A brief discussion about the Financial Market and its ramifications.
Introduction
Based on its cash reality, an Economy has two agents, they’re [1]:
- Agent A: Spend less resources than receive
- Agent B: Spend more resources than receive
Agent A is commonly denominated as resources saver, while agent B is considered a resources taker. A resources is a common term for money.
Suppose that spend are labelled with X and revenue with R, then we can state the above description in a mathematical form by:
- Saver: R – X > 0
- Taker: R – X < 0
Agent A, has his revenue overcoming its spend, hence an excess of money in hands. Nonetheless, when the saver opts-in to hold money, he becomes exposed to several undesirables effects, in particular:
Inflation: The persistent and general rise in the price level, caused by the imbalance between high money supply and low money demand. Which makes, in practice, the saver sees his money loses its purchasing power over time.
Opportunity cost: If saver isn’t interested in using his money for a determined period, he can apply it in some investment, therefore providing profitability.
In contrast, the taker is who has a lack of cash. In other words, his revenue is below its spend. This is the case of an entrepreneur, which is beginning or expanding his businesses, in this situation he might need money to pay his obligations.
Looking at what was said above, is possible to see certain complementarity between saver and taker. From this observation comes up the concept of the financial market [1]:
The financial market is the environment, physical or abstract, wherein forces of supply and demand reach equilibrium state between each other. Put differently, it’s the mechanism whereby resources go from savers to takers.
Figure 1 shows the abstract concept of Financial Market. Wherein the arrows symbolize the direction and sense whereby resources flow from savers to takers through Financial Market.
When transferring resources, the saver is financing the taker. And for such, he requires remuneration to resign his right of making use of the money which belongs him for some time, this remuneration is called interest. In other words, interest can be understood as the cost of the money, there’s the price of the asset denominated money.
To exemplify the importance of the Financial Market, here is an example:
Suppose that Mary has achieved her planned budget and got a surplus equals to $1000,00. Consider too, that Joseph, on the other hand, had a deficit of $1000,00. Without the Financial Market, we would have idle resources on one side and the lack of resources in another.
The market allows the exceeding resource to find who demands it. And the more developed the market is, the more efficient will be the transfer process. One way to link Mary to Joseph in the preceding the example is through of a bank, it’s worth mentioning that this is only one possible way between several others to do the process, so:
- To pick up Mary’s resources, the bank issues a Certificate of Deposit (CD). In this contract, the bank retains the resources by some amount of time and in exchange, it promises to return the value plus some percentage of it.
- To finance Joseph, the bank lends the money caught from Mary and charges a percentage of the value lent.
In this example, the bank has acted as an intermediary agent and incurs the costs of fund-raising and loan, between these, the cost of build the bank agency, payment of employees etc.
Furthermore, it was exposed to some kinds of risks, among these, the risk of credit, which represents the probability of Joseph doesn’t pay what is due.
To finance this operation and cover the risks, the bank demands certain remuneration and this is calculated from the difference between the rate which the bank charges to lend resources and that which it pays to take resources borrowed. This difference is denominated spread.
Besides the transfer function, competes to Financial Market, in lesser or greater degree, the correct definition of remuneration rates, which regulate the whole economical system, providing the basis of the price system which permits the efficient allocation of resources.
To simplify the analysis, it’s common to break the Financial Market into four conceptually components [2]:
- Money Market
- Credit Market
- Foreign Exchange Market
- Capital Market
Hereinafter, we have a summary of each component. I intend to write a specific article for each of these in the future. It’s worth to mention this is one possible classification and there are others based, for example, whether the negotiation is done directly between the issuer and the investor or between two investors, etc.
Money Market
The Money Market is where the resources are transferred in operations of very short term. This is the market where the Central Bank (CB) executes its monetary policy, regulating the money supply and for consequence the liquidity and other causal variables, such as inflation.
As an example of a common transaction which precedes in Money Market, we have the equalization of a banks’ position cash at the end of the day. In this case, one bank (S) may have ended the day with a larger amount of cash than is defined by the CB, its board of directors etc. On the other hand, we have a bank (D) that ended its day with insufficient cash funds. To balance their cash incomes, the bank S lends its surplus and is remunerated for that and the bank D borrows what needs and pays for it, they go to Financial Market.
The operation can be done with the following steps:
- To raise capital, bank D issues a short term debt security
- Bank S buys the security issued by D and pays money for it
- At the end of the agreed period, bank D redeems its security and pays for it and the value paid represents the previously borrowed plus the interest
The average weighted rate of the loans negotiated between banks is of particularly important, because it serves as the base for all interest rate of the world’s economy and it’s the foundation of the pricing process of all other assets. This rate is commonly called overnight rate, for example, the Federal Fund Rate (USA) and LIBOR (UK).
Credit Market
It’s in the Credit Market that transactions of short to mid-term are made.
Generally, the operations in the Credit Market precede between financial institutions and people/enterprise. We call a financial company as a bank if it can pick up money with demand deposit. As examples of financial companies which isn’t banks, we have leasing companies and credit companies.
Some common products of Credit Market are consumer credit, mortgages etc.
Foreign Exchange Market
Every country, or group of countries (Eurozone’s case), has its currency.
For example, dollar (USD), pound (GBP), Euro (EUR) etc.
Due to the international character of the modern economy, there’s a raise need to transact one country’s currency for another country’s currency. And the Foreign Exchange Market is where agents trade different currencies.
Suppose for example, that an investor from the USA wishes to put money in some Germany’s company. To do it, the investor has to sell his dollars to buy euros which will be invested in Germany’s company. When he desires to redeem his money back, he will sell his euros and buyback dollars.
The currency, by its own, is a commodity. Therefore it has a price and the exchange rate is the price of one currency expressed in another.
For example, when we said that the €1.00 is been sold at U$1.20, we want to say that to buy 1.00 euro you must pay 1.20 dollars. Or, the weighted average of the selling operations of euros indicates that the exchange rate of the euro is U$1.20.
Capital Market
The objective of the Capital Market relies on long-term operations, acting where the banking segment hasn’t interested in being present. Through Capital Market, companies can raise funds to expand and maintain their businesses. And by the issuance of shares, small investors can become owners of the companies and participate in the daily decisions.
By the Capital Market, the companies can eliminate the banking intermediary, therefore decreasing costs. And by the stock market, one component of the Capital Market where shares are traded, there’s no need to repay debts (in the strict sense of the word) and the investor’s payment is obtained by the company’s growth.
Conclusion
In this article, we’ve introduced the concept of Financial Market. After this, we exposed their components. It is worth to say that this division is merely didactic and in practice can be difficult or impossible to differentiate between each other.
References
[1] BHOLE, L. M. Financial Institutions & Markets. 5E. Published by Tata McGraw-Hill Education.
[2] ASSAF, A. N. Mercado Financeiro. 2E. Published by Atlas.
Originally published at https://medium.com/@rvarago