06-07-2012, 11:33 AM
Financial Markets and Institutions:
Financial Markets and Institutions.docx (Size: 89.66 KB / Downloads: 29)
Financial markets serve six basic functions. These functions are briefly listed below:
• Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.
• Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.
• Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.
• Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.
• Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.
• Efficiency: Financial markets reduce transaction costs and information costs.
In attempting to characterize the way financial markets operate, one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured.
Who are the Major Players in Financial Markets?
By definition, financial institutions are institutions that participate in financial markets, i.e., in the creation and/or exchange of financial assets. At present in the United States, financial institutions can be roughly classified into the following four categories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."
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). Examples of brokers include real estate brokers and stock brokers.
Diagrammatic Illustration of a Stock Broker:
Payment ----------------- Payment
------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares
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. Real-world examples of dealers include car dealers, dealers in U.S. government bonds, and Nasdaq stock dealers.
Diagrammatic Illustration of a Bond Dealer:
Payment ----------------- Payment
------------>| |------------->
Bond | Dealer | Bond
Buyer | | Seller
<-------------| Bond Inventory |<-------------
Bonds | | Bonds
-----------------
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.
Financial Intermediaries:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that engage in financial asset transformation. That is, financial intermediaries purchase one kind of financial asset from borrowers -- generally some kind of long-term loan contract whose terms are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to savers, generally some kind of relatively liquid claim against the financial intermediary (e.g., a deposit account). In addition, unlike brokers and dealers, financial intermediaries typically hold financial assets as part of an investment portfolio rather than as an inventory for resale. In addition to making profits on their investment portfolios, financial intermediaries make profits by charging relatively high interest rates to borrowers and paying relatively low interest rates to savers.