 FINANCIAL MARKETS IN THE FINANCIAL

SYSTEM
Financial Market
• A market in which financial assets (securities) can be
purchased or sold. Financial markets facilitate
transfers of funds from person or business without
investment opportunities (i.e., “Lender-Savers”, or
“Surplus Unit”) to those who have investment
opportunities (i.e., “Borrower-Spenders”, or “Deficit
Unit”).

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Types of Markets
1. Physical asset versus financial asset markets.
• Physical asset markets (also called “tangible” or
“real” asset markets) are those for products such as
wheat, autos, real estate, computers, and machinery.
• Financial asset markets, on the other hand, deal with
stocks, bonds, notes, mortgages, and other claims on
real assets, as well as with derivative securities whose
values are derived from changes in the prices of other
assets.
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Types of Markets
2. Exchange And Over-the-counter Markets
 Exchange Market: Once issued, a financial claim
(security) can be traded in the secondary market on an
organized security exchange, such as the NYSE.
 Over the counter Markets: Securities not listed on an
exchange are bought and sold in the over-the- counter
(OTC) market. The OTC market differs from organized
exchanges because the market has no central trading
place.
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3. Money versus capital markets.
MONEY MARKETS are the markets for short-term, highly
liquid debt securities.
Commercial paper
 a short-term debt obligation of a private-sector firm or a
government-sponsored corporation
 has maturity of between 90 days and 9 months
 is usually unsecured
Bankers’ acceptance
 a promissory note issued by a non-financial firm to a bank in
return for a loan
 the bank resells the note in the money market at a discount
and guarantees payment
 is issued at a discount and has a maturity of less than six
months.
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Treasury bills
 securities with a maturity of one year or less, issued
by national governments
 treasury bills issued by a government in its own
currency are generally considered the safest of all
possible investments in that currency
 are used as principal source of financing where a
government is unable to convince investors to buy its
longer-term obligations.

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Federal Funds
Technically, federal funds are bank deposits held with
the Federal Reserve bank. Banks with deposits in
excess of required reserves may lend those excess
reserves— called fed funds—to other banks.

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CAPITAL MARKETS are the markets for intermediate-
or long-term debt and corporate stocks.
Bond Market:
• the word “bond” means contract, agreement, or
guarantee.
• an investor who purchases a bond is lending
money to the issuer
• a bond represents the issuer’s contractual
promise to pay interest and repay principal
according to specified terms.

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• bonds offer a way for governments to borrow from
many individuals rather than just a handful of
bankers
• are the most widely used of all financial
instruments.
Mortgages:
Mortgages are long-term loans secured by real estate. They
are the largest segment in the capital markets in terms of
the amount outstanding.
Stock Market:
• where equity claims are traded
• common(ordinary) stock and preferred stock
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4. Primary vs secondary markets.
• Primary markets are the markets in which corporations
raise new capital.
• Secondary markets are markets in which existing,
already outstanding, securities are traded among investors
after they have been issued by corporations.
• The corporation whose securities are being traded is not
involved in a secondary market transaction and, thus, does
not receive any funds from such a sale.
• Secondary markets also exist for mortgages, various other
types of loans, and other financial assets
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 .
5 Private vs public markets.
• Private Markets - Markets in which transactions are
worked out directly between two parties.
• Public Markets - Markets in which standardized
contracts are traded on organized exchanges.
- Major advantages of a private placement are the speed at
which funds can be raised and the low transaction costs.
- The disadvantage is that privately placed securities cannot
legally be sold in the public markets because they lack SEC
registration. As a result, private placement securities are less
marketable than a comparable registered security.
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6. Foreign Exchange Markets
• The foreign exchange market is the market in which
foreign currencies are bought and sold. Foreign
currencies such as the British pound, the Japanese
yen, the euro, and the Swiss franc are traded against
the U.S. dollar or are traded against other foreign
currencies.

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7. Derivative Markets
Derivatives are financial securities whose values are
derived from the values of other underlying
instruments, such as bonds.
Derivatives can be used either to reduce risks or to
speculate.
Suppose an importer’s costs rise and its net income
falls when the dollar falls relative to the birr. That
company could reduce its risk by purchasing
derivatives whose values increase when the dollar
declines.

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Types of derivatives
• Forwards: A forward contract is a customized
contract between two entities, where settlement takes
place on a specific date in the future at today’s pre-
agreed price.
• Futures: A futures contract is an agreement between
two parties today to buy or sell an asset at a certain
time in the future at a certain price. Futures contracts
are special types of forward contracts in the sense
that the former are standardized exchange- traded
contracts.
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• Options: Options are of two types - calls and puts.
• Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a
given price on or before a given future date.
• Puts give the buyer the right, but not the obligation to
sell a given quantity of the underlying asset at a given
price on or before a given date.
• Spot markets are markets in which assets are bought or
sold for “on-the-spot” delivery (literally, within a few
days).

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The role of financial markets
• Raising capital
• Commercial transactions- financial markets provide
the grease that makes many commercial transactions
possible
• Investing- provide an opportunity to earn a return on
funds that are not immediately needed
• Risk management- futures, options and other
derivatives contracts can provide protection against
many types of risk
• Eliminate arbitrage

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