Financial institutions and market

Chapter Four: Financial Markets in the Financial System July 30, 2016
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Chapter Four: Financial Markets in the Financial System
4.1. The Organization and Structure of Markets
4.1.1. Elements of the Financial System
Conceptually, the financial system includes a complex of institutions and mechanisms which
affect the generation of savings and their transfer to those units who will invest these funds.
 The financial system may be said to be made of all those channels through which savings
become available for investments.
The main elements of the financial system are variety of:
 Financial Instruments (Financial Assets or Securities)
 Financial Intermediaries, and
 Financial Markets that require the role/function of security dealers, brokers, specialists,
and analysts.
1. Financial Assets
Financial assets are claims against the assets or resources of other economic units and are held as
a store of value and for the return that is expected.
 While the value of a tangible (or physical) asset depends on its physical properties, a
financial asset represents a claim to future cash flows in the form of interest, dividends,
and so on.
 It is a claim on a stream of income and/or a claim on a particular asset.
 The entity (or the economic unit) that offers the future cash flows is the issuer of the
financial instrument; and the owner (holder) of the security is the investor.
Depending upon the nature of the claim/return, an instrument may be classified as:
 Debt Security such as bonds, debentures, term loans, etc;
 Equity Security, i.e. common shares; and
 Hybrid Security such as preference shares and convertible bonds.
Based on the type of issuer, a security may be classified as:
 Direct (Primary) Claim(s).
 These are securities that are directly issued by business firms and governments in
order to raise funds from the public and referred to as direct claims (primary claims).
Example: Shares, T-Bills, Bonds (or Debentures), etc.
 Indirect (Secondary) Claim(s).
 Indirect financial assets are claims against financial intermediaries (i.e. those
instruments issued by financial intermediaries, such as banks, insurances, etc, in order
to initially raise funds from the public and then transfer these funds to satisfy the
financial needs of business firms and governments through lending those funds).

Example: Checking & Saving Accounts; Health, Life, and Accident Insurance
Policies;
Retirement Plans; and Shares in Mutual Funds.
 Derivatives (Conditional Claims).
 The term conditional, perhaps, may not be scientific and is used in this material just
to describe derivative instruments, whose value depend conditionally on the value of
some other asset or market indexes.
 The Derivate Instruments include options, forwards, and futures contracts the values
of which are derived from the value of some other assets and/or indices.
The prevalence of a variety of securities to suit the investment requirements of heterogeneous
investors offer different investment choice to them and are an important element in the maturity
and sophistication of the financial system.
2. Financial Intermediaries
Financial intermediaries are institutions that channel the savings of investors (i.e. the savings of
households & businesses) in to investments through providing loans.
 As institutional sources of funds, financial intermediaries act as a link between savers and
the investors, which results in institutionalization of personal savings.
 Their main function is to convert direct claims (direct financial assets) in to indirect
securities.
 The indirect securities offer to individual investors a variety of financial assets in the
form of individual security by pooling which it has created, for example, units of mutual
funds.
3. Financial Markets
Financial markets perform a crucial function in the financial system as “facilitating
organizations.”
 Unlike financial intermediaries, they are not a source of funds but are a link and provide a
forum in which suppliers of funds and demanders of loans (for investments) can transact
business directly.
 While the loans and investments of financial intermediaries are made without the direct
knowledge of the suppliers of funds (i.e., without the knowledge of investors), suppliers
of funds in the financial markets know where their funds are being lent (and/or invested).
[NB. Financial Intermediaries are those depository as well as non-depository financial
institutions that convert primary claims in to secondary claims; whereas Financial Middlemen
are those individuals and/or institutions (i.e. brokerage firms, dealer firms, and investment
bankers) that buy and directly sale (or resale) primary securities to the public. In this regard, both
Financial Intermediaries as well as Financial Middlemen play important roles in the Financial
System in general and in the Financial Markets in particular].
4.1.2. Types of Financial Markets.
The two key financial markets are the money markets and capital markets.

