Question

For every question, please write down each main step before you obtain the final answer. Correct final answer with incorrect related work (calculation) or without any work may receive 0 point. On the contrary, incorrect final answer with correct related work (calculation) will receive partial credits.

Question 3 – Financial Markets [10 points]: Kampfire, Inc., a very successful manufacturer of camping equipment, is considering going public next month to raise funds to help finance the company’s future growth. The financial manager of Kampfire has approached the investment banking firm at which you work seeking help with its decision. Your boss asked you to explain the nature of the U.S. financial markets and the process of issuing equity to the financial manager. To help with this task, your boss has asked you to answer the following questions in explaining the U.S. financial system to the financial manager:

What is a financial market? How are financial markets differentiated from markets for physical assets?

Differentiate between money markets and capital markets.

Differentiate between a primary market and a secondary market. If Microsoft decided to issue additional common stock and an investor purchased 1,000 shares of this stock from Merrill Lynch, the underwriter, would this transaction be a primary market transaction or a secondary market transaction?

Describe the three primary ways in which capital is transferred between savers and borrowers.

Securities can be traded on physical exchanges or in the over-the-counter market. Define each of these markets, and describe how stocks are traded in each one.

Answer 1

Financial Market: Financial Market is a place where financial products(financial instruments) are traded. Financial Instruments are the financial products which are issued in the market by the corporations, institution, government to raise money for their capital needs. The people with surplus money subscribe to these financial instruments, they may be individuals, corporations, financial institutions, government, agencies, etc.

Financial Market is a place where no physical goods are being bought and sold, unlike physical assets market. Here money or money's worth is being exchanged for money or monetary instruments, which carries a rate of return either fixed or variable. The investors buy the instruments, with the intention of selling it in future at a higher price or derive interest from the instrument. In physical assets market, the goods dont carry any rate of interest or are not expected to increase in future, rather it depreciates in value with due course of time.

Money Market: Money market is a market, where the financial insruments have a very short maturity. The maturity may be from same day to less than a year. It has a very high liquidity. Examples...Treasury bills, commercial papers, municipal notes,etc.

Capital Markets: Capital market is a place where corporations issue long term securities like bonds, shares to the common public to raise capital. It comprises of primary and secondary market.

Primary Market: Here the corporations issue shares or bonds directly to the investors, with the help of Underwriter. The investors directly subscribe to the shares or bonds from the company, and the company also makes allotment as per the allotment system.

Secondary Market: In this market, both the buyers and sellers are investors. the sellers of the shares make a quoate in the secondary market with the help of the broker in the exchange, and the buyer bids for the best price and quantity through the broker at the exchange. As the price and quantity matches, a trade transaction between buyer and seller is executed.

If Microsoft issue the additional stock and investor purchased with the help of underwriter. This transaction is a Primary Market Transaction. Because the underwriter helps or assists the issuer to issue the shares directly to the investors, A secondary market transaction means a trade between two investors.

Three primary ways in which capital is transferred between savers and borrowers:

1. Through Banks: The Banks act as a middleman between the savers and borrowers. The banks accepts deposits from the people who have surplus money, and guarantees a rate of interest on the deposits to the savers. And with this deposits, the bank gives it to the borrowers, who are in need of money. The borrowers pay a rate of interest (higher than the savings rate) on the loan taken from the bank. Thus bank acts as a financial intermediary between the borrower and savers, thus earning from the interest rate differential between the deposits and loans.

2. Through Capital Markets: Here the savers are the investors, which may be individuals, corporations, financial institutions, governments, etc. and the borrowers are Corporations and government who are in need of money. When the borrowers are in need of capital, they issue long term financial instruments like shares and bonds to the savers.

3. Other Financial Institutions: Financial institutions like mutual funds companies, insurance companies raise money from the savers by offering them financial products like mutual funds, insurance policies. They invest this money in the capital market to earn a rate of return on the money. Thus through capital market, it reaches to the borrowers, who are in need of money.