Explore and Describe Financial Instruments and Institutions (Essay Sample)

FINANCIAL INSTRUMENTS AND INSTITUTIONS
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INSTITUTIONFinancial markets allow buying and selling of financial assets. Besides allowing the exchange of previously issued financial assets; provide a platform facilitating borrowing and lending through trading currently issued securities. A financial market is thus an elaborate system of a commercial institution and intermediaries set up to facilitate the transfer of funds from units having surplus funds to those having limited resources. Financial markets play the role of investment, financing, pricing, payment and risk management plus asymmetric information problem resolution. The financial market plays its investing function by ensuring transfer of resources from ultimate lenders to borrowers; they channel cash from economic agents to those having scarce for productive investment. They enhance income to depositors on their savings and dividends thus adding onto the National income. They ensure risk sharing and diversification by transferring risks from savers to investors. Financial markets ensure productive use of the loaned funds and also boost buildup of capital since they provide a mechanism where we gain from the influx of savings thus aiding in the country’s capital formation. They allow setting of prices of the instruments from demand and supply forces. Financial markets allow selling of a financial asset to gain from marketability and liquidity. They also act as a source of information from the numerous past records of the participants thus lowering the transaction costs of obtaining the information.
Financial markets play a financing role by providing the borrower with cash as and when needed for investment, ensure liquidity by selling and buying the financial assets, offering lenders with earning assets to allow them to gain from the financial instruments, enhancing savings and liquidity to banks, enabling credit creation and ensuring aggregate economic growth.Financial institutions play the role of financial intermediary by linking borrowers to lend, i.e., connecting buyers and sellers through financial asset transformation. Financial institutions have an important role in the financial system to solve information asymmetry problem of adverse selection and moral hazard. Adverse selection is the lack of full information in financial markets to make informed decisions. Financial institutions by screening out bad credit risks and keeping watch on borrowers.
Financial intermediaries can help solve this problem by gathering information through credit reference bureaus and sharing information on delinquent accounts (non-performing loans) about potential borrowers and screening out bad credit risks (Berger, 1997). They link with credit reference bureaus to help monitor the borrower's activities. Financial institutions lower transaction costs by reducing the time and money spent in financial dealings. Financial institutions are experts in reducing transaction costs and from economies of scale advantage. It allows depositors invest in more productive investment opportunities. Financial institutions ensure risk sharing and diversification. The risk is the deviations from the expected returns. By buying a wide variety of different assets from many borrowers, they use diversification for risk sharing. Risk sharing is enhanced through assets diversification entailing spreading out funds over a vast portfolio of assets bearing different risks. Financial institutions reduce the cost of monitoring borrowers by enabling depositors to pool their resources and through financial analysts, invest in them who then monitor and gather information from borrowers(Berger, 1997). They ensure maturity intermediation as there is a higher risk of mismatching securities with differing maturities by creating a large pool of deposits to satisfy borrowers and lenders. Some financial institutions example mutual funds by providing denomination intermediation services. This is because numerous assets are denominated in large figures which are not affordable to small savers, financial institutions allow the low-income earners to buy assets even if denominated in large denominations.
Primary markets are those in which first issued securities are traded. The new issues of financial instruments can be through private placement, initial public offers, book building and seasoned public offers. Primary markets are meant to raise capital for corporations and government. The preliminary issue can only obtain funds from this market. An investment bank comes to play by underwriting the IPO. A company selling its stocks in a primary market does so by hiring an underwriting firm for reviewing the offer and prepare a prospectus showing the price and other requirements of the issued securities. Secondary markets are those in which already issued securities are traded among different parties, the shares become “second hand.” Secondary markets are important for two reasons: they make it easier for investors to buy or sell financial securities to raise cash, that they make the financial security more liquid. Also, they assist in price determination of the financial securities. (Price discovery). For a secondary market, an investor demands a broker to buy the securities in his place. The security price varies with the market, and the investor's cost is the brokerage commission. The buying price is not directly related to the previous security price like the first issuance. The issuing company this ti...