Financial Markets

and Institutions
Financial Markets
“Markets through which entities with surplus
(“excess”) financial funds transfer those
surplus funds to entities who have a
shortage (“shortfall”) of available funds.”
 Financial markets are markets for
financial instruments, also called
financial claims or securities.
 Stock markets, bond markets, mortgage
markets.
 Financial Instruments/Securities
 (1) Instruments which represent a claim on
the issuer’s (of the financial instrument) future
income and/or assets. Examples include:
 Bonds: Debt instruments with a contractual
agreement (indenture specifies interest
payment, maturity date, etc.).
 Common Stocks: Instruments representing an
ownership position in a corporation.
 (2) Instruments which are neither debt nor
equity based and thus belong in their own
category.
 Foreign Exchange
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Classifications of Financial Instruments
 (1) Financial instruments can be categorized by form
depending on whether they are cash instruments or
derivative instruments:
 Cash instruments are financial instruments whose

value is determined directly by markets.

 Stock and bonds
 Derivative instruments are financial instruments

which derive their value from some other

(underlying) financial instrument or variable.
 Futures, forwards, options (puts and calls)
 Originated in Chicago in the 1850s (CBOT) for

commodities (flour, hay, corn), but now involves

financial assets as well.
Classifications of Financial Instruments
 (2) As noted, financial instruments can also be
categorized depending on whether they are
equity based (reflecting ownership of the issuing
entity) or debt based (reflecting a loan the
investor has made to the issuing entity).
 If debt, financial assets can be further
categorized into short term (one year or less) or
long term.
 Short term: money market instruments

 Long term: capital market instruments

Classification of Financial Markets
 Primary Financial Market
 Where new securities are sold to initial buyers (e.g., IPOs)
 Important for raising new capital (involves public and private
placements and investment bankers)
 Secondary Financial Market
 Where securities previously issued (in primary markets) are bought
and sold (traded among investors).
 Secondary markets provide liquidity for previously issued securities –
Allows for conversion of financial assets into cash before asset
matures.
 Done through organized exchanges (central locations; e.g., NYSE,
LSE) or through
 Over-the-counter arrangements (dealers in different locations; e.g.,
NASDAQ, and U.S. Government bond market) or through
 US Government Sponsored Enterprises (GSEs): Federal National
Mortgage Association and Federal Home Loan Mortgage Corporation.
 Money and capital markets
 Short term versus long term maturities of traded instruments.
The Capital Market
 Exchange of long-term securities—in excess
of one year
 Generally used to secure long-term financing for
capital investment
 Stock market—Largest part of capital market and
held by private and institutional investors
 Corporate bond market—Held by insurance
companies, pension and retirement funds
 Local and state government bonds—Primarily held
for tax-exempt feature
 Government securities—Held by commercial banks,
the Fed, individual Americans/foreigners, and dealers
The Money Market
 Exchange of short-term instruments—less than one
year
 Highly liquid, minimal risk
 Use of a temporary surplus of funds by banks or
businesses
 U.S. Treasury bills—short-term debts of US government
 Bank Certificates of Deposits—liabilities of issuing bank,
interest bearing to corporations that hold them
 Commercial paper—short-term liabilities of prime business firms
and finance companies
 Federal Funds—Exchange of excess/deficient reserves between
banks on an overnight basis.
Overview of Financial Markets

 Public Offering versus Private Placement

 A public offering is the nonexclusive sale of securities
to the general public.
 Public offerings are normally executed with the help
of a securities firm that provides investment
banking services.
 The securities firm may underwrite the offering,
which means that it guarantees the amount
to be received by the issuing firm.
Overview of Financial Markets

 Public Offering versus Private Placement

 A private placement is the sale of new securities
directly to an investor or a group of investors.
 In general, only institutional investors such as pension
funds or insurance companies can afford to invest
in private placements.
Investment bankers “underwrite” new issues
of securities.

 Buy entire issues of securities from DSUs

 Find SSUs to buy securities at higher price

 Profit from difference - “underwriting

spread”

Copyright© 2006 John Wiley & Sons,

Inc.
12
 Brokers and dealers
 Brokers buy or sell at best possible price for
their clients.

