1. Financial markets exist to connect lenders and borrowers, allowing companies and governments to raise capital from investors. 2. The money market provides short-term funding of up to one year, while the capital market supplies long-term funding greater than one year through stock and bond markets. 3. The capital markets are closely watched as indicators of economic conditions. Companies and governments issue stocks and bonds to raise funds for capital projects, acquisitions, or expanding business lines. Investors provide the funds by purchasing these securities.

1. Banking and Financial Institutions CHAPTER 1 Class Notes
By: HM Umar Farooq Rana 1
Financial Markets
A financial market is a place for buying and selling of financial securities such as stocks and
bonds. Financial markets exist to bring together lenders (investors) with borrowers (governments
and companies).
It facilitates:
 The raising of capital (in the capital markets)
 The transfer of risk (in the derivatives markets)
They are used to match those who want capital to those who have it.
Typically a borrower issues a receipt to the lender promising to pay back the capital. These
receipts are securities which may be freely bought or sold. In return for lending money to the
borrower, the lender will expect some compensation in the form of interest or dividends.
Financial Market in Pakistan consists of (i) Money Market which provides short term funds and
(ii) Capital Market which makes long terms funds available to businesses and industries.
Money markets are used for a short-term basis, usually for assets up to one year.
Conversely, capital markets are used for long-term assets, which are any asset with maturity
greater than one year. Capital markets include the equity (stock) market and debt (bond) market.
Together the money and capital markets comprise a large portion of the financial market and are
often used together to manage liquidity and risks for companies, governments and individuals.
Capital Markets
Capital markets are perhaps the most widely followed markets. Both the stock and bond markets
are closely followed and their daily movements are analyzed as proxies for the general economic
condition of the world markets. As a result, the institutions operating in capital markets - stock
exchanges, commercial banks and all types of corporations, including nonbank institutions such
as insurance companies and mortgage banks - are carefully scrutinized.
The institutions operating in the capital markets access them to raise capital for long-term
purposes, such as for a merger or acquisition, to expand a line of business or enter into a new
business, or for other capital projects. Entities that are raising money for these long-term
purposes come to one or more capital markets. In the bond market, companies may issue debt in
the form of corporate bonds, while both local and federal governments may issue debt in the
form of government bonds. Similarly, companies may decide to raise money by issuing equity on
the stock market. Government entities are typically not publicly held and, therefore, do not
usually issue equity. Companies and government entities that issue equity or debt are considered
the sellers in these markets.
The buyers, or the investors, buy the stocks or bonds of the sellers and trade them. If the seller,
or issuer, is placing the securities on the market for the first time, then the market is known as
the primary market. Conversely, if the securities have already been issued and are now being
traded among buyers, this is done on the secondary market. Sellers make money off the sale in

2. Banking and Financial Institutions CHAPTER 1 Class Notes
By: HM Umar Farooq Rana 2
the primary market, not in the secondary market, although they do have a stake in the outcome
(pricing) of their securities in the secondary market.
The buyers of securities in the capital market tend to use funds that are targeted for longer-term
investment. Capital markets are risky markets and are not usually used to invest short-term
funds. Many investors access the capital markets to save for retirement or education, as long as
the investors have long time horizons, which usually means they are young and are risk takers.
Money Market
The money market is often accessed alongside the capital markets. While investors are willing to
take on more risk and have patience to invest in capital markets, money markets are a good place
to "park" funds that are needed in a shorter time period - usually one year or less. The financial
instruments used in capital markets include stocks and bonds, but the instruments used in the
money markets include deposits, collateral loans, acceptances and bills of exchange. Institutions
operating in money markets are central banks, commercial banks and acceptance houses, among
others.
Money markets provide a variety of functions for either individual, corporate or government
entities. Liquidity is often the main purpose for accessing money markets. When short-term debt
is issued, it is often for the purpose of covering operating expenses or working capital for a
company or government and not for capital improvements or large scale projects. Companies
may want to invest funds overnight and look to the money market to accomplish this, or they
may need to cover payroll and look to the money market to help. The money market plays a key
role in ensuring companies and governments maintain the appropriate level of liquidity on a
daily basis, without falling short and needing a more expensive loan or without holding excess
funds and missing the opportunity of gaining interest on funds.
Investors, on the other hand, use the money markets to invest funds in a safe manner. Unlike
capital markets, money markets are considered low risk; risk-adverse investors are willing to
access them with the anticipation that liquidity is readily available. Older individuals living on a
fixed income often use the money markets because of the safety associated with these types of
investments.
The Bottom Line
There are both differences and similarities between capital and money markets. From the issuer
or seller's standpoint, both markets provide a necessary business function: maintaining adequate
levels of funding. The goal for which sellers access each market varies depending on their
liquidity needs and time horizon. Similarly, investors or buyers have unique reasons for going to
each market: Capital markets offer higher-risk investments, while money markets offer safer
assets; money market returns are often low but steady, while capital markets offer higher returns.
The magnitude of capital market returns is often a direct correlation to the level of risk, however
that is not always the case.

