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2.1 Financial markets: functions and participants 34 2.2 Trading mechanisms 36 2.3 Industrial organization of financial markets 41 2.4 Trading and asset prices in a call market 45 2.5 Bid–ask spreads: inventory-based models 48 2.6 Bid–ask spreads: information-based models 49 2.7 Summary 52 References 54 ix. One aspect of the financial markets, and far from the most important one. There were financial markets long before there were exchanges and, in fact, long before there was organised trading of any sort. Guide to Financial Markets.indd 1 14:14.

A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Securities include stocks and bonds, and precious metals.

The term 'market' is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (such as the NYSE, LSE, JSE, BSE) or an electronic system (such as NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, to stock exchanges.

• 2Raising capital
  • 2.1Lenders
• 7Components of financial market

Types of financial markets[edit]

Within the financial sector, the term 'financial markets' is often used to refer just to the markets that are used to raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another common use of the term is as a catchall for all the markets in the financial sector, as per examples in the breakdown below.

• Capital markets which consist of:
  • Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.
  • Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.
• Commodity markets, which facilitate the trading of commodities.
• Money markets, which provide short term debt financing and investment.
• Derivatives markets, which provide instruments for the management of financial risk.^[1]
• Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market.
• Foreign exchange markets, which facilitate the trading of foreign exchange.
• Cryptocurrency market which facilitate the trading of digital assets and financial technologies.

The capital markets may also be divided into primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets allow investors to buy and sell existing securities. The transactions in primary markets exist between issuers and investors, while secondary market transactions exist among investors.

Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold without a loss of value. Securities with an active secondary market mean that there are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount.

Raising capital[edit]

Financial markets attract funds from investors and channel them to corporations—they thus allow corporations to finance their operations and achieve growth. Money markets allow firms to borrow funds on a short term basis, while capital markets allow corporations to gain long-term funding to support expansion (known as maturity transformation).

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages.

More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

The following table illustrates where financial markets fit in the relationship between lenders and borrowers:

Lenders[edit]

The lender temporarily gives money to somebody else, on the condition of getting back the principal amount together with some interest or profit or charge.

Individuals and doubles[edit]

Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:

• Puts money in a savings account at a bank
• Contributes to a pension plan
• Pays premiums to an insurance company
• Invests in government bonds

Companies[edit]

Companies tend to be lenders of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets. Alternatively, such companies may decide to return the cash surplus to their shareholders (e.g. via a share repurchase or dividend payment).

Borrowers[edit]

• Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase.
• Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion.
• Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalized industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).

Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed, the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council.

Public Corporations typically include nationalized industries. These may include the postal services, railway companies and utility companies.

Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.

Borrowers having similar needs can form into a group of borrowers. They can also take an organizational form like Mutual Funds. They can provide mortgage on weight basis. The main advantage is that this lowers the cost of their borrowings.

Derivative products[edit]

During the 1980s and 1990s, a major growth sector in financial markets was the trade in so called derivatives.

In the financial markets, stock prices,share prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk.^[2] It is also called financial economics.

Derivative products or instruments help the issuers to gain an unusual profit from issuing the instruments. For using the help of these products a contract has to be made. Derivative contracts are mainly 4 types:^[3]

1. Future
2. Forward
3. Option
4. Swap

Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past,^[when?] when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements.^[4]

The picture of foreign currency transactions today shows:

• Banks/Institutions
• Speculators
• Government spending (for example, military bases abroad)
• Importers/Exporters
• Tourists

Analysis of financial markets[edit]

See Statistical analysis of financial markets, statistical finance

Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of 'technical analysis' is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change. The role of human psychology in price variations also plays a significant factor. Large amounts of volatility often indicate the presence of strong emotional factors playing into the price. Fear can cause excessive drops in price and greed can create bubbles. In recent years the rise of algorithmic and high-frequency program trading has seen the adoption of momentum, ultra-short term moving average and other similar strategies which are based on technical as opposed to fundamental or theoretical concepts of market Behaviour.