Dealers “make markets” by carrying inventories

of securities.

 buy at “bid price;” sell at “ask price”

 “Bid-ask spread” is dealer’s gross profit

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The Capital Market
 Exchange of long-term securities—in excess
of one year
 Generally used to secure long-term financing for
capital investment
 Stock market—Largest part of capital market and
held by private and institutional investors
 Corporate bond market—Held by insurance
companies, pension and retirement funds
 Local and state government bonds—Primarily held
for tax-exempt feature
 Government securities—Held by commercial banks,
the Fed, individual Americans/foreigners, and dealers
The Money Market
 Exchange of short-term instruments—less than one
year
 Highly liquid, minimal risk
 Use of a temporary surplus of funds by banks or
businesses
 U.S. Treasury bills—short-term debts of US government
 Bank Certificates of Deposits—liabilities of issuing bank,
interest bearing to corporations that hold them
 Commercial paper—short-term liabilities of prime business firms
and finance companies
 Federal Funds—Exchange of excess/deficient reserves between
banks on an overnight basis.
Organized and Over-the-Counter
Markets
Organized Exchanges: physical, relatively
exclusive.
 Physical trading floor and facilities available to
members of exchange, for securities listed on
exchange.
 New York Stock Exchange
 Chicago Board of Trade (futures)

OTC Markets: virtual, relatively inclusive.

 Decentralized network available to any licensed
dealer willing to buy access and obey rules, for
wide range of securities.
 The NASDAQ is a famous OTC market.

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 Spot and Futures Markets
 Spot Markets: immediate payment for
immediate delivery
 Futures or Forward Markets: immediate
payment for promise of future delivery
“Futures” contracts: standardized as to amounts,
forms, and dates; trade on organized exchanges

“Forward” contracts: individualized between

parties with particular needs

Copyright© 2006 John Wiley & Sons,

Inc.
17
Option Markets

 Rights in underlying securities or commodities—

writer grants owner some exclusive right for
some certain time

 Main types of options: Puts (options to sell)

Calls (options to buy)

 Options on listed securities and widely held

commodities trade actively on organized
exchanges

Copyright© 2006 John Wiley & Sons,

Inc.
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Foreign Exchange Markets

 Any currency is convertible to any other at some

exchange rate

 “Forex” involves spot, future, forward, and option

markets

Copyright© 2006 John Wiley & Sons,

Inc.
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International and Domestic Markets
 Help participants diversify both sources and uses of
funds
 Examples of major international markets:
Eurodollars—US dollars deposited outside U.S.
Eurobonds—bonds issued outside US but denominated in
$US
Foreign Bond-Bond issued in home currency
& traded in home MKT by MNC.
Int.Equity Mkt-simultaneous sell of block of
shares in different countries.

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 Functions of Financial
Markets
 Mechanism for raising funds!
 Done in primary financial markets (e.g.,

IPOs)
 Mechanism for converting financial assets
into cash before maturity.
 Done in secondary financial markets

(e.g., NYSE, OTC bond markets)

 Functions of Financial Markets
 Provides the means for entities to protect
their financial/commercial positions.
 Done in derivatives markets (options,

futures, forwards)
 Mechanism for generating a return on
surplus funds.
 Through interest, dividends, capital

appreciation
 Functions of Financial
Markets
 Allocates financial resources among
competing users.
 And, we assume, if done so in the most

efficient manner (i.e., to the most

productive users):
 The process will improve economic
efficiency and
 Result in highest possible economic
growth!
 Functions of Financial Markets
 Provides financial signals to market participants
 Interest rates, stock prices, exchange rates as
measures of market’s perception of risk and changing
risk:
 Stock prices and interest rates may tell us something about
the market’s assessment of companies, financial institutions,
and even overall financial markets: 2008 credit crisis.
 Exchange rates and government interest rate spreads may
tell us something about the market’s assessment of
countries or regions): 2010 – 2012 Crisis in the Euro-zone.
 Perhaps we can use financial market signals as a
leading indicator of economic activity.