Lesson Corporate Finance: Financial Markets Basics

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What are <A HREF="markets.wikipedia">markets</A>? What do they do? Why do they exist?

Markets move money. People want to move money across time and scenarios to manage their <A HREF="cash_flow.wikipedia">cash flows</A>. And <A HREF="financial_contracts.lesson">financial contracts</A> are the means for moving money. A financial market is the place where people come together and execute (or in financial jargon �trade�) these contracts. A market could be a physical place (e.g. a floor trading pit in an exchange) or an electronic bulletin board or even a telephone network. For example most <A HREF="foreign_exchange.wikipedia">foreign currency</A> trades among big banks happen over telephones.

Why do people want to move money across time and scenarios? It is very helpful to think in terms of cash flows. Everyone in an economy owns a cash flow stream. We all do. Your stream is perhaps a net outflow of cash (if you agree to the accounting convention that your parents� money is yours as well!) until you graduate. You expect some net inflow in salaries and bonuses after graduating and then again at some point it will become net outflow again.

How do you manage this stream � negative in the beginning, positive in the intermediate time and negative towards the end � so that the positive reasonably covers the negatives that have different characteristics? By different characteristics I meant the fact that the negatives are more certain than the inflows and they occur at different points in time. You may find inflation, high interest rates, economic activity, oil prices and currency depreciation affecting your inflows, while outflows remain more or less certain. How can you manage?

There are firms with much more complicated cash flow streams. Their negatives and positives are far more uncertain and dynamic. Their cash requirement and generation would depend on the business they operate in, the economic conditions, etc.

Very few entities are happy with their �natural� cash flows and justifiably so. All these entities
usually resort to <A HREF="financial_markets.wikipedia">financial markets</A> and enter into different financial contracts (i.e. buy or sell financial assets or securities) to �manage� or re-engineer their cash flows to suit their likings. They either enter into financial contracts with such cash flow streams that the owning those results in a �net� stream that suits their liking. All of them need to find parties, who would be willing to enter into these contracts.

Why would a bank enter into a <A HREF="loan.wikipedia">loan agreement</A> with you? Because they have their own cash flow problems to manage. They need to pay interests on deposits they hold. They need to pay their operating expenses. So they need to do something with all the money that they have now so that they can generate some more money in future to cover all these expenses and hope to make some profits in the bargain.

The markets are important in the sense that they reduce search costs. Markets are classified in a number of ways. One obvious way to classify them is based on the type of financial contracts they trade. So stocks are traded in stock (or <A HREF="stock.wikipedia">equity</A>) markets, bonds in <A HREF="bond_markets.wikipedia">bond markets</A> (or debt or gilt
or sovereign markets), <A HREF="derivatives.wikipedia">derivatives </A>in derivatives markets (or options markets) and so on. In fact now the derivative markets are so huge that we have markets within them based on product categories (for instance, <A HREF="swap_(finance).wikipedia">swap</A> markets, <A HREF="eurodollar.wikipedia">Eurodollar</A> futures markets and etc).

Another way to classify is based on whether they trade standard contracts or customized contracts. <A HREF="Stock_Exchange.lesson">Stock exchanges</A> trade standard contracts. There are markets called <A HREF="Over_the_counter_market.wikipedia">Over-The-Counter</A> (OTC) markets, which are made up of a network of financial institutions like <A HREF="investment_banks.wikipedia">investment banks </A>and <A HREF="commercial_banks.wikipedia">commercial banks</A>, where one can trade �customized� contracts. There are advantages and disadvantages of both. If you have standard contracts, documentation and legal costs are eliminated. Moreover, everyone understands these contracts. The time and cost of transaction are minimal. However, the flip side is that you may not find a contract that exactly suits your needs. You may have to enter into multiple contracts to approximate your need. OTC markets complement these. In OTC you can buy or sell a customized contract. However, transacting can be costly and involved.