Financial Markets – Basic Concept

A financial market is a system where buyers and sellers trade financial instruments such as shares, bonds, and other securities.

It helps companies raise money and helps investors invest their savings.

• Primary Market

The primary market is where securities are issued for the first time and money goes directly to the company.

• Secondary Market

The secondary market is where investors buy and sell existing securities among themselves, and the company does not receive money.

After a company issues security (shares or bonds) for the first time in the primary market, those securities are later traded among investors in the secondary market.

👉 the secondary market does NOT provide new funds to the company.
👉 It allows investors to buy and sell existing securities.

This trading creates liquidity, which makes investing safer and more attractive.

Types of Secondary Markets

Secondary markets operate in three main forms:

• Auction Market

Buyers and sellers trade directly, and prices are decided through open competition.
Traditionally done on a physical trading floor, but now mostly electronic.

• Dealer Market

There is no central trading floor. Dealers buy and sell from their own inventory and quote a bid (buy) and ask (sell) price.
They earn profit from the difference called the spread.

• Electronic Communication Networks (ECNs)

These are fully electronic systems that automatically match buy and sell orders.
They do not use traditional market makers and allow trading even after market hours.

Why Secondary Markets Are Important

✔ Provide liquidity
✔ Provide continuous price information
✔ Make primary market fundraising easier
✔ Reduce investor risk

💡 Exam Insight: Liquidity reduces required return → lowers cost of capital.

Bond Markets

A bond is a long-term loan given by investors to a company or government.
In return, the issuer pays regular interest and repays the principal at maturity.

Bonds are usually tradable in the market and most pay fixed interest.

Bond Dealers

Bond dealers act as market makers.
They quote a bid price (buy price) and an ask price (sell price) and earn profit from the spread.

Bond Quotation Rule

Most bonds have a face value of $1,000, but they are quoted per $100 of face value.

If a bond quote is 101, it means 101% of face value.
So, a $1,000 bond will sell for $1,010.

U.S. Government Securities

These are debt instruments issued by the government to borrow money.
They are considered very safe because they are backed by the government.

• Treasury Bills (T-Bills)

Short-term securities with maturity of up to 1 year.
They are sold at a discount and do not pay periodic interest.
Very low risk.

• Treasury Notes

Medium-term securities with maturity of 1 to 10 years.
They pay interest every six months.

• Treasury Bonds

Long-term securities with maturity of 10 to 40 years.
They also pay interest every six months.

Money Market Instruments

Money market is for short-term borrowing and lending, usually for less than one year. It is used by governments, companies, and banks to manage short-term cash needs.

Main Instruments:

• Treasury Bills (T-Bills)

These are short-term loans issued by the government. They are very safe because they are backed by the government.

• Commercial Paper

This is short-term debt issued by strong companies to raise money. It is unsecured and usually held until it matures.

• Banker’s Acceptances

This is a bank-guaranteed payment used mainly in international trade. It reduces risk because the bank promises to pay.

• Repurchase Agreements (Repos)

This is a short-term loan where securities are sold with an agreement to buy them back later. It is low risk because it is backed by collateral.

Capital Markets vs Money Markets

Market Type	Instruments	Maturity
Capital Market	Stocks, long-term bonds	More than 1 year
Money Market	Treasury bills, commercial paper	Less than 1 year

Derivatives Markets

Derivatives are financial contracts whose value depends on another asset like stocks, currencies, or commodities. They are mainly used for risk management (hedging) or speculation.

• Futures

A futures contract is an agreement to buy or sell an asset at a fixed price on a future date. It is traded on an exchange and must be completed on the agreed date.

• Option

An option gives the buyer the right, but not the obligation, to buy or sell an asset at a fixed price. The buyer can choose whether to use the contract or not.

• Swaps

A swap is an agreement between two parties to exchange cash flows in the future. It is commonly used to exchange interest rates or currencies.

Clearing System

Derivatives traded on exchanges go through a clearing system. Traders must deposit margin money, which helps reduce the risk of default. The exchange acts as a guarantee, ensuring both sides fulfill the contract.

Market Efficiency

The Efficient Market Hypothesis (EMH) says that security prices reflect all available information. Because of this, investors cannot consistently earn extra (abnormal) profits, and securities are usually fairly priced.

• Weak Form:

Prices reflect past prices and trading data. This means technical analysis cannot consistently beat the market.

• Semi-Strong Form:

Prices reflect all public information, including financial statements and news. This means fundamental analysis cannot consistently earn abnormal returns, and this form has the most evidence.

• Strong Form

Prices reflect all public and private information. Even insiders cannot consistently earn extra profits, but this form is generally not accepted because insider trading can create abnormal gains.

Summary

• Financial markets connect buyers and sellers of financial instruments, helping companies raise funds and allowing investors to invest, creating efficient capital allocation.

• The primary market issues new securities to raise capital, while the secondary market trades existing securities and provides liquidity without giving new funds to the company.

• Secondary markets operate as auction markets, dealer markets, and electronic networks (ECNs), improving price discovery and market efficiency.

• Money markets deal with short-term instruments (less than 1 year) like T-bills and commercial paper, while capital markets handle long-term securities such as stocks and bonds.

• Derivatives (futures, options, swaps) are used mainly for hedging and risk management, and exchange-traded contracts require margin and clearing systems to reduce default risk.

• Under the Efficient Market Hypothesis (EMH), prices reflect available information (weak, semi-strong, strong forms), making it difficult to consistently earn abnormal returns.