CRITICALLY EXPLAIN WHY WE SHOULD STUDY THE FINANCIAL MARKETS AND INSTITUTIONS. |
The financial system consists of financial markets and financial institutions. Financial market is a general term that includes a number of different types of markets for the creation and exchange of financial assets, such as stocks and bonds. Financial institutions are firms such as commercial banks, credit unions, insurance companies, pension funds, and finance companies that provide financial services to the economy. The distinguishing feature of financial institutions is that they invest their funds in financial assets, such as business loans, stocks, and bonds, rather than real assets, such as plants and equipment. The critical role of the financial system in the economy is to gather money from people and businesses with surplus funds to invest and channel money to those who need it. Businesses need money to invest in new productive assets to expand their operations and increase the firms cash flow, which should increase the value of the firm. Consumers, too, need money, which they use to purchase things such as houses, cars or to pay college tuition bills. A well-developed financial system is critical for the operation of a complex industrial. Highly industrialized countries cannot function without a competitive and sound financial system that efficiently gathers money and channels it into the best investment opportunities.
As stated above, one important function of the financial system is to direct money to the best investment opportunities in the economy. If the financial system works properly, only business projects with high rates of return and good credit are financed. Those with low rates of return or poor credit will be rejected. Thus, financial systems contribute to higher production and efficiency in the overall economy. The system moves money from lender-savers (whose income exceeds their spending) to borrower-spenders (whose spending exceeds their income)] The largest lender-savers in the economy are households, but some businesses and many state and local governments at times have excess funds to lend to those who need money. The largest borrower-spenders in the economy are businesses, followed by the Government.
Money flows through the financial system in two basic ways: directly, through wholesale financial markets and indirectly, through financial institutions. In direct transactions, the lender-savers and the borrower-spenders deal “directly” with one another; borrower-spenders sell securities, such as stocks and bonds, to lender-savers in exchange for money. These securities represent claims on the borrowers future income or assets. A number of different interchangeable terms are used to refer to securities, including financial instruments and financial claims. The major buyers and sellers of securities in the direct financial markets are commercial banks; other financial institutions, such as insurance companies and business finance companies; large corporations; the government; hedge funds; and some wealthy individuals. It is important to note that financial institutions are major buyers of securities in the direct financial markets. For example, life and casualty insurance companies buy large quantities of corporate bonds and stocks for their investment portfolios. Although few individuals participate in direct financial markets, they can gain access to many of the financial products produced in these markets through retail channels at investment banking firms or financial institutions such as commercial banks.
As already mentioned, financial market is a very general term. A complex industrial economy includes many different types of financial markets, and not all of them are involved in direct financing.
PRIMARY AND SECONDARY MARKETS
A primary market a financial market in which new security issues are sold by companies directly to investors A primary market is any market where companies sell new security issues (debt or equity).Primary markets are not well known to the general public because they are wholesale markets and the sales take place outside of the public view.
A secondary market is any market where owners of outstanding securities can sell them to other investors. Secondary markets are like used-car markets in that they allow investors to buy or sell second-hand, or previously owned, securities for cash. These markets are important because they enable investors to buy and sell securities as frequently as they want. As you might expect, investors are willing to pay higher prices for securities that have active secondary markets. Secondary markets are important to corporations as well because investors are willing to pay higher prices for securities in primary markets if the securities have active secondary markets. Thus, companies whose securities have active secondary markets enjoy lower funding costs than similar firms whose securities do not have active secondary markets.
MARKETABILITY VERSUS LIQUIDITY
Marketability refers to the ease with which a security can be sold and converted into cash. An important characteristic of a security to investors is its marketability. A securitys marketability depends in part on the costs of trading and searching for information, so-called transaction costs. The lower the transaction costs, the greater a securitys marketability. Because secondary markets make it easier to trade securities, their presence increases a securitys marketability.
Liquidity is the ability to convert an asset into cash quickly without loss of value. A term closely related to marketability is liquidity. In common use, the terms marketability and liquidity are often used interchangeably, but they are different. Liquidity implies that when the security is sold, its value will be preserved; marketability does not carry this implication.
BROKERS VERSUS DEALERS
Two types of market specialists facilitate transactions in secondary markets. Brokers are market specialists who bring buyers and sellers together when a sale takes place. They execute the transaction for their client and are compensated for their services with a commission fee. They bear no risk of ownership of the securities during the transactions; their only service is that of “matchmaker.” Dealers, in contrast, “make markets” for securities and do bear risk. They make a market for a security by buying and selling from an inventory of securities they own. Dealers make their profit, just as retail merchants do, by selling securities at a price above what they paid for it. The risk that dealers bear is price risk, which is the risk that they will sell a security for less than they paid for it. Exchanges and Over-the-Counter Markets Financial markets can be classified as either “organized” markets (more commonly called exchanges) or over-the-counter markets. Traditional exchanges, such as the Mauritius Stock Exchange, provide a physical meeting place and communication facilities for members to buy and sell securities or other assets (such as commodities) under a specific set of rules and regulations. Members are individuals who represent securities firms as well as people who trade for their own accounts. Only members can use the exchange. Securities not listed on an exchange are bought and sold in the over-the-counter (OTC) market. The OTC market differs from organized exchanges in that the “market” has no central trading location. Traditionally, stocks traded over the counter have been those of small and relatively unknown firms, most of which would not qualify to be listed on a major exchange.
