8.0 Financial Markets

© 1999-2020, Douglas A.Ruby (06-12-2020)

In an aggregate economy, we often find that the expenditure needs of one sector (households) is less than their income or revenue resulting in a surplus of funds. These funds are known as savings, and more specifically, private savings. The opposite is true for the business sector and government sector of the economy. For these sectors expenditure often exceeds revenue such that there is a need to borrow funds from the household sector. The transfer of funds from one sector to another in the form of lending and borrowing is facilitated by financial markets, financial intermediaries and various financial instruments.

8.0.1 Direct and Indirect Finance

There are two methods by which these funds may be transferred. One method is through financial intermediation which involves commercial banks and the banking system to attract deposits from individuals and institutions and make loans to other individuals or institutions. The key assets for these banks are deposits, money (cash balances) and reserves. These banks act as intermediaries between lender and borrower hopefully minimizing the transactions costs (risk-assessment of borrower and liquidity needs of the depositor) related to this type of financial activity. A second method is known as direct finance where borrower and lender directly interact through activity in equity or debt markets -- also known as Capital Markets. In this case the lender will buy financial instruments (shares of stock or bonds) being sold by borrowers.

Households with surplus funds will seek to choose the best way in which to use these funds. This best way depends on the liquidity needs of the household, attitudes towards financial risk, and desired return when these funds are made available to financial markets.

These households may deposit these funds in a commercial bank or savings institution, where they can maintain a high level of liquidity (easy and quick access to these funds), be exposed to small risk of capital loss, and earn a small return in the form of simple interest. An alternative would be to buy a share of stock or a bond where the returns may be higher in the form of dividends, interest, and capital gains. However, this activity exposes the individual to more risk (default in the case of bonds and capital losses) and less liquidity (having to convert these types of financial instruments into cash).

Other possibilities would be to buy commodity assets or properties that often pay no interest or dividends but may appreciate over time. The returns may be greater combined with more risk and less liquidity. A final option available to the household would be to remain perfectly liquid, that is, to avoid financial risk and hold these surplus funds as cash (money) even though this type of asset pays no return (interest, rents, dividends, or capital gains).

Practice: Financial Data

The information made available by financial markets (as well as commodity and property markets) to the owners of surplus funds helps in making decisions about the best use of these funds. However, because perfect liquidity is an option, money plays a special role in financial market activity.

Financial Markets may be divided up into two related markets. One set of markets are primary markets where the seller of a financial instrument represents the borrower and the buyer of that instrument represents the lender. It is in these primary markets where all new borrowing and lending take place via direct finance. Investement Banks play a special role in primary market activity in that they are the institutions that handle the underwriting (issuance) of new bonds or new shares of stock to the marketplace.

In order to maintain liquidity with respect to ownership of these financial assets, secondary markets also exists for the buying and selling of these instruments. This buying and selling does not represent any new lending or borrowing activity but rather the exchange of stocks, bonds and other securities among investors. This buying and selling activity governs the price of these instruments and their compeitive yields or rates of return.

8.0.2 Financial Instruments

Two common financial instruments, traded in capital markets are Stocks (or Equities) and Bonds. A share of stock conveys certain ownership rights to the holder such that this person may share in the profits or earnings of a publicly-held corporation and, in some cases, have voice in how that company is managed. A bond is a medium or long term debt contract explicitly stating the amount borrowed and to be repaid, date of repayment, and interest to be paid by the borrower to the lender. Bonds may be issued (sold) by large corporations, municipal governments, or the federal government to fund capital investment or to meet budgetary needs.

A third type of financial asset also exists in the form of Money Market Instruments which represent short term debt instruments.

Concepts for Review:
  • Bonds
  • Capital Markets
  • Commercial Banks
  • Direct Finance
  • Financial Instruments
  • Financial Intermediation
  • Financial Intermediaries
  • Financial Markets
  • Indirect Finance
  • Liquidity
  • Money
  • Money Market Instruments
  • Primary (financial) Markets
  • Private Savings
  • Risk
  • Savings
  • Secondary (financial) Markets
  • Stocks

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© 1999-2020, Douglas A.Ruby (05-20-2020)