FINANCIAL MARKETS AND INSTITUTIONS

The Capital Allocation Process

Diagram of the capital formation process for business

1. Direct transfers of money and securities, as shown in the top section, occur when a business
sells its stocks or bonds directly to savers, without going through any type of financial
institution. The business delivers its securities to savers, who, in turn, give the firm the money it
needs. This procedure is used mainly by small firms, and relatively little capital is raised by direct
transfers.
2. As shown in the middle section, transfers may also go through an investment bank (IB) such as
Morgan Stanley, which underwrites the issue. An underwriter facilitates the issuance of
securities. The company sells its stocks or bonds to the investment bank, which then sells these
same securities to savers. The businesses’ securities and the savers’ money merely “pass
through” the investment bank. However, because the investment bank buys and holds the
securities for a period of time, it is taking a risk—it may not be able to resell the securities to
savers for as much as it paid. Because new securities are involved and the corporation receives
the sale proceeds, this transaction is called a primary market transaction.
3. Transfers can also be made through a financial intermediary such as a bank, an insurance
company, or a mutual fund. Here the intermediary obtains funds from savers in exchange for its
securities. The intermediary uses this money to buy and hold businesses’ securities, and the
savers hold the intermediary’s securities. For example, a saver deposits dollars in a bank,
receiving a certificate of deposit; then the bank lends the money to a business in the form of a
mortgage loan. Thus, intermediaries literally create new forms of capital—in this case,
certificates of deposit, which are safer and more liquid than mortgages and thus better for most
savers to hold. The existence of intermediaries greatly increases the efficiency of money and
capital markets.
Financial Markets

People and organizations wanting to borrow money are brought together with those who have surplus
funds in the financial markets.

Types of Markets

Financial markets also vary depending on the maturity of the securities being traded and the types of
assets used to back the securities. For these reasons, it is useful to classify markets along the following
dimensions:

1. Physical asset markets versus financial asset markets

 Physical asset markets (tangible or real asset markets) are tangible assets and can be
seen and touched, with a very identifiable physical presence.
 Financial asset markets in addition to dealing with stocks, bonds, notes, and mortgages
hipotek) are also deal with derivative securities whose values are derived from changes
in the prices of other assets.
2. Spot markets versus futures markets
 Spot markets are The markets in which assets are bought or sold for “on-the-spot”
delivery (literally, within a few days).
 Futures are The markets in which participants agree today to buy or sell an asset at
some future date.
3. Money markets versus capital markets
 Money are The financial markets in which funds are borrowed or loaned for short
periods (less than one year).
 Capital are The financial markets for stocks and for intermediate- or long-term debt (one
year or longer).
4. Primary markets versus secondary markets
 Primary Markets are Markets in which corporations raise capital by issuing new
securities.
 Secondary Markets are 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 are Markets in which transactions are worked out directly between two
or more parties.
 Public Markets are Markets in which standardized contracts are traded on organized
exchanges.

SELF TEST

1. Distinguish between physical asset markets and financial asset markets.

Physical asset markets versus financial asset markets
 Physical asset markets (tangible or real asset markets) are tangible assets and can be
seen and touched, with a very identifiable physical presence.
Example: Land, Building, Machinery, Tools, Equipment, Vehicle, etc.
  Financial asset markets in addition to dealing with stocks, bonds, notes, and mortgages
are also deal with derivative securities whose values are derived from changes in the
prices of other assets.
Example: Loan, Bond, Insurance, etc.
2. What’s the difference between spot markets and futures markets?
Spot markets versus futures markets
 Spot markets are The markets in which assets are bought or sold for “on-the-spot”
delivery (literally, within a few days). Payments in the spot market must be paid in
advance so that the assets are sent immediately.
 Futures markets are The markets in which participants agree today to buy or sell an
asset at some future date. Payments in the futures market are paid on the future
settlement date.
3. Distinguish between money markets and capital markets.
 Money markets are The financial markets in which funds are borrowed or loaned for
short periods (less than one year).
Example of money market instrument: repurchase agreements, commercial paper, etc.
 Capital markets are The financial markets for stocks and for intermediate- or long-term
debt (one year or longer).
Example of capital market instrument: fixed deposits, debentures, etc.
4. What’s the difference between primary markets and secondary markets?
 Primary Markets are Markets in which corporations raise capital by issuing new
securities.
 Secondary Markets are Markets in which securities and other financial assets are traded
among investors after they have been issued by corporations.
5. Differentiate between private and public markets.
 Private Markets are Markets in which transactions are worked out directly between two
or more parties.
 Public Markets are Markets in which standardized contracts are traded on organized
exchanges.
6. Why are financial markets essential for a healthy economy and economic growth?

Economic development is highly correlated with the level and efficiency of financial markets and
institutions. Financial markets help to efficiently direct the flow of savings and investment in
the economy in ways that facilitate the accumulation of capital and the production of goods and
services.

