FINANCIAL MARKETS

In economics, a financial market is a mechanism that

allows people to 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.
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 certain good or service 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.
The primary market is that part of the capital markets
that deals with the issue of new securities. Companies,
governments or public sector institutions can obtain
funding through the sale of a new stock or bond issue.
This is typically done through a syndicate of securities
dealers. The process of selling new issues to investors is
called underwriting. In the case of a new stock issue, this
sale is an initial public offering (IPO). Dealers earn a
commission that is built into the price of the security
offering, though it can be found in the prospectus.
Primary markets creates long term instruments through
which corporate entities borrow from capital market.
 Features of primary markets are:
• This is the market for new long term equity capital. The primary
market is the market where the securities are sold for the first time.
Therefore it is also called the new issue market (NIM).
• In a primary issue, the securities are issued by the company directly
to investors.
• The company receives the money and issues new security
certificates to the investors.
• Primary issues are used by companies for the purpose of setting up
new business or for expanding or modernizing the existing
business.
• The primary market performs the crucial function of facilitating
capital formation in the economy.
• The new issue market does not include certain other sources of new
long term external finance, such as loans from financial institutions.
Borrowers in the new issue market may be raising capital for
converting private capital into public capital; this is known as "going
public."
• The financial assets sold can only be redeemed by the original
holder.
Methods of issuing securities in the primary
market are:
• Initial public offering;
• Rights issue (for existing companies);
• Preferential issue.
• The secondary market, also known as the aftermarket, is the
financial market where previously issued securities and financial
instruments such as stock, bonds, options, and futures are bought
and sold.[1]. The term "secondary market" is also used to refer to the
market for any used goods or assets, or an alternative use for an
existing product or asset where the customer base is the second
market (for example, corn has been traditionally used primarily for
food production and feedstock, but a "second" or "third" market has
developed for use in ethanol production). Another commonly referred
to usage of secondary market term is to refer to loans which are sold
by a mortgage bank to investors such as Fannie Mae and Freddie
Mac.
• With primary issuances of securities or financial instruments, or the
primary market, investors purchase these securities directly from
issuers such as corporations issuing shares in an IPO or private
placement, or directly from the federal government in the case of
treasuries. After the initial issuance, investors can purchase from
other investors in the secondary market.
• The secondary market for a variety of assets can vary
from loans to stocks, from fragmented to centralized, and
from illiquid to very liquid. The major stock exchanges
are the most visible example of liquid secondary markets
- in this case, for stocks of publicly traded companies.
Exchanges such as the New York Stock Exchange,
Nasdaq and the American Stock Exchange provide a
centralized, liquid secondary market for the investors
who own stocks that trade on those exchanges. Most
bonds and structured products trade “over the counter,”
or by phoning the bond desk of one’s broker-dealer.
Loans sometimes trade online using a Loan Exchange.
• Function
• Secondary marketing is vital to an efficient and modern
capital market.[citation needed] In the secondary
market, securities are sold by and transferred from one
investor or speculator to another. It is therefore important
that the secondary market be highly liquid (originally, the
only way to create this liquidity was for investors and
speculators to meet at a fixed place regularly; this is how
stock exchanges originated, see History of the Stock
Exchange). As a general rule, the greater the number of
investors that participate in a given marketplace, and the
greater the centralization of that marketplace, the more
liquid the market.
• Fundamentally, secondary markets mesh the investor's
preference for liquidity (i.e., the investor's desire not to tie
up his or her money for a long period of time, in case the
investor needs it to deal with unforeseen circumstances)
with the capital user's preference to be able to use the
capital for an extended period of time.
• Accurate share price allocates scarce capital more
efficiently when new projects are financed through a new
primary market offering, but accuracy may also matter in
the secondary market because: 1) price accuracy can
reduce the agency costs of management, and make
hostile takeover a less risky proposition and thus move
capital into the hands of better managers, and 2)
accurate share price aids the efficient allocation of debt
finance whether debt offerings or institutional borrowing
 Derivative
• A derivative is a financial instrument - or more simply, an
agreement between two people or two parties - that has a value
determined by the price of something else (called the underlying).
• It is a financial contract with a value linked to the expected future
price movements of the asset it is linked to - such as a share or a
currency. There are many kinds of derivatives, with the most notable
being swaps, futures, and options. However, since a derivative can
be placed on any sort of security, the scope of all derivatives
possible is nearly endless. Thus, the real definition of a derivative is
an agreement between two parties that is contingent on a future
outcome of the underlying.
• The spot market or cash market is a public financial market, in
which financial instruments are traded and delivered immediately.
The spot market can be of both types:
• an organized market, an exchange or
• "over the counter", OTC.
• Over-the-counter (OTC) or off-exchange trading is to trade
financial instruments such as stocks, bonds, commodities or
derivatives directly between two parties. It is contrasted with
exchange trading, which occurs via facilities constructed for the
purpose of trading (i.e., exchanges), such as futures exchanges or
stock exchanges.
• OTC-traded stocks
• In the U.S., over-the-counter trading in stock is carried out by market
makers that make markets in OTCBB and Pink Sheets securities
using inter-dealer quotation services such as Pink Quote (operated
by Pink OTC Markets) and the OTC Bulletin Board (OTCBB). OTC
stocks are not usually listed nor traded on any stock exchanges,
though exchange listed stocks can be traded OTC on the third
market. Although stocks quoted on the OTCBB must comply with
U.S. Securities and Exchange Commission (SEC) reporting
requirements, other OTC stocks, such as those stocks categorized
as Pink Sheets securities, have no reporting requirements.
• OTC contracts
• An over-the-counter contract is a bilateral contract in which two
parties agree on how a particular trade or agreement is to be settled
in the future. It is usually from an investment bank to its clients
directly. Forwards and swaps are prime examples of such contracts.
It is mostly done via the computer or the telephone. For derivatives,
these agreements are usually governed by an International Swaps
and Derivatives Association agreement.
• This segment of the OTC market is occasionally referred to as the
"Fourth Market."
• The NYMEX has created a clearing mechanism for a slate of
commonly traded OTC energy derivatives which allows
counterparties of many bilateral OTC transactions to mutually agree
to transfer the trade to ClearPort, the exchange's clearing house,
thus eliminating credit and performance risk of the initial OTC
transaction counterparts.
Types of derivatives

