Financial Markets

What Are Financial Markets?

Financial markets are markets in which securities or financial instruments are traded. A Security (financial instrument) is a claim on the issuer's future income or assets (any monetary claim or property subject to ownership).

There are two main types:

1. Money
2. Capital Markets

In both markets, primary and secondary markets exist. Primary Markets are securities sold for the first time usually to large investors and corporations, a concept known as initial public offering (IPO).

On the other hand, Secondary markets are those where securities already traded in the primary market are bought and sold. The secondary market is the biggest.

These markets may also be classified by nature of the claim (debt and equity market), the timing of delivery (cash and futures markets), and organization structure (exchange-traded market and over-the-counter markets)

These markets function by having one party transfer the funds they held to another party for a money consideration. This is how financial markets facilitate the flow of funds from those who have excess to those who need it for investment.

The financial markets have different players who participate for various reasons. These players include investors, hedgers, and speculators. Investors have long-term goals as they hold positions for a considerable time (months or years).

Hedgers seek to mitigate different risks and exposures to the uncertainty caused by adverse economic, political, and social changes, among others. Speculators are those that mostly trade intraday and look for short-term gains.

Speculators make up a chunk of household traders and other small and middle-sized institutions. Speculators mainly seek small gains from the daily fluctuations in the markets.

Money markets

Money Markets are those markets in which debt securities of maturities of less than a year are traded. These markets comprise a network of banks, discount houses, institutional investors, and dealers who exchange short-term securities.

The characteristics of the securities traded in these markets are as follows: 

•  They are usually sold in large denominations.
• They have low default risk.
• They are mature in one year or less from their issuance date. 
• The securities have an active secondary market. A secondary market implies that after the initial sale (in what is known as the primary market), the security still has an active market in which it can be resold.

In the money markets, the following are the main institutional players:

1. The Government

The government, through its Treasury Department, uses money markets to raise short-term funds and cover any pressing financial obligations falling due in the short term (a period of less than a year).

2. The Central Bank

The central bank is mainly used by the government, through the treasury, as an agent for distributing its securities. The monetary policy department usually does this to make decisions about market liquidity and money supply.

The central bank also uses the money market to control the money supply by selling and repurchasing securities in the highly liquid primary market. Open market operations help central banks achieve their goals.

3. Commercial Banks

Commercial Banks participate either as issuers or investors of most, if not all, securities in the money market. As a result, banks usually face everyday needs for investment capital to meet their customers' demands.

4. Brokers and Dealers 

A broker is an institution or an individual who acts as an agent on behalf of another party in the money market. Brokers work as match-makers, bringing together buyers and sellers of securities in the market.

On the other hand, Dealers are those institutions or individuals who transact in the markets on behalf of investors. These usually charge a small commission on the total amounts in question.

5. Pension Funds

Funds accumulated from the pensions of the formally employed have resulted in huge cash inflows from pensions. This has resulted in more activity in the money market. The risk in the money market is minimal, which makes it worthwhile.

6. Insurance Companies

Insurance companies are regarded as some of the most liquid financial institutions. As such, most of this liquidity is invested in the money market. As a result, insurance companies have many idol funds from their premiums.

Examples of securities traded in the money market

In money markets, securities trades have a maturity of less than a year and are considered less risky than those traded in the capital markets. This discussion below covers the securities that meet this criterion. 

1. Treasury Bills. Issued by the treasury department through the central bank as a short-term source of money to cover deficits. The Central Bank also uses them during its Open Market Operations (OMO) to control the money supply in the economy. 
2. Repurchase Agreements. Transactions in which an institution purchases government securities with an agreement that the seller will repurchase them within a stated period.
3. Commercial Paper. A company issues an unsecured short-term promissory note to raise short-term cash, often to finance working capital requirements. They settled within a short period.
4. Federal Funds. Short-term funds are transferred between financial institutions, usually for a period of one day. They are called federal funds because the funds transferred between institutions are from the accounts held by these institutions with the central bank.
5. Banker's Acceptance. A banker's acceptance is an order to pay a specified amount to the bearer on a given date. They are sold at a discounted price.

Advantages of Money markets 

Money markets, just like anything, have their advantages and disadvantages. These serve as the criteria for investors to invest or shun investing in money markets. 

Other investors cling more to the advantages than disadvantages which is but a matter of choice. The advantages are:

1. The well-developed secondary market for money market instruments and their high liquidity makes the money market the ideal place for firms to warehouse funds in the interim until viable investment opportunities present themselves.

2. Money markets provide a low-cost source of funds to firms and the government. Interest rates in the money markets are very low and affordable. This helps corporations increase their participation in these markets.

