Chapter 1: Introduction to Financial Markets and Institutions

Introduction

Being one of the subject areas of finance, “financial markets and institutions” covers the ways and processes of how funds are transferred at individual level, at corporate level, and at macroeconomic level in an economy. Financial environment, financial system, financial markets, market participants, and regulatory system are considered to be the key elements of these ways and processes.

The purpose of this chapter is to provide basic information about the financial environment and its key parties. In this way, our aim is to help you establish the link between the information about financial markets and institutions and the decisions of financial managers about business finance.

An Overview of the Financial System

Financial system is an open system in an economy, which enables the main actors of the economy, namely households, firms, and the government to have acceptable returns for their savings, and at the same time to borrow funds at an acceptable cost when needed. The input of the financial system is the inclusion of excess funds to the process of matching the quantity, maturity, and cost/return of borrowings/savings. The output of a financial system is the realization of transfer of funds from those who have excess funds to those who have shortage of funds. The most crucial role of a financial system in an economy is making agricultural, manufacturing, services, and trade activities easier, and sometimes-even possible. People, organizations, and regulations, as the components of the financial system together determine the way financial managers act and decide.

In business finance, there are three groups of decisions to make for financial managers. First group involves investing decisions. Second group covers financing decisions. Third group consists of dividend decisions.

Components of the Financial System

In very broad terms, the financial system is a system of transferring funds from those who have excess funds to those who need to obtain extra funds in an economy. At the same time, it is convenient to remember that financial decisions include both the present and the future. It consists of decisions about taking some actions/positions today, and getting the results at some future date. Those who have excess funds lend their savings today, with the expectation to earn some return in the future for compensating their inconvenience resulting from absence of their money. They are the first component of the financial system, and they are called “ultimate lenders”.

On the other hand, those who need to obtain extra funds to borrow today, with an acceptance of bearing some cost in the future for utilizing funds when they need. They are the second component of the financial system, and they are called “ultimate borrowers”.

There is one more thing that we should keep in mind. Ultimate borrowers or ultimate lenders do not always have to be domestic in countries. It is very common that foreign households, firms, and governments funnel their savings to the domestic markets, while at the same time, domestic households, firms, and governments funnel their savings to a foreign country. Internationalization of financial markets is actualized in two forms:

1. Foreign direct investments
2. Portfolio investments

The third component of the financial system is financial instruments. It is not surprising that cash is sufficient to make all the fund transfers in an economy. There is a need for other “means” of exchange. Financial instruments are securities, providing holders some kind of financial rights or financial claims against issuers in terms of (1) receiving part of their cash flows (e.g. bonds), (2) being their shareholder (e.g. stocks).

The fourth component of the financial system is financial intermediaries. Financial intermediaries are organizations that enable lenders and borrowers to find and trust each other in the financial system. There are two types of financing, regarding the existence of these organizations: direct and indirect financing.

The last component of the financial system is legal and administrative rules and regulations together with regulatory institutions. It would be nearly impossible for a financial system to work smoothly if there were no rules. Because the number of participants in a financial system trying to maximize their financial benefits is huge, things would get complicated very quickly and the system would become collapsed. The participants of financial systems make transactions only if they trust the system that their money and information are safe when they are borrowing or lending funds. These organizations involve regulating the financial system by written laws, standing rules, codes, and guidelines.

The key for the financial system to function efficiently with all its components is the interest rate. Interest rate is a number, expressed in percentages. It reflects the cost of borrowing for borrowers, whereas it reflects the reward of lending for lenders. In other words, it represents the price of raising capital.

Loanable funds theory explains the movements in the general level of market interest rate in a particular country. Loanable funds here, refers to all kinds of borrowings of households, firms, and the government. Usually, firms and governments are net demanders of loanable funds, whereas households are net suppliers.

Financial Markets

Markets are places where buyers and sellers of goods and services come together to make transactions. A market can be in any contextual form: physical, virtual, or hybrid.

Financial markets are places where financial goods and services (mainly financial instruments) are traded.

We can define different kinds of financial markets according to different criteria. The most common classifications are as follows:

1. Based on maturity of financial instruments that are traded,
2. Based on the structure of financial instruments that are traded,
3. Based on whether financial instruments are bought and sold before,
4. Based on the organization status,
5. Based on the timing of payment and shipment.

