Financial Markets, Institutions, and the Financial System
Role of Financial Markets
Financial markets facilitate the flow of funds from savers to borrowers. They include money markets (short-term instruments like Treasury bills, commercial paper) and capital markets (long-term securities like stocks and bonds). Primary markets issue new securities; secondary markets trade existing ones. Stock exchanges provide liquidity and price discovery.
Financial Institutions
Key institutions include commercial banks (deposits, loans), investment banks (underwriting, M&A advice), insurance companies, pension funds, and hedge funds. Central banks (e.g., Bank of England) control monetary policy, issue currency, and act as lender of last resort. The financial system comprises markets, institutions, and regulators (e.g., FCA, PRA in the UK).
Financial Instruments
Equities represent ownership; bonds are debt instruments with fixed interest; derivatives (futures, options, swaps) derive value from underlying assets and are used for hedging or speculation.
Traps
A common trap is confusing primary and secondary markets: an IPO occurs in the primary market, while subsequent trading is in the secondary market. Another trap is mixing up the roles of commercial and investment banks. Also, note that money markets are for short-term (up to one year), while capital markets are for long-term.
Worked Example
A company wants to raise £50 million by issuing new shares. This is a primary market transaction, likely arranged by an investment bank. After issuance, investors can buy and sell these shares on the secondary market (e.g., London Stock Exchange). The company does not receive proceeds from secondary market trades.
Rule of Thumb
Primary market = new issues (funds to issuer); secondary market = trading existing securities (funds between investors). Money market ≤ 1 year; capital market > 1 year.