Financial market and institutions



References/ Meaning and understanding
8. Financial Market and Institutions

8.1 Introduction

8.2 Definition of Financial Market

8.1/C2 Introduction:

A financial market is a market in which people and entities can trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand. Securities include stocks and bonds, and commodities include precious metals or agricultural goods.

There are both general markets and specialized markets. Markets work by placing many interested buyers and sellers, including households, Firms, and government agencies, in one “place”, thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy.

8.2/C2 Definition of Financial Market

The financial system is an important element of an economy. The financial resources are exchanged through the financial system. The financial market is the heart of the financial system. The financial market refers to a place or mechanism through which financial instruments are traded.

According to S.K. Cooper and other “Financial markets are the markets in which financial instruments are traded”.

[S. Kerry Cooper, Donald R Fraser; The financial market place: Texas A and M University-Addison-Wesley Publishing company Inc. Philippines, 1982, p-3]

Similarly, according to Dudley G. Luckett, “Financial market is to be understood as any exchange of a variety of financial instruments”.

The financial market is said to the ‘brain’ of entire economic system. The savings are channelled to investments through financial market. The financial instruments like stock, bond, insurance policy, government securities and debentures are traded in the financial market.

In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them.

The term “market” is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE, BSE, NSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions(merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges. Financial markets can be domestic or they can be international.

Dictionary Says: Definition of ‘Financial Market’

Broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees and market forces determining the prices of securities that trade.

Some financial markets only allow participants that meet certain criteria, which can be based on factors like the amount of money held, the investor’s geographical location, knowledge of the markets or the profession of the participant.

Investopedia Says: Investopedia explains ‘Financial Market’

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. Most financial markets have periods of heavy trading and demand for securities; in these periods, prices may rise above historical norms.

The converse is also true – downturns may cause prices to fall past levels of intrinsic value, based on low levels of demand or other macroeconomic forces like tax rates, national production or employment levels. Information transparency is important to increase the confidence of participants and therefore foster an efficient financial marketplace.

In economics, a financial market is a mechanism that allows people to easily buy and sell financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect the efficient market hypothesis. Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity.

Both general markets and specialized markets exist. Markets work by placing many interested sellers in one “place”, thus making them easier to find for prospective buyers.

An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy that is based, such as a gift economy.

8.1/C3.1 securities:

Document as evidence of a loan, certificate of stock, bonds, etc.

8.1/C3.2 Commodities:

Article of trade, sp. a raw material or product as opposed to a service.

8.1/C3.3 General markets:

where many commodities are traded

8.1/C3.4 Specialized markets:

Where only one Commodity is traded

8.1/C3.5 securities:

a thing deposited or pledged as a guarantee of the fulfillment of an undertaking or the repayment of a loan, to be forfeited in case of default.


8.2/C3 http://en.


8.2/C3 http://www.

Central Library


Jeff Mudara; Financial Institutions and Market: 7th edition, South –Western a part of Cengage Learning, 2006, p-2


S. Kerry Cooper, Donald R Fraser; The financial market place: Texas A and M University-Addison-Wesley Publishing company Inc. Philippines, 1982, p-3


L.M. Bhole; Financial Institutions and Market, Structure, Growth and Innovations: Tata McGrow-Hill Publishing Company Ltd. New Delhi, 2006, p-3


Frank J. Fabozzi, Franco Modigliani, Frank J. Jones and Michel G. Ferri; Foundation of Financial Markets and Institutions: 3rd edition, Pearson education inc. 2002, p-5


8.2/C3 http://www.

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8.3. Types of financial markets 8.3./C2 Types of financial markets:

Within the financial sector, the term “financial markets” is often used to refer just to the markets that are used to raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another common use of the term is as a catchall for all the markets in the financial sector, as per examples in the breakdown below.

Þ Capital markets which consist of:

· Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.

· Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

Þ Commodity markets, which facilitate the trading of commodities.

Þ Money markets, which provide short term debt financing and investment.

Þ Derivatives markets, which provide instruments for the management of financial risk.

Þ Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market.

ÞInsurance markets, which facilitate the redistribution of various risks.

Þ Foreign exchange markets, which facilitate the trading of foreign exchange

The capital markets may also be divided into primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets allow investors to buy and sell existing securities. The transactions in primary markets exist between issuers and investors, while in secondary market transactions exist among investors. Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold without a loss of value. Securities with an active secondary market mean that there are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount. The financial market is broadly divided into 2 types:

1) Capital Market and

2) Money market.

The Capital market is subdivided into

1) primary market and

2) Secondary market

Raising capital

Financial markets attract funds from investors and channel them to corporations—they thus allow corporations to finance their operations and achieve growth. Money markets allow firms to borrow funds on a short term basis, while capital markets allow corporations to gain long-term funding to support expansion. 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 loansand 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.


Who have enough money to lend or to give someone money from own pocket at the condition of getting back

the principal amount or with some interest or charge, is the Lender.

Individuals & Doubles

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:

Þ puts money in a savings account at a bank;

Þ contributes to a pension plan;

Þ pays premiums to an insurance company;

Þ invests in government bonds; or

Þ 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 buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks).


Individuals borrow money via bankers’ loansfor 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 net cash requirement (PSNCR).

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 nationalized 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.

Borrowers having similar needs can form into a group of borrowers. They can also take an organizational form like Mutual Funds. They can provide mortgage on weight basis. The main advantage is that this lowers the cost of their borrowings.

Derivative products

During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short. In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics. Derivative products or instruments help the issuers to gain an unusual profit from issuing the instruments. For using the help of these products a contract has to be made.

Derivative contracts are mainly 3 types:

1. Future


2. Forward Contracts

3. Option Contracts

Currency markets

Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this

may have been true in the distant past,when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements.

The picture of foreign currency transactions today shows:

Þ Banks/Institutions

Þ Speculators

Þ Government spending (for example, military bases abroad)

Þ Importers/Exporters

Þ Tourists

Financial market regulation

In general, financial market regulation is aimed to ensure the fair treatment of participants. Many regulations have been enacted in response to fraudulent practices. One of the key aims of regulation is to ensure business disclosure of accurate information for investment decision making.

When information is disclosed only to limited set of investors, those have major advantages over other groups of investors. Thus regulatory framework has to provide the equal access to disclosures by companies. The recent regulations were passed in response to large bankruptcies, overhauled corporate governance, in order to strengthen

the role of auditors in overseeing accounting procedures. The Sorbanes-Oxley Act of 2002 in US was designed particularly to tighten companies’ governance after dotcom bust and Enron’s Bankruptcy. It had direct consequences internationally, first of all through global companies.

The US Wall Street Reform and Consumer Protection Act (Dodd-Frank) of 2010 aims at imposing tighter financial regulation for the financial markets and financial intermediaries in US, in order to ensure consumer protection. This is in tune with major financial regulation system development in EU and other parts of the world

8.3/C3.1 catchall:

a term or category that encompasses a variety of different elements:





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8.4. Analysis of financial markets 8.4/C2 Analysis of financial markets :

Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis of the so-called technical analysis method of attempting to predict future changes.

One of the tenets of “technical analysis” is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change. In recent years the rise of algorithmic and high-frequency program trading has seen the adoption of momentum, ultra-short term moving average and other similar strategies which are based on technical as opposed to fundamental or theoretical concepts of market Behaviour.

The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modeled better by Lévy stable distributions. The scale of change, or volatility, depends on the length of the time unit to a powera bit more than 1/2. Large changes up or down are more likely than what one would calculate using a Gaussian distribution with an estimated standard deviation.

Financial market slang

Poison pill, when a company issues more shares to prevent being bought out by another company, thereby increasing the number of outstanding shares to be bought by the hostile company making the bid to establish majority

Quant, a quantitative analystwith a PhD [citation needed]

(and above) level of training in mathematicsand statisticalmethods.

Rocket scientist, a financial consultant at the zenithof mathematical and computer programming skill. They are able to invent derivatives of high complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training; rocket scientists do not necessarily build rockets for a living.

White Knight, a friendly party in a take overbid. Used to describe a party that buys the shares of one organization to help prevent against a hostile takeover of that organization by another party. round tripping


Spread, the difference between the highest bid and the lowest offer



8.5. Functions of Financial Market 8.5/C2 Functions of Financial Market:

This section discusses the main functions of financial intermediaries and financial markets, and their comparative roles. Financial systems, i.e. financial intermediaries and financial markets, channel funds from those who have savings to those who have more productive uses for them. They perform two main types of financial service that reduce the costs of moving funds between borrowers and lenders, leading to a more efficient allocation of resources and faster economic growth. These are the provision of liquidity and the transformation of the risk characteristics of assets.[1]

i) Provision of liquidity

The link between liquidity and economic performance arises because many high return investment projects require long-term commitments of capital, but risk adverse lenders (savers) are generally unwilling to delegate control over their savings to borrowers (investors) for long periods. Financial systems mobilise savings by agglomerating and pooling funds from disparate sources and creating small denomination instruments.

These instruments provide opportunities for individuals to hold diversified portfolios. Without pooling individuals and households would have to buy and sell entire firms (Levine 1997). Diamond and Dybvig (1983) show how financial intermediaries can enhance risk sharing, which can be a precondition of liquidity, and can thus improve welfare. In their model, without an intermediary (such as a bank), all investors are locked into illiquid long-term investments that yield high payoffs only to those who consume at the end of the investment.

Those who must consume early receive low payoffs because early consumption requires premature liquidation of long-term investments. When agents need to consume at different (random) times, an intermediary can improve risk sharing – by promising investors a higher payoff for early consumption and a lower payoff for late consumption relative to the non-intermediated case. Financial markets can also transform illiquid assets (long-term capital investments in illiquid production processes) into liquid liabilities (financial instrument). With liquid financial markets savers/lenders can hold assets like equity or bonds, which can be quickly and easily converted into purchasing power, if they need to access their savings. For lenders, the services performed by financial markets and intermediaries are substitutable around the desired risk, return and liquidity provided by particular investments.

Financial intermediaries and markets make longer-term investments more attractive and facilitate investment in higher return, longer gestation investment and technologies. They provide different forms of finance to borrowers. Financial markets provide arms length debt or equity finance (to those firms able to access markets), often at a lower cost than finance from financial intermediaries.

ii) Transformation of the risk characteristics of assets

The second main service financial intermediaries and markets provide is the transformation of the risk characteristics of assets. Financial systems perform this function in at least two ways. First, they can enhance risk diversification and second, they resolve an information asymmetry problem that may otherwise prevent the exchange of goods and services, in this case the provision of capital (Akerlof 1970).

Financial systems facilitate risk-sharing by reducing information and transactions costs. If there are costs associated with the channeling of funds between borrowers and lenders, financial systems can reduce the costs of holding a diversified portfolio of assets. Intermediaries perform this role by taking advantage of economies of scale; markets do so by facilitating the broad offer and trade of assets comprising investors’ portfolios.

Financial systems can reduce information and transaction costs that arise from an information asymmetry between borrowers and lenders.[2] In credit markets an information asymmetry arises because borrowers generally know more about their investment projects than lenders.

A borrower may have an entrepreneurial “gut feeling” that cannot be communicated to lenders, or more simply, may have information about a looming financial risk to their firm that they may not wish to share with past or potential lenders. An information asymmetry can occur ex ante or ex post. An ex ante information asymmetry arises when lenders can not differentiate between borrowers with different credit risks before providing a loan and leads to an adverse selection problem. Adverse selection problems arise when lenders are more likely to make a loan to high-risk borrowers, because those who are willing to pay high interest rates will, on average, be worse risks.

The information asymmetry problem occurs ex post when only borrowers, but not lenders, can observe actual returns after project completion. This leads to a moral hazard problem. Moral hazard problems arise when borrowers engage in activities that reduce the likelihood of their loan being repaid. They also arise when borrowers take excessive risk because the costs may fall more on lenders compared to the benefits, which can be captured by borrowers.

The problem with imperfect information is that information is a “public good”. If costly privately-produced information can subsequently be used at less cost by other agents, there will be inadequate motivation to invest in the publicly optimal quantity of information (Hirshleifer and Riley 1979).

The implication for financial intermediaries is as follows. Once financial intermediaries obtain information they must be able to obtain a market return on that information before any signalling of that information advantage results in it being bid away. If they cannot prevent information from being revealed prior to obtaining that return, they will not commit the resources necessary to obtain it.

One reason financial intermediaries can obtain information at a lower cost than individual lenders is that financial intermediation avoids duplication of the production of information faced by multiple individual lenders. Moreover, financial intermediaries develop special skills in evaluating prospective borrowers and investment projects. They can also exploit cross- customer information and re-use information over time.

Financial intermediaries thus improve the screening of potential borrowers and investment projects before finance is committed and enforce monitoring and corporate control after investment projects have been funded. Financial intermediation thus leads to a more efficient allocation of capital. The information acquisition cost may be lowered further as financial intermediaries and borrowers develop long-run relationships (Petersen and Rajan 1994 and Faulkender and Petersen 2003).

Financial markets create their own incentives to acquire and process information for listed firms. The larger and more liquid financial markets become the more incentive market participants have to collect information about these firms. However, because information is quickly revealed in financial markets through posted prices, there may be less of an incentive to use private resources to acquire information.

In financial markets information is aggregated and disseminated through published prices, which means that agents who do not undertake the costly process of ex ante screening and ex post monitoring, can freely observe the information obtained by other investors as reflected in financial prices. Rules and regulation, such as continuous disclosure requirements, can help encourage the production of information.

Financial intermediaries and financial markets resolve ex post information asymmetries and the resulting moral hazard problem by improving the ability of investors to directly evaluate the returns to projects by monitoring, by increasing the ability of investors to influence management decisions and by facilitating the takeover of poorly managed firms. When these issues are not well managed, investors will not be willing to delegate control of their savings to borrowers. Diamond (1984), for example, develops a model in which the returns from firms’ investment projects are not known ex post to external investors, unless information is gathered to assess the outcome, i.e. there is “costly state verification” (Townsend 1979).

This leads to a moral hazard problem. Moral hazard arises when a borrower engages in activities that reduce the likelihood of a loan being repaid. For example, when firms’ owners “siphon off” funds (legally or illegally) to themselves or their associates through loss-making contracts signed with associated firms.

iii) Price discovery

Price discovery function means that transactions between buyers and sellers of financial instruments in a financial market determine the price of the traded asset. At the same time the required return from the investment of funds is determined by the participants in a financial market.

The motivation for those seeking funds (deficit units) depends on the required return that investors demand. It is these functions of financial markets that signal how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments.

iv) Liquidity

Liquidity function provides an opportunity for investors to sell a financial instrument, since it is referred to as a measure of the ability to sell an asset at its fair market value at any time. Without liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off. Debt instrument is liquidated when it matures, and equity instrument is until the company is either voluntarily or involuntarily liquidated. All financial markets provide some form of liquidity. However, different financial markets are characterized by the degree of liquidity.

v) reduction of transaction

The function of reduction of transaction costs is performed, when financial market participants are charged and/or bear the costs of trading a financial instrument. In market economies the economic rationale for the existence of institutions and instruments is related to transaction costs, thus the surviving institutions and instruments are those that have the lowest transaction costs.

The key attributes determining transaction costs are

· asset specificity,

· uncertainty,

· frequency of occurrence.

Asset specificity is related to the way transaction is organized and executed. It is lower when an asset can be easily put to alternative use, can be deployed for different tasks without significant costs.

Transactions are also related to uncertainty, which has

(1) external sources (when events change beyond control of the contracting parties), and

(2) depends on opportunistic behavior of the contracting parties. If changes in external events are readily verifiable, then it is possible to make adaptations to original contracts, taking into account problems caused by external uncertainty. In this case there is a possibility to control transaction costs. However, when circumstances are not easily observable, opportunism creates incentives for contracting parties to review the initial contract and creates moral hazard problems.

Thehigher the uncertainty, the more opportunistic behavior may be observed, and the higher transaction costs may be born. Frequency of occurrence plays an important role in determining if a transaction should take place within the market or within the firm. A one-time transaction may reduce costs when it is executed in the market. Conversely, frequent transactions require detailed contracting and should take place within a firm in order to reduce the costs.

When assets are specific, transactions are frequent, and there are significant uncertainties intra-firm transactions may be the least costly. And, vice versa, if assets are non-specific, transactions are infrequent, and there are no significant uncertainties least costly may be market transactions. The mentioned attributes of transactions and the underlying incentive problems are related to behavioral assumptions about the transacting parties. The economists (Coase (1932, 1960, 1988), Williamson (1975, 1985), Akerlof (1971) and others) have contributed to transactions costs economics by analyzing behaviourof the human beings, assumed generally self-serving and rational in their conduct, and also behaving opportunistically.

Opportunistic behavior was understood as involving actions with incomplete and distorted information that may intentionally mislead the other party. This type of behavior requires efforts of ex ante screening of transaction parties, and ex post safeguards as well as mutual restraint among the parties, which leads to specific transaction costs.

Transaction costs are classified into:

1) costs of search and information,

2) costs of contracting and monitoring,

3) costs of incentive problems between buyers and sellers of financial assets.

1) Costs of search and informationare defined in the following way:

· search costs fall into categories of explicit costs and implicit costs. Explicit costs include expenses that may be needed to advertise one’s intention to sell or purchase a financial instrument. Implicit costs include the value of time spent in locating counterparty to the transaction. The presence of an organized financial market reduces search costs.

· Information costs are associated with assessing a financial instrument’s investment attributes. In a price efficient market, prices reflect the aggregate information collected by all market participants.

2) Costs of contracting and monitoring are related to the costs necessary to resolve information asymmetry problems, when the two parties entering into the transaction possess limited information on each other and seek to ensure that the transaction obligations are fulfilled.

3) Costs of incentive problems between buyers and sellers arise, when there are conflicts of interest between the two parties, having different incentives for the transactions involving financial assets. The functions of a market are performed by its diverse participants. The participants in

financial markets can be also classified into various groups, according to their motive for trading:

· Public investors, who ultimately own the securities and who are motivated by the returns from holding the securities. Public investors include private individuals and

institutional investors, such as pension funds and mutual funds.

· Brokers, who act as agents for public investors and who are motivated by the remuneration received (typically in the form of commission fees) for the services they provide. Brokers thus trade for others and not on their own account.

· Dealers, who do trade on their own account but whose primary motive is to profit from trading rather than from holding securities. Typically, dealers obtain their return from the differences between the prices at which they buy and sell the security over short intervals of time.

· Credit rating agencies (CRAs) that assess the credit risk o f borrowers. In reality three groups are not mutually exclusive. Some public investors may occasionally act on behalf of others; brokers may act as dealers and hold securities on their own, while dealers often hold securities in excess of the inventories needed to facilitate their trading activities. The role of these three groups differs according to the trading mechanism adopted by a financial market.

vi) Borrowing and Lending:

Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.

vii) 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.

viii) 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.

ix) Risk Sharing:

Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.

x) Liquidity:

The financial markets provide liquidity for sellers of securities in the secondary market. Liquidity is usually defined as the ease with which you can sell an asset on short notice without a loss in its value.

•    Assets with good liquidity:

*    Stock issues included in the Dow Jones Averages or the NASDAQ 100 index

*    Options on popular stocks

*    Gold coins

*    Treasury Bills, Notes, and Bonds

•    Assets with poor liquidity:

*    Enron Common Stock

*    Russian bonds issued by the Czar in 1905

xi) Efficiency:

Financial markets reduce transaction costs and information costs.

xii) Transfer of Funds

Financial markets facilitate the transfer of funds from savers and investors to spenders. In the terminology used by some a textbook authors, the funds are transferred from a surplus spending units ( SSU’s ) to deficit spending units ( DFU’s ). These funds transfers occur in the primary financial markets.

SSU = net saver

DSU = net spender

3 Major Sectors

  • Households     –     typically net SSU’s
  • Business    –    typically net DSU’s
  • Government     –    almost always net DSU’s

xiii) Securities pricing

Financial markets facilitate pricing of various financial securities. Securities pricing is accomplished through the supply-demand forces in a potential market.

Behind the supply and demand forces, however, individual investors make decisions about what they feel are the intrinsic values of different financial assets. Where the supply and demand curves meet the market arrives at an equilibrium price.

Resource allocation

In the primary financial markets, securities are sold by businesses and government entities that are raising money. Firms raising money for investment purposes must compete with other security issuers (public and private) for available money.

Since the investors who provide these funds are interested in earning the highest return for a given level of risk, they have an incentive to evaluate these different investment opportunities and choose the best investments. Through this process, they channel available investment funds in the economy to their highest and best possible uses.

xv) Securities pricing:

Financial markets facilitate pricing of various financial securities. Securities pricing is accomplished through the supply-demand forces in a potential market.

Behind the supply and demand forces, however, individual investors make decisions about what they feel are the intrinsic values of different financial assets. Where the supply and demand curves meet the market arrives at an equilibrium price.

xvi) Saving mobilization:

Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments etc. is an important role played by financial markets.

xvii) Investment:

Financial markets play a crucial role in arranging to invest funds thus collected in those units which are in need of the same.

xviii) National Growth:

An important role played by financial market is that, they contributed to a nation’s growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for productive purposed is also made possible.

xix) Entrepreneurship growth:

Financial markets contribute to the development of the entrepreneurial claw by making available the necessary financial resources.

xx) Industrial development:

The different components of financial markets help an accelerated growth of industrial and economic development of a country, thus contributing to raising the standard of living and the society of well being.

xxi) Reduction of transaction costs

The function of reduction of transaction costs is performed, when financial market participants are charged and/or bear the costs of trading a financial instrument. In market economies the economic rationale for the existence of institutions and instruments is related to transaction costs, thus the surviving institutions and instruments are those that have the lowest transaction costs.

The key attributes determining transaction costs are

Þ asset specificity,

Þ uncertainty,

Þ frequency of occurrence.

Asset specificityis related to the way transaction is organized and execut ed. It is lower when an asset can be easily put to alternative use, can be deployed for different tasks without significant costs. Transactions are also related to uncertainty, which has

(1) external sources (when events

change beyond control of the contracting parties), and

(2) depends on opportunistic behavior of the contracting parties. If changes in external events are readily verifiable, then it is possible to make adaptations to original contracts, taking into account problems caused by external uncertainty. In this case there is a possibility to control transaction costs. However, when circumstances are not easily observable, opportunism creates incentives for contracting parties to review the initial contract and creates moral hazard problems. The higher the uncertainty, the more opportunistic behavior may be observed, and the higher transaction costs may be born.

Frequency of occurrence plays an important role in determining if a transaction should take place within the market or within the firm. A one-time transaction may reduce costs when it is executed in the market. Conversely, frequent transactions require detailed contracting and should take place within a firm in order to reduce the costs. When assets are specific, transactions are frequent, and there are significant uncertainties intra-firm transactions may be the least costly. And, vice versa, if assets are non-specific, transactions are infrequent, and there are no significant uncertainties least costly may be market transactions. The mentioned attributes of transactions and the underlying incentive problems are related to behavioural assumptions about the transacting parties. The economists (Coase (1932, 1960, 1988), Williamson (1975, 1985), Akerlof (1971) and others) have contributed to transactions costs economics by analyzing behaviourof the human beings, assumed generally self-serving and rational in their conduct, and also behaving opportunistically.

