financial markets
financial markets
are - any type of financial transaction that you can think of that helps
businesses grow and investors make money. Here is an overview of the financial
markets, from the simple to the complex
Broad term
describing any marketplace where buyers and sellers participate in the trade of
assets such as equities, bonds, currencies and derivatives. Financial markets
are typically defined by having transparent pricing, basic regulations on
trading, costs and fees and market forces determining the prices of securities
that trade.
Some financial
markets only allow participants that meet certain criteria, which can be based
on factors like the amount of money held, the investor’s geographical location,
knowledge of the markets or the profession of the participant.
Financial markets
can be found in nearly every nation in the world. Some are very small, with
only a few participants, while others – like the New York Stock Exchange
(NYSE) and the forex markets – trade trillions of dollars daily.
Most financial
markets have periods of heavy trading and demand for securities; in these
periods, prices may rise above historical norms. The converse is also true –
downturns may cause prices to fall past levels of intrinsic value, based on low
levels of demand or other macroeconomic forces like tax rates, national
production or employment levels.
Information
transparency is important to increase the confidence of participants and
therefore foster an efficient financial marketplace.
Capital
Markets'
A market in
which individuals and institutions trade financial securities.
Organizations/institutions in the public and private sectors also often sell
securities on the capital markets in order to raise funds. Thus, this type of
market is composed of both the primary and secondary markets.
Both the stock and
bond markets are parts of the capital markets. For example, when a
company conducts an IPO, it is tapping the investing public for
capital and is therefore using the capital markets. This is also
true when a country's government issues Treasury bonds in the bond
market to fund its spending initiatives.
Definition
of 'Money Market'
A segment of
the financial market in which financial instruments with high liquidity
and very short maturities are traded. The money market is used by
participants as a means for borrowing and lending in the short term, from
several days to just under a year. Money market securities consist of
negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury
bills, commercial paper, municipal notes, federal funds and repurchase
agreements (repos).
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The money market is
used by a wide array of participants, from a company raising money by
selling commercial paper into the market to an investor purchasing
CDs as a safe place to park money in the short term. The money market is
typically seen as a safe place to put money due the highly liquid nature
of the securities and short maturities, but there are risks in the market that
any investor needs to be aware of including the risk of default on securities
such as commercial paper.
Capital
Markets'
A market in which individuals
and institutions trade financial securities. Organizations/institutions in
the public and private sectors also often sell securities on the capital
markets in order to raise funds. Thus, this type of market is composed of both
the primary and secondary markets.
Both the stock and bond markets
are parts of the capital markets. For example, when a
company conducts an IPO, it is tapping the investing public for
capital and is therefore using the capital markets. This is also
true when a country's government issues Treasury bonds in the bond
market to fund its spending initiatives.
Major
participants and players in financial markets
Major participants and players in financial
markets
In the financial
markets, there is a flow of funds from one group of parties (funds-surplus
units) known as investors to another group (funds-deficit units) which require
funds. However, often these groups do not have direct link. The link is
provided by market intermediaries such as brokers, mutual funds, leasing and
finance companies, etc. In all, there is a very large number of players and
participants in the financial market. These can be grouped as follows :
The individuals: These are net savers and
purchase the securities issued by corporates. Individuals provide funds by
subscribing to these security or by making other investments.
The Firms or corporates: The corporates are net
borrowers. They require funds for different projects from time to time. They
offer different types of securities to suit the risk preferences of investors’
Sometimes, the corporates invest excess funds, as individuals do. The funds
raised by issue of securities are invested in real assets like plant and
machinery. The income generated by these real assets is distributed as interest
or dividends to the investors who own the securities.
Government: Government may borrow funds to take
care of the budget deficit or as a measure of controlling the liquidity, etc.
Government may require funds for long terms (which are raised by issue of
Government loans) or for short-terms (for maintaining liquidity) in the money
market. Government makes initial investments in public sector enterprises by
subscribing to the shares, however, these investments (shares) may be sold to
public through the process of disinvestments.
