FINANCIAL MARKETS AND INSTITUTIONS

CHAPTER ONE
Financial Markets and Institutions

1. Why Study Financial Markets and Institutions?

2. Overview of Financial System

Indeed, well functioning financial markets are a key factor in producing high economic growth, and
poorly performing financial markets are one reason that many countries in the world remain
disparately poor.
Activities in financial markets also have direct effects on personal wealth, the behavior of businesses
and consumers, and the cyclical performance of the economy.

Financial Markets
 The arenas through which funds flow.
 A financial market is a market in which people trade financial securities and derivatives at
low transaction costs. Some of the securities include stocks and bonds, raw material and
precious metals, which are known in the financial markets as commodities.

BY: MEHTAB ISMAIL KUMBHAR

FINANCIAL MARKETS AND INSTITUTIONS

Debt Markets and Interest Rates

A security (also called a financial instrument) is a claim on issuer’s future income or assets (any
financial claim or piece of property that is subject to ownership).
A bond is a debt security that promise to make payments periodically for a specified period of time.
Debt markets, also often referred to generically as the bond market, are specially important to
economic activity because they enable corporations and governments to borrow to finance their
activities and because they are where interest rates is determined.
An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed
as a percentage of the rental of $100 per year).
There are many interest rates in the economy--- mortgage interest rates, car loan rates and interest
rates on many different types of bonds. Interest rates are important on a number of levels. On a
personal level, high interest rates could deter you from buying a house or car because the cost of
financing it would be high. Conversely, high interest rates could encourage you to save because you
can earn more interest income by putting aside some of your earnings as savings. On a more general
level, interest rates have an impact on the overall health of the economy because they have affect
not only consumers’ willingness to spend or save but also businesses’ investment decisions.
High interest rates, for example, might cause a corporation to postpone building a new plant that
would provide more jobs.
Because changes in interest rates have important effects on individuals, financial institutions,
businesses, and the overall economy, it is important to explain fluctuations in interest rates that have
been substantial over the past 20 years.
For example, the interest rate on three-month Treasury bills peaked over 16% in 1981.
This interest rate fell to 3% in late 1992 and 1993, rose to above 5% in the mid- to late 1990s, and
fell to below 1% in 2004, only to begin rising again.

BY: MEHTAB ISMAIL KUMBHAR

FINANCIAL MARKETS AND INSTITUTIONS

The Stock Market

A common stock (typically just called a stock) represent a share of ownership in a corporation. It is
a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to
the public is a way for corporations to raise funds to finance their activities.
The stock market, in which claims on the earnings of corporations (shares of stock) are traded, is the
most widely followed financial markets in almost every country that has one; that’s why it is often
called simply “ market”
A big swing in the prices of shares in the stock market is always a major story on the evening news.
People often speculate on where the market is heading and get very excited when they can brag
about their latest “big killing” but they become depressed when they suffer a big loss. The attention ,
the market receives can probably be best explained by on simple fact;
 It is a place where people can get rich___ or poor ____quickly.
 Stock prices are extremely volatile.
The stock market is also an important factor in business investment decisions, because the price of
shares affects the amount of funds that can be raised by selling newly issued stock to finance
investment spending. A higher price for a firm’s shares means that it can raise a larger amount of
funds, which can be used to buy production facilities and equipment.