3. Money markets are a useful tool in implementing monetary policy. This implementation is usually achieved in the following ways: 

• The central bank sets the federal funds rate through its discretionary powers, which acts as an overtone for other interest rates. 
• The purchase and sale of treasury bills to control the money supply.

Disadvantages Of Money Markets

Let us take a look at some of the disadvantages below:

Due to their relatively low risk of default and the near inexistence of any other risk in money market instruments, financial instruments in these markets usually have low returns.

1. Minimum balance requirements

Most banks have a minimum threshold for their accounts. This hinders low-income earners as they would not be able to meet such needs.

2. Interest rates

Money markets also pay higher interest rates as the deposit in your account increases. Hence, money markets are good for a considerably large amount of funds that some could not afford.

3. Fees

Banks charge maintenance fees on a monthly or yearly basis just for holding an account with them. These fees may eat away a chunk of funds generated in the money market account and reduce the real gains.

4. Withdraw restrictions

Individuals can not withdraw their funds anyhow, as several restrictions may apply regarding withdrawing. Fees for excess withdrawal may also be charged.

Capital markets 

Capital Markets are those in which securities (debt and equity instruments) with a maturity of more than a year are traded. Capital markets generally serve as the engine for investment fund generation.

When corporations and the government seek to raise money for investment purposes, they rush to capital markets where individuals and other corporate investors are willing to buy stakes in companies, bonds, and treasury bills.

Some of the renowned world capital markets include but are not limited to the new york stock exchange, the Japanese stock exchange, the London stock exchange, the Shanghai stock exchange, and in Africa, the Johannesburg stock exchange.

Apart from financial instruments with a maturity of more than a year, securities with no maturities, also known as perpetuities, are traded in this market. These provide interest rate payments forever to the investors.

Below are the numerous instruments traded in the capital markets. These instruments fit all the characteristics of capital instruments, either those with maturities of more than a year, those with less than a year, and those without maturity.

Bonds 

Bonds are long-term debt obligations issued by corporations and government units. They represent a debt owed by the issuer to the investor, which obligates the issuer to pay a specified amount at a given date, basically with periodic interest payments. 

The face value is also known as par value; sometimes, the maturity value is the amount of the bond to be paid by the issuer at maturity. Finally, the coupon rate is the price in terms of interest that the issuer should pay to the bondholder. 

The periodic interest payments are often referred to as coupon payments, mostly fixed. If the terms of repayment of a bond are breached, the bondholder has a claim on the assets of the issuer. 

Some of the most common participants in the bonds market include the Government and its Agencies which issue bonds as a source of long-term funding for its long-term projects. 

Next are Corporations Bonds issued by corporations, referred to as corporate bonds, and are given as a long-term source of funds or for recapitalization purposes. Finally, Households & Foreign Investors form a large percentage of bond-holders.

Equity or shares

Shares represent a share in the ownership of a corporation. As security, equity represents a claim on the earnings and assets of the corporation. Issuing stock to the public is a way for corporations to raise funds to finance their activities. 

Stock markets, where claims on the earnings of corporations are traded, are the most widely followed and reported financial markets out of the rest. And their performance is widely used to measure the economy's overall health.

Shares mostly fall into Common or Ordinary Shares and Preference Shares. Preference shareholders have a prior claim to assets as compared to ordinary shareholders. Preference shareholders may also receive fixed dividends.

The main participants in the stock market are corporations. In addition, households (individual investors), foreign investors, other companies, and investment funds, among others, provide the demand for shares in the stock market.

Mortgages

Mortgages are long-term loans to individuals or businesses to purchase a home, land, or other real property where such property acts as collateral for the loan. The borrower pays it off over time by combining principal and interest payments.

In their primary or initial state, Mortgages fall into the following categories: Home Mortgages. These are issued for the purchase of 1 to 4-family dwellings. Multifamily Dwelling Mortgages are used to purchase apartment complexes and town dwellings. 

Commercial Mortgages are issued to finance the purchase of a real estate for business purposes. Farm Mortgages are used to finance the purchase of agricultural real estate.

However, in recent years secondary markets for mortgages have developed. Such trades usually take place in two ways:  

1. Mortgage Sales – This is where a mortgage originated and issued by one financial institution is sold to another institution without recourse. 
2. Mortgage-backed securities – These are securities whose cash flows are derived from underlying bundles of mortgage securities.

Market Participants In the primary market, Commercial banks and other Financial Institutions that deal in credit are the main originators of mortgages, while Households and Corporations are the main customers. 

