Chapter Two: Financial markets

• Introduction
• Features of good Financial Market
• Organization of financial markets
• Financial Securities
• Stock Exchanges and their role
• Major Stock Markets/ exchanges
 Introduction
• There are numerous components of financial
systems. These are: Institutions, markets,
securities and services.
• These components are continuously interacted
with complex investment process, which is
affected by different determinates.
• Financial markets deal with stocks, bonds, notes,
mortgages, and other claims on real assets, as well
as with derivative securities whose values are
derived from changes in the prices of other assets.
 Introduction
• Securities market is a component of the wider
financial market where securities can be
bought and sold between subjects of the
economy on the basis of demand and supply.
• Security markets encompasses equity
markets, bond markets and derivatives.
 Introduction
A securities market is a system of interconnection between all
participants that provides effective conditions:
1. to attract new and fresh capital by means of issuance new
security (securitization)
2. to transfer real asset into financial asset,
3. to invest money for short or long term periods with the aim
of deriving profitability.
4. commercial function (to derive profit from operation on this
market)
5. price determination (demand and supply balancing, the
continuous process of prices movements guarantees to state
correct price for each security so the market corrects
mispriced securities)
 Introduction
6. Informative function (market provides all participants with
market information about participants and traded
instruments)
7. regulation function (securities market creates the rules of
trade, contention regulation, priorities determination)
8. Transfer of ownership (securities markets transfer existing
stocks and bonds from owners who no longer desire to
maintain their investments to buyers who wish to increase
those specific investments.
9. Insurance (hedging) of operations though securities market
(options, futures, etc.)
 Introduction
• A market is the means through which buyers and sellers
are brought together to aid in the transfer of goods
and/or services.
• The market need not have a physical location and does
not necessarily own the goods or services involved.
• For a good market, ownership is not involved; the
important criterion is the smooth, cheap transfer of
goods and services.
• In most financial markets, those who establish and
administer the market do not own the assets but simply
provide a physical location or an electronic system that
allows potential buyers and sellers to interact.
 Introduction
• They help the market function by providing
information and facilities to aid in the transfer of
ownership.
• Market can deal in any variety of goods and
services.
• For any commodity or service with a diverse
clientele, a market should evolve to aid in the
transfer of that commodity or service.
• Both buyers and sellers will benefit from the
existence of a smooth functioning market.
 Introduction
• In general financial market brings buyers and
sellers together to aid in the transfer of
financial instruments.
– Does not require a physical location.
– The market does not necessarily own the goods or services
involved.
– A market can deal in any variety of goods and services.
Characteristics of a Good Financial Market
 Marketability: refers to likelihood of being sold
quickly. The expected price should be fairly certain,
based on the recent history of transaction prices and
current bid-ask quotes.
• price continuity: which means that prices do not
change much from one transaction to the next unless
substantial new information becomes available.
• Depth: which means that numerous potential
buyers and sellers must be willing to trade with
securities (Many participants)
 Characteristics of a Good Financial Market
3. Low Transaction costs: Lower costs (as a percent of the value of the
trade) make for a more efficient market. Efficient market is defined as
one in which the cost of the transaction is minimal. This attribute is
referred to as internal efficiency.
4. Rapid adjustment to new information: Buyer or seller wants the
prevailing market price to adequately reflect all the information
available regarding supply and demand factors in the market.
• If such conditions change as a result of new information, the price
should change accordingly.
• Therefore, participants want prices to adjust quickly to new
information regarding supply or demand, which means that prices
reflect all available information about the asset.
• This attribute is referred to as external efficiency or informational
efficiency.
Organization of the Securities Market
– People and organizations wanting to borrow
money are brought together with those having
surplus funds in the financial markets.
– These markets may have a physical location or
may exist only as computer networks
– Markets vary in types of securities that are traded
and in the way securities are traded
 Organization of the Securities Market

• There are great many different financial markets in a developed

economy, each market deals with a somewhat different type of
instrument in terms of the instrument’s maturity and the assets
backing it.
• Different markets serve different types of customers, or operate in
different parts of the country.
• For these reasons, it is often useful to classify markets along
various dimensions:
• Security markets can be organized and classified in different forms.
 Organization of the Security Market
Financial markets can be classified in to the
following:
• Money vs. Capital markets (Based on
Maturity)
• Primary vs. Secondary markets (Based on
seasoning)
• Debt Vs equity market (nature of claims)
• Stock exchanges Vs. OTC (Base on fiscal
place)
 Organization of the Securities Market
Money vs. Capital markets.
• Money markets are the markets for short-term, highly
liquid debt securities like T-bills and commercial
papers.
• Capital markets are the markets for intermediate- or
long-term debt and corporate stocks.
• There is no hard and fast rule on this classification but
generally “short term” generally means less than one
year, “intermediate term” means one to five years,
and “long term” means more than five years.
 Organization of the Securities Market
• Securities market can be further classified as Primary
markets and Secondary market
Primary Market
• The primary market is where new issues of bonds, preferred stock,
or common stock are sold by government units, municipalities, or
companies to acquire new capital.
• Market where new securities are sold and funds
would go directly to issuing unit.
• Primary markets are security markets where new issues of
securities are traded.
• It is also called New Issue Market (NIM)
• Trades on the primary market raise fresh capital for firms
 Four types of secondary markets
1. Direct Search market
The secondary market that offers you the least amount
of price information is that in which the buyers and
sellers have to search each other out directly. For this
reason, this is called a direct search secondary
market.
Stocks that trade in direct search markets are the ones
people buy and sell so infrequently that a third party,
such as a broker or a dealer, has no incentive to
provide any kind of service to facilitate this trading
 2. Brokered Market
• When the trading of a specific stock becomes
sufficiently heavy, brokers begin to offer
specialized search services to market
participants. For a fee, called a brokerage
commission, brokers help find compatible
trading partners and negotiate acceptable
transaction prices for their clients
• brokered market is better than a direct search
market, a brokered market cannot guarantee
that orders will be executed promptly
 3. Dealers Market

