MODULE 1: INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS

Source: Financial Markets and Institutions

Jeff Madura
11th Edition
Cengage Learning

1.0 Definition
A financial market is a market in which financial assets (securities) such as stocks
and bonds can be purchased or sold. Funds are transferred in financial markets when
one party purchases financial assets previously held by another party. Financial
markets facilitate the flow of funds and thereby allow financing and investing by
households, firms, and government agencies.

2.0 Role of Financial Markets

Financial markets transfer funds from those who have excess funds to those who
need funds. They enable college students to obtain student loans, families to obtain
mortgages, businesses to finance their growth, and governments to finance many of
their expenditures. Many households and businesses with excess funds are willing to
supply funds to financial markets because they earn a return on their investment. If
funds were not supplied, the financial markets would not be able to transfer funds to
those who need them. Those participants who receive more money than they spend
are referred to as surplus units (or investors). They provide their net savings to the
financial markets. Those participants who spend more money than they receive are
referred to as deficit units. They access funds from financial markets so that they can
spend more money than they receive. Many individuals provide funds to financial
markets in some periods and access funds in other periods.

EXAMPLE College students are typically deficit units, as they often borrow from
financial markets to support their education. After they obtain their degree, they
earn more income than they spend and thus become surplus units by investing their
excess funds. A few years later, they may become deficit units again by purchasing a
home. At this stage, they may provide funds to and access funds from financial
markets simultaneously. That is, they may periodically deposit savings in a financial
institution while also borrowing a large amount of money from a financial institution
to buy a home. ●

Many deficit units such as firms and government agencies access funds from
financial markets by issuing securities, which represent a claim on the issuer. Debt
securities represent debt (also called credit, or borrowed funds) incurred by the
issuer. Deficit units that issue the debt securities are borrowers. The surplus units
that purchase debt securities are creditors, and they receive interest on a periodic
basis (such as every six months). Debt securities have a maturity date, at which
time the surplus units can redeem the securities in order to receive the principal
(face value) from the deficit units that issued them. Equity securities (also called
stocks) represent equity or ownership in the firm. Some large businesses prefer to
issue equity securities rather than debt securities when they need funds but might
not be financially capable of making the periodic interest payments required for debt
securities.

A key role of financial markets is to accommodate corporate finance activity.

Corporate finance (also called financial management) involves corporate decisions
such as how much funding to obtain and what types of securities to issue when
financing operations. The financial markets serve as the mechanism whereby
 corporations (acting as deficit units) can obtain funds from investors (acting as
surplus units).

Another key role of financial markets is accommodating surplus units who want to
invest in either debt or equity securities. Investment management involves decisions
by investors regarding how to invest their funds. The financial markets offer
investors access to a wide variety of investment opportunities, including securities
issued by the Treasury and government agencies as well as securities issued by
corporations. Financial institutions serve as intermediaries within the financial
markets. They channel funds from surplus units to deficit units. For example, they
channel funds received from individuals to corporations. Thus they connect the
investment management activity with the corporate finance activity, as shown in
Exhibit 1.1. They also commonly serve as investors and channel their own funds to
corporations.

3.0 Securities Traded in Financial Markets

Money Market Securities

Money markets facilitate the sale of short-term debt securities by deficit units to surplus
units. The securities traded in this market are referred to as money market securities, which
are debt securities that have a maturity of one year or less. These generally have a
relatively high degree of liquidity, not only because of their short-term maturity but also
because they are desirable to many investors and therefore commonly have an active
secondary market. Money market securities tend to have a low expected return but also a
low degree of credit (default) risk. Common types of money market securities include
Treasury bills (issued by the Treasury Department of the government), commercial paper
(issued by corporations), and negotiable certificates of deposit (issued by depository
institutions).

Capital Market Securities

Capital markets facilitate the sale of long-term securities by deficit units to surplus units.
The securities traded in this market are referred to as capital market securities. Capital
market securities are commonly issued to finance the purchase of capital assets, such as
buildings, equipment, or machinery. Three common types of capital market securities are
bonds, mortgages, and stocks, which are described in turn.