Informational Efficiency in Financial Markets

Informational efficiency is the degree of speed and cost of important information to reach market participants in the financial markets.

Financial markets are considered efficient when no one participant alone has the power to change the price of a financial instrument. It is theoretically not possible in full terms, but partial efficiency may be possible in some markets.

However, in real cases, most financial markets are at a point between being semi-efficient and inefficient, if we think of efficiency level as a scale from the most inefficient to the most efficient. In those levels of efficiency, it is possible to find an underpriced financial instrument and buy it, hold it until its price increases, and sell it in order to have capital gain which is above the market average.

Capital gain or loss stems from the difference between the buying and selling prices of financial assets. When the market prices appreciate, investors have capital gain as they liquidate their investment. When the market prices appreciate, investors have capital loss as they liquidate their investment.

Risk and Return in Financial Markets

All participants in financial markets need to consider risk and return. “The concept of risk refers in general to the magnitude and likelihood of unanticipated changes that have an impact on a firm’s cash flows, value or profitability. Uncertainty is a somewhat broader concept, closely related to risk and often used synonymously.” (Oxelheim and Wihlborg, 2008).

Academic research studies have classified individuals according to their attitudes towards risk in three categories: Those who like to take risk (people with a risk-seeking attitude), those who dislike taking risk (people with a risk-averse attitude), and those who neither like nor dislike taking risk (people with a risk-neutral attitude).

Researchers have a consensus that most people have a risk-averse attitude towards risk. They dislike assuming risk unless they expect to have a greater benefit in return.

In this regard, we can say that risk-averse investors are those who purchase assets with high risk only if they expect a premium return. Perceived risk and expected return tend to be related: the greater the perceived risk, the greater the return required by decision-makers (Pike and Neale, 1996).

Interest Rates

Interest rate is an analytical tool that is used in borrowing and lending funds in financial markets. Interest rate is closely related with the time value of money. By using interest rate, lenders compensate for risks and opportunity costs, resulting from trade off reinvesting opportunities.

Using interest rate, we can find the value of money at any particular past or future date in time. The future worth of a particular quantity of money received today is called “future value of money”.

Theory of Portfolio Choice

In order to understand the behavior of interest rates in the economy, we should know how demand and supply in the bond market and in the market for money works. For any decision-making about buying/holding a financial asset or selecting a financial asset over asset groups; investors take these 4 factors into account: (1) wealth, (2) expected return, (3) risk, and (4) liquidity (Mishkin, 2016: 132). The theory of portfolio choice provides insights about factors influential on the demand for an asset to be bought/to be held in the portfolios.

Financial Instruments

In the financial system, ultimate lenders lend their money to ultimate borrowers for a period of time in order to gain some return from their investment. On the operational side, borrowers issue financial instruments to sell to lenders in order to obtain financing. Lenders on the other hand, compare financial instruments that are in the market and try to find the best ones in terms of risk/return profile and in terms of market price in order to include these securities to their portfolio and hold them. Their aim is to gain some return.

Main Characteristics of Financial Instruments

Lenders (investors) in the financial system compare securities according to some characteristics that affect risk, return, and therefore the market price of securities.

• Estimability of risk
• Maturity
• Liquidity
• Splitability

Debt Instruments and Equity Instruments

The fundamental classification of financial instruments is based on the type of claims on future cash flows of the issuer of the security. There are two main groups: debt instruments and equity instruments.

Debt instruments represent a claim on future cash flows of the issuer of the security in the form of interest return. Equity instruments represent a claim on future cash flows of the issuer of the security in the form of dividends. If we want to compare private debt instruments with equity instruments, we should primarily look at their risk and maturity.

Financial Intermediaries

Financial intermediaries are organizations that collect savings and channel them to parties in need in financial markets. These intermediary organizations provide ease and efficiency in transferring funds between two parties.

We may broadly classify financial intermediaries in two groups as (1) depository financial institutions, and (2) non-depository financial institutions.

Main depository institutions are deposit banks. In Turkey, the dominant financial institution in the financial system is banks. Main non-depository institutions are portfolio management companies, insurance companies, unemployment insurance funds, and pension investment funds.