They enable students and families to obtain loans, businesses to finance growth, and the government to finance their expenditures. People and organizations that need money are brought together with those having surplus funds in the financial markets. Without financial markets many students could not go to college, many households could not purchase a home, many corporations could not grow and government may not provide as many public services. Households and businesses that supply funds to financial markets earn a rate of return on their investments and those who demand funds have to pay the cost Of using funds.
In financial markets, the businesses could raise funds by issuing securities or borrowing from banks. Financial markets help in bringing lenders and borrowers of funds together with the help of financial intermediaries directly or indirectly. Lenders or suppliers of funds exchange money for other financial assets that tend to provide a better future return. The main participants in the financial markets are households, corporations (companies), and the government. These participants stand as the suppliers and demanders of the funds in the financial markets.
Importance of Financial Markets
The development of financial markets in any economy determines the degree of success of financial activities. Because financial markets add to the liquidity of financial securities, investors are generally interested to buy those securities for which a market exists. Financial markets are essentials for a healthy economy for the following reasons:
FACILITATE THE TRADING OF FINANCIAL ASSETS. Financial markets facilitate the trading of financial assets such as shares, debentures, and bonds. The buyer and seller of financial assets and services participate in the financial markets to facilitate the buying and selling of these financial assets.
IMPROVE LIQUIDITY AND HELP IN PRICE DISCOVERY OF SECURITIES. Financial markets help to improve the liquidity of financial assets or securities by providing a mechanism to facilitate the exchange of financial assets. They also facilitate keeping the securities in continuous trading thereby assisting in the price discovery process.
FACILITATE TRANSFORMATION OF SAVING INTO INVESTMENT. The existence of financial markets in any economy facilitates the flow of savings generated from one sector of the economy to another, where there is a demand for funds. Borrowers and savers participate in financial markets thereby transforming savings into investment.
SATISFY THE FINANCING NEEDS OF BUSINESSES AND HOUSEHOLDS. Financial markets help to satisfy the financing need of businesses and households. The businesses could raise funds by issuing securities or borrowing from banks in the financial markets. Households also could satisfy their financing needs by borrowing from financial markets. Financial markets bring lenders and borrowers of funds together with the help of financial intermediaries.
Types of Financial Markets
Financial markets may be categorized into different types. One way to classify the financial markets is to distinguish between primary market and secondary market. Another classification is based on the life span of the securities traded in the market. They are called the money market and the capital market. Different types of financial markets are in existence to serve different types of customers. Basic types of financial markets are as follows:
a) Primary Markets and Secondary Markets
When securities are issued by corporations, they are traded in primary markets. In other words, these are the markets in which corporations raise new capital by selling securities. The proceeds from the issue in these markets go to issuing corporations. For example, suppose a hypothetical firm ‘A’ is a newly established firm and is planning to sell 100,000 shares of common stock at Rs 100 per share to raise Rs 10,000,000 of new capital. These shares are sold in the primary markets. To sell these shares in primary markets covering prospective investors of the wide geographical area it can take the help of financial intermediaries like investment bankers.
Primary markets can be of two types – seasoned and unseasoned markets. A seasoned market is a primary market, which deals with offering an additional amount of an already existing security. If a corporation has to issue an additional amount of existing securities, they are traded in the seasoned primary market. An unseasoned market is a market for initial offerings of securities to the public. It is often referred to as market for initial public offerings (IPOs). It involves the first time issues of securities. For example, suppose a corporation with 100,000 authorized shares of common stock issues 60,000 of these shares for the first time to raise capital, it is called a transaction of the unseasoned primary market. After the years, if the same company issues additional 30,000 shares of common stock out of its existing authorization, this additional issue becomes the transaction of the seasoned primary market.
Secondary markets are the market for trading on outstanding securities, where the trading between investors (buying securities) to investors (selling securities) takes place. The original issuer does not participate in secondary markets, and the proceeds from securities transactions do not go to the issuer. For example, suppose the hypothetical firm ‘A’ sold new shares in primary markets. After these shares are completely sold off in the primary markets, they are traded among buying and selling investors in secondary markets. The exchange takes place in the form of cash and share certificates between buying and selling investors. The proceeds are not available to firm ‘A’.
Secondary markets may be classified as Organized Securities Exchange and over the-Counter markets (They are dealt with in the forthcoming section in detail). In Organized Securities Exchanges, only the listed securities are traded; whereas in the Over-The-Counter market, securities that are not listed in the Organized Securities Exchange are also traded. Nepal Stock Exchange (NEPSE) is an example of an Organized Securities exchange where trading of outstanding securities, as opposed to newly issued stocks or bonds, takes place.
An active secondary market is crucial for any securities once they are sold off in primary markets. The existence of secondary markets facilitates trading among investors to investors, thus adding to the liquidity of securities. Investors are motivated to buy securities in primary markets only if the secondary markets for the securities exist.
