CHAPTER FOUR

THE FINANCIAL MARKETS IN THE FINANCIAL SYSTEM

4.1 Introduction
A Market is an institutional mechanism where supply and demand will meet to exchange goods
and services. Market is a place or event at which people gather in order to buy and sell things in
order to trade.In modern economies, households provide labor, management skills, and natural
resources to business firms and governments in return for income in the form of wages, rents and
dividends. Consequently, one can see that markets are used to carry out the task of allocating
resources which are scarce relative to the demand of the society. Along with many different
functions, the financial system fulfills its various roles mainly through markets where financial
claims and financial services are traded (though in some least-developed economies Government
dictation and even barter are used). These markets may be viewed as channels which move a vast
flow of loanable funds that are continually being drawn upon by demanders of funds and
continually being replenished by suppliers of funds.

4.2 The Organization of Markets

Broadly speaking, markets can be classified in to factor markets, product market and financial
markets.
a) Factor markets: - are markets where consuming units sell their labor, management skill, and
other resources to those producing units offering the highest prices, i.e. this market allocates
factors of production (Land, labor and capital – and distribute incomes in the form of wages,
rental income and so on to the owners of productive resources).

b) Product markets: - are markets where consuming units use most of their income from
the factor markets to purchase goods and services i.e. this market includes the trading of
all goods and services that the economy produces at a particular point in time.

c) Financial markets: - are markets where funds are transferred from people who have an
excess of available funds to people who have a shortage. Financial markets such as the
bond and stock markets are important in channeling funds from people who do not have
a productive use for them to those who do.

4.3 Structure of Financial Markets

The various structures of financial markets are discussed below.

4.3.1 Primary and Secondary Markets

1. Primary Market
It is a financial market in which new issues of a security such as a bond or stock are sold to
initial buyers by the corporation or government agency borrowing the funds. New securities are
issued by firms in the primary market, and purchased by investors.The primary markets for
securities are not well known to the public because the selling of securities to the initial buyers
takes place behind closed doors. An important financial institution that assists in the initial sale
of securities in the primary market is the investment bank. It does this by under writing
securities: It guarantees a price for a corporation’s securities and then sells them to the
public.Therefore, the sale of new securities to the general public is referred to as a public offering
and the first offering of stock is called an initial public offering. The sale of new securities to one
investor or a group of investors (institutional investors) is referred to as a private placement.

2. Secondary Market
Secondary market is a financial market in which securities that have been previously issued (and
are thus second handed) can be resold. If investors desire to sell the securities that they
previously purchased, they use the secondary market. When an individual buys a security in the
secondary market, the person who has sold the security receives money in exchange for the
security, but the corporation that issued the security acquires no new funds. A corporation
acquires new funds only when its securities are first sold in the primary market. Nonetheless,
secondary market serves two important functions:
1) They make it easier to sell these financial instruments to raise cash; that is, they make the
financial instruments more liquid. The increased liquidity of these instruments then makes
them more desirable and thus easier for the issuing firm to sell in the primary market.

2) They determine the price of the security that the issuing firm sells in the primary market. The
firms that buy securities in the primary market will pay the issuing company no more than
the price that they think the secondary market will set for this security. The higher the
security’s price in the secondary market, the higher will be the price that the issuing firm will
receive for anew security in the primary market and hence the greater the amount of capital it
can raise. Conditions in the secondary market are therefore the most relevant to corporations
issuing securities. It is for this reason that books, which deal with financial markets, focus on
the behavior of secondary markets rather than primary markets.

4.3.2 Exchanges and Over-the–Counter Markets

1. Organized Exchanges (Auction) Markets
An auction market is some form of centralized facility (or clearing house) by which buyers and
sellers, through their commissioned agents (brokers), execute trades in an open and competitive
bidding process. The "centralized facility" is not necessarily a place where buyers and sellers
physically meet. Rather, it is any institution that provides buyers and sellers with a centralized
access to the bidding process. All of the needed information about offers to buy (bid prices) and
offers to sell (asked prices) is centralized in one location which is readily accessible to all would-
be buyers and sellers, e.g., through a computer network. An auction market is typically a public
market in the sense that it open to all agents who wish to participate. Auction markets can either
be call markets -- such as art auctions -- for which bid and asked prices are all posted at one time,
or continuous markets -- such as stock exchanges and real estate markets -- for which bid and
asked prices can be posted at any time the market is open and exchanges take place on a
continual basis. Experimental economists have devoted a tremendous amount of attention in
recent years to auction markets.