Opportunistic behaviourwas understood as involving actions with incomplete and distorted information that may intentionally mislead the other party. This type of behavior requires efforts of ex ante screening of transaction parties, and ex post safeguards as well as mutual restraint among the parties, which leads to specific transaction costs.

Transaction costs are classified into:

1) costs of search and information,

2) costs of contracting and monitoring,

3) costs of incentive problems between buyers and sellers of financial assets.

1) Costs of search and information are defined in the following way:

Þ Search costs fall into categories of explicit costs and implicit costs.

Explicit costs include expenses that may be needed to advertise one’s intention to sell or purchase a financial instrument. Implicit costs include the value of time spent in locating counterparty to the transaction. The presence of an organized financial market reduces search costs.

Þ Information costs are associated with assessing a financial instrument’s investment attributes. In a price efficient market, prices reflect the aggregate information collected by all market participants.

2) Costs of contracting and monitoring are related to the costs necessary to resolve information asymmetry problems, when the two parties entering into the transaction possess limited information on each other and seek to ensure that the transaction obligations are fulfilled.

3) Costs of incentive problems between buyers and sellers arise, when there are conflicts of interest between the two parties, having different incentives for the transactions involving financial assets. The functions of a market are performed by its diverse participants. The participants in

financial markets can be also classified into various groups, according to their motive for trading.

Public investors, who ultimately ownthe securities and who are motivated by the returns from holding the securities. Public investors include private individuals and

institutional investors, such as pension funds and mutual funds.

Þ Brokers, who act as agents for public investors and who are motivated by the remuneration received (typically in the form of commission fees) for the services

they provide. Brokers thus trade for others and not on their own account.

Þ Dealers, who do trade on their own account but whose primary motive is to profit from trading rather than from holding securities. Typically, dealers obtain their return from the differences between the prices at which they buy and sell the security over short intervals of time.

Þ Credit rating agencies (CRAs) that assess the credit risk o f borrowers.

In reality three groups are not mutually exclusive. Some public investors may occasionally act on behalf of others; brokers may act as dealers and hold securities on their own, while dealers often hold securities in excess of the inventories needed to facilitate their trading activities. The role of these three groups differs according to the trading mechanism adopted by a financial market.

Financial intermediaries and their functions

Financial intermediary is a special financial entity, which performs the role of efficient allocation of funds, when there are conditions that make it difficult for lenders or investors of funds to deal directly with borrowers of funds in financial markets. Financial intermediaries include depository institutions, insurance companies, regulated investment companies, investment banks, and pension funds. The role of financial intermediaries is to create more favourable transaction terms than could be realized by lenders/investors and borrowers dealing directly with each other in the financial market.

The financial intermediaries are engaged in:

Þ obtaining funds from lenders or investors and

Þ lending or investing the funds that they borrow to those who need funds

The funds that a financial intermediary acquires become, depending on the financial claim, either the liability of the financial intermediary or equity participants of the financial intermediary. The funds that a financial intermediary lends or invests become the asset of the financial intermediary.





Central Library


Frank J. Fabozzi, Franco Modigliani, Frank J. Jones and Michel G. Ferri; Foundation of Financial Markets and Institutions: 3rd edition, Pearson education inc. 2002, p-5


S. Kerry Cooper, Donald R Fraser; The financial market place: Texas A and M University-Addison-Wesley Publishing company Inc. Philippines, 1982, p-15


Frank J. Fabozzi, Franco Modigliani and Frank J. Jones; Capital market, Institutions and Instrument: Prentice
Hall of India pvt. 2006, p-9


Robert O. Edmistyter; Financial Institutions: Market and Management: 2nd edition McGrow-Hill Book Company, 1986, part-1, p-8




Leonardo da Vinci programme project

“Development and Approbation of Applied Courses

Based on the Transfer of Teaching Innovations

in Finance and Management for Further Education

of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria”



8.5/C3 http://www.




The Dual Role of Financial Markets

in Economic Development:

Engine of Growth and Source of Instability

A survey of economic theory

with reflections on the East Asian financial crisis

IPC Working Paper No. 18

Dr. Adalbert Winkler

Frankfurt, June 1998








Robert E. Wright and Vincenzo Quadrini. Money and Banking: “Chapter 2, Section 4: Financial Markets.” pp.(


Steven Valdez, An Introduction To Global Financial Markets


T.E. Copeland, J.F. Weston (1988): Financial Theory and Corporate Policy, Addison-Wesley, West Sussex


E.J. Elton, M.J. Gruber, S.J. Brown, W.N. Goetzmann (2003): Modern Portfolio Theory and Investment

Analysis, John Wiley & Sons, New York


E.F. Fama (1976): Foundations of Finance, Basic Books Inc., New York


Marc M. Groz (2009): Forbes Guide to the Markets, John Wiley & Sons, Inc., New York


R.C. Merton (1992): Continuous-Time Finance, Blackwell Publishers Inc.


Keith Pilbeam (2010) Finance and Financial Markets, Palgrave


Steven Valdez, An Introduction To Global Financial Markets, Macmillan Press Ltd.


The Business Finance Market: A Survey, Industrial Systems Research Publications, Manchester (UK),

new edition 2002


Financial Markets with Yale Professor Robert Shiller (

8.6 Role of Financial Markets

in Economic Development

8.6/C2 Role of Financial Markets in Economic development:

Engine of Growth and Source of Instability:

In recent years an increasing amount of attention has been devoted to the connection between financial markets and economic development. New insights in growth theory and the theory of finance establishing a link between”finance and growth” or”finance and development” have spurred interest in this topic, as has the appearance of a large number of empirical studies which have demonstrated a clear positive correlation between indicators providing a quantitative measure of activities of and on financial markets and quantitative indicators of the level of economic development.

However, the positive connotation suggested by this literature represents only one side of the coin. The empirical evidence also shows that crisis-like developments in the financial markets have occurred with increasing frequency in recent years, and that such phenomena at least temporarily limit the scope for economic development.

The East Asian financial crisis is the latest and most severe example. How can one explain the fact that a sector which can be regarded as being at least partially responsible for a successful course of economic development is at the same time considered to be responsible at least for triggering crises which slow down economic development, often causing ground to be lost which it takes the economy years to regain?

This is a question for economic theory, and it is not the first time it has been asked, given that this dual impact of financial markets characterizes the economic development of basically any country. Thus, after creating a uniform basis and standard for comparison using a flow-of-funds analysis , the following survey will seek to describe how economic theory has dealt, or is dealing, with the dual impact of financial markets on economic development .

Four theories have been selected for consideration – neo-classical and Keynesian theory, the New Development Finance approach and the new theory of finance which is grounded in the economics of information. Each emphasises ifferent aspects of the relationship between financial markets and economic development, but so far it has proved impossible to arrive at a consensus view. Accordingly, the role of financial markets in economic development is still a controversial issue – and with good reason, as is shown by the Asian example of smooth financial development and extraordinary growth (1960 – 1996), followed by a severe financial crisis (1997). This is why, in the concluding section, the question is turned around:

Does the Asian example – seen against the background of this theoretical surveys – give an indication of the direction in which theoretical research should move if it wishes to better explain the dual impact of financial markets outlined above? The answer is a clear Yes, pointing to the need for a more detailed analysis of the monetary aspects of the relationship between financial markets and economic development and of financial development itself.

Financial markets and economic development: An initial approach to the topic based on a flow-of-funds analysis

The empirically observable correspondence between the development of the financial markets and that of the real economy comes as no surprise. Indeed, in textbooks on macroeconomics and the theory of finance one need look no further than the introductory sections on the topic of financial markets to find explicit mention of the very close connections between economic activities and events in the financial markets: “Financial markets are important because they are intimately linked to every other market and every individual in the economy. … The importance of financial markets therefore lies in their linkage with all our spending decisions, both in our personal lives and in the business world.” Carrying out a flow-of-funds analysis is perhaps the easiest way of highlighting this close interlinkage of financial and real activity.

Such an analysis posits that for each economic agent, i.e. at the level of individual economic units (micro level), the savings accumulated in a given period, in other words the increase in net worth, are equal to the sum of investment,

i.e. the increase in real capital, plus the increase in financial assets. The term FSMicroor, as the case may be, ∆FAMicromay be either positive or negative depending on whether the economic agent in question shows a financial surplus or deficit during the relevant period.

(1) SMicro= IMicro+ FSMicro


(1a) SMicro= IMicro+∆FAMicro


S = savings = ∆net worth

I = investment = ∆real capital

Micro = at the disaggregated level (micro level)

FS = financial surplus, if SMicro> IMicro, and financial deficit, if IMicro> SMicro, and

FS = ∆FAMicro, where FA = financial asset

Using equation (1), the central function and central characteristic of financial markets can be illuminated: Financial markets – perform one primary function, namely, that of intertemporal andinterpersonal resource

transfer, have the attribute of being monetary markets, i.e. the transactions on financial markets involve claims to the future payment of money, financial as opposed to real assets. Due to the fact that financial markets have the attribute of organising an interpersonal resource transfer, precisely this attribute recedes from view if the focus shifts to the level of the economy as a whole.

Given that an economic agent or a group of economic agents – e.g. all private households or firms – can only show a financial surplus (or incur a financial deficit) if at least one other economic agent or group of economic agents has incurred an equal financial deficit (or accumulated an equal financial surplus), at the aggregate level the following applies:

(2) ∑FSMicro= ∑ ∆FAMicro= ∑FAMicro= 0

Equation (2) contains the well-known condition that the sum of all financial balances, and thus the total net monetary assets of all economic agents in an economy, must work out to zero. Accordingly, aggregate savings are equal toaggregate investment, as is specified in equation (3):

(3) S = I

Thus, the preceding discussion may be summed up as follows:

– Financial balances, stocks of monetary assets and changes in these quantities are a manifestation of an interpersonal resource transfer. – Financial balances, stocks of monetary assets and changes in these quantities are a manifestation of an intertemporal resource transfer on a disaggregated level. For the individual economic agent, they represent an additional means of increasing net worth (S) or of financing real capital (I).

Because the formation of real capital is – apart from technological progress – the most important variable affecting economic development, and, as a result, equations (1) – (3) underscore the close relationship between financial markets and economic development.

– Financial balances, stocks of monetary assets, and changes in these quantities are monetary variables which are clearly linked, via a flow-of-funds relationship, to the

formation of real capital when a disaggregated view of the economy is taken. On the aggregate level, however, financial balances, credits and debts are cancelled out, making it impossible to establish a direct connection between financial and real variables. Thus, ever since economic theory began to study the nature of the connection between financial markets and economic development, the focus has been on three questions:

1) Is the interpersonal resource transfer growth-promoting? And if so, why?

2) Is the market relationship underlying this resource transfer particularly problematic? And if so, why?

3) Does the creation of stocks of monetary assets which takes place in financial markets impart to the savings/investment process a particular quality (leaving open for the moment the question of precisely how this quality might be defined) in the sense that monetary factors exert an influence on economic development? And if so, how is this influence exerted?

8.7 Definition money market 8.7/C2 Definition money market:

Money Market an integral part of the financial market of a country. It provides a medium for the redistribution of short term loan able funds among financial institutions, which perform this function by selling deposits of various types, certificate of deposits and discounting of bills, TREASURY BILLs etc.

Money market consists of all the institutions which are engaged in the borrowing and lending of short term funds. The members of money market are central bank at the top, commercial banks, co-operative banks, saving banks, specialized financial institutions, discount houses and stock exchange. Money market may her be distinguished from capital markets.

The meaning of money market becomes clear from the following definitions:-According Dudley G. Luckett -‘The money market is a market for short term (less than one year) loans. Its very name suggests that it is money that is being bought and sold”.

In the words of J.A. Cocharan, “The money market is a market which trades in short term, highly liquid, negotiable debt instruments of one year or less in maturity”.

World Bank has defined the money market as, “A market in which short term securities such as treasury bills, certificates of deposits and commercial bills are traded”.

In a strict sense we can say that money market is that market which provides loan for short term. It mainly duster the activities of the discount houses, commercial banks and the central bank of the country. In India or Pakistan like State bank, Commercial Banks, Co-operative banks and saving banks provide the short term loans. So money market in India or Pakistan mainly consists upon these institutions.

In brief, the money market is a means of exchange of short term credit. It is quite different from the capital market which deals in long term credit

The participants in the money market are: the central bank, commercial banks, the government, finance companies, contractual saving institutions like the pension funds, insurance companies, savings and loan associations etc. The instruments that are generally traded in the money market constitute: treasury bills, short-term central bank and government bonds, negotiable certificates of deposits, bankers acceptances and commercial papers like the bills of exchange and promissory notes, mutual funds etc.

Whenever a bear marketcomes along, investors realize (yet again!) that the stock market is a risky place for their savings. It’s a fact we tend to forget while enjoying the returns of a bull market! Unfortunately, this is part of the risk-return tradeoff. To get higher returns, you have to take on a higher level of risk. For many investors, avolatile marketis too much to stomach – the money market offers an alternative these higher-risk investments.

The money market is better known as a place for large institutions and government to manage their short-termcash needs. However, individual investors have access to the market through a variety of different securities. In this tutorial, we’ll cover various types ofmoney market securities and how they can work in your portfolio.

The money market is a subsection of the fixed income market. We generally think of the term fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that maturesin less than one year). Money market investments are also called cash investments because of their short maturities. Money market securities are essentially IOUs issued by governments, financial institutions and large corporations. These instruments are very liquidand considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities.

One of the main differences between the money market and the stock market is that most money market securities trade in very high denominations. This limits access for the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this to the stock market where a broker receives commission to acts as an agent, while the investor takes the risk of holding the stock.

Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems. The easiest way for us to gain access to the money market is with a money market mutual funds, or sometimes through a money market bank account.

These accounts and funds pool together the assets of thousands of investors in order to buy the money market securities on their behalf. However, some money market instruments, like Treasury bills, may be purchased directly. Failing that, they can be acquired through other large financial institutions with direct access to these markets. There are several different instruments inthe money market, offering different returns and different risks. In the following sections, we’ll take a look at the major money market instruments.

The money market is a mechanism that deals with the lending and borrowing of short term funds (less than one year).

• A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded.

• It doesn’t actually deal in cash or money but deals with substitutes of cash like trade bills, promissory notes & govt papers which can be converted into cash without any loss at low transaction cost.

• It includes all individual, institution and intermediaries.

The money market in Bangladesh is in its transitional stage. The various constituent parts of it are in the process of formation, while continuous efforts are being made to develop appropriate and adequate instruments to be traded in the market. At present, government treasury bills of varying maturity, Bangladesh Bank Bills and Certificates of Deposits etc in limited supply are available for trading in the market.

However, the short-term CREDIT market of the banking sector experienced a tremendous growth since liberation. In 1999, a total of about 6000 branches of the scheduled banks provided short-term credit throughout the country in the form of cash credit, overdraft and demand loan. The rates of interest are determined by the individual banks and as such the market is quite competitive. Each bank maintains its liquidity and supply of fund is arranged throughout the country with the help of an interconnected network of branches. BANGLADESH BANK as central bank of the country exercises its role in this market through the use of instruments such as bank rate, open market operations and changes in statutory liquidity requirements.

The money market of Bangladesh reached its present phase through a series of changes and evolution. Initially, after liberation, money market was the major constituent part of the financial market of the country. Capital market, its other segment was a relatively smaller part. All financial institutions of the country were nationalised after liberation. The growth and evolution of money market in the country took place during the period from 1971 to the early eighties under various sets of interventionist rules and regulations of the government and as such it could hardly reflect the actual market conditions.

However, in this period a vast financial superstructure with large network of commercial bank branches was established in the country. Simultaneously, specialised financial institutions under government sector also emerged with the objective of mobilising financial resources and channelling them for short, medium and long-term credit and investments.

The market participants had to operate in an environment of directed lending and loan disbursement goals, and predetermined rates of interest fixed by the authority. However, rate of interest in the call market was flexible but due to prevalence of liberal refinance facility at concessional rates from Bangladesh Bank, the activities of call money market remained insignificant. In the beginning of the 1980s, money market in Bangladesh entered a new era with the denationalisation of two nationalised banks and establishment of some private banks. With this development money market assumed the characteristics of a competitive market in the country. However, the administered interest rate structure and the government’s policy of priority sector lending continued to operate as factors that deterred the development of a liberalised money market in the country.





8.8 Characteristics of money market 8.8/C2 Characteristics of money market:

The money market is a market for financial assets that are close substitutes for money. It is a market for overnight short-term funds and instruments having a maturity period of one or less than one year. It is not a place (like the Stock market), but an activity conducted by telephone. The money market constitutes a very important segment of the Indian financial system.

Money market mutual funds are an investment account that financial institutions offer to investors. These funds have some liquidity because most money market mutual funds allow you to write up to three checks per month. If you need instant access to your money, a checking account would be better. However, if you want a higher rate of return than a savings account with limited access to your money, a money market mutual fund may be a good investment for you

The characteristics of the money market are:

i) Existence of Central Bank:

In the developed money market, the role of Central Bank is notable. It controls the entire money market operations by making the availability of funds depending upon the economic cycles. It can be done through its open market operations.

(ii) Highly organised Banking System:

As they are the main dealers in short-term funds, the commercial banks are considered as nervous system of the money market. Therefore, a well developed money market will have a highly organised and developed commercial banking system.

(iii) Existence of sub-markets:

In developed money market the various sub-markets existed and functioning smoothly. That is, the money market will have a developed sub- markets such as bill market, call money market, acceptance market, discount market, etc. It can be said that larger the number of sub-markets, the broader and more developed will be the structure of the money market.

(iv) Prevalence of healthy competition:

In each sub-market there should be a reasonable and healthy competition. That is, in a developed money market, there are a large number of borrowers, lenders and dealers. Then only each market will be active enough to achieve the purpose of its existence.

(v) Integration of sub-markets:

In the developed money market there will be a perfect integration among various sub-markets of the money market. Their functioning is interdependent. The funds flow from one sub-market to another and the activities of one sub- market should create effects in the other markets also.

(vi) Availability of proper credit instruments:

The developed money market should have the necessary credit instruments such as treasury bills, promissory notes, bills of exchange, etc. They should be freely available.

(vii) Flexibility and adequacy of funds:

In a developed money market, there must be ample resources. The flow of funds into the money market should also be flexible enough, i.e., the flow of funds can be increased or decreased depending upon the demand for funds.

(viii) International attraction:

The developed money markets attract funds from foreign countries also. The dealers, borrowers and lenders of foreign countries are eagerly coming forward to participate in the activities of developed money market.

(ix) Uniformity of interest rates:

Prevalence of uniformity in interest rates in different parts of the country is the characteristic feature of a developed money market.

(x) Stability of prices:

Stability of prices all over the country will be an outcome of the effective functioning of a developed money market.

(xi) Highly developed industrial system:

The money market will function smoothly and can achieve the basic purpose of its existence only when there is a highly developed indus-trial system. Developed money market demands for such a system.

(xii) Safety:

Money market securities are considered to be very safe because they are issued by companies that must have very high credit ratings. The U.S. Securities and Exchange Commission (SEC) requires that a minimum of 95 percent of the securities in a money market’s fund must have earned the highest possible rating from at least two major institutions that provide credit ratings. It is extremely rare for a money market fund to lose value. However, investors need to remember that returns are not guaranteed and a lossis possible, even if highly unlikely. Also, an individual money market security may lose value where a fund made up of multiple securities may gain.

(xiii) Liquidity:

One aspect of money market securities that many investors find very important is the high degree of liquidity they have. These securities typically have a very short lifespan and mature in as little as a day, though a longer period, usually about three months, is more typical. In fact, the U.S. SEC says that money market securities must have an average maturity of 90 days. All money market securities mature in under a year, adding to their liquidity and providing investors with a speedy return on their investments.

(xiv) Types:

Most money market securities are items that tend to have a face value of at least $100,000, and often much more. These are most often certificates of deposit, U.S. Treasury instruments, repurchase agreements and federal bank loans. This type of paper also includes municipal securities, money market futures and commercial paper. Money market funds typically use a mix of different securities to make up the fund, but in some cases a fund

may specialize in only one type.

(xv) Discounts:

Money market securities all share the common characteristic of being offered at a discount. This means that they are sold for an amount that is less than the face value of the item, providing additional incentive for buyers. However, when the item matures, it does so at its full face value, providing the investor with a significant benefit on his original investment, something that is highly appealing due to the short-term nature of these securities.

(xvi) Rate of Return:

The rate of return on money market mutual funds is usually higher than other accounts offered by banks such as savings accounts, but varies based on the performance of the investments. The rate usually ranges between 1 percent and 6 percent according to Investopedia. However, unlike other bank accounts, a money market mutual fund does have the potential to lose money should the investments perform poorly.

(xvii) Investments:

Strict regulations are in place regarding what instruments money market mutual funds can invest in, which include short-term debts such as bonds that cannot have a term of more than 13 months. The average maturity date for all securities the fund invests in must be 90 days or less. These are conservative investments that are in place to limit the potential for these funds to lose value.


The dividends paid on money market mutual funds are taxable in the year that you earn them. If you earn more than $1,500 in dividends in a tax year, you must file a Schedule B as part of your tax return. Some money market mutual funds are designed to invest only in tax-free investments such as municipal bonds, so the returns are all tax free.

(xix) Fees:

The financial institution that manages the money market mutual fund will charge a fee for managing the investments. These fees are usually less than 0.5 percent of the account. Like other accounts such as savings accounts and money market deposit accounts, there are usually minimum account balances you must maintain to avoid paying additional fees.


In exchange for the benefits offered by money market mutual funds, you lose some of the security that traditional bank accounts offer. Because the money is invested in securities, it is not protected by FDIC insurance. If the bank fails, you will lose your investment.


