CHAPTER FOUR

FINANCIAL MARKETS IN FINANCIAL SYSTEM

3.1 The Concept and Structure of Markets

A Market is institutional mechanism where supply and demand meet to exchange goods and services; or a
place or event at which people gather in order to buy and sell things in order to trade. A market is not
necessarily a physical and geographically identifiable place, and goods traded are not necessarily physical
goods. Trading might take place over the telephone, and goods traded might be knowledge, etc. There are
different markets in a system, such as
• the services market
• the products market
• The financial markets.
3.2 Financial Markets and its Formation
Financial markets may be viewed as channels through which moves a vast flow of loan able funds that it
continually being drawn upon by demanders of funds and continually being replenished by suppliers of funds.
Filled with a desire to lend or to borrow, the end users of most financial systems are faced with a choice
between three broad approaches:
1. They may decide to deal directly with another, which is costly, risky, inefficient, consequently; and not
very likely, or
2. They may decide to use one or more of many organized markets. In these markets, lenders buy the
liabilities issued by the borrowers. If the liability is newly issued, then the issuer receives funds directly
from the lender. More frequently, however, a lender will buy an existing liability from another lender. In
effect, this refinances the original loan though the borrower who is completely unaware of this
secondary transaction, or
3. They may decide to deal via intermediaries. In this case, lenders have an asset – a bank deposit or
contribution to a life insurance or pension fund – which cannot be traded but can only be returned to the
intermediary.
A call market- is a market in which transactions only take place at specific times or intervals, and the price of
goods is determined by the market, rather than the activities of buyers and sellers.
• This type of market can be less volatile than a so-called “auction market” in which people buy and
sell continuously, but it can also be difficult to navigate.
• As a general rule, this technique is used when trading volume is low and there are very few players
involved.
Auction Markets- In the auction or conventional market, orders are filled as needed, with people buying and
selling with the traders who will offer the best prices.
• An auction market is some form of centralized facility (or clearing house) by which buyers and sellers,
through their commissioned agents (brokers), execute trades in an open and competitive bidding
process.
An auction market is typically a public market in the sense that it open to all agents who wish to
participate. Auction markets can either be call markets -- such as art auctions -- for which bid and asked
prices are all posted at one time, or continuous markets -- such as stock exchanges and real estate markets -
- for which bid and asked prices can be posted at any time the market is open and exchanges take place on
a continual basis.

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3.3 Organization of Financial Markets within the Financial System
Markets can be organized in different ways depending on the characteristic of the market or instrument used to
create categories. Financial markets that are operating efficiently improve the economic welfare of everyone in
the society.

Depending on the characteristics of financial claims being traded and the needs of different investors, the
flow of funds through financial markets around the world may be divided into different segments. These
include:

1) The Money Market and Capital Market;

2) Primary and Secondary Markets;
3) Open and Negotiated Markets;
4) Spot; Futures; Forward; and Option Markets.

3.3.1 Money Market versus Capital Market

Money Market

• The money market is the market for short-term financial instruments.

• Money market instruments include Treasury bills, banker’s acceptances, commercial paper, Federal
funds, municipal notes, and other securities.

Features of Money Market

The following are the general features of a money market:
1. It is market purely for short-term funds or financial assets called near money.
2. It deals with financial assets having a maturity period up to one year only.
3. It deals with only those assets which can be converted into cash readily without loss and with minimum
transaction cost.
4. Generally transactions take place through phone i.e., oral communication. Relevant documents and
written communications can be exchanged subsequently. There is no formal place like stock exchange
as in the case of a capital market.
5. Transactions have to be conducted without the help of brokers.
6. The components of a money market are the Central Bank, Commercial Banks, Non-banking financial
companies, discount houses and acceptance house. Commercial banks generally play a dominant in this
market.

Objectives of Money Market

The following are the important objectives of a money market:

• To provide a parking place to employ short-term surplus funds.
• To provide room for overcoming short-term deficits.
• To enable the Central Bank to influence and regulate liquidity in the economy through its intervention
in this market.
• To provide a reasonable access to users of Short-term funds to meet their requirements quickly,
adequately and at reasonable costs.

Capital Market
• Traditionally, this has referred to the market for trading long-term debt instruments (those that mature
in more than one year). That is, the market where capital is raised.
• More recently, capital markets is used in a more general context to refer to the market for stocks, bonds,
derivatives and other investments.

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Securities trading on organized capital markets are monitored by the government; new issues are approved by
authorities of financial supervision and monitored by participating banks.

• Where the term to maturity of the instrument is up to five years, the security is classified as a short-term
capital market instrument.
• Where the term to maturity is five to ten years, the security is classified as medium term, and where the
term to maturity is more than 10 years, the security is known as long-term.

