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Financial Markets and Institutions

Executive Summary

This paper entails a comprehensive analysis of financial markets and institutions. The essay analyses the various types of financial markets. These markets are analysed by identifying and evaluating their characteristics with regard to rate of return and degree of risk. An analysis of various money and capital market instruments is conducted. The paper also identifies the market trends, which policy makers in financial markets and institutions have to take into account. The paper also identifies and explains the various financial institutions. The stock market is identified as one of the most important secondary market segments. Furthermore, the paper recognises the importance of nurturing a high level of market efficiency and the role of financial markets in an economy. A number of recommendations on how to improve financial markets and institutions are illustrated.

Introduction

Investors and financial managers operate in a complex financial environment, which consists of “regulatory and tax policies, the state of the economy, and financial markets and institutions and the prevailing financial environment influences the available financial alternatives, hence the investors’ decisions” (Madura, 2008, p. 68). Subsequently, it is imperative for financial managers to develop a comprehensive understanding of financial institutions. Previous studies indicate that a well-designed financial system is fundamental in the growth and prosperity of an economy (Burton & Nesiba, 2010). Individual investors, governments, and businesses require capital in order to meet their investment and expenditure needs. The transfer of funds mainly occurs through various avenues such as direct transfers, financial intermediaries, or investment banking houses. The contribution of financial markets and institutions in the growth of both developed and developing economies cannot be underestimated. This report entails an analysis of financial markets and institutions. The report mainly focuses on the US economy.

Types of financial markets

Different types of markets are specifically designed to serve disparate customer groups and economies. Some financial market participants may require funds to invest over a short period while others may prefer funds to invest in for a long term. Furthermore, financial markets provide funds to deal with diverse risk-averse characteristics of investors. According to Madura (2008), some investors are more risk averse as compared to others. Subsequently, they avoid risk. Moreover, financial markets can be distinguished depending on their trading and maturity structure. Below is an illustration of some of the main categorisation of financial markets.

Capital versus money markets

Madura (2008) defines these financial markets to include markets, which are designed to facilitate the transfer of various debt securities. These markets are categorised based on the securities’ maturity period. The money markets include “markets that deal with highly liquid and short-term debt securities” (Madura, 2008, p.69). Subsequently, money markets mainly deal with securities whose trading period is less than one year. Money markets are characterised by low expected returns and low degree of risk as well as high level of liquidity. On the other hand, capital markets refer to markets that deal with securities whose trading period is more than one year. Subsequently, they provide funds for long-term investment purposes. The degree of risk and the rate of return in the capital market are relatively high (Riahi-Belkaoui, 2005).

Secondary and primary markets

Madura (2008) defines primary markets as the markets, which are designed to provide businesses with an opportunity to raise the required financial capital by facilitating the issuance of new financial securities. On the other hand, “secondary markets refer to markets through which existing securities are traded” (Madura, 2008, p. 71). Therefore, secondary markets facilitate effective transfer of ownership of securities from one party to another. Secondary markets are characterised by a high rate of liquidity. Therefore, the securities can be liquidated without losing value.

Financial market instruments

Money market instruments

Trading in the financial market entails diverse instruments. Below is an analysis of the main money market instruments in the US.

  1. Treasury bills – This term refers to short-term debt instruments, which are issued by the United States government. Treasury bills have diverse maturity periods, which include 3, 6, and 12 months. The bills are issued with the objective of funding different federal government expenditures. Longstaff (2004) contends that the “US treasury bills are the most liquid and safest of all the money market instruments, because they are the most actively traded” (p.511).
  2. Certificate of deposits – Chandra (2008) defines certificate of deposit as the debt instruments, which are issued by banks to depositors. The CD’s pay a certain predetermined interest and they have a specific maturity date.
  3. Commercial paper – this term refers to “a short-term debt security, which is issued by large and recognised financial institution such as AT&T” (Chandra, 2008, p. 111). Commercial papers are used by large organisations to address their immediate financial needs. The commercial papers provide organisations with an opportunity to borrow from the financial institutions.
  4. Repurchase agreements – The repurchase agreements mainly refer to short-term loans, which are issued to organisations with the Treasury bills serving as guarantee.
  5. Federal funds – Brigham and Ehrhadt (2013) define federal funds as overnight loans, which are issued by the commercial banks to other banks.

