Financial Market and Institutions

Lecture-1, 2, 3

Financial market:
Financial markets facilitate the flow of funds from surplus units to deficit units. Those
individuals/ households business or government who supply funds to the financial market are called
surplus units and among these thee the households is the major group in the surplus units.
On the other hand those who use the financial markets to obtain funds are called deficit units
and among the users business is the major group in the deficit units. Funds are transferred to deficit
units through the issuance of different instruments (called securities) in the financial markets by the
deficit units. The deficit units sell securities to the surplus units in order to obtain funds as par their
requirements. (Short- term or long-term)
A security is a certificate that expresses a claim on the issuer. Generally financial markets are
viewed as a system comprised of individuals and institutions, instruments and procedures that that
bring together the savers and the borrowers. It is comprised of different markets that deal with
different types of securities/ instruments in terms of different maturities and asset backing. In sum the
financial markets facilitate:
1.
2.
3.
4.
5.
6.

Raising of capital- In capital market

Transfer of risk- Derivative market
Transfer of liquidity that occurs in the money market
Price discovery- Both money and capital markets
International trade that occurs in the currency market
Global transactions with integration of international financial markets

Classification of Financial markets:

The most common financial market classifications area. Debt vs. Equity market: Debt markets are markets where loans are traded. A debt
instrument is a contract that specifies the amount and schedule of when a borrower would
repay the funds provided by the lender. Equity markets on the other hand are markets where
stocks of the companies are traded. Equity represents ownership in a corporation and entitled
the equity holders to share the income of the company. [Classification based on legal
obligation of the issuer]
b. Money vs. Capital market: Money market is the market for debt securities with maturity of
one year or less. The purpose of this market is to provide liquidity to the business,
government or individuals to meet short-term needs for cash. Capital markets are the markets
for immediate or long-term debt and corporate stocks with maturities for a period longer than
one year or with no maturity mention. [Classification based on maturity of the instruments]
c. Primary vs. Secondary market: Primary market is the market in which the corporations raise
funds by issuing new stocks/ securities. On the other hand secondary market is the market for
securities already issued through primary market. Whenever a newly formed or a privately
held company is offering securities to the public for the first time, the company is said to be
going public and the process of going public is called IPO.
d. Private vs. Public market: Private markets are market in which securities are traded among
sophisticated investors who generally are known to each other and the deals in such market
can be structured to fit the parties need. Transaction in public markets take place in
standardized form because the securities are traded among large number of investors
unknown to each other. [Classification based on relationship among participants]
e. Spot vs. Future market: In spot market securities are traded for On the spot delivery basis.
Whereas future markets are markets of securities the delivery of which occurs at some future
date but the price being agreed at the time of contract. [Classification based on nature of deal
of securities]
f. Intermediate vs. Non-Intermediate market: Intermediated financial markets include market
for financial instruments that are created and traded among financial intermediaries
themselves. For example, markets for CDs and call money market. Whereas nonintermediate financial market is the market where exchange of directly issued primarily

Lawliet Prokash

Financial Market and Institutions

Lecture-1, 2, 3

securities by non-financial institutions take place such as corporate bonds and stocks are the
examples of non-intermediate financial market securities.
g. Derivate markets: A market which provides different instruments for the management of
financial risk that arises due to transaction in the financial market. Example of the derivative
instruments are forward, future and option contracts, insurance and foreign exchange market
are also the part of financial market.

Features of Financial market:

A financial market has the following features1. Existence of various individuals and institutions: Financial market usually operates through
network of different individuals and Financial Institutions called participants in the financial
market.
2. Market for transaction of financial assets: Financial assets of different maturities (Short and
long) are traded in the financial markets.
3. Interacting place for surplus and deficit unit: Financial market is the place where the deficit
units sell securities to raise funds and the surplus units buy those securities for generating
income.
4. Create investment opportunities: Through selling securities the company raise funds to invest
in their business and the surplus units buying those securities create an environment of
economy activity that boost up investment opportunities.
5. Create channels of cash flows in the economy: Funds are channeled through or indirectly in
different sectors of the economy.
6. Existence of competition and complementary organization- Financial markets operate through
functioning of different organization and instructions such as the brokers dealers etc. There
exists a strong competition among them and they are also complimentary to each other for
smooth functioning of the market.
7. Existence of regulatory bodies: Various regulatory bodies such as SEC, Central bank,
Finance ministry etc. directly and indirectly regulate and monitor the activities of financial
markets.
8. A place for maintaining liquidity: Through buy and sell of securities the financial markets
maintain liquidity of the participants.

Functions of Financial market:

Function of Financial market can be viewed as,
1.
2.
3.
4.

Intermediary functions
Financial functions
Liquidity adjustment functions
Accelerating economic growth and employment.