The scale of changes in price over some unit of time is called the volatility.It was discovered by Benoit Mandelbrot that changes in prices do not follow a normal distribution, but are rather modeled better by Lévy stable distributions. The scale of change, or volatility, depends on the length of the time unit to a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate using a normal distribution with an estimated standard deviation.

Financial market slang[edit]

• Poison pill, when a company issues more shares to prevent being bought out by another company, thereby increasing the number of outstanding shares to be bought by the hostile company making the bid to establish majority.
• Bips, meaning 'bps' or basis points. A basis point is a financial unit of measurement used to describe the magnitude of percent change in a variable. One basis point is the equivalent of one hundredth of a percent. For example, if a stock price were to rise 100bit/s, it means it would increase 1%.
• Quant, a quantitative analyst with advanced training in mathematics and statistical methods.
• Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill. They are able to invent derivatives of high complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training.
• IPO, stands for initial public offering, which is the process a new private company goes through to 'go public' or become a publicly traded company on some index.
• White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one organization to help prevent against a hostile takeover of that organization by another party.
• Smurfing, a deliberate structuring of payments or transactions to conceal it from regulators or other parties, a type of money laundering that is often illegal.
• Bid–ask spread, the difference between the highest bid and the lowest offer.
• Pip, smallest price move that a given exchange rate makes based on market convention. ^[5]
• Pegging, when a country wants to obtain price stability, it can use pegging to fix their exchange rate relative to another currency. ^[6]

Functions of financial markets[edit]

• Intermediary functions: The intermediary functions of financial markets include the following:
  • Transfer of resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers.
  • Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income.
  • Productive usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production.
  • Capital formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country.
  • Price determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in the economy based on the demand and to the supply through the mechanism called price discovery process.
  • Sale mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets.
  • Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets.
• Financial Functions
  • Providing the borrower with funds so as to enable them to carry out their investment plans.
  • Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures.
  • Providing liquidity in the market so as to facilitate trading of funds.
  • Providing liquidity to commercial bank
  • Facilitating credit creation
  • Promoting savings
  • Promoting investment
  • Facilitating balanced economic growth
  • Improving trading floors

Components of financial market[edit]

Based on market levels[edit]

• Primary market: Primary market is a market for new issues or new financial claims. Hence it’s also called new issue market. The primary market deals with those securities which are issued to the public for the first time.
• Secondary market: A market for secondary sale of securities. In other words, securities which have already passed through the new issue market are traded in this market. Generally, such securities are quoted in the stock exchange and it provides a continuous and regular market for buying and selling of securities.

Simply put, primary market is the market where the newly started company issued shares to the public for the first time through IPO (initial public offering). Secondary market is the market where the second hand securities are sold (securitCommodity Marketies).

Based on security types[edit]

• Money market: Money market is a market for dealing with the financial assets and securities which have a maturity period of up to one year. In other words, it’s a market for purely short-term funds.
• Capital market: A capital market is a market for financial assets which have a long or indefinite maturity. Generally, it deals with long-term securities which have a maturity period of above one year. The capital market may be further divided into (a) industrial securities market (b) Govt. securities market and (c) long-term loans market.
  • Equity markets: A market where ownership of securities are issued and subscribed is known as equity market. An example of a secondary equity market for shares is the New York (NYSE) stock exchange.
  • Debt market: The market where funds are borrowed and lent is known as debt market. Arrangements are made in such a way that the borrowers agree to pay the lender the original amount of the loan plus some specified amount of interest.
• Derivative markets: A market where financial instruments are derived and traded based on an underlying asset such as commodities or stocks.
• Financial service market: A market that comprises participants such as commercial banks that provide various financial services like ATM. Credit cards. Credit rating, stock broking etc. is known as financial service market. Individuals and firms use financial services markets, to purchase services that enhance the workings of debt and equity markets.
• Depository markets: A depository market consists of depository institutions (such as banks) that accept deposits from individuals and firms and uses these funds to participate in the debt market, by giving loans or purchasing other debt instruments such as treasury bills.
• Non-depository market: Non-depository market carry out various functions in financial markets ranging from financial intermediary to selling, insurance etc. The various constituencies in non-depositary markets are mutual funds, insurance companies, pension funds, brokerage firms etc.

