Financial markets

Министерство  науки и образования Украины

Одесский  Государственный университет 
 

Кафедра иностранных языков 
 
 
 
 

Реферат на тему:

«Financial markets» 
 
 

Выполнила

студентка 24 группы КЭФа

Долготёр  А. В

Проверила:

Карпова Е. О 
 
 

Одесса 2009

Introduction

In economics, a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity.

Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. 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 such as a gift economy.

In finance, financial markets facilitate –

• The raising of capital (in the capital markets);
• The transfer of risk (in the derivatives markets);
• International trade (in the currency markets)

– and 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.

Definition

In economics, typically, the term market means the aggregate of possible buyers and sellers of a thing and the transactions between them.

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 (like the NYSE) or an electronic system (like 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, similar to stock exchanges.

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 standardized 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: 

Lenders

Individuals

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; or
• invests in company shares.

Companies

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 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 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 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 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. It is also called financial economics.

Currency markets

Seemingly, the most obvious buyers and sellers of foreign exchange are importers/exporters. While this may have been 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/Institutions
• Speculators
• Government spending (for example, military bases abroad)
• Importers/Exporters
• Tourists

Analysis of financial markets

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 scale of changes in price over some unit of time is called the volatility. It was discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian 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 Gaussian distribution with an estimated standard deviation.

Financial markets in popular culture

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 skillful. 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 market slang

• Geek, a Quant
• Grim, an ageless person known for his/her whistle and tendency to relate current events to financial market
• 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.
• White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of an organization to help prevent the takeover of that organization by another party (that is making a hostile bid).
• POISON PILL, measures taken by a company to prevent being bought out by another company

A Fresh Look At The Financial Markets

With the advent of the internet and electronic trading, investors have access to a large number of financial markets and exchanges representing a vast array of financial products. Some of these markets have always been open to private investors; others remained the exclusive domain of major international banks and financial professionals until the very end of the twentieth century. These markets are not all equal; each requires unique skills and knowledge. As such, investors need to identify the market most suitable to their abilities, personality and investment goals, and then gain the specific skills required to profit in that market. Here we'll take a fresh look at the markets available to private investors and let you in on what you need to know to trade them.

Capital Markets 
The capital markets generally offer ease of access and encouragement to private investors, limited leverage opportunity and, as a result, limited upside potential. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities - stocks and bonds in the company's name. These are bought and sold in the capital markets.  
 
Private individuals are seizing on the opportunity to invest more than ever before: according to the "Outline of the U.S. Economy" (2001) by Christopher Conte and Albert R. Karr and the U.S. State Department, "the portion of all U.S. households owning stocks, directly or through intermediaries like pension funds, rose from 31% to 41% between 1989 and 1995." Reflecting this increase in private participation, the capital markets are extensively regulated - in the U.S. by the Securities and Exchange Commission (SEC).

The high private investor participation, varied product offerings, limited margin and extensive government regulation all combine to make the capital markets relatively safe for non-professional traders. But with this limited risk comes limited profit potential - this is a classic example of the risk-return tradeoff.  This is partly because there is often a physical limitation as to how fast a company or economy can grow and partly because of the reduced leverage available. For example, most private investors are restricted to borrowing no more than 50% of the face value of their stocks in a margin account.

Stocks 
Many private investors' first foray into financial trading in the capital markets is via the stock market. It's relatively easy to understand, offers a wide selection, features many recognizable companies and products, is readily accessible, and its high trading volume creates liquidity that allows investors to "get out" with relatively little hassle. Given these factors, it's not surprising that the New York Stock Exchange's annual trading volume rose almost 15-fold between 1980 and 1998 - from 11,400 million shares to 169,000 million shares ("Outline of the U.S. Economy", 2001). 
 
Bond Markets 
A bond is a type of debt security that can be bought and sold by investors on credit markets around the world. This market - alternatively referred to as the debt, credit or fixed-income market - traded $45 trillion worldwide and $25.2 trillion in the U.S. in 2006, according to the Bond Market Association. It is much larger in nominal terms that the world's stock markets. This is considered a passive, low-risk, low-volatility investment. This market also has correspondingly low returns compared to the stock markets when examined over long time periods.  
 
