1.2 Financial markets

1.2Financial markets

In economics a market is an organisational device which brings together buyers and

sellers. Textbooks usually hurry on to point out that a market does not have to have

a physical location, though plainly it could do so. For example, until October 1986

trading in stocks and shares in the UK was concentrated on the physical location of

the London Stock Exchange trading oor. With the introduction of new technology,

however, dealers have since dispersed to their companies’ ofces. In fact, nancial

markets offer some of the best examples of buyers and sellers interacting over a

widely dispersed geographical area. Markets for foreign exchange, for example, of

necessity ‘bring together’ buyers and sellers in different countries. The latest com-

munication technology now permits nancial institutions in the US to deal in

shares in Tokyo as readily as they can in New York. This is not just a technological

marvel. As we shall see when we come to discuss the regulation of nancial activity,

the ‘internationalisation’ of nancial markets has serious implications.

Financial market:An organisational framework within which nancial instruments can

be bought and sold.

1.2.1Types of product

What is it that is traded in nancial markets? Normally, the expression ‘nancial

market’ is used in reference to a market wherein some sort of nancial product is

being traded. By product we simply mean what we have hitherto been referring to

as an asset or liability. As a briefer alternative to ‘asset and liability’ it is common to

talk about the trading of nancial claims.

Claims exist in many specic forms. The specic form which a claim takes is a

nancial instrument. Table 1.1 gives a brief exemplary list of such instruments. The

table is useful in that it indicates something of the range of instruments in existence

and also because it enables us to distinguish certain broad categories of instrument.

Table 1.1A selection of instruments

l	Bank deposits
l	Building society deposits
l	National Savings certicates
l	Treasury bills
l	Government bonds
l	Commercial bills
l	Equities
l	Life insurance policies
l	Eurobonds
l	Certicates of deposit

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Chapter 1 • Introduction: the nancial system

It is because instruments differ and therefore meet the needs of different sorts of

borrower and lender that we talk of nancial markets, i.e. in the plural.

There are various ways in which we can group markets together in order to assess

their closeness to one another. Firstly, we could divide our list of instruments into

those which can be traded directly between holdersof such claims and those which

cannot. Company shares and government stock, for example, once created can be

bought and sold in organised markets without their original issuers ever again being

involved. Instruments which can be bought and sold between third parties are

known as securities. National Savings certicates and building society deposits, by

contrast, cannot be bought and sold in this way. The only way to ‘dispose’ of such

an asset is to ‘sell’ it back to its originator.

Discretionary nancial saving:Day-to-day decisions to acquire nancial assets of

varying kinds and in varying quantities.

Contractual nancial saving:The regular acquisition of a nancial asset of a kind, of an

amount and on a date specied in a contract.

Exercise 1.1

Classifying nancial products Take the nancial section of a weekend newspaper and: (a)Count the total number of nancial products being advertised for savers.

(b)	Classify them into those offered by deposit-taking institutions and those offered by non-deposit-taking institutions.

(c)	Reclassify them into those which savers can acquire as they wish (or at their discretion) and those which they have to buy regularly (or contractually).

Alternatively, one could distinguish instruments which are issued with a xed rate

of interestfor as long as they exist – government bonds, for example – from those

assets whose yield varies according to market conditions. The latter category includes

a wide range of claims from bank deposits to company shares.

A very popular basis for distinguishing types of instrument is maturity. This means

the length of time which has to elapse before the claim is repaid. This may be very

long. With company shares, for example, it is theoretically innity. Some government

stocks are issued with twenty-ve years to maturity. Contrast this with treasury bills

which are issued for ninety-one days or even bank deposits which can be demanded

immediately or ‘at sight’. Traditionally, differences of maturity have been used, as

in Table 1.2, to create a distinction between ‘capital’ markets (markets for long-term

claims) and ‘money’ markets (markets for very short-term claims).

Maturity:The length of time that has to elapse before an asset matures or is repaid.

Occasionally ‘initial maturity’, the time to maturity from the day the asset is rst created;

more frequently ‘residual maturity’, the remaining time to maturity reckoned from today.

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		1.2 Financial markets
Table 1.2	‘Capital’ and ‘money’ markets

Capital markets

lThe market for bonds lThe market for equities lThe market for mortgages lThe eurobond market

Money markets

lThe discount market lThe interbank market lThe certicate of deposit market lThe local authority market lThe eurocurrency market

Exercise 1.2The liquidity of nancial assets

Take any six of the nancial products which you identied in Exercise 1.1 and rank them

for liquidity, beginning with the most and nishing with the least liquid. Use the charac-

teristics we discussed in section 1.1.3 to guide you.

But be warned. As nancial innovation continues, as new markets and new types

of instrument are developed, the degree of interdependence is increasing. Further-

more, the deregulation of nancial markets, a feature of policy in both in the UK

and US in the 1980s, has also helped to reduce barriers between nancial markets and

institutions. In Chapter 3 we shall see that the lowering of demarcations between banks

and building societies has had substantial repercussions for UK monetary policy. All

of these distinctions between types of nancial market are becoming more difcult

to maintain.

The behaviour of nancial markets, like the behaviour of other markets, can be

analysed using the apparatus of conventional economics. We can talk about the

supply of, the demand for, the utility and sacrice involved in consuming and pro-

ducing nancial instruments. However, the way in which we approach the analysis

depends upon whether we are dealing with instruments which can be traded

between third parties or whether we are dealing with trading between the buyer and

the originator of the instrument. In sections 1.2.2 and 1.2.3 we analyse the market

for this latter type of instrument. The seller is ultimately responsible for the supply.

The buyer is dealing therefore with the creator of the instrument. In section 1.2.4

we shall point out briey that the details of this analysis are not directly applicable

to markets for securities where trade is between third parties as in the markets for

company shares, government bonds and so on. The analysis of these very important

markets is more complex and is postponed until Chapters 5 and 6.

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Chapter 1 • Introduction: the nancial system

Figure 1.2