FINANCIAL MARKETS

A Financial Market is an institution or arrangement that facilitates the exchange of financial assets. They are mechanisms in our society for converting public savings into investments such as buildings, machinery, infrastructure and inventories of goods and raw materials. This enables the economy to grow, new jobs to be created and living standards to rise.

Financial markets therefore perform the essential economic function of channelling funds from economic units which have surplus funds (net savers) to economic units with a net deficit of funds (investors). There are several
basic methods of classifying financial markets as follows:

1. A classification of the markets based on the type of instrument or service as follows:

  • Debt Markets
  • Equity Markets
  •  Financial services Markets

2. A broad classification that distinguishes between

  • Primary &
  • Secondary Markets

3. A classification of markets based on the term to maturity and liquidity of the instrument. This method categorizes financial markets into

  • Money Markets &
  • Capital Markets

4. A classification of markets according to when the financial instruments being traded will be delivered. This classification categorizes markets into:

  • Spot markets
  • Futures or forward markets
  • Option markets

5. A classification of markets into open and negotiated markets.

  • Auction market
  • Bourse
  • Over-the-counter market

6. Financial markets can also be classified in terms of the extent of financial intermediation involved in the sale of the financial instruments as follows:

  • Direct finance markets
  • Semi-direct finance markets
  • Indirect finance markets

3.1 Money markets and Capital markets

3.1.1 Money Markets
Money markets are financial markets that are used for the trading of short term debt instruments, generally those with original maturity of less than one year. The money market is the place where individuals and institutions with temporary surpluses of funds meet the needs of borrowers who have temporary fund shortages. Thus, the money markets enable economic units to manage their liquidity positions. For example, a security or loan with a maturity period of less than one year is considered a money market instrument. One of the principle 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.

2.1.2 Capital Markets
The capital market is designed to finance long-term investments by businesses, governments and households. Capital market instruments are mainly longer term debt securities (generally those with original maturities of more than one year) and equities. Examples include bonds and shares traded on the stock exchange.

2.1.3 Money market and Capital market financial instruments
A financial instrument is defined as, a claim against the income or wealth of a business firm, house hold or unit of government, normally represented by a certificate, receipt or other legal document, and which is usually created by the lending of money. Financial Assets are by therefore nature intangible assets e.g

  • Treasury Bills
  • Bonds
  • Shares

Financial assets have played the following roles:
1. Transfer funds from surplus units to deficit units to invest in intangible assets.
2. Transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds.

2.1.4 Money market instruments
They are short-term dated securities. Because of their short terms to maturity, they undergo the least price fluctuations and are therefore the least risky instruments. The following are examples of money market instruments;
1. Treasury Bills:

  • These are shot-term debt instruments issued by the government
  • They are issued in 3,-6,- and 12-month maturities to finance government activities
  • They pay a set amount at maturity and have no interest payments
  • Interest is covered by the fact that they are initially sold at a discount, that is, an amount lower than the amount they are redeemed at on maturity
  • They are the most liquid of all the money market securities because they are the most actively traded
  • Interest rates on T-bills are usually the anchor for all other money market interest rates
  • They re also the safest among the money market instruments because the chances of default are minimal (the government can always raise taxes or issue currency to pay off its debts)
  • T-bills are popular due to their zero default risk, ready marketability, and high liquidity.

Types of Treasury Bills
There are several types of bills that are issued by governments:

1. Regular series bills:

  • These are issued routinely every week or month in competitive auctions
  • They have original maturities of three months, six months and one year.
  • New three and six month bills are auctioned weekly,; one year bills are normally sold once each month

2. Irregular- series bills

  • These are issued only when the Treasury has a special cash need
  • They can be strip bills or cash management bills
  • Strip bills- these comprise of a package offering of bills requiring investors to bid for an entire series of different bill maturities.
  • Investors who bid successively must accept bills at their bid price each week for several weeks running

3. Cash Management bills
Consist simply of reopened issues of bills that were sold in prior weeks The reopening of a bill issue normally occurs when there is an unusual or unexpected Treasury need for cash

4. Commercial paper:

  • A commercial paper is a short-term debt instrument issued by large banks and well known corporations.
  • it promises to pay back higher specified amount at a designated time in the immediate future – say, 30days
  • Issuers of commercial paper sell the instrument directly to other institutions as a way of rising funds for their immediate needs instead of borrowing from banks
  • Commercial paper is a form of direct finance and therefore an instrument of financial disintermediation
  • Issuance of commercial paper is a cheaper way of raising funds for a firm than borrowing from a bank
  • A firm must be large and creditworthy enough for lenders to accept its paper
  • Funds raised from paper issue are mainly used for current transactions e.g. to purchase inventories, pay taxes, meet pay-rolls, e.t.c rather than capital transactions( long-term investments)
  • There is however a growing trend of corporations’ issuance of paper to raise bridging finance for long-term projects such as buildings, manufacturing assembly lines, e.t.c.
  • Commercial paper is mainly traded in the primary market
  • Opportunities for resale in the secondary market are limited, although some dealers redeem the notes they sell in advance of maturity and others trade paper issued by large finance companies and bank holding companies
  • Because of the limited resale possibilities, investors are usually careful to purchase those paper issues whose maturity matches their planned holding periods.