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8.9 Importance of money market 8.9/C3 Importance of money market:

A developed money market plays an important role in the financial system of a country by supplying short-term funds adequately and quickly to trade and industry. The money market is an integral part of a country’s economy. Therefore, a developed money market is highly indispensable for the rapid development of the economy. A developed money market helps the smooth functioning of the financial system in any economy in the

following ways:

i) Development Of Trade And Industry:

Money market is an important source of financing trade and industry. The money market, through discounting operations and commercial papers, finances the short-term working capital requirements of trade and industry and facilities the development of industry and trade both – national and international.

ii) Development Of Capital Market:

The short-term rates of interest and the conditions that prevail in the money market influence the long-term interest as well as the resource mobilization in capital market. Hence, the development of capital depends upon the existence of a development of capital money market.

iii) Smooth Functioning of Commercial Banks:

The money market provides the commercial banks with facilities for temporarily employing their surplus funds in easily realisable assets. The banks can get back the funds quickly, in times of need, by resorting to the money market. The commercial banks gain immensely by economizing on their cash balances in hand and at the same time meeting the demand for large withdrawal of their depositors. It also enables commercial banks to meet their statutory requirements of cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR) by utilishing the money market mechanism.

iv) Effective Central Bank Control:

A developed money market helps the effective functioning of a central bank. It facilities effective implementation of the monetary policy of a central bank. The central bank, through the money market, pumps new money into the economy in slump and siphons if off in boom. The central bank, thus, regulates the flow of money so as to promote economic growth with stability.

v) Formulation Of Suitable Monetary Policy:

Conditions prevailing in a money market serve as a true indicator of the monetary state of an economy. Hence, it serves as a guide to the Government in formulating and revising the monetary policy then and there depending upon the monetary conditions prevailing in the market.

Vi) Non-Inflationary Source Of Finance To Government:

A developed money market helps the Government to raise short-term funds through the treasury bills floated in the market. In the absence of a developed money market, the Government would be forced to print and issue more money or borrow from the central bank. Both ways would lead to an increase in prices and the consequent inflationary trend in the economy.

Vii) Money-Market Fund Basics:

Money market funds operate on the same basic principle as any other mutual fund. They gather together money from a large number of small investors, and use it to build a large-scale, diversified investment portfolio. However, money market funds are restricted by law to a portfolio made up of the safest and most conservative investments: government securities, commercial debt from extremely stable companies and various guaranteed-interest products. Money market funds make it easy for you to move your cash in and out, preserving your “liquidity” or ease of access.

viii) Bank-Like Qualities:

Money market funds compete with high-interest bank accounts as a safe place to keep your money. To do that, they’ve adopted many bank-like features. You can easily deposit money or withdraw it from a money market fund, and you can even write checks on the account. Some accounts limit the number of checks you can write without incurring fees, but overall the experience is very similar. Like banks, some funds allow you to conduct transactions by telephone or online. The funds often have a minimum initial investment, and might ask you to maintain a minimum balance.

ix) Cash Storage:

That’s not necessarily an issue, because money market funds make an excellent reservoir for your funds when they’re not in active use. For example, if you keep several months’ expenses for emergencies, a money market fund is the ideal place to keep it. It earns more than it will at the bank, but your money is just as accessible when you need it. One important difference: Bank deposits are guaranteed by the FDIC, but mutual fund returns are not. It’s extremely rare to take losses in a money market fund, but it could theoretically happen.

x) Investment Portfolios:

Money market funds also serve as emergency cash storage for portfolios. If you’ve sold at a loss for tax purposes, you might park the proceeds in a money market fund for 31 days before re-investing it, to avoid the “wash sale” rules. They’re also handy if the markets are uncertain, and you want your money to be in a safe place while you consider your options. If you see the opportunity to pounce on an undervalued investment, your capital is as close as your checkbook or your online brokerage account. As you get closer to retirement, allocating more of your portfolio to money market funds can also preserve your capital against an ill-timed market crash.

xi) Financing Industry:

A well developed money market helps the industries to secure short term loans for meeting their working capital requirements. It thus saves a number of industrial units from becoming sick.

xii) Financing trade:

An outward and a well knit money market system play an important role in financing the domestic as well as international trade. The traders can get short term finance from banks by discounting bills of exchange. The acceptance houses and discount market help in financing foreign trade.

xiii) Profitable investment:

The money market helps the commercial banks to earn profit by investing their surplus funds in the purchase of. Treasury bills and bills of exchange, these short term credit instruments are not only safe but also highly liquid.

The banks can easily convert them into cash at a short notice.

xiv) Self sufficiency of banks:

The money market is useful for the commercial banks themselves. If the commercial banks are at any time in need of funds, they can meet their requirements by recalling their old short term loans from the money market.

xv) Effective implementation of monetary policy:

The well developed money market helps the central bank in shaping and controlling the flow of money in the country. The central bank mops up excess short term liquidity through the sale of treasury bills and injects liquidity by purchase of treasury bills.

xvi) Encourages economic growth:

If the money market is well organized, it safeguards the liquidity and safety of financial asset This encourages the twin functions of economic growth, savings and investments.

xvii) Help to government:

The organized money market helps the government of a country to borrow funds through the sale of Treasury bills at low rate of interest The government thus would not go for deficit financing through the printing of notes and issuing of more money which generally leads to rise in an increase in general prices.

xviii) Proper allocation of resources:

In the money market, the demand for and supply of loan able funds are brought at equilibrium The savings of the community are converted into investment which leads to pro allocation of resources in the country.


The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short-term financial instruments commonly called “paper.” This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of interbank lending–banks borrowing and lending to each other using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency. Finance companies typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit.

Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Certain large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf via commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt. Trading companies often purchase bankers’ acceptances to be tendered for payment to overseas suppliers. Retail and institutional money market funds Banks Central banks Cash management programs Merchant Banks

Common money market instruments

Þ Certificate of deposit- Time deposit, commonly offered to consumers by banks, thrift institutions, and credit unions.

Þ Repurchase agreements- Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

Þ Commercial paper- Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.

Þ Eurodollar deposit- Deposits made in U.S. dollars at a bank or bank branch located outside the United States.

Þ Federal agency short-term securities – (in the U.S.). Short-term securities issued by government sponsored enterprisessuch as the Farm Credit System, the Federal Home Loan Banksand the Federal National Mortgage Association.

Þ Federal funds- (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Þ
Þ Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.

Þ Municipal notes- (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.

Þ Treasury bills- Short-term debt obligations of a national government that are issued to mature in three to twelve months.

Þ Money funds- Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.

Þ Foreign Exchange Swaps- Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future Short-lived mortgage-and asset-backed securities

Discount and accrual instruments

There are two types of instruments in the fixed income market that pay the interest at maturity, instead of paying it as coupons. Discount instruments, like repurchase agreements, are issued at a discount of the face value, and their maturity value is the face value. Accrual instruments are issued at the face value and mature at the face value plus interest.


8.9/C3 http://www

8.9/C3 U.S. Securities and Exchange Commission: Invest Wisely — An Introduction to Mutual Funds(

8.9/C3 U.S. Securities and Exchange Commission: Money Market Funds(

8.9/C3 Federal Deposit Insurance Corporation: Insured or Not Insured?(


Illinois State Treasurer: About the Illinois Funds(



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8.10 Constituent\ institutions of Money market 8.10/C2 Constituent\ institutions of Money market:

Money market is not a homogeneous market. It is composed of heterogeneous sub-markets, each specialising in a specific short- term credit instrument. The following are the important constituents of money market:

1. Call Money Market:

The call money market deals with very short-period or call loans. Bill brokers and dealers in the stock exchange generally borrow money at call from the commercial banks. These loans are granted for a very short period, not exceeding seven days in any case. The borrowers have to repay the loans immediately whenever the banks call them back. No collateral securities are required against these loans.

Þ Market for very short period

Þ mainly deals with one day loans

Þ loan period does not exceed seven Days

Þ loans are generally made without

Þ Any collateral security

Þ low rate of interest

Þ high liquidity

2. Collateral Loan Market:

Collateral loan market refers to a market for loans secured against collateral securities like stocks and bonds. The collateral is returned to the borrower at the time when he repays the loan. In case the borrower fails to repay the loan, the collateral becomes the property of the lender.

Collateral loans are mostly granted by the commercial banks to private parties in the market and for a short period of a few months. Sometimes smaller banks also receive collateral loans from bigger banks.

Þ Loans are given for few Months.

Þ Loans are backed by securities.

Þ collateral money is returned

Þ When loan is repaid.

Þ loans are generally advanced

Þ By commercial banks to private

Þ Parties in the market.

3. Acceptance Market:

Acceptance market is a market for banker’s acceptances. A banker’s acceptance is a draft drawn by a business firm upon a bank and accepted by it whereby the bank is required to pay to the order of a specific party or to the bearer a specific sum of money at a specific future date. Banker’s acceptances are used mostly in financing the commercial transactions both within and outside the country. The banker’s acceptance is different from a cheque in that while the former is payable at a specified future date, the letter is payable on demand. Banker’s acceptance can be easily sold or discounted in the money market, called acceptance market.

Þ Market for bankers Acceptances

Þ old form of commercial credit

Þ drafts drawn upon a bank are

Þ Accepted and are payable on a

Þ Specified future date

A bankers’ acceptance(BA) is a short-term credit investment created by a non-financial firm and guaranteed by a bank tomake payment. Acceptances are traded at discounts from face valuein the secondary market. For corporations, a BA acts as a negotiable time draft for financing imports, exports or other transactions in goods. This is especially useful when the creditworthiness of a foreign trade partner is unknown. Acceptances sell at a discount from the face value:

Face Value of Banker’s Acceptance $1,000,000

Minus 2% Per Annum Commission for One Year -$20,000

Amount Received by Exporter in One Year $980,000

One advantage of a banker’s acceptance is that it does not need to be held until maturity, and can be sold off in the secondary markets where investors and institutions constantly trade BAs.

4. Bill Market:

Bill market specializes in the sale and purchase of different types of short-term papers or bills. The important types of bills are:

(a) bills of exchange and

(b) Treasury bills.

Since discounting of bills is the main business in the bill market, it is also known as discount market. It should be noted that the bill market does not deal with long-term treasury bonds and other long-term papers which involve long-term lending,

(i) Bill of exchange:

The bill of exchange is a written unconditional order signed by the drawer (seller) requiring the drawee (buyer) to pay on demand or at a fixed future date a definite sum of money. After the bill has been drawn by the drawer (seller), it is accepted by the drawee (buyer). Once the buyer puts his acceptance on the bill, it becomes a legal document. Such bills of exchange are discounted and re-discounted by the commercial banks for lending credit to the bill brokers or for borrowing from the central banks.

(ii) Treasury Bills:

While the bill of exchange is a commercial paper, the Treasury bill is government paper. The treasury bills are short-term government securities generally of three months’ duration. They are sold by the central bank on behalf of the government. They bear no interest rate and are offered on the basis of competitive bidding. Thus those who are satisfied with the lowest interest rate will be allotted the bills. Treasury bills, being government papers, inspire greater confidence among the investors.

Þ Market where bills are bought And sold

Þ deals in short term papers like Bills of exchange and treasury Bills

Þ bills of exchange are Commercial papers

Þ treasury bills are government Paper securities

Treasury Bills(T-bills) are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially, T-bills are a way for the U.S. government to raise money from the public. In this tutorial, we are referring to T-bills issued by the U.S. government, but many other governments issue T-bills in a similar fashion.

T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities. T-bills are purchased for a price that is less than their par(face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment.

This differs from coupon bonds, which pay interest semi-annually. Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at auctions. If you want to buy a T-bill, you submit a bid that is prepared either non-competitively or competitively. In non-competitive bidding, you’ll receive the full amount of the security you want at the return determined at the auction.

With competitive bidding, you have to specify the return that you would like to receive. If the return you specify is too high, you might not receive any securities, or just a portion of what you bid for. (More information on auctions is available at the TreasuryDirectwebsite.)

The biggest reasons that T-Bills are so popular is that they are one of the few money market instruments that are affordable to the individual investors. T-bills are usually issued in denominations of $1,000,$5,000, $10,000, $25,000, $50,000, $100,000 and $1 million.Other positives are that T-bills (and all Treasuries) are considered to be the safestinvestments inthe world because the U.S. government backs them. In fact, they are considered risk-free. Furthermore, they are exempt from state and local taxes.

The only downside to T-bills is that you won’t get a great return because Treasuries are exceptionally safe. Corporate bonds, certificates of depositand money market funds will often givehigher rates of interest. What’s more, you might not get back all of your investment if you cash out before the maturitydate.

5. Commercial papers:

Commercial paper (CP) is a short -term debt instrument issued only by large, well known, creditworthy companies and is typically unsecured. The aim of its issuance is to provide liquidity or finance company’s investments, e.g. in inventory and accounts receivable. The major issuers of commercial papers are financial institutions, such as finance companies, bank holding companies, and insurance companies.

Financial companies tend to use CPs as a regular source of finance. Non-financial companies tend to issue CPs on an irregular basis to meet special financing needs. Thus commercial paper is a form of short-term borrowing. Its initial maturity is usually between seven and forty-five days. In US, the advantage of issuing CPs with maturities less than nine months is that they do not have to register with the Securities Exchange Commission (SEC) as a public offering. This reduces the costs of registration with SEC and avoids delays related to the registration process.

For many corporations, borrowing short-term money from banks is often a laborious and annoying task. The desire to avoid banks as much as possible has led to the widespread popularity of commercial paper. Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories.

It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than nine months, with maturities of between one and two months being the average.

For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper. Over the past 40 years, there have only been a handful of cases where corporations have defaulted on their commercial paper repayment. Commercial paper is usually issued in denominations of$100,000 or more. Therefore, smaller investors can only invest in commercial paper indirectly through money market funds.

6. Certificates of deposit:

Certificate of deposit (CD) states that a deposit has been made with a bank for a fixed period of time, at the end of which it will be repaid with interest. Thus it is, in effect, a receipt for a time deposit and explains why CDs appear in definitions of the money supply such as M4. It is not the certificate as such that is included, but the underlying deposit, which is a time deposit like other time deposits. An institution is said to ‘issue’ a CD when it accepts a deposit and to ‘hold’ a CD when it itself makes a deposit or buys a certificate in the secondary market. From an institution’s point of view, therefore, issued CDs are liabilities; held CDs are assets. The advantage to the depositories that the certificate can be tradable.

Thus though the deposit is made for a fixed period, he depositor can use funds earlier by selling the certificate to a third party at a price which will reflect the period to maturity and the current level of interest rates. The advantage to the bankis that it has the use of a deposit for a fixed period but, because of the flexibility given to the lender, at a slightly lower price than it would have had to pay for a normal time deposit.

A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on demand like those in a Checking account.

CDs offer a slightly higher yield than T-Bills because of the slightly higher defaultrisk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the amount of interest you earn depends on a number of other factors such as the current interstate environment, how much money you invest, the length of time and the particular bank you choose. While nearly every bank offers CDs, the rates are rarely competitive, so it’s important to shop around. A fundamental concept to understand when buying a CD is the difference between annual percentage yield(APY) and annual percentage rate(APR). APY is the total amount of interest you earn in one year, taking compound interestinto account.

APR is simply the stated interest you earn in one year, without taking compounding into account. The difference results from when interest is paid. The more frequently interest iscalculated, the greater the yield will be. When an investment pays interest annually, its rate and yield are the same. But when interest is paid more frequently, the yield gets higher.

For example, say you purchase a one-year, $1,000 CD that pays 5% semi-annually. After six months, you’ll receive an interest payment of $25 ($1,000 x 5 % x .5 years). Here’s where the magic of compounding starts. The $25 payment starts earning interest of its own, which over the next six months amounts to $ 0.625 ($25 x 5% x .5 years). As a result, the rate on the CD is 5%, but its yield is 5.06. It may not sound like a lot, but compounding ads up over time. The main advantage of CDs is their relative safety and the ability to know your return ahead of time.

You’ll generally earn more than in a savings account, and you won’t be at the mercy of the stock market. Plus, in the U.S. the Federal Deposit Insurance Corporation guarantees your investment up to $100,000. Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are paltry compared to many other investments. Furthermore, your money is tied up for the length of the CD and you won’t be able to get it out without paying a harsh penalty.

7. Repurchase agreements:

A repurchase agreement (REPO) is an agreement to buy any securities from a seller with the agreement that they will be repurchased at some specified date and price in the future. In essence the REPO transaction represents a loan backed by securities.

If the borrower defaults on the loan, the lender has a claim on the securities. Most REPO transactions use government securities, though some can involve such short-term securities as commercial Papers and negotiable Certificates of Deposit. Since the length of any repurchase agreement is short-term, a matter of months at most, it is usually assumed as a form of short-term finance and therefore, logically, an alternative to other money market transactions.

8. International money market securities:

Apart from variety of money market instruments which enable short-term lending and borrowing to take place in the domestic currency, in recent years some of the fastest growing markets have been the so-called Eurocurrency markets. These are markets in which the borrowing and lending denominated in a currency of some other country takes place. In general, Eurocurrency market instruments are the same as other money market instruments. When such instruments are denominated in some other currency, they are identified as ‘euro -‘, though it can be any currency (e.g. US dollars, or Japanese yen). The trading can also take place anywhere (in European countries or in New York or Tokyo or Hong Kong).


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8.11 Characteristics of a Developed Money Market 8.11/C2 Characteristics of a Developed Money Market:

In every country of the world, some type of money market exists. In some countries like U.K. these are highly developed, whereas in some other countries like India, these are not so well-developed. Professor S.N. Sen has described the characteristics of a developed money market in his book Central Banking in Undeveloped Money Markets’. The absence of one or more of the following characteristics of a developed money market will make a particular money market an underdeveloped one.

1. Highly Organised Commerical Banking System.

Commercial banks are the most important constituent of money markets. A fully developed money market is characterized by the presence of a highly organised commercial banking system, while in an underdeveloped money market the banking system is not fully developed. In a developed money market, the other constituents of the money market are well-linked with the commercial banks and through them to the Central Bank.

2. An Apex Central Bank.

The second essential characteristic of a developed money market is the presence of an apex central bank at the top. The main function of the central bank is to help, control and stabilise the monetary and banking system of the country. It is generally a very powerful bank exercising control over the other constituents of the money market. It acts as the lender of last resort and gives temporary financial assistance to commercial banks in times of need by re-discounting their eligible bills.

3. Adequate Availability of Credit Instruments.

In a developed money market, there is an adequate availability of credit instruments like promissory notes, bill of exchange, treasury bills, short-period government bonds, etc.

4. Number of Dealers.

There should be a number of dealers and brokers in developed money market that should buy and sell the credit instruments. An underdeveloped money market, on the other hand, is characterised by the absence of adequate credit instruments and dealers to deal in them.

5. Existence of a Large Number of Sub-markets.

Another essential characteristic of a developed money market is the existence of a large number of specialised sub-markets, such as, call market, bill market, collateral market and acceptance market. The larger the number of specialisedsub-markets, the more highly developed is the money market.

6. Proper Co-ordination among Sub-markets.

The whole organisation of the money market should work in properly coordinated and integrated manner. Various sub-markets of a developed money market should be complementary to each other and not be independent or isolated.

7. Integrated Interest Structure.

The money market to be a developed one should have well coordinated and integrated interest structure. Any change in the bank rate in the country should bring proportional changes in the interest rates in the market.

8. Responsive.

A developed money market is highly responsive to domestic and international events. Any event that takes place in the economic or political field anywhere in the world affects the money market.

9. Remittance Facilities.

In a developed money market, cheap facilities for the remittance of funds from one place to another are readily available. Money market cannot work smoothly in the absence of cheap remittance facilities.

10. Other Factors.

In addition to the above mentioned important characteristics of developed money market, there are other contributory factors such as large volume of trade, stable political conditions, etc. London Money Market is the best example of a highly developed money market as all the characteristics of a developed money market are found there. The lack of any of the above characteristics produces a less developed money market and when these are totally absent, the money market will be an underdeveloped money market.

11.Presence of a Central Bank:

The second essential feature of the organisation of a developed money market is the presence of a central bank. Just as a State cannot exist and function properly without a head, so also a money market cannot function properly without a central bank. The central bank keeps the cash reserves of all commercial banks and comes to their rescue and the money market as a whole in times of difficulties by rediscounting eligible securities. In times of emergency and crisis, the central bank enables the money market to convert near-money into cash. Besides, it performs a valuable service through open-market operations when it absorbs surplus cash during off-seasons and provides additional liquidity in times of financial stringency. Thus the central bank is the leader of the money market, as well as its controller and guide. Without an efficient central bank, a developed money market cannot exist. In an undeveloped money market, either the central bank does not exist or is in its infancy without adequate capacity to influence and control the money market.

12. Availability of Proper Credit Instruments:

An effective money market will require a continuous supply of highly acceptable and, therefore, negotiable securities such as bills of exchange, treasury bills, short-term government bonds, etc. At the same time, there should be a number of dealers in the money market who should buy and sell these securities. Without their presence, there cannot be any competition or “life” in the money market. Thus the availability of adequate short-term assets and the presence of dealers and brokers to deal in them are essential conditions for the evolution of an organised and developed money market. An undeveloped money market, on the other hand, is characterised by the absence of sufficient short-termcredit instruments as well as dealers and brokers to deal in them.

12. Existence of a Number of Sub-markets:

The fourth essential condition for the evolution of a developed money market is the organisation of the money market into a number of sub-markets, each speci alising in particular type of short-term assets. Each type of short-term asset-depending upon the nature of the asset and period of maturity involved-is dealt with in a separate market. While a developed money market consists of a number of sub-markets each specialising in a particular type of short-term asset, an undeveloped market does not possess all the important and essential sub-markets particularly the bill market. Besides, there is no coordination between the different sections of the money market in an undeveloped money market.

13. Availability of Ample Resources:

The fifth essential condition for a developed money market is the availability of ample resources to finance the dealings in the various sub-markets. These resources generally come from within the country but it is also possible that foreign funds may also be attracted.

While developed money markets, like London and New York, attract funds from all over the world, undeveloped money markets do not attract foreign funds mainly because of political instability and absence of stable exchange rates. Apart from these above important factors which are responsible for the evolution of a developed money market over a number of years, there should be many other contributory factors also, such as a large volume of international trade leading to the system of bills of exchange, industrial development leading to the emergence of a stock market, stable political conditions, absence of discrimination against foreign concerns, and so on. It is difficult to come across many developed money markets. London money market is the best example of such a market, for all the characteristics of a developed money market are to be found there. The Indian money market is a good example of an undeveloped money market.


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8.12 Usefulness of a Developed Money Market

8.12/C3 Usefulness of a Developed Money Market:

The money market is an important institution in a modern economy and it has influenced profoundly industrial and commercial developments:

(a) In Financing Industry and Commerce:

In the first place, the money market isof very great help in financing industry and commerce. Industries are helped intheir working capital requirements through the system of finance bills, commercialpaper, and so on. It has played a very important part in the financing of trade and commerce. Both internal as well as international trade is normally financed through the system of bills of exchange which are discounted by the bill market.

(b)Investment of Short-term Funds:

The money market plays a very important rolein providing necessary assets for the investment of short-term funds of commercial banks. Commercial banks find such assets in the call money market as well as in the bill market. Thus, the money market offers the commercial banks a very good means of temporarily employing their funds in liquid or near-money investments.

(c)Help to the Central Bank:

The money market is of great help to the central bank of the country. For one thing, the money market and short-term rates of interest which prevail there serve as a good barometer of monetary and banking conditions in the country and thus provide a valuable guide to the determination of central banking policy. For another, the developed money market being a highly integrated structure enables the central bank to deal with the most sensitive of the sub-markets so that the influence of the operation of the central bank may spread to other sections also.

