MODULE 2 – FUNDAMENTALS OF FINANCIAL STRUCTURES AND ORGANIZATIONS OF FINANCIAL

MARKETS MARKETS

FUNCTIONS OF FINANCIAL MARKETS PRIMARY MARKET

� In the primary market, investors buy securities

directly from the company issuing them, while
in the secondary market, investors trade
securities among themselves, and the company
with the security being traded does not
participate in the transaction.

� When investors purchase securities on the

primary capital market, the company offering
the securities has already hired an
underwriting firm to review the offering and
The arrows show that funds flow from lender-savers to created a prospectus outlining the price and
borrower-spenders via two routes: direct finance, in other details of the securities to be issued.
which borrowers borrow funds directly from financial � Companies issuing securities via the primary
markets by selling securities, and indirect finance, in capital market hire investment bankers to
which a financial intermediary borrows funds from obtain commitments from large institutional
lender-savers and then uses these funds to make loans investors to purchase the securities when first
to borrower-spenders. offered. Small investors are not often able to
Financial markets perform the essential economic purchase securities at this point, because the
function of channeling funds from households, firms, company and its investment bankers seek to
and governments that have saved surplus funds by sell all of the available securities in a short
spending less than their income to those that have a period of time to meet the required volume and
shortage of funds because they wish to spend more must focus on marketing the sale to large
than their income. investors who can buy more securities at once.
Marketing the sale to investors can often
Those who have saved and are lending funds, the include a "road show" or "dog and pony show,"
lender-savers, are at the left and those who must in which investment bankers and the
borrow funds to finance their spending, the borrower- company's leadership travel to meet with
spenders, are the right. potential investors and convince them of the
value of the security being issued.
The principal lender-savers are households, but
business enterprises and the government (particularly WHAT IS UNDERWRITING?
state and local government), as well as foreigners and
their governments, sometimes also find themselves � Underwriting is the process by which
with excess funds and so lend them out. investment bankers raise investment capital
from investors on behalf of corporations and
The most important borrower-spenders are governments that are issuing either equity or
businesses and the government (particularly the debt securities. The word "underwriter"
federal government), but households and foreigners originally came from the practice of having
also borrow to finance their purchases of cars, each risk-taker write his name under the total
furniture, and houses. amount of risk he was willing to accept at a
specified premium.
In direct finance, borrowers borrow funds directly
from lenders in financial markets by selling them IPO (Initial Public 0ffering)
securities (also called financial instruments), which are
claims on the borrower’s future income or assets. � IPOs can be complicated because many
Securities are assets for the person who buys them, but different rules and regulations dictate the
they are liabilities (IOUs or debts) for the individual or processes of institutions, but they all follow a
firm that sells (issues) them. general pattern:

Financial markets are critical for producing an efficient 1. 1. A company contacts an underwriting firm to
allocation of capital (wealth, either financial or determine the legal and financial details of the
physical, that is employed to produce more wealth), public offering.
which contributes to higher production and efficiency 2. A preliminary registration statement, detailing
for the overall economy. Indeed, when financial the company's interests and prospects and the
markets break down during financial crises, as they did specifics of the issue, is filed with the
during the recent global financial crisis, severe appropriate authorities.
economic hardship results, which can even lead to
dangerous political instability.
 The appropriate governing bodies must The Role of an Investment Banker
approve the finalized statement as well as a
final prospectus, which details the issue's price, 1. Identify risks associated with a
restrictions and benefits, and is issued to those project before the company moves
who purchase the securities. This final forward.
prospectus is legally binding for the company. 2. Gives advice on how best to plan their
SECONDARY MARKET development.

� The secondary market is where securities are 3. Serves as a facilitator between a

traded after the company has sold all the stocks company and investors when the
and bonds offered on the primary market. company wants to issue stock or bonds.

� Markets such as the New York Stock Exchange 4. Assists with pricing financial
(NYSE), London Stock Exchange or Nasdaq are instruments so as to maximize revenue
secondary markets. and with navigating regulatory
requirements.
� On the secondary market, small investors have
a better chance of buying or selling securities, Investment Bankers must:
because they are no longer excluded from IPOs  be very trustworthy.
due to the small amount of money they
represent. Anyone can purchase securities on  abide by their firm's stipulated code of conduct
the secondary market as long as they are and will generally sign a confidentiality
willing to pay the price for which the security is agreement.
being traded.
There is a typical hierarchy of positions
� On the secondary market, an investor requires in investment banking, which is as follows,
a broker to purchase the securities on his or from most junior to most senior: Analyst,
her behalf. The price of the security fluctuates Associate, Vice President, Senior Vice
with the market, and the cost to the investor President, Managing Director.
includes the commission paid to the broker.
The volume of securities sold also varies from MONEY MARKET AND CAPITAL MARKET
day to day, as demand for the security
MONEY MARKET
fluctuates. The price paid by the investor is no
longer directly related to the initial price of the  Money market - in which only short-term
security as determined by the first issuance, financial instruments are traded.
and the company that issued the security is not  Money markets are used for a short-term
a party to any sale between two investors. basis, usually for assets up to one year.
 Money markets are a good place to "park"
Investment Bankers
funds that are needed in a shorter time period
 An investment banker is an individual who - usually one year or less.
works in a financial institution that is in the  Instruments used in the money markets
business primarily of raising capital for include deposits, collateral loans, acceptances
companies, governments and other entities, or and bills of exchange.
who works in a large bank's division that is  Provide a variety of functions for either
involved with these activities, often called an individual, corporate or government entities.
investment bank.  Liquidity is often the main purpose for
accessing money markets.
 Investment bankers may also provide other  Plays a key role in ensuring companies and
services to their clients such as mergers and governments maintain the appropriate level
acquisition advice, or advice on specific of liquidity on a daily basis, without falling
transactions, such as a spin-off or short and needing a more expensive loan or
reorganization. In smaller organizations that without holding excess funds and missing the
do not have a specific investment banking arm, opportunity of gaining interest on funds.
corporate finance staff may fulfill the duties of  Investors, on the other hand, use the money
investment bankers. markets to invest funds in a safe manner.
 Considered low risk
 CAPITAL MARKET

 Capital markets are perhaps the most widely

followed markets. Both the stock and bond
markets are closely followed and their daily
movements are analyzed as proxies for the
general economic condition of the world
markets. As a result, the institutions operating
in capital markets - stock exchanges,
commercial banks and all types of
corporations, including non-bank institutions
such as insurance companies and mortgage
banks - are carefully scrutinized.
 Institutions operating in the capital markets
access them to raise capital for long-term
purposes
 The buyers, or the investors, buy the stocks or
bonds of the sellers and trade them.
 Investors are willing to take on more risk and
have patience to invest in capital markets
 Financial instruments used in capital markets
include stocks and bonds
 Offer higher-risk investments
 Offer higher returns