Finance Notes: Financial Markets

A financial market is a market in which individuals, private companies, and public institutions can trade financial securities, commodities, and other assets at prices that reflect supply and demand. Securities include stocks and bonds, as well as commodities, such as precious metals or agricultural commodities.

Financial markets allow participants to raise capital, make profits, and manage investment risks.

Role Players

The prominent role players in financial markets include: Governments, Central banks, Investment banks, Insurance and re-insurance companies, clearinghouses, dealers, intermediates, and brokers.

Classification

By the Type of Asset Traded

Equity markets: shares of different types of companies are bought and sold. Shares are ownership titles representing a fraction of the company’s capital that confer certain rights on the holder.

Debt markets: government/corporate/treasury/municipal bonds are bought as sold.

Derivatives markets: a derivative is a contract between two parties who agree on the price of an underlying asset for a given period of time

Foreign exchange markets: So-called convertible currencies are exchanged against each other at exchange rates that are constantly changing. In a futures market, there is a difference between the transaction date and the settlement date, whereas in a cash market, transactions are made immediately with reference to a “spot” price … In a spot market, the transaction amount is determined from the spot price.

By Maturity of the Financial Asset

Money markets: refers to the informal market where financial institutions and large companies invest their assets or borrow on a short-term basis. They include: Deposits, Certificates of Deposits, Treasury bills, Commercial Paper.

Capital Markets: allow the meeting between economic agents with a capital surplus and agents with financing needs. They are subdivided into three compartments: the financial market, the money market and the bond market. The key drivers of capital markets are debt and equity.

By Owner of the Financial Asset

Dealer Market: Securities are purchased or sold by a dealer out of his/her own inventory

Auction Market: an environment that facilitates competition between buyers and sellers. In an auction market, buyers indicate the maximum price they are willing to pay for an asset and sellers indicate the lowest price they would be willing to pay.

Elements of Financial Markets

The main elements of Financial Markets are:

  1. Price determination and discovery,
  2. Information aggregation and coordination,
  3. Risk sharing,
  4. Liquidity,
  5. Efficiency

Risk and Probability

Techniques for Managing Risk in Financial Markets

There are basically four (04) techniques of risk mitigation:

  1. Avoidance,
  2. Loss prevention or reduction: the risk is accepted with special measures to minimize the potential loss,
  3. Diversification,
  4. Transferring Risk: the risk-averse party pays a premium to the loss-covering party taking into account some factors such as the size of the potential loss, the likelihood of the loss occurring, and the profile of the risk-averse party.

Instruments for Managing Risk

Risk and Financial Instruments

In its simplest expression, risk can be described as the volatility or fluctuation of a financial instrument over a given period of time. The greater the volatility or fluctuation of a financial instrument, the greater the risk of capital loss to the investor.

Bonds

Investing in bonds has long been considered one of the safest investments, especially if the investor holds the securities to maturity. However, it does involve a number of risks such as liquidity risk, interest rate risk, foreign exchange risk and inflation risk.

Equities

Investing in equities is of twofold interest to an investor: he can hope to increase his financial wealth in the long term (by realizing a capital gain on resale) while at the same time receiving regular income throughout the duration of his investment thanks to the dividends received.

However, investing in equities is considered one of the riskiest investments in the sense that a capital loss may occur between the time of purchase and resale of the securities.

Unlisted securities

An unlisted share cannot be bought or sold on the stock market. Unlisted shares are generally issued by small and medium-sized companies seeking financing directly from investors. The choice of unlisted shares must be made with a long-term savings objective in mind.

Investing in unlisted shares can meet several objectives: they may be companies that you know or want to help in a solidarity shareholding approach, or you may consider that these companies have strong growth potential and can be sources of return, etc.

A non-guaranteed capital

By investing in unlisted shares, you may lose all or part of your capital. Indeed, the evolution of the savings invested will depend on the health of younger and more fragile companies. By nature, SMEs are generally riskier than larger, listed companies. 

Not a liquid investment

The resale of unlisted shares is uncertain: without a regulated market on which to buy and sell unlisted shares, it is difficult to determine their price.

Moreover, finding objective information about the company that helps to determine the share’s return prospects can be complicated (except on crowdfunding platforms, where certain data must be specified).

Therefore, there is no guarantee that you will find a buyer to whom you can sell your shares.

Universal Risks

Systemic risk: means that an entire economy is affected – as a system – and not just a company or a household.

Black Swan Risk: The Black Swan Theory developed by the statistician Nassim Nicholas Taleb, notably in his essay The Black Swan, is a theory according to which a certain unpredictable event which has a low probability of occurring (called a “rare event” in probability theory) and which, if it does occur, has consequences of considerable and exceptional significance. Taleb first applied this theory to finance. In finance, rare events are often undervalued in terms of price.

References

DE HAAN, Jakob, OOSTERLOO, Sander, et SCHOENMAKER, Dirk. European financial markets and institutions. Cambridge University Press, 2009.

AGGARWAL, Raj et GOODELL, John W. Markets and institutions in financial intermediation: National characteristics as determinants. Journal of Banking & Finance, 2009, vol. 33, no 10, p. 1770-1780.

KOTHARI, S. P., et al. The role of financial reporting in reducing financial risks in the market. In : Conference Series-Federal Reserve Bank of Boston. Federal Reserve Bank of Boston; 1998, 2000. p. 89-102.

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