Introduction to Finance - Chapter 6

Introduction to Finance - Chapter 6: Financial Markets

• Financial system is a crucial part of the whole economic system
• It ensures the economy's money supply and liquidity.
• It maintains, regulates and operates the payment system.
• It allocates savings from savers to borrowers.
• It reallocates income across economic actors over time.

Financial System Functions

• Monetary system: Secures money supply and liquidity.
• Supervising system: Maintains, regulates, and operates the payment system.
• Financial markets, financial intermediaries: Allocate savings to borrowers.
• Fiscal system: Reallocates income across economic actors.

Financial Markets

• Definition: A platform for exchanging financial instruments and money.
• This is where borrowers get funds from savers.

Primary Function of Financial Markets

• Connect savers and borrowers.
• Demand side: Borrowers need funds for liquidity issues or investments.
• Supply side: Savers with excess funds looking for returns.
• Money gets exchanged for financial instruments.

Segments of Financial Markets

• Term (money or capital markets): Based on terms (e.g., less than a year vs. more than a year).
• Geographic scope (domestic or international): Domestic or international transactions.
• Standardization (unique or standardized): Standardized financial instruments are easier for trade
• Time of settlement (spot or futures/forwards): Immediate vs. future settlement of trades.
• Function of trade (primary or secondary): Primary for new issuance vs. secondary for existing securities.
• Type of trade (private or public): Private for bespoke deals; public for regulated transactions
• Platform of trade (stock exchange or OTC): Regulated vs. over-the-counter markets.

Money vs. Capital Markets

• Money markets deal with securities less than a year out, often with lower risk and return. (e.g. Treasury Bills)
• Capital markets deal with securities more than a year out, often with higher risk and return (e.g. stocks, bonds).

Primary vs. Secondary Markets

• Primary markets: Where firms raise capital from savers (e.g. initial public offerings).
• Secondary markets: Where investors can trade existing securities (e.g stock exchange trading).

Stock Exchange vs. OTC

• Stock exchanges (or organised exchanges): Centralized platforms where standardized trading occurs.
• OTC (Over The Counter): Decentralized markets where trading takes place through banks and other financial institutions for non-standardized products.

Spot vs. Future/Forward Markets

• Spot market: The trade is settled within a day.
• Future/forward market: Contracts for trades that settle at a later date. Terms and conditions are agreed in advance, but the exchange itself is in the future.

Financial Intermediation

• Direct funding: Savers give funds directly to borrowers - High risk to savers due to information asymmetry and uncertainty about the borrower
• Financial intermediaries: Intermediaries help in channeling savings to borrowers and manage risks.
• Financial Intermediaries offer the following services to both parties:
  • Gathering information
  • Assessing creditworthiness
  • Managing and reducing risk
  • Pooling small deposits of savers
  • Transforming maturity needs
  • Minimising transaction costs and information asymmetry

Financial Intermediaries - Definition

• Collect savings at their own risk and lend/invest accordingly.
• Provide returns and services for their savers.
• Intermediation mainly for indirect funding (indirect funding is when funds are transferred through an intermediary)

Types of Financial Intermediaries

• Monetary intermediaries: Collect deposits (e.g., banks, credit institutions, money markets funds)
• Non-monetary intermediaries: Do not collect deposits (e.g., investment funds, insurance companies)

Functions of Financial Intermediation - Intermediating Information and Knowledge

• Savers and borrowers lack enough information about each other and their creditworthiness.
• Intermediaries mitigate these problems by gathering and evaluating information, and managing risks.

Functions of Financial Intermediation - Risk Transformation

• Direct funding: Savers bear all the investment risk.
• Indirect funding: Reduces the risk for savers by separating the risk from the borrower. Intermediaries diversify the risk of individual assets to reduce the overall risk of the investments.

Functions of Financial Intermediation - Size Transformation

• Savers and borrowers have differing needs for the sizes of investments
• Intermediation pools smaller amounts into larger, and larger amounts are broken down into smaller investments helping to match investment needs..

Functions of Financial Intermediation - Maturity Transformation

• Savers and borrowers need funds for differing lengths of time.
• Intermediation facilitates harmonization between these differing needs.
• Allows intermediaries to maintain liquidity.