1. Money Market
The money market is created by the financial relationship between suppliers and demanders of
short–term funds with maturities of one year or less.
 Money markets exist because investors (i.e. individuals, business entities, governments,
and financial institutions) often have temporarily idle funds that they wish to place in
some type of liquid asset or short term interest – earning instrument.
 At the same time, other entities (organizations) find themselves in need of seasonal
(temporary) financing.
 The money market brings together these suppliers and demanders of short–term liquid
funds.
The broad objectives of money market are three fold. These are:
 An equilibrating mechanism for evening out short term surpluses and deficiencies in the
financial system;
 A focal point of intervention by the central bank for influencing liquidity in the
economy; and
 A reasonable access to the users of short – term funds to meet their requirements at
realistic (reasonable) costs and temporary employment of funds for earning return to the
suppliers of funds.
2. Capital Market
The capital market is a financial relationship created by a number of institutions and is an
arrangement that allows suppliers and demanders of long–term funds (i.e. funds with maturities
exceeding one year) to make exchange transactions (provide funds via receiving securities).
 The capital market is a market for long-term funds.
 Included among the instruments used to raise long-term funds are securities issues of
businesses and government units.
 The backbone of the capital markets is formed by the various security exchanges (equity
markets) that provide a forum for equity transactions (i.e. trading of stocks).
 The long-term debt securities are also traded in another segment of the capital market
(referred to as long-term debt markets).
Mechanisms for efficiently offering and trading securities contribute to the functioning of capital
markets, which is important to the long-term growth of business.
 The capital market comprises the following two markets:
 New Issues (Primary) Markets – Markets for Initial Public Offering (IPO), and
 Stock (Security) Exchanges or Stock Markets – Secondary Markets.
 It should be noted also that secondary markets exist Over-the-Counter (OTC) for trading
long-term debt securities such as bonds.
4.2. Money Markets: Characteristics and Importance

4.2.1. Characteristics
Money markets provide a channel for the exchange of financial assets for money, with emphasis
upon loans to meet purely short-term cash needs.
 The money market is the mechanism through which holders of temporary cash surpluses
meet economic units that face temporary cash deficits.
 It is designed, on one hand, to meet the short-run cash requirements of
corporations, financial institutions, and governments by providing a mechanism
for granting loans as short as overnight and as long as one year to maturity.
 At the same time, the money market provides an investment outlet for those
spending units (also principally corporations, financial institutions, and
governments) that hold surplus cash for short period of time and wish to earn at
least some return on temporarily idle funds.
The essential function of the money market, of course, is to bring these two groups in to contact
in order to make borrowing and lending possible.
 in the short run.
 Paper Market.
4.3. Money Market Instruments
The principal financial instruments issued and traded in the money market are the following:
 Government Treasury Bills (T-Bills)
 Federal Agency Securities
 Dealer Loans
 Repurchase Agreements
 Bank Certificates of Deposits (CDs)
 Federal Funds
 Commercial Paper
 Banker’s Acceptances
 Financial Futures
 Euro Dollar Deposits
The next section discusses the characteristics of – and yields on – some of the money market
instruments.
4.3.1. Treasury Bills (T-Bills)
General
Treasury Bills represents the large volume of daily purchases or sales in the money markets.
 In this regard, the interest rates on T-Bills are the base for all other money market interest
rates.