Forecasting Financial Markets Pdf

See also[edit]

Notes[edit]

1. ^'Understanding Derivatives: Markets and Infrastructure - Federal Reserve Bank of Chicago'. chicagofed.org. Retrieved 2017-12-12.
2. ^Robert E. Wright and Vincenzo Quadrini. Money and Banking: “Chapter 2, Section 4: Financial Markets.” pp. 3 [1] Accessed June 20, 2012
3. ^Khader Shaik (23 September 2014). Managing Derivatives Contracts: A Guide to Derivatives Market Structure, Contract Life Cycle, Operations, and Systems. Apress. p. 23. ISBN978-1-4302-6275-6.
4. ^Steven Valdez, An Introduction To Global Financial Markets
5. ^Momoh, Osi (2003-11-25). 'Pip'. Investopedia. Retrieved 2017-12-12.
6. ^Law, Johnathan (2016). 'Pegging'. A dictionary of business and management. Oxford University Press. ISBN9780199684984. OCLC950964886.

References[edit]

• T.E. Copeland, J.F. Weston (1988): Financial Theory and Corporate Policy, Addison-Wesley, West Sussex (ISBN978-0321223531)
• E.J. Elton, M.J. Gruber, S.J. Brown, W.N. Goetzmann (2003): Modern Portfolio Theory and Investment Analysis, John Wiley & Sons, New York (ISBN978-0470050828)
• E.F. Fama (1976): Foundations of Finance, Basic Books Inc., New York (ISBN978-0465024995)
• Marc M. Groz (2009): Forbes Guide to the Markets, John Wiley & Sons, Inc., New York (ISBN978-0470463383)
• R.C. Merton (1992): Continuous-Time Finance, Blackwell Publishers Inc. (ISBN978-0631185086)
• Keith Pilbeam (2010) Finance and Financial Markets, Palgrave (ISBN978-0230233218)
• Steven Valdez, An Introduction To Global Financial Markets, Macmillan Press Ltd. (ISBN0-333-76447-1)
• The Business Finance Market: A Survey, Industrial Systems Research Publications, Manchester (UK), new edition 2002 (ISBN978-0-906321-19-5)

External links[edit]

• Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial Markets Group

Make Financial Markets Work for You

What are the financial markets? It can be confusing because they go by many terms. They include capital markets, Wall Street, and even simply 'the markets.” Whatever you call them, financial markets are where traders buy and sell assets. These include stocks, bonds, derivatives, foreign exchange, and commodities. The markets are where businesses go to raise cash to grow. It’s where companies reduce risks and investors make money.

Types of Financial Markets

Financial Markets Pdf Free Download

The Stock Market is a series of exchanges where successful corporations go to raise large amounts of cash to expand. Stocks are shares of ownership of a public corporation that are sold to investors through broker-dealers. The investors profit when the companies increase their earnings. This keeps the U.S. economy growing. It's easy to buy stocks, but it takes a lot of knowledge to buy stocks in the right company.

To a lot of people, the Dow is the stock market. The Dow--the nickname for the Dow Jones Industrial Average--is just one way of tracking the performance of a group of stocks. There is also the Dow Jones Transportation Average and the Dow Jones Utilities Average. Many investors ignore the Dow and instead focus on the S&P 500 or other indices to track the progress of the stock market. The stocks that make up these averages are traded on the world's stock exchanges, two of which include the New York Stock Exchange and the NASDAQ.

How the stock market works depends on the actions and decisions of both buyers and sellers concerning their perceptions on profitabilities of the companies being traded.

