A Guide to Financial Markets

As we all know that this is the crucial period for first year and final year MBA students, we are starting
a series on financial markets to help you get instant information about what constitute financial
markets, what are the types of markets, who are the major players and what kind of financial
instruments are traded or exchanged in these markets. To begin with, we start with an overview of the
financial markets.

Financial Market: Exchange Money

Financial market is a market for the exchange of money. It brings together two kinds of people:
People who need money are Borrowers
Borrowers in the financial market can be individuals (who need money for personal consumption like
buying a house, car, etc.), private & public companies (which need funds for expansion, setting up
manufacturing facilities, launching a new product, R&D, etc.), governments and other local authorities
like municipalities (to spend on public service and infrastructure like roads, healthcare, sanitation).
People who have surplus money are Lenders
Lenders in the financial market are actually the investors who have extra funds and want to use the
additional money to earn more money. Their invested money is used to finance the requirements of
borrowers. In return the investors expect to earn in the form of interests, dividends, company
ownership, etc. Some of these types of investments are depositing money in bank accounts, paying
premiums to insurance companies, investing in shares of different companies, corporate bonds,
government bonds, pension funds, and mutual funds, etc. Let us take the example of bank deposits
and see how the extra funds flow from the lender to the borrower:

Let us assume X has surplus money with which he opens a fixed deposit in a bank. On the other
hand there is person Y who needs extra funds to buy a car. Y approaches the bank to borrow the
required funds. The bank which has taken fixed deposits from multiple customers like X puts together
the funds and lends it to Y in the form of an auto loan. In return the bank charges an interest on the
loan from Y and pays a part of it as interest earned to its customers (like X) who have a fixed deposit
with the bank. The difference of the interest earned from Y and paid to customers like X becomes the
revenue for the bank. This is how money flows from the lender (X) to the borrower (Y) through an
intermediary (Bank). Roles of intermediaries have been discussed in further details below.
Financial markets bring together borrowers & lenders
Financial market is a broad term describing any marketplace where buyers and sellers participate in
the trade of financial products such as equities, bonds, currencies and derivatives. A financial market
includes among others, the following:
Capital markets which include: Equity Markets, Credit Markets and Money Markets
Foreign exchange markets (Forex)
Commodity exchanges
Derivative markets
The list can be endless. Financial markets can be found in nearly every nation in the world. Some are
very small, with only a few participants, while others like the New York Stock Exchange (NYSE)
and the Forex markets trade trillions of dollars daily.
Functions of Financial Markets
Financial markets serve five 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 (by the lender) or consumption purposes (by the borrower).
Information Aggregation and Coordination: Financial markets act as collectors and aggregators of
information about financial product values and the flow of funds from lenders to borrowers. This is an
important function when it comes to transparency and results in better price discovery.
Price Determination: Financial markets provide the platform by which prices are set both for newly
issued as well as existing financial products. This function is similar to the way price mechanisms
work in other markets through demand and supply. A higher demand for a particular financial product
results in a higher price and vice versa. The price of financial products is also based on a variety of
factors viz., political developments, prices of commodity products, economic events, etc.
Risk Management: Financial markets allow a transfer of risk from one person to another. Examples of
risk sharing are present in foreign currency transactions, derivatives etc. If an exporter is worried
about the Indian Rupee appreciating, he can lock in the exchange rate by booking a forward contract.
This is just one of the various ways by which one can manage the risk.
Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate
these assets. For example, in the absence of efficient financial markets, Lender A would not be
comfortable in investing his excess funds in buying shares of company X (any other company). While
he would want to invest his money and earn high returns, he is not sure whether he will be able to find
a buyer to sell off his shares if the need arises to liquidate (convert his assets to cash). This is
because there is no market to bring the buyer and seller together. As an outfall of this, Company X
which needs the funds will not be able to raise the same, which in turn will impact whatever growth

plan it had (whatever it was going to use the funds for). Thus the transfer of funds from lender to
borrower will cease and in turn affect overall economic growth.
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.

The Key Players in Financial Markets

In continuation to our previous publication covering Overview of the Financial Markets , we now look
at the key players in financial markets, their structures, differences and role of each participant in
detail.

