchange where the securities are listed. A recognized stock
exchange means a stock exchange being recognized by the national government
through the Securities and Exchange Commission (SEC). Securities are bought and
sold in recognized stock exchanges through members who are known as brokers. The
price at which the securities are bought and sold on a recognized stock exchange is
known as official quotation.
The securities of an entity may be listed at any of the following stages:
• At the time of public issue of shares or debentures
• At the time of rights issue of shares or debentures
• At the time of bonus issue of shares
• Shares issued on amalgamation or merger
In a stock exchange, a person who wishes to sell his security is called a seller, and a
person who is willing to buy the particular stock is called the buyer. The rate of stock
depends on the simple Jaw of demand and supply.
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