Mutual funds give you the ability to buy a lot of stocks at once. In a way, this makes them an easier tool to invest in than individual stocks. By reducing stock market volatility, they have also had a calming effect on the U.S. economy. Despite their benefits, you still need to learn how to select a good mutual fund.

The Bond Market is where organizations go to obtain very large loans. When stock prices go up, bond prices go down. There are many different types of bonds, including Treasury Bonds, corporate bonds, and municipal bonds. Bonds also provide some of the liquidity that keeps the U.S. economy functioning smoothly.

It's important to understand the relationship between Treasury bonds and Treasury bond yields. When Treasury bond values go down, the yields go up to compensate. When Treasury yields rise, so do mortgage interest rates. Even worse, when Treasury values decline, so does the value of the dollar. This makes import prices rise, which can trigger inflation. Treasury yields can also predict the future. For example, an inverted yield curve heralds a recession.

The Commodities Market is where companies offset their futures risks when buying or selling natural resources. Since the prices of things like oil, corn, and gold are so volatile, companies can lock in a known price today. Since these exchanges are public, many investors also trade in commodities for profit only. They have no intention of purchasing large quantities of pork bellies, for example.

Oil is the most important commodity in the U.S. economy. It is used for transportation, industrial products, plastics, heating, and electricity generation. When oil prices rise, you'll see the effect in gas prices about a week later. If oil and gas prices stay high, you'll see the impact on food prices in about six weeks.

The commodities futures market determines the price of oil. What are futures? They are a way to pay for something today that is delivered tomorrow. This removes some of the volatility in the U.S. economy. It allows businesses to control future costs of the critical commodities they use every day.

Futures also increase a trader's leverage by allowing him or her to borrow the money to purchase the commodity. This leverage can create outsize gains if traders guess right. It also magnifies the losses if traders guess wrong. If enough traders guess wrong, it can have a huge impact on the U.S. economy, actually increasing overall volatility. Commodities trading was responsible for record-high oil prices in 2008 and 2011, which resulted in food riots and even the Arab Spring.

Another important commodity is gold. It's bought as a hedge against inflation. Gold prices also go up when there is a lot of economic uncertainty in the world. In the past, every dollar could be traded in for its value in gold. However, when the U.S. went off the gold standard, it lost this relationship to money. Still, many people look at gold as a safer alternative to cash or currency.

Derivatives are complicated financial products that base their value on underlying assets. Sophisticated investors and hedge funds use them to magnify their potential gains. In 2007, hedge funds increased in popularity due to their supposed higher returns for high-end investors. Since hedge funds invest heavily in futures, some argued they decreased the volatility of the stock market and, therefore, the U.S. economy. The hedge fund investments in subprime mortgages and other derivatives caused the 2008 global financial crisis.

Even before this, hedge funds had demonstrated their risky nature. In 1997, the world's largest hedge fund at the time, Long Term Capital Management, practically brought down the U.S. economy.

Forex Trading is a decentralized global market in which currencies are bought and sold. More than $5.3 trillion are traded per day, and 87 percent involves the U.S. dollar. Almost one-fourth of the trades are done by banks for their customers to reduce the volatility of doing business overseas. Hedge funds are responsible for another 11 percent, and some of it is speculative. This market affects exchange rates and, thus, the value of the dollar and other currencies. Exchange rates work on the basis of demand and supply of a nation’s currency, as well as of that nation’s economic and financial stability.

Functions of Financial Markets

Financial markets create an open and regulated system for companies to acquire large amounts of capital. This is done through the stock and bond markets. Markets also allow these businesses to offset risk. They do this with commodities, foreign exchange futures contracts, and other derivatives.

Since the markets are public, they provide an open and transparent way to set prices on everything traded. They reflect all available knowledge about everything traded. This reduces the cost of obtaining information because it's already incorporated into the price.

The sheer size of the financial markets provides liquidity. In other words, sellers can unload assets whenever they need to raise cash. The size also reduces the cost of doing business. Companies don't have to go far to find a buyer or someone willing to sell.