Key Players in Financial Markets: Roles

There are various kinds of participants in financial markets who assume different kinds of roles. They
may be issuers, investors or other intermediaries. Some of the prominent ones have been provided
below.
Issuers
Markets bring together buyers and sellers: either directly or through intermediaries. In this context, the
seller is called the issuer and the price of what is sold is called the Issue price. There are two broad
categories of issuers in financial markets; government (including municipal bodies and governmental
agencies) and corporates.
Governments and municipal bodies need money to spend on public goods : roads, defense, health,
social security and so on : and they generally face a fund deficit. They can not issue equity- you can
not take an ownership interest in a government and so apart from taxation and selling public assets
(privatization) , borrowing money is one of the options. Governments generally cannot borrow directly
from consumers.
So, central government securities (primarily debt securities like bonds) are issued and traded in a
wholesale market through financial intermediaries.
Corporates are legal entities (such as an association, turn, government, government agency,
institution) identified by a particular name. They sell three categories of investment propositions in the
primary market:

Short-term debt (less than one year)

Long-term debt (more than one year)
Equity

Investors
Investors are the lenders in any market. Investors can be of two kinds:
Retail Investors
Retail investors: Retail investors are those individuals who participate in markets for their personal
account and not for another company or organization.
Institutional Investors
Institutional investors: An institutional investor is an entity, company, mutual fund, insurance
corporations, brokerage, or other such group that has a large amount of money or assets to invest.
These firms typically represent investors who might be retail or other firms.
Financial Intermediaries
These are institutions or individuals which facilitate to channel funds between surplus and deficit
agents and thus often act as middlemen.
Bank
A Bank is a financial institution which:

Accepts demand and time deposits

Provides loans to individuals and organizations, and
Provides services such as documentary collections, international banking, trade financing.

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 in 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 (the buyers, the sellers,
or both).

For example, if seller X wants to sell 100 shares of Reliance but does not know where to find a buyer
who will be willing to buy 100 shares at the price he is offering, X can contact a broker. The broker will
find a seller who is willing to buy 100 shares of Reliance at the price being offered. Once the
transaction is completed the broker will get a commission for brokering the deal. However the broker
will not hold any inventories i.e., the broker will not buy shares either from the market or from other
sellers and hold them till he gets a buyer to offload the same. If contacted by a buyer or seller, he will
have located a corresponding buyer or seller to complete the transaction.
Dealers
The Dealer
Like brokers, dealers facilitate trade by matching buyers with sellers of assets. Unlike brokers,
however, a dealer can and does take positions (i.e., maintain inventories) in the assets he trades.
This permits the dealer to sell out of inventory rather than always having to locate sellers to match
every offer to buy. Unlike brokers, dealers do not receive sales commissions. Dealers make profits by
buying assets at a price which is lower than the price at which they are sold.
The price at which a dealer offers to sell an asset is called as the offer price or ask price. The price at
which a dealer offers to buy an asset is called as the bid price. The difference between the bid price
and ask price is called the bid-ask or the bid-offer spread and represents the dealer profit margin.
Mutual Funds
You can think of a mutual fund as an organization that brings together a group of people and invests
their money in stocks, bonds, and other securities. Each investor owns units, which represent a
portion of the holdings of the fund. In a mutual fund, the financial risk of the investment belongs to the
investor. The fund charges a small fee for managing the fund.
Investment Banks

An investment bank primarily conducts following functions:

Provides advice to clients: Advising corporations on various aspects during mergers & acquisitions
as well as capital structures. Advising on capital structures includes advice on whether they should
raise capital by issue of bonds or stock, or any other mezzanine structures. They charge the client
fees for their advisory role.
Helps clients raise money: It assists in the initial sale of newly issued securities by engaging in
different activities:
Assistance in legal and procedural formalities: Before securities are issued, there are a lot of legal
formalities which need to be carried out. These include preparing the prospectus, submitting the same
to the regulator, book running, etc.
Advice on pricing: Investment bankers help the issuer get an optimum price for the security which is
being issued.
Underwriting: Guaranteeing corporations that the securities on offer will be fully subscribed to. This
is in return for what is called as underwriting fees. For example, if company A wants to go public, it
can directly go to the end investors with their shares. However there is no guarantee that it will be
able to find investors who are willing to buy their shares (especially if the company is not well known
or new). Here the investment bank steps in and agrees to buy all the shares at an agreed price if
people do not subscribe to the same. They will then sell these shares in the market (using their
distribution chain) for a higher price making a profit on the margin.
Market Makers
A market maker is an intermediary who is willing and ready to buy and sell securities. The market
maker provides a two way quote in the market, thus creating a market for the securities.
Let us imagine a hypothetical situation where there is only one buyer and one seller for security X on
any given day. If this security is traded on the exchange, and the exchange is open for 6 hours, then
for the trade to happen, the buyer and seller need to meet at a common time on the exchange If the
timing does not match, then the trade will not take place, even though a buyer and a seller exist for
the security.
It is in these cases that a market maker is useful. By providing a two way quote, he buys from the
seller and later during the day, he sells the securities to the buyer, thus creating a market. The market
maker earns from the Bid-Ask spread. The more liquid the security, the narrower is the Bid-Ask
spread. Thus market makers help to create liquidity and efficiency in the market.
Infrastructure Providers
Stock Exchanges
Stock is a share in the ownership of a company. Stock represents a claim on the company assets and
earnings. Whether you say shares, equity or stock, it all means the same thing.
Most stocks are traded on exchanges. Exchanges are places where buyers and sellers meet and
decide on a price. Retail Investors get access to the exchanges through brokers, who are members of
the exchange. Some of the major exchanges in the world are the New York Stock Exchange,
NASDAQ, Bombay Stock Exchange, etc.
Some exchanges are physical locations where transactions are carried out on a trading floor. The
other type of exchange is a virtual kind; composed of a network of computers where trades are made
electronically. The purpose of a stock market is to facilitate the exchange of securities between
buyers and sellers. Actual trades are based on an auction market model where a potential buyer bids
a specific price for a stock and a potential seller asks a specific price for the stock. (Buying or selling
at market means you will accept any ask price or bid price for the stock, respectively.) When the bid
and ask prices match, a sale takes place.
Depositories
A bank or company which holds securities deposited by others, and where exchanges of these
securities take place is defined as a depository. It can also be defined as an organization where the
securities of an investor are held in electronic form, at the request of the investor through the medium
of a Depository Participant.