Bonds
Bonds are long-term debt securities issued by the Treasury, government agencies,
and corporations to finance their operations. They provide a return to investors in
the form of interest income (coupon payments) every six months. Since bonds
represent debt, they specify the amount and timing of interest and principal
payments to investors who purchase them. At maturity, investors holding the debt
securities are paid the principal. Bonds commonly have maturities of between 10 and
20 years. Treasury bonds are perceived to be free from default risk because they are
issued by the U.S. Treasury. In contrast, bonds issued by corporations are subject to
default risk because the issuer could default on its obligation to repay the debt.
These bonds must offer a higher expected return than Treasury bonds in order to
compensate investors for that default risk. Bonds can be sold in the secondary
market if investors do not want to hold them until maturity. Because the prices of
debt securities change over time, they may be worthless when sold in the secondary
market than when they were purchased.

Mortgages
Mortgages are long-term debt obligations created to finance the purchase of real
estate. Residential mortgages are obtained by individuals and families to purchase
homes. Financial institutions serve as lenders by providing residential mortgages in
their role as a financial intermediary. They can pool deposits received from surplus
units, and lend those funds to an individual who wants to purchase a home. Before
granting mortgages, they assess the likelihood that the borrower will repay the loan
based on certain criteria such as the borrower’s income level relative to the value of
the home. They offer prime mortgages to borrowers who qualify based on these
criteria. The home serves as collateral in the event that the borrower is not able to
make the mortgage payments. Subprime mortgages are offered to some borrowers
who do not have sufficient income to qualify for prime mortgages or who are unable
to make a down payment. Subprime mortgages exhibit a higher risk of default, thus
the lenders providing these mortgages charge a higher interest rate (and additional
up-front fees) to compensate. Subprime mortgages received much attention in 2008
because of their high default rates, which led to the credit crisis. Many lenders are no
longer willing to provide subprime mortgages, and recent regulations (described later
in this chapter) raise the minimum qualifications necessary to obtain a mortgage.
Commercial mortgages are long-term debt obligations created to finance the
purchase of commercial property. Real estate developers rely on commercial
mortgages so they can build shopping centers, office buildings, or other facilities.
Financial institutions serve as lenders by providing commercial mortgages. By
channeling funds from surplus units (depositors) to real estate developers, they
serve as a financial intermediary and facilitate the development of commercial real
estate.

Mortgage-Backed Securities
Mortgage-backed securities are debt obligations representing claims on a package of
mortgages. There are many forms of mortgagebacked securities. In their simplest
form, the investors who purchase these securities receive monthly payments that are
made by the homeowners on the mortgages backing the securities.

Stocks
Stocks (or equity securities) represent partial ownership in the corporations that
issue them. They are classified as capital market securities because they have no
maturity and therefore serve as a long-term source of funds. Investors who purchase
stocks (referred to as stockholders) issued by a corporation in the primary market
can sell the stocks to other investors at any time in the secondary market. However,
stocks of some corporations are more liquid than stocks of others. More than a
million shares of stocks of large corporations are traded in the secondary market on
 any given day, as there are many investors who are willing to buy them. Stocks of
small corporations are less liquid, because the secondary market is not as active.
Some corporations provide income to their stockholders by distributing a portion of
their quarterly earnings in the form of dividends. Other corporations retain and
reinvest all of their earnings in their operations, which increase their growth
potential.

As corporations grow and increase in value, the value of their stock increases;
investors can then earn a capital gain from selling the stock for a higher price than
they paid for it. Thus, investors can earn a return from stocks in the form of periodic
dividends (if there are any) and in the form a capital gain when they sell the stock.
However, stocks are subject to risk because their future prices are uncertain. Their
prices commonly decline when the firm performs poorly, resulting in negative returns
to investors.

Derivative Securities
In addition to money market and capital market securities, derivative securities are also
traded in financial markets. Derivative securities are financial contracts whose values are
derived from the values of underlying assets (such as debt securities or equity securities).
Many derivative securities enable investors to engage in speculation and risk management.

4.0 Securities Regulations

Much of the information that investors use to value securities issued by firms is provided in
the form of financial statements by those firms. In particular, investors rely on accounting
reports of a firm’s revenue and expenses as a basis for estimating its future cash flows.
Although firms with publicly traded stock are required to disclose financial information and
financial statements, a firm’s managers still possess information about its financial condition
that is not necessarily available to investors. This situation is referred to as asymmetric
information. Even when information is disclosed, an asymmetric information problem may
still exist if some of the information provided by the firm’s managers is intentionally
misleading in order to exaggerate the firm’s performance.