Chapter 1

Why Markets Matter

 A financial market is a market in which financial assets (securities) such as stocks and
bonds can be purchased or sold. Funds are transferred in financial markets when one
party purchases financial assets previously held by another party. Financial markets
facilitate the flow of funds and thereby allow financing and investing by households,
firms, and government agencies. This chapter provides some background on financial
markets and on the financial institutions that participate in them.

 Role of financial markets

Financial markets perform the essential economic function of channeling funds from
households, firms, and governments that have saved surplus funds by spending less
than their income to those that have a shortage of funds because they wish to spend
more than their income. This function is shown schematically in Figure 1. Those who
have saved and are lending funds, the lender-savers, are at the left, and those who must
borrow funds to finance their spending, the borrower-spenders, are at the right. The
principal lender-savers are households, but business enterprises and the government,
as well as foreigners and their governments, sometimes also find themselves with
excess funds and so lend them out. The most important borrower-spenders are
businesses and the government, but households and foreigners also borrow to finance
their purchases of cars, furniture, and houses. The arrows show that funds flow from
lender-savers to borrower-spenders via two routes.
In direct finance (the route at the bottom of Figure 1), borrowers borrow funds
directly from lenders in financial markets by selling them securities (also called
financial instruments), which are claims on the borrower’s future income or assets.
Securities are assets for the person who buys them, but they are liabilities (IOUs or
debts) for the individual or firm that sells (issues) them. For example, if General Motors
needs to borrow funds to pay for a new factory to manufacture electric cars, it might
borrow the funds from savers by selling them a bond, a debt security that promises to
make payments periodically for a specified period of time, or a stock, a security that
entitles the owner to a share of the company’s profits and assets.

Figure 1 Flows of funds through the financial system

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 Basic functions of financial markets
o Price setting. The value of an ounce of gold or a share of stock is no more, and
no less, than what someone is willing to pay to own it. Markets provide price
discovery, a way to determine the relative values of different items, based upon
the prices at which individuals are willing to buy and sell them.
o Asset valuation. Market prices offer the best way to determine the value of a firm
or of the firm’s assets, or property. This is important not only to those buying and
selling businesses, but also to regulators. An insurer, for example, may appear
strong if it values the securities it owns at the prices it paid for them years ago,
but the relevant question for judging its solvency is what prices those securities
could be sold for if it needed cash to pay claims today.
o Arbitrage. In countries with poorly developed financial markets, commodities and
currencies may trade at very different prices in different locations. As traders in
financial markets attempt to profit from these divergences, prices move towards
a uniform level, making the entire economy more efficient.
o Raising capital. Firms often require funds to build new facilities, replace
machinery or expand their business in other ways. Shares, bonds and other types
of financial instruments make this possible. The financial markets are also an
important source of capital for individuals who wish to buy homes or cars, or even
to make credit-card purchases.
o Commercial transactions. As well as long-term capital, the financial markets
provide the grease that makes many commercial transactions possible. This
includes such things as arranging payment for the sale of a product abroad, and
providing working capital so that a firm can pay employees if payments from
customers run late.
o Investing. The stock, bond and money markets provide an opportunity to earn a
return on funds that are not needed immediately, and to accumulate assets that
will provide an income in future.
o Risk management. Futures, options and other derivatives contracts can provide
protection against many types of risk, such as the possibility that a foreign
currency will lose value against the domestic currency before an export payment
is received. They also enable the markets to attach a price to risk, allowing firms
and individuals to trade risks so they can reduce their exposure to some while
retaining exposure to others.

 Structure of Financial Markets

The following descriptions of several categorizations of financial markets illustrate the
essential features of these markets. (See Figure 2)

o Debt and 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 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 10 years or longer. Debt instruments
with a maturity between one and 10 years are said to be intermediate-term.

