INTRODUCTION

A financial market is a market in which financial assets (securities) such as stocks and bonds
can be purchased or sold. Funds are transferred in financial markets when one party purchases
financial assets previously held by another party. Financial markets facilitate the flow of funds
and thereby allow financing and investing by households, firms, and government agencies.

Financial markets transfer funds from those who have excess funds to those who need funds.
Those participants who receive more money than they spend are referred to as surplus units (or
investors). They provide their net savings to the financial markets. Those participants who
spend more money than they receive are referred to as deficit units. They access funds from
financial markets so that they can spend more money than they receive. Many individuals
provide funds to financial markets in some periods and access funds in other periods.

Financial markets include Primary as well as Secondary markets. Primary markets facilitate
the issuance of new securities. Secondary markets facilitate the trading of existing securities,
which allows for a change in the ownership of the securities.

FUNCTIONS OF FINANCIAL MARKETS

Financial markets play an important role in the allocation of scarce resources in an economy
by performing the following important functions: -

1. Accommodating Corporate Finance Needs: A key role of financial markets is to

accommodate corporate finance activity. Corporate finance (also called financial
management) involves corporate decisions such as how much funding to obtain and
what types of securities to issue when financing operations. The financial markets serve
as the mechanism whereby corporations (acting as deficit units) can obtain funds from
investors (acting as surplus units).

2. Accommodating Investment Needs: Another key role of financial markets is

accommodating surplus units who want to invest in either debt or equity securities.
Investment management involves decisions by investors regarding how to invest their
funds. The financial markets offer investors access to a wide variety of investment
opportunities, including securities issued by the government agencies as well as
securities issued by corporations.

3. Mobilisation of Savings and Channelling them into the most Productive Uses: A
financial market facilitates the transfer of savings from savers to investors. It gives
savers the choice of different investments and thus helps to channelize surplus funds
into the most productive use.
 4. Facilitating Price Discovery: You all know that the forces of demand and supply help
to establish a price for a commodity or service in the market. In the financial market,
the households are suppliers of funds and business firms represent the demand. The
interaction between them helps to establish a price for the financial asset which is being
traded in that particular market.

5. Providing Liquidity to Financial Assets: Financial markets facilitate easy purchase

and sale of financial assets. In doing so they provide liquidity to financial assets, so that
they can be easily converted into cash whenever required. Holders of assets can readily
sell their financial assets through the mechanism of the financial market.

6. Reducing the Cost of Transactions: Financial markets provide valuable information

about securities being traded in the market. It helps to save time, effort and money that
both buyers and sellers of a financial asset would have to otherwise spend to try and
find each other. The financial market is thus, a common platform where buyers and
sellers can meet for fulfilment of their individual needs.

(How Financial Markets Facilitate Corporate Finance and Investment Management)

INTERMEDIARIES IN FINANCIAL MARKETS

Since financial markets are imperfect, securities buyers and sellers do not have full access to
information. Individuals with available funds are not normally capable of identifying credit
worthy borrowers to whom they could lend those funds. In addition, they do not have the
expertise to assess the creditworthiness of potential borrowers. Financial institutions are needed
to resolve the limitations caused by market imperfections. They accept funds from surplus units
and channel the funds to deficit units. Without financial institutions, the information and
transaction costs of financial market transactions would be excessive.

Financial institutions can be classified as depository and non-depository institutions.

Role of Depository Institutions

Depository institutions accept deposits from surplus units and provide credit to deficit units
through loans and purchases of securities. They are popular financial institutions for the
following reasons: -
1. They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
2. They repackage funds received from deposits to provide loans of the size and maturity
desired by deficit units.
3. They accept the risk on loans provided.
4. They have more expertise than individual surplus units in evaluating the
creditworthiness of deficit units.
5. They diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could.

Commercial Banks
In aggregate, commercial banks are the most dominant depository institution. They serve
surplus units by offering a wide variety of deposit accounts, and they transfer deposited funds
to deficit units by providing direct loans or purchasing debt securities. Commercial bank
operations are exposed to risk because their loans and many of their investments in debt
securities are subject to the risk of default by the borrowers.

Savings Institutions
Savings institutions, which are sometimes referred to as thrift institutions, are another type of
depository institution. Savings institutions include savings and loan associations (S&Ls) and
savings banks. Like commercial banks, savings institutions offer deposit accounts to surplus
units and then channel these deposits to deficit units. Savings banks are similar to S&Ls except
that they have more diversified uses of funds. Over time, however, this difference has
narrowed. Savings institutions can be owned by shareholders, but most are mutual (depositor
owned). Like commercial banks, savings institutions rely on the federal funds market to lend
their excess funds or to borrow funds on a short-term basis.

