14.1 What are financial markets? What function do they perform? How would an economy be worse off without them?
Financial markets are institutions and procedures that facilitate transactions in all types of financial claims. Financial markets perform the function of allocating savings in the economy to the ultimate demander(s) of the savings. Without these financial markets, the total wealth of the economy would be lessened. Financial markets aid the rate of capital formation in the economy.
The economy would be worse of without financial markets for several reasons. Savers would not be able to earn a return on their savings. People who need capital wouldn’t be able to get the funds from other people and so would have to rely only on their own money. The inability to get capital from others would slow the growth of businesses and reduce the purchases of consumers because they can no longer get loans. These would lead to decreased demand for products and services as well as a decrease in available jobs both of which would harm the economy.
14.3 Distinguish between the money and capital markets
Money Markets facilitates transactions using short-term financial instruments; whereas, Capital Markets facilitates transactions using long-term financial instruments.
A money market is a market for short term debt securities such as banker’s acceptances, commercial paper, repos, negotiable certificates of deposit, and Treasury Bills with a maturity of one year or less and often 30 days or less. Money market securities are generally very safe investment which returns a relatively low interest rate that is most appropriate for temporary cash storage or short-term time horizons. A capital market is where debt or equity securities are traded.
14.4 What major benefits do corporations and investors enjoy because of the existence of organized security exchanges?
Organized stock exchanges provide for:
• A continuous market. This means a series of continuous security prices is generated. Price changes between trades are dampened, reducing price volatility, and enhancing the liquidity of securities.
• Establishing and publicizing fair security prices. Prices on an organized exchange are determined in the manner of an auction. Moreover, the prices are published in widely available media like newspapers.
• An aftermarket to aid businesses in the flotation of new security issues. The continuous pricing mechanism provided by the exchanges facilitates the determination of offering prices in new flotation’s. The initial buyer of the new issue has a ready market in which he can sell the security should he need liquidity rather than a financial asset.