FINANCIAL Chapter 3

MARKETS
NATURE OF FINANCIAL
MARKETS
Financial markets can be defined as the place where deficit
units and surplus units meet.
The primary function of the financial market is to move
funds from surplus to deficit
 In this market, funds are transferred from the surplus units
to the deficit units.
 A surplus unit is where the units generate more income than
they spend, and have funds left over.
 Other units generate less income than they spend and need
to acquire additional funds in order to sustain their
operations. These are called deficit units.
NATURE OF FINANCIAL
MARKETS
Banks act as financial intermediaries: accept deposits
then lend out to customers.
Banks bridge the gap between borrowers and savers.
Financial markets provide the avenue for the buying and
selling of the instruments in the secondary market,
therefore it facilitate the effective use of funds.
Parties to financial markets :
Borrowers – need money to finance investment or make
purchases.
Savers (Investors) – Those with extra money to invest – have
excess cash .
Financial Institutions (Intermediaries) – help bring together
borrowers and savers.
 CAPITAL ALLOCATION
PROCESS
1. Direct transfer
Securities (Stocks or Bonds)
Business Savers
Cash

2. Indirect transfer through investment bankers

Business’ Business’
Securities Securities
Investment
Business Savers
Banks
Cash Cash

3. Indirect transfers through a financial intermediary

Business’ Intermediary’s
Securities Securities
Business Financial
Savers
Cash Intermediary Cash
1. DIRECT TRANSFER

A business sells its stocks or bonds directly to

savers without going through any type of
financial institutions
2. INDIRECT TRANSFER
THROUGH INVESTMENT
BANKERS

Investment banker is a financial specialist who underwrites and

distributes new securities and advises corporate clients about raising
external financial capital.
In this process, the securities being issued just passed through the
investment banking houses.
The securities are not transformed into a different type of securities.
 3. INDIRECT TRANSFERS
THROUGH A FINANCIAL
INTERMEDIARY

The financial intermediary collects the savings of individuals

and issues its own securities in exchange for these savings.
Then the intermediary uses the funds collected from the
individual savers to offer new products packaged as their own.
For example, saver deposits money in a bank, receiving
certificate of deposit; then the bank lends the money to a
business in a form of mortgage loan.
STRUCTURE OF
FINANCIAL MARKET
i) Maturity: Money Markets and Capital Markets

ii) Time of Issuing: Primary Markets and Secondary Markets

iii) Financial Claim: Debt Markets and Equity Markets

iv) Delivery Time: Spot Markets and Future Markets

v) Physical Location: Stock Exchange and Over-the-counter

Markets
 i) Maturity: Money Markets
and Capital Markets
• Money Markets
markets for short-term, highly liquid debt securities, which
generally have maturities of one year or less.
Many of these securities trade in large denominations
therefore the market is largely dominated by the major banks
and financial institutions.

• Capital Markets
markets for long-term debt and corporate stocks with
maturities of generally more than one year. Example:
bond and share market.
The backbone of the capital market is formed by the security
exchange that provides a forum for debt and equity
transactions.
 ii) Time of Issuing: Primary Markets
and Secondary Markets
• Primary Markets
The segment of the financial markets on which securities
are offered for sale for the first time (i.e. new securities
are issued) in a listed market.
It is a market where investor purchases new securities is
participating in a primary market. E.g., initial public offer
(IPO). Net proceeds from sales of new securities go to
issuing company.

• Secondary Markets
It is a market that deals in existing securities, thus
enabling investors dispose off their holdings whenever
they wish.
For an individual to buy shares, he/she needs only to call
his broker or trade online through the exchange. E.g.,
 PRIMARY VS SECONDARY
MARKETSPrimary Markets Unsold portion
of shares

Issue 1,000,000 new Sell 1,000,000 new

shares shares
Institutional/
Company ABC Investment bank Retail Investors

Underwriting (i.e. Cash for the new shares

guarantee needed for bought
capital to be raised)

Cash for the 1,000,000

new shares

Investment bank Exchange Institutional

Investors

Retail Investors

Secondary Markets 12
 iii) Financial Claim: Debt
Markets and Equity
Markets

• Debt Market
The holders are lenders and will receive a fixed
amount of money (interest) e.g. bond
Debtholders have priority on any financial claims.

