Financial Markets PDF

**CHAPTER 4** **FINANCIAL MARKETS** Learning Objectives: At the end of this chapter the students are able to: 1. Identify the types of markets and regulations; 2. Differentiate organized and over-the-counter market, secondary and primary market; and 3. Define and determine the types of...

**CHAPTER 4** **FINANCIAL MARKETS** Learning Objectives: At the end of this chapter the students are able to: 1. Identify the types of markets and regulations; 2. Differentiate organized and over-the-counter market, secondary and primary market; and 3. Define and determine the types of equity securities, debt securities, foreign exchange and derivatives **Definition of Market** A market is a means by which the [exchange](https://www.britannica.com/topic/barter-trade) of goods and services takes place as a result of buyers and sellers being in contact with one another, either directly or through mediating agents or institutions. **Types of Markets** Markets vary widely for several reasons, including the kinds of products sold, location, duration, and size. The constituency of the customer base, size, legality, and other factors are equally influential. **1.Organized Market** An organized market, also known as an exchange, is a formal market in a specific place in which buyers and sellers meet to trade according to agreed rules and procedures. Stock exchanges, financial futures exchanges, and commodity markets are examples of organized markets. The prices of securities are decided by the market demand and supply forces. The market operator defines the rules, authorizes membership, organizes, and supervises trading, and ensures the proper functioning of the market and its technical facilities. It can be a physical trading location such as premises, etc. or it can be an electronic platform. Participation in an organized market is limited to market members who are authorized by the market operator to trade directly. It was established with the aim of governing the trade of securities by the general public and companies. Organizational markets are markets in which companies and individuals purchase goods for purposes other than personal consumption. **2. Over-the-Counter Market** 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. Over-the-counter markets do not have physical locations; instead, trading is conducted electronically. In an OTC market, dealers act as market-makers by quoting prices at which they will buy and sell a security, currency, or other financial products. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was completed. **Nature of OTC market:** - Limited Liquidity Sometimes the securities being traded over-the-counter lack buyers and sellers. As a result, the value of a security may vary widely depending on which market markers trade the stock. Additionally, it makes it potentially dangerous if a buyer acquires a significant position in a stock that trades over-the-counter should they decide to sell it at some point in the future. The lack of liquidity could make it difficult to sell in the future. - Risks of Over-the-Counter Markets While OTC markets function well during normal times, there is an additional risk, called a [counter-party risk](https://www.investopedia.com/terms/c/counterpartyrisk.asp), 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, as was the case during the 2007--08 global credit crisis. Mortgage-backed securities and other derivatives such as [CDOs](https://www.investopedia.com/terms/c/cdo.asp) and [CMOs](https://www.investopedia.com/terms/c/cmo.asp), which were traded solely in the OTC markets, could not be priced reliably as liquidity totally dried up in the absence of buyers. This resulted in an increasing number of dealers withdrawing from their market-making functions, exacerbating the liquidity problem, and causing a worldwide credit crunch. Among the regulatory initiatives undertaken in the aftermath of the crisis to resolve this issue was the use of clearinghouses for post-trade processing of OTC trades. **Difference Between Organized and OTC** -------------------------- --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- **Feature** **Organized** **Over-the-Counter (OTC)** Purpose The primary purpose is to provide a regulated and centralized platform for the trading of financial securities, commodities, or other assets. It aims to facilitate efficient and transparent transactions among market participants. The primary purpose of the OTC market is to allow for the trading of financial instruments directly between buyers and sellers without the need for a centralized exchange. It provides flexibility for trading a wide range of financial assets Regulation and Structure Organized markets are highly regulated and have a well-defined structure.They often have a centralized exchange or platform where trading occurs. The OTC market is less regulated. Trades are conducted directly between two parties without the need for a centralized exchange. Standardization In organized markets, there is often a high degree of standardization in terms of contract sizes, delivery methods, and other trading parameters. This helps to create a level playing field for participants. OTC markets often involve customized contracts. This means that terms and conditions of trades can be negotiated directly between the buyer and seller, leading to more flexibility but potentially less transparency. Transparency Prices and trading information are typically highly transparent. This means that participants can readily access information and ask prices, trade volumes, and historical data. The OTC market tends to be less transparent compared to organized markets. Information about prices and trade volumes may not be as readily available to the public. Market Surveillance There is a strong emphasis on market surveillance and regulatory oversight in organized markets. This is done to prevent market