CHAPTER FOUR

FINANCIAL MARKETS IN THE FINANCIAL SYSTEM

A financial market is a market in which financial assets are traded. In addition to enabling
exchange of previously issued financial assets, financial markets facilitate borrowing and lending
by facilitating the sale by newly issued financial assets. A financial market is a market in which
financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are
transferred in financial markets when one party purchases financial assets previously held by
another party. Financial markets facilitate the flow of funds and thereby allow financing and
investing by households, firms, and government agencies

Financial markets ( bond and stock markets ) and financial intermediaries ( banks, insurance
companies, pension funds) have the basic function of getting people together by moving funds
from those who have a surplus of funds to those who have a shortage of funds. More
realistically, when Apple invents a better product, it may need funds to bring its new product to
market. Similarly, when a local government needs to build a road or a school, it may need more
funds than local property taxes provide. Well functioning financial muskets and financial
intermediaries are crucial to economic health.
To study the effects of financial markets and financial intermediaries on the economy, we need
to acquire an understanding of their general structure and operation.
4.1.Functions of Financial Markets
Financial markets perform the essential economic function of channeling funds from households,
firms and governments that have saved strophes funds by spending less than their income to
those that have a shortage of funds because they wish to spend more than their income. Those
who have saved and are lending funds, the lender savers, are at the left, and those who must
borrow funds to finance their spending, the borrower spenders, are at the right.

The principal lender savers are households, but business enterprises and the government
(particularly state and local government) as well as foreigners and their governments sometimes
also find themselves north excess funds and so lend them out. The most important borrower
spenders are businesses and the government (particularly the federal government), but
households and foreigners also borrow to finance their purchases of cars.
Indirect finance, borrowers borrow funds directly from lenders in financial markets by selling
them securities ( also called financial instruments) which are claims on the borrower’s future
income or assets securities are assets for the person who buys them but liabilities ( IOUS or
debts) for the individual or firms that sells ( issues ) them.

Financial markets and institutions

Example. If general motors needs to borrow funds to pay for a new factory to manufacture
electric cars, it might borrow the funds from savers by selling them bonds, debt securities that
promise to make payments periodically for a specified period of lime.
Financial markets are thus essential to promoting economic efficiency. Without financial
markets; it is hard to transfer funds from person who has no investment opportunities to one who
has them. Therefore the existence of financial markets is beneficial even if some over borrows
for a purpose other than increasing production in a business.
Now we can see why financial markets have such an important function in the economy they
allow funds to more from people from people who lack productive investment. Opportunities to
people who have such opportunities. Financial markets are critical for producing an efficient
allocation of capital, which contributes to higher production and efficiency for the overall
economy.
Well- functioning financial markets also directly improve the well-being of consumers by
allowing them to time their purchases better. They provide funds to young people. To buy what
they need and can eventually afford without forcing them to wait until they have saved up the
entire purchase price. Financial markets that are operating efficiently improve the economic
welfare of everyone in the society.
Thus, we can summarize the basic functions of Financial Markets as follows:
● Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power)
from savers who have spent less than their income to investors or consumers who have spending
needs that exceed their income.
● 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.
● 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.
● Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
● Liquidity: Financial markets provide the holders of financial assets with a chance to resell or
liquidate these assets.

● Efficiency: Financial markets reduce transaction costs and information costs. In attempting to
characterize the way financial markets operate, one must consider both the various types of
financial institutions that participate in such markets and the various ways in which these
markets are structured.

