<Last updated 12.04.2020>
Hi! If you are interested in Economics, I’ve prepared the below to help your understanding about the Financial Sector. You should take a look at this short article in which I explain what are Financial Institutions and why they are important for the economy.
Financial Institutions act as intermediaries, through which savings are invested, transforming them into new capital increasing production leading to economic growth.
The following are the markets in which these institutions operate.
1) Financial Markets: a) Bond Market b) Stock Market
Remember that a market has buyers, sellers and a particular product, or products, for which the market gets its name. The Bond Market has bonds exchanged between participants while the Stock Market has stocks exchanged. An investor acts as the buyer of the bond. The issuer acts as the seller.
> The Bond Market: Governments and large organizations when they need funding to build highways, buildings etc. they issue bonds. Bonds is a fixed-income security, is a debt instrument, created for the purpose of raising capital (it sets the obligations of the issuer to the owner (lender)). Bonds can be bought or sold in the secondary market.
A bond has:
Date of Maturity: the date at which the loan must be repaid.
Interest rate: paid periodically until date of maturity.
Principal (initial money capital): the initial loan amount.
In these markets operate institutions through which depositors (savers) provide directly funds to organizations that wish to borrow (they need funding).
> The Stock Market (it is a secondary market): A business can sell stocks/shares to the public and these stocks are instruments that can be bought and sold in an exchange (stock exchange/secondary market). In the exchange the issuing business does no longer receive money. The only thing that changes are the holders/owners. Stock prices are formed by demand and supply for stocks. Depending on people’s expectations regarding the future profits of a business (listed in the exchange) demand and supply shift accordingly.
Businesses use both Stocks and Bonds to finance their investments. Both act us financial instruments but what are their main differences?
- The holder of a stock owns part of the business that issued the stock but the holder of a bond is just a lender.
- The holder of a stock is entitled to a portion of the company’s earnings but the bond holders receive only fixed Interest.
- The holder of a bond receives the interest first if the business has economic difficulties, before the stock holders receive dividend.
> Stocks carry a high degree of risk, this is the reason why they have high returns.
Financial Intermediaries are organizations through which depositors/savers provide indirect funding to those who want to borrow. They act as intermediaries (in between lenders and borrowers).
> Banks: The most famous financial intermediaries. Their main activity is to collect deposits and use them to provide loans. Banks pay interest to depositors and receive higher interest from borrowers. The difference between the two is part of the bank’s revenue.
> Mutual Funds: is a form of Investment Company. Their primary purpose is the collection of deposits from various investors and their inclusion in a portfolio consisting of different bonds and stocks. The investor/share holder of the mutual fund has indirectly bought all stocks that the mutual fund bought resulting in having risk diversification. Mutual funds have the main purpose of investing in such a way that they succeed in having the maximum possible return. The return for the investor is the difference between the initial funds invested at that time and the value of the investment at the time of liquidation. At any time, investors must have the right to take back the capital/funds and their profits, liquidation.
– Having a diversified portfolio reduces risk since the return does not depend on only one business but many since they own only a small portion of each business.
> The stock exchange: provides an alternative source from where businesses can acquire funds in the long-term. Stocks of listed companies are sold easily through the stock exchange.
> Venture Capitals: A type of private equity, a form of financing that is provided by firms or funds to small, early-stage, emerging firms that are deemed to have high growth potential, or which have demonstrated high growth. A new and popular alternative source of funding. Businesses that get funding from venture capitals see great results compared to their competitors.
Example of businesses that got funding from venture capitals: -Apple – Microsoft – Google – E-bay
Investors in venture capital funds are typically very large institutions such as pension funds, financial firms, insurance companies, and university endowments—all of which put a small percentage of their total funds into high-risk investments.
> Business Angels: These people are usually wealthy and they want to invest their excess capital in new startup companies giving them the chance to enter the market. Usually, these people are active and successful, or they were in the past executive directors with important knowledge and experience.
Importantly, these people generate good reputation and makes the business more attractive. They basically “lend” the business their good fame and reputation. They also have an active role in the business, participate in the management board and they provide advice unofficially or work within the business, part-time.
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