Financial Markets and Financial Intermediaries

¶ … Financial Markets and Financial Intermediaries Exist:

Financial Markets:

Market is a term used in economics used to mean the combined of number of possible buyers and sellers of a commodity and the transactions which take place between them. Basically, this term is from time to time used for what are more strictly exchanges or organizations that aid the trade in financial securities such as stock or commodity exchange. A market can either be a physical location or an electronic system. While much trading of stocks takes place on an exchange, two corporations or people may agree to sell stock without using an exchange. Nonetheless, trading of both currencies and bonds is mostly on a bilateral basis regardless of people who are building electronic systems which are similar to stock exchanges.

The market where financial securities such as stocks, bonds and commodities e.g. precious metals are exchanged at efficient market prices is known as financial market. The efficient market prices mean the impartial price which replicates belief at combined speculation of all investors about the future viewpoint. In the financial markets, the buying and selling of stocks and bonds either takes place directly (i.e. between buyers and sellers) or by the medium of Stock Exchange. These financial markets can also be either domestic or international markets.

These financial markets are also defined as mechanisms which allow to buy and sell (or trade) financial securities. In economics, these markets enable the trade of financial securities which include stocks and bonds, agricultural goods and other fungible items at low costs and at prices which reflect the efficient market proposition.

It's important to note that financial markets have continued to advance over several hundred years and are usually undertaking steady innovation to improve liquidity. These markets also exist in two major categories which are general markets where many merchandise are traded and specialized markets where only one product is traded. Generally, markets work by placing many potential buyers and sellers in a central place and consequently making it easier for these buyers and sellers to find each other. A country's economy generally relies on the interactions between buyers and sellers. The starting point of financial markets is borrowers and lenders who have different roles as described below:

Borrowers:

The borrowers of the financial market are either individuals, privately owned companies, public firms, government and other local authorities such as municipalities. These individuals normally take short or long-term mortgage loans from banks for personal reasons including the purchase of property. The private companies on the other hand take short or long-term loans for the expansion of their businesses or upgrading their businesses infrastructure. Public Corporations such as the railway companies and postal services also take loans from financial markets to collect required money. To bridge the gap between government revenue and government spending, the government also takes loans from financial market. Finally, local authorities sometimes borrow the money on their own and sometimes the government borrows on their behalf ("Types of Financial Market," n.d.).

Lenders:

Investors in the financial market are commonly referred to as lenders. The invested money by lenders is used to fund or finance the requirements of borrowers. There are different forms of lenders' investments which help in generate lending activities. These types of investments include the depositing of money in savings bank accounts, paying of premiums to insurance companies, investing in the shares of various companies, investing in government bonds and the investment in pension and mutual funds.

In order to understand the main reasons why financial markets exist, we should first know the different types of financial markets which exist. These different types of financial markets are:

Capital Markets:

These markets consist of both the primary markets where newly issued bonds and stocks are traded and the secondary markets where the exchange of already existing bonds and stocks take place. These markets can also be divided into the bond market which provides financing through bond issuance and the subsequent trading in bonds and the stock market which offers the financing through shares or common stock issuance and the trading in shares. Regardless of the category, capital markets generally facilitate the raising of capital.

Money Markets:

These are markets used for short-term, highly liquid debt securities and they basically help the short debt financing and capital. Examples of money markets include bankers' acceptances, repos, flexible deposit certificates and treasury bills with a maturity of less than a year. The securities in the money markets are normally safe investments with relatively low interest rate returns which are most suitable for temporary cash storage or short-term financial needs (James 2008).

Derivatives Markets:

This is a major growth sector in the financial markets which has developed since the 1980s and 1990s. The derivative markets majorly trade in derivative products or derivatives in short. While stock prices, bond prices, currency rates, interest rates and dividends create risk by going up and down, derivatives are financial products which are used to control or ironically exploit risk. This kind of trading in the derivative products is known as financial economics.

The other types of financial markets in existence include foreign exchange markets for foreign exchange trading, insurance markets which facilitate the relocation of various risks, commodity markets that organize the trading of commodities and futures markets for provision of standardized forward contracts for future trading in products.

Reasons why Financial Markets Exist:

Being financial mechanisms which allow people to trade financial securities, commodities, and other fungible items at low costs of transactions, financial markets exist to facilitate three main things:

Raising of Capital:

Through capital markets, financial markets are essential for capital or fund raising. The financial markets majorly exist to help borrowers to find suitable lenders at a central place. The process of financing is also made easy by banks which act as intermediaries. These intermediaries or banks use the money saved and deposited by a group of people to give loans to other groups of people who may be in need of the money. While insurance companies and mutual funds also act as intermediaries, banks mainly provide financing in the form of loans and mortgages. On the other hand, more complicated transactions in the financial markets occur in the stock exchange. Here, a company can buy another company's shares, sell its own shares to raise funds or alternatively buy its own shares existing in the market.

