FINANCIAL MARKETS

Financial market

At any point in time in an economy, there are individuals /organizations with excess amounts
of funds, others with a lack of funds they need for example, to consume or to invest.

Exchange between these two groups of agents is settled in a financial markets. The first group is
referred to as lenders and the other group are borrowers.

Financial market is a market in which financial assets are traded. In addition to enabling
exchange of previously issued financial assets, financial markets facilitate borrowing and lending
by facilitating the sale by newly issued financial assets.

Financial markets refer to an elaborate system of the financial institution and intermediaries and
arrangement put in place and developed to facilitate the transfer of funds from surplus economic
units (savers) to deficit economic units (investors).

Financial market is a market in which financial assets (securities) e.g. stocks and bonds can be
purchased or sold.

Financial markets are critical for producing an efficient allocation of capital, which contributes to
higher production and efficiency for overall as well as economic security for the citizenry as a
whole.

Financial markets also improve the lot of individual participants by providing investment returns
to lender – savers and profit or use opportunities to borrower – spenders.

Structure/classification of Financial Markets

(a) Debt and Equity Markets

A firm or an individual can obtain funds in a financial market in two ways.

The most common method is to issue a debt instrument, such as a bond or a mortgage, which
is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar
amounts at regular intervals (interest and principal payments) until a specified date (the maturity
date), when a final payment is made.

The maturity of a debt instrument is the number of years (term) until that instrument’s expiration
date. A debt instrument is short-term if its maturity is less than a year and long-term if its maturity
is 10 years or longer.

Debt instruments with a maturity between one and 10 years are said to be intermediate-term.
The second method of raising funds is by issuing equities, such as common stock, which are
claims to share in the net income (income after expenses and taxes) and the assets of a
business.

If you own one share of common stock in a company that has issued one million shares, you are
entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the firm’s assets.

Equities often make periodic payments (dividends) to their holders and are considered long-
term securities because they have no maturity date.

In addition, owning stock means that you own a portion of the firm and thus have the right to
vote on issues important to the firm and to elect its directors.

The main disadvantage of owning a corporation’s equities rather than its debt is that an equity
holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays
its equity holders.

The advantage of holding equities is that equity holders benefit directly from any increases in
the corporation’s profitability or asset value because equities confer ownership rights on the
equity holders.

Debt holders do not share in this benefit because their dollar payments are fixed.
(b) Primary and Secondary Markets

A primary market is a financial market in which new issues of a security, such as a bond or
a stock, are sold to initial buyers by the corporation or government agency borrowing the funds.

The primary markets for securities are not well known to the public because the selling of
securities to initial buyers often takes place behind closed doors. An important financial
institution that assists in the initial sale of securities in the primary market is the investment
bank. It does this by underwriting securities: It guarantees a price for a corporation’s securities
and then sells them to the public.

A secondary market is a financial market in which securities that have been previously
issued can be resold. Securities brokers and dealers are crucial to a well-functioning secondary
market. Brokers are agents of investors who match buyers with sellers of securities; dealers
link buyers and sellers by buying and selling securities at stated prices.

(c) Exchanges and Over-the-Counter Markets

Secondary markets can be organized in two ways.

One method is to organize exchanges, where buyers and sellers of securities (or their agents
or brokers) meet in one central location to conduct trades. The New York and American
Stock Exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn,
silver, and other raw materials) are examples of organized exchanges.

The other method of organizing a secondary market is to have an over-the-counter (OTC)

market, in which dealers at different locations who have an inventory of securities stand
ready to buy and sell securities “over the counter” to anyone who comes to them and is
willing to accept their prices. Because over-the-counter dealers are in contact via computers
and know the prices set by one another, the OTC market is very competitive and not very
different from a market with an organized exchange.

(d) Money and Capital Markets

Another way of distinguishing between markets is on the basis of the maturity of the
securities traded in each market.

The money market is a financial market in which only short-term debt instruments
(generally those with original maturity of less than one year) are traded.

Money market securities are usually more widely traded than longer-term securities and so tend
to be more liquid. In addition, short-term securities have smaller fluctuations in prices than
long-term securities, making them safer investments. As a result, corporations and banks
actively use the money market to earn interest on surplus funds that they expect to have only
temporarily.