Capital market instruments

Chandra (2008) posits, “These instruments have a maturity duration of more than one year” (p. 114). Capital market instruments are subject to rapid price fluctuations, which make them relatively riskier as compared to the money market instruments.

  1. Stocks – they include “the equity claims on an organisation’s net income” (Brigham & Ehrhardt, 2013, p. 93).
  2. Mortgages – they include loans, which are issued to governments and individuals to assist them in achieving their housing and other real estate and land needs. Diverse customer groups extensively use the instrument, which makes it the largest debt instrument.
  3. Corporate bonds – these bonds refer to “long-term debt instruments, which are mainly issued by organisations characterised by strong credit rating” (Brigham & Ehrhadt, 2013, p. 70). In most cases, the bondholders are paid interest twice per year and are fully paid upon their maturity. Furthermore, some bonds can easily be converted into shares.
  4. Government securities – these include the long-term debt instruments that are offered by the United States government to investors. The purpose of these securities is to assist the US government seal federal budget deficits.
  5. Local and state government bonds – these bonds are issued by the US local and states governments. The bonds are specifically designed to assist the US government in providing various public utilities such as roads and schools. The bonds are exempted from state and federal taxes.
  6. Government agency securities – these instruments include the long-term bonds, which are offered by diverse government agencies. Examples of such agencies include the Tennessee Valley Authority, Ginnie Mae, and the Federal Farm Credit Banks. The US government provides a guarantee to such securities.

Financial market trends

Financial markets have “undergone numerous changes over the past two decades and some of the major changes relate to the integration of new computer technologies, increased competition, high rate of globalisation, and increased market deregulation” (Sabri, 2008, p. 69) The growth of financial markets has presented policy makers with numerous complexities. First, the high rate of globalisation has spurred the need for a high rate of cooperation amongst the financial market regulators. Despite this, cooperation is subject to a number of factors such as differences in organisational structures and reluctance by different countries to minimise their monetary policy control. Another major trend relates to the emergence of derivative securities.

Financial Institutions

Different financial institutions have been developed in an effort to enhance the financial intermediation role. Some of the main categories of financial institutions are evaluated below.

  1. Commercial banks – these institutions serve diverse categories of customers. Their main role entails accepting deposits and issuing loans. However, they have evolved over the years in an effort to cope with intense competition.
  2. Investment banking houses – Some of the major investment banking houses includes Morgan Stanley, Credit Suisse Group, and Merrill Lynch. Investment houses provide diverse financial services to institutional and individual investors intending to raise capital. Some of the services offered include assisting organisations to design effective investment securities that are attractive to diverse investment groups. Secondly, they purchase “securities designed from the institutional investors and resell to savers” (Madura, 2008, p. 117). Their operations mainly occur in the primary market segment. Thus, investment-banking houses facilitate the transfer of financial capital from the demand side [businesses] to the supply side [savers] (Papadopoulos, 2011).
  3. Savings and loans associations – these financial institutions were initially designed to provide financing to commercial, residential, and individual mortgage customers. They operate by accumulating funds from small savers and issuing the funds to mortgage borrowers and other customer groups.
  4. Credit unions – these unions include the various “cooperative associations, which are developed by members with a common purpose” (Madura, 2008, p. 116). Subsequently, the members are characterised by a common bond. For example, the members may be employees from the same organisation.
  5. Mutual savings banking – these financial institutions are “similar to the S&Ls” (Madura, 2008, p.117). They accept and issue funds to investors and homebuyers on a long-term basis.
  6. Pension funds – these refers to retirement plans, which are funded by government agencies or organisations in order to cater for their employees’ retirement needs. The “pension funds mainly invest in various investment vehicles such as real estates, stocks, bonds, and mortgages” (Chandra, 2008, p. 99).
  7. Mutual funds – Madura (2008) defines mutual funds as corporations whose operations entail receiving deposits from individual and institutional customers and utilising the funds received to buy securities such as short-term and long-term debt instruments. Mutual funds operate based on risk minimisation by diversifying their investment portfolio. Madura (2008) adds, “Diverse categories of mutual funds are designed to meet the customers’ objectives” (p. 118). Examples of such funds include the stock and bond funds
  8. Hedge funds – These institutions operate in a manner similar to that of the mutual funds. The institutions receive and utilise the funds received from customers in buying diverse securities. In the US, “the hedge funds are not regulated unlike the mutual funds, which are controlled by the Securities Exchange Commission [SEC]” (Madura, 2008, p. 99). Most hedge funds are known for their risk taking characteristics. Subsequently, some hedge funds have incurred huge losses such as in 1998 when Russia experienced a decline in its economic performance.

