Financial Markets And The Role of The Primary And Secondary Markets

Financial Markets And The Role of The Primary And Secondary Markets

Financial Markets and the role of the primary and secondary marketsDefinition of Financial Market

A financial market may be defined simply as a market for the exchange of capital and credit in the economy. Money markets concentrate on short-term debt instruments; capital markets trade in long-term debt and equity instruments. The purpose of these markets is to channel savings and surplus liquidity into long-term productive investments.

In economics, a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), 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.

The financial markets can be divided into different subtypes:

• Capital markets which consist of:

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

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

• Commodity markets, which facilitate the trading of commodities.

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

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

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

• Insurance markets, which facilitate the redistribution of various risks.

• Foreign exchange markets, which facilitate the trading of foreign exchange.

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 loans and mortgages.

Financial Market instrument are defined as long-term financial instruments generally with maturity exceeding one year.

Capital Markets

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities. A capital market is a market where both government and companies raise long term funds to trade securities on the bond and the stock market. It consists of both the primary market where new issues are distributed among investors, and the secondary markets where already existent securities are traded.

In the capital market, mortgages, bonds, equities and other such investment funds are traded. The capital market also facilitates the procedure whereby investors with excess funds can channel them to investors in deficit.

Financial Instruments

The capital market provides both overnight and long term funds and uses financial instruments with long maturity periods. The following financial instruments are traded in this market:

• Equity instruments

• Credit market instruments

• Derivative instruments

• Foreign exchange instruments

• Hybrid instruments

• Insurance instruments

In today's financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity, for example.

Negotiability of Financial Instruments

As the financial markets function with the help of financial instruments through which financial resources are mobilized and invested, these instruments require to be negotiable. The negotiability means that these instruments can be bought and sold and ownership of instruments transferred from one person to another through the act of buying and selling between a party who wishes to invest surplus funds and the holder who is willing to dispose of a particular instrument. The examples of negotiable instruments are cheques, certificates of deposits, promissory notes, banker acceptances, bonds, etc.

Role of the Primary Market

In the primary market, securities are issued on an exchange basis. The underwriters, that is, the investment banks, play an important role in this market: they set the initial price range for a particular share and then supervise the selling of that share. Investors can obtain news of upcoming shares only on the primary market. The issuing firm collects money, which is then used to finance its operations or expand business, by selling its shares. Before selling a security on the primary market, the firm must fulfill all the requirements regarding the exchange. After trading in the primary market the security will then enter the secondary market, where numerous trades happen every day. The primary market accelerates the process of capital formation in a country's economy.

The primary market categorically excludes several other new long-term finance sources, such as loans from financial institutions. Many companies have entered the primary market to earn profit by converting its capital, which is basically a private capital, into a public one, releasing securities to the public. This phenomena is known as "public issue" or "going public."

There are three methods though which securities can be issued on the primary market: rights issue, Initial Public Offer (IPO), and preferential issue. A company's new offering is placed on the primary market through an initial public offer.

The Role of the Secondary Market

The secondary market is a market for used goods where one investor can buy a security from other investors instead of the issuer. All the securities are first created in the primary market and then, they enter into the secondary market.

Banking thrives on the existence of secondary financial markets. The commercial banks invest in very short-term financial assets, which they can convert into cash very quickly at negligible conversion cost. There are several ingredients of a secondary financial market: financial papers, dealers, and financial institutions.

Various kinds of financial assets such as securities, bonds, shares, debentures, commercial papers are the financial instruments. Merchant banks, investment banks, mutual funds, investment funds etc. are the financial institutions. Then, there are a large number of buyers and sellers who deal in these financial papers.

The establishment of an efficient secondary market will be crucial to the smooth functioning of PLS investment. There are two main reasons for this.

1. It is difficult to value the underlying assets and their earning potential, particularly for small periods or during the gestation period. No such problem arises in the case of debt contract, since the earnings and time schedule are agreed at the beginning of the project.

2. Long-term PLS financing outside the Stock Market may also be illiquid, which discourages investors. This is not peculiar to PLS, but, together with item I above, it can cause further difficulties.

The secondary market can provide the valuation method and, by making trading possible, solves the liquidity problem. Contracts made by financial intermediaries can be listed on the Stock Market and traded just like primary securities and their value will be available at all times.

Thus the existence of the secondary market solves both the problems mentioned above. The elimination of a known cost of capital is replaced by a mechanism which continuously updates the value of capital and gives adequate opportunities for risk transfer through the trading of ownership.