1. Two Financial Intermediaries, their Functions and Role in an Economy
Companies or organizations that connect different economic agents with surplus and deficit of funds are usually known as “Financial Intermediaries”. In their true essence, financial intermediaries pays an active role as channels between those who have large reserves of money to make investments and those who are in immediate need of money. Some common financial intermediaries are insurance companies, credit unions, banks and pension funds. Let us make discussion two financial intermediaries such as commercial banks and brokerage houses.
Commercial Banks
Banking institutions are financial intermediaries that collect deposits from those who have reserves (surplus) of money to save and extend interest based loans to those who are in need of liquidity or cash flow. In other words, banks act as financial intermediaries by receiving deposits from various sources (depositors) and channelize those funds to profitable arenas to earn interest income .
Banks generally offer retail and corporate banking services to their clients as a financial intermediary. Banks also facilitate traders by opening letters of credit on their behalf. Additionally, banks also enter into derivative transactions to help their clients mitigate their market risk which is more common in interest rate swaps where fixed and flexible interest rates are exchanged as per client’s requirements. These days, banks help small and medium businesses to raise larger capital and go public by providing underwriting services for Initial Public Offering (IPO) of common equity shares.
Brokerage Houses
They are important financial intermediaries as they make investments in the stock market on behalf of their clients. Brokerage houses act as a financial intermediary by collecting capital from different customers. As these organizations have expertise in investment management, they invest the collected capital and help their clients earn capital gains from increase in per share price in exchange/return for a small brokerage fee/commission. Brokerage houses play a major role in an economy by investing in common stock of profitable companies and help such organizations raise large capital. Brokerage houses also help their customer earn some extra income from capital gains.
2. Difference between Money and Capital Markets with Respective Activities
In every economy, financial markets are broadly divided into two distinct categories that include money and capital market. Market where short-term securities or assets are traded is known as money market. In other words, the place where securities or assets of up to one year or less are bought and sold is known as money market. In contrast, market where medium to longer term securities or assets are traded is known as capital market. This is a business arena where securities with maturity of more than one year are bought and sold between different market participants .
Money markets usually deal with debt securities including treasury bills, certificates of deposits and commercial papers. Therefore, one can say that risk free instruments or securities are bought and sold in money markets. In contrast, capital markets allow businesses to raise finance or capital through equity and debt sources. The major purpose of money markets is to provide liquidity to an economy whereas capital markets operate with an aim to help businesses raise capital to finance their working capital operations .
As money markets offer its participants to buy and sell risk free to low risk instruments or securities, the return on investment offered in money markets is relatively low. In comparison to this, as securities of relatively higher risk are traded in the capital markets, the return on investment, in form of capital and dividend gains, is high relative to the ones offered in money markets.
3. Derivative Asset and Related Example
When we call an asset as a derivative, it means that finance managers are referring to a financial contract or instrument that derives its financial worth from any other underlying asset (such as shares, currency, stock market index and any other commodity etc) . For instance, stock options give common stockholders a right to sale and purchase the shares for a certain strike (exercise) price on a certain expiry date. In this kind of derivative transaction to avoid non-market risk, the underlying asset in this regard is the company’s shares.
It is quite notable that derivatives do not have their own financial worth. Instead, they derive their value from an underlying asset. That is why; such an underlying asset or commodity is referred to as a derivative, in financial terms. This is because such an underlying asset or commodity is used for minimizing, hedging or mitigation of risk.
Consider the example of one of the most popular derivatives, future contracts. Farmers usually enter into these derivative transactions to mitigate or hedge the risk about fall in prices of their agricultural production. If, for example, they lock in a certain price of corn today for a three month period and the price of corn increases at expiry date, corn farmers are protected by this derivative transaction. This is because if corn price had fallen down more than the expected level, farmers may have suffered from losses. However, by entering into the derivative transaction to lock-in price today, farmers keep themselves on a safe side. In this transaction, the underlying asset or derivative is price of corn which is expected to fall on a certain date or month.
References
Bishop, T. (2012). Money, Banking and Monetary Policy. Thomas Bishop.
Gaughan, P. A. (2009). Measuring Business Interruption Losses and Other Commercial Damages. John Wiley & Sons.
Hahn, L. A., & Hagemann, H. (2015). Economic Theory of Bank Credit. Oxford University Press.
Petty, J. W., Titman, S., Keown, A. J., Martin, P., Martin, J. D., & Burrow, M. (2015). Financial Management: Principles and Applications. Pearson Higher Education AU.
