Financial Markets Operations Management

CHAPTER 4 Market Participation

4.1 INTRODUCTION

In the financial world, there is a relationship between those entities that require funds and those that have funds. We can refer to these entities as borrowers and lenders respectively.

Q&A

Question

Why might borrowers and lenders find it difficult to deal directly with each other?

Answer

There are three main reasons for this:

1. Size: Lenders tend to have smaller amounts of funds available to lend whereas borrowers require much larger amounts of funds.
2. Maturity: Lenders tend to have deposit or savings accounts on a “demand” basis (i.e. at call) whereas borrowers require funds across a maturity range that starts at call and ends at long term (e.g. for 25 years or more).
3. Risk: Lenders are exposed to the risk that borrowers may not be willing or able to repay amounts of borrowed funds. This is known as credit risk and can result in lenders losing all of their funds. Furthermore, lenders may not be able to assess the credit risk of existing and potential borrowers.

For these reasons, there will be a number of intermediaries that stand between the lenders and borrowers and help to transform the size of loans from small to large, transform the short-term wishes of the lenders into the longer-term needs of the borrowers and, finally, provide the ability to diversify the credit risk of the borrowers.

These relationships are shown in Figure 4.1 and we will discuss these in subsequent sections of this chapter.

FIGURE 4.1 ...