Intermediari finanziari - Financial markets and Institutions

Financial markets and institutions

Financial markets

Financial markets are those of bonds and shares. The main goal of a financial market is to transfer funds from a surplus to a deficit unit. For example, I want to build a robot that cleans my house, but I need money to invest in my idea. A friend of mine is interested in my creation and wants to take part in it. So he gives me some money so that I can make my robot and get rich because many people will buy it, and my friend will have high returns on investments. So financial markets make this relationship between the units easier and thus promote economic efficiency.

In other words, a surplus unit, say a household, will have some savings, or money that was not spent, the difference between the income and the consumption, and will give it to a deficit unit, or the part who has a shortage of money. The surplus unit is also known as the lender saver, whilst the deficit one is known as the borrower spender. Generally, lender savers are households, while borrower spenders are corporations, the government, and the rest of the world, but sometimes these roles may interchange. Every time there is this transfer from surplus to deficit, we have a financial instrument that has:

• A technical function, agreement between the parts
• A legal title, equity or debt
• An interest rate
• An amount
• A currency
• A maturity

In a direct finance scheme, funds pass directly from those two units: borrowers borrow funds by selling securities. Securities are financial instruments that are claims on the issuer’s future assets or income. Examples of securities are bonds and shares. When financial intermediaries intervene in the transaction, we talk about indirect finance.

Ways to obtain funds

A firm, as a deficit unit, can obtain funds in two ways:

• By selling bonds
• By selling shares

In the first case, we talk about a debt. You lend money to a firm; it has to give you the money back at a certain time, the maturity date, together with some interests, which are the costs of borrowing money. The maturity is reached when the firm must expire its debt. A debt is considered short-term if the maturity is reached in less than a year, long-term if its maturity is 10 years or more.

In the second case, you buy equities. This means you are one of the shareholders of the firm, and you have the right to get your part of dividends. You won’t have any interest, and the debt is considered long-term because you don’t have any maturity. Being a shareholder involves some disadvantages. For example, you are a residual claimer. This means you are the last to be paid back with your dividends; the first ones are always your creditors. As an advantage, they profit from any increase in the capital of the firm, whilst the creditors don’t.

Market divisions

The market where these securities are sold is divided into two:

• The primary market, where new securities are sold, normally it takes place at closed doors
• The secondary market, where securities are resold

An investment bank is the financial institution that assists in the sale of securities in the primary market. The bank is said to underwrite the securities that is to guarantee their price, sell them to the public, and buy the unsold. The secondary market is managed by brokers and dealers. Brokers look for the counterpart, dealers are the counterpart.

Functions of the secondary market

The secondary market serves two important functions:

• They make the financial instruments more liquid and thus make it easier to sell in the primary market
• They determine the price of the security that will be sold in the primary market because they can’t be sold at a price higher than the one in the secondary market

The secondary market is organized in two methods:

• Official market, the stock exchange, regulated
• Over the counter, OTC… internet etc., not formally regulated

Market maturity divisions

Another internal division according to maturity between markets is:

• Money market
• Capital market

The first one is where short-term securities are sold. It’s more liquid and suffers from small fluctuations. It’s the most common one. A form of money market is the banker’s acceptance, which is the order by a bank to the one who buys to pay the bearer on a certain date, a sort of IOU. Banker acceptances can be bought and sold until they mature. They are sold on a discounted basis like commercial paper and T-bills. Dealers in this market match up firms that want to discount a banker’s acceptance (sell it for immediate payment) with companies wishing to invest in banker’s acceptances. Interest rates on banker’s acceptances are low because the risk of default is very low.

The second one is where long-term securities are sold.

Investors and their choices

The market is made of investors as well. Who are the investors, and according to what do they choose? A strong assumption says they choose completely rationally. The behavioural finance assumption theory says they have an irrational component. All the investors share three common features:

• Risk
• Return
• Liquidity

Risk is the probability that your real returns will match the expectations. Ex. BOT, buoni ordinari del Tesoro, are Italian treasury bills that are risk-free but they are not very liquid. Return is what you get back from your investment. Liquidity is the period of time needed to transform your investment into cash. Risk is directly proportional to return but inversely proportional to liquidity. Investors may share other two secondary features that are:

• Ethics
• Secrecy

Indirect finance

There’s another way to sell securities to investors, known as indirect finance. As we said before, it uses intermediaries. Why?

• Because of transaction costs
• Because of risk sharing
• Because of information asymmetry

All these features are known as market imperfections. Intermediaries can reduce the costs because they are experts in their sector and because of economies of scale. The process of risk sharing is related to asset transformation: risky assets are turned into safer assets for investors. Moreover, intermediaries suggest diversification of assets to reduce the risk.

The two parts do not own the same information about the transaction. Akerlof talked about this topic in his document: A market for lemons. Lemons are used cars. In this market, there’s not a correct information on the price of the cars according to their value. Let’s say that used cars that are still in good condition have a price of 2000 and the ones who are the worst have a price of 1000. Since there’s information asymmetry, people don’t really know which car is good and which car is bad, so they are ready to spend the arithmetic medium between the two prices that are 2000 plus 1000 divided by 2, 1500. This price will be too much for the ones who wanted to spend 1000 only and too little for the ones who wanted to spend 2000, they will think the car is of worse quality than the one they wanted to buy. So the market will collapse because both categories of cars will disappear from the market.

This information asymmetry causes two problems:

• Adverse selection
• Moral hazard

Adverse selection is ex-ante because it happens before the transaction takes place. Moral hazard is ex-post, that is after the transaction.