Types of commercial paper: There are two types:

Direct paper – issued directly to the investor, sold by large finance companies and bank holding companies that deal directly with the investor rather than using a securities dealer as an intermediary. Directly placed paper must be sold in large volume to cover the substantial cost of distribution ad marketing.

Dealer paper – also known as industrial paper dealer is usually issued by security dealers on behalf of their corporate customers.

1) It is mainly issued by non-financial companies as well as smaller bank holding companies and finance companies who borrow less frequently than firms issuing direct paper.
2) The issuing company may sell the paper directly to the dealer, who buys less discount and commissions and then attempts to resell it at the highest possible price in the market.
3) Alternatively, the issuing company may carry all the risk, with the dealer only agreeing to sell the issue at the best price available less commission, referred to as a best effort basis.
4) Another method that may be used is the open-rate method in which the borrowing company receives some money in advance but the balance depends on how well the issue sells in the open market.

Maturity of Commercial Paper:

  • Maturities of commercial paper ranges from three days (‘weekend paper’) to nine months
  • Most commercial paper notes carry an original maturity of 60 days or less, with an average maturity ranging from 20 to 45 days
  • Yields of commercial paper are calculated by the bank discount method
  • Just like with treasury bills, most commercial paper is issued at par, where by the investor yield is arises from the price appreciation of the security between its purchase date and maturity date.

Advantages of Issuing Commercial paper

  1. It is a cheaper method of raising funds for a company because the interest rate is generally lower than bank loans
  2. Interest rates are usually more flexible than for bank loans
  3. It is a quicker method of raising funds either through a dealer or direct finance. Dealers usually keep in close contact with the market and generally know where funds may be found quickly
  4. Generally large amounts of funds may be borrowed more conveniently than through say, bank loans mainly because there are legal restrictions concerning the amount of money that a ban can lend to a single company.
  5. The ability to issue commercial paper gives a company considerable leverage when negotiating with banks.

2.1.5 Capital market instruments

These are debt and equity instruments which have maturities greater than one year. They have far wider price fluctuations than money market instruments ad are considered to be fairly risky investments.

The most common capital market instruments in use include:
1. Corporate Stocks
2. Mortgages
3. Corporate bonds
4. Marketable long-term Government securities
5. State and Local government bonds
6. Bank Commercial loans
7. Consumer Loans

1. STOCKS
These are equity claims on the net income and assets of a corporation. They confer on the holder, a number of rights as well as risks. There are two types of Corporate stocks:

  • Common stock &
  • Preferred (or preference) shares

Common Stock

  • Most important form of corporate stock
  • It represents residual claim against the assets of the issuing firm
  • Entitles the owner to share in the net earnings of the firm when it is profitable and to share in the net market value (after all debts are paid) of the company assets if it is liquidated.
  • Stock holders risk exposure is limited to the extent of investment in the company
  • If a company with outstanding shares of common stock is liquidated, the debts of the firm are paid first from the assets available, then preferred stock holders are paid their share and whatever remains is distributed among the common stock holders on a pro-rata basis
  • The volume of stock that a corporation may issue is known as the Authorised share capital and additional shares can only be issued by amending the Articles and Memorandum of Association with the approval of current stock holders in a general meeting
  • The level of a company’s authorized share capital is usually a reflection of their need for equity capital and also their desire to broaden he ownership base.
  • The par value of common stock is usually an arbitrarily assigned value printed o each stock certificate and its usually low relative to the stock’s current market value.
  • The rights of common stock shareholders include:
  • Right to elect the company’s board of directors, which in turn chooses the officers responsible for the day to day running of the company
  • Pre-emptive right (unless specifically denied by the articles and memorandum of association) to purchase any new stock issued by the firm in order to maintain a pro-rata share of ownership.
  • Right of access to the minutes of stock holders’ meetings and to lists of existing shareholders.
    Note: some companies issue classified shares, e.g class A and B whereby class B shares have no voting rights.