Regulators: Financial system is regulated by
different government agencies. The relationships among other participants, the
trading mechanism and the overall flow of funds are managed, supervised and
controlled by these statutory agencies. In India, two basic agencies regulating
the financial market are the Reserve Bank of India (RBI ) and
Securities and Exchange Board of India (SEBI). Reserve Bank of India, being the
Central Bank, has the primary responsibility of maintaining liquidity in the
money market’ It undertakes the sale and purchase of T-Bills on behalf of the
Government of India. SEBI has a primary responsibility of regulating and
supervising the capital market. It has issued a number of Guidelines and Rules
for the control and supervision of capital market and investors’ protection.
Besides, there is an array of legislations and government departments also to
regulate the operations in the financial system.
Market Intermediaries: There are a number of
market intermediaries known as financial intermediaries or merchant bankers,
operating in financial system. These are also known as investment managers or
investment bankers. The objective of these intermediaries is to smoothen the
process of investment and to establish a link between the investors and the
users of funds. Corporations and Governments do not market their securities
directly to the investors. Instead, they hire the services of the market
intermediaries to represent them to the investors. Investors, particularly
small investors, find it difficult to make direct investment. A small investor
desiring to invest may not find a willing and desirable borrower. He may not be
able to diversify across borrowers to reduce risk. He may not be equipped to
assess and monitor the credit risk of borrowers. Market intermediaries help
investors to select investments by providing investment consultancy, market
analysis and credit rating of investment instruments. In order to operate in
secondary market, the investors have to transact through share brokers. Mutual
funds and investment companies pool the funds(savings) of investors and invest
the corpus in different investment alternatives. Some of the market
intermediaries are:
- Lead Managers
- Bankers to the Issue
- Registrar and Share Transfer Agents
- Depositories
- Clearing Corporations
- Share brokers
- Credit Rating Agencies
- Underwriters
- Custodians
- Portfolio Managers
- Mutual Funds
- Investment Companies
These market
intermediaries provide different types of financial services to the investors.
They provide expertise to the securities issuers. They are constantly operating
in the financial market. Small investors in particular and other investors too,
rely on them. It is in their (market intermediaries) own interest to behave
rationally, maintain integrity and to protect and maintain reputation,
otherwise the investors would not be trusting them next time. In principle,
these intermediaries bring efficiency to corporate fund raising by developing
expertise in pricing new issues and marketing them to the investors.
Primary
Market'
A market that issues
new securities on an exchange. Companies, governments and other groups obtain
financing through debt or equity based securities. Primary markets are
facilitated by underwriting groups, which consist of investment banks that will
set a beginning price range for a given security and then oversee its sale
directly to investors.
Also known
as "new issue market" (NIM).
The primary markets
are where investors can get first crack at a new security issuance. The issuing
company or group receives cash proceeds from the sale, which is then used to
fund operations or expand the business. Exchanges have varying levels of
requirements which must be met before a security can be sold.
Once the initial
sale is complete, further trading is said to conduct on the secondary market,
which is where the bulk of exchange trading occurs each day. Primary markets
can see increased volatility over secondary markets because it is difficult to
accurately gauge investor demand for a new security until several days of
trading have occurred
Secondary
Market'
A market where
investors purchase securities or assets from other investors, rather than from
issuing companies themselves. The national exchanges - such as the New York
Stock Exchange and the NASDAQ are secondary markets.
Secondary markets
exist for other securities as well, such as when funds, investment banks, or
entities such as Fannie Mae purchase mortgages from issuing lenders. In any
secondary market trade, the cash proceeds go to an investor rather than to the
underlying company/entity directly.
A newly issued IPO
will be considered a primary market trade when the shares are first purchased
by investors directly from the underwriting investment bank; after that any
shares traded will be on the secondary market, between investors themselves. In
the primary market prices are often set beforehand, whereas in the secondary
market only basic forces like supply and demand determine the price of the
security.
In the case of
assets like mortgages, several secondary markets may exist, as bundles of
mortgages are often re-packaged into securities like GNMA Pools and re-sold to
investors.
