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BAC 410 Topic 2

The financial system facilitates the movement of funds from savers to borrowers, promoting economic growth by addressing information asymmetry. Financial markets, which include capital and money markets, primary and secondary markets, and exchange-traded and over-the-counter markets, play a crucial role in this process by enabling the trading of financial instruments. They provide essential functions such as price discovery, liquidity, and reduced transaction costs, which enhance market efficiency.

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11 views23 pages

BAC 410 Topic 2

The financial system facilitates the movement of funds from savers to borrowers, promoting economic growth by addressing information asymmetry. Financial markets, which include capital and money markets, primary and secondary markets, and exchange-traded and over-the-counter markets, play a crucial role in this process by enabling the trading of financial instruments. They provide essential functions such as price discovery, liquidity, and reduced transaction costs, which enhance market efficiency.

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Fountain Kananga
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Topic 2: Financial

Markets
• The Financial system makes it possible for the movement of funds
from entities with funds allocate those funds to those who have
potentially more productive ways to deploy those funds, potentially
leading to faster growth for a country’s economy.
• A financial system makes possible a more efficient transfer of funds is
by overcoming the information asymmetry problem between those
with funds to invest and those needing funds. In general,
information asymmetry means that one party to a transaction has
more or superior information than the other party, resulting in an
imbalance of power in a transaction the financial system has three
components:
• 1. financial markets,
• 2. financial intermediaries, and
• 3. Regulators of financial activities
Financial Markets
• A financial market is a market where financial instruments are
exchanged. The more popular term used for the exchanging of
financial instruments is that they are “traded.”
•The arrows show that funds flow from lender-savers to borrower-spenders via two routes.
•The first route is the direct finance route at the bottom of the diagram, when borrowers
borrow funds directly from lenders in financial markets by selling them securities (also
called financial instruments), which are claims on the borrowers' future income or assets.
•Securities are assets for the buyer but liabilities for the seller. For example, if British
Airways needs to borrow funds to pay for a new aircraft, it might borrow the funds from a
saver by selling the saver a bond, a debt security that promises to make payments
periodically for a specified period of time.
•The channelling of funds from savers to spenders is a crucial function for the
economy because the people who save are frequently not the same people who
have profitable investment opportunities available to them, i.e the entrepreneurs.
Without financial markets, it is hard to transfer funds from a person with surplus
funds and no investment opportunities to one who has investment opportunities
but no funds. They would be unable to transact and both would be worse off as
result. Financial markets are thus essential to promoting economic efficiency
•Financial markets can be classified in several ways.
1. Capital and money markets
2. Primary and secondary markets
3. Exchange-traded and over-the-counter mark
Money Markets and Capital Markets

•Capital markets are markets for medium-term and long-term capital.


•Money markets are markets for short-term capital.
The Following diagram illustrates the differences between short-term,
long term and medium term securities.
Money Markets

•Money markets are markets for:


1. Trading short-term financial instruments
2. Short-term lending and borrowing
• The money markets are operated by the banks and other financial
institutions. Although the money markets largely involve borrowing
and lending by banks, some large companies, as well as the
government, are involved in money market operations
Money Market Instruments
• Commercial paper
• Repurchase agreements
• Certificates of deposit
• Treasury bills
Capital Markets

•Capital markets are markets for trading in long-term finance, in the form of
long-term financial Instruments such as equities and corporate bonds.
•A stock market acts as a primary market for raising finance, and as a
secondary market for the trading of existing securities.
•Securities are tradable financial instruments. They can take the form of equity
(such as shares), debt (such as bonds and debentures) or derivatives.
Primary and secondary Markets
•Primary markets enable organizations to raise new finance. Secondary markets enable
investors to buy and sell existing investments to each other.
•The financial markets serve two main purposes.
a. As primary markets they enable organisations to raise new finance, by issuing new shares or
new bonds.
b. As secondary markets they enable existing investors to buy and sell existing investments,
should they wish to do so. The marketability of securities is a very important feature of the
capital markets, because investors are more willing to buy stocks and shares if they know
that they could sell them easily, should they wish to.
Exchange-traded instruments and
over the counter markets
Secondary markets for financial securities can be organized on
exchanges, where buyers and sellers of securities buy and sell securities
in one location, the exchange. Examples of exchanges include the
Lusaka Stock exchange London Stock Exchange and the New York
Stock Exchange for the trading of shares
•Alternatively, secondary markets can operate as over-the-counter
(OTC) markets, where transactions do not involve buying and selling
through an exchange, but customers negotiate individual transactions,
usually with a financial intermediary such as a bank.
Role of Financial Markets

Financial markets provide the following three major economic


functions:
1. Price discovery
2. Liquidity
3. Reduced transaction costs
• Price discovery means that the interactions of buyers and sellers in a
financial market determine the price of the traded asset. Equivalently,
they determine the required return that participants in a financial
market demand in order to buy a financial instrument. Because the
motivation for those seeking funds depends on the required return that
investors demand, it is this function of financial markets that signals
how the funds available from those who want to lend or invest funds
will be allocated among those needing funds and raise those funds by
issuing financial instruments
• Second, financial markets provide a forum for investors to sell a
financial instrument and is said to offer investors “liquidity.” This is an
appealing feature when circumstances arise that either force or
motivate an investor to sell a financial instrument. Without liquidity,
an investor would be compelled to hold onto a financial instrument
until either conditions arise that allow for the disposal of the financial
instrument or the issuer is contractually obligated to pay it off. For a
debt instrument, that is when it matures, whereas for an equity
instrument that is until the company is either voluntarily or
involuntarily liquidated. All financial markets provide some form of
liquidity.
•The third economic function of a financial market is that it reduces the cost of
transacting when parties want to trade a financial instrument. In general, one can
classify the costs associated with transacting into two types: search costs and
information costs. Search costs in turn fall into categories: explicit costs and implicit
costs. Explicit costs include expenses that may be needed to advertise one’s
intention to sell or purchase a financial instrument; implicit costs include the
value of time spent in locating a counterparty to the transaction. The presence of
some form of organized financial market reduces search costs.
•Information costs are costs associated with assessing a financial
instrument’s investment attributes. In a price efficient market, prices
reflect the aggregate information collected by all market participants.

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