• Equity Market (Share market)

• Shareholders are the owners of the company.
• The shareholders have financial claims or will be
paid after the debtholders receive their payments.
 iv) Delivery Time: Spot
Markets and Future
Markets
• Spot Markets
• Financial assets are for ‘on the spot’ delivery.
• Goods are sold for money and delivered immediately or
within a short span of time.

• Future Markets
Financial assets are for future delivery, e.g. trading in
Derivatives Market. Example:
a. Futures Trading - Trade now settlement 3 months from now
b. Option trading - gives you the right to buy or sell in the
Decide
future
• Price
Transaction Decide Transaction
• Delivery • Price • Delivery
• Payment • Delivery date • Payment

Today Future Today Future

 v) Physical Location: Stock
Exchange and Over-the-counter
Markets

Stock exchange
A market in which trading is via exchanges.
A stock exchange has the benefit of facilitating liquidity,
providing transparency, and maintaining the current
market price.

Over-the-counter markets
Trading is done directly between two parties, without the
supervision of an exchange.
It includes all facilities that are needed to conduct
security transactions not conducted on the organised
exchanges.
 PURPOSES OF FINANCIAL
MARKETS
1. Facilitation of savings
 Allow individuals to consume less today (increase savings) to be
able to be in position to consume more in the future
2. Provision of a platform and channel
 To raise financing by the users (firms) of finance
 Demand for and supply of funds can interact and arrive at a
suitable market price for funds
3. Provision of financial services
 Allow participants to work out and balance their risk tolerance and
expected returns
 E.g. investors with higher tolerance of risk can invest in shares
while investors with lower risk tolerance can invest in bonds
16
FINANCIAL
INTERMEDIARIES
Financial intermediary is an institution that accepts
money from savers and uses those funds to make loans
and other financial investments in their own name.
Financial intermediaries exist to smooth the flow of
funds from surplus sectors of the economy to deficit
sectors.
 Commercial
banks

Mutual
Investment funds/Unit
banks Examples of trust
Financial companies

Intermediarie
s

Life/General
Pension
insurance
funds
companies
Commercial Mutual funds /
banks Unit trust
Also known as retail banks.
companies
They are corporations that
Traditional ‘department accept money from savers
stores of finance’ that and then invest these funds
serves variety of savers to buy stocks, bonds, etc.
and borrowers.

These organizations pool

Central banks expand or funds and thus reduce risks
contract the money supply by diversification.
through commercial banks
Individuals invest their
money in unit trusts and
Receives money on current then the unit trust
or deposit accounts, pays company uses the
and collects cheques drawn investors’ money to
by or paid in by customers, purchase stocks, bonds or
and making advances to other investment vehicles
customers. on behalf of the investors.
Life / General
Insurance Pension funds
Companies
Retirement plans funded by
They take savings in the form of corporations or government
premiums; invest these funds in agencies for their workers.
stocks, bonds, real estate, and
mortgages; and finally make
payment to the beneficiaries of E.g. KWSP / EPF
the insured parties.

Life Insurance – Payment paid

upon death, maturity or surrender
of policy.

General Insurance – Payment

against a peril e.g. accident, fire
etc.
 Investment banks
Investment banks provide a range of specialised
services for customers, mainly in the industrial and
commercial sector.