(d) Help to the Government:

Lastly, the money market helps the government. The money market supplies the government with necessary short-term funds through the treasury bills. Thus, a developed money market is of great assistance to industry and commerce, to the commercial banking system, to the central bank of the country and to the government


Role of central bank in money market

8.13/C2 Role of central bank in money market:

Money Market consists of all the institutions which are engaged in the borrowing and lending of short term funds. The members of money market are

(1) central bank at the top

(2) commercial banks

(3) Co-operative banks

(4) Saving Banks

(5) Specialized financial institutions

(6) Discount houses and

(7) Stock exchanges

Money Market may here be distinguished from capital market. Capital market is a collection of specialized institutions engaged in the employment of medium and long term funds primarily for the raising of new capital.

In a developed country, the money market is highly organized and diversified; whereas in a developing country there are a few organized institutions which trade in the borrowing and lending of short term debts. In a developing country, the commercial banks cooperative banks saving banks and other financial institutions do exist but they are relatively few and are usually concentrated in big city arrears. There is also no stable and active market for the sale and purchase of bonds and securities.

The lack of financial institutions greatly hampers economic progress in a country. When the number of institutions are a few and scattered people consume more of their income. Saving in kept under mattresses or at some other hidden places. Saving is also done in kind. In order to attract the people to save, an incentive and sale outlet is to be provided to them. The financial institutions provide the safe means of accumulating surplus funds of the people and putting them to productive use. The central bank here comes to the help of money market. It establishes art extensive system of commercial banks, saving banks etc., in which people can deposit savings and the investors, can borrow as and when they need The central bank thus helps in the increase of funds available for capital formation.


Financial markets essentially involve the allocation of resources. They can be thought of as the “brain” of the entire economic system, the central locus of decision making: if they fail, not only will the sector’s profits be lower than they would otherwise have been, but the performance of the entire economic system may be impaired. The standard theories of the efficiency of competitive markets are based on the premise that there is perfect information or, more precisely, that the information held by individuals or firms is not affected by what they observe in the market and cannot be altered by any action they can undertake, including acquiring more information. Thus the fundamental theorems of welfare economics, which assert that every competitive equilibrium is Pareto efficient, provide no guidance with respect to the question of whether financial markets, which are essentially concerned with the production, processing, dissemination, and utilization of information, are efficient.

On the contrary, economies with imperfect information or incomplete markets are, in general, not constrained Pareto efficient (Greenwald and Stiglitz 1986); there are feasible government interventions that can make all individuals better off. Thus not only is there no presumption that competitive markets are efficient, but there is a presumption that they are inefficient. Moreover, even with no other barriers to entry, in the presence of costly information there is a presumption that markets will not, in general, be fully competitive. This strengthens the presumption that markets, in the absence of government intervention, are not constrained Pareto efficient. Determining whether or how government interventions can improve matters is a more subtle question. But first it may be useful to discuss why costly information gives rise to market failure.


Information differs from conventional commodities in several important ways. Information is, in a fundamental sense, a public good. The two essential features of a pure public good are nonrivalrous consumption (the consumption of the good by one individual does not detract from that of another) and nonexcludability (it is impossible, or at least very costly, to exclude anyone from enjoying the public good). Information possesses both of these attributes. (For instance, if I tell someone something I know, I still know it; his knowledge of that fact does not subtract from mine.)

As is well known, competitive market economies provide an insufficient supply of all public goods–including information. Because of the difficulties of appropriating the returns to information, there are often externalities associated with its acquisition. Others benefit from the information acquired by an individual. Moreover, expenditures on information can be viewed as fixed costs; they do not need to increase with the amount of lending (although lenders may spend more on acquiring information when larger amounts are involved). Because of the fixed-cost nature of information, markets that are information-intensive are likely to be imperfectly competitive. There may, in fact, be many firms engaged in similar activities, but it will not pay firms to obtain exactly the same information–say, concerning a particular borrower (see Stiglitz 1975b; for a brief discussion of the implications for credit markets see Jaffee and Stiglitz 1990). Without perfect competition, markets will not, ingeneral, be efficient.

Finally, if there are to be incentives to gather information, markets must be, to some extent, informationally inefficient; not all information can be transmitted from informed to uninformed investors (Grossman and Stiglitz 1976, 1980).

Accordingly, financial markets–whose essential role is to obtain and process information–are likely not only to differ from markets for conventional goods and services but to differ in ways that suggest that market failure will be particularly endemic in financial markets.


We now turn to a description of several of the key manifestations of market failure in financial markets.

Monitoring as a public good.

Problems of information as a public good arise in at least two contexts in financial markets: information about the solvency of financial institutions, which is obviously of great value to investors (or depositors) who are considering entrusting funds to or withdrawing funds from a particular financial institution; and information about the management of these institutions, which affects the risk and return on investments. Monitoring solvency can be viewed as one aspect of the more general problem of monitoring the use of capital. How well an economy functions depends on the efficiency with which its capital is allocated. It is management’s responsibility to allocate resources efficiently and to monitor the firm’s workers. But who monitors the managers? In principle,the answer is the board of directors. This only pushes the question back one step: who monitors the board of directors? And what incentives do they have to do a good job?

Monitoring, like other forms of information, is a public good. If one shareholder takes actions that enhance the value of the shares of the firm (for instance, by improving the quality of management), all shareholders benefit. If one lender takes an action that reduces the likelihood of default–for instance, by monitoring management more closely–all lenders benefit. As in the case of any public good, there is an undersupply; too little effort is expended on monitoring financial institutions–with the expected consequences. First, because the managers know that they are not being monitored, they may take inappropriate risks or attempt to divert funds to their own use.

Second, because investors cannot rely on financial institutions, fewer resources will be allocated through the institutions, and they will not be able to perform their functions as well as they might otherwise.

Externalities of monitoring, selection, and lending.

One of the most important functions of financial institutions is to select among alternative projects and to monitor the use of the funds. The observation that another lender is willing to supply funds reassures the potential investor. It confers an externality, the benefit of which is not taken into account when the first lender undertakes his or her lending activity.

By the same token, the second lender may confer a negative externality on the first lender. (Because the likelihood of default is a function of the total amount borrowed, lenders may try to restrict borrowers from securing funds from other sources; Arnott and Stiglitz 1991.) There are other “within market” externalities. Investors, too, have imperfect information. When a bank fails, they may conclude that similar events may have adversely affected other banks as well and

may decide to withdraw their funds, possibly inducing a run. The presence of a large number of “bad” firms seeking to raise equity makes it more difficult for good firms to raise capital because potential investors find it difficult to sort out the two. This is an example of the familiar kind of externality associated with selection problems: the existence of firms that bad risks imposes screening costs and can even “spoil” a market (see Stiglitz 1975c). Some externalities extend across markets. Actions in the credit market affect the equity arket, and vice versa. For instance, the fact that a bank is willing to lend money affects the firm’s ability to raise equity capital, both because it has a positive signaling effect and because potential stockholders know that it is more likely that the firm will be supervised by the bank. In recent years equity owners have exerted strong negative externalities on creditors by restructuring; by increasing debt, they have reduced the market value of outstanding debt.

Under modern capitalism, at least for large firms with widely diversified ownership, there is a separation of ownership and control that gives rise to an important class of monitoring problems and externalities. Shareholders exercise effective control neither directly, through the proxy mechanism, nor indirectly, through the takeover mechanism. Banks, through their threat not to renew credit, often exercise far more influence. This view can be traced back to Berle (1926) and was revived by Stiglitz (1985).

In either case, those exercising controlhave significant effects on others; for instance, bank monitoring, while it may reduce the likelihood of insolvency, may also reduce the upside potential of equity. The design of financial institutions and regulations may affect the extent and form of monitoring as well as the extent to which externalities are internalized. The close relationships between banks and their borrowers observed in Japan may facilitate monitoring (see Aoki 1992), and the fact that banks may own shares in the firm may reduce the potential scope for conflicts of interest between the banks and shareholders. In the United States such links are prohibited by the Glass-Steagall Act, and banks that are involved in the management of firms which have borrowed money may lose their seniority status as creditors in the event of bankruptcy.

Externalities of financial disruption.

The macroeconomic consequences of disruptions of the financial system provide one of the more important rationales for government intervention. The failure of even a single financial institution can have significant effects. It is often argued that the cost of bankruptcy is greatly overestimated because the assets of the firm do not disappear but merely change ownership.

Although there may be some truth in this contention, the essential asset of a bank–its information capital–is not easily transferred. In the event of bankruptcy, this information capital may be largely dissipated. Thus the bankruptcy of a single bank–and even more so the bankruptcy of multiple banks–may disrupt the flow of credit to particular borrowers. Bank insolvency has indirect effects as well.

Borrowers may have to curtail their activities, with further repercussions on customers and suppliers. This may lead to a cascade of effects familiar to students of general equilibrium theory (see Stiglitz 1987a). There are also signaling effects: for instance, even if a bankruptcy does not trigger a financial panic, some depositors will withdraw funds from other financial institutions because of a perceived risk of default. These withdrawals may have an adverse effect on other financial institutions by leading investors to question their viability.

When institutions make decisions, however, they do not take these externalities into account; they only look at their private costs and benefits. Thus the public interest in the solvency of financial institutions may exceed the private interests of the owners and managers. Governments cannot sit idly by when faced with the impending collapse of a major financial institution. Moreover, both banks and investors know that the government will step in because it cannot commit itself not to intervene in the economy.

There have been isolated cases in which the government has not intervened, but these cases have usually involved small banks whose failure posed no threat. The difficulty of holding the government to specific commitments is one of the central ways in which the government differs from the private sector.

The private sector relies on the government to enforce its contracts. But who can enforce government commitments? The government thus performs the role of an insurer, whether or not it has explicitly issued a policy.

The provision of insurance tends to alter behavior, giving rise to the well-known problem of moral hazard; that is, the insured has a reduced incentive to avoid the insured-against event. In this case, banks, knowing that they are effectively insured, may take greater risks than they otherwise would. In particular, they may undertake risks similar to those being undertaken by other banks, since they assume that although the government might ignore the problems of a single bank, it could not allow the entire financial system to go belly-up. So long as the bank does what other banks are doing, the probability of a rescue is extremely high. Most insurance gives rise to moral hazard problems.

Insurance firms attempt to mitigate the moral hazard problem by imposing restrictions. For instance, fire insurance companies typically require that sprinklers be installed in commercial buildings. Once we recognize the role of government as an insurer (willing or unwilling), financial market regulations can be seen from a new perspective, as akin to the regulations an insurance company imposes. The effects of some versions of financial market liberalization are similar to an insurance company’s deciding to abandon fire codes, with similar disastrous consequences.

Missing and incomplete markets.

It is surprising that equity markets, even in industrial countries, are so weak, since equity provides a mechanism for sharing risks and there is considerable evidence that individuals (and firms) are risk averse. In some important sense, therefore, these markets are not working well. (See Greenwald, Stiglitz, and Weiss 1984. Contrary to the Modigliani-Miller theorem, when information is imperfect, financial structure matters, as does the range of available financial instruments; see Stiglitz 1988.) Similarly, the prevalence of credit rationing suggests the existence of fundamental problems with credit markets.

Not only are certain key markets (such as those insuring a variety of risks) missing, but even long-term contracts that would seem desirable were not available until relatively recently (in a historical sense). In many countries their existence was the direct result of government actions (see Rey and Stiglitz 1992). Recent theories provide a single set of explanations for these well-documented imperfections in the capital market:

information is imperfect and costly to obtain. Problems of adverse selection and moral hazard imply that the effective costs of transactions in certain markets may be so high as to limit trade or to lead to the demise of those markets (see Akerlof 1970; Greenwald, 1986; Stiglitz 1982). The government has several marked advantages in risk-bearing.

First, because it can force membership in insurance programs, it can avoid the adverse selection problems that plague risk markets in general and insurance markets in particular. Adverse selection has a social cost as well. Insurance firms must spend large amounts to improve the quality of their pool of insured policyholders, and the prices (premiums and interest rates) of insurance reflect these expenditures.

A second advantage is the government’s ability to mitigate the effects of moral hazard that arise because lenders lack information. The government has the power to compel the disclosure of information through a range of indirect instruments, including taxes, subsidies, and regulations (for a discussion see Arnott and Stiglitz 1986). Information available in the income tax system, for instance, can be used to reduce the risks of loan default and to design loan payments contingent on income.

A third advantage is that private markets cannot handle the kinds of social risk associated with macroeconomic disturbances. Markets are good at insuring individuals against accidents. But if all individuals are similar, who is to absorb the social risk? It can be spread across generations, but only the government can engage in such intergenerational transfers of risk. Offsetting these advantages, however, the government is at a marked disadvantage in assessing risks and premiums, in part because such assessments are, to a large extent, subjective. The government inevitably has to employ relatively simple rules in risk assessments–rules that almost surely do not capture all the relevant information–and political considerations will not allow it to differentiate on bases that the market would almost surely employ.

By contrast, the market converts the subjective judgments of a large number of participants into an objective standard. If a bank, say, complains about the risk premium charged by the market (in the form of the rate it must pay to attract uninsured depositors), there is a simple answer: show the market the evidence that the risk has been overestimated. The jury of the market renders a verdict. If the information is credible, the risk premium will reflect that information.

The difficulties of determining whether interest rates are actually appropriate exacerbates an ever-present problem with government lending programs: the opportunity to provide (often hidden) subsidies. Students in the United States and large farmers in Brazil, for example, have been the beneficiaries of hidden subsidies.

The temptation to use such subsidies for political purposes is one that many governments have found difficult to resist. Another perspective, arguing the government should assume a significant amount of risk within financial markets, emphasizes the government’s responsibility for dealing with the risks associated with the insolvency of financial institutions. If the regulatory structure is designed and enforced appropriately, insolvencies should be relatively rare. In practice, macroeconomic downturns are a major cause of insolvencies, and avoiding such downturns is the responsibility of the government. Making the government bear the costs of a failure to live up to its responsibilities provides a natural incentive for it to do its job well.

Imperfect competition.

Earlier I noted that information naturally gives rise to imperfect competition. This is important because the underlying belief in the efficiency of market economies is based on the premise that competition not only exists, but is “perfect.” Yet in most countries competition in the banking sector is limited. The distinguishing characteristic of most markets is that any seller is willing to sell to any buyer at the preannounced price. This is true in deposit markets, but in loan markets borrowers may face a very limited number of suppliers and may find it difficult to switch from one to another.

Each bank has specialized information about its customer base. A customer who has a long track record with one bank and therefore is viewed as a good loan prospect by that bank may be unknown to another bank and may therefore be considered a riskier prospect (see Stiglitz and Weiss 1983). Thus the fact that there are ten lenders supplying loans in a market does not mean that each customer has a choice of ten suppliers. Even when there are many banks, competition may be limited.

Pareto inefficiency of competitive markets.

As is true for many theorems, the proof of the fundamental theorem of welfare economics (the theorem that underlies economists’ faith in markets) employs a large number of assumptions, some essential, some for simplification. Two of the assumptions are absolutely crucial; in their absence, the theorem is not in general true: there must be a complete set of markets, and information must be exogenous–that is, unaffected by any action a participant in the market can take.

As should bynow be clear, these assumptions are particularly disturbing in the case of financial markets. Gathering information is one of the essential functions of financial markets; sharing and transferring risk is another. Still, many risks remain uninsured, with the result that financial (risk) markets are incomplete. Greenwald and Stieglitz (1986) note that when information is endogenous or markets incomplete, the economy is not constrained Pareto optimal: there are government interventions that take into account the costs of information and of establishing markets that can make all individuals better off.

These particular market failures go beyond those referred to earlier. Even when there are markets, and even when they are competitive, private returns diverge from social returns. The failure of the standard results concerning the efficiency of markets can be approached in two ways: by looking at why the standard arguments fail or by looking at how government interventions might improve matters. The standard argument is based on the assumption of market-clearing prices; prices then measure the marginal benefit of a good to a buyer and the marginal cost to the seller. But credit markets cannot operate like ordinary auction markets, with the funds going to the highest bidder.

With imperfect information, markets may not clear. In credit markets those who are willing to pay the most may not be those for whom the expected return to the lender is the highest; the expected return may actually decrease as the interest rate increases because the probability of default may rise. As a result, there may be credit rationing: even though there is an excess demand for credit, lenders may not increase the interest rate. Rather, the interest rate will be set to maximize the lenders’ expected return. Thus credit is rationed when, at this profit-maximizing interest rate, there exists excess demand for credit.

Moreover, social returns may differ from private returns. Lenders focus only on the expected return that they receive; the total return includes the (incremental) surplus (profit) accruing to the entrepreneur. The projects with the highest expected return to the lender may not be those with the highest total expected return, but they are the ones that get funded.

Thus part of the rationale for directed credit is that good projects may be rationed out of the market. Several government programs reflect this perception of a discrepancy between social and private returns, although in some cases the view is that the market is excessively conservative and in other cases that it undertakes unnecessary risks. In any countries the collapse of the real estate market has had far-reaching effects on the entire financial system. But even short of these effects, social returns to real estate may differ from private returns.

This can be seen in a situation where banks, instead of rationing credit, lend to those willing to pay the highest interest rate. Consider the example of speculative real estate loans versus loans for manufacturing. Because the maximum returns in manufacturing are limited, there is a limit to the amount that borrowers are willing to pay.

The returns on real estate, however, are highly variable; prices can–and frequently do–rise by more than 40 percent a year. (In any case, what matters is investors’ perceptions about the possible returns, and these indeed may be high.) So long as there is limited liability and lenders are willing to make highly leveraged loans and accept real estate as collateral, it pays real estate speculators to take out loans even at seemingly exorbitant interest rates (more than 30 percent).

They are in a “heads I win, tails you lose” situation. If their hopes are realized, they walk off with huge gains (particularly when viewed as a percentage of their invested equity); if not, the lender is left holding the bag. Thus even if there were no externalities associated with investing in manufacturing–no linkages outside the investment itself–the social returns to manufacturing might exceed those resulting from real estate speculation. The interest rate charged does not reflect the social returns to investment. These arguments establish that markets may not allocate capital to the uses with the highest return. There may be systematic deviations between social and private returns that direct government intervention–restricting some classes of loans and encouraging other classes–may partially address.

Uninformed investors.

This final category of problems has motivated considerable government intervention but is not, in a formal sense, a market failure. What happens if individuals have information but do not process it correctly? What happens if a lender discloses the terms of the contract accurately but consumers cannot distinguish effectively between compound and simple interest, do not understand provisions concerning indexing, and so on?

Indeed, there is a more general problem: decisions concerning investments are based on probability judgments that are outside the province of economic analysis. As welfare economists, we make no judgment about whether an investor’s calculation of the relative probabilities of different outcomes is right or wrong, as part of the general doctrine of consumer sovereignty, but for some probability judgments there may be objective data concerning relative frequencies. Of course, there is always a judgment call concerning whether past experience is applicable for inferring future likelihoods. Still, research (see Kahneman and Tversky 1974) has drawn attention to the fact that there may be systematic biases in most individuals’ probability judgments. In that case, are policymakers to make judgments about resource allocations on the basis of misperceived subjective probabilities or on the basis of more relevant relative frequencies (where these can be obtained)? Should the government intervene to ensure that individuals’ subjective judgments are determined with more complete knowledge of relative frequencies or in fact are in accord with the government’s perception of the relevant relative frequencies?

Some of the disclosure requirements imposed by governments seem designed to make sure that firms do not take advantage of uninformed consumers. But information is at the heart of capital markets; much trading is based on differences in information. When someone buys shares, she or he is probably more optimistic than the seller. What information should traders be required to disclose?

Some of the disclosure requirements imposed by government seem addressed to these problems, which, in terms of more conventional terminology, would fall under the rubric of “merit goods and bads” rather than outright market failures. There is a consensus that, by prohibiting unfair practices, government helps to create a more level playing field and promote investor confidence; if there is a widespread view that markets are rigged, trade will be thin and markets will not function well. Still, there is controversy over whether these practices benefit financial markets, whether the regulations attempting to restrict these practices may actually make matters worse, and whether instead principles of “caveat emptor” should apply.

Role of Central Bank

Principles of regulation

The government does have powers (arising from its ability to compel and proscribe) that the private sector lacks. At the same time, it is subject to constraints and limitations (including equity constraints and restricted ability to enter into commitments) that may make it less effective than private sector enterprises.

The essential problem of public regulatory policy is to ascertain which interventions can bring to bear the strength of the government so as to improve the workings of financial markets. Once regulations are put in place, governments must monitor banks to ensure compliance. Regulators should be guided by certain principles in choosing what should be regulated and what standards should be set.

Indirect control mechanisms

Not all variables are easily observable. Consider the requirement that banks take “prudent actions” and exercise faithfully their fiduciary responsibilities. Ascertaining whether a particular loan is or is not prudent is tricky. Having government regulators appraise every property to see whether the collateral is in fact adequate is feasible but expensive. Reviewing every action to see whether there might be a conflict of interest or a violation of a fiduciary responsibility would be prohibitively costly. Accordingly, regulators must rely on indirect controls.These take two forms, incentives and restrictions.


Incentive-based regulations provide an environment in which the incentives of managers are aligned with those of regulators. Adequate net worth requirements, for instance, provide an incentive to be prudent. If the bank goes bankrupt, the owners have more to lose; it is as simple as that. There is a general theorem showing that when net worth falls below a certain critical threshold, banks switch from a risk-averse to a risk-loving stance; that is, of two investments with equal total mean returns, banks would actually prefer the riskier loan.


As noted earlier, insurance firms attempt to mitigate the moral hazard problem by imposing restrictions–we could as well call them regulations–on those they insure. Or they set different rates depending on whether the insured party conforms to some regulation; for instance, houses with sprinklers would qualify for lower rates for fire insurance.

They thus try to mitigate the moral hazard problem by restricting behavior that will result in a higher probability of accident. Similar considerations apply to banking. Many banks, if not forbidden to do so, would make bad loans to their officers and to relatives of their officers. This may be a matter of fraud and deception: the bank officers may be attempting to transfer wealth to themselves by charging interest rates below the actuarially fair levels. Or it may be no more than bad judgment–the bank officers may be enthusiastic about their own projects and consider the probability of success very high. Because such errors are so common, because monitoring a project is so difficult, and because the opportunities for fraud and misjudgment are so rife, it is not unreasonable for regulators to restrict loans to insiders. But if the project is viable, the insiders should be able to get loans from other sources.

Restrictions on loans to insiders do not completely address the problem, however, because of “reciprocity.” The owners of bank A may make loans to the owners of bank B, and conversely, at rates that do not reflect the true actuarial risk of default. These problems are exacerbated when the owner of a bank is an industrial firm and the bank can be persuaded to give favorable treatment to the firm’s suppliers and customers.