Credit Unions
Credit unions differ from commercial banks and savings institutions in that they (1) are non-
profit and (2) restrict their business to credit union members, who share a common bond (such
as a common employer or union). Like savings institutions, they are sometimes classified as
thrift institutions in order to distinguish them from commercial banks. Because of the “common
bond” characteristic, credit unions tend to be much smaller than other depository institutions.
They use most of their funds to provide loans to their members.

Role of Non-Depository Financial Institutions

Non-depository institutions generate funds from sources other than deposits but also play a
major role in financial intermediation.
Finance Companies
Most finance companies obtain funds by issuing securities and then lend the funds to
individuals and small businesses. The functions of finance companies and depository
institutions overlap, although each type of institution concentrates on a particular segment of
the financial markets

Mutual Funds
Mutual funds sell shares to surplus units and use the funds received to purchase a portfolio of
securities. They are the dominant non-depository financial institution when measured in total
assets. Some mutual funds concentrate their investment in capital market securities, such as
stocks or bonds. Others, known as money market mutual funds, concentrate in money market
securities. Typically, mutual funds purchase securities in minimum denominations that are
larger than the savings of an individual surplus unit. By purchasing shares of mutual funds and
money market mutual funds, small savers are able to invest in a diversified portfolio of
securities with a relatively small amount of funds.

Securities Firms
Securities firms provide a wide variety of functions in financial markets. Some securities firms
act as a broker, executing securities transactions between two parties. The broker fee for
executing a transaction is reflected in the difference (or spread) between the bid quote and the
ask quote. The mark-up as a percentage of the transaction amount will likely be higher for less
common transactions, since more time is needed to match up buyers and sellers. The mark-up
will also likely be higher for transactions involving relatively small amounts so that the broker
will be adequately compensated for the time required to execute the transaction.

Insurance Companies
Insurance companies provide individuals and firms with insurance policies that reduce the
financial burden associated with death, illness, and damage to property. These companies
charge premiums in exchange for the insurance that they provide. They invest the funds
received in the form of premiums until the funds are needed to cover insurance claims.
Insurance companies commonly invest these funds in stocks or bonds issued by corporations
or in bonds issued by the government. In this way, they finance the needs of deficit units and
thus serve as important financial intermediaries. Their overall performance is linked to the
performance of the stocks and bonds in which they invest.

Pension Funds
Many corporations and government agencies offer pension plans to their employees. The
employees and their employers (or both) periodically contribute funds to the plan. Pension
funds provide an efficient way for individuals to save for their retirement. The pension funds
manage the money until the individuals with draw the funds from their retirement accounts.
The money that is contributed to individual retirement accounts is commonly invested by the
pension funds in stocks or bonds issued by corporations or in bonds issued by the government.
Thus, pension funds are important financial intermediaries that finance the needs of deficit
units.
 (Intermediaries in Financial Markets)

PARTICIPANTS IN FINANCIAL MARKETS

There are several other participants in financial markets apart from the intermediaries listed
above. They are as follows: -

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).

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.
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:

 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 form a syndicate to
underwrite the issue jointly;
 Sales Assistance: Assisting in the sale of these securities to the public.

Some of the best-known U.S. investment banking firms are Morgan Stanley, Merrill Lynch,
Salomon Brothers, First Boston Corporation, and Goldman Sachs.

Custodians: Custodians are organizations which are allowed to hold securities on behalf of
customers and carry out operations on their behalf. They handle both funds and securities of
Qualified Institutional Borrowers (QIBs) including FIIs.

Depositories: Depositories hold securities in demat (electronic) form, maintain accounts of

depository participants who, in turn, maintain accounts of their customers. On instructions of
stock exchange clearing house, supported by documentation, a depository transfers securities
from buyers to sellers’ accounts in electronic form.

Stock Exchanges: A Stock exchange is duly approved by the Regulators to provide sale and
purchase of securities by “open cry” or “on-line” on behalf of investors through brokers. The
stock exchanges provide clearing house facilities for netting of payments and securities
delivery. Such clearing houses guarantee all payments and deliveries. Securities traded in stock
exchanges include equities, debt, and derivatives.

Stock Market Regulator: Securities Exchange Board of India (SEBI) was set up in 1988 to
regulate the functions of securities market. It was set up with the main purpose of keeping a
check on malpractices and protecting the interest of investors. It was set up to meet the needs
of three groups: -
1. Issuers: For issuers it provides a market place in which they can raise finance fairly and
easily.
2. Investors: For investors it provides protection and supply of accurate and correct
information.
3. Intermediaries: For intermediaries it provides a competitive professional market.