manipulation, fraud, and other forms of misconduct. Since OTC trades are private agreements between two parties, there is less regulatory oversight and surveillance. This can lead to a higher risk of market manipulation and fraud. Participants Participants in organized markets are usually institutional investors, such as mutual funds, pension funds, and hedge funds. Individual retail investors also participate but to a lesser extent. OTC markets cater to a wide range of participants, including institutional investors, corporations, and individual retail investors. It\'s particularly common for debt securities, derivatives, and foreign exchange to be traded OTC. -------------------------- --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- **3. Primary Market** The primary market is where securities are created. It is in this market that firms sell ([float](https://www.investopedia.com/terms/f/float.asp)) new stocks and bonds to the public for the first time. It\'s often referred to as the \"new issue market\".An initial public offering, or IPO, is an example of a primary market. These trades provide an opportunity for investors to buy securities from the bank that did the initial underwriting for a particular stock. A company\'s equity capital is comprised of the funds generated by the sale of stock on the primary market. Example: A company ABCWXYZ Inc. hires five underwriting firms to determine the financial details of its IPO. The underwriter details that the issue price of the stock will be \$15. Investors can then buy the IPO at this price directly from the issuing company.  **4. Secondary Market** Secondary market is where existing securities that have already been issued in the primary market are bought and sold among investors. It\'s often called the \"aftermarket\". In the debt markets, while a bond is guaranteed to pay its owner the full par value at maturity, this date is often many years down the road. Instead, bondholders can sell bonds on the secondary market for a tidy profit if interest rates have decreased since the issuance of their bond, making it more valuable to other investors due to its relatively higher coupon rate. Example: If you go to buy Amazon ([AMZN](https://www.investopedia.com/markets/quote?tvwidgetsymbol=amzn)) stock, you are dealing only with another investor who owns shares in Amazon. Amazon is not directly involved with the transaction. **Two specialized categories of Secondary Market:** 1\. Auction Markets In the [auction market](https://www.investopedia.com/terms/a/auctionmarket.asp), all individuals and institutions that want to trade securities congregate in one area and announce the prices at which they are willing to buy and sell. These are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. 2\. Dealer Markets A [dealer market](https://www.investopedia.com/terms/d/dealersmarket.asp) does not require parties to converge in a central location. Rather, participants in the market are joined through electronic networks. The dealers hold an inventory of security, and then stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities. The theory is that competition between dealers will provide the best possible price for investors. **Difference Between Primary and Secondary Market** --------------------- --------------------------------------------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------------------------------------------------------- **Feature** **Primary Market** **Secondary Market** Purpose Its primary purpose is to raise capital for companies by issuing new securities. Provides liquidity to investors. It offers a platform for investors to buy and sell existing securities, providing a way to exit or enter investments. Regulation Highly regulated to ensure fair and transparent issuance of securities. Regulatory bodies oversee the process to protect investors. Also regulated, but often less so compared to the primary market. Regulatory focus is on maintaining market integrity and investor protection. Ownership Transfer Involves the transfer of ownership from the company to investors. Ownership transfers occur between investors; the issuing company is not directly involved. Price Determination Prices are typically determined through negotiations between the issuing company and underwriters, often based on the company\'s valuation. Prices are determined by supply and demand dynamics among investors and are influenced by market forces. Participants Participants include the issuing company, investment banks, underwriters, and initial investors. Participants include individual and institutional investors, stock exchanges, and broker-dealers. --------------------- --------------------------------------------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------------------------------------------------------- **WHAT IS MARKET REGULATION?** Market regulation is often controlled by the government and involves determining who can enter the market and the prices they may charge. The government body\'s primary function in a market economy is to regulate and monitor the financial and [economic](https://www.investopedia.com/ask/answers/regulating-economy.asp) system. Regulations include rules regarding how goods and services can be marketed; what rights consumers have to demand refunds or replacements; safety standards for products, workplaces, food, and drugs; mitigation of environmental and social impacts; and the level of control a given participant is allowed to assume over a market. **TYPES OF MARKET REGULATIONS** **1.Price Regulation** Regulators can set a maximum price that monopolies can charge. Regulators set a price that is below the inflation rate, forcing firms to become more efficient if they are to continue to make profit. This ensures that firms pass the efficiency gains onto consumers. **2**. **Profit Regulation** Instead of regulating prices, regulators