In varying degrees, all organizations operate within a financial environment, which comprises various institutions and markets serving business firms, individuals, and governments.
When a firm temporarily holds idle funds without investing them in productive assets, it has direct contact with financial markets.
Financial institutions and markets serve to bring together buyers and sellers of financial instruments.
More importantly, most firms use the financial environment to support their investment in assets. Ultimately, the market value of an organization’s securities is a measure of whether the organization is a success or a failure.
While business firms compete with each other in product markets, they must continuously interact with financial markets.
In light of the significance of this condition to financial managers, as well as to individuals as consumers of financial services, this section is devoted to exploring the financial system and the constantly changing environment in which capital is raised.
Financial Markets and Financial Environment
Financial markets are less physical places and more systems for directing savings to the ultimate investor in real assets.
They play a key role in moving funds from the savings sector (units with surplus funds) to the investment sector (units with a deficit of funds).
Certain financial institutions hold a prominent position in channeling the flow of funds in the economy. The secondary market, financial intermediaries, and financial dealers are key institutions that facilitate the flow of funds. Their unique roles will be discussed as this section unfolds.
Cash and Capital Markets
Financial markets can be divided into two categories: Cash Markets and Capital Markets.
- Cash Market: Involves the market for short-term (less than one-year original maturity) government and corporate debt securities. It also includes government securities initially issued with maturities of over one year but now having a year or less until maturity.
- Capital Market: Refers to the market for relatively long-term (greater than one-year original maturity) financial instruments, such as bonds and stocks.
Primary and Secondary Markets
Within cash and capital markets, there exist both Primary Markets and Secondary Markets:
- Primary Market: Also known as the “new issues” market. Here, newly issued securities are sold for the first time, transferring funds from ultimate savers to ultimate investors. This market provides direct financing to firms.
- Secondary Market: In this market, existing securities are bought and sold. Transactions in these already existing securities do not provide additional financing for capital investment.
A useful analogy is the market for cars:
- The sale of new cars provides revenue to car manufacturers.
- The sale of used cars in the secondary market does not generate new funds for the manufacturer but facilitates transactions.
Similarly, the existence of a secondary market encourages the purchase of new securities. If investors know they can easily sell a security later in a secondary market, they are more likely to invest in new securities. Therefore, a strong secondary market enhances the efficiency of the primary market.
Purpose of Financial Markets
Financial assets exist in an economy because the funds of different people, corporations, and governments at a point in time differ from their investment in real assets.
By real assets, we mean tangible items such as houses, buildings, machinery, inventories, and durable goods.
If funds exactly matched the investment in real assets for every economic unit in an economy at a given time, there would be no external financing, no financial assets, and no cash or capital markets. Each economic unit would be self-sufficient, paying for current consumption and investment in real assets out of current income.
A financial asset is created only when an economic unit’s investment in real assets exceeds its savings, and it finances this excess by borrowing or issuing securities. Naturally, another economic unit must be willing to lend.
This interaction of borrowers with lenders determines interest rates. In the economy as a whole, savings surplus units (those whose funds exceed their investment in real assets) provide funds to investment deficit units (those whose investment in real assets exceeds their savings).
This exchange of funds is facilitated by financial instruments, or securities, representing financial benefits to holders and financial obligations to issuers.
The purpose of financial markets in an economy is to allocate savings efficiently to ultimate users.
- Without financial markets, units with surplus funds would not easily transfer them to units needing capital.
- In modern economies, most nonfinancial corporations use more than their internal savings for investment in real assets.
- Most households, conversely, have total savings in excess of total investment.
Efficiency in financial markets involves bringing together ultimate investors in real assets and ultimate savers at the lowest possible cost and risk.
Read Also: Basic Concepts of Financial Management
