An Overview of the Financial System
A financial system transfers money from lenders to borrowers aligned by financial intermediaries that gather different securities and form portfolios with differing combinations of maturity, risk and return.
Financial intermediaries (banks, insurance companies, pension funds) perform an important economic function by transferring funds of the lenders to borrowers who invest them in real assets leading to higher levels of production.
Types of Markets
- Money markets are the markets for debt securities with maturities of one year or less.
- Capital markets are the markets for intermediate term and long-term debt and corporate stocks.
- Primary markets are markets in which corporations raise new funds. So newly issued securities are sold in the primary markets.
- Secondary markets are markets in which existing, previously issued securities are traded among investors.
Money Markets
The money market refers to trading short-term assets and funds between institutions and traders. Money market instruments have high liquidity so they can easily be converted into cash. They have also strong secondary markets, and short maturity. Money markets are dominated by the central bank and commercial banks, therefore they have low default and market risk.
Key features:
- Short-term debt instruments are traded (generally those with original maturity of less than one year)
- High volume of transactions
- Safety and liquidity are the main motives of investors
- Short-term debt instruments have smaller fluctuations in prices than long-term securities
Capital Markets
The capital market is the market in which longer-term debt and equity instruments are traded (generally those with original maturity of one year or greater). Capital market instruments have weak secondary markets, therefore they have low liquidity.
Capital markets are used primarily to sell financial products such as equities and debt securities. These products have long maturity, and high market risk.
Key features:
- Securities are held for long periods, so volume of transactions is relatively lower.
- High yield is the driving motive of the investors.
- No single institution dominates the capital market.
Capital markets are divided into two categories:
- Primary markets
- Secondary markets
Primary Markets
A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to investors. The primary markets for securities are not well known to the public. So Investment banks assist in the initial sale of securities in the primary market. They guarantee a price for a firm’s securities and then sells them to the public.
Secondary Markets
A secondary market is a financial market in which securities that have been previously issued. Secondary markets can be organized in two ways. One is to organize exchanges, the other is over-the counter market. The stocks of larger companies are traded in organize exchanges but the stocks of smaller firms are traded in over the counter markets.
Final Thoughts
Financial markets and financial intermediaries are a very important part of the financial system. They have the basic function of getting people together by moving funds from those who have a surplus of funds to those who have a shortage of funds. The key benefit to these markets is that they allow funds to move from people who lack productive investment opportunities to people who have such opportunities.
