Financial Markets

Financial markets refer broadly to any marketplace where the trading of securities occurs,
including the stock market, bond market, forex market, and derivatives market, among others.
Financial markets are vital to the smooth operation of capitalist economies.

Financial Market

Understanding the Financial Markets

Financial markets play a vital role in facilitating the smooth operation of capitalist economies by
allocating resources and creating liquidity for businesses and entrepreneurs. The markets make
it easy for buyers and sellers to trade their financial holdings. Financial markets create securities
products that provide a return for those who have excess funds (Investors/lenders) and make
these funds available to those who need additional money (borrowers).

The stock market is just one type of financial market. Financial markets are made by buying and
selling numerous types of financial instruments including equities, bonds, currencies, and
derivatives. Financial markets rely heavily on informational transparency to ensure that the
markets set prices that are efficient and appropriate. The market prices of securities may not be
indicative of their intrinsic value because of macroeconomic forces like taxes.

Some financial markets are small with little activity, and others, like the New York Stock
Exchange (NYSE), trade trillions of dollars of securities daily. The equities (stock) market is a
financial market that enables investors to buy and sell shares of publicly traded companies. The
primary stock market is where new issues of stocks, called initial public offerings (IPOs), are
sold. Any subsequent trading of stocks occurs in the secondary market, where investors buy
and sell securities that they already own.

Prices of securities traded in the financial markets may not necessarily reflect their true intrinsic
value.

Types of Financial Markets

Over-the-Counter Markets
An over-the-counter (OTC) market is a decentralized market—meaning it does not have
physical locations, and trading is conducted electronically—in which market participants trade
securities directly between two parties without a broker. An OTC market handles the exchange
of publicly traded stocks that are not listed on the NYSE, Nasdaq, or the American Stock
Exchange. In general, companies that trade on OTC markets are smaller than those that trade
on primary markets, as OTC markets require less regulation and cost less to use.

Bond Markets
A bond is a security in which an investor loans money for a defined period at a pre-established
interest rate. You may think of a bond as an agreement between the lender and borrower that
contains the details of the loan and its payments. Bonds are issued by corporations as well as
by municipalities, states, and sovereign governments to finance projects and operations. The
bond market sells securities such as notes and bills issued by the United States Treasury, for
example. The bond market also is called the debt, credit, or fixed-income market.

Money Markets
Typically the money markets trade in products with highly liquid short-term maturities (of less
than one year) and are characterized by a high degree of safety and a relatively low return in
interest. At the wholesale level, the money markets involve large-volume trades between
institutions and traders. At the retail level, they include money market mutual funds bought by
individual investors and money market accounts opened by bank customers. Individuals may
also invest in the money markets by buying short-term certificates of deposit (CDs), municipal
notes, or U.S. Treasury bills, among other examples.

Derivatives Market
A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Derivatives are
secondary securities whose value is solely derived from the value of the primary security that
they are linked to. In and of itself a derivative is worthless. Rather than trading stocks directly, a
derivatives market trades in futures and options contracts, and other advanced financial
products, that derive their value from underlying instruments like bonds, commodities,
currencies, interest rates, market indexes, and stocks.

Forex Market
The forex (foreign exchange) market is the market in which participants can buy, sell, exchange,
and speculate on currencies. As such, the forex market is the most liquid market in the world, as
cash is the most liquid of assets. The currency market handles more than $5 trillion in daily
transactions, which is more than the futures and equity markets combined. As with the OTC
markets, the forex market is also decentralized and consists of a global network of computers
and brokers from around the world. The forex market is made up of banks, commercial
companies, central banks, investment management firms, hedge funds, and retail forex
brokers and investors.

Financial Institution

A financial institution (FI) is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange. Financial
institutions encompass a broad range of business operations within the financial services sector
including banks, trust companies, insurance companies, brokerage firms, and investment
dealers. Virtually everyone living in a developed economy has an ongoing or at least periodic
need for the services of financial institutions.

Financial institutions can operate at several scales from local community credit unions to
international investment banks.

Financial Institution
How Financial Institutions Work
Financial institutions serve most people in some way, as financial operations are a critical part
of any economy, with individuals and companies relying on financial institutions for transactions
and investing. Governments consider it imperative to oversee and regulate banks and financial
institutions because they do play such an integral part of the economy. Historically, bankruptcies
of financial institutions can create panic.

In the United States, the Federal Deposit Insurance Corporation (FDIC) insures regular deposit
accounts to reassure individuals and businesses regarding the safety of their finances with
financial institutions. The health of a nation's banking system is a linchpin of economic stability.
Loss of confidence in a financial institution can easily lead to a bank run.

