Financial Markets

In economics, a financial market is a mechanism which allows people to trade, normally governed by the theory of supply and demand, and thereby allocates resources through a price mechanism. It typically involves a bid and ask process.

Financial Markets

In economics, a financial market is a mechanism which allows people to trade, normally governed by the theory of supply and demand, and thereby allocates resources through a price mechanism. It typically involves a bid and ask process.

Both general markets (where many commodities are traded) and specialised markets (where only one commodity is traded) exist. Markets work by placing many interested sellers in one "place", thus making them easier to find for prospective buyers. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy that is based, e.g., on gifts.

Financial markets facilitate:
The raising of capital (in the capital markets);
The transfer of risk (in the derivatives markets); and
International trade (in the currency markets).

They are used to match those who want capital to those who have it.

Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends.

Contents:
1 Definition
2 Types of financial markets
3 Raising capital
3.1 Lenders
3.2 Borrowers
4 Derivative products
5 Currency markets
6 Financial markets in popular culture
6.1 Financial markets slang
7 References

Definition

The term Financial markets can be a cause of much confusion.

Financial markets could mean:

1. organisations that facilitate the trade in financial products. i.e. Stock exchanges facilitate the trade in stocks, bonds and warrants.

2. the coming together of buyers and sellers to trade financial products. i.e. stocks and shares are traded between buyers and sellers in a number of ways including: the use of stock exchanges; directly between buyers and sellers etc.

In academia, students of finance will use both meanings but students of economics will only use the second meaning.

Financial markets can be domestic or they can be international.

Types of financial markets

The financial markets can be divided into different subtypes: 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.
Futures markets, which provide standardised forward contracts for trading products at some future date; see also forward market.
Insurance markets, which facilitate the redistribution of various risks.
Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.

Raising capital

To understand financial markets, let us look at what they are used for, i.e. what is their purpose?

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks 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:
Relationship between lenders and borrowers Lenders Financial Intermediaries Financial Markets Borrowers Individuals Companies Banks Insurance Companies Pension Funds Mutual Funds Interbank Stock Exchange Money Market Bond Market Foreign Exchange Individuals Companies Central Government Municipalities Public Corporations

Lenders

Individuals do not think of themselves as lenders but they lend to other parties in many ways. Lending activities may be:
putting money in a savings account at a bank;
contributing to a pension plan;
paying premiums to an insurance company;
investing in government bonds; or
investing in company shares.

Companies tend to be borrowers 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.

There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks.)

Borrowers

Individuals borrow money via bank 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 modernisation 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 nationalised industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the public sector borrowing requirement (PSBR).

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 nationalised 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.

Derivative products

During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short.

In the financial markets, stock 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.

Currency markets

see Foreign exchange market

Seemingly, the most obvious buyers and sellers of foreign exchange are importers/exporters. This may be true in the distant past whereby importers/exporters created the initial demand for currency markets. Importers and exporters now represent only 1/32 of foreign exchange dealing, according to BIS.

The picture of foreign currency transactions today shows:
Banks and Institutions
Speculators
Government spending (for example, military bases abroad)
Importers/Exporters
Tourists

Financial markets in popular culture

Gordon Gekko is a famous caricature of a rogue financial markets operator, famous for saying "greed ... is good".

Only negative stories about financial markets tend to make the news. The general perception, for those not involved in the world of financial markets is of a place full of crooks and con artists. Big stories like the Enron scandal serve to enhance this view.

Stories that make the headlines involve the incompetent, the lucky and the downright skilful. The Barings scandal is a classic story of incompetence mixed with greed leading to dire consequences. Another story of note is that of Black Wednesday, when sterling came under attack from hedge fund speculators. This led to major problems for the United Kingdom and had a serious impact on its course in Europe. A commonly recurring event is the stock market bubble, whereby market prices rise to dizzying heights in a so called exaggerated bull market. This is not a new phenomenon; indeed the story of Tulip mania in the Netherlands in the 17th century illustrates an early recorded example.

Financial markets are merely tools. Like all tools they have both beneficial and harmful uses. Overall, financial markets are used by honest people. Otherwise, people would turn away from them en masse. As in other walks of life, the financial markets have their fair share of rogue elements.

Financial markets slang

Big swinging dick, a highly successful financial markets trader. The term was made popular in the book Liar's Poker, by Michael Lewis

Geek, a Quant

Nerd, a Quant

Quant, a quantitative analyst skilled in the black arts of Phd level (and above) 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 frightening 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; rocket scientists do not necessarily build rockets for a living.

References

An Introduction To Global Financial Markets, Steven Valdez, Macmillan Press Ltd. (ISBN 0333764471)

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