MONEY AND CAPITAL MARKETS
Money markets are global markets where short-term debt instruments, which have maturities of less than one year, are sold. Money market instruments are lower in risk than other securities because of their high liquidity and low default risk. In fact, the term “money” market is used because these instruments are close substitutes for cash. Large companies use money markets to adjust their liquidity positions. Liquidity, as mentioned, is the ability to convert an asset into cash quickly without loss of value. Liquidity problems arise because companies cash receipts and expenditures are rarely perfectly synchronized. To manage liquidity, a firm can invest idle cash in money market instruments; then, if the firm has a temporary cash shortfall, it can raise cash overnight by selling money market instruments from its portfolio.
Capital markets are global markets where intermediate-term and long-term debt and corporate stocks are traded. In these markets, large firms finance capital assets such as plants and equipment. Compared with money market instruments, capital market instruments are less marketable, carry more default risk, and have longer maturities.
PUBLIC AND PRIVATE MARKETS
Public markets are organized financial markets where the general public buys and sell securities through their stockbrokers. The Mauritius Stock Exchange, for example, is a public market. The FSC regulates public securities markets in Mauritius. This commission is responsible for overseeing the securities industry and regulating all primary and secondary markets in which securities are traded. Most corporations want access to the public markets because they are wholesale markets where issuers can sell their securities at the lowest possible funding cost. The downside for corporations selling in the public markets is the cost of complying with the various FSC regulations. Some examples of money market instruments are treasury bills, other marketable short-term securities, Bank negotiable CDs, Commercial paper. Examples capital market instruments: Treasury notes, Treasury bonds, State and local government bonds, Corporate and foreign bonds, Corporate stock (at market value), Mortgages.
In contrast to public market, private market involves direct transactions between two parties. Transactions in private market are often called private placements. In private market, a company contacts investors directly and negotiates a deal to sell them all or part of a security issue. Larger firms may be equipped to handle these transactions themselves. Smaller firms are more likely to use the services of an investment bank, which will help locate investors, help negotiate the deal, and handle the legal aspects of the transaction. Major advantages of a private placement are the speed at which funds can be raised and low transaction costs. Downsides are that privately placed securities cannot legally be sold in the public markets because they lack Stock Exchange registration and the amounts that can be raised tend to be smaller.
FUTURES AND OPTIONS MARKETS.
Futures and options are often called derivative securities because they derive their value from some underlying asset. Futures contracts are contracts for the future delivery of such assets as securities, foreign currencies, interest cash flows, or commodities. Corporations use these contracts to reduce (hedge) risk exposure caused by fluctuation in things such as foreign exchange rates or commodity prices. Options contracts call for one party (the option writer) to perform a specific act if called upon to do so by the option buyer or owner. Options contracts, like futures contracts, can be used to hedge risk in situations where the firm faces risk from price fluctuations.
FOREIGN EXCHANGE MARKETS
Foreign exchange markets provide three basic economic benefits:
1. A mechanism to transfer purchasing power from individuals who deal in one currency to individuals who deal in a different currency, facilitating the import and export of goods and services.
2. A way for corporations to pass the risk associated with foreign exchange price fluctuations to professional risk-takers. This hedging function is particularly important to corporations in the present era of floating, or variable, exchange rates.
3. A channel for importers and exporters to acquire credit for international business transactions. The time span between shipment of goods by exporters and their receipt by importers can be considerable. While the goods are in transit, they must be financed. Foreign exchange markets provide a mechanism through which financing and currency conversions can be accomplished efficiently and at low cost.
Foreign exchange markets are international markets where currencies are bought and sold in wholesale amounts. There is no single formal foreign exchange market; there are a group of informal markets closely interlocked through international banking relationships. Participants are linked by telephone, telegraph, and cable. The market trades any time of day or night and every day of the year. Virtually every country has some type of active foreign exchange market. The major participants in the foreign exchange markets are multinational commercial banks, large investment banking firms, and small currency boutiques that specialize in foreign exchange transactions. The other major participant is the Central Bank, which intervene in the markets primarily to smooth out fluctuations in the exchange rates.
Because events in the financial markets will have direct effects on our financial well-being, the study of Financial Markets and Institutions is essential. In the economy, they have an impact on how efficiently funds are moved from savers to borrowers.