The chapter discusses the fundamentals of financial markets, including the primary functions of capital and money markets. It defines key terms like underwriters, brokers, dealers, and clearing and settlement. It also describes the different types of markets that exist for various financial claims, including primary and secondary markets, organized exchanges and over-the-counter markets, spot and futures markets, and options markets. The roles of different participants in the markets are discussed along with how the markets promote efficiency through allocating resources, disseminating information, and keeping transaction costs low.

1. Contemporary Issues in Management
Lecture 1

2. Chapter One
Fundamentals of Financial
Markets

3. Main points in this chapter:
• The primary functions of the important
capital and money markets.
• Different types of markets exist for different
types of financial claims.
• Different types of markets exist for different
types of financial claims, and that different
people play different roles in each type of
market. However, that certain functions are
the same across markets.

4. Some Important terms
“underwriters”
• Help bring new issues of
financial claims to market
and price them
appropriately.

5. “brokers”
• match buyers with
sellers of similar
financial claims
“dealers,” “market
makers,” or “specialists”
• provide traders of
securities with
“immediate”
transactions.

6. “clearing and settlement”
• procedures to guarantee that people who sell
securities for cash receive the right amount of cash
and that purchasers of securities receive the
securities they contracted to buy

7. • Information specialists
disseminate information generated in
the financial markets so people can
properly assess the current value and
availability of financial claims with
particular characteristics.

8. • There are many ways for people to come
together to exchange financial claims.
• People can meet face-to-face or via
computer in “over-the-counter” markets.
• Or, they can meet in organized groups at
the “specialist’s post” on an organized
stock exchange or in the appropriate
futures "pit” on a futures exchange.
• They can also use computerized services
to arrange transactions in some financial
markets.

9. Types of markets

10. Functions of Capital Market :
• Individuals own real assets in order to produce
income and wealth.
• Earning a stream of future income by using
resources to provide services either directly to
final consumers or indirectly by helping make
future production possible.
• Real goods expected to generate a future
stream of returns are called capital goods; they
are the stock of assets used in production.

11. ISSUERS OF CAPITAL MARKET CLAIMS
• Economic units such as corporations or
governments buy capital assets because
they will aid in future production.
• Instead, they may prefer to pay for capital
assets in part out of future revenues
generated by the production from the
asset itself.

12. • Business entities and the federal
government are the largest net
borrowers (deficit spending units),
• and individuals are the largest net
suppliers of funds (surplus spending
units).

13. Economic units may issue primary
claims on capital assets reasons
• 1-a deficit spending unit (DSU) may issue
debt merely because it otherwise could
not afford to buy the capital asset.
• 2- it may issue debt because it does not
want to take the risk of investing a large
portion of its resources on a single capital
expenditure.

14. • 3-a DSU can diversify its business risk and
thereby reduce the chance that cash flows
from all of its investments will decline
simultaneously.
• 4-Surplus Units (SSUs) may be reluctant to
invest in those investments that will
decline simultaneously.
• 5- Spreading the risk through the sale and
resale of capital market claims is an
important function of capital markets.

15. PURCHASERS OF CAPITAL MARKET
CLAIMS
• The ultimate purchasers of capital market
claims are surplus spending units.
• Households are the largest suppliers of
funds to financial markets.
• Financial institutions are also important
participants, even though their net
position is not large relative to individuals
because of their role as financial
intermediaries.

16. • Individuals may invest directly in
the capital market, but more likely
they invest indirectly through such
depository institutions as
commercial banks and insurance
companies.

17. Market Efficiency
• Capital markets help increase economic
efficiency in various ways.
• Different aspects of capital market
efficiency are described below :
• Allocational Efficiency
• Informational Efficiency
• Operational Efficiency

18. Allocational Efficiency
• A form of economic efficiency that implies
that investable funds will be allocated to
their highest valued use.
• Business firms invest in the projects
offering the highest rates of return and
that households invest in direct or indirect
financial claims offering the highest yields
for given levels of risk.

19. Informational Efficiency
• The ability of investors to obtain accurate
information about the relative values of
different securities.
• Prices of securities are the best indicators
of relative value.
• informational efficiency helps business
firms get the information they need to
make intelligent investment decisions.