A healthy economy is dependent on efficient funds transfers from people who are net savers to
firms and individuals who need capital. Without efficient transfers, the economy simply could
not function. Therefore, it is absolutely essential that our financial markets function efficiently-
not only quickly, but also at a low cost.

1. Differentiation Between Financial Market and Financial Institutional!

Financial Market
Financial Market refers to a marketplace, where creation and trading of financial assets, such as
shares, debentures, bonds, derivatives, currencies, etc. take place. It plays a crucial role in
allocating limited resources, in the country’s economy. It acts as an intermediary between the
savers and investors by mobilising funds between them. The financial market provides a
platform to the buyers and sellers, to meet, for trading assets at a price determined by the demand
and supply forces.
Functions of Financial Market:
 It facilitates mobilisation of savings and puts it to the most productive uses.
 It helps in determining the price of the securities. The frequent interaction between
investors helps in fixing the price of securities, on the basis of their demand and supply in
the market.
 It provides liquidity to tradable assets, by facilitating the exchange, as the investors can
readily sell their securities and convert assets into cash.
 It saves the time, money and efforts of the parties, as they don’t have to waste resources
to find probable buyers or sellers of securities. Further, it reduces cost by providing
valuable information, regarding the securities traded in the financial market.
The financial market maybe have or maybe not have a physical location, so the exchange of asset
between the parties can also take place over the internet or phone also.
Classification of Financial Market
1. By Nature of Claim
a. Debt Market:
The market where fixed claims or debt instruments (such as debentures or bonds) are
bought and sold between investors.
b. Equity Market:
Equity market is a market where in the investors deal in equity instruments. It is the
market for residual claims.
2. By Maturity of Claim
a. Money Market:
The market where monetary assets (such as commercial paper, certificate of deposits,
treasury bills, etc.) which mature within a year. It is the market for short-term funds. No
such market exist physically. The transactions are performed over a virtual network, i.e.
fax, internet or phone.
b. Capital Market:
The market where medium and long term financial assets are traded in the capital market.
It is divided into two types:
 Primary Market (Financial Market): Where in the company listed on an exchange,
for the first time, issues new security or already listed company brings the fresh
issue.
 Secondary Market (Stock Market): An organised marketplace, where in already
issued securities are traded between investors, such as individuals, merchant
bankers, stockbrokers and mutual funds.
 3. By Timing of Delivery
a. Cash Market:
The market where the transaction between buyers and sellers are settled in real-time.
b. Futures Market:
Futures market is one where the delivery or settlement of commodities takes place at a
future specified date.
4. By Organizational Structure
a. Exchange-Traded Market:
A financial market, which has a centralised organization with the standardised procedure.
b. Over-the-Counter Market: 
An OTC is characterised by a decentralised organisation, having customised procedures.

Financial Institutional
Financial Institution is an intermediary between consumers and the capital or the debt markets
providing banking and investment services. A financial institution is responsible for the supply
of money to the market through the transfer of funds from investors to the companies in the form
of loans, deposits, and investments. Financial institutions encompass a broad range of business
operations within the financial services sector including banks, trust companies, insurance
companies, brokerage firms, and investment dealers. Virtually everyone living in a developed
economy has an ongoing or at least periodic need for the services of financial institutions. Large
financial institutions such as JP Morgan Chase, HSBC, Goldman Sachs or Morgan Stanley can
even control the flow of money in an economy.
Two main types of financial institutions are:
1. Depository banks and credit unions which pay interest on deposits from the interest earned
on the loans.
2. Non-depository insurance companies and mutual funds which collect funds by selling their
policies or shares to the public and provide returns in the form periodic benefits and profit
payouts.
How Financial Institutions Work
Financial institutions serve most people in some way, as financial operations are a critical part of
any economy, with individuals and companies relying on financial institutions for transactions
and investing. Governments consider it imperative to oversee and regulate banks and financial
institutions because they do play such an integral part of the economy. Historically, bankruptcies
of financial institutions can create panic.
Types of Financial Institutions
Financial institutions offer a wide range of products and services for individual and commercial
clients. Types of Financial Institution, that is:
 Commercial Banks
A commercial bank is a type of financial institution that accepts deposits, offers checking
account services, makes business, personal, and mortgage loans, and offers basic financial
products like certificates of deposit (CDs) and savings accounts to individuals and small
businesses. Banks also act as payment agents via credit cards, wire transfers, and currency
exchange.
 Investment Banks
Investment banks specialize in providing services designed to facilitate business operations, such
as capital expenditure financing and equity offerings, including initial public offerings (IPOs).
They also commonly offer brokerage services for investors, act as market makers for trading
exchanges, and manage mergers, acquisitions, and other corporate restructurings.
 Insurance Companies
Insurances Companies providing insurance, whether for individuals or corporations. Protection
of assets and protection against financial risk, secured through insurance products, is an essential
service that facilitates individual and corporate investments that fuel economic growth.
 Brokerage Firms
Investment companies and brokerages, such as mutual fund and exchange-traded fund (ETF)
provider Fidelity Investments, specialize in providing investment services that include wealth
management and financial advisory services. They also provide access to investment products
that may range from stocks and bonds all the way to lesser-known alternative investments, such
as hedge funds and private equity investments.