Again, the cost of detecting such abuses is very high. It is far simpler to stipulate that an industrial firm may not own a bank. (The firm’s shareholders would derive an advantage from ownership of the bank only if the firm was to take advantage of its ownership position or if the management of the firm–say, an automobile manufacturer–had some managerial comparative advantage in running a bank. The former is an argument against having industrial firms own banks; the latter seems unpersuasive.) The problem we have just examined can be looked at from another perspective: banks provide their owners with a strong incentive for misjudgments that benefit themselves, and regulators need to correct such incentive problems.

In addition, a financial institution with a substantial amount of equity in a firm may have an incentive to lend the firm funds to “tide it over” a short-run shortage of cash. It will be inclined to interpret the problem the firm faces as minor, as a problem of liquidity rather than insolvency. A similar situation occurs when a financial institution sponsors an equity issue and recommends that its customers buy it.

If the firm later faces a cash shortfall, the financial institution has an incentive to provide funds to shore it up in order to maintain its reputation as an issuer of equity. Its desire to maintain that reputation may conflict with its incentives to make prudent loans. There are, of course, many ways that a bank can aid a firm. It may provide a loan directly or make a loan to a major customer of the firm to enable the customer to buy more of the firms’ products. Because of the difficulties of monitoring all the possible forms of aid, it may make sense for regulators to restrain any institutions that make loans with government deposit insurance–either implicit or explicit–from undertaking certain other financial services.

Setting regulatory standards

The selection of the appropriate regulatory standard will depend on how well the variable in question can be measured. It is possible that the variable is measured with error, and, if the regulated firms have influence over what is measured, there may be systematic bias as well. Consider the problem of the net worth requirement.

Ensuring that the bank does not become insolvent depends on the variability of the asset portfolio as well as on the frequency with which net worth is monitored. If net worth is monitored continuously, then as soon as a bank’s assets decrease in value, the decline in its net worth is registered, and any bank that falls below a certain threshold is instantly closed down. In that case a relatively low standard might be chosen. In practice, however, there are lags in detection and enforcement. The greater these lags, the higher the standard needed to ensure the probability that the true value of the variable in question will be above the desired level.

The greater the variability in the value of the assets, the higher the probability that a problem will arise, given any particular set of lags. That is why it makes sense to have the type of risk-based capital standards that were developed during the 1980s. Although these standards recognize that there is less risk associated with a government treasury bill than with a commercial loan, the risk adjustments are far from perfect.

Even with some risk adjustment, given the varying lags in and quality of information and the different degrees of volatility in asset prices, net worth and capital requirements should be tailored to the specific country. Thus while an argument can be made for a uniform minimum standard, in practice the standards of the Bank for International Settlement (BIS) have become the standard.

I would argue, however, that in some countries and during some periods standards should be higher–perhaps substantially higher. The regulations must also be based on the recognition that there are important asymmetries of information between the bank and the regulators, since the “books” of the bank are largely under the bank’s control, so that the information presented to regulators may quite possibly be distorted.

Thus banks are in a position to sell undervalued assets (and thereby record a capital gain over book value) but hold on to overvalued assets and carry them on their books at book value. When banks systematically engage in this practice, book value will systematically overestimate true value.

Resource and incentive problems

Limitations on resources and incentives often hamper the effectiveness of regulation. Governments should do more than just complain about these limitations; they need to recognize these limitations in the design of regulations and regulatory structures and try to take advantage of information and incentives within the marketplace. The problem concerning resources is straightforward. The administrative resources available to the government are decisive for the effectiveness of its performance.

The limitations on salaries of government employees, as well as other budgetary restraints, put government monitors at a marked disadvantage. Is it likely that a $15,000-a-year (or even a $45,000-a-year) civil servant will be able to detect the machinations of $100,000-a-year accountants? The more complex the regulatory structure, the more likely that the differences in resources will come into play.

The problem of incentives is more complex and involves the design and enforcement of regulations. As noted earlier, private insurance firms have an incentive-provided by the profit motive–to look for regulations that are cost-effective; that is, regulations which reduce the occurrence of the insured-against event by enough to warrant the inconvenience imposed on the insured and are relatively inexpensive to enforce.

The public sector often has no such direct incentive. Occasionally, competition among communities and governments provides such incentives. Many businesses are footloose and choose to locate where there is a favorable regulatory climate. This does not necessarily mean an environment that minimizes regulation; Singapore has established itself as a regional financial center, in part because of the effectiveness of its regulatory system.

More generally, our task as public policy analysts is to look for cost-effective regulations. Another concern is that incentives for enforcing the regulations may be insufficient. Bureaucrats and politicians often have an incentive to postpone the strong enforcement of banking regulations in the hope that problems with banks will disappear–or at least will not surface during their watch on the bridge. The costs of postponement, which have proved to be significant, are borne by others.

It may be hard to design effective incentive structures where consequences of actions today are realized only years into the future. At the very least, appropriate accounting systems that reflect the costs of assuming certain risks attract attention to what the government is doing and in this way help provide appropriate incentives.

Thus the incentive to provide loans at less than actuarially fair interest rates is mitigated to some extent by the requirement that the actuarial value of the loss be included in the budget in the year in which the loan is made. Since macroeconomic instability is one of the major causes of default, making sure that the government bears some of the consequences may be an effective incentive for stabilizing the economy. By the same token, making sure that the government bears some of the consequences for failed financial institutions provides it with greater incentives to monitor those institutions effectively.

Regulators do not always engage in regulatory forbearance. A significant problem in the United States in the aftermath of the savings and loan debacle is that regulators have been overzealous. Having been criticized for allowing too many banks to fail and for waiting too long, they have taken the opposite tack, and there have been widespread allegations that they have shut down banks prematurely. The full consequences for taxpayers or investors are not taken into account.

Discretion versus rules.

One solution to the problem of regulatory forbearance (or of overzealous regulators) would be to reduce the government’s discretionary judgment and establish strict guidelines under which intervention will occur. There is always a tension between rules and discretion. It is impossible to design rules that fit every situation. Less discretion therefore ensures a greater chance (at least compared with perfectly exercised discretion) of inappropriate action–say, closing a bank that should not be shut down or allowing a “bad” bank to stay open. Under any simple set of rules, these same two mistakes will occur. Tightening the standards will increase the probability of one type of error while reducing the other.

Which point in the continuum is chosen depends on the costs of the two types of errors and the relative likelihood that each will arise. Some regulatory structures are much simpler than others and leave relatively little scope for discretion. These include net worth and capital requirements, with simple adjustments for risk, and ownership restrictions. By contrast, ensuring that no transaction violates some fiduciary standard is costly and inevitably entails considerable discretion.

Multiple monitoring agencies.

Another standard objection to regulatory structures that provide considerable discretion is that they can breed corruption. In this connection it is useful to have more than one agency engage in monitoring. Corruption aside, all monitoring is fallible. Considering the large costs associated with allowing insolvent institutions to operate, one way of reducing the likelihood of that occurring is to have more than one independent monitor.

A more general problem is, who monitors the monitors In principle, the monitors have supervisors. But often the supervisors are not well informed. If there is more than one monitoring agency, a system of peer monitoring can be employed; each monitoring agency in effect monitors not only the financial institutions but also each other (see Stiglitz 1990 and Arnott and Stiglitz 1991).

Government’s limited ability to monitor the regulators suggests that duplicative regulatory oversight may have strong advantages which are well worth the extra costs. Reformers who ignore the central importance of information and control may look at organizational charts and suggest streamlining them to end the allegedly wasteful duplication. Such reform efforts may, from this perspective, be fundamentally misguided.

Using the private sector to extend the reach of regulation.

Government can take advantage of resources and incentives in the private sector to stretch its regulatory reach and make its monitoring more effective. The earlier suggestion that the government should focus on regulating such variables as net worth or capital, which it can observe at relatively low cost, falls into this category.

Government is, in effect, using the force of private incentives; its only role is to see that those private incentives are operative by ensuring that the firm has enough of its own wealth at stake. Governments need to remember too that the private market may serve as a regulatory mechanism. A party who has been hurt by fraudulent behavior can sue. Governments can enhance these incentives, as was done in the case of antitrust, with treble damages.

The government can also employ information provided by markets to guide its regulatory behavior. Share prices and the prices of (uninsured) bonds of financial institutions convey information about the market’s confidence in those financial institutions. A fall in those prices may provide important information for government regulators. And when the government sells off some deposit insurance risk through a reinsurance market, the prices on that market can provide it with valuable information concerning the risk of default.

Setting prudential standards

The three major principles of sound prudential regulation are to maintain high net worth and capital requirements, to restrict interest rates on insured deposits, and to restrict ownership and transactions where “fiduciary” standards are more likely to be violated. I have already said something about the first and third. After briefly elaborating on net worth requirements, I shall focus my remarks on the second.

Net worth requirements.

How important it is to measure net worth accurately depends on the standards that are chosen. When net worth standards are low, small errors may have broad consequences: a bank that is viewed as viable may actually have a negative net worth. If the net worth requirement is 20 percent of deposits and banks are closed when their net worth falls below that level, it is less likely that the true net worth is negative, and less likely that the government will be left holding the bag.

The controversy over whether bank assets should be marked to market needs to be viewed from this perspective. The consensus among economists is that this would be beneficial; otherwise, a bank may have a negative net worth even though its book value is positive. But the bank’s behavior is driven by its true net worth, not its book value.

Banks claim that marking to market results in a biased estimate because some assets are difficult to mark to market and these assets may be undervalued. But, as noted above, if there is a bias, it goes the other way: banks are always in a position to realize any capital gains. In the absence of marking to market, banks may sell assets whose market value has increased and hold assets whose market value has declined, so that the book value of the assets systematically exceeds their true net worth. With sufficiently high net worth requirements, the whole issue of whether we mark to market becomes less important. By the same token, failure to adjust deposit insurance premiums to reflect risk will be less important because the premium need only reflect the probability that the net worth of the bank becomes negative, and this probability (with appropriately high net worth standards) will be quite low.

Interest rate restrictions.

There is a wide body of opinion that opposes restrictions on interest rates. But when the government is providing insurance, it has the responsibility of any insurer to reduce the likelihood that the insured-against event will occur. Limitations on interest rates should be viewed in this context. Allowing banks to pay high interest rates when explicit or implicit deposit insurance exists results in perverse incentives: banks compete for funds, and those offering the highest interest rates (effectively guaranteed by the government) attract funds.

But to pay those high interest rates, they have to take high risks–augmenting the already-present incentive to take excessive risks. A process I have described elsewhere as the Gresham’s law of financial markets takes place; risk-loving banks drive out more prudent ones. It makes no sense for the government to allow the private sector to take advantage of its implicit subsidy.

If we believe that government insurance is as credible as a government guarantee that it will pay back a treasury bill, then there is no justification for paying higher interest rates than on treasury bills. Since banks may be providing additional services, rates could be lower. To repeat: the regulation on insured deposit rates is intended not to restrict competition but to restrict the ability of banks to take advantage of any implicit subsidy.

Financial repression

For the past quarter century governments of developing countries have been warned to avoid financial repression. Financial repression provides one of the classic examples of welfare-decreasing government interventions in the market. The standard argument against it is that low interest rates reduce savings and thus inhibit economic growth. It is argued that because financial institutions are essential to the efficient allocation of capital, free competitive markets are needed to ensure that resources go to those who value them the most.

The borrowers who are willing to pay the highest interest rates on loans are those whose projects will yield the highest return. If governments restrict interest rates and replace efficient market allocation mechanisms with capricious public selection processes, the result is less capital, and what capital there is will be less efficiently allocated. These theoretical arguments have been buttressed with convincing empirical and anecdotal evidence. Countries that abandoned financial repression did well, and cross-sectional and time-series studies confirmed that there was a positive relationship between growth and real interest rates. More recently, however, this relationship has been reexamined.

Studies of savings seem to indicate little relationship between national savings and interest rates. This should not be surprising, since theory suggests that, at least at the household level, income and substitution effects go in opposite directions. Most econometric studies show low interest elasticities. It is worth noting that Japan’s postal savings banks paid relatively low interest rates and yet were able to raise huge amounts of money, suggesting that other factors (such as convenience and safety) may far outweigh interest rates in determining the level of savings.

Recent theoretical work has emphasized the importance of the corporate veil: the fact of imperfect information implies that funds do not move costlessly between the household and corporate sectors. Lowering interest rates can be viewed as a transfer from the household sector to the corporate sector. Of course, if there were no corporate veil, such a transfer would have no consequences, but if there is a corporate veil, it may make a large difference.

If the marginal propensity to save is higher for corporations than for households (and there are a variety of reasons why we might expect this to be so in a world of credit and equity rationing), this transfer ofwealth results in an increase in aggregate savings. The argument that financial repression leads to inefficient allocation is equally suspect.

It is based on the failure to recognize the distinction between credit markets and other markets. The analogy between the allocation of credit and the allocation of other goods is fundamentally inappropriate. Closer examination suggests that financial repression can actually improve the efficiency with which capital is allocated, or more broadly, the total expected returns per dollar of capital. There are several reasons for this.

First, as Stiglitz and Weiss (1981) emphasize, higher interest rates adversely affect incentives and the mix of applicants, even when these effects are not so strong as to outweigh the direct benefit of higher interest rates. Even if the government selected projects at random, lowering the interest rate could increase the expected quality of borrowers, and this effect would be even greater if it were assumed that the government had some positive selection capabilities.

Second, financial repression increases firm equity because it lowers the cost of capital. Equity capital has several advantages over loan capital, leading to investments with higher expected returns. The firm reduces the prospect of bankruptcy that occurs when it cannot meet its debt obligations. (This prospect of bankruptcy acts as a major deterrent to undertaking high-yield, high-risk investments.)

And firms are more likely to select good projects when they have more of their own capital at stake. Indeed, financial repression can be used as the basis of an incentive scheme to encourage higher savings and more efficient allocation of capital. Financial repression creates a scarcity. Some will get the capital they want at the interest rate being offered, while others will not. The government can set up a contest so that those who perform well (as measured by, say, exports) get more access to capital. Such contests can have strong positive effects. The arguments against financial repression are based on a number of errors in previous empirical studies.

• Failure to distinguish between small and large repressions. There is little doubt that high negative rates of return can have significant deleterious effects on the economy. These large repressions seem to have driven earlier econometric studies. When countries with negative real interest rates are excluded from the sample, higher real interest rates seem to be associated with lower rates of growth.

• Failure to identify the problem. High negative rates of return are symptomatic of a wider range of government failures. If “good government” brings about a more efficient allocation of resources and avoids severe financial repression, there will be a negative correlation between financial repression and growth, but it would be incorrect to infer from this that the low level of economic growth is caused by financial repression.

Without ways of measuring “good government,” it is difficult to identify the correct causal structure. One hint at an answer is the rate of inflation. High rates of inflation can be thought of as a reflection of “bad government,” or at least bad macroeconomic policies.

The question is, correcting for the rate of inflation (the overall quality of government), does financial repression have a negative effect on growth? Our preliminary studies suggest that it does not (Murdock and Stiglitz 1993).

• Failure to take account of demand-curve shifts. High real interest rates can be a result of good investment opportunities (high demand for capital) rather than of a lack of financial repression. Unless the economy is completely open, domestic interest rates do not provide a good measure of the extent of financial repression.

A better measure is the difference between the curb market and ordinary rates of interest. Regressions for the Republic of Korea that include this variable show no evidence of a significant effect of repression on growth (or on incremental capital-output ratios). The estimated coefficients suggest that financial repression has a slightly positive effect, perhaps for the reasons cited above (Murdock and Stiglitz 1993).

The role of central bank is ‘now considerably widened. It plays its traditional regulatory role. In. addition to this, it now performs a variety of developmental and promotional functions which earlier were regarded as being outside the normal purview of central banking. The central bank now builds up a financial structure which helps in mobilizing domestic resources.

This section reexamines the role of the state in financial markets and identifies seven major market failures that provide a potential rationale for government intervention. In practice, government interventions in capital markets, even in industrial countries, have been persuasive. The paper provides taxonomy of those interventions with respect to both the objectives they serve and the instruments they employ.

There is a role for the government in financial markets, but the success of government interventions has been mixed. It is important that interventions be well designed. The section sets out principles of government regulatory interventions and applies them to prudential regulation.

It then examines three other areas of intervention–directed credit, financial regression, and competition policy–and identifies circumstances in which some amount of financial repression may actually be beneficial. The role of the government in financial markets is a long-standing debate that has engaged economists around the world. There are certain recurrent themes in this debate.

• The history of modern capitalism has been marked by the linked phenomena of financial crises and economic recessions. Although bank runs are not as prevalent as they were in the nineteenth century, the economic costs of financial debacles–such as those associated with the collapse of the savings and loan associations in the United States–are no smaller.

Nor is the United States the only country beset by problems; in recent years government intervention has been required in Japan, in a number of European countries, and in numerous developing countries. What action, if any, should the state take to ensure the solvency and stability of financial institutions?

• The past decade has been marked by important financial innovations. New technologies record transactions at record speed; partly with the aid of these new technologies, new instruments and institutions have been created.

Do these changes necessitate a reevaluation of the role of the state Sophisticated and well-developed capital markets are seen as the hallmark of a developed economy? Not surprisingly, as the developing countries move toward more sophisticated financial systems, they have sought to create the requisite institutions. What role should the government play in creating such systems?

• Finally, the spirit of deregulation that has been a dominant theme in economic policy discussions during the past two decades is increasingly being felt in financial markets as well. The claim is that market liberalization will enable the financial system to perform its main function of allocating scarce capital more efficiently and will thus benefit the rest of the economy.

I argue that much of the rationale for liberalizing financial markets is based neither on a sound economic understanding of how these markets work nor on the potential cope for government intervention. Often, too, it lacks an understanding of the historical events and political forces that have led governments to assume their present role. Instead, it is based on an ideological commitment to an idealized conception of markets that is grounded neither in fact nor in economic theory.

These resources are then used to finance the development programmes in respect of agriculture, trade, transport, industry through special financial institutions created for this purpose. The main measures which the central bank has taken in improving the conditions of the under-developed money market are as follows:–

(1) The central bank itself as the pivot of money market, has taken up the responsibility for the development of an adequate and sound money and capital market in the country. The establishment and spread of financial institutions provides an outlet and an incentive for productive savings. They also increase the amount of funds for capital formation. The central bank thus performs a development and promotional role in the country.

(2) Commercial Bank.

The commercial banks are the principal borrowers and lenders of short term funds in the money market. These banks are now performing a variety of development functions. They are advancing loans to small business and industry and agriculture up to a maximum limit fixed by the central hank of the country.

In order to keep the funds of the bank highly liquid and free of default, the central bank prescribes the lending policy and fixes the reserve ratio. It also inspects the accounts and supervises the activities so that the banks do not indulge in indiscriminate lending.

(3) Saving banks.

Saving banks are set up to encourage the habit, of saving among small savers. Saving bank deposits are paid on demand. The deposits of the saving banks are mostly invested in government projects.

(4) Co-operative banks.

Co-operative banks are set up both in rural and urban areas for the promotion of thrift, self help and mutual and mainly among the members of the society. The co-operative banks advance short term loans to agriculturalists for the purchase of inputs. They raise funds through the issue of shares and sale of bonds and debentures. The central bank inspects the accounts of these banks and also issues directions.

(5) Assistance to specialized financial institutions.

The central bank, in developing country, provides assistance to specialized financial institutions for enabling, them to extend adequate finance to different sectors of the economy.

In Pakistan, the State Bank of Pakistan gives loans to Agriculture Development Bank of Pakistan for financing seasonal agricultural operation and for development of agriculture. The House Building Finance Corporation, Industrial Development Bank of Pakistan, etc., get financial assistance from SBP.

(6) Credit targets.

In order to boost up agricultural and industrial production, the central bank prescribes loan targets for commercial banks. This step in take in with a view to ensuring adequate flow of bank credit to priority sectors.

(7) Export Finance Scheme.

The, commercial banks, under the instructions of Central Bank, provides finance to the exporters at the concessional rate. The central bank also provides refinance at zero rate of interest.

(8) Treasury bills.

The central bank issues treasury bills on behalf of the Treasury. The treasury bills are issued by the government to raise money on a short term basis. The treasury bills are purchased by scheduled banks and discount houses. In Pakistan, the commercial banks invest in Treasury Bill for earning profit. There are no discount houses in Pakistan.

(9) Commercial banks borrowing.

The central bank allows the specialized banks and the commercial banks to borrow from it. These funds are then made available to finance development programmes in respect of agriculture, trade, transport, industry, etc.

(10) Monetary and credit policy.

The central bank pursues a monetary and credit policy in the country which improves market efficiency, stimulates the flow of saving and investment and improves the money market conditions in the country.


8.12/C3 http://www.

8.14 Definition of capital market 8.14/C2 Definition of capital market:

The market dealing in long term finance is known as capital market. This market makes available funds for long-term investment. Hence, capital market is a market for long term credit.

The meaning of capital market becomes clear from the following definitions:-According to Dudley G. Luckett, “A capital market is just what the name implies: a market for capital funds. Strictly speaking, the capital market encompasses any transactions involving long-term debt or equity obligations”.

In the words of S.K. Cooper and others, “The framework for the borrowing and lending of funds for periods longer than a year is called the capital market”.

Capital markets provide for the buying and selling of long term debt or equity backed securities. When they work well, the capital markets channel the wealth of savers to those who can put it to long term productive use, such as companies or governments making long term investments. Financial regulators, such as the UK’s Financial Services Authority(FSA) or the U.S. Securities and Exchange Commission (SEC), oversee the capital markets in their designated jurisdictions to ensure that investors are protected against fraud, among other duties.

21st century capital markets are almost invariably hosted on computer based Electronic trading systems; most can be accessed only by entities within the financial sector or the treasury departments of governments and corporations, but some can be accessed directly by the public.

There are many thousands of such systems, most only serving only small parts of the overall capital markets. Entities hosting the systems include stock exchanges, investment banks, and government departments. Physically the systems are hosted all over the world, though they tend to be concentrated in financial centerslike London, New York, and Hong Kong. Capital markets are defined as marketsin which money is provided for periods longer than a year. A key division within the capital markets is between the primary markets and secondary markets. In primary markets, new stock or bond issues are sold to investors, often via a mechanism known as underwriting. The main entities seeking to raise long term funds on the primary capital markets are governments (which may be municipal, local or national) and business enterprises (companies).

Governments tend to issue only bonds, whereas companies often issue either equity or bonds. The main entities purchasing the bonds or stock include pension funds, hedge funds, sovereign wealth funds, and less commonly wealthy individuals and investment banks trading on their own behalf. In the secondary markets, existing securities are sold and bought among investors or traders, usually on a securities exchange, over-the-counter, or elsewhere. The existence sof secondary markets increases the willingness of investors in primary markets, as they know they are likely to be able to swiftly cash out their investments if the need arises.