• OTC and exchange-traded

• In broad terms, there are two distinct groups of derivative
contracts, which are distinguished by the way they are
traded in the market:
• Over-the-counter (OTC) derivatives are contracts that
are traded (and privately negotiated) directly between two
parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate
agreements, and exotic options are almost always traded
in this way. The OTC derivative market is the largest
market for derivatives, and is largely unregulated with
respect to disclosure of information between the parties,
since the OTC market is made up of banks and other
highly sophisticated parties, such as hedge funds.
Reporting of OTC amounts are difficult because trades can
occur in private, without activity being visible on any
exchange.

According to the Bank for International
Settlements, the total outstanding notional
amount is $684 trillion (as of June 2008). Of this
total notional amount, 67% are interest rate
contracts, 8% are credit default swaps (CDS),
9% are foreign exchange contracts, 2% are
commodity contracts, 1% are equity contracts,
and 12% are other. Because OTC derivatives
are not traded on an exchange, there is no
central counter-party. Therefore, they are
subject to counter-party risk, like an ordinary
contract, since each counter-party relies on the
other to perform.
• Exchange-traded derivative contracts (ETD) are those
derivatives instruments that are traded via specialized
derivatives exchanges or other exchanges. A derivatives
exchange is a market where individuals trade
standardized contracts that have been defined by the
exchange. A derivatives exchange acts as an
intermediary to all related transactions, and takes Initial
margin from both sides of the trade to act as a
guarantee. The world's largest derivatives exchanges (by
number of transactions) are the Korea Exchange (which
lists KOSPI Index Futures & Options), Eurex (which lists
a wide range of European products such as interest rate
& index products), and CME Group (made up of the
2007 merger of the Chicago Mercantile Exchange and
the Chicago Board of Trade and the 2008 acquisition of
the New York Mercantile Exchange).

According to BIS, the combined turnover in the world's
derivatives exchanges totaled USD 344 trillion during Q4
2005. Some types of derivative instruments also may
trade on traditional exchanges. For instance, hybrid
instruments such as convertible bonds and/or convertible
preferred may be listed on stock or bond exchanges.
Also, warrants (or "rights") may be listed on equity
exchanges. Performance Rights, Cash xPRTs and
various other instruments that essentially consist of a
complex set of options bundled into a simple package
are routinely listed on equity exchanges. Like other
derivatives, these publicly traded derivatives provide
investors access to risk/reward and volatility
characteristics that, while related to an underlying
commodity, nonetheless are distinctive.
• Common derivative contract types
• There are three major classes of derivatives:
• Futures/Forwards are contracts to buy or sell an asset on or before
a future date at a price specified today. A futures contract differs
from a forward contract in that the futures contract is a standardized
contract written by a clearing house that operates an exchange
where the contract can be bought and sold, whereas a forward
contract is a non-standardized contract written by the parties
themselves.
• Options are contracts that give the owner the right, but not the
obligation, to buy (in the case of a call option) or sell (in the case of
a put option) an asset. The price at which the sale takes place is
known as the strike price, and is specified at the time the parties
enter into the option.
• The option contract also specifies a maturity date. In the case of a
European option, the owner has the right to require the sale to
take place on (but not before) the maturity date; in the case of an
American option, the owner can require the sale to take place at
any time up to the maturity date. If the owner of the contract
exercises this right, the counter-party has the obligation to carry
out the transaction.
• Swaps are contracts to exchange cash (flows) on or before a
specified future date based on the underlying value of
currencies/exchange rates, bonds/interest rates, commodities,
stocks or other assets.
• More complex derivatives can be created by combining the
elements of these basic types. For example, the holder of a
swaption has the right, but not the obligation, to enter into a swap
on or before a specified future date.
FURURES CONTRACTS

