Introduction

The Financial Markets allow people, companies, and other organizations, to transfer funds from those who have an excess of available funds to those who have a shortage.

They are a crucial component to ensure that the economy of a country is solid and they are also often one of the key factors to ensure high economic growth. In fact, their role in channeling funds from those that have an excess to those that need money for a different reason is an efficient mechanism that helps economies to be more solid.

The strong relevance that financial markets have on the economy means also that the activities of financial markets tend to have also a direct effect on the real economy, which includes the behavior of businesses and consumers, personal wealth, and the economic cycles.

Example:

In order to better understand the importance of financial markets, it is better to make a real life example:

Suppose that John, an experienced engineer who has been working for years in the renewable energy sector, wants to open a company that sells and installs solar panels. Unfortunately, even though he has some savings that he has accumulated during his working life, in order to start the company, buy the machinery and hire workers, he needs a larger amount of money.

Sarah, on the other hand, is a successful entrepreneur, that has plenty of savings accumulated over the years, but now she wants to retire and therefore would like to get some returns out of those savings.

It would be ideal if John and Sarah could get together so that Sarah could provide funds to John, who will then be able to pay to Sarah an interest on the loan.

Financial markets (bond and stock markets) and financial intermediaries (banks, insurance companies, etc.) serve that function. They are in the middle between those that have excessive funds (like Sarah), and those who need funds (like John), and they help in moving funds from one to the other.

Financial markets could allow John to have the funds that he needs to start his new company, allowing him to hire people and to make new investments that will help the company grow. At the same time, Sarah will receive a return from the capital that she has invested, all this happens even without John and Sarah meeting.

The reason why well-functioning financial markets and financial intermediaries are crucial to economic health is that they allow capital to be transferred in a smooth and efficient way, meeting and satisfying the necessities of all the actors that operate in the economy.

The function of Financial Markets

A said before, the essential economic function that financial markets perform is that of channeling funds from those subjects that have saved surplus funds, like firms, households, and governments, to other actors that have a shortage of funds, because they expect to spend more than their income.

They can be, for example, business firms that want to invest in new machinery, households that want to buy a car, governments that want to spend more on infrastructures, or other individuals and organization that, as said before, wish to spend more than their income and therefore find themselves in a situation where they have a shortage of funds.

Financial markets allow funds to move from people and organizations who lack the investment opportunities to invest them to other actors that have such opportunities, therefore we can say that financial markets are critical for producing an efficient allocation of wealth, which is a key contributor to higher production and efficiency for the overall economy.

Direct finance vs Indirect finance

When talking about financial markets it is important to distinguish between the direct finance and indirect finance.

In direct finance, lenders can lend funds directly to borrowers, without any connection with a third party institution. Usually, in this case, the borrower sells to the lender security, which is a claim on the future income or assets of the borrower. One example of these securities is government bonds, which are issued by the government and are bought by banks or other individuals, which automatically become lenders, and will receive a regular payment by the government in the form of interest.

In indirect finance, there is the introduction of a third party, an intermediary that helps with the transaction. In this case, borrowers borrow money from the financial market through any kind of third-party intermediary.

The structure of Financial Markets

Primary and Secondary Markets

  • Primary market: is a financial market in which new issues of a security (eg. stocks or bonds), are sold to initial buyers by the company or the government agency that is borrowing the funds. However, the initial sale of securities tend to not be well known to the general public, in fact, for operative reasons, it often takes place behind closed doors. In this initial phase, the actor that issues the new security is generally assisted by investment banks, that by underwriting securities, are able to guarantee a price for those securities, and then sell them to the general public.
  • Secondary market: it is a financial market in which the securities that have been previously issued can be sold again. Some of the best-known examples of secondary markets are the New York Stock Exchange or the NASDAQ. When an individual purchases a security in the secondary market, the corporation that has issued the security (in the primary market) acquires no new funds, but only the seller of that security does. In the secondary market, we see the presence of two new figures that are very important for the functioning of the secondary market, brokers, and dealers. Brokers have the role of matching buyers with sellers, while dealers, on the other hand, link buyers and sellers by buying and selling securities at stated prices. Secondary markets serve another crucial function, they make financial instruments more liquid, which means that selling financial instruments to raise cash becomes easier and quicker, and therefore makes them more desirable, because in any moment you know that if you need some money, you can sell a certain number of shares of a company and in a matter of minutes you can have that money on your bank account, while with other assets it is not so easy. For example, think of someone that buys a house, if for any reason he needs money with urgency, he will have to sell that house at a price that is below the market value in order to find more easily a buyer, and even if he is able to find a buyer it is unlikely that the entire procedure will take a short time to be settled, especially when the economy is not doing well. On the other hand, if that investor has the same amount of money invested in securities, in normal times he just has to make an order from his computer or through an intermediary and he has the money on his account.

Debt and Equity Markets

Debt and equity markets are the two ways that are available to individuals and firms to obtain funds to finance their operations, whether it is investments or consumption.

  • They can issue a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower (the actor that needs funds) to pay the holder of the instrument fixed amounts of money at regular intervals, composed by interest and principal payments, until the date when the final payment is made, the maturity date. Debt instruments can have very different maturities (the time until that instrument’s expiration date), in fact, they can be short-term if the maturity of the debt instrument is less than a year, intermediate-term, if the maturity is between one and ten years, or long-term if its maturity is ten years or longer.
  • The second method available to raise new funds is through the issuance of equities, which are claims to share in the net income (income after expenses and taxes) and the assets of a business, owning shares in a company means owning a small part of that company, thus being entitled to profits of that company (if business is good), in exchange for the investment made. In addition, owning a portion of the firm means that you have the right to vote on issues important to the firm and to elect its directors. Shareholders earn a return from their investments through dividends, which are periodic payments that equities make to their holders.

Exchanges and Over-the-Counter Markets

Exchanges and over-the-counter (OTC) markets are two ways in which secondary markets can be organized.

On the one hand, exchanges, are central locations where buyers and sellers of securities or intermediaries (agents and brokers) meet to conduct trades.

On the other hand, secondary markets can be organized in another way, the over-the-counter (OTC) market, in which dealers with the use of computers and the internet are able to buy and sell securities “over the counter” to anyone that comes to them and is willing to make a transaction that satisfies their prices. With OTC markets there is not one physical place where transactions take place.

Money and Capital Markets

Money and capital market are another way of distinguishing between markets on the basis of the maturity of the securities traded in each market.

In fact in the money market, only short-term debt instruments are traded which makes it a more liquid market because the securities traded in this market tend to be more widely traded than long-term securities.

While the capital market is the market in which longer-term debt instruments and equity instruments are traded, these securities tend to have larger fluctuations in price than those traded in the money market, and therefore some investors that look for stability prefer to operate in the money market rather than in the capital market.