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01 Financial - Markets - 2 - 140-6-15
01 Financial - Markets - 2 - 140-6-15
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Financial markets studies, based on capital market theory, focus on the financial system,
the structure of interest rates, and the pricing of financial assets.
An asset is any resource that is expected to provide future benefits, and thus possesses
economic value. Assets are divided into two categories: tangible assets with physical
properties and intangible assets. An intangible asset represents a legal claim to some future
economic benefits. The value of an intangible asset bears no relation to the form, physical
or otherwise, in which the claims are recorded.
Financial assets, often called financial instruments, are intangible assets, which are
expected to provide future benefits in the form of a claim to future cash. Some financial
instruments are called securities and generally include stocks and bonds.
Any transaction related to financial instrument includes at least two parties:
1) the party that has agreed to make future cash payments and is called the issuer;
2) the party that owns the financial instrument, and therefore the right to receive the
payments made by the issuer, is called the investor.
Financial assets provide the following key economic functions.
they allow the transfer of funds from those entities, who have surplus funds
to invest to those who need funds to invest in tangible assets;
they redistribute the unavoidable risk related to cash generation among
deficit and surplus economic units.
The claims held by the final wealth holders generally differ from the liabilities issued by
those entities who demand those funds. They role is performed by the specific entities
operating in financial systems, called financial intermediaries. The latter ones transform
the final liabilities into different financial assets preferred by the public.
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either voluntarily or involuntarily liquidated. All financial markets provide some form of
liquidity. However, different financial markets are characterized by the degree of liquidity.
3) The function of reduction of transaction costs is performed, when financial market
participants are charged and/or bear the costs of trading a financial instrument. In market
economies the economic rationale for the existence of institutions and instruments is
related to transaction costs, thus the surviving institutions and instruments are those that
have the lowest transaction costs.
The key attributes determining transaction costs are
asset specificity,
uncertainty,
frequency of occurrence.
Asset specificity is related to the way transaction is organized and executed. It is lower
when an asset can be easily put to alternative use, can be deployed for different tasks
without significant costs.
Transactions are also related to uncertainty, which has (1) external sources (when events
change beyond control of the contracting parties), and (2) depends on opportunistic
behavior of the contracting parties. If changes in external events are readily verifiable, then
it is possible to make adaptations to original contracts, taking into account problems
caused by external uncertainty. In this case there is a possibility to control transaction
costs. However, when circumstances are not easily observable, opportunism creates
incentives for contracting parties to review the initial contract and creates moral hazard
problems. The higher the uncertainty, the more opportunistic behavior may be observed,
and the higher transaction costs may be born.
Frequency of occurrence plays an important role in determining if a transaction should
take place within the market or within the firm. A one-time transaction may reduce costs
when it is executed in the market. Conversely, frequent transactions require detailed
contracting and should take place within a firm in order to reduce the costs.
When assets are specific, transactions are frequent, and there are significant uncertainties
intra-firm transactions may be the least costly. And, vice versa, if assets are non-specific,
transactions are infrequent, and there are no significant uncertainties least costly may be
market transactions.
The mentioned attributes of transactions and the underlying incentive problems are related
to behavioural assumptions about the transacting parties. The economists (Coase (1932,
1960, 1988), Williamson (1975, 1985), Akerlof (1971) and others) have contributed to
transactions costs economics by analyzing behaviour of the human beings, assumed
generally self-serving and rational in their conduct, and also behaving opportunistically.
Opportunistic behaviour was understood as involving actions with incomplete and
distorted information that may intentionally mislead the other party. This type of behavior
requires efforts of ex ante screening of transaction parties, and ex post safeguards as well
as mutual restraint among the parties, which leads to specific transaction costs.
Transaction costs are classified into:
1) costs of search and information,
2) costs of contracting and monitoring,
3) costs of incentive problems between buyers and sellers of financial assets.
1) Costs of search and information are defined in the following way:
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search costs fall into categories of explicit costs and implicit costs.