Intercompany
market
The intercompany
involves direct lending between companies. The supply of funds in the
intercompany market comes from companies that have cash flows surplus to their
current requirements. The demand for funds comes from companies who do not have
cash flows sufficient to meet their current obligations. Given the nature of
trading within the market, it is regarded as an example of a money market.
Financial Intermediaries
Most people do not
enter financial markets directly but use intermediaries or middlemen.
Commercial banks are the financial intermediary we
meet most often in macroeconomics, but mutual funds, pension funds, credit
unions, savings and loan associations, and to some extent insurance companies
are also important financial intermediaries.1 When people deposit money in a
bank, the bank uses the funds to make loans to home buyers for mortgages, to
students so they can pay for their education, to business to finance
inventories, and to anyone else who needs to borrow. A person who has extra
money could, of course, seek out borrowers himself and bypass the intermediary.
By eliminating the middleman, the saver could get a higher return. Why, then,
do so many people use financial intermediaries?
Financial
intermediaries provide two important advantages to savers. First, lending
through an intermediary is usually less risky
than lending directly. The major reason for reduced risk is that a financial
intermediary can diversify. It makes a great many loans, and even though some
of those loans will be mistakes, the losses will be largely offset by loans
that are sound. In contrast, an average saver could directly make only a few
loans, and any bad loans would substantially affect his wealth. Because an
intermediary can put its "eggs" in many "baskets," it
insures its depositors from substantial losses.
Another reason
financial intermediaries reduce risk is that by making many loans, they learn
how to better predict which of the people who want to borrow money will be able
to repay. Someone who does not specialize in this lending may be a poor judge
of which loans are worth making and which are not, though even a specialist
will make some mistakes.
A second advantage
financial intermediaries give savers is liquidity.
Liquidity is the ability to convert assets into a spendable
form--money--quickly. A house is an illiquid asset; selling one can take a
great deal of time. If an individual saver has lent money directly to another
person, the loan can also be an illiquid asset. If the lender suddenly needs
cash, he must either persuade the borrower to repay quickly, which may not be
possible, or he must find someone else who will buy the loan from him, which
may be very difficult. Although the intermediary may use its funds to make
illiquid loans, its size allows it to hold some funds idle as cash to provide
liquidity to individual depositors. Only when a great many depositors want to
withdraw deposits at the same time, which happens when there is a
"run" on the institution, will the financial intermediary be unable
to provide liquidity. Unless it can obtain help from the government or other
institutions, it will be forced to suspend payments to depositors.
In addition to
lending money to individuals and groups, there are other ways in which banks
are part of financial markets. Banks borrow and lend funds among themselves in
the federal-funds market. They buy and
sell foreign exchange. They buy and sell government and commercial debt. And
finally, one form of bank debt serves as money in modern economies, and banks
create this debt as a result of their financial transactions.
Economists are
concerned that financial intermediaries can be a source of shocks to the
economy, bumps that can disrupt the normal flow of economic life. This concern
arises for at least two reasons. First, bank debt serves as money, so
disruptions to banks can affect the amount of money in circulation. We explore
this idea in later chapters. Second, financial intermediaries are tied together
through chains of debts and assets. Because of these linkages, the failure of
one financial intermediary can weaken others, increasing their chances of
failure. As a result, there is the possibility that if a key financial
intermediary fails, that failure can create a domino effect that could cause
other financial institutions to fail, ultimately causing the financial sector
to "seize up" and stop functioning. Serious disruption of the
financial markets will disrupt the rest of the economy. We will develop this
idea a bit further in later sections of this chapter.
Financial intermediation consists of
“channeling funds between surplus and deficit agents”. A financial intermediary is a financial
institution that connects surplus and deficit agents. The classic example of a
financial intermediary is a bank that transforms bank deposits into bank loans.
Through the process
of financial intermediation, certain assets or liabilities are transformed into
different assets or liabilities. As such, financial intermediaries channel
funds from people who have extra money (savers) to those who do not have enough
money to carry out a desired activity (borrowers).
