Introduction to Finance: Financial Markets (PDF)

# Introduction to Finance ## Chapter 6: Financial Markets ### 1. Financial System The financial system is that part of the whole economic system that is reliable for: - securing the money supply and liquidity of the economy; - maintaining, regulating and operating the payment system; - allocatin...

# Introduction to Finance ## Chapter 6: Financial Markets ### 1. Financial System The financial system is that part of the whole economic system that is reliable for: - securing the money supply and liquidity of the economy; - maintaining, regulating and operating the payment system; - allocating the savers money to borrowers; - reallocating the incomes of different economic actors in time and space. ### Functions of Financial Systems | FUNCTION | SUBSYSTEM OF FINANCIAL SYSTEM RELIABLE FOR THE FUNCTION | |---------------------------------------------|--------------------------------------------------------------| | Securing the money supply and liquidity of the economy. | Monetary system. | | Maintaining, regulating and operating the payment system. | Supervising system. | | Allocating the savers money to borrowers. | Financial markets, financial intermediaries | | Reallocating the incomes of different economic actors in time and space. | Fiscal system. | ### 2. Financial Markets **Definition:** - The platform of the exchange of financial instruments and money denominated in the currencies of different countries. **In other words:** - Those markets where borrowers who need money/capital make contact with the savers, who have money/capital surplus. ### Primary function of financial markets - Connects savers with borrowers. **Demand side:** - They need money: - because on the short run they have liquidity problems, or - on the long run they need capital for financing their activities and investments. - They get money in exchange for financial instruments. **Supply side:** - Savers/investors, who have money surplus: - In a given time period they do not plan to use all the money they have, therefore they offer their money for borrowers hoping for future profits. - The give money in exchange for financial instruments. ### Segments of financial markets - Term: money or capital markets - Geographic scope: domestic or international - Standardization: unique or standardized - Time of settlement: spot or futures/forwards markets - Function of trade: primary or secondary markets - Type of trade: private or public - Platform of trade: stock exchange or OTC ### Money vs. Capital Markets #### Money markets - The market of such debt securities that's term is less than a year. (Example: Treasury bills) - Liquidity - Usually lower returns and risks #### Capital markets - The market of such debt and equity type of securities that's term is more than a year. (Examples: stocks, government bonds, corporate bonds, etc.) - Long term financing - The opportunity of higher returns and the threat of higher risks ### Primary vs. Secondary Markets #### Primary markets: - Those markets, where firms, governments and other organizations obtain capital from the savers. #### Secondary markets: - Those markets where investors can trade the already circulating securities. - The high volume of trade, the presence of many investors in the secondary markets makes the trade more efficient and transparent. - An active secondary market secures the liquidity of the financial markets. (We are able to sell our securities and convert them into money.) ### The relationship of primary and secondary markets - The more firms appear in the stock exchange the more securities can be traded with on the secondary markets therefore the volume of trade will increase. - The secondary market secures the liquidity of the primary market. - If the trade is less active than the market is going to be less liquid, which hinders the IPO of firms. ### Stock exchange vs. OTC **Stock exchanges** (*are such concentrated trading platforms with many traders, where*) - trading is centralized, - the demand and supply of financial instruments are connected, - standardized financial instruments can be traded, - traders with stock exchange membership are enabled for trading, - as the products are standardized the price of the financial instruments is the only feature that balances the demand and supply. **On OTC (Over the Counter) markets** - trading with financial instruments is not centralized, trading, bypasses' the stock exchange - trading happens through banks or other financial institutions. #### Typical products traded on OTC markets: - foreign exchange (FOREX) - government bonds - cryptocurrency - securities not listed on the stock exchange ### Spot vs. Future/Forward Markets - On spot markets the trade is settled within a day, the accounting of the trade is done within 5 days. - On future/forward markets the contract about the trade and the actual settlement of the trade are separated in time. The settlement and payment on the pre-arranged price and quantity is settled in the future. ### 3. Financial Intermediation ### Direct Funding - The savers give money directly to the borrowers. - The savers stand the whole risk of the deal. **Example:** Jaime's parents have significant savings. Jamie would like to buy a house but right now he does not possess the necessary funds. Fortunately, his parents offer him their savings, therefore he is able to buy the house. If Jaime is not able to pay back the money to his parents, then the whole loss of the deal will be burdened to the parents. ### Problems of Direct Funding Let's assume that (from our previous example) Jaime's parents do not have the necessary money in order to finance their son. Would You give him money? **A few problems:** - I don't know Jaime, I do not know how trustworthy he is. - Does he need the money for as long a period as long I can give it to him? - Does he need as much money as I can give to him? #### Problems of direct funding (1) - **Lack of information.