Traditionally help companies raise capital by

seeking listing via Initial Public Offering exercises.
(Mr DIY)

Help design securities with features that are

currently attractive to investors, buy these securities
from the corporation and resell them to savers

Since the investment bank generally guarantees that

the firm will raise the needed capital, the
investment bankers are also called underwriters
 BENEFITS OF FINANCIAL
INTERMEDIARIES
i) Channeling of Funds
The main role of financial intermediation is providing ways of
linking lenders of money with potential borrowers.
A lender does not need to find an individual borrower, but can
deposit his money with a bank, investment trust or other financial
intermediary.
Reduce the inefficiencies that would exist if users of funds could get
loans only by borrowing directly from savers.
A financial intermediary such as commercial banks, investment
funds, etc gather financial resources from sources of cash such as
savers and investors and distributes them to productive units in need
of debt or equity financing.
 BENEFITS OF FINANCIAL
INTERMEDIARIES
ii) Aggregate of Savings
This role in linking lenders and borrowers means that the
intermediary is able to “package” the amounts lent by savers
into the amounts which borrowers require.
E.g. banks gather small amounts of savings from a large
number of individuals and repackaging them into larger
bundles for lending to business.
 BENEFITS OF FINANCIAL
INTERMEDIARIES
iii) Pooling of Risk/Diversification
For an individual lender, if a borrower defaults on the loan,
then that individual lender suffers all the losses.
If, however, a financial intermediary makes the loan, then the
risk is spread over all the depositors with the financial
intermediary.
The financial intermediary does not in itself reduce the risk of
a loan going into default but that risk is spread over all the
depositors with the intermediary.
 BENEFITS OF FINANCIAL
INTERMEDIARIES
iv) Maturity Transformation of Funds
The financial intermediary provides “maturity transformation”,
bridging the gap between the desire of many lenders for liquidity
and the need of most borrowers for loans over longer periods.
Borrowers typically want to borrow for a longer period of time
than lenders wish to lend.
A major feature of financial intermediaries is that they are able
to accommodate these different requirements.
Savers and borrowers have greater choices, or financial
flexibility with respect to denominations, maturities, and other
characteristics
 BENEFITS OF FINANCIAL
INTERMEDIARIES
v) Reduction in transaction cost
Given the size of the majority of financial institutions, they
are able to benefit from economies of scale in a number of
areas.
These will include:
 Economies in the administration associated with taking in
deposits and making loans, due to these transactions becoming
routine.
 Economies in the employment of specialist personnel, since the
volume of business will allow such people to be fully
employed.
 Economies in the acquisition and interpretation of financial
information.
 BENEFITS OF FINANCIAL
INTERMEDIARIES
vi) Advisory
Financial intermediaries can advice their customers on
financial matters (e.g. on the best way to invest their funds and
on alternative ways of obtaining finance.)
This helps to encourage the flow of savings and the efficient
use of them
 THE CENTRAL BANK
Bank Negara Malaysia (BNM)
i) It is responsible to issue currency.

• BNM shall arrange for the printing of currency notes and the minting of coins;
issue, re-issue and exchange notes and coins at its office and at such agencies
as it may, from time to time, establish or appoint; arrange for the safe custody
of unissued stocks of currency and for the preparation, safe custody the money.
 
ii) It maintains reserves to safeguard the value of currency.

• The currency’s official external reserves are held and maintained by BNM.
• Such holdings are generally held in the form of gold, reserves position in
various investments.
• It also intervenes in the foreign exchange markets to stabilise the value of the
Ringgit with reserves.
iii) It acts as a banker and financial adviser to the government.

• As fiscal agent and financial adviser, it manages the national debt and the
raising of government loans, both locally and internationally, though well
managed loan program.
iv) It acts on behalf of government in dealing with borrowing.

• It represents the government to borrow money from external sources e.g in

the issue of Malaysian Government Securities (MGS).
v) It supervises the banking system and promotes monetary stability.

• BNM has to shoulder the responsibility of promoting monetary stability and a

sound financial structure.
vi) It acts as an agent for the government in carrying out its monetary
policies.

• BNM uses various monetary policy tools to adapt to the current economic
environment