Categories of Financial Markets - Essay Example

Financial Markets Introduction A financial market refers to the market for transacting financial assets like equities, bonds, derivatives and currencies. They facilitate borrowing and lending of the financial assets. Typically, financial markets are defined through the transparent pricing, the basic trading regulations and the market forces influencing the trade securities. Trading in financial markets can be direct between buyers and sellers, or can be through the stock exchange (Richard 2005, p.43-48). Financial markets encompass six major functions, which include borrowing and lending where they allow funds transfer among the agents for consumption or investment purposes. They enhance the determination of prices for the financial assets that are newly issued, and the existing stocks of the financial assets. The markets enhance the coordination and the aggregation of information on the financial assets and the money flow from the lenders to the borrowers. They allow for the transfer of risk from the investors to those who provide the funds. They enhance the liquidity by providing the financial asset holders with the chance of reselling or liquidating the assets. The financial markets are critical in enhancing the efficiency through reduction of the information and transaction costs (Richard 2005, p.43-48). The characterization of the financial markets entails consideration of the financial institution types participating in the markets and the different structures of the markets. Three sample types of financial institutions include; first, the depository institutions like banks and credit unions, which advance deposits and loans and accept deposits. The second is the contractual institutions are like the insurance companies and the pension funds while the third type is the investment institutes like the brokerage firms and investment banks (Richard 2005, p.43-48). Categories of Financial Markets There are different categories of the financial markets each dealing with a different instrument based on maturity and the assets backing it up. The different categories of financial markets have different customers and operations (Richard 2005, p.43-48). Below are the different categories of the financial markets. Capital Markets: Stocks/Bonds/Equities Capital markets trade in stocks, bonds and securities. Companies in capital markets raise funds for expanding businesses or establishing new ones through issuing of the securities. Capital markets mobilize the domestic saving and the reallocation of the financial resources. They provide the avenue for divestiture of the state owned enterprises, and shares are sold through the stock exchange where the public participate in the ownership. Companies raise the long-term finance using equity and debt financing. Capital rose from the bonds, shares or through other instruments may be invested by the companies in expanding the production and improving competitiveness. The institutions and organizations in private and public sectors sell securities in capital markets. This financial market comprises of both the primary and the secondary markets. Primary markets involve rising of the capital by corporations, and the corporation selling the new stock receives the proceeds. On the other hand, secondary markets entail trading of the outstanding and existing securities among the investors. They deal with already existing instead of the newly created stock (Richard 2005, p.43-48). The stock markets enhance transactions of shares by investors in the publicly traded companies. They facilitate access to capital by the companies and investors are provided with a slice of ownership in potential gains of the company based on future performance. The bond market refers to a debt investment market where entities are given loans by investors. Funds are borrowed for defined time at fixed interest rate. Bonds are critical in funding major projects and activities. The bond market is also referred as fixed income, credit or the debt market (Richard 2005, p.43-48). Derivative Markets Derivative markets deal with transactions of financial instruments like the contracts or options. Derivatives refer to the financial contracts designed for the creation of market price exposure to changes in the underlying asset, commodity or event. Derivatives are critical in risk management and hedging, but they affect the stability in financial markets as well as the overall economy. They are investment markets involved with buying and selling of the derivatives (Madura 2004, p.56-62). Derivatives derive value from other securities (underlier) that can be currency, bond, stock, mortgage or commodity. Investment on stable underlier assumes decreased risks. Derivatives can be sold and purchased as futures or over-the-counter offerings. Some examples of common derivatives include the future, options, forwards, swaps and the contracts-for-difference. These instruments are complex and require defined strategies by the market participants. Derivative markets may involve the physical asset markets, which deal with the tangible commodities rather than swapping instruments, which are pieces of paper having contractual provisions’ entitlements to certain rights by the owners of real assets (Madura 2004, p.56-62). Currency Markets/ Foreign Exchange Market These financial markets trade in sovereign currencies where a currency is traded for another. Most of currency trading is done by the commercial banks, central banks and the large companies. The currency markets do not trade at exchanges but trade directly between the traders. The participants buy, sell, speculate and exchange currencies. Currency market forms the largest financial market worldwide. Currency markets are liquid and are constructed of the global network that links participants worldwide. Currency market trades currencies among the banks and the financial institutions (Madura 2004, p.56-62). Private markets Private markets entail the direct financial transactions between two parties. Examples are the bank loans and the private debt placements with the insurance companies. The parties define the structure of the transactions in the manner appealing to them. The liquidity in securities within private markets is minimal due to greater standardization and regulation (Madura 2004, p.56-62). Spot and futures markets These markets depend on the mode of transaction of the assets. The spot market results when the transaction is within a short duration, like few days. The futures market is when the transactions are scheduled for a future date (Madura 2004, p.56-62). Money markets These