The stock market

According to PWC (2014), the stock exchange constitutes one of the most effective and active secondary markets. Businesses are increasingly utilising the stock exchange in their quest to seek long-term capital from the public. This aspect has led to increment in the intensity of competition amongst the major stock exchange markets. A study conducted by Price Waterhouse Coopers on the competitiveness of the major stock markets shows that the attractiveness of the major markets will change dramatically by 2025. The chart below illustrates the projected change.

Percentage preference
Now 2025
Toronto Stock Exchange 5 4
Tokyo Stock Exchange 12 3
South Korea Exchange 2 3
Singapore Exchange 6 14
Shanghai Stock Exchange 4 55
Russian Exchanges [RTS & MICEX] 1 11
NASDAQ 46 18
NYSE 74 39
London Stock Exchange 72 27
Indian Exchanges 5 38
Hong Kong Exchange 27 27
Deutsche Borse 17 8
Bovespa 5 29
Australian Securities Exchange 5 7
Comparison of Stocks Exchange performance by 2025
Source: (PWC, 2014).

The above graph shows that the attractiveness of the stock exchange markets in the emerging markets such as India, Brazil, and China will increase more significantly as compared to emerging economies. Subsequently, it is imperative for the respective governments of the developing economies to consider the most effective ways to improve their attractiveness. This move will play a critical role in stimulating their economic growth.

Financial market efficiency

The efficiency of a particular capital market plays a fundamental role in determining its attractiveness to investors. Busse and Green (2002) argue that one of the ways through which organisations can improve market efficiency is by improving availability of market information. Financial markets should ensure that investors readily access information regarding the performance of various institutions and the economy. The high rate of technological innovation has significantly improved market efficiency. Currently, information can be readily be accessed through various online platforms. The price of securities in an efficient market responds rapidly to market information. Subsequently, it is imperative for investors to understand the prevailing level of market efficiency. There are three main levels of market efficiency in the stock market as evaluated herein.

  1. Weak-form– This form of efficient market hypothesis asserts that the historical price movement of stocks is reflected on the stocks’ current market price. If this were true, then it would not make sense to evaluate the market trends. The hypothesis argues that it would not be effective to rely on past price movement to predict future prices.
  2. Semi strong-form efficiency- “This form of EMH postulates that all the information about current market prices is already reflected in the securities prices” (Madura, 2008, p. 126). The flipside of this form of EMH is that it underestimates the importance of relying on past information in predicting the future prices of securities.
  3. Strong-form efficiency- This form of EMH holds that the prevailing stock prices are inclusive of the most important market information. Subsequently, possessing insider information would be pointless in the trading process.

Studies conducted “over the past 25 years shows that stock markets are more efficient under the weak form of EMH” (Madura, 2008, p. 126).

