Function of financial markets and their role in value creation

Welcome to the World of Financial Markets!

Hello there! Welcome to one of the most important chapters in your HKICPA QP journey. Think of this chapter as the "foundation" of a house. Before we learn how to manage a company's money, we need to understand the Financial Environment it lives in.

Financial markets might seem like complex webs of numbers and shouting traders, but at their heart, they are quite simple. They are just places where people with extra money meet people who need money to grow a business. By the end of these notes, you'll see how these markets help create value for companies and for society as a whole. Don't worry if it seems a bit abstract right now—we’ll break it down step-by-step!

1. What is a Financial Market?

In simple terms, a financial market is a mechanism that brings together buyers and sellers of financial assets (like shares or bonds).

The Analogy: Think of a financial market like Carousell or eBay. Instead of selling second-hand clothes or electronics, people are "selling" the right to future profits (stocks) or "buying" the promise of getting their money back with interest (bonds).

The Two Main Players

To understand the market, you just need to know these two groups:

1. Surplus Units (Savers): Individuals or companies who have more money than they need to spend right now (e.g., you putting money in a savings account).

2. Deficit Units (Borrowers): Companies or governments who need more money than they currently have to invest in new projects (e.g., a company building a new factory in Hong Kong).

Quick Review: Financial markets act as the "bridge" that allows money to flow from the Savers to the Borrowers.

2. Main Functions of Financial Markets

Why do we need these markets? They serve four vital functions that help businesses create value:

A. Intermediation (The "Matchmaker" Role)

Markets connect those who have money with those who need it. Without a formal market, a company would have to go door-to-door asking people for loans. The market makes this process efficient.

B. Price Discovery

How much is a share of a company worth? Markets figure this out by looking at Supply and Demand. Every time a trade happens, the market "tells" us what the current value of that company is. This helps managers make decisions about whether to issue more shares.

C. Providing Liquidity

Liquidity is a fancy word for how quickly you can turn an asset into cash without losing much value. Example: If you own shares in a listed company on the HKEX, you can sell them in seconds. If you own a physical building, it might take months to sell. Financial markets make assets "liquid."

D. Risk Management

Markets allow businesses to trade away risks they don't want. For example, an airline can use the financial markets to "lock in" fuel prices so they don't have to worry about oil prices going up suddenly.

Key Takeaway: Financial markets create value by making it cheaper, faster, and safer for businesses to get the money they need to grow.

3. Types of Financial Markets

The curriculum divides markets into different categories based on what is traded and when it is traded. Let's look at the two most important divisions.

Primary vs. Secondary Markets

This is a common area where students get confused, but the distinction is simple:

1. Primary Market: This is where new securities are created. When a company "goes public" through an Initial Public Offering (IPO), it sells shares for the first time. The money goes directly to the company to help it grow.

2. Secondary Market: This is where "used" securities are traded among investors (e.g., the Hong Kong Stock Exchange). If you buy Tencent shares today, you are buying them from another investor, not from Tencent itself. The money goes to the other investor, not the company.

Memory Aid: Think of the Primary Market like buying a brand new iPhone from the Apple Store. Think of the Secondary Market like buying that same iPhone later on Carousell.

Money Markets vs. Capital Markets

This division is based on Time.

1. Money Markets: For short-term lending and borrowing (usually less than one year). These are used for "working capital"—paying the daily bills. Items traded include Treasury Bills and Commercial Paper.

2. Capital Markets: For long-term financing (longer than one year). These are used for "big projects" like building a skyscraper or buying another company. This includes the Stock Market (Equity) and the Bond Market (Debt).

Did you know? Most of the daily "news" you hear about the stock market refers to the Secondary Capital Market.

4. Financial Intermediaries: The "Middlemen"

Sometimes, savers don't want to buy shares directly. They prefer to put their money in a Financial Intermediary. These include:

• Commercial Banks: They take your deposits and lend them to businesses.
• Institutional Investors: Pension funds, insurance companies, and unit trusts. They collect small amounts of money from many people and invest it in big chunks.

Why are they important for value creation?

1. Risk Transformation: A bank takes many small, "safe" deposits and turns them into one large, "risky" loan. They spread the risk so one single failure doesn't ruin the savers.
2. Aggregation: They collect small savings from thousands of people to provide the huge sums a corporation needs.
3. Maturity Transformation: Savers might want their money back in a week (short-term), but a business needs a loan for five years (long-term). Intermediaries bridge this time gap.

5. How Markets Create Value (The Big Picture)

In your exam, you might be asked how the financial environment contributes to Value Creation. Here is the step-by-step logic:

1. Efficient Allocation: Markets ensure that money goes to the companies that can use it most productively (those with the highest potential returns).
2. Lower Cost of Capital: Because markets are efficient and liquid, investors are willing to accept a lower return because they know they can sell their shares easily. A lower "cost of capital" means it is cheaper for companies to borrow, making more projects profitable.
3. Information Flow: Continuous price updates help managers see how the "outside world" views their performance. If the share price drops, it's a signal that management needs to improve.

Don't forget: In the context of the HKICPA QP, Value is usually defined as the Net Present Value (NPV) of future cash flows. Financial markets help maximize this by providing the necessary funds at the best possible price.

6. Summary and Quick Tips

Common Mistake to Avoid: Many students think the "Secondary Market" is useless to a company because the company doesn't get any new cash from it. This is wrong! Without a secondary market, no one would buy in the primary market because they would be "stuck" with the shares forever. The secondary market provides the liquidity that makes the primary market possible.

Key Points Recap:

• Financial Markets link surplus units (savers) to deficit units (borrowers).
• Primary markets are for new money; Secondary markets are for trading existing securities.
• Money markets are short-term (< 1 year); Capital markets are long-term.
• Intermediaries (like banks) create value through risk and maturity transformation.
• Liquidity and Price Discovery are the "secret ingredients" that allow businesses to grow efficiently.

Keep going! You've just mastered the environment in which businesses breathe. Next, you'll learn how to navigate the specific tools used within this environment!