In the U.S., a
financial intermediary is typically an institution that facilitates the
channeling of funds between lenders and borrowers indirectly. That is, savers
(lenders) give funds to an intermediary institution (such as a bank), and that
institution gives those funds to spenders (borrowers). This may be in the form
of loans or mortgages.[3] Alternatively, they may lend the money directly via
the financial markets, which is known as financial disintermediation.
Functions
performed by financial intermediaries
Financial
intermediaries provide 3 major functions:
- Maturity transformation
Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs) - Risk transformation
Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk) - Convenience denomination
Matching small deposits with large loans and large deposits with small loans
Advantages
of financial intermediaries
There are 2
essential advantages from using financial intermediaries:
- Cost advantage over direct lending/borrowingMarket failure protection the conflicting needs of lenders and borrowers are reconciled, preventingmarket failure
The cost advantages of using financial
intermediaries include:
- Reconciling conflicting preferences of lenders and borrowers
- Risk aversion intermediaries help spread out and decrease the risks
- Economies of scale using financial intermediaries reduces the costs of lending and borrowing
- Economies of scope intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs)
The Eurobond market
The Eurobond market
is made up of investors, banks, borrowers,
and trading agents that buy, sell, and transfer Eurobonds. Eurobonds are a
special kind of bond issued by European
governments and companies, but often denominated in non-European currencies
such as dollars and yen. They are also issued by international bodies such as
the World Bank. The creation of the unified European currency, the euro, has
stimulated strong interest in euro-denominated bonds as well; however, some
observers warn that new European Union tax harmonization policies may lessen
the bonds' appeal.
Eurobonds are unique
and complex instruments of relatively recent origin. They debuted in 1963, but
didn't gain international significance until the early 1980s. Since then, they
have become a large and active component of international finance. Similar to
foreign bonds, but with important differences, Eurobonds became popular with
issuers and investors because they could offer certain tax shelters and
anonymity to their buyers. They could also offer borrowers favorable interest
rates and international exchange rates.
The Eurobond market
consists of several layers of participants. First there is the issuer, or
borrower, that needs to raise funds by selling bonds. The borrower, which could
be a bank, a business, an international organization, or a government,
approaches a bank and asks for help in issuing its bonds. This bank is known as
the lead manager and may ask other banks to join it to form a managing group
that will negotiate the terms of the bonds and manage issuing the bonds. The
managing group will then sell the bonds to an underwriter or directly to a
selling group. The three levels—managers, underwriters, and sellers—are known
collectively as the syndicate. The underwriter will actually purchase the bonds
at a minimum price and assume the risk that it may not be possible to sell them
on the market at a higher price. The underwriter (or the managing group if
there is no underwriter) sells the bonds to a selling group that then places
bonds with investors. The syndicate companies and their investor clients are
considered the primary market for Eurobonds; once they are resold to general
investors, the bonds enter the secondary market. Participants in the market are
organized under the International Primary Market Association (IPMA) of London
and the Zurich-based International Security Market Association (ISMA)
Eurocurrency
Market'
The market where
financial banking institutions provide banking services denominated in foreign
currencies. They may accept deposits and provide loans. Unlike Eurocredit
markets, however, loans in this market are made short-term.
The
money market in which Eurocurrency, currency held in banks outside of
the country where it is legal tender, is borrowed and lent by banks
in Europe. The Eurocurrency market is utilized by large firms and extremely
wealthy individuals who wish to circumvent regulatory requirements, tax laws
and interest rate caps that are often present in domestic banking, particularly
in the United States.
'Eurocurrency Market'
Rates on deposits in
the Eurocurrency market are typically higher than in the domestic market,
because the depositor is not protected by domestic banking laws and does not
have governmental deposit insurance. Rates on loans in the Eurocurrency market
are typically lower than those in the domestic market, because banks are not
subject to reserve requirements on Eurocurrency and do not have to pay deposit
insurance premiums.
A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
'Inverted Yield Curve'
An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
urve'
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