Financial intermediaries, such as banks, brokerage firms, and insurance companies facilitate the transfer of
capital.
The capital market (securities market) is the market for securities, where companies and the government can
raise long-term funds.
Securities are broadly categorized into debt and equity securities such as bonds and common stocks,
respectively. The company or other entity issuing the security is called the issuer.
3.3.2. Open versus Negotiated Markets
Financial market can also be divided into open market and negotiated market. There is a distinction between
markets in the global financial system that is often useful focuses on open markets versus negotiated markets.
• In open markets, financial instruments are sold to the highest bidder, and they can be traded as often
as is desirable before they mature.
• In negotiated markets, the instruments are sold to one or a few buyers under private contract.
Open Market
• The open market means an impersonal market.
• In this market good quality securities are bought and sold in large quantity.
• There may not be contract between buyers and seller. The security market is an example of open
market. In this market the equity securities of big companies are sold and purchased by big-small
investors. It is a market in which buyers enter competitive bids and sellers enter competitive offers at
the same time.

Negotiated Market
• The market in which the lender and the borrower negotiate the loan and personal basis is called
negotiated market.
• In this market, corporate securities are sold by personal negotiation to one or more than one buyer. In it,
the securities purchased are dept with security until maturity. A bank taking loan from a bank or a
businessman taking loan from credit institution fall under negotiated is called non-intermediate
financial market.

• Most stock exchanges are negotiated markets: buyers express interest by posting bid prices and sellers
do the same with ask prices.
• A negotiated market operates according to the law of supply and demand!
• Negotiable market is a closed-market transaction which is the opposite of an open-market transaction.
3.3.3 Primary versus Secondary Markets
In financial market basically there are also two common markets- primary market and secondary market.

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Primary Market

• Primary Market, also called the new issue market, is the market for issuing new securities.
• The primary market refers to where shares are created, are sold by the issuing company to investors,
and are listed for the first time on an exchange.
• The primary market is a market for new capitals that will be traded over a longer period.
• In the primary market, securities are issued on an exchange basis. The underwriters, that is, the
investment banks, play an important role in this market: they set the initial price range for a particular
share and then supervise the selling of that share.
• For most purposes, the primary market is synonymous with an initial public offering *(IPO), which
occurs when a private company first sells shares to the general public and is listed on an exchange.

* Initial public offering (IPO) is stock issued for the very first time to the public when a company "goes
public."

Secondary Market

• The secondary market is the one we all know, where existing shares are bought and sold by investors,
traders and speculators alike.
• The defining characteristic of the secondary market is that investors buy and sell among themselves.
They trade previously issued securities without any involvement by the issuing companies.
• Its chief function is to provide liquidity to security investors-that is, provide an avenue for converting
financial instruments into ready cash. If you sell shares of stock or bonds you have been holding for
some time to a friend or call a broker to place an order for shares currently being traded on the stock
exchanges, you are participating in a secondary-market transaction.
• It is the market where, an investor can buy a security directly from another investor in lieu of the issuer.
It is also referred as "after market".
• The securities initially are issued in the primary market, and then they enter into the secondary market.
• All the securities are first created in the primary market and then, they enter into the secondary market.
• Secondary market is a place where any type of used goods is available.
• The volume of trading in the secondary market is far larger than trading in the primary market.
However the secondary market does not support new investment
3.3.4 Spot versus Futures/Forward, and Option Markets
We may also distinguish between spot markets, futures or forward markets, and option markets.

• A spot market is one in which assets or financial services are traded for immediate delivery (usually
within one or two business days). If you pick up the telephone and instruct your broker to purchase X-
Corporation shares at today’s price, this is a spot market transaction. You expect to acquire ownership
of X-Corporation shares within a matter of minutes.
The spot market is also called the "cash market" or "physical market", because prices are settled in cash on
the spot at current market prices, as opposed to forward prices.

• A future or forward market, is designed to trade contracts calling for the future delivery of financial
instruments. For example, you may call your broker and ask to purchase a contract from another
investor calling for delivery to you of Birr 1 million in Government bonds six months from today.
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 • The purpose of such a contract would be to reduce risk by agreeing on a price today rather than waiting
six months, when government bond prices might have risen. Futures markets, which provide
standardized forward contracts for trading products at some future date.
• Options markets also offer investors in the money and capital markets an opportunity to reduce risk.
These markets make possible the trading of options on selected stocks and bonds, which are agreements
(contracts) that given an investor the right to either buy from or sell designated securities to the writer
of the option at a guaranteed price at any time during the life of the contract.
• An option is more flexible than a forward transaction. It allows the option owner the right to buy or sell
a specific amount of foreign currency at a certain price before the chosen expiration date. Depending on
the market, the option owner may exercise his option or allow the option to lapse and buy at the less
expensive current market rate.

3.3.5 Debt versus Equity Markets

In modern economies, all organizations -- including nonprofit institutions, government agencies and businesses
-- seek funding by issuing debt and equity instruments in financial markets. These markets are also known as
securities exchanges.

Debt Markets- The debt market is the market where debt instruments are traded.
• Debt instruments are assets that require a fixed payment to the holder, usually with interest.
• In other words a debt instrument is a contract in which one party -- the borrower -- agrees to repay
another party -- the lender -- at a specified future date, known as the maturity date.
Examples include corporate bonds, accounts payable and interest.
• Short-term debt securities are instruments that a borrower must repay within a year. Long-term
instruments have a maturity exceeding 12 months. In the corporate context, debt instruments may be
secured or unsecured. Secured debt agreements require that a borrower provide a collateral -- or
financial guarantee -- before a lender advances funds.
• Debt instrument holders, also known as bondholders, receive periodic interest payments during the
loan term and the principal amount when the loan matures.