A second important division falls between the stock markets (for equity securities, also known as shares, where investors acquire ownership of companies) and the bond markets (where investors become creditors)

Examples of Capital market transactions

A company raising money on the primary markets

When a company wants to raise money for long term investment, one of its first decisions is whether to do so by issuing bonds or shares. If it chooses shares, it avoids increasing its debt, and in some cases the new shareholders may also provide non monetary help, such as expertise or useful contacts. On the other hand, a new issue of shares can dilute the ownership rights of the existing shareholders, and if they gain a controlling interest, the new shareholders may even replace senior managers. From an investor’s point of view, shares offer the potential for higher returns and capital gains if the company does well.

Conversely, bonds are safer if the company does poorly, as they are less prone to severe falls in price, and in the event of bankruptcy, bond owners are usually paid before shareholders. When a company raises finance from the primary market, the process is more likely to involve face-to-face meetings than other capital market transactions. Whether they choose to issue bonds or shares, companies will typically enlist the services of an investment bank to mediate between themselves and the market.

A team from the investment bank often meets with the company’s senior managers to ensure their plans are sound. The bank then acts as an underwriter, and will arrange for a network of broker(s)to sell the bonds or shares to investors. This second stage is usually done mostly through computerized systems, though brokers will often phone up their favored clients to advise them of the opportunity.

Companies can avoid paying fees to investment banks by using a direct public offering, though this is not a common practice as it incurs other legal costs and can take up considerable management time.

A government raising money on the primary markets

When a government wants to raise long term finance it will often sell bonds to the capital markets. In the 20th and early 21st century, many governments would use investment banks to organize the sale of their bonds. The leading bank would underwrite the bonds, and would often head up a syndicate of brokers, some of whom might be based in other investment banks. The syndicate would then sell to various investors.

For developing countries, a Multilateral development bank would sometimes provide an additional layer of underwriting, resulting in risk being shared between the investment bank(s), the multilateral organization, and the end investors. However, since 1997 it has been increasingly common for governments of the larger nations to bypass investment banks by making their bonds directly available for purchase over the Internet. Many governments now sell most of their bonds by computerized auction.

Typically large volumes are put up for sale in one go; a government may only hold a small number of auctions each year. Some governments will also sell a continuous stream of bonds through other channels. The biggest single seller of debt is the US Government; there are usually several transactions for such sales every second, which corresponds to the continuous updating of the US real time debt clock.

Trading on the secondary markets

Most capital market transactions take place on the secondary market. On the primary market, each security can be sold only once, and the process to create batches of new shares or bonds is often lengthy due to regulatory requirements. On the secondary markets, there is no limit on the number of times a security can be traded, and the process is usually very quick. With the rise of strategies such as high frequency trading, a single security could in theory be traded thousands of times within a single hour. Transactions on the secondary market don’t directly help raise finance, but they do make it easier for companies and governments to raise finance on the primary market, as investors know if they want to get their money back in a hurry, they will usually be easily able to re-sell their securities.

Sometimes however secondary capital market transactions can have a negative effect on the primary borrowers – for example, if a large proportion of investors try to sell their bonds, this can push up the yields for future issues from the same entity. An extreme example occurred shortly after President Clintonbegan his first term as president; Clinton was forced to abandon some of the spending increases he’d promised in his election campaign due to pressure from the bond markets.

In the 21st century, several governments have tried to lock in as much as possible of their borrowing into long dated bonds, so they are less vulnerable to pressure from the markets. A variety of different players are active in the secondary markets. Regular individuals account for a small proportion of trading, though their share has slightly increased; in the 20th century it was mostly only a few wealthy individuals who could afford an account with a broker, but accounts are now much cheaper and accessible over the internet. There are now numerous small traders who can buy and sell on the secondary markets using platforms provided by brokers which are accessible with web browsers. When such an individual trades on the capital markets, it will often involve a two stage transaction.

First they place an order with their broker, then the broker executes the trade. If the trade can be done on an exchange, the process will often be fully automated. If a dealer needs to manually intervene, this will often mean a larger fee. Traders in investment banks will often make deals on their bank’s behalf, as well as executing trades for their clients. Investment banks will often have a department called Capital markets: staff in this department try to keep aware of the various opportunities in both the primary and secondary markets, and will advise major clients accordingly.

Pensionand Sovereign wealth fundstend to have the largest holdings, though they tend to buy only the highest grade (safest) types of bonds and shares, and often don’t trade all that frequently. According to a 2012 Financial Times article, hedge funds are increasingly making most of the short term trades in large sections of the capital market (like the UK and US stock exchanges) , which is making it harder for them to maintain their historically high returns, as they are increasingly finding themselves trading with each other rather than with less sophisticated investors.

There are several ways to invest in the secondary market without directly buying shares or bonds. A common method is to invest in mutual funds or exchange traded funds. It’s also possible to buy and sell derivatives that are based on the secondary market; one of the most common being contract for difference- these can provide rapid profits, but can also cause buyers to lose more money than they originally invested.

Capital controls

Capital controls are measures imposed by a state’s government aimed at managing capital account transactions -in other words, capital market transactions where one of the counter-parties involved is in a foreign country. Whereas domestic regulatory authorities try to ensure that capital market participants trade fairly with each other, and sometimes to ensure institutions like banks don’t take excessive risks, capital controls aim to ensure that the macro economic effects of the capital markets don’t have a net negative impact on the nation in question.

Most advanced nations like to use capital controls sparingly if at all, as in theory allowing markets freedom is a win-win situation for all involved: investors are free to seek maximum returns, and countries can benefit from investments that will develop their industry and infrastructure.

However sometimes capital market transactions can have a net negative effect – for example, in a financial crisis, there can be a mass withdrawal of capital, leaving a nation without sufficient foreign currency to pay for needed imports. On the other hand, if too much capital is flowing into a country, it can push up inflation and the value of the nation’s currency, making its exports uncompetitive. Some nations such as India have also used capital controls to ensure that their citizen’s money is invested at home, rather than abroad.


Capital Markets: An Engine for Economic Growth

8.15/C2 Capital Markets: An Engine for Economic Growth:

Economic growth in a modem economy hinges on an efficient financial sector that pools domestic savings and mobilizes foreign capital for productive investments. Without an effective set of financial institutions, productive projects may remain unexploited. Inefficient financial institutions will have the effect of taxing productive investment and thus reducing scope for increasing the stock of equipment needed to compete globally. Inefficiency can substantially cut growth from the levels that might have been possible given appropriate policies and market structures.

This paper focuses on the link between growth and capital markets, in particular, stock markets. Section 2 explores the latest research on this subject and presents empirical evidence indicating that stock markets are indeed important to economic development. Of paramount importance is their efficiency.

This means that assets are traded at “fair” prices: the seller does not sell too cheaply, and the buyer does not pay too much for the asset. To function well, there must be a large group of traders, and information about the assets must he readily available. Finally, particular care must be paid to the structural characteristics of the market to ensure that thc trading process is enhanced rather than hindered.
Underdeveloped or poorly functioning capital inarket deter foreign investors because the markets are ihiquid and trading is expensive. Direct investment is adversely affected if raising local capital is difficult and costly.

Illiquidity and high transaction costs also hinder the capital-raising efforts of large domestic corporations and may push them to foreign markets. In Section 3, we explore the relationship between global capital market integration and economic growth.

A country that restricts its capital markets not only is less attractive to foreign investors but also imposes maj or economic penalties on local companies. This reduces growth rates below their full potential and makes it more difficult for domestic firms to compete in world markets.
Some concluding remarks, as well as a future research agenda, arc offered in the final section of the paper.

Stock Markets and Economic Growth

Financial Development
and Growth
is only in the last few years that interest in the link between financial development and economic growth has surged.

Whereas previous research focused exclusively on technological progress as the main engine of growth, the new models show that growth can be self-sustaining without technological progress (for example, see Lucas 1988). In many of these new models, financial development has the ability to increase economic growth through various channels (sec the survey of Pagano 1993).

By far the primary role of financial institutions and capital markets is to allocate capital effid. Entry, that is, to allocate funds to the investment projects with the highest marginal product of capital.
Concretely, the financial sector pools funds from dispersed households and allocates them efficiently to dispersed entrepreneurs. Through the first activity, an efficient financial sector allows households to diversify risk and maintain liquid investments (e.g., bank deposits). Their second activity involves information gathering and selecting investment projects (“screening’ together with monitoring entrepreneurial activities. These tasks cannot be efficiently carried out by individuals. Greenwood and Jovanovic (1990),
Bencivenga and Smith (1991) and St-Paul (1992) develop sophisticated economic models stressing the growth-enhancing role of financial intermediation,

Empirically, early research by Goldsmith (1969), McKinnon (1973),
and Shaw (1973) document a positive correlation between financial development and economic growth. However, questions remain about causality: does financial development affect growth, does economic growth lead to more financial development, or both? Recent research has not completely resolved the issue but suggests strongly that financial development is an important determinant of future economic growth.

The most comprehensive of this research to date is by King and Levine (1993).
They use
See Sachs and Warner (1995, 1996), Rajan and Zingales (1996), Demirg%iç-Kunt and Levine (1996a,b), Demirgüç-Kunt and Miksimovic (1996)
and Levine and Zenros (1996)
for example. Four measures of financial development related to the development of a banking sector. Their findings can he summarized as follows.

First, using cross-country regressions they find that all financial indicators have strong positive correlation with economic growth. Second, and more importantly, their analysis shows that countries with higher indicators of financial development at one point subsequently had higher real GOP growth rates, more specifically in the next 10 or 30 years. King and Levine conclude, “Our findings suggest that government policies toward financial systems may have an important causal effect on long-mn growth” (p. 540).

These empirical studies all focus on the bank sector. The role of stock markets for economic growth is relatively unexplored. In the next subsection, we explore whether stock markets are in fact essential to economic progress and present new evidence showing stock markets to be positively correlated with economic growth.
Stock Markets and Economic Growth:

A number of economists have suggested that the existence of stock markets has little relevance to real economic activity (see Stiglitz 1989; Mayer 1989). From a casual reading of the corporate finance literature, this view is not so surprising [see Harris and Raviv 1991].

For example, since managers typically have more information that outsiders, equity may be mispriced in the market from their point of view. Given that they have the choice of borrowing, the managers may only issue new equity if equity is ovcrpriccd.

This may make investors reluctant to invest in new equity issues and it is consequently not surprising that many companies do not heavily rely on new equity to finance new investments. Below, we argue that this view misses some important roles the stock market can play in the growth process.

A hility to Diversify

Without efficiently run capital markets, investors have limited means to diversify their portfolios. As a result, investors may avoid equity stakes because they are too risky. Hence, corporations may the four measures are

(1) the ratio of liquid liabilities to GDP;

(2) deposit bank domestic credit divided by deposit hank dcmtic credit plus central bank domestic credit;

(3) ratio of dams on the nonficiancial private sector to domestic credit; and

(4) ratio of gross claims on the private sector to GDP find, it difficult to raise equity capital. With the creation of stock markets, individuals can diversify (irm-specific risks, thus making investment in firms more attractive.
There is another angle on the diversification argument. Corporations in countries with poorly functioning capital markets may choose lower value –

low risk projects to inefficiently diversify
order to attract investment capital. These projects may not even he within the realm of the corporation’s special expertise. They serve the purpose of diversifying because the capital markets have not provided the means for investors within that country to efficiently diversify. 1-lence, the stock market may play a key role in economic growth.

Moral Hazard

From a corporate finance perspective, the stock market plays a subtle but important role in mitigating the moral hazard problem. Moral hazard often arises because managers gain from decisions affecting firm value only to the extent of the shares they hold.

Suppose a manager holds 1% of the firm’s equity and his compensation (either flat rate or tied to firm earnings) produces most of his income. This manager his in incentive to take actions that mnimize his compensation in ways that might have little or nothing to & with maximizing the firm’s value (and equity value).

For example, many ways of manipulating earnings can lead
to higher compensation. Since the manager’s equity ownership is small, he may have an incentive to
take “imprudent actions.”
F-low can the moral hazard problem be reduced? One possibility is debt. Debt holdings decrease incentives for imprudent actions in two ways: they increase the fraction of equity ownership held by managers,, and they increase the probability of bankruptcy after imprudent actions.3 Another possibility for mitigating the moral hazard problem is compensating managers with binding contracts that are contingent on long-term performance. Such contracts require a good measure of the long-term value of the firm.

For example, as mentioned earlier, current profit is not a good measure for this purpose because it can be manipulated and it reflects short-term considerations.
Of course in most countries1 the existence of interest rate deductions in the tax code is an important factor favoring debt holdings Clearly, such a measure should be unbiased1 free from manipulation by the management or outsiders1 and verifiable.
The tatter argument suggests an important use of efficient stock markets. Stock markets are efficient if the stock price incorporates all available information in the marketplace. Thus, the stock price in an efficient market gives us a good measure of the firm’s performance and its long-term value. Tying the manager’s compensation to stock prices reduces the incentives for imprudent actions and therefore increases the firm’s value, Without an efficient market, the managcr and the shareholders can still agree on the value of the firm (which may be different from the value observed in an inefficient market), but it would be difficult to establish a contract because the value is not verifiable,
This idea can be extended to the whole economy: an efficient stock market can enhance growth by mitigating moral hazard and consequently increasing productivity.

‘The significance of this effect depends on the magnitude of the moral hazard problem and on the proportion of the economy that is representccl in the stock market. Thus, one may expect a positive correlation between stock market coverage (total market value as a fraction of gross domestic product [GD P1) and growth from ‘this effect, Also, the gains from efficient stock markets may be greater if disciplining managers through other means is ineffective.

Change of ownership

En addition to providing performance measures to he used in employment contracts, the stock market disciplines managers indirectly through change of ownership. If the managers are not doing a good job, the stock price declines below the potential value of the assets. Such firms are then takeover targets for investors, who Will increase the value of the shares by replacing current managers. Clearly, managers should refrain from productivity-decreasing actions when faced with the threat of takeovers.


Another key growth contribution of an efficient stock market is its effect on entrepreneurs. An entrepreneur considers not only the profits generated in a new venture but also the possibility of a lump-sum gain through selling the venture to the public. If the stock markets are not efficient, the public offering is less feasible as a result of high transaction costs or the uncertaint of getting a fair price in the stock market.

Thus, inefficient stock markets may reduce the incentive to enter new ventures, reducing overall long-term productivity of the economy.
An efficient stock market reduces the transaction costs of trading the ownership of the physical assets and thereby opens the way for the emergence of an optimal ownership structure. Certain individuals possess the entrepreneurial spirit for “ncw start” ventures, and such entrepreneurs should be involved in thc innovation phase of a firm’s development. As the finn matures, they often transfer ownership to another class of investors, one that specializes in running mature firms. The entrepreneurs can then move on to another fledgling company.

This is the idea of optimal ownership. Clearly, transferring the ownership of such assets would be very difficult without stock markets. The idea that stock markets contribute to the economy by providing rewards to innovators is an important one in the model studied by King and Levine (1993).

A Caveat: The Need for Liquid and Efficient Stock Markers

In the context of stock markets, liquidity is of paramount importance. For example, liquidity is necessary for the effective generation and dissemination of firm-specific information. That is, movements in the stock price are likely to reveal important information about changes in the firm value in liquid markets. A market is liquid if transactions of large size can be made instantaneously and continuously without moving the price significantly.

In fact, all of the benefits listed above will be substantially hindered if the market for stocks is not liquid. Indeed, ifliquidity and increased transaction costs are the most important symptoms of inefficient stock markets. Such inefficiencies may be caused by the market power of brokers or other individuals, which increases transaction costs, and by the dominance of the market by a small number of firms or individuals. The latter may result in the manipulation of stock prices, keeping them artificially low or high to suit the purposes of these in power. However, the net result is the eradication of the gains to be obtained from the stock market. Such inefficiencies can also result in the loss of public confidence in capital markets, leading to reduced participation of the public and thereby making the situation worse.
Stock Markets and Economic Growth:

Empirical Evidence Work on growth through stock market development has been scanty. Atje and Jovanovic (1989)
compare the impact of the level of stock market development and bank development on subsequent economic growth.

They find a large effect of stock market development as measured by the value traded divided by GDP on subsequent development, hut they fail
to find a similar effect for bank lending. In their conclusion they write, “it is even more surprising that more countries are not developing their stock markets as quickly as they can. as a means of speeding up their economic development” (p. 636). of course, one study may riot be the definitive answer to this important question, and more empirical work needs to be done, To complement the evidence of the Atje and Jovanovic study, we computed correlations between a number of stock market development indicators and growth of real GDP in 18 countries during the 1986—92 period.

Six measures of stock market development were considered: number of stocks listed, market capitalization (expressed in dollars), total value traded (again in doUars), turnover ratio (value traded divided by market capitalization), market capitalization divided by GDP, and total value traded divided by GDP. The data are averages of these variables for the period 1988—92 as reported by IJemirguc-Kunt and Levine (1993). Eighteen countries were ranked according to these measures of stock market development and according to economic growth, as measured by real GDP growth during the 1986—92 period.

All variables were ranked from high to low (e.g., the country with the highest GDP growth rate gets rank one). We then computed the rank correlation between the different stock market development measures and economic growth.

If the ranks according to economic growth were to completely correspond to the ranks according to stock market .They control for other factors, such as schooling and initial income level. Development, the rank correlation would be one. The rank correlations presented in Table are without exception positive. The small number of countries used in the analysis makes the standard error of these correlations rather high; namely 0.23. Nevertheless, the evidence broadly confirms that stock market development is positively associated with economic growth.


8.15/C3 Atje, R., arid B. Jovanovic. 1989. “Stock Markers and Development” European Economic Review 37:632— 64 D.

8.10/C3 Bekaert, G. 1995. ‘Market Integration and Investment Barriers in Emerging Markets.” World Rank Economic Review 9, 75-107.


Bekaert, C., C. B. Erb, C. R. Harvey and T. E. Viskanta. 1997. “The Behavior of Emerging Market Returns.” In The Future of Emerging Market Capital Flows, E. Altman, R. evich and J. Mei, Eds., Kiuwer, forthcoming.

E Bekaert, G., and C. R. Harvey. 1995. “Time-Varying World Market Integration.” Journ4 of Finance, 403- 444.

E Bekaert, G., and C. R. Harvey. 1997a. “Emerging Equity Market Volatility.D Journal of Financial Economics 43:1, January, 29-78.

E T3ekaert, C., arid C. R. Harvey. 199Th. “Capital Market Integration, Stock Markets and World Development,” Working paper, Stanford University and Duke University.

E Bcnchrcnga, V. R., and B. I). Smith. 1991. ‘Financial tatennediation and Endogenous Growth. Rruiew of Economic Studies 52:195—209.

E Chu.han, p. 1992. “Sources of Portfolio Investment in Emerging Markets” World Bank Working Paper. Manuscript – Dcrnirguc-Kunt, A., and R. Levine. 1996a, “Stock Markets1 Corporate Finance, and Economic Growth: An Overview,” World Bank Economic Review, 10, 223-240.

E Demirgüc-Kunt, A., arid K. Levine. 1996b. “Stock Market Development and Financial Jsicermetharies: Stylized Facts,” World Brk Economic Revgew, 10, 291-322,

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E Goldsmith, R. W. 1969. “Financial Structure arid Development.” New Haven, Conn.: Yal.e University Press.

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E Harris, M., and A. Raviv. 1991. “The Theory of Capital Structure.” journal of Finance 46:297—355.

8.16 Money Market Vs. Capital Market 8.16/C2 Money Market Vs. Capital Market:

Money markets and capital markets are both essential for the global economy in terms of offering financing for firms and organisations to carry out operations and expand business activities. Both markets trade in large denominations of currency daily and both markets do not have physical presence; trade is carried out through cyber platforms with computerized systems.

Money market is mainly accessible for large corporations and financial institutions, whereas, capital markets are accessible to small individual investors. The maturity period of a money market instrument is very short; up to less than one year, as opposed to the maturity period for capital market instruments, which are for more than one year up to about 20 to 30 years. The money market usually caters to the short term working capital needs of firms, and the long term financial needs and funds for expansion are usually obtained from capital markets.

The key distinguishing feature between the money and capital markets is the maturity period of the securities traded in them. The money market refers to all institutions and procedures that provide for transactions in short-term debt instruments generally issued by borrowers with very high credit ratings.

By financial convention, short-term means maturity periods of one year or less. Notice that equity instruments, either common or preferred, are not traded in the money market. The major instruments issued and traded are U.S. Treasury bills, various federal agency securities, bankers” acceptances, negotiable certificates of deposit, and commercial paper. Keep in mind that the money market is an intangible market. You do not walk into a building on Wall Street that has the words “Money Market” etched in stone over its arches. Rather, the money market is primarily a telephone and computer market.

The capital market refers to all institutions and procedures that provide for transactions in long-term financial instruments. Long-term here means having maturity periods that extend beyond one year. In the broad sense, this encompasses term loans and financial leases, corporate equities, and bonds. The funds that comprise the firm’s capital structure are raised in the capital market. Important elements of the capital market are the organized security exchanges and the over-the-counter markets.

Difference and demarcation between money market and capital market is made on the basis of maturity period of instruments and claims. Short-term instruments maturing within a period of one year are traded in money market whereas the capital market deals with longer maturity financial assets and claims. Though both types of markets facilitate the transfer of funds from savers to deficit-users, still the difference between the two is maintained with reference to the time-period covered by the transactions.

Capital market includes trading in securities, mutual fund units and government debt instruments. On the other hand’ money market facilitates dealings in short-term financial instruments such as inter-corporate deposits, certificate of deposits, treasury bonds, commercial papers, commercial bills, etc. Money market and capital market can be differentiated as follows :

1. Maturity

In general, these two markets are separated on the basis of the maturity of the credit instruments related to these markets. The maturity of the instruments of money market is one year or less than one year. On the other hand, the maturity of the instruments of capital market is more than one year.

2. Risks

The risks are less in money market. Because, there is less possibility of default of the credit of less than one year maturity. Likewise, the risk of interest rate is also low in the money market. On the other hand, the credit of the capital market is of long term nature. Due to this risks are more and are of varied nature in capital market.

3. Instruments

The main instruments of money market are -treasury bills, commercial papers, certificate of deposit which are of short-term nature. On the other hand, the main instruments of the capital market are -debentures, equities or shares and government securities which are of long-term nature.

4. Institutions

The different financial institutions related to short-term credit participate in the money market. But there is predominance of commercial banks. In fact, the commercial bank is an institution related to the money market. On the other hand, different kinds of financial intermediaries participate in the capital market. The main participants of the capital market are -development bank, finance company, provident fund, insurance company, Investment Company and so on. The service institutions are also involved in the capital market such as investment banking, commission brokers association, investment consultancy etc. In recent clays, the commercial banks also provide long-term loans to some extent. So they may also be included among the participants of the capital market.