Advantages of capital markets

Capital markets, just like anything, have their advantages and disadvantages. These serve as the criteria for investors to invest or shun investing in money markets. But, unfortunately, other investors cling to the advantages rather than the disadvantages.

Some of the advantages are:

Capital Markets facilitate the movement of funds from economic agents with an excess of funds to those with a shortage of funds. These movements help channel funds from inactivity to points of activity to spur economic growth.

Substantially higher returns are usually obtained in capital markets than in money markets and deposit investments. Higher market volatility can cause securities to double their price in a few days, months, or years.

Returns arising out of investments in the capital market are subject to tax benefits in some jurisdictions. But, unfortunately, tax always eats up the gain from investments; tax benefits can be a great ordeal for investors in capital markets.

The structure of the secondary markets for capital market instruments allows for individual investors more than that of money markets. In money markets, mostly the players are huge institutions which large amounts of funds, unlike in capital markets.

Capital Markets provide a viable source of funds for the government, its agencies, and corporations through issuing various debt and equity securities. When companies want to grow their capital, capital markets are the go-tos.

Securities such as shares can be used as liens for securing the debt. Investors in the capital market benefit from wealth or capital gains arising from increases in the prices of securities.

Disadvantages Of Capital Markets

The disadvantages include:

For one to transact in capital markets, there is a stipulation that they have to carry out their investments through registered brokers. So, naturally, this brings with it extra costs through brokerage fees and commissions. 

Other costs may be incurred from seeking expert advice on which securities to buy or sell and portfolio building. Expertise advice may attract a high cost as professionals provide it.

Investments in capital markets are highly risky due to high market volatility as compared to money markets. Volatility in these markets can make you lose even more than 50% of your value in a single day.

Sudden events in the market may cause such volatility. Examples of such events include but are not limited to wars, natural disasters, corporate scandals, and technological changes.

Capital markets do not ordinarily give fixed returns due to their fluctuating nature. Unlike most money instruments, investors experience variable returns on their investments in capital markets. At times no returns at all.

Buying and selling instruments in the capital markets mostly require the advice of professionals to make the right decisions. The complex nature of capital market securities is the reason for this.

Analyzing the future price movements in securities involves complex quantitative and qualitative analyses, which may cover a broad area in the financial sector. This demands not only time but also special expertise and experience.

Functions of the Markets

Function markets play some roles in the global economy. For example, without financial markets, countries would not experience vast economic growth and improvement in people's livelihoods.

1. Price Determination

These markets provide a centralized trading place for different financial instruments. This allows for the forces of demand and supply to work by delivering an equilibrium price of the underlying assets.

2. Funds mobilization

These markets also facilitate the mobilization of funds from lender savers to borrower spenders who put the funds in different investment avenues based on their strategies. 

A good example is a company issuing common stock to get funds from the public for their business investment. The funds are hence mobilized through the stock exchange.

3. Liquidity

Liquidity entails the availability of both sides in trading transactions, i.e., buyers and sellers. Financial markets bring in buyers and sellers of different financial instruments with other intentions. 

This makes it easy for someone who wants to purchase or sell an asset for cash or exchange. Liquidity also brings the advantage of reduced spreads in security. The higher the liquidity, the lesser the spreads.

4. Risk Sharing

These markets create a system whereby financial risk is shared between or among different entities. Since the person undertaking the investment differs from the person providing funds for the investment. 

The bundling of financial assets into different vehicles also bundles up risk and provides it as a tradable instrument among different market participants. This risk is then shared among several market players.

A good example of such is securitization, where mortgage-backed securities are bundled together and sold as investments to other parties. The risk is passed from one party to another to reduce risk concentration on one entity.

5. Easy access

Organized financial markets make meeting and participating easy for all parties who transact in these markets. This saves money and time for different market participants in the markets. 

The advent of technology has made financial markets even more accessible through the internet. The internet has enhanced connectivity among different market players.

At a click of a button from anywhere in the world, participants can execute transactions in any financial market anytime without needing physical presence.

6. Reduction in Transaction costs and provision of information

In investments, transaction costs are accumulated from information seeking, traveling, commissions, legal advice, etc. the internet, as well as higher volumes, has decreased these transnational costs.

Since financial markets have become well-regulated, they provide information that investors might have otherwise needed to pay for from other sellers as regulators seek to protect the interest of investors and enhance ethical practices.

The online interconnectedness of the markets has helped eliminate the transactional cost of traveling, among others. For example, the use of wire technology in the markets has completely eliminated transportation costs.

Researched and authored by Edwin Saile |  LinkedIn

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