2. Over-the-counter (OTC) markets

An over-the-counter market has no centralized mechanism or facility for trading. Instead, the
market is a public market consisting of a number of dealers spread across a region, a country, or
indeed the world, who make the market in some type of asset. That is, the dealers themselves
post bid and asked prices for this asset and then stand ready to buy or sell units of this asset with
anyone who chooses to trade at these posted prices. The dealers provide customers more
flexibility in trading than brokers, because dealers can offset imbalances in the demand and
supply of assets by trading out of their own accounts. Many well-known common stocks are
traded over-the-counter through NASDAQ (National Association of Securities Dealers'
Automated Quotation System)

4.3.3 Debt and Equity Market

1. Debt Market
This is a financial market where debt instruments such as bonds or mortgages are traded.These
instruments are contractual agreements by the borrower to pay the holder of the instruments
fixed dollar amounts at regular intervals (interest and principal payments) until the specified date
(the maturity date). The maturity of a debt instrument is the time term to the instrument’s
expiration date. A debt instrument is short-term if its maturity is less than a year and long term if
its maturity is ten years of longer. Debt instruments with a maturity between one and ten years
are said to be intermediate term.

2. Equity Market
It is a financial market where equity securities, such as common stock, which are claims to share
in the net income (income after expenses and taxes) and the assets of a business, are traded.
Equities usually make payments (dividends) to their holders and are considered long-term
securities because they have no maturity date.The main disadvantage of owning a corporation’s
equities rather than its debt is that an equity holder is a residual claimant; i.e. the corporation
must pay all its debt holders before it pays its equity holders. The advantage of holding equities
is that equity holders benefit directly from any increases in the corporation’s profitability or asset
value because equities confer ownership rights on the equity holders. Debt holders do not share
in the benefit because their dollar payments are fixed.
4.3.4 Money and Capital Markets
1. The Money Market
The money market is a financial market in which only short term debt instruments (maturity of
less than one year) are traded. Securities with short-term maturities (1 year or less) are called
money market securities, while securities with longer-term maturities are called capital market
securities. Money market securities, which are discussed in detail latter, have the following
characteristics.
 They are usually sold in large denominations
 They have low default risk
 They have smaller fluctuation in prices than long-term securities, making them safer
investments
 Widely traded than long-term securities and so more liquid.
Money market transactions do not take place in any one particular location or building. Instead,
traders usually arrange purchases and sales between participants over the phone and complete
them electronically. Because of this characteristic, money market securities usually have an
active secondary market. This means that after the security has been sold initially, it is relatively
easy to find buyers who will purchase it in the future. An active secondary market makes the
money market securities very flexible instruments to use to fill short term financial needs.
Another characteristic of the money markets is that they are whole-markets. This means that
most transactions are very large. The size of this transaction prevents most individual investors
from participating directly in the money markets. Instead, dealers and brokers, operating in the
trading rooms of large banks and brokerage houses, bring customers together.

2. The Capital Market

Capital market is a financial market for debt and equity instruments with maturities of greater
than one year. They have far wider price fluctuations than money market instruments and are
considered to be fairly risky investments. Firms that issue capital securities and the investors
who buy them have very different motivations than those who operate in the money markets.
Firms and individuals use the money markets primarily to warehouse funds for short period of
time until a more important need or a more productive use for the funds arises. To the contrary,
firms and individuals use the capital markets for long term investments.

