Chapter 4

FINANCIAL MARKETS AND INSTITUTIONS

A financial market is a market in which people and entities can trade financial
securities, commodities, and other fungible items of value at low transaction costs and at prices
that reflect supply and demand. Securities include stocks and bonds, and commodities include
precious metals or agricultural goods.
A financial institution is an establishment that focuses on dealing with financial transactions,
such as investments, loans and deposits. Conventionally, financial institutions are composed of
organizations such as banks, trust companies, insurance companies and investment dealers.
Investopedia
The Importance of Financial Markets and Institutions:
1. For financing if the company needs a source of capital
2. For investment if the company has surplus of cash
The Flow of Savings to Corporations

CORPORATION
Investment in real
assets

INVESTORS
Cash rose from share issues
Cash
reinvested

Shareholders in
closely held
corporation

FIGURE 2.1 Flow of savings to investment in a closely held corporation. Investors use
savings to buy additional shares. Investors also save when the corporation reinvests on their
behalf.

CORPORATION
Investment in
real assets

Financial Markets
Stock Markets
Fixed Income Markets
Money Markets
Markets for
1. Commodities
2. Foreign
Exchange
3. Derivatives

INVESTORS
Worldwide

Reinvestment
Financial Institutions
Banks
Insurance Companies
Financial
Intermediaries
Mutual Funds
Pension Funds

FIGURE 2.2 Flow of savings to investment for a large, public corporation. Savings come from
investors worldwide. The savings may flow through financial markets or financial intermediaries.
The corporation
The Stock
Market also reinvests on shareholders behalf.

A stock market is probably the most important financial market.

A stock market or equity market is the aggregation of buyers and sellers (a loose
network of economic transactions, not a physical facility or discrete entity) of stocks (also called
shares); these may include securities listed on a stock exchange as well as those only traded
privately.
Initial Public Offering (IPO) the first issue of stock in the stock market.
The new issues of shares increases both the amount of cash held by the company and the
number of shares held by the public. Such an issue is known as a primary issue, and it is sold in
the primary market.
A transfer of ownership of stock through buying or selling from one owner to another is
called secondary transactions and take place in a secondary market. This sale and purchase
transaction has no effect in the company itself.

The Bond Market

A bond market is a financial market where participants can issue new debt, known as the
primary market, or buy and sell debt securities, known as the secondary market. This is usually
in the form of bonds, but it may include notes, bills, and so on.
Other Financial Markets

Foreign-exchange Markets Any corporation engaged in international trade must be able

to transfer money back and forth between dollars and other currencies. Foreign exchange
is traded over-the-counter through a network of the largest international banks.
Commodities Markets - is a market that trades in primary rather than manufactured
products.
Markets for options and other derivatives Derivatives are securities whose payoffs
depend on the prices of other securities or commodities.

Financial Intermediaries
A financial intermediary is an organization that raises money from the investors and
provides financing for individuals, companies, and other organizations. For corporations,
intermediaries are important sources of financing.
Important Classes of Intermediaries:
1. Mutual Funds
2. Pension Funds
Mutual Funds raise money by selling shares to investors. It is an investment company that
pools the savings of many investors and invests in a portfolio of securities. Mutual funds
offer investors low-cost diversification and professional management. For investors, its more
efficient to buy a mutual fund than to assemble a diversified portfolio of stock and bonds.
Hedge Fund a private investment pool, open to wealthy or institutional investors, that is
only lightly regulated and therefore can pursue more speculative policies than mutual funds.
Vulture Fund specializes in the securities of distressed corporations.
Pension Funds - A fund established by an employer to facilitate and organize the investment
of employees' retirement funds contributed by the employer and employees. The pension
fund is a common asset pool meant to generate stable growth over the long term, and provide
pensions for employees when they reach the end of their working years and commence
retirement.
Financial Institutions

A financial institution is an intermediary that does more than just pool and invest savings.
Institutions raise financing in special way, such as accepting deposits or selling insurance
policies and they provide additional financial services. Unlike in mutual fund, they not only
invest in securities but also loan money directly to individuals, businesses, or other
organizations. Examples of which are banks and insurance companies.

Commercial Banks major sources of loans for corporations

COMPANY

$$$ Million
Issues debt
to bank

Bank
(Institution)

$$$ Million
Accepts
deposits

Investors
(Depositors)

Investment Banks advise and assist companies in raising financing

Insurance Companies for long term financing of business. They are massive
investors in corporate stocks and bonds, and they often make long-term loans
directly to corporations.

$$$ Million
COMPANY

Issues debt

$$$ Million
Insurance
Company
(Institution)

Sells policies

Investors
(Policy
Holders

Functions of Financial Markets and Intermediaries

1.
2.
3.
4.
5.

Transporting cash across time

Risk transfer and diversification
Liquidity
The payment mechanism
Information provided by Financial Markets
a. Commodity Prices b. Interest Rates c. Company Values d. Cost of Capital