• In finance, a futures contract is a standardized contract between

two parties to buy or sell a specified asset of standardized quantity
and quality at a specified future date at a price agreed today (the
futures price). The contracts are traded on a futures exchange.
Futures contracts are not "direct" securities like stocks, bonds, rights
or warrants. They are still securities, however, though they are a
type of derivative contract. The party agreeing to buy the underlying
asset in the future assumes a long position, and the party agreeing
to sell the asset in the future assumes a short position.
• The price is determined by the instantaneous equilibrium between
the forces of supply and demand among competing buy and sell
orders on the exchange at the time of the purchase or sale of the
contract.
• In many cases, the underlying asset to a futures contract may not
be traditional "commodities" at all – that is, for financial futures, the
underlying asset or item can be currencies, securities or financial
instruments and intangible assets or referenced items such as stock
indexes and interest rates.
• The future date is called the delivery date or final settlement date.
The official price of the futures contract at the end of a day's trading
session on the exchange is called the settlement price for that day
of business on the exchange.
• A closely related contract is a forward contract; they differ in certain
respects. Future contracts are very similar to forward contracts,
except they are exchange-traded and defined on standardized
assets. Unlike forwards, futures typically have interim partial
settlements or "true-ups" in margin requirements. For typical
forwards, the net gain or loss accrued over the life of the contract is
realized on the delivery date.
• A futures contract gives the holder the obligation to make or take
delivery under the terms of the contract, whereas an option grants the
buyer the right, but not the obligation, to establish a position previously
held by the seller of the option. In other words, the owner of an options
contract may exercise the contract, but both parties of a "futures
contract" must fulfill the contract on the settlement date. The seller
delivers the underlying asset to the buyer, or, if it is a cash-settled
futures contract, then cash is transferred from the futures trader who
sustained a loss to the one who made a profit. To exit the commitment
prior to the settlement date, the holder of a futures position has to
offset his/her position by either selling a long position or buying back
(covering) a short position, effectively closing out the futures position
and its contract obligations.
• Futures contracts, or simply futures, (but not future or future contract)
are exchange-traded derivatives. The exchange's clearing house acts
as counterparty on all contracts, sets margin requirements, and
crucially also provides a mechanism for settlement.
FORWARD CONTRACRS