can control the maximum level of profits. In the US, this is known as the 'rate of return' regulation. Prices are set to allow firms to cover their operating costs and earn a 'fair' rate of return based on the capital employed. It is used to prevent firms from setting too high prices and it encourages them to invest. However, firms could employ too much capital and allow it to depreciate so that regulators can increase rates. Additionally, firms do not earn more if their costs are reduced, thus it provides little incentive for firms to reduce costs and improve efficiency. **3.Quality Standards and Performance Targets** Regulators can establish quality standards to ensure that consumers are not exploited through poor-quality goods and services. Regulators can also impose different targets on firms ranging from price, quantity, consumer rights, and cost of production. This can help firms improve their service towards consumers and gain more consumers. In practice, this could lead to firms meeting their targets, but not improving. **4**. **Merging Policies** To prevent the abuse of monopoly power, regulators can stop monopolies from forming in the first place. Regulators do this by blocking mergers and takeovers or by forcing a monopoly to demerge. By blocking mergers and takeovers, regulators prevent firms from gaining monopoly power and prevent consumers from getting exploited. By forcing firms to demerge, regulators promote more competition within a market and eliminate monopolies. **EQUITY SECURITIES: DEBT SECURITIES: FOREX AND DERIVATIVES** **EQUITY SECURITIES** It represents ownership in a company. These securities are also known as stocks or shares. When an individual or entity purchases equity securities, they become a partial owner of the company and have the potential to participate in its profits and losses. It is used to provide investors with an opportunity to invest in companies and share in the profits as the company grows. Equity securities also allow companies to raise capital by selling shares to public or private investors. **Types of Equity Securities** 1. Common stock- Common stockholders have ownership rights in the company and typically have voting rights, allowing them to participate in corporate decisions and elect the company\'s board of directors.They may receive dividends if the company chooses to distribute profits to shareholders, though dividends are not guaranteed. In the event of liquidation or bankruptcy, common shareholders have lower priority compared to creditors and preferred shareholders in accessing the company\'s assets. 2. 3. Convertible securities- which are debt securities that can be converted into common stock at a certain price or ratio. **DEBT SECURITIES** It represents loans made by investors to entities issuing the securities. These securities are also known as bonds or fixed-income securities. When an individual or entity purchases debt securities, they lend money to the issuer and receive periodic interest payments and the return of principal at maturity. Debt securities provide a fixed income stream to investors and allow entities to raise capital by borrowing from the market. They provide a means for governments, corporations, and other entities to finance their projects, operations, or expansion plans. **Types of Debt Securities** 1. Government Bonds - A government bond is a debt security issued by a government to support government spending and obligations. Government bonds can pay periodic interest payments called coupon payments. Government bonds issued by national governments are often considered low-risk investments since the issuing government backs them. 2. Corporate Bonds- A corporate bond is a type of debt security issued by a corporation and sold to investors. The company gets the capital it needs and in return, the investor is paid a pre-established number of interest payments at either a fixed or variable interest rate. 3. Commercial Paper - Short-term, unsecured debt issued by corporations to raise capital for operational needs. 4. Treasury Bills - Treasury bills are debt instruments issued by governments, typically with maturities of one year or less. They are issued at a discount to their face value, which means they are sold for less than their eventual repayment amount. The difference between the purchase price and the face value represents the interest earned by investors. **FOREX (Foreign Exchange)** It refers to the trading of different currencies in the global marketplace. It involves the buying and selling of currencies to profit from the fluctuations in exchange rates. The purpose of forex trading is to facilitate international trade and investment, as well as to speculate on currency exchange rate movements. It allows individuals, businesses, and financial institutions to convert one currency into another for various purposes. **Structure of Forex Market** Forex Market structure explains that operations are segregated into two levels: 1. Interbank Market - it is where large banks trade currencies for the purposes such as hedging, balance sheet adjustments, and on behalf of clients. 2. Over-the-counter (OTC) Market - it id where companies, individuals, investors trade on foreign currencies using online platforms and brokers. **DERIVATIVES** This are financial instruments whose value is derived from an underlying asset or benchmark. They are contracts between two or more parties, based on the future price movements of the underlying asset. The commonly used assets are stocks, bonds, currencies, commodities, and market indices. The two main purpose of derivatives are: 1. To **hedge** - using derivatives for the objective of minimizing risk in the physical market 2. To **speculate** - speculation on derivatives is motivated by profit, rather than desire to mitigate risk. **Types of Derivatives** 1. Forwards - A forward contract is an agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today. However, forwards contracts are over-the-counter products, which means they are not regulated and are not bound by specific trading rules and regulations. 