BBMF1813 PRINCIPLES OF FINANCE

TUTORIAL 3: FINANCIAL MARKETS (WEEK 3)

Question 1

i. What is financial market? Explain the roles of financial market.

 Financial markets can be defined as the place where deficit units and
surplus units meet.
 In this market, funds are transferred from the surplus units to the deficit
units.
 A surplus unit is where the units generate more income than they spend,
and have funds left over.
 Other units generate less income than they spend, and need to acquire
additional funds in order to sustain their operations. These are called
deficit units.

ii. Discuss the parties to the financial market.

 Borrowers (deficit unit) – need money to finance investment or make

purchases.
 Savers/Investors (surplus unit) – Those with extra money to invest and
have excess cash.
 Financial Institutions (Intermediaries) – help bring together borrowers and
savers by facilitating flow of funds from surplus units to deficit units.
 A lender does not need to find an individual borrower but can deposit his
money with a bank, building society, investment trust or other financial
intermediary.
 An intermediary can act as a broker, handling a transaction on behalf of
others and as a principal holding money balances of lenders for lending on
to borrowers.

Question 2

Differentiate between:

a) Money Markets and Capital Markets

Money markets – markets for short-term, highly liquid debt securities, which
generally have maturities of one year or less. e.g. Banker Acceptance,
Negotiable Certificate of Deposit

Capital markets – markets for long-term debt and corporate stocks with
maturities of generally more than one year. e.g. Bond, Loan, Shares
 b) Debt Markets and Equity Markets

Debt markets – The holders are lenders and will receive a fixed amount of
money (interest). Debtholders have priority on any financial claims. (Bond)

Equity market – Shareholders are the owners of the company. The

shareholders have financial claims or will be paid after the debtholders receive
their payments. (Shares)

c) Primary Markets and Secondary Markets

Primary markets – financial market in which corporation will raise capital by

issuing new securities, e.g. IPO (initial public offering, company selling shares
to public for the first time)
 Net proceeds go to issuing corporations

Secondary markets – financial market in which securities are traded among

investors after the securities have been initially issued. e.g. Bursa Malaysia,
NYSE, Singapore Exchange, HKSE etc.
 Corporations do not receive fund from trading of securities

Question 3

Describe any TWO (2) ways in which capital can be transferred from suppliers of
capital to those who are demanding capital.

1. Direct Transfer of Funds

Occurs when a business sells its stocks or bonds directly to savers without going
through any type of financial institutions.

The Business
Firm’s securities (share, bonds) Savers
Firms (Surplus Units)
(Direct Units)
Funds (dollars of savings)

2. Indirect Transfer Through Financial Intermediary

The financial intermediary collects the savings of individuals and issues its own
securities in exchange for these savings. The intermediary uses the funds collected
from the individual savers to offer new products packaged as their own e.g.,
commercial banks use the savers deposits to offer credit cards/loans under their brand.

The Business Savers

Firms Firm’s
Financial Intermediary
(Surplus Units)
Securities
(Deficit Units) Intermediary Securities

Funds Funds
Question 4

Financial intermediation involves channeling funds between the surplus and deficit
units.

Discuss the benefits of financial intermediation.

1. Channeling of Funds
The main role of financial intermediary is providing ways of linking lenders of money
with potential borrowers. A lender does not need to find an individual borrower, but
can deposit his money with a bank, investment trust or other financial intermediary.
Reduce the inefficiencies that would exist if users of funds could get loans only by
borrowing directly from savers. A financial intermediary such as commercial banks,
investment funds, etc. gather financial resources from sources of cash such as savers
and invertors and distributes them to productive units in need of debt or equity
financing.

2.Aggregate of Savings
This role in linking and borrowers means that the intermediary is able to “package”
the amounts lent by savers into the amounts which borrowers require.
E.g. banks gather small amounts of savings from a large number of individuals and
repackaging them into larger bundles for lending to business.

3. Pooling of Risk/Diversification
For an individual lender, if a borrower defaults on the loan, then that individual lender
suffers all the losses.
If, however, a financial intermediary makes the loan, then the risk is spread over all
the depositors with the financial intermediary.
The financial intermediary does not in itself reduce the risk of a loan going into
default but that risk is spread over all the depositors with the intermediary.

4. Maturity Transformation of Funds

The financial intermediary provides “maturity transformation”, bridging the gap
between the desire of many lenders for liquidity and the need of most borrowers for
loans over longer periods.
Borrowers typically want to borrow for a longer period of time than lenders wish to
lend.
A major feature of financial intermediaries is that they are able to accommodate these
different requirements. Savers and borrowers have greater choices, or financial
flexibility with respect to denominations, maturities, and other characteristics.

5. Reduction in transaction cost

Given the size of the majority of financial institutions, they are able to benefit from
economies of scale in a number of areas.
These will include:
Economies in the administration associated with taking in deposits and making loans,
due to these transactions becoming routine. (transaction volume increase, cost
decrease)
Economies in the employment of specialist personnel, since the volume of business
will allow such people to be fully employed. (business volume increase, employment
increase)
Economies in the acquisition and interpretation of financial information. (interest rate
of deposit/loan, industry/economic outlook)

6. Advisory
Financial intermediaries can advice their customers on financial matters (e.g. on the
best way to invest their funds and on alternative ways of obtaining finance.)
This helps to encourage the flow of savings and the efficient use of them.