103 : FINANCIAL MARKETS
103: Financial
Markets
Table of Contents
Financial Markets
include any place or system that provides buyers and sellers the means to trade
financial instruments and facilitate the interaction between those who need
capital with those who have capital to invest. Markets play a vital role in
facilitating the smooth operation of capitalist economies by allocating
resources and creating liquidity for businesses and entrepreneurs. The markets
rely heavily on informational transparency to ensure that the set prices that
are efficient and appropriate.
The market prices
of securities may not be indicative of their intrinsic value because of
macroeconomic forces. Participants in the financial markets create value for
their accounts by approximating the intrinsic value through various statistical
techniques, comparing it to the market price and taking a position either to
buy or sell.
An over-the-counter
(OTC) market is a decentralized market in which market participants trade
stocks, commodities, currencies, or other instruments directly between two
parties and without a central exchange or broker. OTC markets do not have
physical locations, instead trading is conducted electronically. In general, OTC markets are typically less
transparent than exchanges and are also subject to fewer regulations. Because
of this, liquidity in the OTC market may come at a premium.
While OTC markets
function well during normal times, there is an additional risk, called a
counter-party risk, that one party in the transaction will default prior to the
completion of the trade or will not make the current and future payments
required of them by the contract. Lack of transparency can also cause a vicious
cycle to develop during times of financial stress.
Perhaps the most popular
of financial markets are stock markets. These are venues where companies list
their shares and they are bought and sold by traders and investors. Stock
markets, or equities markets, are used by companies to raise capital in the
primary market via an initial public offering (IPO), with shares subsequently
traded among various buyers and sellers in what is known as a secondary market.
Most trading in
stocks is done via regulated exchanges, and these play an important role in the
economy as both a gauge of the overall health of the economy as well as
providing capital gains and dividend income to investors, including those with
retirement.
Typical
participants in a stock market include both retail and institutional investors
and traders, as well as market makers and specialists who maintain liquidity
and provide two-sided markets.
Investors will own
company shares in the expectation that share value will rise or that they will
receive dividend payments or both. The stock exchange acts as a facilitator for
this capital-raising process and receives a fee for its services from the
company and its financial partners.
The bond market is
often called the debt market, fixed-income market, or credit market, it is the
collective name given to all trades and issues of debt securities. Governments
typically issue bonds in order to raise capital to pay down debts or fund
infrastructural improvements.
Bonds are either
issued on the primary market, which rolls out new debt, or traded on the
secondary market, in which investors may purchase existing debt via brokers or
other third parties.
Bonds have been
traded far longer than stocks have. Bonds do not trade on a formal exchange but
banks market them through broker-dealer networks and they are also considered
OTC securities.
Typically, the
money markets trade in products with highly liquid short-term maturities and
are characterized by a high degree of safety and a relatively low return in
interest. At the wholesale level, the money markets involve large-volume trades
between institutions and traders. At the retail level, they include money
market mutual funds bought by individual investors and money market accounts
opened by bank customers. Individuals may also invest in the money markets by
buying short-term certificates of deposit (CDs), municipal notes, or treasury bills etc.,
The money market
is one of the pillars of the global financial system. It involves overnight
swaps of vast amounts of money between banks and governments. The majority of
money market transactions are wholesale transactions.
A derivative is a
contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets i.e., index.
Derivatives are secondary securities whose value is solely derived from the
value of the primary security that they are linked to. In and of itself a
derivative is worthless. Rather than trading stocks directly, a derivatives
market trades in futures and options contracts, and other advanced financial
products, that derive their value from underlying instruments like bonds,
commodities, currencies, interest rates, market indexes, and stocks.
Futures markets
are where futures contracts are listed and traded. Unlike forwards, which trade
OTC, futures markets utilize standardized contract specifications, are
well-regulated, and utilize clearinghouses to settle and confirm trades.
Options markets, such as the Chicago Board Options Exchange (CBOE), similarly
list and regulate options contracts. Both futures and options exchanges may
list contracts on various asset classes, such as equities, fixed-income
securities, commodities, and so on
Derivatives can be
a useful tool for businesses and investors alike. They provide a way to do the
following, lock in prices, hedge against unfavorable movements in rates,
mitigate risks
The forex (foreign
exchange) market is the market in which participants can buy, sell, hedge, and
speculate on the exchange rates between currency pairs. The forex market is the
most liquid market in the world, as cash is the most liquid of assets. The forex
market operates 24 hours, 5.5 days a week. The currency market handles more
than $6.6 trillion in daily transactions, which is more than the futures and
equity markets combined.
As with the OTC
markets, the forex market is also decentralized and consists of a global
network of computers and brokers from around the world. The forex market is
made up of banks, commercial companies, central banks, investment management
firms, hedge funds, and retail forex brokers and investors.
The forex market
is made up of two levels: the interbank market and the over-the-counter (OTC)
market.
Real estate
represents a significant portion of most people's wealth. here are a number of
factors that impact real estate prices, availability, and investment potential.
Demographics
provide information on the age, income, and regional preferences of actual or
potential buyers, what percentage of buyers are retirees, and what percentage
might buy a vacation or second home.
Interest rates
impact the price and demand of real estate, lower rates bring in more buyers,
reflecting the lower cost of getting a mortgage, but also expand the demand for
real estate, which can then drive-up prices.
Real estate prices
often follow the cycles of the economy, but investors can mitigate this risk by
buying REITs or other diversified holdings that are either not tied to economic
cycles or that can withstand downturns.
These are the
parties that are involved in the activities that go on in the financial markets
they include
Dealers
Dealers are people
or firms who buy and sell securities for their own account, whether through a
broker or otherwise. Dealers are important figures in the market. They make
markets, underwrite securities, and provide investment services to investors.