Capital market trading occurs in either the primary market or the secondary market. The primary
market is where new issues of stocks and bonds are exchanged. Investment funds, corporations,
and individual investors can all purchase securities offered in the primary market. A primary
market transaction is the one where the issuer of securities actually receives the proceeds of the
sale. When firms sell securities for the very first time, the issue is called Initial Public Offering
(IPO). Subsequent sales of a firm’s new stocks or bonds to the public are simply primary market
transactions.
The capital markets have well-developed secondary markets. A secondary market is where the
sale of previously issued securities takes place, and it is important because most investors plan to
sell long-term bonds and stocks before maturity. Secondary market for capital market
instruments may take place either in an organized exchanges market or in an over the counter
market.

Capital Markets can be classified in to two broad categories; the bond market and the equity
(stock) markets.

i. The Bond Market

The bond market is composed of longer-term borrowing debt instruments than those that trade in
the money market. These instruments are some times said to comprise the fixed income capital
market, because most of them promise either a fixed stream of income or stream of income that
is determined according to a specified formula. In practice, these formulas result in a flow of
income that far from fixed. Therefore the term “fixed income” is probably not fully appropriate.
It is simpler and more straightforward to call these securities either debt instruments or bonds.

A bond is a security that is issued in connection with a borrowing arrangement. The borrower
issues (sells) a bond to the lender for some amount of cash; the bond is in essence the “IOU” of
the borrower. The arrangement obligates the issuer to make specified payments to the bond
holder on specified dates. A typical bond obligates the issuer to make semiannual payment of
interest called, coupon payments, to the bond holder for the life of the bond. These are called
coupon payments because, in pre computer days, most bonds had coupons that investors would
clip off and present to the issuer of the bond to claim the interest payment. When the bond
matures, the issuer repays the debt by paying the bond’s par value (or its face value). The
coupon rate of the bond determines the interest payment: The annual payment equals the coupon
rate times the bond’s par value. The coupon rate, maturity date, and par value of the bond are
part of the bond indenture, which is the contract between the issuer and the bond holder.
Types of Bonds: Long term bonds traded in the capital markets include government (Treasury)
bonds, corporate bonds, municipal bonds, and foreign bonds.

ii. The Stock Market/Equities Market

Equities represent ownership shares in a corporation. Each share of common stock entitles its
owners to one vote on any matters of corporate governance put in to a vote at the corporation’s
annual meetings and to a share in the financial benefits of ownership.Investors can earn a return
from a stock in one of two ways; the yield or capital gains.
 Yield is the income the investor receives while owning an investment.
 Capital gains are increases in the value of the investment itself, and are often not
available to the owner until the investment is sold.
Types of Stock/Equity: There are two most important forms of equity investments; these are the
common stock /ordinary shares (in America) and preferred stock/ preference shares (in British
terminologies).
A. Common Stock/ Ordinary shares
Common stock, as an investment has the following basic characteristic features:
Residual claim means stockholders are the last in line of all those who have a claim on the assets
and income of the corporation. In a liquidation of the firm’s assets, the shareholders have claim
to what is left after paying all other claimants, such as tax authorities, employees, suppliers,
bondholders, and other creditors. In a going concern, shareholders have claim to the part of
operating income left after interest and taxes have been paid. Management either can pay this
residual as cash dividends to shareholders or reinvest it in the business to increase the value of
the shares.

Limited liability means that the most shareholders can lose in the event of the failure of the
corporation is their original investment. Shareholders are not like owners unincorporated
businesses, whose creditors can lay claim to the personal assets of the owner. In the event of the
firm’s bankruptcy corporate stock holders at worst have worthless stock. They are not personally
liable for the firm’s obligations: Their liability is limited.

Voting Right: Each share of a common stock provides the holder with one vote in the election of
board of directors and on other decision making activities.

Dividends: Payment of dividends to shareholders is at the corporation’s board of directors

discretion

Preemptive Rights: Allows common stock holders to maintain their proportionate ownership in
the corporation when new shares are issued.

B. Preferred Stock/ Preference Shares

Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to the
holder a fixed stream of income each year. In this sense, preferred stock is similar to an infinite-
maturity bond, that is, perpetuity. It also resembles a bond in that it does not give the holder
voting power regarding the firm’s management.