Risks Management:

Financial markets achieve the transference of risks (which is the other main reason why they exist) through the derivatives markets. The risk management role of both the financial and non-financial institutions is taken care of by the derivatives markets. As a matter of fact, major financial and non-financial institutions are using forward or future contracts, swaps, options and other combinations of derivative for the purpose of managing risk and increasing returns. The growing market demand for risk management instruments in the economy has led to the growth of derivatives markets. However, if these derivative instruments are misused or a major fault occurs in the derivatives market, the economy suffers ("Meaning Derivatives Market," n.d.).

International Trade:

The third main reason why financial markets exist is to facilitate international trade through currency markets such as the foreign exchange markets. In these foreign exchange markets, relative prices of national units of account are determined. The prices of these various national units are important because nations around the globe trade with each other. Though some nations trade more than other nations, all nations do trade with others even illicitly. Due to the fact that barter trade is not practical in most circumstances, money is commonly used as the medium of exchange in international trade.

Nonetheless, in international trade, this money and units of account are always different depending on the country where someone is. Therefore, to facilitate transactions, the buyer normally exchanges his/her country's money for the money of the seller's country. A country can buy another country's goods at a cheap rate when its unit of account is stronger than that country's. This country can also buy many units of a foreign currency as long as its unit of account remains stronger. As a result, the country can import more goods from the other country (Wright, Quadrini and Hammes n.d.).

The currency markets are important because the key buyers and sellers of currency are the importers and exporters of commodities. The foreign exchange markets are significant because they determine a nation's economic health and the well-being of its citizens based on the strength of its currency against other currencies.

Financial Intermediaries:

Financial intermediaries are financial institutions which act as the mediator between investors and the firms which are raising funds. These financial intermediaries commonly known as financial institutions include banks, investment dealers, insurance companies, mutual and pension funds. The financial intermediation is a process that usually takes place when a financial intermediary borrows money from a source to loan to another source for the purposes of funding, investment or resources.

This type of financial assistance is essential in economic development and growth because the availability of these savings and earnings channels directly affects community's economy. The cost of these funds and funds availability continue to go down due to the competition taking place between these savings and earnings channels. The joining of two distinct parties in investing and growth through financial intermediaries is mostly completed via a financial institution supported by Federal Deposit Insurance Corporation (FDIC).

In the financial intermediation process, financial institutions play a key role by channeling monies from loans and savings to needs of individuals, businesses and governments. As individual persons and businesses save their monies at financial institutions, their accounts normally collect transaction or account maintenance fees. The transaction or account maintenance fees are in turn given to another investment opportunity. A clear example of this is that the money collected from a bank's patrons is used as the bank's money for loans or mortgages.

As mentioned earlier, banks are not the only types of financial intermediaries as other organizations can as well act as financial intermediaries. These financial institutions which can play the role of financial intermediaries can be divided into two major types i.e. The depository and non-depository institutions. Savings and loan depositories, credit unions and usual banks are examples of depository institutions while insurance companies, financial brokers, financial advisors, life insurance companies, mutual and pension funds are examples of the non-depository institutions (Lennon 2009).

Basically, insurance companies function in the same way i.e. money given to others to cover for losses or repairs based on the purchased insurance type is collected when a customer pays their monthly or seasonal insurance premium. It's important for these financial intermediaries to function with care and diligence because the monies used for investments belong to the customer. These monies should also be handled with loyalty and respect because it was earned from the institution's customers.

Reasons why Financial Intermediaries Exist:

Financial intermediation process is very significant to everyone and the reasons listed below are some main reasons why these intermediaries exist.

Provision of loans:

Being financial institutions which borrow money from savers and lend to individuals or firms, financial intermediaries simplify the lending and borrowing of money. Financial intermediaries help the growth of small businesses by loaning monies to these businesses for their successful operations. Being a third party in the lending process, a financial intermediary arrange for two or more parties within the same community to help each other in growth and expansion. Lenders or savers in a particular financial institution gain interest on their savings by allowing it to be used for loans. On the other hand, the financial intermediaries earn business from both sides of the agreement.

Without financial intermediaries, it would be difficult to equal small amounts of individual savings to the larger amounts of loans desired by borrowers. The difficulty in equaling the savings and loans would have also made borrowing to be a more difficult and tedious process.

Financial Advice:

The other main reason why financial intermediaries exist is for the purpose of financial advice to companies. For example, when a rapidly expanding company decides to publicly issue its stock through the Initial Public Offer (IPO), the company is greeted with increased scrutiny from financial intermediaries. A company normally goes for the IPO to quickly gain more capital for the success of the business. These intermediaries subject the company to increased scrutiny because by financing or structuring the loan, the financial institution becomes heavily invested. The financial intermediary also becomes responsible for promoting and facilitating the offering of the company's stock. Financial intermediaries also evaluate themselves to determine whether the intention for the IPO is worthy or profitable for them.