Financial markets and institutions

 4.2. The Organization and Structure of Markets
Now that we understand the basic function of financial markets, let’s look at their structure. The
following deceptions of several categorizations of financial markets illustrate essential features
of these markets. We can classify the markets on different basis as stated below.
 Based on the time of issuance and trading
a) Primary market  Based on the maturity of securities
b) secondary market traded
 Based on the types of securities traded a) Money market
a) Debt /Bond/market b) Capital market
b) Equity/stock market  Based on the structure of the market
c) Derivatives market a) Over the counter market
d) Foreign exchange market b) Organized exchange market
4.2.1. Debt and Equity Markets
A firm or an individual can obtain funds in a financial market in two ways. The most Common
method is to issue a debt instrument, such as a bond or a mortgage, which is a contractual
agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular
intervals ( interest and principal payments ) until a specified date ( the maturity date ) when a
final payment is made. The second method of raising funds is by issuing equities such as
common stock, which are claims to share in the net income (income after expenses and taxes)
and the assets of a business. If you own one share of common shares, you are entitled to 1 one
millionth of the firm’s net income and 1 one millionth of the firm’s assets.
4.2.2. Primary and Secondary Markets
A primary market issues new securities on an exchange. Companies, governments and other
groups obtain financing through debt or equity based securities. Primary markets, also known as
"new issue markets," are facilitated by underwriting groups, which consist of investment banks
that will set a beginning price range for a given security and then oversee its sale directly to
investors.
The primary markets are where investors have their first chance to participate in a new security
issuance. The issuing company or group receives cash proceeds from the sale, which is then used
to fund operations or expand the business.
Participants of primary market: based on the regulation of the financial market of specific
jurisdiction the participants may vary. But, the common participants of primary markets are,
primary dealers, regulators, investors (mostly institutional investors including primary dealers
themselves), investment banks (underwriting) and sometimes mutual funds.

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Primary market instruments: both bond and equities are presented for initial public offering
(IPO) in the primary market
Secondary market
The secondary market is where investors purchase securities or assets from other investors,
rather than from issuing companies themselves. The Securities and Exchange Commission (SEC)
registers securities prior to their primary issuance, then they start trading in the in the secondary
market on the New York Stock Exchange, NASDAQ or other venue where the securities have
been accepted for listing and trading

The secondary market is where the bulk of exchange trading occurs each day. Primary markets
can see increased volatility over secondary markets because it is difficult to accurately gauge
investor demand for a new security until several days of trading have occurred. In the primary
market, prices are often set beforehand, whereas in the secondary market only basic forces like
supply and demand determine the price of the security.
Participants of Secondary markets: Regulators, Stock exchanges, Depositories, Brokers,
Foreign, institutional investors, Merchant bankers, Primary dealers, Mutual funds, Custodians,
Bankers to an issue, Credit rating agencies and etc. are the participants of secondary markets
Secondary market instruments: all types of financial instruments are traded in this market
without any exceptions.
4.2.3. Exchanges and Over-The-Counter Markets
Secondary markets can be organized in two ways- one method is to organize exchanges, where
buyers and sellers of securities (or their agents or brokers) meet in one central location to
conduct traders. The New York and American stock exchange for stocks and the Chicago board
of trade for Commodities (wheat, corn, silver, and other raw materials) are examples of
organized exchanges.
Many common stocks are traded over-the-counter, although a majority of the largest
corporations have their shares traded at organized stock exchanges. The U.S government bond
market, with a larger trading volume than the new York stock exchange, by contrast, is set up as
an over the counter market . Forty or so dealers establish a “market “in these securities by
standing ready to buy, and sell U.S government bonds. Others over the counter markets include
those that trade other types of financial instruments such as negotiable certificates of deposit,
federal funds, banker’s acceptances and foreign exchange.
4.2.4. Money and Capital Markets
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Another way of distinguishing between markets is on the basis of the maturity of the securities
traded in each market. Thus, money market is a financial in which only short term debt
instruments (generally those with original maturity of less than one year) are traded. On the other
hand, the money market is designed for the making of short term loans it is the institution
through which individuals and institutions with temporary surpluses of funds meet the needs of
borrowers who have temporary funds shortages (deficits). Thus, the money market enables
economic units to manage their liquidity positions. By convention, a security or loan maturing
with in 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 live of tax collections.
The money market also supplies funds for speculative buying of securities and commodities. In
contrast, the capital market id designed to finance-to-finance long-term investments by Business
governments, and households. Trading of funds in the capital market makes possible the
construction of factories of factories highways, schools, and homes. Financial instruments in the
capital market have original maturities of more than one year and range in size from small loans
to multimillion-dollar credits.
Who are the principal suppliers and demanders of funds in the money market and the capital
market? In the money market, commercial banks are the most important institutional supplier of
funds (lender) to both business firms and governments.
Additionally, the capital market is the market in which longer-term debt (generally those with
original maturity of one year or greater) and equity instrument sane traded.
When compare the money market and capital market money market securities are usually more
widely traded than longer term securities to be more liquid non financial business corporations
with temporary cash surpluses also provide substantial short term funds to the money market. On
the demand for funds side, the largest borrower in the U.S money market is the treasury
department, which borrows billions of dollars weekly.
Other governments around the world are after among the leading borrowers in their own
domestic money markets.
The largest and best-known corporations and securities dealers are also active borrowers in
money markets around the world. Due to the large size and strong financial standing of these
well-known money markets and lenders, money market instruments are considered to be high-
quality,” near money” IOU.