However, preferred stock is an equity investment. The firm retains discretion to make the
dividend payments to the preferred stock holders: It has no contractual obligation to pay those
dividends. Instead, preferred dividends are usually cumulative: that is, unpaid dividends
cumulate and must be paid in full before any dividends may be paid to holders of common stock.
In contrast, the firm does not have a contractual obligation to make timely interest payments on
the debt. Failure to make these payments sets off corporate bankruptcy proceedings.
Preferred stock also differs from bonds in terms of its tax treatments for the firm. Because
preferred stock payments are treated as dividends rather than as interest on debt, they are not tax-
deductible expenses for the firm.

Even though preferred stock ranks after bonds in terms of the priority of its claim to the assets of
the firm in the event of corporate bankruptcy, preferred stock often sells at lower yields than
corporate bonds. Presumably this reflects the value of the dividend exclusion, because the higher
risk of preferred stock would tend to result in higher yields than those offered by bonds.

Corporations issue preferred stock in variations similar to those of corporate bonds. Preferred
stock can be callable the issuing firm, in which case it is said to be redeemable It also can be
convertible in to common stock at some specified conversion ratio.

4.3.4 The Derivatives Market

Firms are exposed to several risks in the ordinary course of operations and when borrowing
funds. For some risks, management can obtain protection from an insurance company. For
example, management can insure a plant against destruction by fire by obtaining a fire insurance
policy from a property and casualty insurance company. There are capital market products
available to management to protect against certain risks that are not insurable by an insurance
company. Such risks include risks associated with a rise in the price of commodity purchased as
an input, a decline in a commodity price of a product the firm sells, a rise in the cost of
borrowing funds, and an adverse exchange rate movement. The instruments that can be used to
provide such protection are called derivative instruments. The term derivatives refers to a large
number of financial instruments, the value of which is based on, or derived from, the prices of
securities, commodities, money or other external variables. These instruments include futures
contracts, forward contracts, option contracts, and swap agreements.

1. Futures Contract
A futures contract is an agreement between a buyer/seller and an established exchange or its
clearinghouse in which the buyer/seller agrees to take/make delivery of something at a specified
price at the end of a designated future date. The thing that the two parties agree eitherto take or
make the delivery is referred to as the underlying for the contract or simplytheunderlying. The
price at which the parties agree to transact in the future is called the futures price and the
designated date at which the parties must transact is called the settlement date or delivery
date.The basic economic function of futures markets is to provide an opportunity for market
participants to hedge against the risk of adverse price movements.Futures contracts involving the
trading of traditional agricultural commodities (such as grain and livestock), imported foodstuffs
(such as coffee, cocoa, and sugar), or industrial commodities are known as commodity futures.
Futures contracts based on a financial instrument or a financial index are known as financial
futures. Financial futures include stock index futures, interest rate futures, and currency futures.
 2. Forward Contracts
A forward contract, just like a futures contract, is an agreement for the future delivery of the
underlying at a specified price at the end of a designated period of time.

Difference between futures and forward contracts

 Futures contracts are standardized agreements as to the delivery date, quantity, and
quality of the deliverable, and are traded on organized exchanges. Whereas a forward
contract is usually non-standardized (that is, the terms of each contract are negotiated
individually between buyer and seller), has no clearinghouse, and secondary markets are
often nonexistent or extremely thin.
 Unlike a futures contract, which is an exchange-traded product, a forward contract is an
over-the-counter instrument.
 The parties in a forward contract are exposed to credit risk because either party may
default on the obligation. The risk that the counterparty may default is referred to as
counterparty risk. Counterparty risk is minimal in the case of futures contracts because
the clearinghouse associated with the exchange guarantees the other side of the
transaction.
 Futures contracts are not intended to be settled by delivery. In contrast, forward contracts,
are intended for delivery.
 Futures contracts are marked to market at the end of each trading day. Consequently,
futures contracts are subject to interim cash flows as additional margin may be required
in the case of adverse price movements, or as cash is withdrawn in the case of favorable
price movements. A forward contract may or may not be marked to market, depending on
the wishes of the two parties. For a forward contract that is not marked to market, there
are no interim cash flow effects because no additional margin is required.
 Other than these differences, most of what we say about futures contracts applies equally
to forward contracts.