Preferred Stock

  • These carry a stated annual divided stated as a percentage of the par value e.g. a 8% preference share is entitled to 8% divided on each share held provided the company declares a divided
  • They occupy the middle ground between debt and equity including the advantages and disadvantages of both instruments used in raising long-term finance.
  • In case of liquidation, they are paid after other creditors but before equity holders
  • They have no voting rights
  • They can be cumulative– meaning the arrearage of dividends must be paid in full before common stock holders receive anything or participate- meaning they allow the holder to share in the residual earns accruing to common stock holders. Most are however non-participative
  • Some preferred stocks are convertible into shares of common stock a the investor’s option

Recent developments in the area of preferred stocks include development of:

  • Variable rate preferred stock: These carry a floating divided rate that makes the stock a substitute or short-term debt. Many allow their divided rate to be reset several times during the year, which ma be accomplished by a marketing
    agent or via a special auction.
  • Dutch auction preferred shares: whereby stock buyers submit bids and the highest priced bid becomes the price paid by all winning bidders. Frequently the divided rate has a ceiling rate based on a key market reference rate such as the yield on commercial paper.
  • Preference shares with an exchange option , giving the issuing company the choice of exchanging the preferred stock for debt securities
  • “MIPS” or Monthly income preferred shares which are counted as equity but carry tax deductible interest payments like debt
    Preferred shares represent an intermediate investment between bonds and common stock.
    They provide more income than bonds but a greater risk
    They fluctuate more widely than bond prices for the same change in interest rates
    Compared common stock, preferred shares generally provide less income but are in turn less risky.

2. Mortgages

  • These are loans to house holds or firms to purchase housing, land or other real structures where the structure or land it self serves as collateral for the loans.
  • Interest cost of home mortgages is tax deductible
  • Mortgages can be residential mortgages (loans secured by single family homes and other dwelling units) and non-residential mortgages which are secured by business and firm properties.

3. Corporate bonds

  • These are long-term bonds issued by corporations with very strong credit ratings.
  • They are mainly instruments used to raise long-term finance for businesses
  • They are mainly in form of corporate notes or corporate bonds.
  • A note is a corporate debt whose maturity is five years or less
  • A bond, on the other hand, carries an original maturity of more than five years.
  • A typical corporate bond pays interest at specific intervals, commonly half yearly, with the par or face value of the bond becoming payable when the bond matures
  • Each bond is accompanied by an indenture, a contract listing the rights and obligations of both the borrower and investor.
  • Indentures usually contain restrictive covenants designed to protect holders against actions by a borrowing firm or its shareholders that might weaken the value of the bonds. Examples of restrictions include covenants that prohibit increases in a borrowing corporation’s divided rate (which would reduce the growth of its net worth), limit additional borrowing, restrict merger arrangements or limit the sale of the borrower’s assets.
  • Bonds can either be term bonds- meaning bonds in a particular issue mature on a single date or serial bonds which carry a range of maturity dates. Most bonds issued by the state and local governments are serial bond
  • Most corporate bonds carry call privileges, allowing early redemption if market conditions prove favourable.
  • Some bonds are however increasingly being issued without call privileges due to the trend toward shorter maturities, the added interest cost involved, and the availability of hedging instruments
  • Many corporate bonds are backed by sinking funds designed to ensure that the issuing company will be able to pay off the bonds when they come due. Periodic payments are done into the fund on a schedule usually related to the depreciation of any assets supported by the bonds.

Common types of Corporate Bonds

  • Debentures: not supported by any specific asset of the issuing corporation
  • Subordinated Debentures: also known as a junior security _ holders are paid only after all secured and unsecured senior creditors are paid in case of liquidation,
  • Mortgage Bonds: these are debt securities representing a claim against specific assets owned by a corporation. They could be closed end or open end mortgage bonds. Closed end bonds o not permit the issuance of any additional debt against the assets pledged under the mortgage. Open end bonds on the other hand allow additional debt to be issued against the pledged assets,
    which may dilute the position of current bond holder. For this reason, openend bonds typically carry higher yields than closed-end bonds
  • Collateral Trust bonds: these are debt instruments secured by stocks and bonds issued by governments and other corporations. Such a bond is really an interest in a pool of securities held by the bond issuer. The pledged securities are held in trust for the benefit of bond holders, although the borrowing company usually receives any interest and divided payments generated by the
    pledged securities, and retain voting rights on any stock pledged.
  • Income bonds: these are often used in corporate reorganizations and in other situations when a company is in financial distress. Interest on these bonds is paid only when income is actually earned. Holders however have a prior claim on earnings over both stockholders and holders of subordinated debentures
  • Equipment Trust Certificates: they resemble a lease in form. They are mostly used to acquire industrial equipment or rolling sock (such as railroad cars or airplanes).
  • Industrial Development bonds (IDBs): mostly issued by a local government borrowing authority to provide buildings, land or equipment to a business firm. Because the governments can borrow cheaper than private businesses, the lower debt costs may be passed to the firm as inducement to move to a new location, bringing jobs to the local economy. The business firm normally guarantees both interest and principal payments on IDBs by renting the buildings, land, or equipment at a rental fee high enough to cover debt service costs.
  • Pollution Control Bonds: these are used to aid private companies in financing the purchase of pollution control equipment. Local governments purchase pollution control equipment with the proceeds of a bond issue and lease that equipment to business firms
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