Unit 4

Financial Market in the Financial System

1.1 The organization and structure of markets

The organization of markets
A Market is an institutional mechanism where supply and demand meet to exchange
goods and services; or a place or event at which people gather in order to buy and sell
things in order to trade. Exciting with many different functions, the financial system
fulfills its various roles mainly through markets where financial claims and financial
services are traded (though in some least-developed economies Government dictation and
even barter are used). These markets may be viewed as channels through which moves a
vast flow of loan able funds that continually being drawn upon by demanders of funds and
continually being replenished by suppliers of funds. Filled with a desire to lend or to
borrow, the end users of most financial systems are faced with a choice between three
broad approaches:
 Firstly, they may decide to deal directly with another, which is costly, risky,
inefficient, consequently; and not very likely.
 More typically, they may decide to use one or more of many organized markets. In
these markets, lenders buy the liabilities issued by the borrowers. If the liability is
newly issued, then the issuer receives funds directly from the lender. More
frequently, however, a lender will buy an existing liability from another lender. In
effect, this refinances the original loan though the borrower is completely unaware
of this secondary transaction.
 Alternatively, borrowers and lenders may decide to deal via intermediaries. In this
case, lenders have an asset – a bank deposit or contribution to a life insurance or
pension fund – which can not be traded but can only be returned to the
intermediary. Similarly, intermediaries create liabilities, typically in the form of
loans for borrowers. These remain in the intermediaries balance sheets until they
are repaid. Intermediaries themselves will also make use of markets, issuing security
to finance some of their activities and buying shares and bonds as part of their asset
portfolio.
The role of markets in an economy
The financial markets perform a vital function within the economic system. The financial
markets channel savings which come mainly from households to those individuals and
institutions who need more money (funds) for spending than are provided by current
income. It is known that the basic function of any economy is to allocate scarce resources
in order to produce the goods and services needed by society.
Figure 4 (Circular flow production and payment)
Land and other
Flow of Goods and Services
Natural resources Production
Sold to the public
Labor and managerial skills Flow of
Capital equipment Payments

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 Kidwell, D. 2003/Modified
The diagram shows that the system is just a circular flow between producing units (mainly
business and government) and consuming units (mainly households). In modern
economies, households provide labor, management skills, and natural resources to
business firms and governments in return for income in the form of wages, rents and
dividends. Therefore, one can see that markets are used to carry out the task of allocating
resources which are scarce relative to the demand of the society. Here we are referring to
the markets which are different from the financial markets; the goods market and the
factor markets.
 Therefore, we can see that (in the next sub unit) the essential three types of
markets at work within the economic system.
1.1.3 The Structure of Markets
It is known that the basic function of any economy is to allocate scarce resources in order
to produce the goods and services needed by society. In modern economies, households
provide labor, management skills, and natural resources to business firms and
governments in return for income in the form of wages, rents and dividends.
Consequently, one can see that markets are used to carry out the task of allocating
resources which are scarce relative to the demand of the society. Here we are referring to
the markets which are different from the financial markets, the goods market and the
factor markets.
These are:- Factor markets, Product market and Financial markets.
a) Factor markets: - are markets where consuming units sell their labor,
management skill, and other resources to those producing units offering the
highest prices. i.e. this market allocates factors of production (Land, labor and
capital – and distribute incomes in the form of wages, rental income and so on
to the owners of productive resources.
b) Product market: - are markets where consuming units use most of their income
from the factor markets to purchase goods and services i.e. this market includes
the trading of all goods and services that the economy produces at a particular
point in time.
c) Financial markets: - There are markets in which flow of funds, flow of financial
services, income and financial claims is affected i.e. essentially; financial
markets do have three main tasks. These are:
1. They determine the nature of credit available at a macroeconomic level;
2. They attract savers and borrowers; and
3. They set interest rate and security prices.

Allocating resources which are scarce relative to the demand of society, one can see that
the market place determines what goods and services will be produced and in what
quantity. This is accomplished mainly through changes in the prices of commodities and
services offered in the market. In addition, it is easy to understand that markets also
distribute income. In a pure market system, the income of an individual or business firm
is determined solely by the contributions each makes to production. Markets provide
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superior productivity, innovation and sensitivity to consumer needs with increased profits,
higher wages and other economic benefits.

What Types of Financial Market Structures Exist?

