Overview of Financial Markets Financial Markets & Institutions

Chapter 2

INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS

Role of Markets in the Economic Assemblage

In modern world, market is usually regarded as an important economic institution, which can meet
the demand of multifarious needs of the common people. “Modern societies use markets to allocate
labor time, raw materials, energy, managerial skills, and capital. Managerial skills and capital in
order to produce the thousands of goods and services necessary for survival and growth. Markets are
the channels through which buyers and sellers meet to exchange goods, services, and resources.”

In practice, the marketplace determines that type of goods and services to be fabricated and produced
for the community in general. If the price or rate of consumer goods and services rises, business
units may also produce and supply more and more of those to the consumers. Fresh and innovative
firms may enter into the market immediately to produce more than the targeted goods or services
experiencing magnified demand and going up prices. On the contrary, a decline in price, usually
leads to decrease in production of goods and services in the economy as a whole. Some firms drop
their business from the market in the long run. “Markets reward superior productivity, innovation,
and sensitivity to customer needs with increased profits, higher wages and salaries, and other
economic benefits.” The following citation and relevant illustration (Figure 1.4) show the role of
market in the economy.

There are essentially three types of markets at work within the economic system: (1) factor markets.
(2) product markets, and (3) financial markets (see Figure 1-4). In factor markets consuming units
sell their labor, managerial skills, and other resources to those producing units offering the highest
prices. The factor markets allocate the so-called factors of production (land, labor and capital) and
distribute incomes in the form of salaries, wages, rental income, etc. to the owners of productive
resources. As Figure- 1-4 shows, consuming units use most of their income from the factor markets
to purchase goods and services in product markets. Food, shelter, clothing, medical care,
automobiles, books, theater tickets, gasoline, and swimming pools are among the many goods and
services sold in product markets.

Financial markets may serve as an integral part in the economy. The financial market channelizes
resources coming mainly from the internal resource base to serve human beings and organization to
meet the requirements. The financial markets can be termed as the heart of the financial system of
any country, which determine the volume of credit, mobilization of savings, interest rates and
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security prices. A diagram can be helpful for better understanding in this regard, which is shown in
Figure 1-4.

Types of Markets in the Economic System

Product
Product Markets
Markets

Financial Markets

Producing Flow
Flow of
of funds
funds Flow
Flow of
of
Producing units
units financial services, income,
Consuming
Consuming
(mainly
(mainly business financial services, income, units
business and units (mainly
(mainly
firms
firms and
and and financial
financial claims
claims households)
households)
governments)
governments)

Factor
Factor Markets
Markets

In order to produce goods and services modern economies needs huge amounts of capital provisions.
In modern times, investments in new equipment magnify the effectiveness of labor and develop
higher standard of living facilities. Since, investment or financing generally requires massive
amounts of capital, it is possible by selling financial assets- stocks, bonds, etc. in the financial
markets through which large amounts of funds can be generated within a short period of time. Those
who deal in supplying funds in the financial markets, receive only promises in return for the loan.
Financial assets i.e., shares and bonds promise the supplier of funds a future flow of income, which
may be in the form of dividend payments, interest payments or capital gains from the assets.

Financial Market is a market in which financial assets (securities) are traded and thus funds are
transferred in financial markets. Financial markets facilitate the flow of funds and thereby allow
financing and investing by households, firms, and government agencies.  
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Functions Performed by the Global Financial System and the Financial Markets

The financial markets make possible the exchange of current income for future income and the
transformation of savings into investment so that production, employment, and income can grow.

The suppliers of funds to the financial system can expect not only to recover their original funds but
also to earn additional income as a reward for waiting and for assuming risk.
Savings function. The global system of financial markets and institutions provides a conduit for the
public’s savings.
Wealth function. The financial instruments sold in the money and capital markets provide an
excellent way to store wealth.
Liquidity function. Financial markets provide liquidity for savers who hold financial instruments
but are in need of money.
Credit function. Global financial markets furnish credit to finance consumption and investment
spending.
Payments function. The global financial system provides a mechanism for making payments for
goods and services.
Risk protection function. The financial markets around the world offer businesses, consumers, and
governments protection against life, health, property, and income risks.
Policy function. The financial markets are a channel through which governments may attempt to
stabilize the economy and avoid inflation.

Overview of Financial Markets

Financial markets transfer funds from those who have excess funds to those who need funds. They
enable students to obtain student loans, families to obtain consumer credit or mortgages, businesses
to finance their growth, and governments to finance their expenditures. Without financial markets,
many families could not purchase a home, corporations could not grow, and the government could
not provide as many public services. Households and businesses that supply funds to financial
markets earn a return on their investment.
The main participants in financial markets can be classified as households, businesses, and
government agencies. Those participants who provide funds to the financial markets called surplus
units. Participants who use financial markets to obtain funds are called deficit units.

Types of Financial Markets

Definition: markets where financial assets are traded.

