FINANCIAL ENVIRONMENT

Flow of Funds from financial institutions and markets

Why do Financial Markets and Financial Institutions Exist?

To facilitate the flow of funds from the supplier to the demander (of funds)

1.) FINANCIAL MARKETS

Financial markets are forums in which suppliers of funds and demanders of funds can transact
business directly.

In direct finance borrowers borrow funds directly from lenders in financial markets by selling
them securities (also called financial instruments), which are claims on the borrower’s future
income or assets. Securities are assets for the person who buys them, but they are liabilities (IOUs
or debts) for the individual or firm that sells (issues) them.

To raise money, firms can use either private placements or public offerings. A private placement
involves the sale of a new security directly to an investor or group of investors, such as an
insurance company or pension fund. Most firms, however, raise money through a public offering of
securities, which is the sale of either bonds or stocks to the general public.

Importance of financial markets

1.) 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.

2.) Well-functioning financial markets also directly improve the well-being of consumers by
allowing them to time their purchases better. They provide funds to young people to buy what

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they need and can eventually afford without forcing them to wait until they have saved up the
entire purchase price.

PRIMARY VS. SECONDARY MARKET

When a company or government entity sells stocks or bonds to investors and receives cash in
return, it is said to have sold securities in the primary market. After the primary market
transaction occurs, any further trading in the security does not involve the issuer directly, and the
issuer receives no additional money from these subsequent transactions. Once the securities begin
to trade between investors, they become part of the secondary market

MONEY MARKET VS. CAPITAL MARKET

The money market is created by a financial relationship between suppliers and demanders of
short-term funds (funds with maturities of one year or less). The money market exists because some
individuals, businesses, governments, and financial institutions have temporarily idle funds that
they wish to invest in a relatively safe, interest-bearing asset. The key financial instruments traded
in a money market are marketable securities, which are Short-term debt instruments such as

 Treasury bills – Financial instruments with highly stable marketability with maturities
below one year
 Commercial paper – Short-term promisory note issued by a large established business firm
with a strong credit rating
 Negotiable certificates of deposit issued by government, business, and financial institutions,
respectively.

The capital market is a market that enables suppliers and demanders of long-term funds to make
transactions. The key capital market securities are bonds (long-term debt) and both common stock
and preferred stock (equity, or ownership).

 Bonds are long-term debt instruments used by business and government to raise large
sums of money, generally from a diverse group of lenders

 Shares of common stock are units of ownership, or equity, in a corporation. Common

stockholders earn a return by receiving dividends— periodic distributions of cash—or by
realizing increases in share price.

 Preferred stock is a special form of ownership that has features of both a bond and
common stock. Preferred stockholders are promised a fixed periodic dividend that must be paid
prior to payment of any dividends to common stockholders. In other words, preferred stock has
“preference” over common stock

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BROKER VS. DEALER MARKETS

The key difference between broker and dealer markets is a technical point dealing with the way
trades are executed. That is, when a trade occurs in a broker market, the two sides to the
transaction, the buyer and the seller, are brought together and the trade takes place at that point:
Party A sells his or her securities directly to the buyer, Party B. In a sense, with the help of a broker,
the securities effectively change hands on the floor of the exchange

Example of broker market:

 Securities exchanges
Organizations that provide the marketplace in which firms can raise funds through the sale of new
securities and purchasers can resell securities.

In contrast, when trades are made in a dealer market, the buyer and the seller are never brought
together directly. Instead, market makers execute the buy/sell orders. Market makers are
securities dealers who “make markets” by offering to buy or sell certain securities at stated prices.
Essentially, two separate trades are made: Party A sells his or her securities (in, say, Dell) to a
dealer, and Party B buys his or her securities (in Dell) from another, or possibly even the same,
dealer. Thus, there is always a dealer (market maker) on one side of a dealer–market transaction.

Dealer Markets One of the key features of the dealer market is that it has no centralized trading
floors. Instead, it is made up of a large number of market makers who are linked together via a
mass-telecommunications network. Each market maker is actually a securities dealer who makes a
market in one or more securities by offering to buy or sell them at stated bid/ask prices. The bid
price and ask price represent, respectively, the highest price offered to purchase a given security
and the lowest price at which the security is offered for sale.

Example of Dealer Markets

 Nasdaq market
An all-electronic trading platform used to execute securities trades.

 Over-the-counter (OTC)market
Market where smaller, unlisted securities are traded.

Efficient Market Theory

From a firm’s perspective, the role of a capital market is to be a liquid market where firms can
interact with investors to obtain valuable external financing resources. From investors’
perspectives, the role of a capital market is to be an efficient market that allocates funds to their
most productive uses.

Efficient market
A market that allocates funds to their most productive uses as a result of competition among
wealth-maximizing investors and that determines and publicizes prices that are believed to be close
to their true value.

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2.) FINANCIAL INSTITUTIONS

Financial institutions serve as intermediaries by channelling the savings of individuals,

businesses, and governments into loans or investments. Financial institutions are required by the
government to operate within established regulatory guidelines. This is also called indirect finance
because it involves a financial intermediary that stands between the lender-savers and the
borrower-spenders and helps transfer funds from one to the other.

The process of indirect finance using financial intermediaries, called financial intermediation, is
the primary route for moving funds from lenders to borrowers.

Advantage of Financial Institutions (In comparison with Financial Markets)

1.) Lesser Transaction Cost because of economies of scale
2.) Lesser Risk because of risk sharing
3.) Solve the problem of adverse selection and moral hazard

Commercial banks are among the most important financial institutions in the Economy because
they provide savers with a secure place to invest funds and they Offer both individuals and
companies loans to finance investments, such as the Purchase of a new home and the expansion of a
business.

Investment banks are institutions that

(1) Assist companies in raising capital
(2) Advise firms on major transactions such as mergers or financial restructurings , and
(3) Engage in trading and market making activities.

Other Financial Institutions

Contractual Savings Institutions

Contractual savings institutions, such as insurance companies and pension funds, are financial
intermediaries that acquire funds at periodic intervals on a contractual basis.

Insurance Companies – Financial Intermediaries that helps people protect against financial loss

Pension 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 contributed automatically or
manually

Investment Intermediaries
This category of financial intermediaries includes finance companies, mutual funds, money market
mutual funds, and investment banks.

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 (who make
purchases of such items as furniture, automobiles, and home improvements) and to small
businesses.

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Mutual Funds
Mutual funds serve as a key financial intermediary. They pool investments by individual investors
and use the funds to accommodate financing needs of governments and corporations in the primary
markets. They also frequently invest in securities in the secondary market.

Questions for Reflection:

1.) What is the main difference between financial markets and financial institutions?
2.) What are the risks of financial markets and financial institutions? What are the ways to manage
these risks ?

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