 The government IOUs, which includes T-Bills, notes, and long-term bonds, carry great
weight in the financial system due to their zero default risk, ready marketability, and high
liquidity.
 Security dealers, at the heart of the market, make the market go and aid the federal
government in selling billions of dollars in new securities each year.
 U.S.T-bills are direct obligations of the U.S. government.
 By law, they must have an original maturity of one year or less.
4.3.2. DealerLoans and Repurchase Agreements
General
The money market depends heavily up on the buying & selling activities of securities dealers in
order to move funds from cash-rich units to those with cash shortages. In this regard, dealers
 Are primary market makers for government securities, i.e. buy and sell government
securities;
 Trade in both new & previously issued T-bills, bonds, and notes;
 Also buy & sell other money market instruments;
 Are the principal points of contact with the money market for thousands of individual and
institutional investors and are essential to the efficient functioning of the market.
Dealers supply a huge volume of securities daily to the financial market place.
 They, in this regard, depend heavily on the money market for borrowed funds.
 Most of the dealer houses invest little of their own equity in the business.
 The bulk of their operating capital is obtained through short-term borrowings from
commercial banks, non financial corporations, and other institutions.
4.3.3. Commercial Paper
What is Commercial Paper?
Commercial paper is one of the oldest of all money market instruments.
 By definition, commercial paper consists of short term, unsecured promissory
notes issued by well known companies that are financially strong and carry high
credit ratings.
 The funds are used for current transactions – i.e., to purchase inventories, pay taxes, meet
payrolls, and cover other short-term obligations.
 However, a growing number of paper issues today are used provide “bridge financing”
for long term projects such as building of ships, office buildings, etc.
 In these instances, issuing companies usually plan to convert their short term
paper issues in to long term, more permanent financing when the capital market is
more favorable.

4.3.4. International Money Market Instruments: Bankers’ Acceptances and Eurodollars
4.3.4.1. Bankers’ Acceptances
Meaning of Bankers’ Acceptances
A banker’s acceptance is a time draft drawn on a bank by an exporter or an importer to pay for
merchandise or to buy foreign currencies.
 If the bank honors the draft, it will stamp “Accepted” on its face and endorse the
instrument.
 By so doing, the issuing bank has unconditionally guaranteed to pay the face value of the
acceptance at maturity, shielding exporters and investors in international markets from
default risk.
 Acceptances carry maturities ranging from 30 to 270 days.
 They are actively traded among bank and non-bank financial institutions, manufacturing
and industrial corporations, and securities dealers as a high quality investment and source
of ready cash.
4.3.4.2. Eurodollars
General
Eurodollars are international money market instruments.
 Comparable to the domestic market, a chain of international money markets trade in
deposits that are denominated in the world’s most convertible currencies (such as Dollars,
Marks, Pound, Francs, and Yen) stretches around the globe.
This so called Eurocurrency Market has arisen because of a tremendous need worldwide for
funds denominated in the above major currencies.
 Firms may need huge amount of other nation’s currencies to carry out transactions in the
countries where they are represented.
 To meet this kind of need, in the 1950s, large international banks head quartered in
London, Paris, Zurich, Tokyo, etc began to accept deposits from businesses, individuals,
and governments denominated in currencies other than that of the host country and to
make loans in those same foreign currencies.
 Thus, the Eurocurrency market was born.
4.4. Capital Markets
Capital markets are markets for long term funds that are formed by the various securities
exchanges (or organized exchanges) and over-the-counter (OTC) markets.
 The capital markets comprise the Long-Term Debt Markets and Corporate Stock
Markets (also called Equity Markets).
The next section discusses the underlying features, basic instruments, as well as the general
structure of capital markets, which are by definition markets for long term funds.

