Financial Institutions and Markets
April 27, 2010
SOURCES OF FUNDS FOR BUSINESS ORGANISATIONS
Most firms have ongoing needs to raise cash to fund investments. They can obtain funds from external sources or from internal sources. On the other hand, some firms and individuals have surplus funds that they may need to invest. People and organizations wanting to borrow money are brought together with those having surplus funds in the financial markets.
Financial markets are institutions and procedures that facilitate transactions in all types of financial claims. They are forums where suppliers of funds and those who require the funds can transact business directly. There are many different financial markets dealing with different types of instruments and serving different types of customers. Financial institutions are intermediaries that channel the savings of individuals, businesses and governments into loans or investments. They are required by law to operate within established regulatory guidelines. Major financial institutions include:
- Commercial banks - savings and loan institutions
- Insurance companies - pension funds
- Credit unions - mutual funds
These institutions attract funds from individuals, businesses and governments, combine them and make loans to individuals and businesses. Financial institutions actively participate in the financial markets as both suppliers and demanders of funds.
Financial markets act as the vehicle through which the forces of demand and supply for a specific type of financial claim are brought together. The two key financial markets are the money markets and the capital markets.
Money markets are those that deal with short-term debt instruments or marketable securities with maturities of one year or less e.g. Treasury bills, commercial paper etc. Money market is represented by current assets on the balance sheet.
Capital markets are markets for long-term debt such as bonds and stocks which are generally one year or more. Examples are bonds which are long-term debt instruments used by business and governments to raise large sums of money from a diverse groups of lenders.
Another example is common stock and preferred stock. Common stockholders earn a return by receiving dividends or by realizing increases in their share prices. Preferred stockholders receive a fixed periodic dividend that must be paid prior to payment of any common-stock dividends.
To raise money, firms can use either private placements or public offerings.
Private placements involve the sale of a new security issue, typically bonds or preferred stock directly to an investor or a group of investors such as an insurance company or pension fund.
Public offering is the sale of either bonds or stocks to the general public. Initial public offering market (I.P.O) is when a company offers its shares to the public for the first time.
3. Primary markets and Secondary Markets
A Primary market is a financial market in which new securities are sold. It is the only issue in which the issuer is directly involved in the transaction i.e. the company actually receives the proceeds from the sale of securities.
Secondary markets are markets in which pre-owned or existing securities are traded among investors.
4. Eurocurrency Market
This is the international equivalent of the domestic money market. It is a market for short-term bank deposits denominated in U.S dollars or other easily convertible currencies. Euro-currency deposits arise when a corporation or individual makes a bank deposit in a currency other than the local currency of the country where the bank is located. E.g. If a multinational corporation deposits U.S dollars in a London bank, this would create a Eurodollar deposit (a dollar deposit in a London bank).
In spot markets, assets traded are bought or sold “on the spot” delivery (immediately or within a few days).
In futures markets, assets are bought or sold for delivery at some future date.
Depending on an organization’s size and scope of operations, it may be able to borrow all over the world or it could be confined to a small local area.
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