The costs of collecting and aggregating information determine to a large extent, the types
of financial market structures that emerge. These structures take four basic forms;
namely: Auction Markets; Over-the-counter markets; Organized Exchanges; and
Intermediation Financial Markets.
i. Auction Markets
An auction market is some form of centralized facility (or clearing house) by which buyers
and sellers, through their commissioned agents (brokers), execute trades in an open and
competitive bidding process. The "centralized facility" is not necessarily a place where
buyers and sellers physically meet. Rather, it is any institution that provides buyers and
sellers with a centralized access to the bidding process. All of the needed information
about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one
location which is readily accessible to all would-be buyers and sellers, e.g., through a
computer network.
An auction market is typically a public market in the sense that it open to all agents who
wish to participate. Auction markets can either be call markets -- such as art auctions --
for which bid and asked prices are all posted at one time, or continuous markets -- such as
stock exchanges and real estate markets -- for which bid and asked prices can be posted at
any time the market is open and exchanges take place on a continual basis. Experimental
economists have devoted a tremendous amount of attention in recent years to auction
markets.
Many auction markets can trade in relatively homogeneous assets (e.g. treasury bills,
notes, and bonds) to cut down on information costs. Alternatively, some auction markets
(e.g., in second-hand jewelry, furniture, paintings etc.) allow would-be buyers to inspect
the goods to be sold prior to the opening of the actual bidding process.
This inspection can take the form of a warehouse tour, a catalog issued with pictures and
descriptions of items to be sold, or (in televised auctions) a time during which assets are
simply displayed one by one to viewers prior to bidding.
 Auction markets depend on participation for any type of asset not being too "thin."
The costs of collecting information about any one type of asset are sunk costs independent
of the volume of trading in that asset. Consequently, auction markets depend on volume to
spread these costs over a wide number of participants.
ii. Over-the-counter markets:
An over-the-counter market has no centralized mechanism or facility for trading. Instead,
the market is a public market consisting of a number of dealers spread across a region, a
country, or indeed the world, who make the market in some type of asset. That is, the
dealers themselves post bid and asked prices for this asset and then stand ready to buy or
sell units of this asset with anyone who chooses to trade at these posted prices. The dealers
provide customers more flexibility in trading than brokers, because dealers can offset
imbalances in the demand and supply of assets by trading out of their own accounts.
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 Many well-known common stocks are traded over-the-counter through NASDAQ
(National Association of Securities Dealers' Automated Quotation System).
iii. Organized Exchanges
The financial markets, such as the New York Stock Exchange, which combines auction
and OTC market features, are called Organized Exchanges. Specifically, organized
exchanges permit buyers and sellers to trade with each other in a centralized location, like
an auction. However, securities are traded on the floor of the exchange with the help of
specialist traders who combine broker and dealer functions. The specialists broker trades
but also stand ready to buy and sell stocks from personal inventories if buy and sell orders
do not match up.
iv. Intermediation Financial Markets:
An intermediation financial market is a financial market in which financial intermediaries
help transfer funds from savers to borrowers by issuing certain types of financial assets to
savers and receiving other types of financial assets from borrowers. The financial assets
issued to savers are claims against the financial intermediaries, hence liabilities of the
financial intermediaries, whereas the financial assets received from borrowers are claims
against the borrowers, hence assets of the financial intermediaries.
Financial markets taking the first three forms are generally referred to as
securities markets.
Some financial markets combine features from more than one of these
categories, so the categories constitute only rough guidelines.

1.2 Importance of Financial Markets in the Economy

Financial markets perform the essential economic function of channeling funds from
households, firms, and governments that have saved surplus funds by spending less than
their income to those that have a shortage of funds because they wish to spend more than
their income. The principal lender-savers are households, but business enterprises and the
government (particularly state and local government), as well as foreigners and their
governments, also sometimes find themselves with excess funds and so lend them out.
The most important borrower-spenders are businesses and the government but
households and foreigners also borrow to finance their purchases of cars, furniture, and
houses. The first way is the direct finance, in which borrowers borrow funds directly from
lenders in financial markets by selling them securities (also called financial instruments),
which are claims on the borrower’s future income or assets.

The second route is called indirect finance, because it involves a financial intermediary
that stands between the lender-savers and the borrower-spenders and helps transfer funds
from one to the other. A financial intermediary does this by borrowing funds from the
lender-savers and then using these funds to make loans to borrower-spenders. For
example, a bank might acquire funds by issuing a liability to the public (an asset for the
public) in the form of savings deposits. It might then use the funds to acquire an asset by
making a loan to firms or by buying a bond in the financial market. The ultimate result is
that funds have been transferred from the public (the lender-savers) to the borrower-
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spender with the help of the financial intermediary (the bank). The process of indirect
finance using financial intermediaries called financial intermediation is the primary path
for moving funds from lenders to borrowers.
Why is this channeling of funds from savers to spenders so important to the economy?
The answer is that the people who save are frequently not the same people who have
profitable investment opportunities available to them, the entrepreneurs. Without
financial markets, it is hard to transfer funds from a person who has no investment
opportunities to one who has them; both of them would be stuck with the status quo, and
both would be worse off. Financial markets are hence essential to promoting economic
efficiency. Thus financial markets are critical for producing an efficient allocation of
capital, which contributes to higher production and efficiency for the overall economy.
Well-functioning financial markets also directly improve the well-being of consumers by
allowing them to time their purchases better. They provide funds to young people to buy
what they need and can eventually afford without forcing them to wait until they have
saved up the entire purchase price. Financial markets that are operating efficiently
improve the economic welfare of everyone in the society.
1.3 Formation of Financial Markets within the Financial System
Depending on the characteristics of financial claims being traded and the needs of
different investors, the flow of funds through financial markets around the world may be
divided into different segments. These include: The Money Market and Capital Market;
Primary and Secondary Markets; Open and Negotiated Markets as well as Spot; Futures,
Forward, and Option Markets.

