Financial Markets & Institutions

Dr. Mahmoud Barakat

Ms. Shada Tarek

Function of Financial Market

Financial markets perform the essential economic function of channelling funds from
households, firms, and governments that have saved surplus funds by spending less than
their income to those that have a shortage of funds because they wish to spend more than
their income.
In direct finance, borrowers borrow funds directly from lenders in financial markets by
selling them securities.
• Define Securities: Securities are claims on the borrower’s future income or assets.
• Securities are assets for the person who buys them, but they are liabilities (debts)
for the individual or firm that sells (issues) them.

Why is this channelling of funds from savers to spenders so important to the economy?
The people who save are frequently not the same people who have profitable investment
opportunities available to them, the entrepreneurs. Without financial markets, it is hard to
transfer funds from a person who has no investment opportunities to one who has them.
Financial markets are thus essential to promoting economic efficiency.
i. Financial Markets allow funds to move from people who lack productive
investment opportunities to people who have such opportunities.
ii. Financial markets are critical for producing an efficient allocation of capital
(wealth, either financial or physical, that is employed to produce more wealth),
which contributes to higher production and efficiency for the overall economy.
iii. Well-functioning financial markets also directly improve the well-being of
consumers by allowing them to time their purchases better.

Structure of Financial Markets

1. Debt and Equity Markets
A firm or an individual can obtain funds in a financial market in two ways…
i. Issuing Debt
ii. Issuing Equity

Define Debt Instrument: A debt Instrument such as a bond or a mortgage, is a contractual

agreement by the borrower to pay the holder of the instrument fixed dollar amounts at
regular intervals (interest and principal payments) until a specified date (the maturity date).
• A debt instrument is short-term if its maturity is less than a year and long-term if
its maturity is 10 years or longer.
Financial Markets & Institutions
Dr. Mahmoud Barakat
Ms. Shada Tarek
• Debt instruments with a maturity between one and 10 years are said to be
intermediate-term.

Define Equity: Equity such as common stock, which claims to share in the net income
(income after expenses and taxes) and the assets of a business.
Equities often make periodic payments (dividends) to their holders and are considered
long-term securities because they have no maturity date.
• Owning stock means that you own a portion of the firm and thus have the right to
vote on issues important to the firm and to elect its directors.

What are the Advantages and Disadvantages of Owning Equity?

• The main disadvantage of owning a corporation’s equities rather than its debt is
that an equity holder is a residual claimant; that is, 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

2. Primary and Secondary Markets

Define Primary Market: A primary market is a financial market in which new issues
of security, such as a bond or a stock, are sold to initial buyers by the corporation
or government agency borrowing the funds.
• An important financial institution that assists in the initial sale of securities
in the primary market is the investment bank.
Define Secondary Market: A secondary market is a financial market in which
securities that have been previously issued can be resold.
• For Example: NASDAQ and Foreign Exchange Markets

Define Brokers: Brokers are agents of investors who match buyers with sellers of
securities.
Define Dealers: dealers link buyers and sellers by buying and selling securities at stated
prices.
A corporation acquires new funds only when its securities are first sold in the primary
market.

Secondary markets serve two important functions:

• First, they make it easier and quicker to sell these financial instruments to
raise cash; that is, they make the financial instruments more liquid.
• Second, they determine the price of the security that the issuing firm sells
in the primary market.
Financial Markets & Institutions
Dr. Mahmoud Barakat
Ms. Shada Tarek

3. Money and Capital Markets

Define Money Market: The money market is a financial market in which only short-
term debt instruments (generally those with original maturity of less than one year)
are traded.
Define Capital Market: The capital market is the market in which longer-term debt
and equity instruments are traded.

Short-term securities have smaller fluctuations in prices than long-term securities, making
them safer investments. As a result, corporations and banks actively use the money market
to earn interest on surplus funds that they expect to have only temporarily.

Functions of Financial Intermediaries: Indirect Finance

Why are financial intermediaries and indirect finance so important in financial markets?
1. Transaction Cost
Define Transaction Cost: the time and money spent in carrying out financial
transactions.
Financial intermediaries can substantially reduce transaction costs because they
have developed expertise in lowering them and because their large size allows them
to take advantage of economies of scale.
Define Economies of Scale: the reduction in transaction costs per dollar of
transactions as the size (scale) of transactions increases.

2. Risk Sharing
Low transaction costs allow financial intermediaries to share risk at low cost,
enabling them to earn a profit on the spread between the returns they earn on risky
assets and the payments they make on the assets they have sold.

The process of risk sharing is also sometimes referred to as asset transformation,

because in a sense, risky assets are turned into safer assets for investors.

Financial intermediaries also promote risk sharing by helping individuals to

diversify and thereby lower the amount of risk to which they are exposed.

Define Diversification: Diversification entails investing in a collection (portfolio)

of assets whose returns do not always move together, with the result that overall
risk is lower than for individual assets.
Financial Markets & Institutions
Dr. Mahmoud Barakat
Ms. Shada Tarek

3. Asymmetric Information
• Adverse selection is the problem created by asymmetric information before
the transaction occurs.

Adverse selection in financial markets occurs when the potential borrowers

who are the most likely to produce an undesirable (adverse) outcome—the
bad credit risks—are the ones who most actively seek out a loan and are
thus most likely to be selected.