That means dealers are the market makers who provide the bid and ask quotes you
see when you look up the price of a security in the over-the-counter market.
They also help create liquidity in the markets and boost long-term growth. A dealer seeks to
profit from the spread between the bid and ask prices, while also adding
liquidity to the market. It neither does business on behalf of a client nor facilitates
transactions between parties.
Broker
A broker is an
individual or firm that acts as an intermediary between an investor and a
securities exchange. Because securities exchanges only accept orders from
individuals or firms who are members of that exchange, individual traders and
investors need the services of exchange members. A broker can also refer to the
role of a firm when it acts as an agent for a customer and charges the customer
a commission for its services.
They are two types
of brokers:
Discount brokers-
execute trades on behalf of a client, but typically don’t provide investment
advice.
Full-service
brokers- provide execution services as well as tailored investment advice and
solutions.
Financial
Advisor
A financial
advisor provides financial advice or guidance to customers for compensation.
Financial advisors can provide many different services, such as investment
management, tax planning, and estate planning. Increasingly, financial advisors
are acting as a "one-stop-shop" by providing everything from
portfolio management to insurance products.
An important
distinction can be made, that is, a financial advisor must actually provide
guidance and advice. A financial advisor can be distinguished from an execution
stockbroker that simply places trades for clients or a tax accountant who
simply prepares tax returns without providing advice on how to maximize tax
advantages. Furthermore, what may pass as a financial advisor in some instances
may simply be a product salesperson, such as a stockbroker or a life insurance
agent. A true financial advisor should be a well-educated, credentialed,
experienced, financial professional who works on behalf of their clients, as
opposed to serving the interests of a financial institution by maximizing the
sales of certain products or capitalizing on commissions from sales.
Investors
There are many
different investors that are active in the marketplace. In fact, the vast
majority of the money that is at work in the markets belongs to investors Major
investors include:
Investment
Banks
Investment banks
are organizations that assist companies in going public and raising money. This
often involves holding at least a portion of the securities over the long term.
Mutual
Funds
Many individuals
keep their money in mutual funds, which make long-term investments in companies
that meet specific criteria. Mutual funds are required by law to act as
investors, not traders.
Institutional
Investors
These are large organizations or persons that
hold large stakes in companies. Institutional investors often include company
insiders, competitors hedging themselves and special opportunity investors.
Retail
Investors
Retail investors
are individuals that invest in the stock market for their personal accounts. At
first, the influence of retail traders may seem small, but as time passes more
people are taking control of their portfolios and, as a result, the influence
of this group is increasing.
Investors
generally focus on the following investment styles:
Investing - those
who buy securities primarily to earn a regular income from such investment and
possibly make some long-term gain on account of price rise in future are called
investors. They take delivery of the securities and make full payment of the
price. Such transactions are called investment transactions.
Speculating -when
the securities are bought with the sole object of selling them in future at
higher prices or these are sold now with the intention of buying at a lower
price in future, are called speculation transactions. The main objective of
such transactions is to take advantage of price differences at different times.
Hedging -simply
means a reduction of risk, enclosing a position in order to restrain it from
risky factors/influences coming from current market situation. A Hedger would
usually strive at reducing the exposure of his/her position to price volatility
and in a derivative market, would enter into a position, which is opposite to
the risk he takes. Hedgers use different derivative strategies in order to
reduce or eliminate price risk.
Arbitrageurs-
usually participate in an extremely rapid environment, with decisions being
made at the blink of an eye, literally. Sometimes the price of a share in the
spot market may be below or may exceed its price in the derivatives market.
Arbitrageurs usually look to dispose of such imperfections and inefficiencies
in the market. They also play a key role in increasing markets liquidity.
Trader
Traders are market
participants who purchase shares in a company with a focus on the market itself
rather than the company's fundamentals. Markets that trade commodities lend
themselves well to traders. After all, very few people purchase wheat because
of its fundamental quality: they do so to take advantage of small price
movements that occur as a result of supply and demand.
Traders typically
concern themselves with price patterns, supply and demand, market emotion and client
services. Ultimately, it is traders that provide liquidity for investors and
always take the other end of their trades. Whether it is through market-making
or fading, traders are a necessary part of the marketplace.
Regulators
Regulatory bodies
are established by governments or other organizations to oversee the
functioning and fairness of financial markets and the firms that engage in
financial activity. The goal of regulation is to prevent and investigate fraud,
keep markets efficient and transparent, and make sure customers and clients are
treated fairly and honestly.
How Do Financial
Markets Work?
Despite covering
many different asset classes and having various structures and regulations, all
financial markets work essentially by bringing together buyers and sellers in
some asset or contract and allowing them to trade with one another. This is
often done through an auction or price-discovery mechanism.
What Are the Main
Functions of Financial Markets?
Financial markets
exist for several reasons, but the most fundamental function is to allow for
the efficient allocation of capital and assets in a financial economy. By
allowing a free market for the flow of capital, financial obligations, and
money the financial markets make the global economy run more smoothly while
also allowing investors to participate in capital gains over time.
Why Are Financial
Markets Important?
Without financial
markets, capital could not be allocated efficiently, and economic activity such
as commerce and trade, investments, and growth opportunities would be greatly
diminished.
Who Are the Main
Participants in Financial Markets?
Firms use stock
and bond markets to raise capital from investors. Speculators look to various
asset classes to make directional bets on future prices, while hedgers use derivatives
markets to mitigate various risks, and arbitrageurs seek to take advantage of
mispricing or anomalies observed across various markets. Brokers often act as
mediators that bring buyers and sellers together, earning a commission or fee
for their services.
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