Functions of the financial markets

  1. Price determination – Financial markets such as the stock exchange markets play a critical role in determining the prices of securities. In most cases, the market forces determine the price, which makes it very effective. The set price reflects the prevailing market information. Subsequently, financial markets are in a position to set the price securities for organisations, which float their securities in the stock market.
  2. Risk sharing – financial markets also allow investors and savers to transfer risk between the demand and the supply side.
  3. Information aggregation and coordination – Financial markets play a significant role in collecting and aggregating diverse market information such as the value of securities. Furthermore, “financial markets also aid in the process of coordinating the flow of funds between the deficit and the surplus sides” (Chandra, 2008, p. 101).
  4. Efficiency- financial markets play an important role in reducing the information and transaction cost.
  5. Liquidity – financial markets play a fundamental function in enhancing the liquidity of financial assets.

Conclusion

This report identifies financial markets as one of the most important components of an economy. Therefore, as Chandra (2008) suggests, it is imperative for policy makers “in both the developing and developed economies to design and implement an effective financial system” (p. 108). Financial markets are categorised into primary and secondary markets and money and capital markets. Madura (2008) notes that the “primary market deals with issuing new securities while the secondary market facilitates trading with the existing securities” (p. 112). On the other hand, money markets provide businesses and institutions with an opportunity to access short-term funds. The degree of risk in the money market is relatively higher as compared to that of the capital market. Furthermore, returns in the capital market are relatively higher when compared to money market returns.

The instruments traded in the capital and the money markets are disparate. Some of the main instruments include treasury bills, certificate of deposits, commercial papers, repurchase agreements, and federal funds. On the other hand, capital instruments include stocks, mortgages, corporate bonds, government securities, local and state government bonds, and government agency securities. The report also shows the disparate financial institutions including commercial banks, investment banking houses, savings and loans associations, credit unions, mutual saving banks, pension funds, and hedge funds. The report further identifies stock market as one of the most important financial markets in the success.

Recommendation

In order to improve their contribution to their respective economies, it is imperative for policy markets to take into account the following aspects.

  1. Financial market policy makers should focus on developing a strong financial system. Some of the aspects that should be taken entail designing optimal regulatory and taxation policies.
  2. It is imperative for governments and the relevant policy makers to integrate a high level of market efficiency by formulating and implementing optimal information disclosure policies. This move will play a fundamental role in minimising insider trading. A high level of market efficiency will remarkably improve the level of trust amongst various stakeholders, which is a critical component in the success of financial markets.
  3. In a bid to enhance market efficiency, it is essential for relevant authorities to implement effective information communication systems, which will improve market efficiency remarkably.
  4. It is also critical for governments to integrate a strong security system in order to enhance financial transactions through various information communication systems.

References

Brigham, E., & Ehrhadt, M. (2013). Financial management: theory and practice. Mason, OH: South Western.

Burton, M., & Nesiba, R. (2010). Introduction to financial markets and institutions. New York, NY: M.E Sharpe.

Busse, J., & Green, C. (2002). Market efficiency in real time. Journal of Financial Economics, 65(4), 415-437.

Chandra, P. (2008). Financial management; theory and practice. New Delhi, India: Tata McGraw Hill.

Longstaff, F. (2004). The flight to liquidity premium in US Treasury bond prices. Journal of Business, 77(3), 511-528.

Madura, J. (2008). Financial markets and institutions. Mason, OH: Thomson.

Papadopoulos, P. (2011). Role and function of stock markets using the exemplar of London Stock Exchange and Frankfurt Stock Exchange. Munchen, Germany: GRIN Verlag.

PWC: Capital markets in 2025. (2014). Web.

Riahi-Belkaoui, A. (2005). Accounting theory. London, UK: Thompson.

Sabri, N. (2008). Financial markets and institutions in the Arab economy. New York, NY: Nova Science Publishers.