UNIT I

FINANCIAL MARKETS- AN
OVERVIEW

Function of Financial
Markets
A financial market is 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., LenderSavers, or Surplus Unit) to those who
have them (i.e., Borrower-Spenders, or
Deficit Unit)

Segments of Financial
Markets
Direct Financing
Funds are transferred directly from
ultimate savers to ultimate borrowers

Indirect Financing
A financial "intermediary" transforms
financial claims with one set of
characteristics into financial claims with
other characteristics e.g. deposits are
used to make loans.

Function of Financial
Intermediaries
Provide customers with liquidity
service
Help to repackage the risk
Willing to create and sell assets with
lesser risk to one party in order to buy
assets with greater risk form another
party
This process is referred to as asset
transformation
4

Types of Financial Markets

Financial markets can be distinguished by
the maturity structure and trading
structure of its securities
Money versus capital markets

The flow of short-term funds is facilitated by

money markets
The flow of long-term funds is facilitated by
capital markets

Types of Financial Markets

Primary versus secondary markets
Primary markets facilitate the issuance of
new securities
e.g., the sale of new corporate stock or new Treasury
securities

Secondary markets facilitate the trading of

existing securities
e.g., the sale of existing stock
Securities traded in secondary markets should be
liquid

Types of Financial Markets

(contd)
Organized versus over-the-counter
markets

A visible marketplace for secondary market

transactions is an organized exchange
Some transactions occur in the over-thecounter (OTC) market (a telecommunications
network)

Securities Traded in Financial

Markets
Money market securities
Money market securities are debt
securities with a maturity of one year or
less
Characteristics:
Liquid
Low expected return
Low degree of risk

Securities Traded in Financial

Markets (contd)
Capital market securities
Capital market securities are those
with a maturity of more than one year
Bonds and mortgages
Stocks

Capital market securities have a higher

expected return and more risk than
money market securities

Securities Traded in Financial

Markets (contd)
Bonds and mortgages
Bonds are long-term debt obligations
issued by corporations and government
agencies
Mortgages are long-term debt
obligations created to finance the
purchase of real estate
Bonds and mortgages specify the
amount and timing of interest and
principal payments
10

Securities Traded in Financial

Markets (contd)
Stocks
Stocks (equity) are certificates
representing partial ownership in
corporations
Investors may earn a return by receiving
dividends and capital gains
Stocks have a higher expected return
and higher risk than long-term debt
securities
11

Securities Traded in Financial

Markets (contd)
Derivative securities
Derivative securities are financial contracts
whose values are derived from the values of
underlying assets
Speculating with derivatives allow investors
to benefit from increases or decreases in the
underlying asset
Risk management with derivatives generates
gains if the value of the underlying security
declines

12

Role of Financial Institutions in

Financial Markets (contd)
Depository institutions
Depository institutions accept deposits
from surplus units and provide credit to
deficit units
Depository institutions are popular
because:

Deposits are liquid

They customize loans
They accept the risk of loans
They have expertise in evaluating
creditworthiness
They diversify their loans
13

Role of Financial Institutions in

Financial Markets (contd)
Commercial banks
Are the most dominant depository
institution
Offer a wide variety of deposit accounts
Transfer deposited funds by providing
direct loans or purchasing debt
securities
Serve both the public and the private
sector
14

Role of Financial Institutions in

Financial Markets (contd)
Savings institutions

Include savings and loan associations (S&Ls)

and savings banks
Are mostly owned by depositors (mutual)
Concentrate on residential mortgage loans

Credit unions

Are nonprofit organizations

Restrict their business to credit union members
Tend to be much smaller than other depository
institutions

15

Role of Financial Institutions in

Financial Markets (contd)
Nondepository financial institutions
Non depository institutions generate
funds from sources other than deposits
Finance companies
Obtain funds by issuing securities
Lend funds to individuals and small
businesses

16

Role of Financial Institutions in

Financial Markets (contd)
Mutual funds
Sell shares to surplus units
Use funds to purchase a portfolio of
securities
Some focus on capital market securities
(e.g., stocks or bonds)
Money market mutual funds concentrate
on money market securities

17

Role of Financial Institutions in

Financial Markets (contd)
Securities firms
Broker function
Execute securities transactions between two parties
Charge a fee in the form of a bid-ask spread

Investment banking function

Underwrite newly issued securities

Dealer function
Securities firms make a market in specific securities
by adjusting their inventory

18

Role of Financial Institutions in

Financial Markets (contd)
Insurance companies
Provide insurance policies to individuals
and firms for death, illness, and damage
to property
Charge premiums
Invest in stocks or bonds issued by
corporations

19

Role of Financial Institutions in

Financial Markets (contd)
Pension funds
Offered by most corporations and
government agencies
Manage funds until they are withdrawn
from the retirement account
Invest in stocks or bonds issued by
corporations or in bonds issued by the
government

20

Overview of Financial
Institutions
Competition between financial
institutions
Financial institutions should operate to
maximize the value of their owners
Present value of future cash flows

Depends on:
Growth and profitability
Degree of risk

21

Overview of Financial Institutions

(contd)
Consolidation of financial institutions
Reduction in regulations has resulted in more
opportunities to capitalize on:
Economies of scale
Economies of scope

Mergers have resulted in financial

conglomerates
Consolidation may increase expected cash
flows or reduce risk, or both

22

Options for Retail Investor

Equity
Debt
Mutual Funds
Fixed Deposits with Banks
Post office schemes
Gold
Real Estate
Insurance

Equity Shares
It commonly referred to as ordinary share
represents the form of fractional ownership in a
business venture.
Equity shareholders have the right to
get dividends as declared.

DEBT
This instrument represents contract whereby one
party lend money to another on pre-determined
terms with regards to rate and periodicity of
interest, repayment of principle amount by the
borrower to the lender.

Classification of DEBT
BONDS: Issued by Govt.(Central and
State),Public Sector Organisation
DEBENTURES: Issued by Private
Corporate Sector.

Mutual Fund
A Mutual fund is a collective investment vehicle
that pools together investor money. This collective
pool of money is invested in accordance to stated
objective.
Mutual Funds are :
A large pool of resources
Managed by professionals
Diversified investment for lower risk & better
return

Fixed Deposits with Banks

It allows an investor to deposit a lump sum of
money for a fixed period ranging from a few
weeks to a few year and earn a pre-determined
rate of interest.
Guaranteed Returns depends upon
term.
Safe and Secured Investments

Post Office Schemes

Offered by Govt. of India
Safe, secure and risk-free Investment
No Tax deduction at source (TDS)
Transferable to any post office in India
Attractive Rate of Interest
Post office monthly income scheme
Kisan Vikas Patra
National Savings certificate
Public Provident Fund

GOLD
Physical Gold in the form of bars and
coins
Gold accounts in banks where units in the
gold a/c in the banks are backed up by
physical gold held in the bank and bank
gives assurance that the investor can
convert the gold back to cash anytime.

Real Estate Investment

Financial instrument that invests
primarily in the real estate such as offices,
apartments, shopping centres, hotels etc.
Tend to pay high returns( often as high as
10%)
Attractive investment opportunity when
the stock market is falling.

Insurance
A promise of compensation for specific
potential future losses in exchange for a
periodic payment. Now it is considered
as a investment tool also:
ULIPs
Traditional Plans

Conclusion
Investors looks at superior returns and measured
risk therefore he has to select a dynamically
balanced asset allocation mix consisting of the
different investment options available in the
Financial Market.