DIFFERENCE BETWEEN PRIMARY AND SECONDARY MARKETS
|| A primary market is the market for raising new capital by the corporations.
|| A secondary market deals with trading of outstanding securities among investors themselves.
|| Proceeds from selling of securities in primary markets go to the issuing corporation.
|| Proceeds from buying and selling of securities in secondary markets do not go to the original issuer. The proceeds flow between investors to investors.
|| In primary markets, the issuer could sell securities to the investing public directly or with the help of investment bankers and other financial intermediaries.
|| In secondary markets, securities are bought or sold among investors through securities brokers.
|| The existence of primary markets facilitates raising new capital for the corporations.
|| The existence of secondary markets facilitates to improve liquidity of outstanding securities.
b) Money Markets and Capital Markets
Money markets deal with the trading of securities with less than one year of life span. In other words, these are the markets for borrowing and lending for a relatively short period of time, usually less than one year. Government, corporations, and individuals requiring short-term loans are major participants in the money market. Government issues Treasury bills to meet its need for short-term funds. Corporations could issue commercial papers or take loans on a short-term basis from banks to satisfy their short-term needs of funds. Other money market instruments include bankers’ acceptance, certificate of deposits, promissory notes, bills of exchange, and others with less than one year of maturity. These money market instruments are actively traded in primary as well as secondary markets.
Capital markets are the market for long-term securities. All long-term securities issued by corporations and government such as common stock, preferred stock, corporate bonds, government bonds are the instruments of capital markets. These capital market instruments are also traded in both primary as well as secondary markets. Capital market instruments are not as liquid as money market instruments because of their longer maturity. However, the existence of secondary markets adds to the liquidity of these instruments. The Nepal Stock Exchange (NEPSE) is an example of a secondary capital market because only the securities with more than one year of maturities are traded there.
DIFFERENCE BETWEEN MONEY AND CAPITAL MARKETS
|| Money Markets
|| Capital Markets
|| Money markets are the markets for short-term securities with less than one year of maturity.
|| Capital Markets are the markets for ling-term securities with more than one year of maturity.
|| Household, corporations and Government requiring funds for less than one year sell securities or borrow in money markets.
|| Corporations and government requiring funds for longer-term period (usually more than one year) sell securities in the capital market.
|| Money market instruments are more liquid because of short maturities.
|| Capital market instruments are not as liquid as money market instruments because of longer maturity.
c) Spot Markets and Futures Markets
Besides, the financial markets could be classified as spot markets and futures markets on the basis of settlement of trading and delivery of assets. In the spot market, settlement of trading and delivery of assets are made on the spot of trading, normally within a few days. On the other hand, a futures market is the market in which the participants agree today to buy or sell some specified assets at a specified price in some future date. For example, an apple juice manufacturer and apple farmer enter into the futures contract in which the apple farmer has to deliver 5 million kgs of apple six months from now at a price of Rs 150 per kg and the juice manufacturer has to pay the agreed price to apple farmer on the specified future delivery date. Such transaction forms a futures market. The futures market facilitates risk hedging for both juice manufacturers and apple farmers which may otherwise occur due to price fluctuations.
d) National and International Markets
Financial markets are not limited to the national territory. Many foreign investors are interested in the international financial markets. Many nations’ corporations prefer to raise funds from financial markets beyond the national boundary. Thus financial markets also can be classified as national and international markets. A national market is one where domestic investors and domestic corporations participate as the suppliers and users of short-term and long-term funds. For example, Nepal Stock Exchange is the national market which deals with secondary trading of domestic companies’ shares of common stock in Nepal and where domestic investors participate in buying and selling of those securities.
The growing internationalization of financial markets has become an important trend. This growth has been basically supported by the trend of globalization in financial market transactions. For example, before the 1980s, U.S. financial markets were much larger than financial markets outside the United States. However, in recent years, the dominance of U.S. markets has been disappearing due to the result of a large increase in the pool of savings in other markets such as Japan. This has been further supported by the deregulation of foreign financial markets, which has enabled corporations and investors to expand their activities globally. The international financial market is a market where individual and institutional investors can trade securities internationally. It is the market where financial instruments are traded between individuals and between countries. It can be seen as a wide set of rules and institutions where financial assets are traded between agents in surplus and agents in deficit and where institutions lay down the rules. International financial markets consist of the international stock market, bond market, currency market, derivatives markets, and money market. London Stock Exchange, New York Stock Exchange, and Tokyo Stock Exchange are some examples of international financial markets.
Besides these markets, there are many other classifications of the markets such as physical asset markets and financial asset markets, private markets, and public markets, among others. These financial markets help in transforming surpluses generated in one part of the economy to another more productive part and thus contribute to the economic prosperity of a nation.