KEY TAKEAWAYS
  A financial institution (FI) is a company engaged in the business of dealing with financial
and monetary transactions such as deposits, loans, investments, and currency
exchange.
 Financial institutions encompass a broad range of business operations within the
financial services sector including banks, trust companies, insurance companies,
brokerage firms, and investment dealers.
 Financial institutions can vary by size, scope, and geography.
Types of Financial Institutions
Financial institutions offer a wide range of products and services for individual and commercial
clients. The specific services offered vary widely between different types of financial institutions.

Commercial Banks
A commercial bank is a type of financial institution that accepts deposits, offers checking
account services, makes business, personal, and mortgage loans, and offers basic financial
products like certificates of deposit (CDs) and savings accounts to individuals and small
businesses. A commercial bank is where most people do their banking, as opposed to an
investment bank.

Banks and similar business entities, such as thrifts or credit unions, offer the most commonly
recognized and frequently used financial services: checking and savings accounts, home
mortgages, and other types of loans for retail and commercial customers. Banks also act as
payment agents via credit cards, wire transfers, and currency exchange.

Investment Banks
Investment banks specialize in providing services designed to facilitate business operations,
such as capital expenditure financing and equity offerings, including initial public offerings
(IPOs). They also commonly offer brokerage services for investors, act as market makers for
trading exchanges, and manage mergers, acquisitions, and other corporate restructurings.

Insurance Companies
Among the most familiar non-bank financial institutions are insurance companies. Providing
insurance, whether for individuals or corporations, is one of the oldest financial services.
Protection of assets and protection against financial risk, secured through insurance products, is
an essential service that facilitates individual and corporate investments that fuel economic
growth.
Brokerage Firms
Investment companies and brokerages, such as mutual fund and exchange-traded fund (ETF)
provider Fidelity Investments, specialize in providing investment services that include wealth
management and financial advisory services. They also provide access to investment products
that may range from stocks and bonds all the way to lesser-known alternative investments, such
as hedge funds and private equity investments.

Interest rates

The interest rate is the amount a lender charges for the use of assets expressed as a
percentage of the principal. The interest rate is typically noted on an annual basis known as
the annual percentage rate (APR). The assets borrowed could include cash, consumer goods,
or large assets such as a vehicle or building.

Interest Rates: Nominal and Real

KEY TAKEAWAYS

 The interest rate is the amount charged on top of the principal by a lender to a borrower
for the use of assets.
 Most mortgages use simple interest. However, some loans use compound interest,
which is applied to the principal but also to the accumulated interest of previous periods.
 A loan that is considered low risk by the lender will have a lower interest rate. A loan that
is considered high risk will have a higher interest rate.
 Consumer loans typically use an APR, which does not use compound interest.
 The APY is the interest rate that is earned at a bank or credit union from a savings
account or certificate of deposit (CD). Savings accounts and CDs use compounded
interest.
Understanding Interest Rates
Interest is essentially a rental or leasing charge to the borrower for the use of an asset. In the
case of a large asset, such as a vehicle or building, the lease rate may serve as the interest
rate. When the borrower is considered to be low risk by the lender, the borrower will usually be
charged a lower interest rate. If the borrower is considered high risk, the interest rate that they
are charged will be higher. Risk is typically assessed when a lender looks at a potential
borrower's credit score, which is why it's important to have an excellent one if you want to
qualify for the best loans.
For loans, the interest rate is applied to the principal, which is the amount of the loan. The
interest rate is the cost of debt for the borrower and the rate of return for the lender.

When Are Interest Rates Applied?

Interest rates apply to most lending or borrowing transactions. Individuals borrow money to
purchase homes, fund projects, launch or fund businesses, or pay for college tuition.
Businesses take loans to fund capital projects and expand their operations by purchasing fixed
and long-term assets such as land, buildings, and machinery. Borrowed money is repaid either
in a lump sum by a pre-determined date or in periodic installments.

The money to be repaid is usually more than the borrowed amount since lenders require
compensation for the loss of use of the money during the loan period. The lender could have
invested the funds during that period instead of providing a loan, which would have generated
income from the asset. The difference between the total repayment sum and the original loan is
the interest charged. The interest charged is applied to the principal amount.

For example, if an individual takes out a $300,000 mortgage from the bank and the loan
agreement stipulates that the interest rate on the loan is 15%, this means that the borrower will
have to pay the bank the original loan amount of $300,000 + (15% x $300,000) = $300,000 +
$45,000 = $345,000.

If a company secures a $1.5 million loan from a lending institution that charges it 12%, the
company must repay the principal $1.5 million + (12% x $1.5 million) = $1.5 million + $180,000
= $1.68 million.

An annual interest rate of 15% translates into an annual interest payment of $45,000. After 20
years, the lender would have made $45,000 x 20 years = $900,000 in interest payments, which
explains how banks make their money.

