FINANCIAL SYSTEM IN PERSPECTIVE
Introduction
Saunders and Cornett (2001) define financial markets as structures through which funds flow. This definition off course encompasses both financial institutions (FIs) and capital markets as structures through which funds flow. Financial markets can be distinguished along two major dimensions
1.Primary markets Vs Secondary markets
a)primary markets
This are markets in which users (firms) rise funds through new issues of financial instruments such as stocks and bonds, Most such issues are arranged through investment banks-who serve as intermediaries between funds suppliers and users. Such intermediation is usually in the form of underwriting –(guaranteeing the issuing firm of a fixed price by buying the whole or part of the lot and selling it to investors at a higher price)
Primary markets financial instruments include equity issues by firms to be traded by the public for the first time (IPOs or initial public offers).
b) Secondary markets
Once financial instruments such as stocks are issued in the primary markets they are often traded in the secondary market. New investors buy from original investors. Examples include NYSE, AMEX, NASDAQ EASDAQ, LSE, NSE, JSE etc
Buyers of secondary market securities are economic agents (consumers, businesses & governments) with excess funds and sellers are economic agents with need for funds.
Exchange of funds between the sellers and buyers is usually through a securities broker who acts as an intermediary. In this case the original issuer of the security is not involved
In addition to stocks, secondary markets also offer bonds, mortgage backed securities, foreign exchange futures and options (derivatives) etc .Secondary markets offer investors liquidity and diversification benefits to investors and also lower transaction costs
Though security issuers are not involved directly in the transfer of funds in the secondary market they obtain information on the current market value of their instrument, this information allows issuers to evaluate how well they are using funds generated from the issue and provides information on how well subsequent offerings might fare in terms of raising additional money (and at what cost)
Money markets Vs Capital markets
Money markets
They trade in debt securities with maturities of one year or less. The short term nature of this nutriments means that fluctuations is their prices in the secondary market is quite minimal
They are usually traded is over the counter (OTC) – this markets have no specific location, rather transactions occur via phone lines, wire transfers and computer trading.
FIs & depository institutions e.g. commercial banks are required by central banks to maintain cash reserves as such excess is traded in these markets
Money market instruments examples – commercial paper, Treasury bills, Negotiable certificates of deposits etc
Capital markets
They trade in equity (stocks) and debt (bond) instruments with maturities in excess of one year. Given their longer maturities, these instruments experience wide price fluctuations in the secondary market than do money market instruments.
Examples of capital market instruments are corporate stocks, residential mortgages, commercial mortgages, corporate bonds; federal and local government bonds bank and consumer loans etc.
Characteristics/ Features of Financial Assets
i) Moneyness
Money is used as a medium of exchange or for settlement of transactions. Assets that can be transformed into money at little cost delay or risk (e.g. time and savings deposits and government securities) are referred to as near money. This property is the moneyness of the asset. It is a desirable property for investors.
ii)Divisibility and Denomination
This refers the minimum size in which a financial asset can be liquidated and exchanged for money. The smaller the size the more the financial asset is divisible. A deposit may be divisible to the last cent, but other financial assets have varying degrees of divisibility depending on their denominations (the dollar/ birr value that the assets will pay at maturity). In the US bonds come in $1000 denominations while commercial paper comes in $25000 denominations. Divisibility is desirable for investors but not borrowers.
iii) Reversibility
This refers to the cost of investing in a financial asset then getting out of it into cash again. It is commonly referred to as the turnaround cost or round-trip cost. This cost comes in the form of commissions for market makers, bid-ask spread and the time and cost of delivery of the asset if any. The bid-ask spread is mainly determined by the thickness or thinness (frequency of the transactions) of the market. A low turn around cost is clearly desirable property of a financial asset.
Cash flow
The return on an investment depends upon the cash distributions (e.g. dividends and expected selling price on shares; and the principle and coupons on bonds) that the asset will pay. Non cash payments (e.g. bonus shares and options) and inflation are also accounted for. When inflation is factored in, we have the real rate of return; otherwise we have the nominal rate of return if the effect of inflation is unaccounted for.
v) Term to maturity
This is the length of the period until the date at which the asset is scheduled to make it final payment or the owner is entitled to demand liquidation. Assets in which the creditor can demand payment at any time are called demand instruments, while those with no maturity e.g. the British Consul are called perpetual instruments. Financial assets may have various provisions that may either extend or shorten their maturity
vi) Convertibility
This is the ability if the financial asset to convert into other assets (either in the same or different classes) a bond may be converted into another bond, a corporate convertible bond into equity shares or preferred stock into common stock. The timing, costs and conditions for conversion are usually spelt out in the legal descriptions of the convertible instrument at the time it is issued
vii) Currency
Due to globalization and increasing integration of global financial system, and in the light of the freely floating and often volatile exchange rates among major currencies, the currency in which the financial asset will make cash flows is very important for investors.
Most assets are dominated one currency, the $, € or ¥ and investors must chose the assets with the currency feature in mind. Some issuers in an attempt to reduce the currency risk are issuing dual-currency instruments, which pay the interest and the principal in different currencies. The $ and the ¥ are the usually paired currencies in this cases.
viii) Liquidity
If the market for a financial asset is extremely thin and one must search for one in a very few suitable buyers, then the asset is said to be illiquid. Less suitable buyers including speculators and market makers may be easily located but will have to be enticed to invest in an illiquid asset