Explicit costs include expenses that may be needed to advertise one’s intention to sell
or purchase a financial instrument. Implicit costs include the value of time spent in
locating counterparty to the transaction. The presence of an organized financial market
reduces search costs.
information costs are associated with assessing a financial instrument’s investment
attributes. In a price efficient market, prices reflect the aggregate information
collected by all market participants.
2) Costs of contracting and monitoring are related to the costs necessary to resolve
information asymmetry problems, when the two parties entering into the transaction
possess limited information on each other and seek to ensure that the transaction
obligations are fulfilled.
3) Costs of incentive problems between buyers and sellers arise, when there are conflicts
of interest between the two parties, having different incentives for the transactions
involving financial assets.
The functions of a market are performed by its diverse participants. The participants in
financial markets can be also classified into various groups, according to their motive for
trading:
Public investors, who ultimately own the securities and who are motivated by the
returns from holding the securities. Public investors include private individuals and
institutional investors, such as pension funds and mutual funds.
Brokers, who act as agents for public investors and who are motivated by the
remuneration received (typically in the form of commission fees) for the services
they provide. Brokers thus trade for others and not on their own account.
Dealers, who do trade on their own account but whose primary motive is to profit
from trading rather than from holding securities. Typically, dealers obtain their
return from the differences between the prices at which they buy and sell the
security over short intervals of time.
Credit rating agencies (CRAs) that assess the credit risk of borrowers.
In reality three groups are not mutually exclusive. Some public investors may occasionally
act on behalf of others; brokers may act as dealers and hold securities on their own, while
dealers often hold securities in excess of the inventories needed to facilitate their trading
activities. The role of these three groups differs according to the trading mechanism
adopted by a financial market.
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obtaining funds from lenders or investors and
lending or investing the funds that they borrow to those who need funds.
The funds that a financial intermediary acquires become, depending on the financial claim,
either the liability of the financial intermediary or equity participants of the financial
intermediary. The funds that a financial intermediary lends or invests become the asset of
the financial intermediary.
Financial intermediaries are engaged in transformation of financial assets, which are less
desirable for a large part of the investing public into other financial assets—their own
liabilities—which are more widely preferred by the public.
Asset transformation provides at least one of three economic functions:
Maturity intermediation.
Risk reduction via diversification.
Cost reduction for contracting and information processing.
Depository
Deposits Institutions
(Commercial Banks,
Savings Institutions,
Purchase
Securities
Credit Unions)
Surplus Units
Finance Companies Deficit Units
(Firms,
Purchase Government,
Shares Agencies, Some
Mutual Funds Individuals)
Premium
Policyholders s Insurance
Companies
Employee
Employers Contributions
and Pension funds
Employees
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Facilitating the trading of financial assets by using its own capital to take a position
in a financial asset the financial intermediary’s customer want to transact in.
Assisting in the creation of financial assets for its customers and then either
distributing those financial assets to other market participants.
Providing investment advice to customers.
Manage the financial assets of customers.
Providing a payment mechanism.
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Fixed income instruments forma a wide and diversified fixed income market. The key
characteristics of it is provided in Table 2.
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claim on the issuer’s assets over equity investors. Second, the tax treatment of the
payments by the issuer can differ depending on the type of financial instrument class.
Table 3. Debt versus equity
Debt Equity
Characteristic Borrower-lender relation, Ownership, no time limit
fixed maturities
Advantages:
for the firm Predictability, independence Flexibility, low cost of finance,
from shareholders’ influence reputation
for the investor Low risk High expected return
Disadvantages:
for the firm Debt servicing obligation Shareholder dependence, short-
sightedness, market volatility
influencing management
decisions
for the investor Low returns High risk
Source: Reszat B. (2008). European Financial Systems in the Global Economy
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From the perspective of country origin, its financial market can be broken down into an
internal market and an external market.