3. Options
An option is a contract in which the writer of the option grants the buyer of the option the right,
but not the obligation, to purchase from or sell to the writer an asset at a specified price within a
specified period of time (or at a specified date). The writer, also referred to as the seller, grants
this right to the buyer in exchange for a certain sum of money, which is called the option price or
option premium. The price at which the asset may be bought or sold is called the exercise price
or strikeprice. The date after which an option is void is called the expiration date. As with a
futures contract, the asset that the buyer has the right to buy and the seller is obligated to sell is
referred to as the underlying.When an option grants the buyer the right to purchase the
underlying from the writer (seller), it is referred to as a call option, or call. When the option
buyer has the right to sell the underlying to the writer, the option is called a put option, or put.
Options, like other financial instruments, may be traded either on an organized exchange or in
the over-the-counter (OTC) market. The advantages of an exchange-traded option include;
 The exercise price and expiration date of the contract are standardized.
 As in the case of futures contracts, the direct link between buyer and seller is severed
after the order is executed because of the interchangeability of exchange-traded options.
 The clearinghouse associated with the exchange where the option trades performs the
same function in the options market that it does in the futures market.
 Finally, the transactions costs are lower for exchange-traded options than for OTC
options.
Differences between Options and Futures Contracts
Unlike in a futures contract, one party to an option contract is not obligated to transact-
specifically, the option buyer has the right butnot the obligation to transact. The option writer
does have the obligationto perform. In the case of a futures contract, both buyer and seller are
obligatedto perform. Of course, a futures buyer does not pay the seller toaccept the obligation,
while an option buyer pays the seller an option price.

In terms of risk/reward characteristic, in the case of a futures contract, the buyer of the contract
realizes a gain when the price of the futures contract increases and suffers a loss when the price
of the futures contractdrops. The opposite occurs for the seller of a futures contract. Because
ofthis relationship, futures are referred to as having a “linear payoff.” However, options do not
provide this symmetric risk/reward relationship.The most that the buyer of an option can lose is
the option price. Whilethe buyer of an option retains all the potential benefits, the gain isalways
reduced by the amount of the option price. The maximum profitthat the writer may realize is the
option price; this is offset against substantialdownside risk. Because of this characteristic,
options arereferred to as having a “nonlinear payoff.”

4. Swaps
In addition to forwards, futures, and options, financial institutions use one other important
financial derivative to manage risk. Swaps are financial contracts that obligate two parties
(counter parties) to the contract to exchange (swap) a set of payments (not assets) it owns for
another set of payments owned by another party. The amount of the payments exchanged is
based on some predeterminedprincipal,called the notional principal amount or simply notional
amount. The amount each counterparty pays to the other is theagreed-upon periodic rate times
the notional amount. The only amounts that are exchanged between the parties are the agreed-
upon payments,not the notional amount.A swap is an over-the-counter contract. Hence, the
counterparties to a swap are exposed to counterparty-risk.The most widely used types of swaps
include interest rate swaps, currency swaps, and commodity swaps.
 4.3.5 Foreign Exchange Market
A Foreign exchange market is a market in which currencies are bought and sold. It is to be
distinguished from a financial market where currencies are borrowed and lent.The foreign
exchange market provides the physical and institutional structure through which the money of
one country is exchanged for that of another country, the rate of exchange between currencies is
determined, and foreign exchange transactions are physically completed. A foreign exchange
transaction is an agreement between a buyer and a seller that a given amount of one currency is
to be delivered at a specified rate for some other currency.

Functions of the Foreign Exchange Market

The foreign exchange market is the mechanism by which a person of firm transfers purchasing
power from one country to another, obtains or provides credit for international trade transactions,
and minimizes exposure to foreign exchange risk.
1. Transfer of Purchasing Power:Transfer of purchasing power is necessary because
international transactions normallyinvolve parties in countries with different national
currencies. Each party usually wants todeal in its own currency, but the transaction can be
invoiced in only one currency.
2. Provision of Credit:Because the movement of goods between countries takes time,
inventory in transit mustbe financed.
3. Minimizing Foreign Exchange Risk: The foreign exchange market provides "hedging"
facilities for transferring foreignexchange risk to someone else.