By the type of financial claim:
Debt Market
Equity market
By the maturity of the claim
Money market: a market for debt securities with short maturity.
Capital market a market for financial assets with longer maturities.
Primary vs. secondary
Primary market : deals with new issues of securities.
Secondary market: exchanging previously issued securities.
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1. Primary vs. Secondary Markets

PRIMARY MARKETS are markets where firms raise funds by issuing new securities, e.g., stocks,
bonds, commercial paper, to finance new projects, expansion, construction of new buildings, R&D,
etc., for which the firms do not have sufficient internal funds. 
Process: Firm hires an investment bank as the underwriter of the security issue, to get initial advice
on the price per share, number of shares, and then to sell the securities to investors, sometimes at a
guaranteed price, in a public offering. 
Alternatively, a primary market sale can be through a private placement, where the entire issue is
sold to a private investment group, usually an institutional investor such as a pension fund, or a
group of institutional buyers.  IPO (initial public offering), a first-time issue of stock.

SECONDARY MARKETS are for the subsequent trading (buying and selling) of securities after a
primary market issue in the bond and stock markets (DSE, CSE, NYSE, AMEX and NASDAQ are
all secondary markets for stocks).  In the secondary market, funds are transferred from one investor
to another (institutional or individual), without no effect on the cash flows of the issuing firm.  
Secondary markets provide an efficient, liquid market for the purchase and sale of securities at low
transaction costs.  Even though it gets no direct funds from sales of its securities in the secondary
market, the issuing firm is very concerned about the prices of its stock, which is largely determined
by the secondary market.  The current market price reflects the current and expected future success
of the firm, provides daily feedback about the firm's operations and the value of the firm (both to the
firm and to investors).     
 2. Money Markets (Short term) vs. Capital Markets (Long term)
MONEY MARKETS
Money market is the issuing and trading arena for highly liquid short-term debt instruments. Short
term normally means less than one-year maturity. The need for money market steams from the
function of financial intermediaries and their interaction with a central monetary authority. Financial
intermediaries within a country mobilize savings from surplus economic units (i.e. households, firms
etc.) and canalize these funds to deficit economic units through credit extension. A central monetary
authority within a country, in order to maintain financial and monetary stability, regulates the
financial intermediaries particularly by imposing cash and liquidity reserve requirements. Money
market facilities an optimal use of resources by bringing together banks and financial institutions,
which are in surplus and those, which are in deficit for a short period. Thus it provides a medium for
the redistribution of short-term loan able funds among financial institutions, which perform this
function by selling deposits of various types, certificate of deposits and discounting of bills, treasury
bills etc. The central bank itself serves as the lender of the last resort to the transaction function very
quickly at a very low cost.

The participants in the money market are the central bank, commercial banks, the government,
finance companies, contractual savings and loan associations etc. The instruments that are generally
traded in the money market constitutes: treasury bills, short-term central bank and govt. bonds
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negotiable certificates of deposits, bankers acceptances and commercial papers like bills of exchange
and promissory notes, money market mutual funds etc. the precondition for a well developed money
market are existence of a well organized banking system, an efficient central bank, availability of a
large volume of high quality short term assets with a large number of dealers therein, adequate flow
of funds from home and abroad, high degree of liquidity of short term assets, perfect mobility of
funds with quick remittance facility, an integrated and market oriented interest structure, high degree
of sensitivity to internal and external trade and above all stability in economic activities.

The components of the organized money markets are Bangladesh Bank the Central Bank of the
country, 4 Nationalized Commercial Banks, 5 govt. owned Development Financial Institutions, 30
local private Banks, 11 foreign Banks and 27 Non-Banking Financial Institutions.

Like all money markets, the organized segment of money market of Bangladesh has three distinct
components viz-Inter-Bank Market, Call Money Market and Bill Market.

Inter-Bank Market in the form of inter-bank deposits and borrowings, operates within a limited scale
and it has virtually no fixed price fixing mechanism, Traditionally, schedule commercial banks lend
to each other where they are in need of temporary funds. Sometimes banks also keep part of their
mobilized resources to others banks as deposit and borrow as and when needed against the lien of
those deposits. Moreover, small banks also keep their funds as deposit to the large banks of safety.
Inter-bank transactions although constitute an integral part of money market, comprises a small
portion of total banking activities. Interbank deposits as percent of total deposits varies mostly from
2 to 5 percent during 1986-2000.

Certificate of Deposits was introduced as a money market instruments in 1983 in Bangladesh. The
objective behind the creation of such instruments was to strengthen the money market and bring idle
funds within the fold of banking system. Black money and unearned income was intended to be
tapped for greater socio-economic benefit of the country and to reduce the threat of those resources
that might pose to the stability of the economy. The Bearer Certificate of Deposit with a fixed
maturity issued by and payable at bank to the Bangladeshi nationals, firms companies. The
certificate does not contain the name of the purchaser or holder. The outstanding amount of CDs
which stood at about Tk.1.05 billion on June, 1988 increase to 2.91 billion by June, 92 and further to
3.81 billion by December 2001.