STRUCTURE OF FINANCIAL MARKET

A financial market consists of two major segments: (a) Money Market; and (b) Capital
Market. While the money market deals in short-term credit, the capital market handles
the medium term and long-term credit.
 (Structure of Financial Market)

MONEY MARKET

The money market is a market for short-term funds, which deals in financial assets whose
period of maturity is up to one year. The money market does not deal in cash or money as such
but simply provides a market for credit instruments such as bills of exchange, promissory notes,
commercial paper, treasury bills, etc. These financial instruments are a close substitute of
money. These instruments help the business units, other organisations and the Government to
borrow the funds to meet their short-term requirement.

MONEY MARKET INSTRUMENTS

Following are some of the important money market instruments or securities.

1. Call Money: Call money is mainly used by the banks to meet their temporary
requirement of cash. They borrow and lend money from each other normally on a daily
basis. It is repayable on demand and its maturity period varies in between one day to a
fortnight. The rate of interest paid on call money loan is known as call rate.

2. Treasury Bill: A treasury bill is a promissory note issued by the RBI to meet the short-
term requirement of funds. Treasury bills are highly liquid instruments, that means, at
any time the holder of treasury bills can transfer of or get it discounted from RBI. These
bills are normally issued at a price less than their face value; and redeemed at face value.
So, the difference between the issue price and the face value of the treasury bill
represents the interest on the investment.
 3. Commercial Paper: Commercial paper (CP) is a popular instrument for financing
working capital requirements of companies. The CP is an unsecured instrument issued
in the form of promissory note. This instrument was introduced in 1990 to enable the
corporate borrowers to raise short-term funds. It can be issued for period ranging from
15 days to one year. Commercial papers are transferable by endorsement and delivery.
The highly reputed companies (Blue Chip companies) are the major player of
commercial paper market.

4. Certificate of Deposit: Certificate of Deposit (CDs) are short-term instruments issued

by Commercial Banks and Special Financial Institutions (SFIs), which are freely
transferable from one party to another. The maturity period of CDs ranges from 91 days
to one year. These can be issued to individuals, co-operatives and companies.

5. Trade Bill: Normally the traders buy goods from the wholesalers or manufactures on
credit. The sellers get payment after the end of the credit period. But if any seller does
not want to wait or in immediate need of money he/she can draw a bill of exchange in
favour of the buyer. When buyer accepts the bill, it becomes a negotiable instrument
and is termed as bill of exchange or trade bill. This trade bill can now be discounted
with a bank before its maturity. On maturity the bank gets the payment from the drawee
i.e., the buyer of goods. When trade bills are accepted by Commercial Banks it is known
as Commercial Bills. So, trade bill is an instrument, which enables the drawer of the
bill to get funds for short period to meet the working capital needs.

CAPITAL MARKET

Capital Market may be defined as a market dealing in medium and long-term funds. It is
an institutional arrangement for borrowing medium and long-term funds and which provides
facilities for marketing and trading of securities.
The market where securities are traded known as Securities market. It consists of two different
segments namely primary and secondary market. These have been explained below: -

PRIMARY MARKET

The Primary Market consists of arrangements, which facilitate the procurement of long-term
funds by companies by making fresh issue of shares and debentures. It is usually done through
private placement to friends, relatives and financial institutions or by making public issue.

SECONDARY MARKET

The secondary market known as stock market or stock exchange plays an equally important
role in mobilising long-term funds by providing the necessary liquidity to holdings in shares
and debentures. It provides a place where these securities can be encashed without any
difficulty and delay.
DISTINCTION BETWEEN CAPITAL MARKET AND MONEY MARKET

Capital Market differs from money market in many ways: -

1. Firstly, while money market is related to short-term funds, the capital market related to
long term funds.
2. Secondly, while money market deals in securities like treasury bills, commercial paper,
trade bills, deposit certificates, etc., the capital market deals in shares, debentures,
bonds and government securities.
3. Thirdly, while the participants in money market are Reserve Bank of India, commercial
banks, non-banking financial companies, etc., the participants in capital market are
stockbrokers, underwriters, mutual funds, financial institutions, and individual
investors.
4. Fourthly, while the money market is regulated by Reserve Bank of India, the capital
market is regulated by Securities Exchange Board of India (SEBI).

REFERENCES

1. Madura, J., (2016) Financial Markets and Institutions, 10th Edition, Cengage Learning.

2. Mishkin, F. S., & Eakins, S. G. (2006). Financial markets and institutions. Pearson
Education India.