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In contrast, the principal suppliers and demanders of funds in the capital market are more varied
than those in the money market are. Families and individuals, for example, tap the capital market
when they borrow to finance a new home. Governments rely on the capital market for funds to
build schools and highways and provide essential services to the public.
The most important borrowers in the capital market are businesses of all sizes that issue long-
term debt instruments representing claims against their future revenues in order to cover the
purchase of equipment and the construction of new facilities. Ranged against these many
borrowers in the capital market are financial institutions such as insurance Companies, mutual
funds, security dealers and pension funds, which supply the bulk of capital market funds.
4.3.Comparison of money market Securities
Money market securities have the following common characteristics:
 Large denomination with few  Low default risk and lower returns
exception  Short maturities
 Tradable in the secondary market except commercial papers and federal funds though there
is difference in terms of degree of activity.
For instance, T- bills are actively traded in secondary market where as the CDs secondary
market is less active.
Money market Instruments
Money market instruments: only short term( their maturity is less than a year) debt instruments
such as , treasury bills (TB), repurchase agreement (REPO),certificate of deposit (CDs),
commercial papers and banker acceptance and other, if any are traded in money market
A. Money Market: Treasury Bills (T-Bills)
Treasury Bills (T-bills) short term obligations of the government issued to cover government
budget shortfalls (deficits) and to refinance maturity government debt. They are the most
marketable money market security. Their popularity is mainly due to their simplicity.
Essentially, T-bills are a way for the government to raise money from the public.

T-bills are short-term securities that mature in one year or less from their issue date. 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, the 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
Br. 9,800 and held it until maturity, you would earn Br.200 on your investment. This differs from
coupon bonds, which pay interest semi-annually.

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Issuing process- Treasury bills (as well as notes and bonds) are issued through a competitive
bidding process at auctions. Submitted bids can be either competitive bids or non competitive
bids. Competitive bids specify the desired quantity of T-bills and the bid price. The highest
bidder receives the first allocation of T-bills and subsequent bids are filled in decreasing order of
the bid until all T-bills auctioned are distributed. With non-competitive bids, the bidder indicates
the quantity of T-bills he or she wants to buy and agrees to pay the weighted average price of the
winning competitive bids. Non- competitive bidders get preferential allocation that is all these
bids are met before the remaining T-bills are allocated to the competitive bidders.

The biggest reasons that T-Bills are so popular are 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 Br1,000, Br5,000, Br10,000, Br25,000, Br50,000, Br100,000 and Br1 million.
Other positives are that T-bills (and all Treasuries) are considered to be the safest investments in
the world because the 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 they are exceptionally
safe. Other money market securities will often give higher rates of interest. What's more, you
might not get back all of your investment if you cash out before the maturity date.

Dear learner, Have you known that the National Bank of Ethiopia (NBE) has issued treasure
bills of various maturity date? Please, watch TV, or read Newspaper (Addis Zemen) to see how
the NBE issue TB and write what you have observed?
B. Money Market: Certificate Of Deposit (CD)
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) and a specified interest rate. Like all time deposits, the
funds may not be withdrawn on demand like those in a checking account. A CD is bearer
instrument whoever holds the CD when it matures receives the principal and interest. It is
actively traded in the secondary market.
Issuing process: banks issuing CDs post a daily set of rates for the most popular maturities of
their CDs. Then subject to its funding requirement the bank tries to sell as many CDs to investors
who are likely to hold them as investments. In some cases the bank and CD investor directly
negotiate a rate, the maturity and the size of the CD. Once this is done the issuing bank delivers

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the CD to a custodian bank specified by the investor. The custodian bank verifies the CD, debits
the amount to the investor’s account and credits the amount to the issuing bank and the funds
will be transferred to issuing bank. The CDs are usually issued in large denominations.

CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk 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 interest rate
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.
The main advantage of CDs is their relative safety and the ability to know your return ahead of
time. You will generally earn more than in a savings account, and you won't be at the mercy of
the stock market.
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 will not be able to get it out without paying a harsh penalty.
C. Money Market: Commercial Paper
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 working capital requirements such as 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. Cases where corporations have
defaulted on their commercial paper repayment are rare. However there is no active secondary
market for commercial paper since commercial paper are unsecured debt. Thus, commercial
paper is generally held from time of issue until maturity by investors.
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.

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D. Money market: Banker’s Acceptance
A bankers' acceptance (BA) is a short-term credit investment created by a non-financial firm and
guaranteed by a bank to make payment. It is a time draft payable to a seller of goods, with
payment guaranteed by a bank. Money bankers acceptance arise from international trade
transactions and the underlying letters of credit( or time drafts) that are used to finance trade in
goods that have yet to be shipped from foreign exporter(seller) to domestic importer (buyer).
This is especially useful when the creditworthiness of a foreign trade partner (the importer) is
unknown.
The creation of a BA generally begins when a domestic importer after placing a purchase order
from foreign exporter (1) arranges a letter of credit through its bank (2). The bank subsequently
notifies the foreign exporter that upon meeting the delivery requirements the exporter is entitled
to draw a time draft against the letter of credit at importer’s bank(i.e withdraw money) for the
amount of the transaction(3). After the export order is shipped(4) the foreign exporter presents
the time draft and the shipping papers to its own (foreign) bank(5), who forwards these to the
domestic importer’s bank. The bank stamps the time draft as accepted and the draft becomes a
banker’s acceptance (6).
Then the bank returns the stamped time drafts(now a banker’s acceptance) to the foreign
exporter’s bank and payment is made on the maturity date or the bank immediately pays the
foreign bank(implicitly the foreign exporter) the discounted value of the banker’s acceptance(7).
When the banker’s acceptance matures, the domestic importer must pay its bank for the
purchases (8) and the bank sends the domestic importer the shipping papers (9). Bankers’
acceptances are traded at discounts from face value in the secondary market.
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.
E. Repurchase Agreements (Repo)
Repo is short for repurchase agreement. Repo is an agreement involving the sale of securities by
one party to another with a promise to repurchase the securities at specified price and on a
specified date in the future. Repo is essentially a collateralized loan. Those who deal in
government securities use repos as a form of overnight borrowing. A dealer or other holder of
government securities (usually T-bills) sells the securities to a lender and agrees to repurchase
them at an agreed future date at an agreed price. They are usually very short-term, from
overnight to 30 days or more. This short-term maturity and government backing means repos
provide lenders with extremely low risk.
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Repos are popular because they can virtually eliminate credit problems. Unfortunately, a number
of significant losses over the years from fraudulent dealers suggest that lenders in this market
have not always checked their collateralization closely enough.
There are also variations on standard repos:

● Reverse Repo - The reverse repo is the complete opposite of a repo. In this case, a dealer buys
government securities from an investor and then sells them back at a later date for a higher price.
● Term Repo - exactly the same as a repo except the term of the loan is greater than 30 days.
Capital Market
Firms that issue capital market securities and the investors who buy them have very different
motivations than those who operate in the money markets. Firms and individuals use the money
markets primarily to warehouse funds for short periods of time until a more important need or a
more productive use for the funds arises. By contrast, firms and individuals use the capital
markets for long term investments.
Capital market trading occurs in either the primary market or the secondary market. The primary
market is where new issues of stocks and bonds are introduced. Investment funds, corporations,
and individual investors can all purchase securities offered in the primary market. You can think
of a primary market transaction as one where the issuer of the security actually receives the
proceeds of the sale.
The capital markets have well-developed secondary markets. A secondary market is where the
sale of previously issued securities takes place, and it is important because most investors plan to
sell long-term bonds before they reach maturity and eventually to sell their holdings of stock.
There are two types of exchanges in the secondary market for capital securities: organized
exchanges and over-the-counter exchanges. Whereas most money market transactions originate
over the phone, most capital market transactions, measured by volume, occur in organized
exchanges. An organized exchange has a building where securities (including stocks, bonds,
options, and futures) trade. Exchange rules govern trading to ensure the efficient and legal
operation of the exchange, and the exchange’s board constantly reviews these rules to ensure that
they result in competitive trading.
4.4.Participants of Capital Market
The primary issuers of capital market securities are federal and local governments and
corporations. The federal government issues long-term notes and bonds to fund the national debt.
State and municipal governments also issue long-term notes and bonds to finance capital