The Foreign Exchange Market

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-
counter (OTC) market for the trading of currencies. This market determines foreign exchange rates
for every currency. It includes all aspects of buying, selling and exchanging currencies at current or
determined prices.
Foreign exchange market (forex, or FX, market), institution for the exchange of one country's
currency with that of another country. Foreign exchange markets are actually made up of many
different markets, because the trade between individual currencies—say, the euro and the U.S. dollar
—each constitutes a market.
The foreign exchange market or forex market is the market where currencies are traded. The forex
market is the world's largest financial market where trillions are traded daily. It is the most liquid
among all the markets in the financial world.
There is no central location for the foreign exchange market, often referred to as the forex (FX)
market. Transactions in the foreign exchange market take place in many different forms, 24 hours a
day, through different channels all over the globe, and wherever one currency is exchanged for
another. The foreign exchange (forex) market is the largest and most liquid asset market on earth,
trading 24/7 around the globe.
There is actually no central location for the forex market - it is a distributed electronic marketplace
with nodes in financial firms, central banks, and brokerage houses. 24/7 forex trading can be
segmented into regional market hours based on peak trading times in New York, London, Sydney,
and Tokyo.
The foreign exchange market assists international trade and investments by enabling currency
conversion. For example, it permits a business in the United States to import goods from European
Union member states, especially Eurozone members, and pay Euros, even though its income is in
United States dollars. The foreign exchange markets play a critical role in facilitating cross-border
trade, investment, and financial transactions. These markets allow firms making transactions in
foreign currencies to convert the currencies or deposits they have into the currencies or deposits they
want. The foreign exchange market (also known as forex, FX, or the currencies market) is an over-
BY: MEHTAB ISMAIL KUMBHAR
FINANCIAL MARKETS AND INSTITUTIONS

the-counter (OTC) global marketplace that determines the exchange rate for currencies around the
world. Participants in these markets can buy, sell, exchange, and speculate on the relative exchange
rates of various currency pairs
Foreign exchange markets are made up of banks, forex dealers, commercial companies, central
banks, investment management firms, hedge funds, retail forex dealers, and invest
The foreign exchange market is an over-the-counter (OTC) marketplace that determines the
exchange rate for global currencies. It is, by far, the largest financial market in the world and is
comprised of a global network of financial centers that transact 24 hours a day, closing only on the
weekends. Currencies are always traded in pairs, so the "value" of one of the currencies in that pair
is relative to the value of the other.

Example
The foreign exchange market assists international trade and investments by enabling currency
conversion. For example, it permits a business in the United States to import goods from European
Union member states, especially Eurozone members, and pay Euros, even though its income is in
United States dollars.

Types of Foreign Exchange Market

 Spot Markets.
 Forward Markets.
 Future Markets.
 Option Markets.
 Swaps Markets.

Spot Markets.
The spot market is the immediate exchange of currencies at the current exchange. On the spot. This
makes up a large portion of the total forex market and involves buyers and sellers from across the
entire spectrum of the financial sector, as well as those individuals exchanging currencies.
The spot market is where financial instruments, such as commodities, currencies, and securities, are
traded for immediate delivery. Delivery is the exchange of cash for the financial instrument.
A futures contract, on the other hand, is based on the delivery of the underlying asset at a future date.
Exchanges and over-the-counter (OTC) markets may provide spot trading and/or futures trading.

How Spot Markets Work

Spot markets are also referred to as “physical markets” or “cash markets” because trades are
swapped for the asset effectively immediately. While the official transfer of funds between the buyer
and seller may take time, such as T+2 in the stock market and in most currency transactions, both
parties agree to the trade “right now.
 .” A non-spot, or futures transaction, is agreeing to a price now, but delivery and transfer of
funds will take place at a later date.
 The current price of a financial instrument is called the spot price. It is the price at which an
instrument can be sold or bought immediately. Buyers and sellers create the spot price by
posting their buy and sell orders. In liquid markets, the spot price may change by the second,
as orders get filled and new ones enter the marketplace.

BY: MEHTAB ISMAIL KUMBHAR

FINANCIAL MARKETS AND INSTITUTIONS

Examples
The New York Stock Exchange (NYSE) is an example of an exchange where traders buy and sell
stocks for immediate delivery. This is a spot market.
The Chicago Mercantile Exchange (CME) is an example of an exchange where traders buy and sell
futures contracts. This is a futures market and not a spot market.

Forward Forex Market

The forward market involves an agreement between the buyer and seller to exchange currencies at
an agreed-upon price at a set date in the future. No exchange of actual currencies takes place, just the
value. The forward market is often used for hedging. A forward market is an over-the-counter
marketplace that sets the price of a financial instrument or asset for future delivery. Forward markets
are used for trading a range of instruments, but the term is primarily used with reference to the
foreign exchange market.
A forward market is an over-the-counter marketplace that sets the price of a financial instrument or
asset for future delivery. Forward markets are used for trading a range of instruments, but the term is
primarily used with reference to the foreign exchange market. It can also apply to markets for
securities and interest rates as well as commodities.
One of the main functions of the forward market is to minimize the risk and fixed the price of an
asset or financial instrument for the future period. When any party wants to minimize the risk and
fixed the price of any asset or financial instrument, such a person can enter into a contract through
the forward market.

