Why financial markets exist

Somewhere today, a nurse's pension savings are paying for a wind farm on another continent. The nurse will never meet the wind farm's owners. Financial markets are the machinery that makes that possible, and every risk this course covers lives somewhere inside that machinery.

Every economy has two groups. SaversA person or organisation with more money now than it needs to spend now. have more money than they need right now: a family putting money aside, a pension fund, a company with spare cash. BorrowersA person or organisation that wants to spend more now than it has, and promises to pay later. want to spend more than they have right now: a young couple buying a home, a company building a factory, a government building a railway.

Each group can help the other. The saver earns something on money that would otherwise sit idle. The borrower gets to act now and pay later, out of the income the house, factory or railway brings.

Why they cannot just find each other. Picture Amira, who has £10,000 saved, and Tom, whose bakery needs £10,000 for a new oven. Even if they lived on the same street, four problems would get in the way:

• Finding each other. Amira does not know Tom needs money, and Tom does not know Amira has it.
• Trust. Amira cannot easily judge whether the bakery is well run.
• Timing. Amira may want her money back in two years. The oven needs five years to pay for itself.
• Risk. If the bakery fails, Amira loses everything she lent.

A financial marketAny place or system where buyers and sellers trade money and financial claims. is any place or system where money and promises to pay are traded. Together with financial intermediariesA firm, such as a bank, insurer or fund, that stands between savers and borrowers. such as banks, insurers and funds, markets solve all four problems. Money can travel by two kinds of route:

In direct finance the saver holds a securityA tradable financial claim, such as a bond or a share.: a tradable claim on the borrower. In indirect finance the saver holds a claim on the intermediary, such as a bank deposit. Click through the four routes below and compare what the saver ends up holding.

Job two: spreading risk

Amira lending all her savings to one bakery is fragile. If that one borrower defaultsA borrower's failure to pay what it promised, on time and in full., she loses the lot. Markets let her lend a little to many borrowers instead, often through a bank or fund that does the spreading for her. This is diversificationSpreading money across many investments so that no single failure hurts too much..

Spreading does something subtle. It does not change the average loss you should expect. It changes how bad a bad year can get. Try it: lend the same £10,000 to more and more borrowers.

Markets also let people pass a risk to someone better placed to carry it. An airline worried about fuel prices can lock in a price today with a trader who is happy to take the other side. A homeowner pays an insurer to take on the risk of fire. Risk does not disappear; it moves to whoever charges least to bear it.

Jobs three and four: prices and the exit door

When thousands of buyers and sellers trade, the price they settle on pools what all of them know. This is price discoveryThe way trading between many buyers and sellers settles on a price that reflects what they all know.. A falling bond price tells everyone, at once, that investors have grown worried about the borrower. Lesson L1.1.06 shows how this works trade by trade.

Markets also give savers a way out. Tom's oven takes five years to pay for itself, but if Amira holds a bond rather than a private loan, she can sell it to another investor after two years. The ease of selling quickly at a fair price is called liquidityHow quickly and cheaply something can be turned into cash without moving its price much., and it is the subject of L1.1.07.

Amira has £10,000 to lend. Each borrower she could lend to has a 2% chance of not repaying, independently of the others, and a borrower who defaults repays nothing. Amounts are in pounds over one year. Try each step before revealing it.

Banks sit at the centre of indirect finance and hold ordinary people's deposits, so they are among the most tightly regulated firms in any economy. L1.2.01 looks at how a bank makes money and L1.2.09 at who supervises it. The Basel capital rules met in later levels exist to make sure a bank can absorb a bad year like the one in the worked example.

• Financial markets connect savers, who have spare money now, with borrowers, who want to spend now and pay later.
• Money travels directly, when savers buy a borrower's securities, or indirectly, through banks, insurers and funds.
• Spreading money across many independent borrowers leaves the average loss unchanged but makes a large loss far less likely.
• Markets also move risk to those best placed to carry it, set prices that pool information, and let investors sell when they need cash.
• Each of these jobs creates a risk that later lessons study: credit, market, liquidity and more.

Saver

A person or organisation with more money now than it needs to spend now.

Borrower

A person or organisation that wants to spend more now than it has, and promises to pay later.

Financial market

Any place or system where buyers and sellers trade money and financial claims.

Financial intermediary

A firm, such as a bank, insurer or fund, that stands between savers and borrowers.

Security

A tradable financial claim, such as a bond or a share.

Direct finance

Savers buy securities straight from the borrower, for example by buying its bonds or shares.

Indirect finance

Savers hand money to an intermediary, which then decides where to lend or invest it.

Default

A borrower's failure to pay what it promised, on time and in full.

Diversification

Spreading money across many investments so that no single failure hurts too much.

Price discovery

The way trading between many buyers and sellers settles on a price that reflects what they all know.

Liquidity

How quickly and cheaply something can be turned into cash without moving its price much.