Ever wonder why we have banks? Where does money come from? Why do we need the Reserve Bank? And yet, these concepts and institutions touch every facet of our lives. Let’s begin a journey to understand the basics of this financial system we are in. Over a period of the next few weeks, we’ll go over the different spokes of the financial wheel from a beginner’s point of view.
Reference material for the following posts comes from the book ‘An Introduction to Global Financial Markets’ by Stephen Valdez.
Why do we need any financial markets? Who are the players?
First there are parties who need to borrow money – these parties could be individuals, like you, private companies or governments. People may need to borrow money to pay off home loans and so on, private companies may need to borrow money to further their growth and expansion, and we all know governments need to spend a lot of money on public projects for which taxes collected from citizens is probably not going to be sufficient!
Then, believe it or not there are parties with surplus funds that they are willing to lend to the borrowers. We all know that idle cash doesn’t make money on its own! They may be people depositing savings in a bank, insurance or pension funds, or companies with profits to invest. In an ideal world where every borrower could meet a lender and vice versa without any intermediary, there would be no need for financial institutions or markets. But as it happens, we need intermediaries to facilitate the transactions between borrowers and lenders – the intermediaries are banks, other financial institutions and markets.
To give you a perspective – a private investor might deposit money in a bank at a 10% rate of interest p.a. for her savings account. Meaning that for a deposit of Rs. 1,00,000, she will get Rs. 1,10,000 back from the bank at the end of the year. How will the bank get the additional Rs. 10,000 to pay the investor at the end of the year? Obviously the bank will need to invest that money elsewhere, where the rate of interest is greater than 10% p.a. leaving enough profit for the bank to pay back the investor plus a surplus amount which is income for itself. We’ll see what options the bank has in a bit, but before that let’s take a look at the different types of securities in play in the financial markets.
Securities at play
Bonds
Bonds, also called debt instruments, are securities that pay out fixed amounts at regular intervals. That’s why bonds are also known as fixed income products or securities. Governments or private companies issue bonds when they want to raise capital. The purchaser of a bond is basically granting a loan to the issuer, which will be paid back over at the end of the borrowing duration. In the meantime, fixed interest payments are made by the borrower (the bond issuer) to the lender (purchaser). The fixed interest payments are also called coupons because in the days of yore, bonds were actually pieces of paper with the principal amount borrowed, interest rate and maturity printed on them. Interest payments could be redeemed by tearing off the coupons attached to the bond!
In our banking example above, the bank could purchase a fixed interest bond with a 12% rate of interest p.a. That means the bank earns Rs. 1,12,000 at the end of the year, leaving enough money to pay back the private investor in addition to a Rs. 2,000 profit for itself.
Of course, the ability of the borrower/issuer of the bond to pay back the principal depends on their creditworthiness which is what makes the bond desirable to purchasers. A government for instance, is considered safe as it’s unlikely to go bankrupt and will be able to repay its borrowings. The creditworthiness of private companies is a range determined by several credit ratings agencies such as Moody’s or Standard and Poor’s who assign ratings based on their analysis of the company’s liquidity.
Equity
The terms equity, common stock and shares are used interchangeably to mean the same thing. Shares are another means for companies to raise money from investors, but unlike bonds where fixed interest payments are made in return for the investment, shareholders don’t get fixed payments but actually own part of the company, corresponding to their share in the company’s profits. The percentage of the company owned by a shareholder would be proportional to the number of shares they own as a percentage of the total number of shares of that company in circulation. If this is the first time the company has issued shares to the public to raise capital, it’s called a new issue or the Initial Public Offering (IPO). Unlike in the case of bonds, there is no expectation for the company to return the original investment; the returns are realized in the form or capital gains when the company is profitable. Since the investor is part owner of the company, profitability increases the share prices, so the shareholder can sell the shares to other interested investors at a higher price in the secondary market.
We shall cover both these types of securities in much more detail in the coming weeks in addition to the several more complicated securities like options, swaps, forwards, futures and derivatives.
Next week, we talk about the history of banking and the different types of banking – commercial banking and investment banking. Stay tuned!
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