Financial Markets: Understanding Securities, Institutions, and Risk
A market is a place where buyers and sellers meet to exchange something of value. This exchange is mutually beneficial and involves non-coerced transactions.
What are Financial Markets?
A financial market is a market in which financial assets (securities), such as stocks and bonds, can be purchased or sold. Financial markets transfer funds from those who have excess funds to those who need funds.
- Surplus units: Participants who receive more money than they spend, such as investors.
- Deficit units: Participants who spend more money than they receive, such as borrowers.
Types of Securities
Securities represent a claim on the issuers:
- Debt securities: Debt (also called credit, or borrowed funds) incurred by the issuer.
- Equity securities: (Also called stocks) Represent equity or ownership in the firm.
Primary and Secondary Markets
- Primary markets: Facilitate the issuance of new securities (e.g., Initial Public Offerings – IPOs).
- Secondary markets: Facilitate the trading of existing securities, which allows for a change in the ownership of the securities.
If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer.
Money Market, Capital Market, and Derivative Securities
- Money Market Securities: Money markets facilitate the sale of short-term debt securities by deficit units to surplus units. These debt securities have a maturity of one year or less.
- Capital Market Securities: Facilitate the sale of long-term securities by deficit units to surplus units.
- Derivative Securities: Financial contracts whose values are derived from the values of underlying assets.
Uses of Derivative Securities
- Speculation: Allow an investor to speculate on movements in the value of the underlying assets without having to purchase those assets.
- Risk management: Financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities.
Valuation of Securities
Impact of information on valuation:
- Estimate future cash flows by obtaining information that may influence a stock’s future cash flows.
- Use economic or industry information to value a security.
- Use published opinions about the firm’s management to value a security.
Impact of the internet on valuation:
- More timely pricing
- More accurate pricing
Key Regulations in Financial Markets
- Securities Act of 1933: Intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities.
- Sarbanes-Oxley Act: Required that firms provide more complete and accurate financial information, eliminate conflicts of interest, improve auditing oversight, and hold CEOs responsible for the accuracy of financial statements, eliminating plausible deniability.
Role of Depository Institutions
Depository institutions accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities.
- Offer liquid deposit accounts to surplus units.
- Provide loans of the size and maturity desired by deficit units.
- Accept the risk on loans provided.
Commercial Banks
Commercial Banks are the most dominant type of depository institution. They transfer deposit funds to deficit units through loans or the purchase of debt securities.
Federal Funds Market: Facilitates the flow of funds between depository institutions.
Role of Financial Institutions
Financial institutions facilitate the flow of funds from individual surplus units (investors) to deficit units. Financial institutions also serve as monitors of publicly traded firms.
Types of Risk in Financial Markets
- Systemic Risk: The spread of financial problems among financial institutions and across financial markets that could cause a collapse in the financial system.
- Unsystematic Risk: Company or industry-related specific hazards.