5. Finance

The money market deals in only short-term funds. It receives short term deposits and also provides the short-term credit. On the other hand, the capital market receives long-term deposits and also grants long term loan and equity capital to the business and the government.

6. Relation with the Central Bank

The money market has close and direct relationship with the central bank. The central bank implements its monetary policy through this market. The central bank directly regulates the commercial banks in the money market. On the other hand, the central bank has influence over the capital market only indirectly through money market. Similarly, the institutions of the capital market are less regulated by the central bank.

7. Credit Instruments:

The main credit instruments of the money market are call money, collateral loans, acceptances, bills of exchange. On the other hand, the main instruments used in the capital market are stocks, shares, debentures, bonds, securities of the government.

8. Nature of Credit Instruments:

The credit instruments dealt with in the capital market are more heterogeneous than those in money market. Some homogeneity of credit instruments is needed for the operation of financial markets. Too much diversity creates problems for the investors.

9. Purpose of Loan:

The money market meets the short-term credit needs of business; it provides working capital to the industrialists. The capital market, on the other hand, caters the long-term credit needs of the industrialists and provides fixed capital to buy land, machinery, etc.

10. Basic Role:

The basic role of money market is that of liquidity adjustment. The basic role of capital market is that of putting capital to work, preferably to long-term, secure and productive employment.

11. Market Regulation:

In the money market, commercial banks are closely regulated. In the capital market, the institutions are not much regulated.

Þ The subject matter of capital market is long-term financial instruments having maturity of more than one year. On the other hand, the thrust of MM is on short-term instruments only.

Þ Money market is a wholesale market and the participants in money market are large institutional investors, commercial banks, mutual funds, and corporate bodies. However, in case of capital market even a small individual investor can deal by sale/purchase of shares, debentures or mutual fund units.

Þ In capital market, the two common segments are primary market and secondary market. Both these segments are interrelated. Securities emerge in primary segment and their subsequent dealings take place in secondary market. However, in case of money market, there is no such sub-division in general. In efficient money market, secondary market transactions may also take place.

Þ Total volume of trade occurs per day in money market is many fold that of the volume per day taking place in capital market.

Þ In capital market, the financial instruments being dealt with are shares (equity as well as preference), debentures (a large variety), public sector bonds and units of mutual funds. On the other hand, money market has different financial instruments such as treasury bills, commercial papers, call money, certificate of deposits, etc.

Þ Money market is a place where banks deal in short term loans in the form of commercial bills and treasury bills. But capital market is a place where brokers deal in long term debt and equity capital in the form of debenture, shares and public deposits.

Þ In money market maturity date of repayment may after one hour to 90 days. But in capital market, loans are given for 5 to 20 years and if issue of shares by co. , its amount will repay at winding of company . But investors have right to sell it to other investors if they need the money.

Þ Rate of interest in money market is controlled by RBI or central bank of any country. But capital market’s interest and dividend rate depends on demand and supply of securities and stock market’s sense conditions. Stock market regulator is in the hand of SEBI.

Þ Main dealer of money market s are commercial banks like SBI, ICICI Bank, UTI and LIC and other financial institutions. Main dealers are all the public and private ltd. Co. and more than 30 million investors. It is increasing trend due to opening of online capital market.

Þ In USA, money market is famous with dealing of money fund and bankers acceptance instruments. But capital market in USA is famous with New York stock exchange and stock regulator is Security exchange commission (SEC)

Þ Money markets and capital markets provide investors access to finance which are used for growth and further expansion, and both markets trade on computerized exchanges.

Þ The main difference between the two markets is the maturity periods of the securities traded in them. Money markets are for short term lending and borrowing, and capital markets are for longer periods.

Þ The forms of securities traded under both markets are different; in money markets, the instruments include treasury bills, certificates of deposit, banker’s acceptances, commercial papers and repo agreements. In capital markets, instruments include stocks and bonds.

Þ As an individual investor, the best place to invest your money would be in the capital markets, either the primary market or secondary market. In the perspective of a large financial institution or corporation looking for larger funding requirements, the money market would be ideal.

So at last we can differ money market and capital market as follows:

The pool of funds represented by the financial markets may be divided into different segments, depending upon the characteristics of financial claims being traded and the needs of different groups. One of the most important divisions in the financial system is between the money market and the capital market.

The money market is designed for the making short-term loans where individuals and institutions with temporary surpluses of funds meet borrowers who have temporary cash shortages. By convention, a security evidencing a loan which matures within one year or less is considered to be a money market instrument.

One of the principal functions of the money market is to finance the working-capital needs of corporations and to provide governments with short-term funds in lieu of tax collections. The money market also supplies funds for speculative buying of securities and commodities.

In contrast, the capital market is designed to finance long-term investments. Trading of funds in the capital market makes possible the construction of factories, office buildings, highways, bridges, schools, homes, and apartments. Financial instruments traded in the capital market have original maturities of more than one year.

Who are principal suppliers and demanders funds in the money market and the capital market? In the money market commercial banks are the most important institutional lender to both business firms and governments. Nonfinancial business corporations with temporary cash surpluses also provide substantial short-term funds to commercial banks, securities dealers, and other corporations in the money market. Finance companies supply large amounts of working capital to major corporate borrowers, as do money market mutual funds which specialize in short-term, high-grade government and corporate securities.

On the demand-for-funds side the largest borrower in the American money market is the U.S Treasury, which borrowers several billion dollars weekly. The largest and best-known U.S. corporations are also active borrowers in the money market through their offerings of short-term notes. Major securities dealers require huge amounts of borrowed funds daily to carry billions of dollars in securities held in their trading portfolio to meet customer demand.

Finally, the Federal Reserve System, which is charged by Congress with responsibility for regulating the flow of money and credit in U.S. financial system, operates on both sides of the money market. Through its open market operations the Fed both buys and sells securities to maintain credit conditions at levels deemed satisfactory to meet the nation’s economic goals. Due to the large size and strong financial standing of these well-known money market borrowers and lenders, money market credit instrument are considered to be highly-quality, “near money” IOUs.

The principal suppliers and demanders of funds in the capital market are more varied than in the money market. An institution must be large and well known with an excellent credit rating to gain access to the money market. The capital market for long-term funds, in contrast, encompasses both well-established and lesser-known individuals and institutions. Families and individuals, for example, tap the capital market when they borrow to finance a new home or new automobile. State and local governments rely upon the capital market for funds to build schools, highways, and public buildings and to provide essential services to the public.

The U.S. Treasury draws upon the capital market in issuing new notes and bonds to pay for federal government programs. The most important borrowers in the nation’s capital market are businesses of all sizes, which issue bonds, notes, and other long-term IOUs to cover the purchase of equipment and the construction of new plants and other facilities. Ranged against these many borrowers in the capital market are financial institutions which supply the bulk of long-term funds.

Prominent here are life and property-casualty insurance companies, pension funds, savings and loan associations, mutual savings banks, finance companies, and commercial banks.

Each of these institutions tends to specialize in a few different kinds of loans consistent with its own cash-flow needs and regulatory restrictions. For example, life insurance companies are major buyers of corporate bonds and commercial mortgages.

Property-casualty insurers stay heavily invested in state and local government (municipal) bonds, corporate stock, and corporate bonds. Pension funds are major buyers of both corporate equities and bonds, while savings and loan associations are principally home mortgage lenders. Mutual savings banks emphasize investments in mortgages and corporate bonds.

Finance companies and commercial banks provide large amounts of capital funds to both individuals and businesses through direct loans and financing. Commercial banks are probably the most diversified of all lenders in the capital market since they provide long-term funds to all major groups in the economy.


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L.M. Bhole; Financial Institutions and Market, Structure, Growth and Innovations: Tata McGrow-Hill Publishing Company Ltd. New Delhi, 2006, p-5

E Ronald I. Robinson, Erwin W. Boehmler, Frank Herbert Gane and Loring C. Farwell; Financial Institutions: 3rd edition, Richard D. Irwin, Inc. 1960, p-193

E Ros; Money and Capital Markets: Financial system in the economy: Business publications, Inc. 1983, p-11

E Murray E. Polakoff, Thomas A. Unrkin and others; Financial Institutions and Markets: 2nd edition, (special edition), Houghton Mifflin company Boston, 1982, p-409 and 440

E S. Kerry Cooper, Donald R Fraser; The financial market place: Texas A and M University-Addison-Wesley Publishing company Inc. Philippines, 1982, p-259,295,311 and 323

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E Economy Watch: Capital Markets(

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E CNNMoney. com: What is a Money Market Fund?(

E Financial Industry Regulatory Authority (FINRA): What You Should Know About Money Market Fund(

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8.17 Problems of money market and capital market 8.17/C2 Problems of money market and capital market:

No doubt with the passage of time our financial institutions are developed. Our banking and non-banking institutions are mobilizing the savings of the people in urban and rural areas. These are also providing loans to trade inside and outside the country. Credit requirement of trade and industry are adequately met by these institutions. The State Bank is also controlling these institutions very well. In spite of all these achievements and efforts, there are many problems of capital and money market, we discuss them in brief :


There is a lack of co-ordination between the various financial institutions. They adopt different policies and due to this lending and borrowing become difficult. There is overlapping and delays in creating the needs of industrial and trade sector.


The economic policies are framed by the bureaucrats instead of technocrats, so they create many problems. Many financial institutions are controlled by the bureaucrats and they have no technical skill, so they lack decision making.


The professional and skilled persons in the financial institutions are leaving the country and getting employment in Middle East for higher wages. The large scale migration of skilled person has created a gap of talented persons in the financial institutions.


In the financial institutions unions are playing very effective role. So due to unions there is inefficiency and indiscipline in the financial institutions.


There is a wasteful expenditure almost in all the financial institutions. There is over staffing in these institutions and due to this rate of output is low. A lot of money is wasted on advertisement and decoration.


The branches of the financial institutions are not opened in the rural areas to collect the savings of the villages. So, some new types of saving instruments should be introduced to attract the farmers.


In advancing loans financing institutions compete with each other to show better performance. Sometimes they lend the money to those people who cannot repay. So before advancing loans they must be careful in checking the character and financial condition of the borrower. Before advancing they must be satisfied about the project for which they are lending.


Political leaders in India or Pakistan are also misusing the credit. Sometimes the financial institutions advance the loan on political grounds. So this practice is not suitable for the money market. In India and Pakistan number of political leaders has been exempted from the loan which was advanced to them by the commercial banks. So these steps are not favorable for the nation and for the financial institutions.


The complaints about of default in loan repayment both by the public and private sector is increasing day by day. The government should take effective steps for the recovery of loan.


Poor quality of manpower is employed in the financial institutions which causes low production. There should be an arrangement of training and higher studies. The talented people should be awarded.


In the financial institutions bribery and mal practices are common. Government should make strict rules to eradicate corruption.


In India and Pakistan literacy rate is very low and people are not bank minded, due to this rate of lending and borrowing is very low in the country.


People know nothing about the financial institution. Financial institutions should publish the publication about their performance. They may also use the press and media for this purpose. Due to above reasons money market and capital market is not well organized in India and Pakistan.

8.18 Definition of primary market 8.18/C2 Definition of primary market:

The word “market” can have many different meanings, but it is used most often as a catch-all term to denote both the primary market and the secondary market. In fact, “primary market” and “secondary market” are both distinct terms; the primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors.

Knowing the functions of the primary and secondary markets are ey to understanding how stocks trade. Without them, the stock market would be much harder to navigate and much less profitable. We’ll help you understand how these markets work and how they relate to individual investors.

Primary market, in its simplest definition, is when an investor buys or purchases directly from the company. This could be in the form of shares, stocks, bonds and the like. Basically, this is an investment wherein the investor directly invested to the company. In this market type, the individual was the first person to own that specific share or stock or what not.

When an investor is under the primary market, his investment purchase directly benefits that company from which he bought the investment. Think of it as a consumer that buys brand new merchandise, say, a car. If you buy a brand new car directly from the car maker, then you are its primary market. Usually investors of the primary market invest directly to procure substantial profits and then resell these once they do not see the need for it anymore or if they need to collect a sum of money for whatever use they would need it for.

Frank J Fabozzi and other–The market which dealing with financial claims that are newly issued called primary market.

The primary market is the market for new securities. -Kerry cooper

The primary market is for the trading of new securities never before issued.— Rose, Peter

The primary markets deal with the trading of newly issued securities. The corporations, governments and companies issue securities like stocks and bonds when they need to raise capital. The investors can purchase the stocks or bonds issued by the companies.

Money thus earned from the selling of securities goes directly to the issuing company. The primary markets are also called New Issue Market (NIM). Initial Public

Offering is a typical method of issuing security in the primary market. The functioning of the primary market is crucial for both the capital market and economy as it is the place where the capital formation takes place.

The primary market is where securities are created. It’s in this market that firms sell (float) new stocks and bonds to the public for the first time. For our purposes, you can think of the primary market as being synonymous with an initial public offering (IPO). Simply put, an IPO occurs when a private company sells stocks to the public for the first time.

The Primary market refers to the market where new securities are issued for the purpose of obtaining capital. Firms and public or government institutions can raise funds from the primary market through making a new issue of stock (to obtain equity financing) or bonds (to obtain debt financing).

When a corporation is making a new issue, it is called an Initial Public Offering (IPO), and the process is referred to as the ‘underwriting’ of the share issue. In the primary market, the securities are issued by the company that wishes to obtain capital and is sold directly to the investor. In exchange for the funds that the share holder contributes, a certificate is issued to represent the interest held in the company.

Primary market, in its simplest definition, is when an investor buys or purchases directly from the company. This could be in the form of shares, stocks, bonds and the like. Basically, this is an investment wherein the investor directly invested to the company. In this market type, the individual was the first person to own that specific share or stock or what not.

When an investor is under the primary market, his investment purchase directly benefits that company from which he bought the investment. Think of it as a consumer that buys brand new merchandise, say, a car. If you buy a brand new car directly from the car maker, then you are its primary market.

Usually investors of the primary market invest directly to procure substantial profits and then resell these once they do not see the need for it anymore or if they need to collect a sum of money for whatever use they would need it for.

E http://www

E http://sawaal. markets-and-secondary-markets.html







8.19 Features of primary markets 8.19/C2 Features of primary markets:

Þ This is the market for new long term equity capital.

ÞThe primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM).

ÞIn a primary issue, the securities are issued by the company directly to investors.

ÞThe company receives the money and issues new security certificates to the investors.

ÞPrimary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

ÞThe primary market performs the crucial function of facilitating capital formation in the economy.

ÞThe new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as “going public.”

ÞThe financial assets sold can only be redeemed by the original holder.




8.20 Definition of secondary market 8.20/C2 Definition of secondary market:

Secondary Market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets. For the general investor, the secondary market provides an efficient platform for trading of his securities.

For the management of the company, Secondary equity markets serve as a monitoring and control conduit—by facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions.

Secondary market deals in securities previously issued.– Rose, Peter

Frank J Fabozzi and other —The market those for exchanging financial claims that previously issued called secondary market.

Secondary market, on the other hand is when an investor buys or purchases from another investor. Again, this could be shares, stocks or bonds. Basically, you are buying these “goods” from a co-investor which has bought these goods in the past. When you are a part of the secondary market, you are still investing on the company from where the stocks or share come from, the only difference is, the person benefiting from your purchase or investment is not the directly the company but the other investor from which you purchased your investment. Just like our previous example, it is like buying a second-hand car wherein, you still bought that car brand but your payment benefited the previous owner. It’s still the same investment, it’s just that the manner you acquired it is different or indirect.

Usually secondary markets are done in order to keep one’s assets liquid. The biggest secondary market arena is the stock exchange as this is where investors gather around and trade with each other on a daily basis.

Secondary market is when an investor buys or purchases from another investor. Again, this could be shares, stocks or bonds. Basically, you are buying these “goods” from a co-investor which has bought these goods in the past.

When you are a part of the secondary market, you are still investing on the company from where the stocks or share come from, the only difference is, the person benefiting from your purchase or investment is not the directly the company but the other investor from which you purchased your investment. Just like our previous example, it is like buying a second-hand car wherein, you still bought that car brand but your payment benefited the previous owner. It’s still the same investment, it’s just that the manner you acquired it is different or indirect.

Usually secondary markets are done in order to keep one’s assets liquid. The biggest secondary market arena is the stock exchange as this is where investors gather around and trade with each other on a daily basis.


In the secondary market, securities are sold by and transferred from one investor or speculator to another. It is therefore important that the secondary market be highly liquid(originally, the only way to create this liquidity was for investors and speculators to meet at a fixed place regularly; this is how stock exchanges originated, see History of the Stock Exchange).

As a general rule, the greater the number of investors that participate in a given marketplace, and the greater the centralization of that marketplace, the more liquid the market. Fundamentally, secondary markets mesh the investor’s preference for liquidity (i.e., the investor’s desire not to tie up his or her money for a long period of time, in case the investor needs it to deal with unforeseen circumstances) with the capital user’s preference to be able to use the capital for an extended period of time.

Accurate share price allocates scarce capital more efficiently when new projects are financed through a new primary market offering, but accuracy may also matter in the secondary market because:

1) price accuracy can reduce the agency costs of management, and make hostile takeover a less risky proposition and thus move capital into the hands of better managers, and

2) Accurate share price aids the efficient allocation of debt finance whether debt offerings or institutional borrowing.

Private Secondary Markets

Partially due to increased compliance and reporting obligations enacted in the Sarbanes-Oxley Actof 2002, private secondary markets began to emerge, like Second Market ( . These markets are generally only available to institutional or accredited investors and allow trading of unregistered and private company securities.

In private equity , the secondary market(also often called private equity secondaries or secondaries) refers to the buying and selling of pre-existing investor commitments to private equity funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds.


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Law, Share Price Accuracy and Econ. Performance, Durnev et al. 102 MICH. L. REV. 331 (2003)

8.21 Primary Vs Secondary Market 8.21/C2 Primary Vs Secondary Market:

Primary and Secondary markets refer to markets, which assist corporations obtain capital funding. The difference between these two markets lies in the process that is used to collect funds. The circumstances under which each market is used to raise capital, alongside the procedures to be followed in raising funds are quite distinct. The following articles provide a clear understanding of each market, their functions, and how they are different from each other.

The primary and secondary markets are both platforms in which corporations fund their capital requirements. While the functions in the primary stock exchange are limited to first issuance, a number of securities and financial assets can be traded and re traded over and over again. The main difference is that, in the primary market, the company is directly involved in the transaction, whereas in the secondary market, the company has no involvement since the transactions occur between investors.

** Primary and Secondary markets refer to markets which assist corporations obtain capital funding. The difference between these two markets lies in the process that is used to collect funds.

** The Primary market refers to the market where new securities are issued by the company hat wishes to obtain capital and is sold directly to the investor

** The secondary market refers to the market where securities that have already been issued are traded. Instruments that are usually traded on the secondary market include stocks, bonds, options and futures.

** The main difference is that, in the primary market, the company is directly involved in the transaction, whereas in the secondary market, the company has no involvement since the transactions occur between investors

** Primary Market

* New issue of securities

* Exchange of funds for financial claim

* Funds for borrower; an IOU(I owe you) for lender

** Secondary Market

Trading previously issued securities

No new funds for issuer

Provides liquidity for seller

** A primary market is the main market to which you are selling.

A secondary market is an additional market to which you are selling

** A primary offering, such as with a corporate bond, means you are buying it directly from the issuer, at par value, usually. A secondary market is where you sell or buy existing issues. I.E. If you bought a bond last year, now need to get your principal, you can sell it in the secondary market.

You may not get par value. If rates are up since you bought the bond, then you will likely have to sell it at a discount to be able to get rid of it. If rates have fallen since you bought it, you could get a premium for it.

** Secondary Market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets.

For the general investor, the secondary market provides an efficient platform for trading of his securities. For the management of the company, Secondary equity markets serve as a monitoring and control conduit.

** In the primary market, securities are offered to public for subscription for the purpose of raising capital or fund. Secondary market is an equity trading avenue in which already existing/pre- issued securities are traded amongst investors. Secondary market could be either auction or dealer market. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market.

** Primary Market is for new issues of securities, as distinguished from the Secondary Market, where previously issued securities are bought and sold. The Secondary market is where securities are traded after they are initially offered in the primary market. Most trading is done in the secondary market.

** A primary market, or the issuing market, is where a security is issued and sold for the first time, either when a company issues capital shares on incorporation and sells them to founders or other investors, this is called public offering.

Securities can also be put for sale to a specific group of investors, which is called private placement. The price at which the security is sold in the primary market

** The financial markets may also be divided into primary markets and secondary markets. The primary market is for the trading of new securities never before issued. Its principal function is the raising of financial capital to support new investment in buildings, equipment, and inventories.

There are two markets that this can occur in – one is the primary marketwhere each company creates its new securities (shares, stocks) and one is the secondary marketwhere these shares are sold between investors for future gain.

The primary marketis where a company creates securities and floats (sells) them to the public for the first time. If the company has never sold securities on the stock market before, then its first offering is known as an Initial Public Offering (IPO).The most important feature of the primary marketis to understand that this is where you are buying securities if a company has decided to float (sell) a new parcel of securities, or if a new company wishes to raise capital by selling securities to the public. The secondary market is where the majority of the true stock trading occurs.

It is called the secondary market because this is where investor’s trade previously owned securities from other traders, not the company itself and therefore the company receives no money from these transactions. The secondary market is just as important as the primary market for a number of reasons. You may be wondering at thisstage – If I am trading in the secondary market and the company is not receiving any money, why woulda company have an interest in me??– and it is a very valid question.

The reason the secondary market is so imperative is because as the share price fluctuates up and down, it affects shareholders wealth – which is their investment and money. Managers are employed to run the company on behalf of the shareholders because they have either provided the initial capital in the primary market, or now hold shares in the secondary market and have rights) which the company cannot ignore. The current share price reflects the company’s performance and future prospects as gauged by investors. This means that if a company is performing poorly – the share price decreases because shareholders no longer want to hold the stock.

The upper management can expect criticism from investors whom still own shares and this can lead to changes at the Executive Board and CEO as shareholders have rights to vote for change in the current upper management team. Poor company performance in the secondary market also may mean that another company who is performing very well, can acquire the company in a takeover bid (another entity attempts to purchase the company

You engage in a primary-market transaction when you purchase shares of stock just issued by a company, borrow money through a new mortgage to purchase a home, negotiate a loan at the bank to restock the shelves of your business, or purchase bonds just issued by the local school district to construct new classrooms.

In contrast, the secondary market deals in securities previously issued. Its chief function is to provide liquidity to security investors-an avenue for converting stocks, bonds, and other securities into ready cash. If you sell shares of stock or bonds you have been holding for some time to a relative or friend or call a broker and place an order for shares currently being traded on the American stock exchange, you are participating in a secondary-market transaction.

The financial and investment market is a wide world where everything seems to be sold and bought every minute. There are various transactions that happen every day between companies, groups and individuals. Investing and letting go of investments are daily decisions that are made around the world.