4.4.1. Long-Term Debt Markets
The popular forms of long-term debt financing instruments are corporate bonds (or corporate
notes).
 These instruments are issued by largest corporations with high credit standing and sold
in the open market.
 This is especially true for the largest corporations whose credit standing & reputation is
so strong that they can avoid dealing directly with an institutional lender such as a bank,
financial company, or insurance company and sell their IOUs in the open market.]
Smaller companies without the necessary standing in the eyes of security investors usually must
confine their long-term financing operations to:
 Negotiated-loans with an institutional lender,
 An occasional stock issue, and
 Heavy use of internally generated cash.
The Most Common Types of Corporate Bonds
The most common types of corporate bonds often issued in the capital markets are discussed
next:
1. Debentures
There are many different types of corporate bonds issued every day in the financial markets.
 Among the most common is the debenture, which is not secured by any specific asset or
assets owned by the issuing corporation.
 Instead, the holder of a debenture is a general creditor of the company and looks to the
earning power and reputation of the borrower as the main source of the bond’s value.
2. Subordinated Debentures
A related form of bond is the subordinated debenture, frequently called a junior security.
 If a company goes out of business and its assets are liquidated, the holders of
subordinated debentures will be paid only after all secured and unsecured senior creditors
receive the monies to which they are entitled.
3. Mortgage Bonds
Debt securities representing a claim against specific assets (normally plant and equipment)
owned by a corporation are known as mortgage bonds.
 These bonds may be either closed end or open end.
 Closed-end mortgages do not permit the issuance of any additional debt against the assets
already pledged under the mortgage.
 Open-end bonds, on the other hand, do allow additional debt to be issued against pledged
assets, and this may dilute the position of the current bondholder.
 For this reason, open-end mortgage bonds typically carry higher yields than closed-end
bonds.

Sometimes several different mortgages bonds with varying priorities of claim will be issued
against the same asset.
 For example, the initial issue of bonds against a corporation’s fixed assets may be
designated first mortgage bonds, and later second mortgage bonds may be issued against
those same assets.
 If the company were liquidated and the pledged assets sold, holders of second mortgage
bonds would receive only funds left over after holders of the first mortgage bonds were
paid off.
A. Markets for Corporate Notes and Bonds (Primary Markets)
Corporate bonds and/or notes may be issued in the primary market through one of the following
alternative techniques:
1. Initial Public Offering (IPO) – represents security issuance to the public (i.e. offering new
securities in the open market for the first time).
 It is a competitive sale (offering).
2. Private Placement (where securities are sold privately to a limited number of investors).
 It is a negotiated sale (i.e. non-competitive offering).
B. Secondary Markets for Corporate Bonds
The resale (secondary) market for corporate notes and bonds is relatively limited as compared to
the resale markets for common stocks, municipal bonds, and other long term securities.
 Trading volume is thin, even for some bonds issued by the largest and best-known
companies.
Part of the reason is
 No central exchange for bond trading exists.
 Corporate bonds are traded on all major exchanges.
 Most secondary market trading for bonds is conducted over the telephone through
brokers and dealers.
 Dealers act as middlemen between institutional investors and issuers (sellers).
 “OTC” brokers arrange trading for a commission.
4.4.2. Corporate Stock Market (Equity Market)
Characteristics
Corporate stocks can be traded in organized exchanges (stock exchanges), over-the-counter
(OTC) markets, or both. The major stock exchanges and the basic characteristics of OTC
markets is discussed below.
1.Over-The-Counter (OTC) Market
Trading of stock through brokers operating off the major exchanges (i.e. in the OTC markets)
also occurs. In this regard,

 Over-The-Counter (OTC) markets are “over the telephone markets”.
 They are much more informal.
Trading in the OTC market’s includes stocks & bonds of many small and medium sized
companies.
B. Organized Stock Exchanges: Case of the NYSE
In the United States, the NYSE is a well known national stock exchange followed by the ASE (or
AMEX).
 The NYSE and ASE (or AMEX) are national markets for trading of corporate stocks
that compete with regional exchanges.
 They are markets for “Listed Stocks”.
 Stock brokers & specialists play major role in these markets.
In general, exchanges provide a “physical location for trading”.
 Trading by member firms must be carried on at the specific location.
 On the floor of NYSE, for instance, there are 18 counters, each with several windows for
trading posts.
 Exchanges permit the enforcement of formal trading rules in order to achieve efficient &
speedy allocation of available equity shares.
In order to trade in organized exchanges, the stock(s) must be issued by a firm listed with the
exchange. In this regard,
 Strong listing qualifications are demanded in order to get companies listed in organized
exchanges.
 The listing requirements limit exchange participants (stock issuers) to strong & largest
firms.
 The rigorous listing requirements help to ensure listed companies to:
 Have sufficient volume of shares available to create an active national market
for their stocks; and
 Disclose sufficient data so that interested investors can make informed
decisions.
The NYSE, as a stock exchange, requires approval of admission by NYSE Board of Directors.
 Listed companies (in NYSE), in this regard,
 Must make an annual disclosure of their financial condition;
 Limit trading by insiders;
 Publish quarterly earnings reports; and
 Help maintain an active and deep public market for their shares.
 If trading interest in a particular firm’s stock falls off significantly, the firm may be
delisted.