Mutual Funds 
By the close of the 1990s, the portion of American households holding mutual funds had increased astronomically, from a mere 6% in 1979 to 37% in 1997. Why the dramatic upswing? Mutual funds are an appealing method for individual investors to participate in the outcomes of a large basket of stocks. The money pooled by mutual funds is invested by professional money managers across multiple industries or sectors, and their increased size allows mutual funds to often become active participants in the courses of action their investments take. Mutual fund investors, in turn, are somewhat sheltered from the natural chaos of the stock market through diversification. Returns in equity (stock)-based mutual funds have historically been solid, if not spectacular. Investing in mutual funds removes the need for fundamental security analysis, but asset allocation and sector diversification knowledge will aid investors in maximizing returns for a given level of risk.

Index Investing 
Many private investors are unable to beat the "broad market" as defined by indexes like the Standard & Poor's 500 Index, and consequently believe that simply buying the whole index to be a safer and easier route. Their logic is sound, but investors must also bear in mind that indexes by their nature are susceptible to market fluctuations.  
 
Still, a smaller investor with limited time and capital can achieve a higher degree of sector or market diversification by buying indexes than they could possibly achieve by buying individual stocks. Fortunately for private investors wishing to invest in indexes, there are two simple and low-cost choices: index mutual funds and exchange-traded funds. Both offer low expense ratios and have high trading volumes, allowing for maximum liquidity. Index investing requires little analytical skill.  
 
Cash or Spot Market 
Investing in the cash or, "spot", market is highly sophisticated, with opportunities for both big losses and big gains. In the cash market, goods are sold for cash and are delivered immediately. By the same token, contracts bought and sold on the spot market are immediately effective. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices. 
 
The cash market is complex and delicate, and generally not suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional market players such as hedge funds, limited partnerships and corporate investors. The very nature of the products traded requires access to far-reaching, detailed information and a high level of macroeconomic analysis and trading skills.  
 
Despite this, an increasing number of private investors are drawn to the massive leverage available and the profit potential. Ironically, it is this high leverage and corresponding high risk that wipes out many new entrants. Professional investors generally do not trade fully leveraged; rather, they operate under disciplined money management rules. It is vital that any private investor wishing to trade within these markets take the time to gain experience and understanding of the market before risking his or her capital. A viable alternative for investors wishing to partake in these opportunities is to invest in a managed account run by an experienced professional.

 
Derivatives Markets 
The derivative is named so for a reason: its value is derived from its underlying asset or assets. A derivative is a contract, but in this case the contract price is determined by the market price of the core asset. If that sounds complicated, it's because it is. The derivatives market adds yet another layer of complexity and is therefore not ideal for inexperienced traders looking to speculate. However, it can be used quite effectively as part of a risk management program.  
 
Leverage can be found in these markets as well, so the chance for  high reward attracts individual investor interest; however many would do better to invest in professionally managed accounts or funds. Complex derivative investing requires a high degree of analytical and mathematical skill as well as a broad macroeconomic understanding. 
 
Examples of common derivatives are forwards, futures, options, swaps and contracts-for-difference (CFDs). Not only are these instruments complex but so too are the strategies deployed by this market's participants.  
 
There have been some spectacular and highly publicized institutional losses in the derivatives market. American political and regulatory bodies have demonstrated their concern about the exploitation of derivative instruments - and, as a result, the exploitation of investors.  
 
There are also many derivatives, structured products and collateralized obligations available, mainly in the over-the-counter (non-exchange) market, that professional investors, institutions and hedge fund managers utilize to varying degrees but play an insignificant role in private investing. 
 

Conclusion

 
A private investor's foray into various markets is a delicate process, with multiple options and multiple chances for error. Each available market - even those dominated by  individual traders/investors - requires specific information and thorough comprehension of the market's engine. The newfound electronic availability of previously exclusive markets only makes research that much more important; perhaps the single biggest indicator of an investor's potential success is the choice of the most suitable market for his or her skills.