A lot of people and companies venture into investing their money as although it is a bit risky, with the right move, your initial investment can grow hugely. One of the things that you need to understand in the investment world is how the market moves. One sector of this vast world is the relationship and the difference of primary and secondary markets. Primary market, in its simplest definition, is when an investor buys or purchases directly from the company.

This could be in the form of shares, stocks, bonds and the like. Basically, this is an investment wherein the investor directly invested to the company. In this market type, the individual was the first person to own that specific share or stock or what not. When an investor is under the primary market, his investment purchase directly benefits that company from which he bought the investment.

Think of it as a consumer that buys brand new merchandise, say, a car. If you buy a brand new car directly from the car maker, then you are its primary market. Usually investors of the primary market invest directly to procure substantial profits and The volume of trading in the secondary market is far larger than trading in primary market.

However the secondary market does not support new investment. Nevertheless, the primary and secondary markets are closely intertwined. For example, a rise in interest rates or security prices in the secondary market usually leads to a similar rise in the prices or rates on primary-market securities and vice verse. This happens because investors frequently switch from one market to another in response to differences in price and yields. Many financial institutions are active in both markets.

When resell these once they do not see the need for it anymore or if they need to collect a sum of money for whatever use they would need it for. Secondary market, on the other hand is when an investor buys or purchases from another investor. Again, this could be shares, stocks or bonds. Basically, you are buying these “goods” from a co-investor which has bought these goods in the past.

When you are a part of the secondary market, you are still investing on the company from where the stocks or share come from, the only difference is, the person benefiting from your purchase or investment is not the directly the company but the other investor from which you purchased your investment. Just like our previous example, it is like buying a second-hand car wherein, you still bought that car brand but your payment benefited the previous owner. It’s still the same investment, it’s just that the manner you acquired it is different or indirect.

Usually secondary markets are done in order to keep one’s assets liquid. The biggest secondary market arena is the stock exchange as this is where investors gather around and trade with each other on a daily basis.

The primary market is where securities are created. It’s in this market that firms sell (float) new stocks and bonds to the public for the first time. For our purposes, you can think of the primary market as being synonymous with an initial public offering (IPO). Simply put, an IPO occurs when a private company sells stocks to the public for the first time. IPOs can be very complicated because many different rules and regulations dictate the processes of institutions, but they all follow a general pattern:

1. A company contacts an underwriting firm to determine the legal and financial details of the public offering.

2. A preliminary registration statement, detailing the company’s interests and prospects and the specifics of the issue, is filed with the appropriate authorities. Known as a preliminary prospectus, or red herring, this document is neither finalized nor is it a solicitation by the company issuing the new shares. It is simply an information pamphlet and a letter describing the company’s intent.

3. The appropriate governing bodies must approve the finalized statement as well as a final prospectus, which details the issue’s price, restrictions and benefits and is issued to those who purchase the securities. This final prospectus is legally binding for the company. The important thing to understand about the primary market is that securities are purchased directly from an issuing company. The secondary market is what people are talking about when they refer to the “stock market”. This includes the New York Stock Exchange (NYSE), Nasdaq and all major exchanges around the world. The defining characteristic of the secondary market is that investor’s trade amongst themselves. That is, in the secondary market, investors trade previously-issued securities without the involvement of the issuing companies. For example, if you go to buy Microsoft stock, you are dealing only with another investor who owns shares in Microsoft. Microsoft (the company) is in no way involved with the transaction. (To learn more, check out How Does Someone Actually Transact Securities? and Why Do Companies Care About Their Stock Prices?)

The secondary market can be further broken down into two specialized categories: auction market and dealer market. In the auction market, all individuals and institutions that want to trade securities will congregate in one area and announce the prices at which they are willing to buy and sell.

These are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. Thus, theoretically, the best price of a good need not be sought out because the convergence of buyers and sellers will cause mutually-agreeable prices to emerge. The best example of an auction market is the NYSE.

How Investors Trade Assets in Primary and Secondary Markets

Buying and selling securities such as stocks and bonds takes place in one of two markets. Learn about the difference between primary and secondary markets from the perspective of an investor. The term marketplace or simply market is a reference to a place where goods and services are bought and sold.

When the corporate structure was first developed in the late nineteenth century, the term market came to figuratively mean aplace where securities such as stocks and bonds are bought and sold. The New York Stock Exchange is one example of a market where trading takes place and is the best known market in the world. However, other markets exist all over the globe where billions of dollars of assets are traded annually.

Stock Exchanges

There are two primary theoretical marketplaces where securities are traded. The term theoretical is used here because the market need not be a physical place where buyers and sellers meet to trade securities. This is akin to references to different markets for selling both new and used automobiles.

The primary market for car sales refers to sales of cars between the manufacturer (or a dealership) and the buyer. A secondary market refers to used car sales and may be between any owner and seller. The point is that primary markets refer to new sales and secondary markets refer to used sales.

A stock exchange is any legally recognized market where securities can be bought and sold. Corporations that issue stock are traded in these markets and typically wish to be listed as an officially traded company so that the shares of stock can be purchased by investorsin a liquid market. In addition, stock exchanges are regulated such that both companies and investors must follow trading rules making the transition of ownership safer and less risky.

The liquidity of the market refers to the ease with which ownership of a company in the form of stocks can be bought and sold without delay or complications afforded by selling the stock on a one-to-one basis between each company and investor.

Primary and Secondary Markets

A primary market refers to any market where new shares of stock are sold. A corporation wishing to sell new shares of stock benefits from this sale because the stock is sold in the market directly by the issuing company. This is in contrast to secondary markets where shares of stock already in circulation and issued at a previous date are traded among investors.

The company who issued the stock does not benefit directly from the sale of stock in a secondary market because the money paid for the stock goes to the seller in exchange for part ownership in the company. In this case, the company is not involved in the transaction.

Buybacks and Secondary Markets

Sometimes corporations interested in buying or selling shares of its own stock. In this case, the company does benefit from the transaction but the stocks are still considered to be trading in secondary markets because the stock was issued at an earlier date. When a company buys its own stock in a buyback, it is reducing the number of shares of stock available for purchase in the secondary market. The company may do this to protect itself from a buyout or to use the stock as compensation for the purchase of a new asset. Either way it signals to the secondary markets that the value of the company is changing and holders of the stock need to reevaluate the worth of their part ownership of the company.

The main difference between primary and secondary markets has to do with who benefits from the sale or purchase of a corporation’s stock. When new stock is issued, the company benefits from the sale and the cash flow from the sale of new stock can be used to invest in the company’s operations.

When stock is bought or sold between investors, the company does not directly benefit from the sale or purchase because money changes hands only between the two investors.

Which is Better?

There is no such thing as a “better” method of market research. Primary market research is the best way to answer questions you have for your company, while secondary market research can provide you with information that may be interesting in some way to your company.

Both represent great ways to improve your business. Market research is vital for a business to succeed. You will need to find as much information you can from as many resources as you can if you hope to get ahead in today’s economy. Sometimes you will need to find information yourself, other times the information may already exist through other channels. Successful companies will always find ways to utilize both new data and existing data into all of their business plans



Frank J. Fabozzi, Franco Modigliani, Frank J. Jones and Michel G. Ferri; Foundation of Financial Markets and Institutions: 3rd edition, Pearson education inc. 2002, p-5


S. Kerry Cooper, Donald R Fraser; The financial market place: Texas A and M University-Addison-Wesley Publishing company Inc. Philippines, 1982, p-22


Frank J. Fabozzi, Franco Modigliani and Frank J. Jones; Capital market, Institutions and Instrument: Prentice
Hall of India pvt. 2006, p-96 and 107

E Ros; Money and Capital Markets: Financial system in the economy: Business publications, Inc. 1983, p-16

E L.M. Bhole; Financial Institutions and Market, Structure, Growth and Innovations: Tata McGrow-Hill Publishing Company Ltd. New Delhi, 2006, p-5

E http://sawaal. markets-and-secondary-markets.html









8.22 Consolidation of Financial Institutions 8.22/C2 Consolidation of Financial Institutions

As regulations have been reduced, manager’s o financial institutions have more flexibility to offer services that could increase their cash flows and value. The reduction in regulations has allowed financial institutions more opportunities to capitalize on economies of scale. Commercial banks have acquired other commercial banks so that they can generate a higher volume of business supported by a given infrastructure.

Methods of consolidation

In general terms, consolidation of the financial services sector involves the resources of the industry becoming more tightly controlled, either because the number of key firms is smaller or the rivalry between firms is reduced. Consolidation may result from combinations of existing firms, growth among leading firms, or industry exit of weaker institutions. This chapter focuses primarily on the first of these causes.

There are several alternatives for firms combining with each other. Each has its strengths and weaknesses and may be particularly appropriate in certain situations. Section 3 presents data on two classes of methods: (1) mergers and acquisitions and (2) joint ventures and strategic alliances.

The primary methods of consolidation employed by firms are mergers and acquisitions. With both of these methods, two formerly independent firms become commonly controlled. Throughout this chapter, the terms merger and acquisition are used interchangeably to refer to transactions involving the combination of two independent firms to form one or more commonly controlled entities.

The distinction between a merger and an acquisition is somewhat vague. A merger is often defined as a transaction where one entity is combined with another so that at least one initial entity loses its distinct identity. Thus, full integration of the two firms takes place and control over a single entity can easily be exercised.

An acquisition is often classified as a transaction where one firm purchases a controlling stake of another firm without combining the assets of the firms involved. Relative to acquisitions, mergers provide a greater level of control, because there is only one corporate entity to manage. Acquisitions are most appropriate when there are operational, geographic or legal reasons to maintain separate corporate structures. Mergers and acquisitions are also sometimes distinguished by defining mergers as transactions involving two firms that are of essentially equal size, while acquisitions are transactions where one party clearly obtains control of another.

A partial, or non-controlling, acquisition is similar to an acquisition of a controlling interest, except that, as the name implies, the acquiring firm does not establish control. Such deals encourage cooperation between potential rivals, because they establish a common interest among the firms.

Partial acquisitions may also serve as a first step for firms before engaging in more complete consolidations of control. Joint ventures and strategic alliances enable firms to work together without either firm relinquishing control of its own operations and activities. Strategic alliances are partnerships between independent firms that involve the creation of tangible or intangible assets.

The level of collaboration is often fairly low and focused on a well-defined set of activities, services or products. Strategic alliances may be most appropriate for the exchange of technical information and sophisticated knowledge or when there are legal, regulatory or cultural constraints making a more thorough collaboration difficult or illegal. Moreover, relative to mergers and acquisitions, strategic alliances generally involve lower formation and dissolution costs. Like partial acquisitions, strategic alliances may enhance cooperation among firms or serve as a first step towards a merger or acquisition.

A joint venture, which may be viewed as a type of strategic alliance, occurs when two or more independent firms form and jointly control a different entity, which is created to pursue a specific objective. This new entity typically draws on the strengths of each partner. Joint ventures facilitate consolidation, because they enable firms to develop strong ties. Joint ventures may also serve as a precursor to more comprehensive consolidation such as mergers.

Effects of consolidation on financial risk

This section considers the potential implications of financial consolidation for financial risk. Financial risk is defined to encompass both individual financial institutions and a systemic financial crisis. The section’s objective is to assess the impact of consolidation on risk, not to judge whether consolidation in combination with other developments has led to a net change in the risk of either individual financial institutions or the financial system. Indeed, it is possible to argue that the probability that a given shock will either threaten the solvency of a particular firm or develop into a systemic event has, on net, declined over the last decade.

Many of the reasons for such a judgement, such as regulatory reforms designed to increase bank capital and reduce moral hazard, and the development of efficient markets for a variety of financial instruments, probably have little to do with consolidation per se.

Others, such as increased geographic diversification, may have resulted substantially from consolidation. In both cases, this section attempts to isolate the “partial” implications of financial consolidation. As the previous paragraph suggests, the objective of isolating the effects of consolidation is much easier to state than to achieve. Consolidation, as discussed in previous, is but one of several powerful forces causing change in the financial system, and each of these forces affects and is affected by the others. The chapter begins by specifying a working definition of systemic financial risk .

The primary objective is to provide a common analytical framework for evaluating the potential impacts of consolidation. This definition is used throughout both the chapter and the broader study.

It emphasises losses of economic value or confidence, as well as the probability of significant adverse effects on the real economy, as defining characteristics of systemic risk. It also argues that the possibilities for negative real economic effects generally arise from disruptions to the payment system and to credit flows, and from the destruction of asset values.

Once systemic risk is defined, the potential implications of financial consolidation on individual firms and systemic risk are discussed for three separate geographic regions: the United States, Europe and Japan . Annexes focus on the potential effects of consolidation on systemic risk management in Canada and on the possible effects of strategic alliances on financial risk.

The geographic distinctions were chosen in large part because each region has distinct economic characteristics, including the structure of its financial system, its position in the macroeconomic cycle, and the nature of its ongoing financial consolidation.

These characteristics could significantly influence the ways in which consolidation is affecting and will affect financial risk. Each geographic section is organised in a similar manner, although the authors were given considerable latitude to pursue issues most relevant to their area.

The discussion of individual firm risk focuses on the question: Can we make a judgement regarding whether consolidation has led or will lead to financial institutions that are more or less risky on a standalone basis? The discussion of systemic risk begins by considering whether financial consolidation has, or is expected to lead to the creation of a new class of firms that are too big to fail, liquidate, or discipline effectively.

The analysis of systemic risk then reviews the potential effects of consolidation on key characteristics of economic “shocks” that may become a systemic event. These characteristics include: (i) “direct” interdependencies between firms and markets through inter firm on- and off-balance sheet exposures, (ii) “indirect” interdependencies through correlated exposures to non-financial sectors and financial markets, and (iii) the degree of transparency of firms and markets, including the role played by market discipline.

For example, consolidation could affect firms’ direct interdependencies through the interbank market by reducing the number of players and counterparties. Consolidation could also affect firms’ indirect interdependencies by encouraging greater reliance on markets for funding as well as by encouraging increasingly similar investment objectives; both could result in an increase in the correlation of firms’ exposures.

Finally, consolidation may induce firms to undertake larger cross-border and cross-product activities that may increase their complexity, thereby affecting their transparency to markets and regulators. Where relevant, both domestic and cross-border effects are discussed. In addition, the importance of both institutions and markets is emphasised. The final portion of each geographic section identifies the key areas of policy concern raised by the previous discussion. As is the case with other portions of the study, specific policy recommendations are not the objective. Rather, identification and perhaps prioritisation of the most important concerns are sought



Abraham, Jean-Paul and Anne-Françoise Pirard (1999): “Competition and co-operation among

European Exchanges – The impact of financial globalisation with special reference to smaller-sized exchanges”, working paper prepared for the 1999 Annual Meeting of the European

Association of University teachers in Banking and Finance, Lisbon, September.


Austin, Stephanie (1995): “Chapter 12: Securities Markets”, in “Securities Processing”, edited

by William L Imhoff, 1995, pp 126-36.

E Conti, Vittorio and Rony Hamaui (1993): “Financial Markets’ liberalisation and the role of

banks”, Cambridge University Press.

EDale, Richard (1994): “International Banking Deregulation – The Great Banking Experiment”,

Blackwell Finance.

EAkhavein, Jalal D., Allen N Berger, and David B Humphrey (1997): “The Effects of Bank

Megamergers on Efficiency and Prices: Evidence from the Profit Function.” Review of

Industrial Organization, 12: 95-139


Allen, Linda and Anoop Rai (1996): “Operational Efficiency in Banking: An International

Comparison.” Journal of Banking and Finance, 20: 655-672.


Allen, Franklin and Douglas Gale (2000): “Financial Contagion”, Journal of Political

Economy, 108: 1-33.


Atkinson, David (1999a): “Bank Mergers That Make Sense; Bank Mergers That Are Just Hype

– How to Tell the Difference”, Goldman Sachs Investment Research.


Bank for International Settlements (CFCS, 1992): “Recent Developments in International

Interbank Relations” (The “Promisel Report”).


Bank for International Settlements (CFCS, 1998): “Implications of Structural Change for the

Nature of Systemic Risk”, September.

8.23 Global expansion by financial institutions 8.23/C Global Capital Market Integration and Economic Growth:

Links Between Market Integration and Growth
Transaction costs are high for foreign investors in many emerging markets. Illiquidity (difficulty in finding a buyer when you are selling and vice versa) combined with taxes (income, withholding, and transaction based) and various capital market restrictions (official regisLration of securities transactions and exchange controls) make foreign market participation very costly to many investors . This sectioii explores the impact that world market integration ha on the cost of capital in developing countries.

Many emerging markets arc segmented. This means that investors are local residents and foreign participation in the local market is limited. Segmentation has many causes; for example, foreigners may be prohibited from participating in the local market. The causes may be morc subtle in terms of regulatory, institutional, and tax barriers to investment. Nevertheless, a market dominated solely by local investors is not likely to be integrated into global capital markets.
In a segmented market, investors’ portfolios are exposed to price fluctuations induced by the state of the local economy. Even though the investor might hold many stocks, this portfolio is not fully diversified, because all of the stocks are linked to the local economy. For example, if a recession or a cusrcncy crisis occurs in the local economy, all stocks will likely lose value. The extent of ‘diversification’ of that local portfolio does not matter. Since all the stocks originate within one country, they all are exposed to fluctuations emanating from the local economy.

Logically, the investors in the segmented capital market require compensation for this risk. This compensation takes the form of higher expected rates of return, which translates into higher costs of capital for corporations operating within that market.
In integrated capital markets, however, compensation is different: the investor holds securities From many countries.

This is a world diversified portfolio. Whereas local economic events will influence stocks in any one country, the investor has a portfolio that reaches across many national borders, A negative shock (bad news) in one country may be offset by a positive shock (good news) in another country. As a result, the investor does not demand compensation for local market volatility. In other words, the diversified international portfolio provides a natural hedge for country-specific events.

The investor, although still concerned about negative shocks in any one country, does not require a risk premium for the lack of country diversification. Thc expected rate of return on the local stock is determined by how it interacts with all of the stocks in the investor’s worldwide portfolio.
Recent research by Bekaert and Harvey (1995) suggests that the expected risk premium on equity investments in many emerging markets can he reduced by increasing their integration into world capital markets. Their research proposes an econometric model that examines two possible regimes:
segmented capital markets and integrated capital markets. Using historical data, the model reveals the evolution of many markets from closed markets to being integrated into world capital markets. Some countries, however, move in the other direction, from integrated to closed.
As explained above, the expected rates of return on equity differ in segmented and integrated markets. In thc segmented market, the expected rate of return is linked to iocal market volatility. In the integrated capital market, the expected rate of return is linked to the way the security interacts with a geographically broader investment portfolio.

Why then would the cost of capital be lower in integrated markets? First, in emerging capital markets, the local market volatility is very high (see Bekaert and Harvey (1997a)). This high volatility leads to high expected rates of return on equity investments in segmented capital markets. Second, emerging markets are attractive investments for world investors because these markets serve as a hedge for such investor& portfolios the local economies are not highly correlated with developed economies). Since the industrial structure of emerging markets is often much different from that of developed markets, bad news in developed markets is often cushioned with good news in emerging markets, and vice versa.

This natural hedging property is very important. It causes a high dcrnancl for the emerging market’s secunties by foreign investors—if the emerging market is integrated into world capital markets. This demand raises equity prices and eventually reduces expected rates of return.

This analysis shows that the cost of capital should he lower in integrated capital markets than in segmented capital markets. The fact that many emerging market enterprises are raising capital in other countries American depository receipts (AIDRs) or Global depository receipts (GDRs) is indirect evidence of a lower cost of capital in world markets.
How do the lower expected rates of return on equity translate into economic growth? Lower discount rates have an immediate impact on corporations operating in the developing market. In segmented capital markets with high discount rates, many investment projects are rejected because the projects’ expected ratcs of return are too low, For example, suppose an investment project could yield art average return of 25% over 10 years. If prospective equity investors require a minimum 30% return for this project, the project will not be undertaken. Lowering the discount rate makes an additional set of investments attractive. Projects that would otherwise not be undertaken become viable, creating jobs and other bcnefits to the economy.
Lower discount rates have an immediate impact on multinational corporations’ willingness to make direct investments in the emerging market. Suppose the multinational corporation is based in the United States and requires projects of average risk in the United States to yield 15%. A similar investment project in the emerging market promises to yield 25% over 10 years (calculated in U.S. dollars), Will this project be undertaken? Not necessarily.

The 15% required rate of return only applies to projects of average risk within the United States. Projects are always evaluated with a discount rate specific to the particular investment project. The project in thc segmented emerging market is not likely- to have the same discount rate as the project in the Unfted States.

Indeed, if the relevant required rate of return in the emerging market was 30%, the multinational corporation would reject the project with an expected return of 25%. A lower discount rate increases the extent to which muftinational corporations make a long-term commitment of resources to a country. This type of investment has many benefits to the local economy.

It leads to job creation1 it is long term in nature, and it often is associated with international expertise being passed on to the local population (transfer of knowledge). These factors contribute positively to economic growth.

Empirical Evidence

This section explores the investment barriers that segment markets from global capital markets and constructs a number of indicators of global capital market integration, examining empirically whether any positive association exists between integration and economic growth.

Unfortunately, no empirical work linking market integration and economic growth exists to date. Rank correlations presented here should be seen as suggestive of the true interactions between market integration and economic growth. Additional research. is planned for the future.

Investment Barriers in Emerging Markets

We distinguish three different kinds of investment barriers: legal barriers arising from the different legal status of foreign and domestic investors (e.g, foreign ownership restrictions and taxes); indirect barriers arising from differences in available information, accounting standards1 and investor protection; barriers arising from emerging market—specific risks (EMSRs) that discourage foreign investment and lead to de facto segmentation EMSRs include liquidity risk, political risk, and economic policy risk (macroeconomic stability).

Chuhan (1992), for instance, reports that market participants in Canada, Germany, Japan, the United Kingdom’s and the United States mentioned liquidity problems as one of the major impediments to investing in emerging markets.

Other EMSRs are related to the notion of country risk. Country risk indicators reflect the likelihood that companies or the government within the country will default on obligations.

Credit rating agencies use country risk analysis to construct country credit ratings, which have a direct impact on the cost of funds risen in international markets. Country risk analysis not only reflects political stability assessments but also incorporates economic environment factors. In particular, unstable macroeconomic policies, leading to high and variable inflation, may jeopardize the credit rating of a coufltry.

Needless to say, these barriers to investment are a direct function of the domestic policies pursued in the various countries. Through a number of indirect routes, countries can attempt to integrate their markets with world markets.

One route is to allow foreign investment companies to set up country funds that invest solely in the local market. Another is to let domestic companies offer securities in other countries typically through ADRs or GORs, which may list on an exchange or trade in the over-the-counter markets1 These indirect channels of access to emerging markets are covered in more detail in Bekaert (1995).


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