• As the trading of a stock becomes even more active, some

market participants may begin to maintain bid and offer
quotations of their own.
• These traders become dealers.
• They buy and sell their own inventory at their own quoted prices.
• Dealer markets eliminate the need for time consuming searches
for trading partners, because investors know they can buy or sell
immediately at the quotes given by a dealer.
• The bid price is the highest price that someone is willing to pay
to buy shares of stock. This also means that this is the highest
price you can expect to get for your shares of stock when selling
them. It is always lower than the ask price.
 4.Auction Market

• an auction market is a place where anyone who

wants to buy and sell can go to.
• This is important because auction markets
virtually eliminate the expense of locating
compatible partners and bargaining for a
favorable price
Difference between Primary market and Secondary Market

Primary Market Secondary Market

1. Market for new securities 1. Market for existing securities.
2. No fixed geographical location 2. Located at a fixed place
3. Results in raising fresh resources 3. Facilitates transfer of
for the corporate sector securities from one corporate
investor to another.
4. All companies participate into 4. Securities of only listed companies
primary market can be traded at Stock exchanges.

5. No tangible form administrative 5. Has a definite administrative

set-up. Recognised set-up and a only by the services it renders
tangible form
6. Controlled by Stock Exchanges and 6. Subjected to control both from
the Companies Act .within and outside.
Organization of the Securities Market
Debt Vs Equity market:
 Debt market: is a market where debt instruments are
traded (eg Gov’t securities like treasury bill, treasury
notes and treasury bonds) corporate securities like
commercial papers, commercial notes, corporate
bonds.
– Debt market can be either money market or capital
market depending on the maturity of the instrument
being traded
 Equity market: is a market where equity instrument
like common stock and preferred stock are traded. All
equity market instruments are capital market
instruments.
 There is no as such short term equity instrument.
 Organization of the Securities Market

Spot vs. Futures markets.

• Spot markets: are markets in which assets are
bought or sold for “on-the-spot” delivery
(literally, within a few days).
• Futures markets: are markets in which
participants agree today to buy or sell an asset
at some future date. This is a market for
futures and options
Stock Exchanges Vs. OTC (Over the counter)
Over the counter (OTC) markets
• Over the counter communication are
electronic network of dealers all over the
world.
• Over-the-counter (OTC) market, involves
trading in stocks not listed on an organized
exchange.
 Participants in the Securities Market
1.Regulators
• The Company Law Board (CLB) administration
• The Department of Economic Affairs (DEA),
functioning of the financial markets as a whole.
• The Department of Company Affairs (DCA),
responsible for the administration of corporate
bodies.
• The Insurance Development and Regulatory
Authority (IRDA)
 Contd..
2. Stock Exchanges
A stock exchange is an institution where
securities that have already been issued are
bought and sold
3. Depositories
A depository is an institution which
dematerializes physical certificates and effects
transfer of ownership by electronic book
entries
 Contd..
4. Brokers
Brokers are registered members of the stock exchanges
through whom investors transact
5. Foreign Institutional Investors
Institutional investors from abroad who are registered
with SEBI to operate in the Indian capital market are
called foreign institutional investors
6. Merchant Bankers
Firms that specialise in managing the issue of securities
are called merchant bankers
 Contd.
7. Primary Dealers
Appointed by the RBI, primary dealers serve as
underwriters in the primary market and as
market makers in the secondary market for
government securities
8. Mutual Funds
A mutual fund is a vehicle for collective
investment. It pools and manages the funds of
investors.
 Contd
9.Custodians
A custodian look after the investment back office of a
mutual fund.
It receives and delivers securities, collects income,
distributes dividends, and segregates the assets
between schemes.
10. Registrars
Also known as transfer agent, a registrar is employed
by a company or a mutual fund to handle all
investor – related services
 contd
11. Underwriter
An underwriter agrees to subscribe to a given
number of shares (or any other security) in the
event the public subscription is inadequate.
The underwriter, in essence, stands guarantee
for public subscription
12. Bankers to an Issue :
The bankers to an issue collect money on behalf
of the company from the applicants.
 Contd..
13. Debenture Trustees: When debentures are issued by a
company, a debenture trustee has to be appointed to
ensure that the borrowing firm fulfills its contractual
obligations.
14. Venture Capital Funds: A venture capital fund is a pool
of a capital which is essentially invested in equity shares
or equity – linked instruments are unlisted companies.
15. Credit Rating Agencies : A credit rating agency assigns
ratings primarily to debt securities. (e.g. ICRA, CRISIL,
S&P, etc.)
 Financial Securities

• Financial Securities are financial instruments

traded in the financial markets. Various types of
securities are traded in the market.
• Securities are classified on the basis of return and
the source of issue.
• On the basis of return or income, securities may be
classified as fixed or variable income securities.
• In the case of fixed income securities, the income
is fixed at the time of issue itself. Bonds,
debentures, preference shares fall into this
category.
 Financial Securities
• In the case of variable income securities, the income
of securities vary from time to time.
• Common shares are typical examples of variable
income securities.
• By sources of issuer, securities may be classified as
government, semi government or corporate securities.
• Based on where they are traded: money market (T-Bill,
REPO, commercial paper etc.) and capital market
instruments (bond, debenture, common stocks,
preference stocks etc.))
END OF CHAPTER TWO