1. The Money Market versus the Capital Market

Money is a medium of exchange which ensures the success of exchange by being the one
item on offer that is always acceptable. Money is necessary because human beings must
exchange to live together in peace, and to prosper.
How important was the discovery of the idea of money?
Money must be a physical entity. Neither the "electronic" money of today nor the notes
and coin which circulate as cash has any official or legal connection with Gold and Silver.
But they once did, and most people think that they still do. As long as that situation
persists, the modern monetary system functions.
Now, how does one go about choosing what is to be used as money?
Simple, one looks for the most tradable good, the good which is in highest demand, the
good that has begun to be accepted, not as an end in it, but as a means to an end. Money is
the good that people do not want to consume, but want to use to make further exchanges
easier. Human beings have lived together for more than two million years. Money in its
modern form - coin of fixed weight and denomination - came into use less than three
thousand years ago. It took a long time to discover the physical good which best serves the
purpose of a medium of exchange.
Money can be used as direct exchange, or barter, is exactly that - my good or service for
your good or service. The problem is that I might want what you have to offer, but you
might not want what I offer in exchange. With no "medium" of exchange, there is no deal.
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Indirect exchange takes place when one party has a "medium" that is always acceptable,
not for what it is, but for what can be done with it. If you offer me money, I will accept it,
because I know that I can exchange it for what I want, whenever I want it.Money is any
marketable good or token used by a society as a store of value, a medium of exchange, or a
unit of account. Money objects can meet some or all of these needs. Since the needs arise
naturally, societies organically create money object when none
exists. In other cases, a central authority creates a money object; this is more frequently
the case in modern societies with paper money.
One of the most important divisions in the financial system is between money market and
the capital market. The money market is designed for the making of short-term loans. It is
the institution through which individuals and institutions with temporary surpluses of
funds meet the needs of borrowers who have temporary funds shortages (deficits). Thus,
the money market enables economic units to manage their liquidity positions.
By conventions, a security or loan maturing within one year or less is considered to be a
money market instrument. One of the principal functions of the money market is to
finance the working capital needs of corporations and to provide governments with short-
term funds in lieu of tax collections. The money market also supplies funds for speculative
buying of securities and commodities.
In other words, the money market is the global financial market for short-term borrowing
and lending. It provides short-term liquid funding for the global financial system. The
money market is a sector of the capital market where short-term obligations such as
Treasury bills, commercial paper and bankers' acceptances are bought and sold.
A money market consists of financial institutions and dealers in money or credit who wish
to either borrow or lend. Participants borrow and lend for short periods of time, typically
up to twelve months.
Money market trades in short term financial instrument commonly called "paper". This
contrasts with the capital market for longer-term funding, which is supplied by bonds and
equity.
In contrast, the capital market is designed to finance long-term investments by businesses,
governments and households. Trading of funds in the capital market makes possible the
construction of factories, highways, schools, and homes. Financial instruments in the
capital market have original maturities of more than one year and range in size from
small loans to multimillion Birr credits.
The capital market includes the stock market, the bond market, and the primary market.
Securities trading on organized capital markets are monitored by the government; new
issues are approved by authorities of financial supervision and monitored by participating
banks. This market brings together all the providers and users of capital.
Financial products such as stocks, bonds, mutual funds, and insurance make the transfer
of capital possible. Financial intermediaries, such as banks, brokerage firms, and
insurance companies facilitate the transfer of capital. Capital market is the broad term for
the market where investment products such as stocks and bonds are bought and sold. It
includes all the people and organizations which support the process. Such markets may
not necessarily have a physical presence.
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The capital markets consist of the primary market, where new issues are distributed to
investors, and the secondary market, where existing securities are traded. So it is the
market in which corporate equity and longer-term debt securities (those maturing in more
than one year) are issued and traded. It consists of a market for medium to long-term
financial instruments; financial instruments traded in the capital market include shares,
and bonds issued by the government, state governments, corporate borrowers and
financial institutions.
 The capital market is the market for long-term loans and equity capital.
The capital market (securities market) is the market for securities, where companies and
the government can raise long-term funds. A security is a fungible, negotiable instrument
representing financial value. Securities are broadly categorized into debt and equity
securities such as bonds and common stocks, respectively. The company or other entity
issuing the security is called the issuer.
 What specifically qualifies as a security is dependent on the regulatory structure in a
country.
For example private investment pools may have some features of securities, but they may
not be registered or regulated as such if they meet various restrictions. Securities may be
represented by a certificate or, more typically, by an electronic book entry. Certificates
may be bearer, meaning they entitle the holder to rights under the security merely by
holding the security, or registered, meaning they entitle the holder to rights only if he or
she appears on a security register maintained by the issuer or an intermediary.
They include shares of corporate stock or mutual funds, bonds issued by corporations or
governmental agencies, stock options or other options, limited partnership units, and
various other formal investment instruments that are negotiable and fungible. Financial
regulators, such as the Securities and Exchange Commission, oversee the capital markets
in their respective countries to ensure that investors are protected against fraud.