2. Futures - Similar to forward contracts, futures are agreements to buy or sell an asset at a future date. However, they are standardized and traded on organized exchanges. 3. Options - Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specific price (referred to as the strike price) during a specific period. 4. Swaps - Swaps are agreements between two parties to exchange cash flows or other financial instruments over a specified period. Interest rate swaps are the most common swaps contracts entered into by investors. **Advantages and Disadvantages of Equity Securities, Debt Securities, Forex and Derivatives** +-----------------------+-----------------------+-----------------------+ | | **Advantages** | **Disadvantages** | +-----------------------+-----------------------+-----------------------+ | Equity Securities | - *Potential for | - *Risk of Loss*: | | | High Returns*: | Prices of stocks | | | Investing in | can be volatile, | | | stocks can lead | and there\'s a | | | to significant | risk of losing a | | | capital | significant | | | appreciation if | portion or all of | | | the company | your investment. | | | performs well. | | | | | - *No Fixed | | | - *Ownership | Income*: Unlike | | | Stake*: | bonds, stocks | | | Shareholders have | don\'t provide a | | | ownership rights | fixed income | | | in the company, | stream, and | | | including voting | dividends are not | | | rights and the | guaranteed. | | | possibility of | | | | receiving | - *Market | | | dividends. | Uncertainty*: The | | | | stock market can | | | - *Liquidity*: | be influenced by | | | Stocks are | various factors, | | | generally more | including | | | liquid compared | economic | | | to other | conditions, | | | investments, | company | | | making it easier | performance, and | | | to buy or sell. | geopolitical | | | | events. | +-----------------------+-----------------------+-----------------------+ | Debt (Bond) | - *Fixed Income*: | - *Lower Potential | | Securities | Bonds provide a | Returns:* Bonds | | | regular and | typically offer | | | predictable | lower returns | | | interest income, | compared to | | | making them | stocks, | | | appealing for | especially in | | | income-oriented | periods of low | | | investors. | interest rates. | | | | | | | - *Lower Risk*: | - *Interest Rate | | | Compared to | Risk*: If | | | stocks, bonds are | interest rates | | | generally | rise, the value | | | considered lower | of existing bonds | | | risk, especially | may decrease, | | | if they are from | potentially | | | reputable | leading to | | | issuers. | capital losses. | | | | | | | - *Diversification* | - *Credit Risk*: | | | : | There\'s a risk | | | Bonds can be used | that the issuer | | | to diversify an | may default on | | | investment | the bond, | | | portfolio, | particularly with | | | potentially | lower-rated or | | | reducing overall | high-yield bonds. | | | risk. | | +-----------------------+-----------------------+-----------------------+ | Forex (Foreign | - *High Liquidity*: | - *High Leverage*: | | Exchange) | The forex market | While leverage | | | is the largest | can amplify | | | and most liquid | profits, it also | | | financial market | increases the | | | globally, making | potential for | | | it easy to enter | substantial | | | and exit | losses, making | | | positions. | forex trading | | | | highly risky. | | | - *Diversification* | | | | : | - *Complexity*: | | | Forex trading | Forex trading | | | allows investors | involves | | | to diversify | understanding | | | their portfolios | macroeconomic | | | by trading | factors, | | | currency pairs | geopolitical | | | from different | events, and | | | countries. | global markets, | | | | which can be | | | - *Accessibility*: | complex for | | | The forex market | inexperienced | | | operates 24 hours | traders. | | | a day, allowing | | | | for flexible | - *No Fixed | | | trading hours. | Income*: Forex | | | | trading does not | | | | provide fixed | | | | income like | | | | bonds, making it | | | | less suitable for | | | | income-oriented | | | | investors. | +-----------------------+-----------------------+-----------------------+ | Derivatives | - *Hedging*: | - *High Risk*: | | | Derivatives can | Derivatives can | | | be used for risk | be highly | | | management, | speculative and | | | allowing | complex, and if | | | investors to | not used | | | hedge against | appropriately, | | | adverse price | they can lead to | | | movements in | substantial | | | other | losses. | | | investments. | | | | | - *Counter-party | | | - *Leverage*: | Risk*: There\'s a | | | Derivatives offer | risk that the | | | the potential for | counterparty in a | | | magnified returns | derivative | | | (and losses) | contract may | | | through leverage, | default, | | | which can be | potentially | | | appealing to some | resulting in | | | investors. | significant | | | | losses. | | | - *Diverse | | | | Strategies*: | - *Complexity and | | | Derivatives | Lack of | | | provide a wide | Transparency*:Som | | | range of | e | | | strategies, from | derivatives can | | | simple options to | be complex to | | | complex | understand, which | | | structured | may lead to | | | products, | unexpected | | | catering to | outcomes, and | | | different | pricing can be | | | investment | opaque. | | | objectives. | | +-----------------------+-----------------------+-----------------------+ Each financial instrument has its advantages and disadvantages, and the choice of investment should align with an individual\'s financial goals, risk tolerance, and investment strategy. Diversification across different asset classes can help manage risk and enhance overall portfolio performance.