2. Role of Financial Market and Financial Institutional in Capital Allocation!

In a well-functioning economy, capital flows efficiently from those who supply capital to
those who demand it. Suppliers of capital-individuals and institution with “excess funds.” These
groups are saving money and looking for a rate of return on their investment. Demanders or
users of capital-individuals and institutions who need to raise funds to finance their investment
opportunities.
One of the main functions of financial markets is to allocate capital. Capital markets
especially facilitate the raising of capital while money markets facilitate the transfer of liquidity,
matching those who have capital to those who need it. Financial markets attract funds from
investors and channel them to enterprises that use that capital to finance their operations and
achieve growth, from start-up phases to expansion--even much later in the firm's life. Money
markets allow firms to borrow funds on a short-term basis, while capital markets
allow corporations to gain long-term funding to support expansion.
 Financial institutions are intermediary institutions that operate in financial markets. The
existence of these financial institutions aims to make the process of allocating savings to parties
who need investment more efficiently.

3. Operational of Money Market and The Types of Financial Market!

Money Market Operations

The borrowing and re-lending of highly liquid, short-term assets and securities. Examples
include the borrowing and re-lending of U.S. Treasury bills and commercial paper. Money
market operations are conducted between banks.
The primary means of money market operations are open market operations, through
which the Bank provides loans to financial institutions, or purchases from or sells to financial
institutions financial assets.
Types of Financial Markets
1. Stock market
The stock market trades shares of ownership of public companies. Each share comes with a
price, and investors make money with the stocks when they perform well in the market. It is easy
to buy stocks. The real challenge is in choosing the right stocks that will earn money for the
investor.
There are various indices that investors can use to monitor how the stock market is doing. When
stocks are bought at a cheaper price and are sold at a higher price, the investor earns from the
sale.
2. Bond market
The bond market offers opportunities for companies and the government to secure money to
finance a project or investment. In a bond market, investors buy bonds from a company, and the
company returns the amount of the bonds within an agreed period, plus interest.
3. Commodities market
The commodities market is where traders and investors buy and sell natural resources or
commodities such as corn, oil, meat, and gold. A specific market is created for such resources
because their price is unpredictable. There is a commodities futures market wherein the price of
items that are to be delivered at a given future time is already identified and sealed today.
4. Derivatives market
The derivatives market is the financial market for derivatives, financial instruments like futures
contracts or options, which are derived from other forms of assets.
SELF TEST

 What’s the difference between a commercial bank and an investment bank?

Commercial banks take deposits, provide checking and debit account services, and provide business,
personal, and mortgage loans. They also offer basic bank products such as certificates of deposit (CDs)
and savings accounts to individuals and small businesses.

Investment banks are primarily financial middlemen, helping corporations set up IPOs, get debt
financing, negotiate mergers and acquisitions, and facilitate corporate reorganization. Investment banks
also act as a broker or advisor for institutional clients.

 List the major types of financial institutions, and briefly describe the primary function of each.

Depository institutions – deposit-taking institutions that accept and manage deposits and make loans,
including banks, building societies, credit unions, trust companies, and mortgage loan companies;

Contractual institutions – insurance companies and pension funds

Investment institutions – investment banks, underwriters, brokerage firms.

 What are some important differences between mutual funds, Exchange Traded Funds, and
hedge funds? How are they similar?

Mutual Funds: a diversified basket of stocks and/or bonds managed by a fund manager who is
compensated to manage the investments within the fund. By purchasing a mutual fund you have access
to diversification and professional management with a small minimum investment.

ETF: An exchange traded fund is a tradable security unlike most mutual funds. You can buy and sell very
quickly through an exchange. ETFs track a specific asset price or an index. ETFs can track stock market
indicies, sectors, comoddities, whatever.

Hedge Funds are unregulated pools of investor capital that utilize unconventional strategies in order to
provide absolute returns. Hedge funds attempt to generate positive returns regardless of whether or not
the market is up or down.

SELFTEST

 What are the differences between the physical location exchanges and the NASDAQ stock
market?
Physical Location Exchanges Formal organizations having tangible physical locations that
conduct auction markets in designated (“listed”) securities.

 What is the bid-ask spread?

A bid-ask spread is the amount by which the ask price exceeds the bid
price for an asset in the market.