Introduction to the Financial Markets

Introduction

Just in short the term 'financial markets' refers to the group of markets where participants buy and sell financial assets. Like in India example - National Stock Exchange( nseindia.com) and Bombay stock exchange(bseindia.com).

Financial Markets Participants

Participants in the financial markets are the entities who lend or borrow money for investment or consumption. These could be Personals , households, companies, governments etc. Participants borrow and lend money through financial intermediaries on a particular interest rate. Financial intermediaries gather capital from those who have surplus of it in an economy (lenders/ investors) and distribute these savings to those who want it for investment or consumption (borrowers/ spenders). They could be banks, insurance companies, pension funds, mutual funds (unit trusts), etc.

Lenders advantage

The lender get financial assets in return of investment he had done. Financial assets are claims for future financial payments. These assets could be of various types ranging from bank deposit,mutual fund or equity. The rate of return could be in the form of interest, dividend, capital appreciation of the financial assets etc. It would depend on the claim the financial assets represent. It could be fixed or variable as well. 

A financial asset with a fixed claim is known as a debt instrument. The most popular debt instrument is a bond. A bond is a document stating the terms on which the money borrowed will be paid back. For example, it may be a 5-year bond, with interest payments of 9.5% in annual installments. Therefore, the company (or government) that issued the bond will pay a fixed rate of interest of 9.5% in a year to the holder of the bond.

A financial asset with a varying claim is an equity. Money is raised through the sale of shares in a company (equity). The holder of an equity claim (shareholder) may receive income in the form of a dividend. The payment of dividends depends on the earnings of the company as well as on its reinvestment plans. Shareholders will also receive capital gains (or losses) if the value of the share increases (decreases) by the time they sell the shares.

Equity generally takes the form of common stock or preferred stock. Common stock represents ownership in a corporation, whereas preferred stock does not. Instead, preferred stock pays a specified dividend to the stockholder and ranks ahead of common stockholders in the event of liquidation. Note that while preferred stock is generally classified as equity, its claim could be regarded as 'fixed', although management may elect not to pay a preferred stock dividend in any given year.

Common stock is referred to as ordinary shares and preferred stock as preference shares.

Segments in the Financial Markets 

Money markets 

The money market is the market for the purchase, sale, lending and borrowing of short-term financial assets (financial assets with maturities of less than one year). Examples of such financial assets include: 

• Treasury bills - these are securities issued and guaranteed by a government, at a discount from face value, with a maturity of one year or less.
• Euro currencies - these are foreign currencies deposited with a bank account outside the country in which these currencies are used for legal tender.

Capital markets 

The capital market is the market for the purchase, sale, lending and borrowing of medium-term and long-term financial assets (maturities greater than one year). Examples include equity and bonds. 

Derivatives markets 

Derivatives are instruments that derive most of their value from the value of another product. These are: 

• Futures 
• Options 
• Forwards 
• Forward rate agreements 
• Swaps 

Players in Financial Markets 

• Investors/ Lenders (individuals/ companies)
• Consumers/ Borrowers (individuals/ companies)
• Financial intermediaries (banks/ brokers)
• Market Makers or Brokers, Dealers

Market makers act as intermediaries between users of financial markets. Brokers provide a service bringing buyers and sellers together. Their profits are earned through the Commission/Brokerage they charge. Their main function is to 'make a market'.  This means that they give two way quotes ( bid & offer rates) for the financial securities. To this end, they hold an inventory of securities and are ready to buy and sell particular securities at a stated price. Dealers make profits from the spread they receive, the difference between the purchase price and the sale price of the same security.

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