Equity Markets- The equity market (often referred to as the stock market) is the market for trading equity
instruments.

• Stocks are securities that are a claim on the earnings and assets of a corporation. Equity securities are
portions of a company's ownership capital.
• In other words, buyers of equity instruments -- otherwise known as shareholders or stockholders -- own
the company.
• Shareholders receive periodic dividend payments and make profits when share prices increase.
Stockholders also participate in annual meetings and vote on important corporate affairs, including the
appointment and compensation of senior management and directors.

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3.3.6 International, Domestic and Foreign Exchange Market

Competition continues to be market-based and ultimately relies on delivering superior value to consumers.
However, success in global markets depends on knowledge accumulation and deployment. Conducting and
managing international business operations is more complex than undertaking domestic business. Differences
in the nationality of parties involved, relatively less mobility of factors of production, customer heterogeneity
across markets, variations in business practices and political systems, varied business regulations and policies,
use of different currencies are the key aspects that differentiate international businesses from domestic
business. These, moreover, are the factors that make international business much more complex and a difficult
activity.

I. International Marketing

International Marketing in general is the export, franchising, joint venture or full direct entry of a marketing
organization into another country. This can be achieved by exporting a company's product into another
location, entry through a joint venture with another firm in the target country, or foreign direct investment into
the target country. The development of the marketing mix for that country is then required - international
marketing. It can be as straightforward as using existing marketing strategies, mix and tools for export on the
one side, to a highly complex relationship strategy including localization, local product offerings, pricing,
production and distribution with customized promotions, offers, website, social media and leadership.

Internationalization and international marketing meets the needs of selected foreign countries where a
company's value can be exported and there is inter-firm and firm learning, optimization and efficiency in
economies of scale and scope. The firm does not need to export or enter all world markets to be considered an
international marketer. Hence, because of the globalization of financial markets throughout the world, a
corporation is not limited to raising funds in the financial market where it is domiciled.
ii. Domestic Marketing
• Domestic marketing is a marketing restricted to the political boundaries of a country, is called
"Domestic Marketing".
• Domestic marketing is the marketing practices within a marketer's home country.
• In other words, domestic marketing means selling within one's own country.
• Typically, this is the first area where companies seek to market their goods or services. Because the
market, customer needs, tastes, geography, demographics, and distribution methods are likely familiar,
it's often the easiest place for companies to launch a product. The four P's of marketing - product, price,
place and promotion - are often easier for companies to determine within the domestic market.
• A company marketing only within its national boundaries only has to consider domestic competition.

Foreign Exchange Markets (FX)

• The foreign-exchange market exists to facilitate the conversion of currencies, thereby allowing firms to
conduct trade more efficiently across national boundaries.
• Trading in the foreign exchange market is mainly to facilitate international trade and international
investment - the buying and selling of foreign goods, services and financial assets. Think of the three
functions of money - unit of account, medium of exchange and store of value. Foreign goods are
usually priced in foreign currency.

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 German wine/beer is priced in euro for example. The unit of account is the euro; the medium of exchange
is the euro. American liquor distributors need euro to buy the German wine/beer. Also, American
investors may consider the euro a better store of value than the US dollar. They could buy a certificate of
deposit from a German bank denominated in euro, instead of putting money in a U.S. bank. Or American
investors want to buy stock of a company in UK, Brazil or Turkey. They need foreign currency to buy
foreign assets.

Firms can shop for low-cost financing in capital markets around the world and then use the foreign-exchange
market to convert the foreign funds they obtain into whatever currency they require. One factor that obviously
distinguishes international business from domestic business is the use of more than one currency in
commercial transactions. The foreign-exchange market exists to facilitate this conversion of currencies,
thereby allowing firms to conduct trade more efficiently across national boundaries. The foreign-exchange
market also facilitates international investment and capital flows.

Money represents purchasing power, but usually only in one country. Alternatively, different countries have
different currency and the settlement of all business transactions within a country is done/ preferred local
currency. For instance, $, £, or € have no purchasing power in Ethiopia. The foreign exchange market provides
a forum where the currency of one country is traded for the currency of another country. Exchanging one
currency for another takes place in the FX market; (converting purchasing power from one currency into
another). The exchange rate is just the price of one currency in terms of another currency. For instance, a rate
of Br. 16.70 per US $ implies that one US dollar costs Birr 16.70.

FX market deal with a large volume of funds and a large number of currencies belonging to various countries.
For this reason, FX market is not only worldwide market but also is world's largest financial market. Though
there are foreign exchanges markets in all countries, London, New York and Tokyo are the nerve centre of
foreign exchange activity. FX is an OTC (over-the-counter) market. FX OTC market is international network
of bank currency traders, non-bank dealers, FX brokers, linked by computers, phone lines, telex machines,
automated quotation systems, etc. The communication system of FX dealers is extremely advanced,
sophisticated and reliable.

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