The FinanciaI Environment

In varying degrees, all businesses operate within the financial system, which consists of a number of institutions and markets serving business firms, individuals, and governments. When a firm invests temporarily idle funds in marketable securities, it has direct contact with financial markets. More important, most firms use financial markets to help finance their investment in assets. In the final analysis, the market price of a company's securities is the test of whether the company is a success or a failure. While business firms compete with each other in the product markets, they must continually interact with the financial markets. Begause of the importance of this environment to the financial manager, as well as to the individual as a consumer of financial services, this section is devoted to exploring the financial system and the ever-changing environment in which capital is raised.

The Purpose of FinanciaI Markets

Financial assets exist in an economy because the savings of various individuals, corporations' and governments during a period of time differ from their investment in real assets. By real assets, we mean such things as houses, buildings, equipment, inventories, and durable goods. If savings equaled investment in real assets for all economic units in an economy over all periods of time, there would be no external financing, no financial assets, and no money or capital markets. Each economic unit would be self-sufficient. Current expenditures and investment in real assets would be paid for out of current income. A hnancial asset is created only when the investment of an economic unit in real assets exceeds its savings, and it finances this excess by borrowing or issuing stock. Of course, another economic unit must be willing to lend. This interaction of borrowers with lenders determines interest rates. In the economy as a whole, savings-surplus units (those whose savings exceed their investment in real assets) provide funds to savings-deficit units (those whose investments in real assets exceed their savings). This exchange of funds is evidenced by investment instruments, or securities, representing financial assets to the holders and financial liabilities to the issuers.

The purpose of financial markets in an economy is to allocate savings efficiently to ultimate users. If those economic units that saved were the same as those that engaged in capital formation, an economy could prosper without financial markets. In modern economies, however, most nonfinancial corporations use more than their total savings for investing in real assets. Most households, on the other hand, have total savings in excess of total investment. Efficiency entails bringing the ultimate investor in real assets and the ultimate saver together at the least possible cost and inconvenience.

Financial Markets

Financial markets are not so much physical places as they are mechanisms for channeling savings to the ultimate investors in real assets. Figure 2.1 illustrates the role of financial markets and financial institutions in moving funds from the savings sector (savings-surplus units) to the investment sector (savings-deficit units). From the figure we can also note  the prominent position held by certain financial institutions in channeling the flow of funds in the economy. The secondary market, financial intermediaries, and financial brokers are the key institutions that enhance funds flows. We will study their unique roles as this section unfolds.

Money and CapitaI Markets. Financial markets can be broken into two classes - the money market and the capital market. The money market is ioncerned with the buying and selling of short-term (less than one year original maturity) government and corporate debt securities. The capital market, on the other hand, deals with relatively long-term (greater than one year original maturity) debt and equity instruments (e.g., bonds and stocks). This section gives special attention to the market for long-term securities - the capital market. The money market and the securities that form its lifeblood are covered in Part 4 of this book.

Primary and Secondary Markets. Within money and capital markets there exist both primary and secondary markets. A primarymarket is a "new issues" market..Here, funds raised through the sale of new securities flow from the ultimate savers to the ultimate investors in real assets. In a secondary rnarket, existing securities are bought and sold. Transactions in these already existing securities do not provide additional funds to finance capital investment. (Nofe: On Figure 2.1 there is no line directly connecting the secondary market with the investment sector.) An analogy can be made with the market for automobiles. The sale of new cars provides cash to the auto manufacturers; the sale of used cars in the used-car market does not. In a real sense, a secondary market is a "used-car lot" for securities. The existence ofused-car lots makes it easier for you to consider buying a new car because you have a mechanism at hand to sell the car when you no longer want it. In a similar fashion, the existence of a secondary market encourages the purchase of new securities by individuals and institutions. With a viable secondary market, a purchaser of financiai securities achieves marketability. If the buyer needs to sell a security in the future, he or she will be able to do so. Thus, the existence of a strong secondary market enhances the efficiency of the primary market.