Who are the principal suppliers and demanders of funds in the money market and the
capital market?

In the money market, commercial banks are the most important institutional supplier of
funds (lender) to both business firms and governments. Non financial business
corporations with temporary cash surpluses also provide substantial short-term funds to
the money market. On the demand-for-funds side, the largest borrower in the money
market is the Treasury Department, which borrows billions of Birr frequently. Other
governments around the world are very often among the leading borrowers in their own
domestic money markets. The largest and best-known corporations and securities dealers
are also active borrowers in money markets around the world. Due to the large size and
strong financial standing of these well-known money market borrowers and lenders,
money market instruments are considered to be high-quality ,”near money” IOUs
(promises to pay).

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Quite the reverse, the principal suppliers and demanders of funds in the capital market
are more varied than in the money market. Families and individuals, for example, tap the
capital market when they borrow to finance a new home. Governments rely on the capital
market for funds to build schools and highways and provide essential services to the
public.

Ranged against these many borrowers in the capital market are financial institutions,
such as insurance companies, mutual funds, security dealers, and pension funds that
supply the bulk of capital market funds.
The money market and the capital market may be further subdivided into smaller
markets, each important to selected groups of demanders and suppliers of funds. Within
the money market, for example, is the huge Treasury bill market. Treasury bills-short-
term IOUs issued by many governments around the world-are a safe and popular
investment medium for financial institutions, corporations of all sizes, and wealthy
individuals.
Somewhat larger in volume is the market for certificates of deposit (CDs) issued by the
best known banks and other depository institutions to raise funds in order to carry on
their lending activities. Two other important money market instruments that arise from
large corporations borrowing money are bankers’ acceptances and commercial papers. In
another corner of the money market, federal funds-the reserve balances of banks plus
other immediately transferable monies-are traded daily in huge volume. Another segment
of the money market reaches around the globe to encompass suppliers and demanders of
short-term funds in Europe, Asia and Middle East. This is the vast, largely unregulated
Eurocurrency market, in which bank deposits denominated in the world’s major trading
currencies-for example, the dollar, the pound, and Euro-are loaned to corporations and
governments around the globe.
The capital market, too, is divided into several sectors, each having special characteristics.
For example, one of the largest segments of the capital market is devoted to residential
and commercial mortgage loans to support the building of homes and business structures,
such as factories and shopping centers. Households (individuals and families around the
world) borrow in yet another segment, using consumer loans to make purchases ranging
from automobiles to home appliances. There is also an international capital market for
borrowing by large corporations represented by Eurobonds and Euronotes.
Probably the best-known segment of the capital market is the market for corporate stock
represented by the major exchanges, such as the New York Stock Exchanges (NYSE) and
the Tokyo Exchanges, and a vast over the –counter (OTC) market including electronic
stock trading over the internet. No matter where it is sold, each share of stock (equity)
represents a certificate of ownership in a corporation, entitling the holder to receive any
dividends paid out of current earnings. Corporations also sell a huge quantity of corporate
notes and bonds in the capital market each year to raise long-term funds. These securities,
unlike shares of stock, are pure IOUs, evidencing a debt owed by the issuing company.