• In finance, a forward contract or simply a forward is a non-

standardized contract between two parties to buy or sell an asset at a
specified future time at a price agreed today. This is in contrast to a spot
contract, which is an agreement to buy or sell an asset today. It costs
nothing to enter a forward contract. The party agreeing to buy the
underlying asset in the future assumes a long position, and the party
agreeing to sell the asset in the future assumes a short position. The
price agreed upon is called the delivery price, which is equal to the
forward price at the time the contract is entered into.
• The price of the underlying instrument, in whatever form, is paid before
control of the instrument changes. This is one of the many forms of
buy/sell orders where the time of trade is not the time where the
securities themselves are exchanged.
• The forward price of such a contract is commonly contrasted with the
spot price, which is the price at which the asset changes hands on the
spot date. The difference between the spot and the forward price is the
forward premium or forward discount, generally considered in the form
of a profit, or loss, by the purchasing party.
• Forwards, like other derivative securities, can be used to hedge risk
(typically currency or exchange rate risk), as a means of
speculation, or to allow a party to take advantage of a quality of the
underlying instrument which is time-sensitive.
• A closely related contract is a futures contract; they differ in certain
respects. Forward contracts are very similar to futures contracts,
except they are not exchange traded, or defined on standardized
assets. Forwards also typically have no interim partial settlements or
"true-ups" in margin requirements like futures - such that the parties
do not exchange additional property securing the party at gain and
the entire unrealized gain or loss builds up while the contract is
open. However, being traded OTC, forward contracts specification
can be customized and may include mark-to-market and daily
margining. Hence, a forward contract arrangement might call for the
loss party to pledge collateral or additional collateral to better secure
the party at gain.[clarification needed
• OPTION
• In finance, an option is a derivative financial instrument
that establishes a contract between two parties
concerning the buying or selling of an asset at a
reference price during a specified time frame. During this
time frame, the buyer of the option gains the right, but not
the obligation, to engage in some specific transaction on
the asset, while the seller incurs the obligation to fulfill the
transaction if so requested by the buyer. The price of an
option derives from the value of an underlying asset
(commonly a stock, a bond, a currency or a futures
contract) plus a premium based on the time remaining
until the expiration of the option. Other types of options
exist, and options can in principle be created for any type
of valuable asset.
• An option which conveys the right to buy something is
called a call; an option which conveys the right to sell is
called a put. The price specified at which the underlying
may be traded is called the strike price or exercise price.
The process of activating an option and thereby trading
the underlying at the agreed-upon price is referred to as
exercising it. Most options have an expiration date. If the
option is not exercised by the expiration date, it becomes
void and worthless.
• In return for granting the option, called writing the option,
the originator of the option collects a payment, the
premium, from the buyer. The writer of an option must
make good on delivering (or receiving) the underlying
asset or its cash equivalent, if the option is exercised.
• An option can usually be sold by its
original buyer to another party. Many
options are created in standardized form
and traded on an anonymous options
exchange among the general public, while
other over-the-counter options are
customized to the desires of the buyer on
an ad hoc basis, usually by an investment
bank.
• Types of options
• The primary types of financial options are:
• Exchange traded options (also called "listed options") are
a class of exchange-traded derivatives. Exchange traded
options have standardized contracts, and are settled
through a clearing house with fulfillment guaranteed by the
credit of the exchange. Since the contracts are
standardized, accurate pricing models are often available.
Exchange traded options include:
– stock options,
– commodity options,
– bond options and other interest rate options
– stock market index options or, simply, index options and
– options on futures contracts
• Over-the-counter options (OTC options, also
called "dealer options") are traded between two
private parties, and are not listed on an
exchange. The terms of an OTC option are
unrestricted and may be individually tailored to
meet any business need. In general, at least one
of the counterparties to an OTC option is a well-
capitalized institution. Option types commonly
traded over the counter include:
• interest rate options
• currency cross rate options, and
• options on swaps or swaptions.
• A Foreign exchange derivative is a
financial derivative where the underlying is
a particular currency and/or its exchange
rate. These instruments are used either for
currency speculation and arbitrage or for
hedging foreign exchange risk
Foreign Exchange Risk

• When companies conduct business across borders, they must deal in

foreign currencies . Companies must exchange foreign currencies for
home currencies when dealing with receivables, and vice versa for
payables. This is done at the current exchange rate between the two
countries. Foreign exchange risk is the risk that the exchange rate will
change unfavorably before the currency is exchanged.
Hedge
• A hedge is a type of derivative, or a Financial instrument, that derives
its value from an underlying asset. Hedging is a way for a company to
minimize or eliminate foreign exchange risk. Two common hedges are
forwards and options. A Forward contract will lock in an exchange rate
at which the transaction will occur in the future. An option sets a rate at
which the company may choose to exchange currencies. If the current
exchange rate is more favorable, then the company will not exercise
this option.
 Speculation and arbitrage