3. Banking and Financial Institutions CHAPTER 1 Class Notes
By: HM Umar Farooq Rana 3
Although markets are deemed efficient in the long run, short-term inefficiencies allow investors
to capitalize on anomalies and reap higher rewards that may be out of proportion to the level of
risk. Those anomalies are exactly what investors in capital markets try to uncover. Although
money markets are considered safe, they have occasionally experienced negative returns.
Inadvertent risk, although unusual, highlights the risks inherent in investing - whether long or
short term, money markets or capital markets.
Of this, the banking sectors and non-banking sectors are regulated by the central bank, State
Bank of Pakistan. While rest of the market (lease, stock exchanges, modarba, mutual funds and
insurance) is regulaled by Secruities and Exchange Commission of Pakistan.
Purpose of Financial Markets
To understand financial markets, let us look at what they are used for, i.e. what is their
purpose?
Without financial markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks help in this process. Banks take deposits from those who have
money to save. They can then lend money from this pool of deposited money to those who
seek to borrow. Banks popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and
their agents can meet borrowers and their agents, and where existing borrowing or lending
commitments can be sold on to other parties. A good example of a financial market is a
stock exchange. A company can raise money by selling shares to investors and its existing
shares can be bought or sold.
Lenders
Many individuals are not aware that they are lenders, but almost everybody does lend
money in many ways. A person lends money when he or she:
• puts money in a savings account at a bank;
• contributes to a pension plan;
• pays premiums to an insurance company;
• invests in government bonds; or
• invests in company shares.
Companies tend to be borrowers of capital. When companies have surplus cash that is not
needed for a short period of time, they may seek to make money from their cash surplus by
lending it via short term markets called money markets.
There are a few companies that have very strong cash flows. These companies tend to be lenders
rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share

4. Banking and Financial Institutions CHAPTER 1 Class Notes
By: HM Umar Farooq Rana 4
buyback.) Alternatively, they may seek to make more money on their cash by lending it
(e.g. investing in bonds and stocks.)
Borrowers
Individuals borrow money via bankers' loans for short term needs or longer term mortgages to
help finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They also borrow to fund
modernization or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To make up this
difference, they need to borrow. Governments also borrow on behalf of nationalized industries,
municipalities, local authorities and other public sector bodies. In the UK, the total
borrowing requirement is often referred to as the public sector borrowing requirement (PSBR).
Governments borrow by issuing bonds. In the UK, the government also borrows from
individuals by offering bank accounts and Premium Bonds. Government debt seems to be
permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by
governments to reduce the value of the debt is to influence inflation.
Municipalities and local authorities may borrow in their own name as well as receiving funding
from national governments. In the UK, this would cover an authority like Hampshire
County Council.
Public Corporations typically include nationalised industries. These may include the postal
services, railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow internationally with
the aid of Foreign exchange markets.