C. The Third Market
The Third Market is a market for securities listed on a stock exchange but traded over the
counter.
 Brokerage & Dealer Firms not members of an organized exchange are active in this
market.
The original purpose of the third market was to supply large blocks of shares to institutional
investors, especially mutual funds, bank trust accounts, and pension funds.
 These investors engage in Block Trades.
 Block Trades are transactions involving 1000 shares or more.
Large block traders, presumably,
 Possess technical knowledge (know how) to make informed investment decisions.
 Carry out transaction without assistance from a stock exchange and the high brokerage
commissions that may entail.
By trading with third market broker & dealer firms, who compete directly with specialists on the
exchanges, a large institutional investor frequently can lower transactions costs and trade
securities faster.
 The Third Market provides additional competition for the organized exchanges.
 Moreover, along with the over-the-counter markets, the Third Market has been a catalyst
in reducing brokerage fees and promoting trading efficiency.
 For example, the growth of the Third Market and other OTC trading during the
1970s encouraged the unbundling of commissions at many U.S. broker and
dealer firms to more accurately reflect the true cost of each security trade.
 Many brokerage firms, especially those active in odd-lot trading, offer customers
an array (or range) of peripheral services, such as research on market trends and
security credit accounting for purchases and sales, and often the customer pays
for these services whether or not he/she uses them.
 The largest institutional investors, however, have little need for such services and
they seek brokers and dealers offering their services at minimum cost.
For instance, the NYSE was charging fixed commissions on trading.
 This increased the flight of major stock investors in to the third market & in to other
OTC markets.
 This has later brought about pricing policies in the industry geared more directly to
actual services used.
While major stock brokers and dealers used to quote set commissions, the practice of charging
fixed brokerage commissions to stock investors ended on the New York Stock Exchange
(NYSE) on May1, 1975.
 The result was an upward surge in the volume of trading on the organized exchanges.

 In fact, stock trading on Wall Street multiplied fivefold between 1975 and 1985.
More recently, numerous “discount” brokerage houses have appeared in exchanges, leading
many institutional customers to:
 Abandon the third market.
 Return to more traditional channels for executing their security orders as trading prices
continue to decline.
Discount Brokerage Firms, in this regard, offer trading services at commission rates as much as
80% less than the rates quoted by so-called full-service firms.
 The more than 600 discount houses currently operating (many organized by banks) cut
costs by not giving investment advice or offering personal account management to
customers.
1. Stock and Bond Market Indicators
Stock market indicators have come to perform a variety of functions, from serving as
benchmarks for evaluating the performance of professional investors to answering the question
“How did the market do today?”
 Thus, stock market indicators (indexes or averages) have become a part of everyday life.
 The most commonly quoted stock market indicator is the Dow Jones Industrial Average
(DJIA).
 Other stock market indicators cited in the financial press are the
 Standard & Poor’s 500 Composite (S&P 500),
 New York Stock Exchange Composite Index (NYSE Composite),
 NASDAQ Composite Index, and
 Value Line Composite Average (VLCA).
 Other stock market indicators include the Wilshire stock indexes and the Russell stock
indexes, which are followed primarily by institutional money managers.

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