markets entail debt securities that are highly liquid and short-term. Examples are the repos and the negotiable deposit certificates. The securities in money markets have safe investments with low interest rate returns. This is appropriate for the temporary storage of cash and the short-term needs (Madura 2004, p.56-62). Primary and secondary markets A primary market is involved with issuing of new securities where investors have the first chance in participating in the issuance of the new securities. An example is the initial public offering, IPO, which is a subset in primary markets where insiders sell their shares and the companies sell the newly created shares in raising the additional capital (Madura 2004, p.56-62). Secondary markets involve transactions of assets and securities by investors from other investors. Bulk of exchange trading entails the secondary market, which is affected only by forces of demand and supply. The primary markets are where the bulk of exchange trading occurs each day. An example is the Over-the-Counter market for the stocks not trading in stock exchange like the NASDAQ (Madura 2004, p.56-62). Third and Fourth Markets These markets entail volumes in share transactions per trade. The transactions are between brokers and dealers. The third markets entail the transactions by the broker-dealer and the large institutions. The fourth market comprises of the transactions between large institutions. Third and fourth markets reduce the extent of placing orders through main exchange that can adversely affect the security prices. However, the effects of these markets on average investor are minimal. Other financial markets include the mortgage markets that deal with the residential, farmland, industrial and commercial loans. The national, regional, world and the local markets depend on the scope of operations and the size of the organization that confines it to restrictions of that region (Madura 2004, p.56-62). Financial Crisis Effects of Recent Financial Turmoil The financial crisis led to the shutdown of the credit markets around the globe with massive destruction of the real estate wealth and the equity. The effects on the investor confidence triggered the massive selloffs in stock markets around the world. The financial markets integrated in the global financial economy were hard hit due to crisis transmission in real sectors. The transmission of crisis in the real sector plunged the commodity and the export prices due to the shrinkage of the foreign direct investment. The cost of borrowing from the credit markets rose while the emerging and pre-emerging economies were rationed out of credit markets. The crisis led to the decline in the private capital (Gande, John and Senbet 2008, p. 707-732). The recent financial crisis occurred in the second half of the year 2008 caused by the growing quantity and accumulation of bad debt. The crisis affected the banking system by rising bad debts that threatened solvency of banks. The apparent changes in Federal Reserve Policies created panic in the lending market by the banks. The investors in the stock markets experienced a freefall in their bank shares. The decline in shares significantly reduced the capital, hence a massive decline in the lending system by the bank, threatening the stability of the entire system. The housing booms and the deregulation in banks were strong in UK and US, and banks from continental Europe made loans from these banks. The financial crisis affected industrialized countries as a whole. This has resulted to abrupt changes in the bailing out policies by the banks (Gande, John and Senbet 2008, p. 707-732). The events that occurred during the crisis shaped the commercial and business scenes. The values for property increased with ‘buy to let’ markets becoming profitable for the banks worldwide. Some lenders offered loans, which were more than the face value of the underlying property in an effort to expand and retain the market share. These ratios were high and pertained in the regulatory era when lenders lent incomes at twice the higher income. This underestimated the risks involved where organizations raised funds through selling loan deals and the mortgage to other lenders who were unaware of original underlying transactions (Gande, John and Senbet 2008, p. 707-732). The oil prices rose sharply leading to trade recession. The increased rates of unemployment triggered the rise in the mortgage defaults that secured many mortgage on the run-down mobile homes and the inner city properties. Poorly styled mortgages were charged high by the lenders in an effort to compensate for the higher risk taken. Banks were affected in terms of mortgage securitized investments bought from other institutions and were reluctant in lending to other banks within the short-term money markets (Gande, John and Senbet 2008, p. 707-732). As a result of the fears, many banks were faced by liquidity problems reducing the ability of banks and institutions to meet the short-term obligations like repayment of the short-term loans. The businesses were hit by the falling profitability and sales. Securing loans from the banks derailed the trading activities for many businesses. Several brands went out of the business while others closed substantial number of outlets. The rate of unemployment rose among the youths. The fall in the retail sales and the increased unemployment resulted to fall in the government revenues, in the whole world (Gande, John and Senbet 2008, p. 707-732). Conclusion This paper addressed the different categories of financial markets. The function of the financial market varies depending on the transactions carried out which include the transfer of resources from the lenders to the ultimate borrowers. They enhance income and formation of capital by channeling the savings and allowing lenders earn through interests and dividends. Financial markets are critical in providing the mechanism for selling the financial asset and provide information to various market segments. The financial markets provide liquidity that facilitates the trading in funds. Financial markets are composed of primary and secondary markets. Primary markets deal with new issues while secondary markets deal with the sale of securities like money market and capital markets. References List Gande, A., John, K. & Senbet, W. (2008). Bank Incentives, Economic Specialization, and Financial Crises in Emerging Economies, Journal of International Money and Finance 27 (5). pp.707-732. Madura, J. (2004). Financial Markets, London, Sage Publications. p. 56-62. Richard, D. (2005). Financial Markets, CFA Digest 35(1). pp. 43-48. Read More