Compound Interest Rate

Some lenders prefer the compound interest method, which means that the borrower pays even
more in interest. Compound interest also called interest on interest, is applied to the principal
but also on the accumulated interest of previous periods. The bank assumes that at the end of
the first year the borrower owes the principal plus interest for that year. The bank also assumes
that at the end of the second year, the borrower owes the principal plus the interest for the first
year plus the interest on interest for the first year.
The interest owed when compounding is higher than the interest owed using the simple interest
method. The interest is charged monthly on the principal including accrued interest from the
previous months. For shorter time frames, the calculation of interest will be similar for both
methods. As the lending time increases, however, the disparity between the two types of
interest calculations grows.

The table below is an illustration of how compound interest works.

Yea
Beginning Loan Interest 15% Ending Loan
r

1 $300,000 $45,000.00 $345,000

2 $345,000 $51,750.00 $396,750

3 $396,000 $59,512.50 $456,263

4 $456,263 $68,439.68 $524,702

5 $524,702 $78,705.28 $603,407

6 $603,407 $90,511.07 $693,918

7 $693,918 $104,087.73 $798,006

8 $798,006 $119,700.89 $917,707

9 $917,707 $137,656.03 $1,055,363

10 $1,055,363 $158,304.43 $1,213,667

11 $1,213,667 $182,050.10 $1,395,717

12 $1,395,717 $209,357.61 $1,605,075

13 $1,605,075 $240,761.25 $1,845,836

14 $1,845,836 $276,875.44 $2,122,712

15 $2,122,712 $318,406.76 $2,441,118

16 $2,441,118 $366,167.77 $2,807,286

17 $2,807,286 $421,092.94 $3,228,379

18 $3,228,379 $484,256.88 $3,712,636

19 $3,712,636 $556,895.41 $4,269,531

20 $4,269,531 $640,429.72 $4,909,961

At the end of 20 years, the total owed is almost $5 million on a $300,000 loan. A simpler method
of calculating compound interest is to use the following formula:

Compound interest=p×[(1+interest rate)n−1]where:p=principaln=number of compounding peri

ods

When an entity saves money using a savings account, compound interest is favorable. The
interest earned on these accounts is compounded and is compensation to the account holder
for allowing the bank to use the deposited funds. If a business deposits $500,000 into a high-
yield savings account, the bank can take $300,000 of these funds to use as a mortgage loan.

To compensate the business, the bank pays 6% interest into the account annually. So, while the
bank is taking 15% from the borrower, it is giving 6% to the business account holder, or the
bank's lender, netting it 9% in interest. In effect, savers lend the bank money, which, in turn,
provides funds to borrowers in return for interest.

The snowballing effect of compounding interest rates, even when rates are at rock bottom, can
help you build wealth over time; Investopedia Academy's Personal Finance for Grads course
teaches how to grow a nest egg and make wealth last.

APR vs. APY

Interest rates on consumer loans are typically quoted as the annual percentage rate (APR). This
is the rate of return that lenders demand for the ability to borrow their money. For example, the
interest rate on credit cards is quoted as an APR. In our example above, 15% is the APR for the
mortgagor or borrower. The APR does not consider compounded interest for the year.
The annual percentage yield (APY) is the interest rate that is earned at a bank or credit union
from a savings account or certificate of deposit (CD). This interest rate takes compounding into
account.

Borrower's Cost of Debt

While interest rates represent interest income to the lender, they constitute a cost of debt to the
borrower. Companies weigh the cost of borrowing against the cost of equity, such as dividend
payments, to determine which source of funding will be the least expensive. Since most
companies fund their capital by either taking on debt and/or issuing equity, the cost of the
capital is evaluated to achieve an optimal capital structure.

Interest Rate Drivers

The interest rate charged by banks is determined by a number of factors, such as the state of
the economy. A country's central bank sets the interest rate, which each bank use to determine
the APR range they offer. When the central bank sets interest rates at a high level, the cost of
debt rises. When the cost of debt is high, it discourages people from borrowing and slows
consumer demand. Also, interest rates tend to rise with inflation.

Fast Fact: The current interest rate for a 30-year mortgage is around 4%, according to Bank of
America; in 1981, according to The Street, the 30-year fixed mortgage rate was 18.5%.
To combat inflation, banks may set higher reserve requirements, tight money supply ensues, or
there is greater demand for credit. In a high-interest rate economy, people resort to saving their
money since they receive more from the savings rate. The stock market suffers since investors
would rather take advantage of the higher rate from savings than invest in the stock market with
lower returns. Businesses also have limited access to capital funding through debt, which leads
to economic contraction.

ASSESMENT AND ACTIVITIES:

1) What are the different type of financial markets and explain.

2) What are the Financial Institution and explain it’s role in the Financial system.
Using the formula below in computing Simple Interest Rates, compute for if the simple interest
rate is 5% on a loan of $1,000 for a duration of 4 years, the total simple interest will come out to

be?