These are described below1. Intermediate functions: intermediate functions of financial markets includea. Transfer of resources- Financial market facilitates the transfer of real economic
resources from lenders to ultimate borrows.
b. Enhancing income- Financial markets allow lenders toward interest or dividend on
their surplus funds and thus contributing to enhancement of their ultimate income.
c. Productive usage- Financial markets allow for the productive use of the funds
borrowed and thus augmenting income and national production.
d. Capital formation- Financial markets provide facilities through which new savings
flow to aid capital formation of a country.
e. Price determination- Financial markets allow for the determination of the traded
financial assets through the interactions of the buyers and sellers. They provide a
sign for the allocation of funds in the economy based on demand and supply through
the mechanism of price discovery process.

Lawliet Prokash

Financial Market and Institutions

Lecture-1, 2, 3

f.

Sales mechanism- Financial markets provide a mechanism for selling of financial

assets by an investor so as to offer the benefit of marketability and liquidity of such
assets.
g. Information provider- The activities of the participants of the financial markets result
in generation and dissemination of information through various segments of the
market. Such information ultimately reduce the cost of transaction in the market.
2. Financial functions: It includes,
a. Providing the borrowers with funds so as to enable them to carry out their investment
plans
b. Providing the lenders with earning assets so as to enable them to earn wealth by
deploying their saved funds.
3. Liquidity adjustment function: A major function of the financial, market is to provide liquidity
adjustment to the market participants. Liquidity measures the nearness of the financial asset
to cash. Of all the financial assets traded in the financial markets, money market instruments
are most liquid in the sense that they are easily marketable into cash, at little money risk and
credit/ default risk and shorted maturities compared to capital market instruments.
By allocating a portion of wealth in the money market instruments, the wealth
allocation may reduce the risk of keeping low cash balances and at the same time avoid cost
of forgoing interest. Switching back and forth between cash holding and holding of money
market securities is a major way in which money markets are used by the participants for
adjusting their liquidity.
Money markets are used by those who have excess cash for temporary investment
and who needs funds for a shorter period of time.
4. Special role of money in the financial market: Since money is the major component in the
financial system vis--vis in the financial market, its special role need be precisely understood
in the context of financial market. In financial market, money serves a very special role of vast
importance which can be summarized as belowa. Money is the substance that the lenders lend and the borrowers borrow from the
financial market.
b. The debt contracts exchange for money are written, expressed and valued in terms of
money
c. The obligation to pay interest and the return of the principal by the borrower is a
monetary obligation.
d. As medium of exchange the demand for money is universal.
e. Monetary policy is designed by the central bank to stabilize the overall economy, but
its impact is felt most keenly in the financial market.

The participants in the financial markets:

According to behavior of the financial market participants they can be categorized in four broad
groups1. Investors- Individuals and firms purchase financial securities for earning income. They
expect a stabilized income from such investment in the form of either interest or dividend.
Their preference is stability of income from securities.
2. Speculators- They hold financial securities to take benefits of price changes. They generally
buy securities at lower price and sell at a higher price. Their primary focus is capital gain.
3. Arbitragers- Arbitrage takes place when a security is bought in one market and
simultaneously sold at higher price in another market. They try to get the benefit out of price
differences in two different markets
4. Hedgers- They hold financial securities in their own account consisting of securities of
different companies. Hedge occurs when different types of securities are held in order to have
offsetting price management. Higher prices of one security would offset the lower prices of
others.

Lawliet Prokash

Financial Market and Institutions

Lecture-1, 2, 3

Securities traded in financial markets:

Summary of popular securities-

Securities

Issued by

Money market securities

a. Treasury bill
Government

b. Certificate of
deposits (CDs)
c.

Negotiable
CDs

d. Commercial
paper

Banks and
saving
institutions
Large banks
and saving
Institutions
Banks,
Finance co.
and firms
Banks

e. Bankers
acceptance
f. Repurchase
Banks and
agreement
Firms
(REPO)
Capital market securities
a. Corporate
Corporate
bonds
Firms
b. Equity
Corporate
Securities
Firms
c. Mortgages
Financial
Institutions
and Firms

Common
Investors

Common Maturity

Secondary
market status

Different firms,
companies,
financial
Institutions
Households

13 weeks 1 year

Very high

7 days 5 years

Non-existent

Business firms

2 weeks 1 year

Moderate

Other firms

1 day 270 days

Low

30 days 270 days

High

1 day 15 days

Non-existent

10 years 30
years
No maturity

Moderate

15 years 30
years

Moderate

Firms
Firms and
Financial
Institutions
Households and
Firms
Households and
Firms
Financial
Institutions

Lawliet Prokash

Very high