A depository can be compared to a bank for shares. Just as a bank holds cash in your account and
provides all services related to the transaction of cash, a depository holds securities in electronic form
and provides all services related to transaction of shares / debt instruments. A depository interacts
with clients through a Depository Participant (DP) with whom he client has to maintain a Demat
Account. When a transaction happens in the security exchange, the depository is instructed to
transfer the shares from the sellers account to the buyers account (this is similar to the payment
process in a bank where the payment is transferred from the buyers account to the sellers account).
Clearing House
A clearing house takes responsibility for settling the obligations for the respective counter-parties on
maturity of the trades as well as during their tenure. This ensures that trades done through exchanges
have a very low settlement risk.
Information Providers
Information providers provide live and historical quotes for all exchanges, newsroom information,
technical charts, financial analyses, etc. Reuters and Bloomberg are major information providers
across the world for financial data. Live information on prices and market movements helps to make
the markets more transparent by providing reliable information to investors, on the basis of which they
can take decisions.
Regulators
A regulator is an official or body that monitors the behavior of companies and the level of competition
in particular markets. Financial regulations are a form of regulation or supervision, which subjects
market participants to certain requirements, restrictions and guidelines, aiming to maintain the
integrity of the financial system.
Securities & Exchange Commission (SEC)
The US Securities and Exchange Commission (commonly referred to as SEC is an independent
agency which holds primary responsibility for enforcing the federal securities law/and regulating the
securities industry, the nations stock and options exchanges, and other electronic securities markets
in the United States. Similarly, regulators are present m different countries like the Financial Services
Authority (FSA) in UK and the Securities Exchange Board of India (SEBI) in India.
The SEC oversees the key participants in the securities world, including securities exchanges,
securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is concerned
primarily with promoting the disclosure of important market related information, maintaining fair
dealing, and protecting against fraud.
The Federal Reserve
The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the
central banking system of the United States. Other central banks around the world include the
Reserve Bank of India in India, Bank of England in England. Its functions fall under four major areas:
Formulating and implementing the nations monetary policy
Supervising and regulating banking institutions to ensure the safety and soundness of the nations
banking and financial system, and protecting the credit rights of consumers.
Maintaining stability of the financial system and containing systemic risk that may arise in financial
markets.
Providing financial services to depository institutions, the US government, and foreign official
institutions including playing a major role in operating the nations payments system.
Rating Agencies
A credit rating agency is an organization that rates the ability of a person or company to pay back a
loan. These are independent professional firms that conduct in depth research on companies and
securities issued by them. The rating given by a credit rating agency is important because it affects
the perceived risk element incorporated into interest rates that are applied to loans. For example, if
the bonds of company A have a low rating then the company will have to give a higher interest payout
on these bonds in order to compensate for the risk an investor takes by investing in a bond with low
rating (indicating higher risk of default by issuer).
Ratings are done at three levels:

Firm level rating: Rating of the entity itself

Rating of it long-term debt
Rating of its short-term debt

The global players in credit ratings are S&P, Fitch and Moodys.
Hope you got some insights into the world of key players in financial markets. We will
continue to focus on many more important aspects of the financial markets in our subsequent
articles, till then stay tuned to careeranna.com