20. Operational Efficiency
• A market is operationally efficient if the
costs of conducting transactions are as low
as possible.
• high transaction costs can prevent firms
from investing in all desirable projects.
• The forgone investment opportunities
mean that fewer people are employed and
economic output grows at a slower rate or
declines.
• Society becomes worse off.

21. Functions of the Money Markets
• Money markets are markets in which
commercial banks and other businesses
adjust their liquidity position by
borrowing, lending, or investing for short
periods of time.
• In the money markets, businesses,
governments, and, sometimes, individuals
borrow or lend funds for short periods of
time—usually 1 to 120 days.

22. • Treasury securities are the dominant
money market instrument.
• Commercial paper,
• repurchase agreements,
• federal funds, and
• negotiable certificates of deposit and
• banker’s acceptances also are important
money market instruments.

23. • The money market consists of a collection
of markets, each trading a distinctly
different financial instrument.
• There is no formal organization, such as
the New York Stock Exchange for the
equity markets. Central to the activity of
the money markets are the dealers and
brokers who specialize in one or more
money market instruments.

24. • The money markets are also distinct from
other financial markets in that they are
wholesale markets because of the large
transactions involved.
• Money market transactions are called
open market transactions because of their
impersonal and competitive nature.
• There are no established customer
relationships (“accommodate” dealers )

25. • The hub of money market transactions is the
trading rooms of dealers and brokers.
• When the market is open, these rooms are
characterized by tension and a frenzy of
activity.
• Because billions of dollars of business is
conducted over the phone, the motto of the
money markets is “My word is my bond.”
• Of course, mistakes do occur, and they are
typically worked out in the fairest way to all
concerned.

26. • Most transactions are settled in “Federal
Funds,” with parties involved instructing
the Federal Reserve to transfer funds from
the account of one customer’s bank to the
other party’s bank.
• The physical transfer of securities is also
simplified by the availability of safekeeping
facilities in New York City banks.
• Securities are rarely physically shipped
between buyer and seller.

27. Economic Role of the Money Market
• provide an efficient means for economic
units to adjust their liquidity positions.
• Money market instruments allow
economic units to bridge the gap between
cash receipts and cash expenditures,
thereby solving their liquidity problems.
Money markets bridge the gap between
intermittent cash flows

29. Characteristics of Money Market
Instruments
• (1) Low default risk.
• (2) Low price risk (short term to
maturity).
• (3) High marketability i.e. they can be
bought or sold quickly.
• (4)They can be bought or sold with low
costs for executing transactions.

30. INSTRUMENT
TYPICAL
MATURITY
MARKETABILITY DEFAULT RISK
U.S. Treasury bills and other securities maturing within one
year
13 to 52 weeks Excellent None
Federal agency securities, maturing within a year (FNMA,
FHLMC, etc.)
Up to 1 year Good Very Low
Commercial paper (unsecured lOUs of major corporations,
maturity under 270 days)
1 to 270 days Limited Low
Negotiable certificates of deposit (of major banks) 14 to 120 days Good Low
Banker’s acceptances (company lOUs guaranteed by major
banks)
30 to 180 days Good Low
Federal Funds (overnight or short-term loans of immediately
available funds, usually transferred via the
Federal Reserve System)
1 to 7 days Excellent Low
Repurchase agreements (overnight or short-term loans
arranged
1 to 15 days Good Low

31. Types of Capital Markets
• A - Primary and Secondary Markets
• B - Organized Exchanges and Over-the-
Counter Markets
• C - Spot, futures, and Forward Markets
• D - Options Markets
• E - Foreign Exchange Market
• F - International and Domestic Markets

32. A - Primary and Secondary Markets
• Financial claims are initially sold by
DSUs in primary financial markets.
• SSUs are willing to buy financial claims
with their surplus savings because they
want to earn future returns.
• They believe that the future payoff from
owning the claim will be large relative to
the risk of loss.

