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The Nature and Role of Financial Markets and Institutions



     1. The economic environment for business
     2. The nature and role of financial markets and institutions

          The Nature and Role of Financial Markets and Institutions
What is money?

In general money is anything accepted as payment for goods and services or repayment of debts. In a
developed environment money has two main components; 1) notes and coins and 2) banks deposits.

        A medium of exchange:
         Money can be exchanged for other assets.
        A store of wealth:
         Money can be used for savings.
        A unit of value:
         Asset can be valued as an amount of money.

Explain how is it that banks have the power to create new money (new spending power in the

Banks lend money to customers, not necessarily money they have borrowed or money the customer
deposited – they create new money- but in order to do this they must have reserves. This is why bank
runs result in bank failures.

What are Capital Markets?

Capital markets are markets where financial instruments are traded. There are two types of instruments
traded on two separate markets. There is the stock market where share of companies are traded and
the bond market where bonds are traded. Each market has two separate operations; the primary
market where new issues are traded and the secondary market where existing stocks or bonds are
traded. The secondary market is the exit route for persons who have bought securities in primary

What is a Bond?

        Bonds are debt securities
        This is where the issuer issues the bond to the lender
        It is a contract that specifies the rate of interest and the repayment terms

What are Money Markets?

The money market is a market for short term borrowing and lending, and trade of financial instruments.
Global markets

The Capital Market and the Money Market are global markets. Government and Companies can trade
freely on these markets. Individual countries have their own stock markets or financial centres where
these activities take place.

What is Financial Intermediation?

Financial intermediation is a system whereby a financial institution/person mediates between two other
institutions/persons in order to facilitate a transaction. Banks are examples of financial intermediaries -
an Institution may wish to lend money to another Institution using the Bank to facilitate the transaction.

What are the functions of a Financial Intermediary?

There may be a situation where there are many lenders who all wish to lend different relatively small
amounts of money for different periods of time. On the other hand there may be a situation where
there are few borrowers who all want to borrow large sums of money for a fixed period of time thus a
financial intermediary can thus be seen to perform the following functions:

       Borrowing varying amounts of money from lenders and reform them into an amount suitable
        for the final borrower
       Borrowing various amounts of money with different maturity dates and reform them into an
        amount with a maturity suitable for the final borrower

What are the advantages of financial intermediaries in an economy?

       Lenders do not have to search the markets for suitable borrowers
       Borrows do not have to search for lenders
       Risk is reduced for lenders because the intermediary bears the risk
       The system allows for flexibility because lenders are able to vary the terms on which they have
        lent to the intermediary without the intermediary or final borrower being disadvantage.

                                                Part 2 of 2

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