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 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 stock in a company that has issued one million 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 important to the firm and to elect its directors.
The main disadvantage 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 before it pays its 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.

o Primary and Secondary Markets

A primary market is a financial market in which new issues of a security, such
as a bond or a stock, are sold to initial buyers by the corporation or government
agency borrowing the funds. A secondary market is a financial market in which
securities that have been previously issued can be resold.
The primary markets for securities are not well known to the public
because the selling of securities to initial buyers often takes place behind closed
doors. An important financial institution that assists in the initial sale of securities
in the primary market is the investment bank. It does this by underwriting
securities: It guarantees a price for a corporation’s securities and then sells them
to the public.
The New York Stock Exchange and NASDAQ (National Association of
Securities Dealers Automated Quotation System), in which previously issued
stocks are traded, are the best-known examples of secondary markets, although
the bond markets, in which previously issued bonds of major corporations and the
U.S. government are bought and sold, actually have a larger trading volume.
Other examples of secondary markets are foreign exchange markets, futures
markets, and options markets. Securities brokers and dealers are crucial to a well-
functioning secondary market. Brokers are agents of investors who match buyers
with sellers of securities; dealers link buyers and sellers by buying and selling
securities at stated prices.
When an individual buys a security in the secondary market, the person
who has sold the security receives money in exchange for the security, but the
corporation that issued the security acquires no new funds. A corporation
acquires new funds only when its securities are first sold in the primary market.
Nonetheless, secondary markets serve two important functions. First, they make
it easier and quicker to sell these financial instruments 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 pay the issuing corporation no more than the price they
think the secondary 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

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 financial capital it can raise. Conditions in the secondary market are therefore the
most relevant to corporations issuing securities.

o Exchanges and 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 trades. The New York and American Stock
Exchanges for stocks and the Chicago Board of Trade for commodities (wheat,
corn, silver, and other raw materials) are examples of organized exchanges.
The other method of organizing a secondary market is to have an over-
the-counter (OTC) market, in which dealers at different locations who have an
inventory of securities stand ready to buy and sell securities “over the counter” to
anyone who comes to them and is willing to accept their prices. Because over-
the-counter dealers are in computer contact and know the prices set by one
another, the OTC market is very competitive and not very different from a market
with an organized exchange.
Many common stocks are traded over the counter, although a majority of
the largest corporations have their shares traded at organized stock exchanges.
The U.S. government bond market, with a larger trading volume than the New
York Stock Exchange, by contrast, is set up as an over-the-counter market. Forty
or so dealers establish a “market” in these securities by standing ready to buy
and sell U.S. government bonds. Other over-the-counter markets include those
that trade other types of financial instruments such as negotiable certificates of
deposit, federal funds, banker’s acceptances, and foreign exchange.

o Money and Capital Markets

Another way of distinguishing between markets is on the basis of the maturity of
the securities traded in each market. The money market is a financial market in
which only short-term debt instruments (generally those with original maturity of
less than one year) are traded; the capital market is the market in which longer-
term debt (generally with original maturity of one year or greater) and equity
instruments are traded. Money market securities are usually more widely traded
than longer-term securities and so tend to be more liquid. In addition, short-term
securities have smaller fluctuations in prices than long-term securities, making
them safer investments. As a result, corporations and banks actively use the
money market to earn interest on surplus funds that they expect to have only
temporarily. Capital market securities, such as stocks and long-term bonds, are
often held by financial intermediaries such as insurance companies and pension
funds, which have little uncertainty about the amount of funds they will have
available in the future.

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 Figure 2 Classification of financial market

 The investors
The driving force behind financial markets is the desire of investors to earn a return on
their assets. This return has two distinct components:
o Yield is the income the investor receives while owning an investment.
o Capital gains are increases in the value of the investment itself, and are often
not available to the owner until the investment is sold.

 Two categories of investors

o Retail investors are sometimes also called individual investors. These are non-
professional investors who purchase assets such as stocks, bonds, securities,
mutual funds and exchange traded funds. They are only able to make these
purchases by going through another party such as a brokerage firm or investment
adviser.
o Institutional investor is an entity that makes investment decisions on behalf of
individual members or shareholders.