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2. Open versus Negotiated Markets
Another distinction between markets in the global financial system that is often useful
focuses on open markets versus negotiated markets. For example, some corporate bonds
are sold in the open market to the highest bidder and are bought and sold any number of
times before they mature and are paid off. In contrast, in the negotiated market for
corporate bonds, securities generally are sold to one or a few buyers under private
contract.
An individual who goes to his or her local banker to secure a loan for a new car enters the
negotiated market for auto loans. In the market for corporate stocks, there are the major
stock exchanges, which represent the open market. Operating at the same time, however,
is the negotiated market for stock, in which a corporation may sell its entire stock issue to
one or a handful of buyers.
3. Primary versus Secondary Markets
The global financial markets may also be divided into primary markets and secondary
markets. Primary Market, also called the new issue market, is the market for issuing new
securities. Many companies, especially small and medium scale, enter the primary market
to raise money from the public to expand their businesses. They sell their securities to the
public through an initial public offering. The securities can be directly bought from the
shareholders, which is not the case for the secondary market. The primary market is a
market for new capitals that will be traded over a longer period.
In the primary market, securities are issued on an exchange basis. The underwriters, that
is, the investment banks, play an important role in this market: they set the initial price
range for a particular share and then supervise the selling of that share. Investors can
obtain news of upcoming shares only on the primary market. The issuing firm collects
money, which is then used to finance its operations or expand business by selling its
shares. Before selling a security on the primary market, the firm must fulfill all the
requirements regarding the exchange. After trading in the primary market the security
will then enter the secondary market, where numerous trades happen every day.
The primary market accelerates the process of capital formation in a country's economy.
The primary market excludes several other new long-term finance sources, such as loans
from financial institutions. Many companies have entered the primary market to earn
profit by converting its capital, which is basically a private capital, into a public one,
releasing securities to the public. This phenomena is known as "public issue" or "going
public."
 There are three methods through which securities can be issued on the primary
market. These are:
 Rights issue,
 Initial Public Offer (IPO), and
 Preferential issue.
 A company's new offering is placed on the primary market through an initial public
offer.
Firms raise new capital in a primary market transaction by issuing new securities (stocks
or bonds) once and these securities subsequently trade in the secondary market forever.
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Initial public offering (IPO) is stock issued for the very first time to the public when a
company "goes public." The holders of these stocks can have the following rights:
Preemptive rights - on issuance of additional share allows existing investors to maintain
their ownership position (as a percentage) when new stock is issued. Without this right
investors would have their ownership interest diluted.
Rights of offering - allow existing stockholders to buy additional shares in the company at
a subscription price that is generally lower than the market price. Rational stock holders
will either exercise the right or sell it (those who let it expire will find out that the market
value of their remaining holding shrinks-the market price will almost certainly drop when
the rights are exercised since the subscription price is much lower than the market

In contrast, the secondary market deals in securities previously issued. Its chief function is
to provide liquidity to security investors-that is, provide an avenue for converting
financial instruments into ready cash. If you sell shares of stock or bonds you have been
holding for some time to a friend or call a broker to place an order for shares currently
being traded on the stock exchanges, you are participating in a secondary-market
transaction.
In other words, Secondary Market is the market where, unlike the primary market, an
investor can buy a security directly from another investor in lieu of the issuer. It is also
referred as "after market". The securities initially are issued in the primary market, and
then they enter into the secondary market. All the securities are first created in the
primary market and then, they enter into the secondary market. In other words,
secondary market is a place where any type of used goods is available. In the secondary
market shares are maneuvered from one investor to other. That is, one investor buys an
asset from another investor instead of an issuing corporation. So, the secondary market
should be liquid.
Secondary Market has an important role to play behind the developments of an efficient
capital market. It connects investors' favoritism for liquidity with the capital users' wish
of using their capital for a longer period. For example, in a traditional partnership, a
partner can not access the other partner's investment but only his or her investment in
that partnership, even on an emergency basis. Then he or she may breaks the ownership
of equity into parts and sell his or her respective proportion to another investor. This kind
of trading is facilitated only by the secondary market.
The volume of trading in the secondary market is far larger than trading in the primary
market. However, the secondary market does not support new investment. Nevertheless,
the primary and secondary markets are closely intertwined. For example, a rise in
security prices in the secondary market usually leads to a similar rise in prices on
primary-market securities, and vice versa. This happens because some investors will
switch from one market to another in response to differences in price or yield.
Furthermore, it is a market in which stocks once issued are traded –that is bought and
sold by investors. For example it includes the New York stock Exchange (NYSE), National
Association of Securities Dealers Automated Quotation (NASDAQ) and American Stock
Exchange (AMEX).
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  Secondary market for equity serves two purposes: marketability and Share price
valuation:
1. Marketability - allows buyers in the primary market to subsequently sell shares. It
would be hard to sell stock in primary market if there wasn't a secondary market.
2. Share price valuation - active trading in secondary markets establishes a true fair
market value of stock.
 Secondary Market further classified as: Dealer Market; Agency Market; Fully
Automated Trading system; and Stock Market Indexes.
A. Dealer Market – OTC (Over the Counter), dealer network, like NASDAQ, where
dealers ("market makers") specialize in buying/selling certain stocks. You are buying
(selling) the stock from (to) the dealer, not from (to) another investor, who holds the
stock in his/her account.
 Bid (dealer buys)
 Ask (dealer sells)
 Spread is the dealer's commission,
For e.g., $5(bid)-$5.05(ask), 1% spread.
If the market is very competitive; thus the spreads could be very lower. No limits on
the number of dealers/market makers for a certain stock, and no limit on the
number of stocks a dealer can trade.
B. Agency Market – Agencies like AMEX and NYSE are organized as "floor-broker /
specialist-market-maker" centralized trading systems, where face-to-face trading takes
place at a physical location/trading floor.
The broker takes a buy (sell) order from a client/investor/trader, and matches it with a
sell (buy) order from another client/trader. It is more of an auction market.
C. Fully Automated Trading system - It serves in the countries where trading is
completely automated. Quotations and trading takes place directly by computer.
Orders are filled faster, and very few people are needed to operate an exchange.