Financial markets and institutions

projects, such as school and prison construction. Governments never issue stock because they
cannot sell ownership claims. Corporations issue both bonds and stock. One of the most difficult
decisions a firm faces can be whether it should finance its growth with debt or equity. The
distribution of a firm’s capital between debt and equity is its capital structure.

Corporations may enter the capital markets because they do not have sufficient capital to fund
their investment opportunities. Alternatively, firms may choose to enter the capital markets
because they want to preserve their capital to protect against unexpected needs. In either case,
the availability of efficiently functioning capital markets is crucial to the continued health of the
business sector.
The largest purchasers of capital market securities are households. Frequently, individuals and
households deposit funds in financial institutions that use the funds to purchase capital market
instruments such as bonds or stock.
Types of instruments traded in capital market: all long term bonds and all types of stocks are
traded in capital market. Capital market can be debt market for debt securities like bonds, or
equity/stock market.
4.5.Open versus negotiated Markets
Another distinction between market in the global financial system focuses on open market versus
negotiated markets, for example, some corporate bonds are sold in the open market to the highest
bidder and are bought and sold any number of times before they mature and are paid off.In
contrast, in the negotiated market for corporate bonds, securities generally oversold to one or a
few buyers under private contract.
An individual who goes to his or her local banker to secure a loan for new furniture enters the
negotiated market for personal loans. In the market for corporate stocks there are the major stock
exchanges, which represent the open market.
4.6.Spot Market and Futures Market
The spot market is the market in which securities are traded for immediate delivery and payment.
The term “immediate” can mean the same day or a week later depending on the particular
market. The spot market is also called the cash market.
The futures market is the market in which securities are traded for future delivery at a specified
price. The instruments traded in this market are called futures contracts. Futures contracts trade
on organized exchanges such as the Chicago board of Trade, and their contracts are standardized.
If the futures contract is negotiated and sold over the counter, it is referred to as a forward
contract and the market is referred to as a forward market. For example, currencies such as the
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dollar or yen are sold as forward contracts negotiated between two parties. Currencies are also
sold as futures contracts on futures exchanges. Futures contracts in foreign exchange markets are
similar to forward contracts, except that they are standardized and sold on an organized
exchange.
4.7.Derivative Markets
Derivatives are financial contracts whose values are derived from the values of underlying assets.
They are widely used to speculate on future expectations or to reduce a security portfolio’s risk.
Three main types of derivatives markets are:

1. Futures Markets

2. Forward Markets

3. Options
1. A financial futures contract is a standardized agreement to deliver or receive a specified
amount of a specified financial instrument at a specified price and date. The buyer of a
financial futures contract buys the financial instrument, and the seller of a financial futures
contract delivers the instrument for the specified price.