The call Money Market is the most sensitive part of money market, where a good number of players
from banking as well as non-bank financial sector are actively participating on a regular basis.
Initially, this market developed as an inter-bank market where the banks in temporary deficit of cash
usually resorted to borrowing from other banks having surplus fund. The market based financial
system, introduced under FSRP, since early nineties created a more competitive environment in the
call market. Deregulation of interest rate regime, abolition of preferential lending rate, freedom of
banks respect of lending and mobilization of deposits, rapid growth of private banks and non-bank
financial institutions specially leasing, financial and investment companies were the elements of
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healthy development of call money market in the country. At present all the bank and the non-bank
financial institutions are allowed to participate in the call money market.

CAPITAL MARKETS trade:

 Debt (bonds and mortgages) with maturities of more than one year and
 Equities.
3. Foreign Exchange Markets      
Largest single financial market ($1T daily), where foreign currency is traded OTC.   MNCs operate
globally and are exposed to currency fluctuations and currency risk (or foreign exchange risk).   Cash
flows from foreign sales or investments denominated in foreign currency expose a firm or investor to
currency risk.  Example A: Coca Cola has 2% of its sales in Argentina (in pesos), and suffered losses
in 2002 when the peso lost about 1/3 of its value (ex-rate went from 1:1 to 3 pesos/$).   Example B:
When investing in foreign markets your dollar return will decrease (increase) if the foreign currency
depreciates (appreciates) over the term of the investment.  Suppose the € depreciates (appreciates) by
2% over the next year vs. the dollar, the dollar return to a U.S. investor owning German stocks,
bonds or CDs would decrease (increase) by 2%.   
  
4. Overview of Financial Institutions
FIs (commercial banks, credit unions, insurance companies, finance companies, mutual funds)
provide the important and essential function of channeling funds, credit and capital from those with a
surplus of funds (suppliers of capital/credit) to those who need capital/credit (demanders of
capital/credit). 
Without FIs, funds would have to be channeled by a direct transfer between suppliers (households)
and demanders (firms) of credit/capital.  Imagine credit markets operating without commercial
banks, where individuals lent money directly to borrowers (instead of depositing funds into a bank
account) without the bank as an intermediary.  Why might that arrangement lead to a sup-optimal
amount of credit in the economy?
1. Monitoring costs would be very high for individuals making loans or supplying capital directly to
borrowers e.g. companies or other individuals, vs. financial intermediaries.  
2. Financial claims like private loans might be very illiquid, and there might be very high transaction
costs for trading the financial claims.  
3. Individuals would be exposed to a high level of risk, undiversified loan portfolios.  
5. Unique Functions Performed by FI
Because of the problems of: 1) monitoring costs, 2) liquidity and transaction costs, and 3) risk,
credit/capital markets would not be very developed using only direct finance.  However, using
indirect finance through FIs, credit and capital markets develop to a much more advanced level,
significantly increasing the volume of credit in the economy.  FIs can more effectively and
efficiently deal with the potential problems than individuals.  
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1. FI can act on behalf of a large group of investors/savers, and can monitor users of funds on
behalf of borrowers and stockholders efficiently, due to economies of scale.  For example,

 banks hire credit analysts to assess creditworthiness and they monitor businesses who
borrow money,
 mutual funds and institutional investors can hire financial analysts to do market research
and
 investment banks conduct research on companies for clients/fund suppliers in the
underwriting process, e.g., an IPO.  
1. FIs provide liquidity to credit/capital markets.  For example, banks and mutual funds allow
depositors/investors to make an unlimited number of small deposits and withdrawals to their
accounts, increasing liquidity.  Indirect finance through a stock mutual fund is much more liquid
than direct finance in individual stocks.  
2. FIs increase diversification for savers/investors, e.g. putting money in a bank deposit is an
"investment" in a diversified loan portfolio.  Diversification through a mutual fund is much
easier, more efficient, lower cost than trying to diversify using direct finance in stocks,
especially for an average investor.  
3. Because of economies of scale, FIs can achieve efficiencies due to their large scale of operations
and significantly lower overall transaction costs.  
4. FIs provide maturity intermediation.  Most depositors want to make short term deposits, but
most borrowers want long term loans, e.g. borrowers/homeowners want 30 year mortgages but
don't necessarily want to make 30 year bank deposits.  Without FIs bearing the risk of maturity
mismatch, there might not even be a long term mortgage market.  
5. FIs provide denomination intermediation, since some securities are sold in amounts beyond
the reach of an average investor, e.g. min. $100,000 negotiable CDs and min. $250,000
commercial paper packages.  By investing in a money market mutual fund, these investments
become accessible to the average investor.  

Other Economic Functions FIs Provide to the Economy 

6. Commercial banks assist in the transmission of monetary policy, since they are the primary
channel and conduit for the implementation of monetary policy.  Open market operations by the
Fed inject additional bank reserves into the banking system, and that is how new money in the
economy is created.  
7. Special credit markets in the economy can be effectively served by FIs, e.g. savings and loans
and thrifts must specialize in the residential mortgage market, 65% of assets must be mortgage
related.  Goal: to make home ownership possible and affordable.  
8. FIs provide valuable payment services to the economy, in the form of check-clearing and wire
transfers, about $3T daily.      
 
 
  
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