Futures Forex Market:

The futures market is similar to the forward market, in that there is an agreed price at an agreed date.
The primary difference is that the futures market is regulated and happens on an exchange. This
removes the risk found in other markets. Futures are also used for hedging.
Futures are derivative financial contracts that obligate parties to buy or sell an asset at a
predetermined future date and price. The buyer must purchase or the seller must sell the underlying
asset at the set price, regardless of the current market price at the expiration date.
A futures market is an auction market in which participants buy and sell commodity and futures
contracts for delivery on a specified future date. Futures are exchange-traded derivatives contracts
that lock in future delivery of a commodity or security at a price set today.
Examples of futures markets are the New York Mercantile Exchange (NYMEX), the Chicago
Mercantile Exchange (CME), the Chicago Board of Trade (CBoT), the Cboe Options Exchange
(Cboe), and the Minneapolis Grain Exchange. Originally, such trading was carried on through open
outcry and the use of hand signals in trading pits, located in financial hubs such as New York,
Chicago, and London. Throughout the 21st century, like most other markets, futures exchanges have
become mostly electronic.
A futures market is an exchange where futures contracts are traded by participants who are interested
in buying or selling these derivatives.
In the U.S., futures markets are largely regulated by the Commodity Futures Trading Commission
(CFTC), with futures contracts standardized by exchanges.
Today, the majority of trading of futures markets occurs electronically, with examples including the
CME and ICE. Unlike most stock markets, futures markets can trade 24 hours a day.

BY: MEHTAB ISMAIL KUMBHAR

FINANCIAL MARKETS AND INSTITUTIONS

Difference
A forward contract is signed between party A and party B face to face (or over the counter), whereas
in a futures contract there is an intermediary between the two parties. This intermediary is often
called a clearance house, which is a part of a stock exchange.
Forward markets usually deal with OTC products, whereas futures markets deal with products on
exchanges. Forward markets have the terms negotiable among the parties regarding the contract size
and date of delivery, whereas futures contracts are more standardized. A forward contract is signed
between party A and party B face to face (or over the counter), whereas in a futures contract there is
an intermediary between the two parties. This intermediary is often called a clearance house, which
is a part of a stock exchange.
The two parties do not work directly with their counterpart; rather, each party works with the
clearance house that is monitoring the transaction. This implies that the default risk that may appear
problematic in a forward contract is significantly reduced in a futures contract.
A forward contract is signed based on the agreement between the two parties regarding the price, the
quality and the quantity, as well as the delivery date of the underlying asset. They are not
standardised. However, in a futures contract, the transaction is standardised in terms of quantity,
quality, and delivery date. A forward contract usually only has one specified delivery date, whereas
there is a range of delivery dates in a futures contract. A forward contract is not formally regulated,
whereas a futures contract is regulated by the stock exchange where the clearance house is situated.

Option Markets.
Options are among the most important inventions of contemporary finance. Whereas a futures
contract commits one party to deliver, and another to pay for, a particular good at a particular future
date, an option contract gives the holder the right, but not the obligation, to buy or sell.
Options trading is how investors can speculate on the future direction of the overall stock market or
individual securities, like stocks or bonds. Options contracts give you the choice—but not the
obligation—to buy or sell an underlying asset at a specified price by a specified date.
For example, a stock option is for 100 shares of the underlying stock. Assume a trader buys one call
option contract on ABC stock with a strike price of $25. He pays $150 for the option. On the
option's expiration date, ABC stock shares are selling for $35.

Swap Market
The swap market is one of the largest and most liquid global marketplaces, with many willing
participants eager to take either side of a contract.
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of
time. Usually, at the time the contract is initiated, at least one of these series of cash flows is
determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity
price, or commodity price.

BY: MEHTAB ISMAIL KUMBHAR