Financial institutions (or other firms) that desire to hedge against rising interest rates can sell
interest rate futures contracts. Financial institutions that desire to hedge against declining interest
rates can purchase these contracts. If interest rates move in the anticipated direction, the
financial institutions will gain from their futures position, which can partially offset any adverse
effects of the interest rate movements on their normal operations.
Speculators who expect stock prices to increase can purchase stock index futures contracts;
speculators who expect stock prices to decrease can sell these contracts. Stock index futures can
be sold by financial institutions that expect a temporary decline in stock prices and wish to hedge
their stock portfolios.
2. Options are classified as calls or puts. A call option grants the owner the right to purchase a
specified financial instrument (such as a stock) for a specified price (called the exercise price
or strike price) within a specified period of time.
A call option is said to be in the money when the market price of the underlying security exceeds
the exercise price, at the money when the market price is equal to the exercise price, and out of
the money when it is below the exercise price.
The second type of option is known as a put option. It grants the owner the right to sell a
specified financial instrument for a specified price within a specified period of time. As with call
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options, owners pay a premium to obtain put options. They can exercise the options at any time
up to the expiration date but are not obligated to do so. A put option is said to be “in the money”
when the market price of the underlying security is below the exercise price, “at the money”
when the market price is equal to the exercise price, and “out of the money” when it exceeds the
exercise price.
Call and put options specify 100 shares for the stocks to which they are assigned. Premiums paid
for call and put options are determined by the participants engaged in trading. The premium for a
particular option changes over time as it becomes more or less desirable to traders.
Participants can close out their option positions by making an offsetting transaction. For
example, purchasers of an option can offset their positions at any time by selling an identical
option. The gain or loss is determined by the premium paid when purchasing the option versus
the premium received when selling an identical option. Sellers of options can close out their
positions at any time by purchasing an identical option. The stock options just described are
known as American-style stock options. They can be exercised at any time until the expiration
date. In contrast, European-style stock options can be exercised only just before expiration.
In addition to options on stocks there are options on stock indexes, which allow investors the
right to buy (with a call option) or sell (with a put option) a specifiedstock index for a specified
price up to a specified expiration date. There are also options on interest rate futures contracts,
which allow investors the right to buy or sell a specified interest rate futures contract for a
specified price up to a specified expiration date.
3. Comparison of Options and Futures
There are two major differences between purchasing an option and purchasing a futures contract.
First, to obtain an option, a premium must be paid in addition to the price of the financial
instrument. Second, the owner of an option can choose to let the option expire on the expiration
date without exercising it. Call options grant a right, but not an obligation, to purchase a
specified financial instrument. In contrast, buyers of futures contracts are obligated to purchase
the financial instrument at a specified date. If the owner does exercise the call option, the seller
(sometimes called the writer) of the option is obligated to provide the specified financial
instrument at the price specified by the option contract if the owner exercises the option. Sellers
of call options receive an upfront fee (the premium) from the purchaser as compensation.
4. Forward contracts are agreements by two parties to engage in a financial transactionat a
future (forward) point in time. Here we focus on forward contracts that are linked to debt
instruments, called interest-rate forward contracts.
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The advantage of forward contracts is that they can be as flexible as the parties involved want
them to be. This means that an institution like the First National Bank may be able to hedge
completely the interest-rate risk for the exact security it is holding in its portfolio, just as it has in
our example. However, forward contracts suffer from two problems that severely limit their
usefulness. The first is that it may be very hard for an institution like the First National Bank to
find another party (called a counterparty) to make the contract with. There are brokers to
facilitate the matching up of parties like the First National Bank with the Rock Solid Insurance
Company, but there may be few institutions that want to engage in a forward contract
specifically for the 6s of 2029. This means that it may prove impossible to find a counterparty
when a financial institution like the First National Bank wants to make a specific type of forward
contract. Furthermore, even if the First National Bank finds counterparty, it may not get as high a
price as it wants because there may not be anyone else to make the deal with. A serious problem
for the market in interest-rate forward contracts, then, is that it may be difficult to make the
financial transaction or that it will have to be made at a disadvantageous price; in the parlance of
the financial world, this market suffers from lack of liquidity.

4.8. Foreign exchange (FOREX) Market and the Interbank Market

The interbank market is the financial system and trading of currencies among banks and financial
institutions, excluding retail investors and smaller trading parties. While some interbank trading
is performed by banks on behalf of large customers, most interbank trading takes place from the
banks' own accounts.
The FOREX market is where currencies are traded. The FOREX market is the largest, most
liquid market in the world and includes all of the currencies in the world. The FOREX is the
largest market in the world in terms of the total cash value traded, and any person, firm or
country may participate in this market.
There is no central marketplace for currency exchange; trade is conducted over the counter. The
FOREX market are worldwide among the major financial centers of London, New York, Tokyo,
Zürich, Frankfurt, Hong Kong, Singapore, Paris and Sydney.

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