33. Secondary Markets
Primary Markets
are like used-car markets
the best known of the
secondary financial markets is
the New York Stock Exchange
(NYSE), which epitomizes
capitalism around the world.
People are more likely to want
to purchase a primary financial
claim if they believe they will
not have to hold it forever
(in the case of most common
stock) or until its maturity date
(in the case of mortgages, other
loans, and lOUs).
those claims can be resold easily
in “secondary” financial
markets.

34. • Thus, it is cheaper for companies,
governments, and others to issue stock or
borrow money to fund their operations
than would be the case if people had to
hold all financial claims to maturity.
• By making it cheaper for new companies to
issue stock and borrow money, secondary
financial markets assist in the growth of
companies and in the development of
capitalism.

35. B - Organized Exchanges and Over-
the-Counter Markets
Over-the-Counter Markets
Organized Exchanges Markets
by visiting or phoning an “over-the-
counter” dealer or by using a computer
system (such as the Nasdaq system) that
links over-the-counter dealers.
Once issued, a financial claim (security)
can be traded in the secondary market on
an organized security exchange (such as
the NYSE).
have no central location
(NASD)
are made on the floor of the exchange or
through its computer system
dealers “make a market”
a “bid” price at which they are willing to
buy the security
An “ask” price at which they are willing to
sell the security
provide a physical meeting place under a
specific set of rules and regulations

36. Over-the-Counter
Markets
Organized Exchanges
Markets
Dealers may arrange to make small trades
automatically over computer networks, but
large trades and trades in infrequently
traded stocks are usually arranged over the
phone.
Only members of the exchange may
use the facilities, and only securities
listed on the exchange may be traded.
The NYSE is the largest securities
exchange for stocks

37. C - Spot, futures, and Forward Markets
Forward Markets
Futures Markets
Spot Markets
If a contract for the future
delivery of cash in
exchange for a foreign
currency or a security is
negotiated and sold over
the counter, rather than
through an exchange
people trade contracts for
future delivery of
securities (such as
government bonds), cash
goods (such as a kilo of
gold), or the value of
securities (such as the
value of the S&P 500
stock index) sold in the
cash
market.
immediate payment
The term “immediate” can
mean a day or a week,
depending on the terms of
settlement procedures in
the particular market.
The spot market is also
called the “cash” market.

38. • The delivery dates, amounts, and terms of
forward contracts are not standardized.
• In addition, there is a small risk that a
counterparty may default on a forward
contract.
• Thus, most active participants in the forward
markets are large commercial banks,
investment banks, and insurance companies
that are expert at analyzing and reducing
counterparty default risk.

39. D - Options Markets
• Options markets trade options contracts
that call for conditional future delivery of a
security or good or futures contract.
• Typically, an options contract gives the
buyer the right to either buy or sell a
security, depending upon whether the
option is a “call” or “put” option.

40. • Call options give the buyer the right to buy
a predetermined amount of a security at
the predetermined exercise or strike price
on, or possibly before, the expiration date
of the option.
• Put options give the buyer the right to sell
a predetermined amount of a security at
the pre agreed price prior to the option’s
expiration date.

41. • Options on financial futures contracts
are traded on the appropriate futures
exchange (such as the Chicago Board of
Trade for options on the U.S. Treasury
bond futures contract).

42. E - Foreign Exchange Market
• The foreign exchange market is the market
on which foreign currencies are bought and
sold.
• Foreign currencies such as the British
pound, Japanese yen, German mark, or
French franc are traded against the U.S.
dollar or are traded against other foreign
currencies.

43. • Foreign currencies are traded either for
spot or forward delivery over the
counter at large commercial banks or
investment banking firms.
• Futures contracts for foreign currencies
are traded on organized exchanges such
as the Chicago Mercantile Exchange.

44. F - International and Domestic Markets
• Financial markets can be classified as
either domestic or international markets
depending upon where they are located.
• The most important international
financial markets for U.S. firms are the
short-term Eurodollar market and the
long-term Eurobond market.

45. • In these markets, domestic or overseas firms
can borrow or lend large amounts of U.S.
dollars that have been deposited in overseas
banks.
• These markets are closely linked to the U.S.
money and capital markets.
• Large financial institutions, business firms, and
institutional investors, both in the United States
and overseas, conduct daily transactions
between the U.S. domestic markets and the
international markets.

46. Thanks