FINANCIAL INSTITUTIONS AND CH04: FINANCIAL MARKETS IN THE FINANCIAL

MARKETS SYSTEM

CHAPTER 4
FINANCIAL MARKETS IN THE FINANCIAL SYSTEM

4.1. Introduction

Financial market is a mechanism that allows people to buy and sell (trade) financial securities
(such as stocks and bonds) at low transaction cost and at prices that reflect the efficient market
hypothesis. It is structures for which funds flow. In finance, financial markets facilitate:
 The raising of capital (in the capital market)
 The transfer of risk (in the derivative markets)
 International trade (in the currency market)

Typically a borrower issues a receipt to the lender promising to pay back the capital. These
receipts are securities which may be freely bought or sold. In return for lending money to the
borrower, the lender will expect some compensation in the form of interest or dividend. In other
words, financial market is a market where financial assets are exchanged or traded. According to
Brigham, Eurene F. “financial markets are the place where people and organization wanting to
borrow money are brought together with those having surplus funds.

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

4.2. The Organization and Structure of Markets

The following several categorizations of financial markets illustrate essential features,
organization and structure of these markets.

A. Primary Markets vs. Secondary Markets

i. A primary market issues new securities on an exchange. Companies, governments and

other groups obtain financing through debt or equity based securities. Primary markets,
also known as "new issue 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. The primary markets are where investors have their
first chance to participate in 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.

ii. The secondary market is where investors purchase securities or assets from other
investors, rather than from issuing companies themselves. The Securities and Exchange
Commission (SEC) registers securities prior to their primary issuance, then they start
trading in the secondary market on the New York Stock Exchange, NASDAQ or other
venue where the securities have been accepted for listing and trading. The secondary
market 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

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investor demand for a new security until several days of trading have occurred. 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.

Note that, in any secondary market trade, the cash proceeds go to an investor rather than
to the underlying company/entity directly.

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.

B. Third vs. Fourth Markets

You might also hear the terms "third" and "fourth markets." These don't concern individual
investors because they involve significant volumes of shares to be transacted per trade. These
markets deal with transactions between broker-dealers and large institutions through over-the-
counter electronic networks. The third market comprises OTC transactions between broker-
dealers and large institutions. The fourth market is made up of transactions that take place
between large institutions. The main reason these third and fourth market transactions occur is to
avoid placing these orders through the main exchange, which could greatly affect the price of the
security. Because access to the third and fourth markets is limited, their activities have little
effect on the average investor.
C. Capital vs. money market

A capital market is one in which individuals and institutions trade financial securities.
Organizations and 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. Any government or corporation requires capital (funds) to finance its
operations and to engage in its own long-term investments. To do this, a company raises money
through the sale of securities - stocks and bonds in the company's name. These are bought and
sold in the capital markets.

Money Market
The money market is 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), banker's
acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and
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repurchase agreements (repos). Money market investments are also called cash investments
because of their short maturities.
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. Because they are extremely
conservative, money market securities offer significantly lower returns than most other
securities. However, there are risks in the money market that any investor needs to be aware of,
including the risk of default on securities such as commercial paper.

D. Debt vs. 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 income (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
income 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
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.

E. Exchanges vs. Over-The-Counter Markets

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 OTC Market
(over-the-counter market) is a type of secondary market also referred to as a dealer market. The
term "over-the-counter" refers to stocks that are not trading on a stock exchange such as the
NASDAQ, NYSE or American Stock Exchange (AMEX). This generally means that the stock
trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these
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networks is an exchange; in fact, they describe themselves as providers of pricing information

for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than
those that trade shares on a stock exchange. Most securities that trade this way are penny stocks
or are from very small companies.

F. Derivative vs. foreign exchange markets

Derivatives Markets: a derivative is simply a contract which entitles the holder to buy or sell a
commodity at some future date for a predetermined price.Therefore, while a stock or a bond has
intrinsic value (a stock or a bond represents a claim to some asset or income stream), a derivative
has no intrinsic value. Its value is “derived” from the underlying asset.Examples of common
derivatives are forwards, futures, options, swaps…
 Future: The owner of a future has the OBLIGATION to sell or buy something in the
future at a predetermined price.
 Forwards:The owner of a forward has the OBLIGATION to sell or buy something in
the future at a predetermined price. The difference to a future contract is that forwards
are not standardized.
 Options: The owner of option has the OPTION to buy or sell something at a
predetermined price and is therefore more costly than a futures contract.
 Swaps: A swap is an agreement between two parties to exchange a sequence of cash
flows.
Those contracts are called derivative instruments and the markets in which they trade are referred
to as derivative markets.
The foreign exchange market is where international currencies trade and exchange rates are
set.i.e., it is market where currencies are traded. The forex market is the largest, most liquid
market in the world with an average traded value that exceeds $1.9 trillion per day and includes
all of the currencies in the world. The forex is the largest market in the world in terms of the total
cash value traded, and any person, firm or country may participate in this market.
There is no central marketplace for currency exchange; trade is conducted over the counter. The
forex market is open 24 hours a day, five days a week and currencies are traded worldwide
among the major financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong,
Singapore, Paris and Sydney. Until recently, forex trading in the currency market had largely
been the domain of large financial institutions, corporations, central banks, hedge funds and
extremely wealthy individuals. The emergence of the internet has changed all of this, and now it
is possible for average investors to buy and sell currencies easily with the click of a mouse
through online brokerage accounts.

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