• Moral hazard is the problem created by asymmetric information after the

transaction occurs.

Moral hazard in financial markets is the risk that the borrower might engage
in activities that are undesirable (immoral) from the lender’s point of view,
because they make it less likely that the loan will be paid back.

Another way of describing the moral hazard problem is that it leads to

conflicts of interest, in which one party in a financial contract has incentives
to act in its own interest rather than in the interests of the other party. Indeed,
this is exactly what happens if your Uncle Melvin is tempted to go to the
track and gamble at your expense.

Types of Financial Intermediaries

1. Depository Institutions

Define Depository Institutions: Depository institutions are financial intermediaries

that accept deposits from individuals and institutions and make loans.
• Commercial Banks These financial intermediaries raise funds primarily by
issuing checkable deposits, savings deposits and time deposits. They then
use these funds to make commercial, consumer, and mortgage loans.

• Savings and Loan Associations (S&Ls) and Mutual Savings Banks These
depository institutions obtain funds primarily through savings deposits
(often called shares) and time and checkable deposits.

In the past, these institutions were constrained in their activities and mostly
made mortgage loans for residential housing.
Over time, these restrictions have been loosened so that the distinction
between these depository institutions and commercial banks has blurred.
These intermediaries have become more alike and are now more
competitive with each other.
Financial Markets & Institutions
Dr. Mahmoud Barakat
Ms. Shada Tarek

• Credit Unions These financial institutions are typically very small

cooperative lending institutions organized around a particular group: union
members, employees of a particular firm, and so forth. They acquire funds
from deposits called shares and primarily make consumer loans.

2. Contractual Savings Institutions

Define: Contractual savings institutions, such as insurance companies and pension
funds, are financial intermediaries that acquire funds at periodic intervals on a
contractual basis.
Because they can predict with reasonable accuracy how much they will have to pay
out in benefits in the coming years, they do not have to worry as much as depository
institutions about losing funds quickly.
As a result, the liquidity of assets is not as important a consideration for them as it
is for depository institutions, and they tend to invest their funds primarily in long-
term securities.

• Life Insurance Companies Life insurance companies insure people against

financial hazards following a death and sell annuities (annual income
payments upon retirement).
They acquire funds from the premiums that people pay to keep their policies
in force and use them mainly to buy corporate bonds and mortgages. They
also purchase stocks, but are restricted in the amount that they can hold.

• Fire and Casualty Insurance Companies; These companies insure their

policyholders against loss from theft, fire, and accidents. They are very
much like life insurance companies, receiving funds through premiums for
their policies, but they have a greater possibility of loss of funds if major
disasters occur. For this reason, they use their funds to buy more liquid
assets than life insurance companies do.

• Pension Funds and Government Retirement Funds Private pension funds

and state and local retirement funds provide retirement income in the form
of annuities to employees who are covered by a pension plan. Funds are
acquired by contributions from employers and from employees, who either
have a contribution automatically deducted from their paychecks or
contribute voluntarily. The largest asset holdings of pension funds are
corporate bonds and stocks.
Financial Markets & Institutions
Dr. Mahmoud Barakat
Ms. Shada Tarek

3. Investment Intermediaries: This category of financial intermediaries includes

finance companies, mutual funds, and money market mutual funds.

• Define Finance Companies: Finance companies raise funds by selling

commercial paper (a short-term debt instrument) and by issuing stocks and
bonds. They lend these funds to consumers and to small businesses.

• Define Mutual Funds: These financial intermediaries acquire funds by

selling shares to many individuals and use the proceeds to purchase
diversified portfolios of stocks and bonds.

• Investment Banks: It does not take in deposits and then lend them out.
Instead, an investment bank is a different type of intermediary that helps a
corporation issue security.
o First it advises the corporation on which type of securities to issue
(stocks or bonds); then it helps sell (underwrite) the securities by
purchasing them from the corporation at a predetermined price and
reselling them in the market.
o Investment banks also act as deal makers and earn enormous fees by
helping corporations acquire other companies through mergers or
acquisitions.

Multiple-Choice Questions

1. Financial markets have the basic function of

A. bringing together people with funds to lend and people who want to borrow funds.
B. assuring that the swings in the business cycle are less pronounced.
C. assuring that governments need never resort to printing money.
D. both A and B of the above

2. Which of the following are securities?

A. A certificate of deposit
B. A share of Texaco common stock
C. A Treasury bill
D. All of the above
Financial Markets & Institutions
Dr. Mahmoud Barakat
Ms. Shada Tarek

3. Intermediaries who link buyers and sellers by buying and selling securities at stated
prices are called
A. investment bankers.
B. traders.
C. brokers.
D. dealers.

4. Bonds that are sold in a foreign country and are denominated in that country's
currency are known as
A. foreign bonds.
B. Eurobonds.
C. Eurocurrencies.
D. Eurodollars

5. Bonds that are sold in a foreign country and are denominated in a currency other
than that of the country in which they are sold are known as
A. foreign bonds.
B. Eurobonds.
C. Eurocurrencies.
D. Eurodollars.

6. The presence of transaction costs in financial markets explains, in part, why

A. financial intermediaries and indirect finance play such an important role in financial
markets.
B. equity and bond financing play such an important role in financial markets.
C. corporations get more funds through equity financing than they get from financial
intermediaries.
D. direct financing is more important than indirect financing as a source of funds.