** - It is not sure that an 'average' economic actor who has money surplus is able to find another economic actor who requires money. The same problem occurs for borrowers, who do not have information about the savers. - Even if the savers and borrowers find each other, it is not sure that they are able to make a deal. They not necessarily have enough information about each other to evaluate the other party, or they do not possess the competence to evaluate each other. (Analyzing a person's or a firm's creditability is a process that requires significant knowledge and competence.) #### Problems of direct funding (2) - **High risk/uncertainty.** - The lack of information creates high uncertainty. - We are not able to decrease the risks via diversification. - (Diversification is the process, when we do not invest all of our money into one asset, rather we divide our money between different investments. Diversification decreases risks, because even if one of our investments fail it will result in the loss of a small proportion of our money at most.) #### Problems of direct funding (3) - **Savers and borrowers might be planning for different time periods.** - It is very hard (leads to high searching costs) to find savers and borrowers who would like to invest/borrow the money for the same time period. - **Savers and borrowers might be planning in different sums of money.** - It leads to high searching costs and requires a high number of transactions if the savings and borrowings are different in size. ### Financial intermediaries - Direct funding is not working in most cases as a result of the previous problems. - There is a need for such market participants who channel the money from savers to borrowers: - intermediate information and knowledge, and at the same time transform the - risks, - maturity, and - size of the savings. - They are the financial intermediaries. ### Financial intermediaries - definition - **Financial intermediary institutions** - collect savings at their own risk and - lend/invest it at their own risk. - **Financial intermediaries provide returns and services for their savers that are not directly linked to their investment activity.** - **Financial intermediation mainly covers the indirect funding.** ### Direct and Indirect Funding | SAVERS | FINANCIAL MARKETS | BORROWERS | |---------------|------------------------------------------------------------------------------------------------------|-------------------- | | Households | DIRECT FUNDING | Households | | Firms | - private placement of securities <br> - investment banks <br> - business angels, etc. | Firms | | Government | MONEY | Government | | | PRIMARY SECURITIES | | | MONEY | INDIRECT FUNDING | MONEY | | FIN. INST. | - Commercial banks <br> - Insurance companies <br> - Pension funds <br> - Money market funds <br> - Investment funds <br> - etc. | FIN. INST. | ### Example for intermediaries - bank - Let's make a bank deposit. - Now we are the savers with money surplus. We offer this saving for the bank (for the promise of interest payment). - The bank does not accept our deposit, because it wants to keep our money but in order to lend it to the borrowers (also for the promise of interest payment). - Banks become a channel between borrowers and savers. - A person/firms gets the loan from the bank. - The borrower gets the money of the saver through the intermediation of the bank. - The bank gets back the loan (plus interest), which it pays back to the original saver (plus interest). ### Functions of financial intermediation – Intermediating information and knowledge - **Savers (supply)** *do not have enough* - information about who the borrowers are and what are their characteristics and - knowledge to properly evaluate the creditability/investment readiness of the borrowers based on the available information. - **The borrowers (demand)** *do not have enough* - information about who the savers are and - knowledge to evaluate the potential financier. - **Financial intermediaries are able to mend these problems** - as they are well-known for the whole market (like banks) therefore savers and borrowers have information about them. - as they possess such knowledge and competence that enable them to evaluate more efficiently and accurately the creditability of borrowers. ### Functions of financial intermediation – Risk transformation - **Direct funding:** - The saver stands the whole risk of the investment. - **Example:** If we buy a share than we realize the benefits and losses of the changes in the stock price. - **Indirect funding:** - The risk partially or entirely is separated from the risk of the borrower. - **Example:** If we save our money in the form of a bank deposit, then we are entitled for the interest payment preset in the savings account regardless of how the borrowers used our money. - **Financial intermediaries are able to manage and decrease risks more efficiently than savers.** #### Methods reducing the risks in financial intermediation: - more information and knowledge - monitoring and screening - diversification - capital and reserves (Not all financial intermediaries have to invest their equity, such regulation is usually applied in case of banks.) ### Functions of financial intermediation – Size transformation - Each saver and borrower have different amounts of savings and capital needs. - By pooling the savings financial intermediaries are able to harmonize the size of demand and supply. ### Functions of financial intermediation – Maturity transformation - Each saver and borrower plan for different amounts of savings and capital needs. - By pooling the savings financial intermediaries are able to harmonize the maturity of demand and supply. - They are able to maintain their liquidity. ### Types of financial intermediaries | Monetary intermediaries | Non-monetary intermediaries | |--------------------------------------|-------------------------------------| | - Banks | - Financial companies | | - Special credit institutions | - Investment funds | | - Money market funds | - Private equity funds | | | - Investment companies | | | - Insurance companies | | | - Pension funds | | *Collect deposits.* | *Do not collect deposits.* | ### Thank you for your attention!