D. Stock Market Indexes-A Stock Market Index is composite value of a group of stocks
traded on secondary markets. Movements in a stock market index provide investors
with information on movements of a broader range of secondary market securities.
4. Spot versus Futures, Forward, and Option Markets
We may also distinguish between spot markets, futures or forward markets, and option
markets. A spot market is one in which assets or financial services are traded for
immediate delivery (usually within one or two business days). If you pick up the telephone
and instruct your broker to purchase X-Corporation shares at today’s price, this is a spot
market transaction. You expect to acquire ownership of X-Corporation shares within a
matter of minutes.
A future or forward market, on the other hand, is designed to trade contracts calling for
the future delivery of financial instruments. For example, you may call your broker and
ask to purchase a contract from another investor calling for delivery to you of Birr 1
million in government bonds six months from today. The purpose of such a contract

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would be to reduce risk by agreeing on a price today rather than waiting six months, when
government bond prices might have risen.
Finally, options markets also offer investors in the money and capital markets an
opportunity to reduce risk. These markets make possible the trading of options on selected
stocks and bonds, which are agreements (contracts) that give an investor the right to
either buy from or sell designated securities to the writer of the option at a guaranteed
price at any time during the life of the contract.
5. Debt versus Equity Markets:
The issue of Debt market and Equity market has become very important in the modern
day financial context as a lot of companies are in need of generating money that allows
them to execute a wide variety of financial activities like initiation, expansion and
acquisition. The question of equity and debt financing has been an important one for the
business establishments for a considerable period of time now.
Since it is necessary to have a continuous stream of finances coming in the company for
various purposes these financial options have become very important. Thus, it is obvious
that the business enterprises need to be aware of the various implications of these two
sources of financing and make a decision after carefully reviewing their own needs as well
as strengths and weaknesses.
Debt instruments are particular types of securities that require the issuer (the borrower)
to pay the holder (the lender) certain fixed dollar amounts at regularly scheduled intervals
until specified time (the maturity date) is reached, regardless of the success or failure of
any investment projects for which the borrowed funds are used.
An example of a debt instrument is a 30-year mortgage. In contrast, equity is a security
that confers on the holder an ownership interest in the issuer. There are two general
categories of equities: "preferred stock" and "common stock."
i. Common stock shares issued by a corporation are claims to a share of the assets of a
corporation as well as to a share of the corporation's net income -- i.e., the corporation's
income after subtraction of taxes and other expenses, including the payment of any debt
obligations. This implies that the return that holders of common stock receive depends on
the economic performance of the issuing corporation. Holders of a corporation's common
stock typically participate in any upside performance of the corporation in two ways:
by receiving a share of net income in the form of dividends; and
by enjoying an appreciation in the price of their stock shares.
However, the payment of dividends is not a contractual or legal requirement. Even if net
earnings are positive, a corporation is not obliged to distribute dividends to shareholders.
For example, a corporation might instead choose to keep its profits as retained earnings to
be used for new capital investment (self-financing of investment rather than debt or equity
financing). On the other hand, corporations cannot charge losses to their common stock
shareholders. Consequently, these shareholders at most risk losing the purchase price of
their shares, a situation which arises if the market price of their shares declines to zero for
any reason.
ii. Preferred stock shares are usually issued with a par value (e.g., $100) and pay a fixed
dividend expressed as a percentage of par value. Preferred stock is a claim against a
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corporation's cash flow that is prior to the claims of its common stock holders but is
generally subordinate to the claims of its debt holders. In addition, like debt holders but
unlike common stock holders, preferred stock holders generally do not participate in the
management of issuers through voting or other means unless the issuer is in extreme
financial distress (e.g., insolvency).
Who are the major players in financial markets?