 Types of Institutional Investors

o Mutual funds. These companies accept deposits from various small investors.
Then, they invest it in a different class of assets and generate profit for such
investors.
o Hedge funds. Alternative investments using pooled funds that employ different
strategies to earn active return for their investors.
o Insurance companies. Ccompany which provides security from several risks, by
acquiring a monthly or yearly premium from the insured person or business entity.
o Pension funds. Government and private sector companies deduct some amount
yearly from the employees’ salary to deposit it into the pension schemes. These

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 pension fund institutions further block this amount into beneficial long-term
assets.
o Banks. The financial institutions which accept deposits from the individuals or
firms and utilize this money to grant loans and advances.
o Endowment funds. Investment portfolios where the initial money is provided by
donations to a foundation.

 Important attributes of formal financial markets

o Liquidity, the ease with which trading can be conducted. In an illiquid market an
investor may have difficulty finding another party ready to make the desired trade,
and the difference, or “spread”, between the price at which a security can be
bought and the price for which it can be sold, may be high. Trading is easier and
spreads are narrower in more liquid markets. Because liquidity benefits almost
everyone, trading usually concentrates in markets that are already busy.
o Transparency, the availability of prompt and complete information about trades
and prices. Generally, the less transparent the market, the less willing people are
to trade there.
o Reliability, particularly when it comes to ensuring that trades are completed
quickly according to the terms agreed.
o Legal procedures adequate to settle disputes and enforce contracts.
o Suitable investor protection and regulation. Excessive regulation can stifle a
market. However, trading will also be deterred if investors lack confidence in the
available information about the securities they may wish to trade, the procedures
for trading, the ability of trading partners and intermediaries to meet their
commitments, and the treatment they will receive as owners of a security or
commodity once a trade has been completed.
o Low transaction costs. Many financial-market transactions are not tied to a
specific geographic location, and the participants will strive to complete them in
places where trading costs, regulatory costs and taxes are reasonable.

 Forces of change in financial markets

o Technology
Almost everything about the markets has been reshaped by the forces of
technology. Abundant computing power and cheap telecommunications have
encouraged the growth of entirely new types of financial instruments and have
dramatically changed the cost structure of every part of the financial industry.
o Deregulation
The trend towards deregulation has been worldwide. It is not long since
authorities everywhere kept tight controls on financial markets in the name of
protecting consumers and preserving financial stability. But since 1975, when the
United States prohibited stockbrokers from setting uniform commissions for share
trading, the restraints have been loosened in one country after another. Although
there are great differences, most national regulators agree on the principles that
individual investors need substantial protection, but that dealings involving
institutional investors require little regulation.
o Liberalization
Deregulation has been accompanied by a general liberalization of rules governing
participation in the markets. Many of the barriers that once separated banks,
investment banks, insurers, investment companies and other financial institutions
have been lowered, allowing such firms to enter each other’s’ businesses. The
big market economies, most recently Japan and South Korea, have also allowed

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 foreign firms to enter financial sectors that were formerly reserved for domestic
companies.
o Consolidation
Liberalization has led to consolidation, as firms merge to take advantage of
economies of scale or to enter other areas of finance. Almost all the UK’s leading
investment banks and brokerage houses, for example, have been acquired by
foreigners seeking a bigger presence in London, and many of the medium-sized
investment banks in the United States were bought by commercial banks wishing
to use new powers to expand in share dealing and corporate finance. Financial
crisis led to further consolidation, as the insolvency of many major banks and
investment banks led to forced mergers in 2008.
o Globalization
Consolidation has gone hand in hand with globalization. Most of the important
financial firms are now highly international, with operations in all the major
financial centers. Many companies and governments take advantage of these
global networks to issue shares and bonds outside their home countries.
Investors increasingly take a global approach as well, putting their money
wherever they expect the greatest return for the risk involved, without worrying
about geography.

Levinson, M. (2014). The Economist: Guide to the Financial Markets (6th ed.) Profile Books
Ltd London

Madura, J. (2013). Financial markets and institutions (11th ed.) Cengage Learning Stamford

Mishkin, F. and Eakins, S. (2012) Financial Markets and Institutions (7th ed.) Pearson
Education, Inc. Boston