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2.7.4. Share market

The share market (also called stock market and equity market) is the market for the issue and trading of shares. As we have seen, there are two varieties of shares:

- Ordinary shares, the outstanding amount of which makes up the permanent capital of a company, because this instrument has no maturity date.

- Preference shares, the outstanding amount of which makes up the long-term capital of a company, because this instrument usually has a maturity date, i.e. is redeemable.

The share market and the long-term debt market (of which the bond market is a part) together are often referred to as the capital market, because these markets provide for the long-term capital needs of the corporate sector (and government - bonds only in this case). The share market is depicted in Figure 8.

share market

Figure 8: share market

Ordinary shares are permanent capital also in the sense that they represent a share in the ownership of a company (meaning they don't actually represent borrowing - but we, for the sake of simplicity, regard them as representing borrowing). Preference shares are named as such because, in the event of the liquidation of the company, they enjoy preference over ordinary shares [and creditors (e.g. bond holders) enjoy preference over preference shares], in terms of ownership of the assets of the company.

2.7.5. Foreign exchange market

The foreign exchange (forex) market is the market for the exchange of one currency (e.g. corona or LCC25) for another (e.g. US dollar or USD). An example of an exchange rate is USD / LCC 7.35. Almost all currencies are referenced against the USD (for the sake of convenience), and in an exchange rate the USD is the base or vehicle currency (= 1 unit) and the other is the variable currency (= number of units per 1 USD).

The exchange of one currency for another is effected in central bank notes at bureaux de change or in bank deposits (which is why the forex market is often termed the international money market). The latter is the wholesale forex market, and the former the retail forex market, and the latter dwarfs the former.

Box 1: LC exporter (LCC millions)

Assets

Liabilities

Goods (exported)

-100

US bank deposit (USD 10) (earns)

+ 100

US bank deposit (USD 10) (sells in fx mkt)

-100

LC bank deposit (receives)

+ 100

Total change

0

Box 2: US banking system (USD millions)

Assets

Liabilities

US importer deposit (pays for imports)

-10

LC exporter deposit (earns)

+10

LC exporter deposit (sells in fx mkt)

-10

LC importer deposit (buys in fx mkt)

+10

LC importer deposit (pays US exporter)

-10

US exporter deposit (earns)

+10

Total change

0

Box 3: LC importer (LCC millions)

Goods (imported)

US bank deposit (USD 10) (buys in fx mkt) LC bank deposit (pays for fx) US bank deposit (USD 10) (pays)

+100

+ 100 -100

-100

Total change

0

Box 4: LC banking system (LCC millions)

Liabilities

LC exporter deposit (earns) LC importer deposit (pays)

+ 100 -100

Total change

0

Box 5: US importer (USD millions)

Liabilities

Goods (imported)

US bank deposits (pays)

+ 10 -10

Total change

0

Box 6: US exporter (USD millions)

Liabilities

Goods (exported)

US bank deposits (earns)

-10 + 10

Total change

0

An example will make this clear (see boxes 1-6; assumption USD / LCC 10.0). A Local Country (LC) exporter sells goods to a US importer and is paid USD 10 million by a deposit in its name at a US bank. At the same time a LC importer receives goods from a US exporter and needs to pay the US exporter USD 10 million. The LC exporter sells the USD 10 million deposit in the forex market (made by the large banks) in exchange for LCC 100 million, while the LC importer buys USD 10 million in the forex market, and pays LCC 100 million for the USD 10 million. He then pays the US exporter USD 10 million.

In this example the supply of and the demand for forex are equal, and the exchange rate will not have changed. There are other sources of supply and demand. You will recall from our depiction of the financial system shown earlier that one of the four sectors that make up the ultimate lenders and borrowers is the foreign sector. This is where the other part of the forex market fits in. The foreign sector is able to supply funds to LC, domestic institutions are able to lend to the foreign sector, and the foreign sector is able to borrow funds in the local market (i.e. issue securities in the local market).

Thus the forex market, essentially (it is more complex, but this is the essence), is made up of the:

- supply of forex forthcoming from:

- foreign lenders (as depicted) (i.e. foreign investors),

- local institutions borrowing offshore, and

- exporters, and the

- demand for forex forthcoming from:

- foreign borrowers issuing foreign securities locally,

- local institutions lending / investing offshore, and

- importers.

Thus, it will be apparent that in order for a forex market to function there needs to be a demand for and a supply of forex. Demand is the demand for, say, USD, the counterpart of which is the supply of LCC. This cannot be satisfied without a supply of USD, the counterpart of which is a demand for LCC. The forex market brings these demanders and suppliers together, and the exchange rates of the LCC against foreign currencies (the USD and others via the cross rates), is the outcome of these forces of supply and demand.

financial markets

Figure 9: financial markets

In terms of investments, the forex market should be seen as a conduit for foreigners to the local financial markets and for locals to the foreign financial markets. The markets discussed thus far may be depicted as in Figure 9.

financial markets

Figure 10: financial markets

In terms of the lending and borrowing process, the financial markets (spot) can be depicted as in Figure 10. All lending and borrowing (and forex transactions) takes place via financial markets.

2.7.6. Spot and derivative markets

When a financial market transaction is effected today (T+0) and settled asap, it is settled on T+0 or T+ a few days from T+0. For example, in the money market deals are settled on the day of the transaction (T+0), or the next day (T+1). In the bond market settlement takes place on T+3 and in the share market on T+5 (some on T+3). These are termed spot market or cash market deals (see Figure 11).

Spot deals, which are settled asap (T+0 to T+5), are differentiated from derivative market deals. They are deals done on T+0 and settled on specific days in the future other than on spot settlement days (T+0 toT+5). Derivative markets are also sometimes called forward markets (even though there are forwards as part of the derivativesgroup). The derivative markets are depicted Figure 12.

settlement in spot / cash markets & derivative markets

Figure 11: settlement in spot / cash markets & derivative markets

derivative instruments / markets

Figure 12: derivative instruments / markets

The derivative markets are mentioned here for the sake of completeness and also because two of the group, futures and options, can be used, and are used, as substitutes for the instruments of debt and shares. We will return to this issue.

 
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