By definition, financial institutions are institutions that participate in financial markets,

i.e., in the creation and/or exchange of financial assets. Those who play the decisive role in
the circulation of finance can be roughly classified into the following four categories:
"brokers;" "dealers;" "investment bankers;" and "financial intermediaries."
1. Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a
seller (or buyer) to complete the desired transaction. A broker does not take a position in
the assets he or she trades. That is, the broker does not maintain inventories in these
assets. The profits of brokers are determined by the commissions they charge to the users
of their services (either, the buyers, the sellers, or both). Examples of brokers include real
estate brokers and stock brokers.
Figure 5 (Diagrammatic Illustration of a Stock Broker)
Payment ----------------- Payment
------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares

Mishkin, 2004
2. Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take
positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer
to sell out of inventory rather than always having to locate sellers to match every offer to
buy.
Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make
profits by buying assets at relatively low prices and reselling them at relatively high prices
(buy low - sell high). The price at which a dealer offers to sell an asset (the "asked price")
minus the price at which a dealer offers to buy an asset (the "bid price") is called the bid-
ask spread and represents the dealer's profit margin on the asset exchange. Real-world
examples of dealers include: car dealers, dealers in Government bonds, and stock dealers.
Figure 6 (Diagrammatic Illustration of a Bond Dealer)
Payment ----------------- Payment
------------>| |------------->
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 Bond | Dealer | Bond
Buyer | | Seller
<-------------| Bond Inventory |<-------------
Bonds | | Bonds
-----------------
Mishkin, 2004
3. Investment Banks:
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs =
Initial Public Offerings) by engaging in a number of different activities. These activities
include: Advice; Underwriting; and Sales Assistance.
Advice: Advising corporations on whether they should issue bonds or stock, and,
for bond issues, on the particular types of payment schedules
these securities should offer;
Underwriting: Guaranteeing corporations a price on the securities they offer,
either individually or by having several different investment
banks from a syndicate to underwrite the issue jointly; and
Sales Assistance: Assisting in the sale of these securities to the public.
4. Financial Intermediaries:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial
institutions that engage in financial asset transformation. That is, financial intermediaries
purchase one kind of financial asset from borrowers -- generally some kind of long-term
loan contract whose terms are adapted to the specific circumstances of the borrower (e.g.,
a mortgage); and sell a different kind of financial asset to savers, generally some kind of
relatively liquid claim against the financial intermediary (e.g., a deposit account). Unlike
brokers and dealers, financial intermediaries typically hold financial assets as part of an
investment portfolio rather than an inventory for resale.
In addition to making profits on their investment portfolios, financial intermediaries make
profits by charging relatively high interest rates to borrowers and paying relatively low
interest rates to savers. Types of financial intermediaries include: Depository Institutions
(commercial banks, savings and loan associations, mutual savings banks, credit unions);
Contractual Savings Institutions (life insurance companies, fire and casualty insurance
companies, pension funds, government retirement funds); and Investment Intermediaries
(finance companies, stock and bond mutual funds, money market mutual funds).
Figure 7 (Diagrammatic Illustration of a Commercial Bank)
Lending by B Borrowing by B

deposited
------- funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- loan ------- deposit -------
contracts accounts

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 Loan contracts Deposit accounts
issued by F to B issued by B to H
are liabilities of F are liabilities of B
and assets of B and assets of H
NOTE: F=Firms, B=Commercial Bank, and H=Households
Mishkin, 2004

To sum up; the following are the basic functions of the financial markets:
Borrowing and Lending: Financial markets permit the transfer of funds
(purchasing power) from one agent to another for either investment or consumption
purposes.
Price Determination: Financial markets provide vehicles by which prices are set
both for newly issued financial assets and for the existing stock of financial assets.
Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.
Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
Liquidity: Financial markets provide the holders of financial assets with a chance to
resell or liquidate these assets.
Efficiency: Financial markets reduce transaction costs and information costs.
International, Domestic and Foreign Exchange Markets
II. International and Domestic Markets
Because of the globalization of financial markets throughout the world, a corporation is
not limited to raising funds in the financial market where it is domiciled. Globalization
means the integration of financial market throughout the world into a global financial
market. From the perspective of a given country, financial markets can be classified into
two markets: an internal market and an external market. The internal market is also
called the national market. It can be decomposed into two parts: the domestic market and
the foreign market. The domestic market is where issuers domiciled in the country issue
securities and where those securities are subsequently traded.
The foreign market of a country is where issuers not domiciled in the country issue
securities and where the securities are then traded. The rules governing the issuance of
foreign securities are those imposed by regulatory authorities where the security is issued.
For example, securities issued by non-Ethiopian corporations in the Ethiopia must comply
with the regulations set forth in Ethiopia securities law and other requirements imposed
by the other concerned parties.
To add some in other ways, a non-Japanese corporation that seeks to offer securities in
Japan, for example, must comply with Japanese securities law and regulations imposed by
the Japanese Ministry of Finance. The external market, also called the international
market, includes securities with the following distinguishing features:
(1) They are underwritten by an international syndicate,