• Derivatives can be used to acquire risk, rather than to insure or hedge

against risk. Thus, some individuals and institutions will enter into a
derivative contract to speculate on the value of the underlying asset,
betting that the party seeking insurance will be wrong about the future
value of the underlying asset. Speculators will want to be able to buy an
asset in the future at a low price according to a derivative contract when
the future market price is high, or to sell an asset in the future at a high
price according to a derivative contract when the future market price is
low.
• Individuals and institutions may also look for arbitrage opportunities, as
when the current buying price of an asset falls below the price specified
in a futures contract to sell the asset.
• Speculative trading in derivatives gained a great deal of notoriety in
1995 when Nick Leeson, a trader at Barings Bank, made poor and
unauthorized investments in futures contracts. Through a combination of
poor judgment, lack of oversight by the bank's management and by
regulators, and unfortunate events like the Kobe earthquake, Leeson
incurred a $1.3 billion loss that bankrupted the centuries-old institution.
Arbitrage
• In economics and finance, arbitrage is the practice of taking
advantage of a price difference between two or more markets: striking
a combination of matching deals that capitalize upon the imbalance,
the profit being the difference between the market prices. When used
by academics, an arbitrage is a transaction that involves no negative
cash flow at any probabilistic or temporal state and a positive cash flow
in at least one state; in simple terms, it is the possibility of a risk-free
profit at zero cost.
• In principle and in academic use, an arbitrage is risk-free; in common
use, as in statistical arbitrage, it may refer to expected profit, though
losses may occur, and in practice, there are always risks in arbitrage,
some minor (such as fluctuation of prices decreasing profit margins),
some major (such as devaluation of a currency or derivative). In
academic use, an arbitrage involves taking advantage of differences in
price of a single asset or identical cash-flows; in common use, it is also
used to refer to differences between similar assets (relative value or
convergence trades), as in merger arbitrage.
• A person who engages in arbitrage is called an arbitrageur —such as
a bank or brokerage firm. The term is mainly applied to trading in
financial instruments, such as bonds, stocks, derivatives, commodities
and currenci
• Examples
• Suppose that the exchange rates (after taking out the fees for
making the exchange) in London are £5 = $10 = ¥1000 and the
exchange rates in Tokyo are ¥1000 = $12 = £6. Converting ¥1000
to $12 in Tokyo and converting that $12 into ¥1200 in London, for a
profit of ¥200, would be arbitrage. In reality, this "triangle arbitrage"
is so simple that it almost never occurs. But more complicated
foreign exchange arbitrages, such as the spot-forward arbitrage
(see interest rate parity) are much more common.
• One example of arbitrage involves the New York Stock Exchange
and the Chicago Mercantile Exchange. When the price of a stock on
the NYSE and its corresponding futures contract on the CME are
out of sync, one can buy the less expensive one and sell it to the
more expensive market. Because the differences between the
prices are likely to be small (and not to last very long), this can only
be done profitably with computers examining a large number of
prices and automatically exercising a trade when the prices are far
enough out of balance. The activity of other arbitrageurs can make
this risky. Those with the fastest computers and the most expertise
take advantage of series of small differences that would not be
profitable if taken individually.
SPECULATION

• In finance, speculation is a financial action that does not promise

safety of the initial investment along with the return on the principal
sum. Speculation typically involves the lending of money or the
purchase of assets, equity or debt but in a manner that has not been
given thorough analysis or is deemed to have low margin of safety or
a significant risk of the loss of the principal investment. The term,
"speculation," which is formally defined as above in Graham and
Dodd's 1934 text, Security Analysis, contrasts with the term
"investment," which is a financial operation that, upon thorough
analysis, promises safety of principal and a satisfactory return.
• In a financial context, the terms "speculation" and "investment" are
actually quite specific. For instance, although the word "investment" is
typically used, in a general sense, to mean any act of placing money
in a financial vehicle with the intent of producing returns over a period
of time, most ventured money—including funds placed in the world's
stock markets—is actually not investment, but speculation.
• Speculators may rely on an asset appreciating in price due to any of a
number of factors that cannot be well enough understood by the
speculator to make an investment-quality decision. Some such factors
are shifting consumer tastes, fluctuating economic conditions, buyers'
changing perceptions of the worth of a stock security, economic
factors associated with market timing, the factors associated with
solely chart-based analysis, and the many influences over the short-
term movement of securities.
• There are also some financial vehicles that are, by definition,
speculation. For instance, trading commodity futures contracts, such
as for oil and gold, is, by definition, speculation. Short selling is also,
by definition, speculative.
• Financial speculation can involve the buying, holding, selling, and
short-selling of stocks, bonds, commodities, currencies, collectibles,
real estate, derivatives, or any valuable financial instrument to profit
from fluctuations in its price, irrespective of its underlying value.
• In architecture speculation is used to determine works that show a
strong conceptual and strategic focus
Investment vs. speculation

• Identifying speculation can be best done by distinguishing it from

investment. According to Ben Graham in Intelligent Investor, the
prototypical defensive investor is "...one interested chiefly in safety
plus freedom from bother." He admits, however, that "...some
speculation is necessary and unavoidable, for in many common-
stock situations, there are substantial possibilities of both profit and
loss, and the risks therein must be assumed by someone." Many
long-term investors, even those who buy and hold for decades, may
be classified as speculators, excepting only the rare few who are
primarily motivated by income or safety of principal and not
eventually selling at a profit.
• Speculating is the assumption of risk in anticipation of gain but
recognizing a higher than average possibility of loss. The term
speculation implies that a business or investment risk can be
analyzed and measured, and its distinction from the term
Investment is one of degree of risk. It differs from gambling, which is
based on random outcomes. There is nothing in the act of
speculating or investing that suggests holding times, have anything
to do with the difference in the degree of risk separating speculation
from investing.