An Overview of Financial Markets and Institutions

In Investements we discuss the benefits of allowing prices to fluctuate freely in financial markets. [See these notes for a reminder](https://financial-education.github.io/why_we_have_free_markets). Free markets:

1. Incorporate information into prices.
2. This organizes society through price signals.

A primary market is one where the security issuer is involved. For example, the Initial Public Offering (IPO) market is a primary market because the company is selling shares to investors (investors receive equity and the company received cash). Another example is US Treasury auctions of bonds. You can view the results of these auctions here.

A secondary market is one where the issuer of the security is not involved. For example, if you buy NVDA stock today in the stock market, you are buying it from another person who owns NVDA. This is a secondary market transaction. Note I am using stock market as a short-hand for the National Market System (or NMS). Similarly, if you buy Bitcoin on the Coinbase exchange, this is a secondary market transaction.

Why the distinction? We make a distinction because these markets operate very differently and there are different market participants. Think of the difficulty of determining an IPO price—this takes unique skills and methods.

Do Companies Care what their stock price is on the Secondary Market? Absolutely, for a number of reasons:

1. Management performance is evaluated buy how the stock has done.
2. New primary market sales of stock are done near the present stock price in the secondary market.

Money markets are markets for securities which behave roughly like money. Specifically, a money market security is a debt security with a maturity of one year or less. Remembering our intro economics, money is anything that (1) is a medium of exchange, (2) and a store of value. Short-term debt securities, such as T-bills, meet both criteria. Some examples of money-market securities are:

• T-Bills
• Commercial Paper
• Negotiable Certificates of Deposit
• Eurodollar

Capital markets are those markets where securities issued for capital investments are traded. A capital investment is a long-term investment such as in plant and equipment. So capital market securities are defined to be equity securities, and debt securities with a maturity greater than 1 year. Some examples of capital-market securities are:

• Stock
• Corporate Bonds
• Treasury Notes/Bonds
• Asset-Backed (such as by mortgages) Securities

Why the distinction? We make a distinction between these markets because the participants are different, and different factors are taken into account when valuing these securities. For example, money-market mutual funds specialize in buying money market securities. However stock/bond mutual funds, hedge funds, pension funds specialize in buying capital market securities. Moreover when deciding to buy a money market security we only care about the firm's ability to remain solvent over the short-run, so we are interested in measures such as the current or quick ratios. Alternatively, capital market investors care about a firms growth prospects and solvency over years and decades, and thus consider measures such as ROA, and the debt-to-equity ratio.

Market Efficiency is a statement about the (1) speed and (2) accuracy with which information is incorporated into prices. Evidence supports that all public information is quickly and accurately incorporated into prices. That is, markets are now very efficient.

What does market efficiency not mean? It doesn't mean the market will never crash—if new information is revealed the market can decline rapidly.

Liquidity is generally defined as the (1) speed at which you can sell an asset for cash (2) without discounting its value. There is also an equivalent but more investments focused definition: the amount you can buy or sell without significantly increasing or decreasing the price.

Markets are legal frameworks. If the framework fosters more investment, then more firms may attract funding and this increases real asset construction and real economic growth. Therefore much of the laws and regulations surrounding financial markets are made to attract investors (which attracts those who need money/capital).

What general principles foster investment:

1. Transparency. Financial regulations and accounting rules which reduce the information asymmetry between corporate managers and investors.
2. Good and fair legal system which enforced contracts.
3. Uniform enforcement of regulations.

We won't cover financial markets abroad much in this course for a number of reasons. Firstly, the US is the most important market for raising capital—entrepreneurs from around the globe come to the US to finance their business. Secondly, as capital can more easily flow between markets, these markets become more correlated. So there is little benefit from interacting in foreign financial markets (they are correlated with the US market).

Depository institutions offer deposit accounts to the public and generally use the money in these accounts to fund long-term loans. Salient aspects of this service are:

• Deposit accounts can be of any size (often small), and these funds are packaged together to make large loans.
• They aggregate these short-term deposits and provide long-term loans of any size.
• They evaluate the default probability of the loans they provide—the depositors don't have to.
• They don't pass on the loss on a loan to the depositors (though if the bank fails the depositors could experience losses).
• They offer many loans so they provide depositors diversification.

Note, to depository institutions, deposits are liabilities and the loans they offer are assets.

Also note, depository institutions can be members of the Federal Reserve system.

As the name implies, these institutions obtain funding through other means than offering deposits. These firms do not have access to the Federal Reserve System.