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 (2) They are offered at issuance simultaneously to investors in a number of countries,
and
(3) They are issued outside the jurisdiction of any single country.
The international market is commonly referred to as the offshore market or, more
popularly, the Euromarkets. We refer to the collection of all these markets—the domestic
market, the foreign market, and the Euromarkets—as the global financial market. The
global financial market can be further divided based on the type of financial claim: equity
or debt. Several factors have lead to the better integration of financial markets throughout
the world. We can classify these factors as follows:
(1) Deregulation or liberalization of capital markets and activities of market
participants in key financial centers of the world;
(2) Technological advances for monitoring world markets, executing orders, and
analyzing financial opportunities; and,
(3) Increased institutionalization of capital markets. These factors are not mutually
exclusive.
Some market observers and compilers of statistical data on market activity refer to the
external market as consisting of the foreign market and the Euromarkets.
Motivation for Raising Funds Outside of the Domestic Market
There are four reasons why a corporation may seek to raise funds outside its domestic
market:
First, in some countries, large corporations seeking to raise a substantial amount of funds
may have no other choice but to obtain financing in either the foreign-market sector of
another country or the Euromarkets. This is because the fund-raising corporation’s
domestic market is not fully developed to satisfy its demand for funds on globally
competitive terms. Governments of developing countries have used these markets in
seeking funds for government-owned corporations that they are privatizing.

The second reason is that there may be opportunities for obtaining a reduced cost of
funding (taking into consideration issuing costs) compared to that available in the
domestic market. With the integration of capital markets throughout the world, such
opportunities have diminished. Nevertheless, there are imperfections in financial markets
throughout the world that prevent complete integration and thereby may permit a
reduced cost of funds. These imperfections, or market frictions, occur because of
differences in: security regulations in various countries, tax structures, and restrictions
imposed on regulated institutional investors, and the credit risk perception of the issuer.
In the case of common stock, a corporation is seeking to gain a higher value for its stock
and to reduce the market impact cost of floating a large offering.
The third reason to seek funds in foreign markets is a desire by corporate treasurers to
diversify their source of funding in order to reduce reliance on domestic investors. In the
case of common stock, diversifying funding sources may encourage investment by foreign
investors who have different perspectives of the future performance of the corporation.
Finally, a corporation may issue a security denominated in a foreign currency as part of
its overall foreign-currency management. For example, consider an Ethiopian corporation
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that plans to build a factory in a foreign country where the construction costs will be
denominated in that foreign currency. Also assume that the corporation plans to sell the
output of the factory in the same foreign country. Therefore, the revenue will be
denominated in the foreign currency. The corporation then faces exchange-rate risk: The
construction costs are uncertain in Ethiopian birr because during the construction period
the Ethiopian birr may depreciate relative to the foreign currency. Also, the projected
revenue is uncertain in Ethiopian birr because the foreign currency may depreciate
relative to the Ethiopian birr. Suppose that the corporation arranges debt financing for
the plant in which it receives the proceeds in the foreign currency and the liabilities are
denominated in the foreign currency. This financing arrangement can reduce risk because
the proceeds received will be in the foreign currency and will be used to pay the
construction costs, and the projected revenue can be applied to service the debt obligation.
III. Foreign Exchange Markets (FX)
Money represents purchasing power, but usually only in one country. Alternatively,
different countries have different currency and the settlement of all business transactions
within a country is done/ preferred local currency. For instance, $, £, or € have no
purchasing power in Ethiopia. The foreign exchange market provides a forum where the
currency of one country is traded for the currency of another country. Exchanging one
currency for another takes place in the FX market; (converting purchasing power from
one currency into another). The exchange rate is just the price of one currency in terms of
another currency. For instance, a rate of Br. 16.70 per US $ implies that one US dollar
costs Birr 16.70.
FX market deal with a large volume of funds and a large number of currencies belonging
to various countries. For this reason, FX market is not only worldwide market but also is
world's largest financial market. Though there are foreign exchanges markets in all
countries, London, New York and Tokyo are the nerve centre of foreign exchange activity.
FX is an OTC (over-the-counter) market. FX OTC market is international network of
bank currency traders, non bank dealers, FX brokers, linked by computers, phone lines,
telex machines, automated quotation systems, etc. The communication system of FX
dealers is extremely advanced, sophisticated and reliable.
Function and structure of FX markets
Trading in the foreign exchange market is mainly to facilitate international trade and
international investment - the buying and selling of foreign goods, services and financial
assets. Think of the three functions of money - unit of account, medium of exchange and
store of value. Foreign goods are usually priced in foreign currency - German wine/beer
is priced in euro for example. The unit of account is the euro; the medium of exchange is
the euro. American liquor distributors need euro to buy the German wine/beer. Also,
American investors may consider the euro as a better store of value than the US dollar.
They could buy a certificate of deposit from a German bank denominated in euro, instead
of putting money in a U.S. bank. Or American investors want to buy stock of a company
in UK, Brazil or Turkey. They need foreign currency to buy foreign assets.

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