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4. Financial markets

4.1. Learning objectives

After studying this text the learner should / should be able to:

1. Outline the participants in the financial markets.

2. Describe the share and debt markets, and name their collective name.

3. List the instruments of the money and bond markets.

4. Distinguish between fixed-interest and interest-bearing markets.

5. Define the foreign exchange market.

6. List the derivative instruments and briefly describe them.

7. Elucidate the organization of the financial markets.

8. Define the primary and secondary markets.

9. Discuss the functions of secondary markets.

10. Distinguish between OTC and formal markets.

11. List and describe the primary market issuing methods.

12. Define short selling.

13. Appreciate the clearing and settlement procedures of securities transactions.

4.2. Introduction

The financial markets are simply the mechanisms and conventions that exist for the transfer of funds and their counterparts (i.e. the financial instruments) between the various participants.

All the ultimate lenders and borrowers (household, corporate, government and foreign sectors) and all the financial intermediaries are participants in the financial markets. And so are the other financial entities that facilitate the transfer of funds and securities: the broker-dealers, the regulators, the financial exchanges (which essentially do no more that facilitate the transfer of securities) and fund managers.

The participants in the financial system also include:

• hedgers,

• speculators and

• arbitrageurs

but they are already included in the participants in the markets mentioned above. For example, banks can also be hedgers, speculators and arbitrageurs. Insurers, retirement funds and even individuals (= members of the household sector) also hedge at times, and individuals also speculate.

In terms of its main economic function the financial markets provide channels for transferring the excess funds of surplus units to deficit units. Financial markets thus constitute the mechanism that links surplus and deficit units, providing the means for surplus units to finance deficit units either directly or indirectly through financial intermediaries. An allied and vital function is price discovery.

Financial markets provide surplus and deficit units with additional options. Surplus units may purchase primary or indirect securities or reduce their debt by purchasing their own outstanding securities. Deficit units, on the other hand, may issue securities or dispose of some financial assets previously acquired. All these options are made possible by the existence of properly functioning financial markets.

To summarise: the participants in the financial markets are the borrowers (issuers of securities), the lenders (buyers of securities), the financial intermediaries (buyers and issuers of securities) and the broker-dealers, fund managers, exchanges and regulators. The term financial market therefore encompasses the participants and their dealings in particular financial claims (debt and shares), groups of claims, and the manner in which their demands and requirements interact to set prices for such claims (interest rates and prices of shares).

financial system

Figure 1: financial system

The terminology and concepts used in the financial markets can be confusing. For example, reference is made to the primary market, the secondary market, the spot market, the options and futures markets, the forward market, over-the-counter markets, order-driven markets, quoted-driven markets, financial exchanges, the money market, the capital market, the debt market, the share market, the foreign exchange market, the swap market, floor trading, open-outcry trading, screen trading, ATS trading, etc. The following sections endeavour to put all these into proper context:

• Money market.

• Bond market.

• Share market.

• Foreign exchange market.

• Derivatives markets.

• "Types" and organizational structure of financial markets.

• Financial market participants and short selling.

• Clearing and settlement.

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