The internal market, also called the national market, consists of two parts: the domestic
market and the foreign market. The domestic market is where issuers domiciled in the
country issue securities and where those securities are subsequently traded.
The foreign market is where securities are sold and traded outside the country of issuers.
External market is the market where securities with the following two distinguishing
features are trading: 1) at issuance they are offered simultaneously to investors in a number
of countries; and 2) they are issued outside the jurisdiction of any single country. The
external market is also referred to as the international market, offshore market, and the
Euromarket (despite the fact that this market is not limited to Europe).
Money market is the sector of the financial market that includes financial instruments that
have a maturity or redemption date that is one year or less at the time of issuance. These
are mainly wholesale markets.
The capital market is the sector of the financial market where long-term financial
instruments issued by corporations and governments trade. Here “long-term” refers to a
financial instrument with an original maturity greater than one year and perpetual
securities (those with no maturity). There are two types of capital market securities: those
that represent shares of ownership interest, also called equity, issued by corporations, and
those that represent indebtedness, or debt issued by corporations and by the state and local
governments.
Financial markets can be classified in terms of cash market and derivative markets.
The cash market, also referred to as the spot market, is the market for the immediate
purchase and sale of a financial instrument.
In contrast, some financial instruments are contracts that specify that the contract holder
has either the obligation or the choice to buy or sell another something at or by some
future date. The “something” that is the subject of the contract is called the underlying
(asset). The underlying asset is a stock, a bond, a financial index, an interest rate, a
currency, or a commodity. Because the price of such contracts derive their value from the
value of the underlying assets, these contracts are called derivative instruments and the
market where they are traded is called the derivatives market.
When a financial instrument is first issued, it is sold in the primary market. A secondary
market is such in which financial instruments are resold among investors. No new capital
is raised by the issuer of the security. Trading takes place among investors.
Secondary markets are also classified in terms of organized stock exchanges and over-the-
counter (OTC) markets.
Stock exchanges are central trading locations where financial instruments are traded. In
contrast, an OTC market is generally where unlisted financial instruments are traded.
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in response to large bankruptcies, overhauled corporate governance, in order to strengthen
the role of auditors in overseeing accounting procedures. The Sorbanes-Oxley Act of 2002
in US was designed particularly to tighten companies’ governance after dotcom bust and
Enron’s Bankruptcy. It had direct consequences internationally, first of all through global
companies. The US Wall Street Reform and Consumer Protection Act (Dodd-Frank) of
2010 aims at imposing tighter financial regulation for the financial markets and financial
intermediaries in US, in order to ensure consumer protection. This is in tune with major
financial regulation system development in EU and other parts of the world.
1.6. Summary
The financial system of an economy consists of three components: (1) Financial markets;
(2) financial intermediaries; and (3) financial regulators.
The main function of the system is to channel funds between the two groups of end users
of the system: from lenders (‘surplus units’) to borrowers (‘deficit units’). Besides, a
financial system provides payments facilities, a variety of services such as insurance,
pensions and foreign exchange, together with facilities which allow people to adjust their
existing wealth portfolios.
Apart from direct borrowing and lending between end-users, borrowing and lending
through intermediaries and organized markets have important advantages. These include
transforming the maturity of short-term savings into longer-term loans, reduction of risk
and controlling transaction costs.
The field of financial markets and its theoretical foundations is based on the study of the
financial system, the structure of interest rates, and the pricing of risky assets.
The major market players are households, governments, nonfinancial corporations,
depository institutions, insurance companies, asset management firms, investment banks,
nonprofit organizations, and foreign investors.
Financial markets are classified into internal versus external markets, capital markets
versus money markets, cash versus derivative markets, primary versus secondary markets,
private placement versus public markets, exchange-traded versus over-the-counter
markets.
The financial markets and intermediaries are subject to financial regulators. The recent
changes in the regulatory system are happening in response to the problems in the credit
markets and financial crisis that struck 2008.
Key terms
Financial system
Financial markets
Money markets
Capital markets
Debt markets
Derivative markets
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