Money, Banking, and International Financethe United States largest corporations. Furthermore, secondary markets are important because
these markets increase the liquidity of financial instruments. Investors can easily sell or buy
financial securities on secondary markets. Moreover, when government or corporations issue
new securities, the prices from the secondary market set the prices for the new securities in the
primary market.
Why would savers deposit their money into banks, instead of investing directly into the
financial markets? Financial intermediaries provide three functions. First, your bank account has
liquidity. If an emergency arises, you can easily withdraw funds from your account. If you
purchased stock and bonds from the financial markets, you could experience time delays and
pay a transaction cost to withdraw yours money. Second, financial intermediaries have
specialists who collect information about borrowers. Financial intermediaries lend to borrowers
who are not likely to default on their loans. Finally, the financial intermediaries reduce the risk.
They lend to a variety of borrowers through a process called diversification. For example, banks
will issue credit cards, grant mortgages, lend to a variety of businesses, and buy U.S.
government securities. If several credit card holders default, a couple of households stop paying
their mortgages, or a business bankrupts and defaults on a bank loan, overall, the banks could
still earn profits because the majority of bank customers are repaying their loans. On the other
hand, if you directly invested in a company that bankrupts, then you could lose all of your
investment.
Savers could withdraw their money out of the financial intermediaries and invest directly in
the financial markets, such as buying U.S. government securities. We call this process –
financial disintermediation. Savers have two reasons to invest directly in government. First, a
government may pay a higher interest rate than a bank. For example, your savings account earns
2% interest while a U.S. Treasury bill pays 4 % interest. Thus, the investors want to earn the
greater interest rate. Second, the U.S. government has a low risk of default because the
government has the power to tax and “print” money (i.e. seigniorage). If the government
experiences financial trouble, it can raise taxes, issue more government securities, or print
money. One problem does occur. If a government accumulates a massive debt, it usually gets
money for loans first, while businesses come second. If investors have limited funds, then the
businesses might not get the money that they need for investing in machines and equipment.
Consequently, a large government debt could impact the financial markets and hamper business
investment because a large government debt crowds out private investment. For example, the
U.S. government debt has exceeded $17 trillion in 2014. If the U.S. government had a debt of
zero dollars, then the investors would invest their funds in the private markets.
Financial markets have two methods to complete a transaction. Up to this point, you
assumed when a buyer and seller completed a financial transaction, they exchange money for
the financial instrument immediately. We call this the cash market or spot market. However,
buyers and sellers have another option to complete a transaction. Buyer and seller of a financial
instrument can negotiate a price and quantity today, but they exchange money for the financial
instrument on a future specific date. These transactions occur in the derivative market. For
example, you negotiate a price today to buy 10 Treasury bills from a seller for $9,000 each in
six months. You had entered into a contract with the seller for a future transaction. If these