The capital market is the market in which longer-term debt (generally with original
maturity of one year or greater) and equity instruments are traded. Capital market
securities, such as stocks and long-term bonds, are often held by financial intermediaries such
as insurance companies and pension funds, which have little uncertainty about the amount of
funds they will have available in the future.

Types of financial markets

(a) Capital market

The capital market aids raising of capital on a long-term basis, generally over 1 year. It consists
of a primary and a secondary market and can be divided into two main subgroups – Bond
market and Stock market.

 The Bond market provides financing by accumulating debt through bond issuance and
bond trading
 The Stock market provides financing by sharing the ownership of a company through
stocks issuing and trading
A primary market, or the so-called “new issue market”, is where securities such as shares and
bonds are being created and traded for the first time without using any intermediary such as an
exchange in the process. When a private company decides to become a publicly-traded entity, it
issues and sells its stocks at a so-called Initial Public Offering. IPOs are a strictly regulated
process which is facilitated by investment banks or finance syndicates of securities dealers that
set a starting price range and then oversee its sale directly to the investors.

A secondary market, or the so-called “aftermarket” is the place where investors purchase
previously issued securities such as stocks, bonds, futures and options from other investors,
rather from issuing companies themselves. The secondary market is where the bulk of exchange
trading occurs and it is what people are talking about when they refer to the “stock market”. It
includes the NSE, NYSE, Nasdaq and all other major exchanges.

Some previously issued stocks however are not listed on an exchange, rather traded directly
between dealers over the telephone or by computer. These are the so-called over-the-counter
traded stocks, or “unlisted stocks”. In general, companies which are traded this way usually
don’t meet the requirements for listing on an exchange. Such shares are traded on the Over the
Counter Bulletin Board or on the pink sheets and are either offered by companies with a poor
credit rating or are penny stocks.

The strength of Capital markets is their ability to;

(i) Mobilize long term savings

(ii) Provide risk capital
(iii) Encourage broader ownership of firms and
(iv) Efficiency of resource allocation through competitive pricing mechanism.

The development of Capital markets within an economy therefore provides opportunity for
greater funds mobilization, improved efficiency in resource allocation and provision of relevant
signals for investment appraisal.

Main players in Kenya’s capital market

Example: Companies, the government, participating banks, capital market Authority (CMA)
The capital market is the market for long-term loans and equity capital.

Companies and the government can raise funds for long-term investments via the capital market.
The capital market includes the stock market, the bond market, and the primary market.

The government monitors securities trading on organized capital markets; new issues are
approved by authorities of financial supervision and monitored by participating banks. Thus,
organized capital markets are able to guarantee sound investments.

The Kenyan Capital Market Authority (CMA) - In Kenya, The CMA was established in 1989
through the Capital Markets Authority Act Cap 485A. The Authority was established to regulate
and oversee the orderly development of Kenya's Capital Markets. The framework for
regulation is provided by the CMA Act, rules, regulations and guidelines issued there under
which provide guidance to the markets operations.

The CMA as a regulatory agency licenses institutions to operate in the capital markets. One of
the licenses of the Authority is the stock exchange (NSE). A stock exchange is an approved
faculty for trading securities.

The CMA's roles include;

(i) Establishment of operational rules and regulations on private placement of securities

(ii) Development of all aspects of the capital markets with particular emphasis on removal of
impediments to and creation of incentives for long-term investments in financial
markets.
(iii) Protects investors interests by operating a compensation funds that protects investors
from financial loss arising from the failure of licensed brokers or dealers to meet his
contractual obligations
(iv) Listing of securities on a securities exchange.
(v) Licensing of financial markets players; Investment Advisers, Brokers, Dealers,
Underwriters etc.
(vi) Watchdog over the capital markets
(vii) Regulate the operations of the institutions in the capital markets
(viii) The development of a framework to facilitate the use of electronic commerce
for the development of capital markets in Kenya.
(ix) Formulation of rules to monitor:

Functions of capital market

1. Providing long term funds which are necessary for investment decisions.
2. They provide advice to investors as to which investments are viable
3. Long term investments are made liquid as a transfer between shareholders are facilitated
4. It facilitates the international flow of income i.e. cross boarder listing and foreign direct
investment (FDI).
5. It enables or facilitates liquidation and marketing of long term securities.
6. It acts as a channel through which investments find their way into the market.

Stock market

A common stock (typically just called a stock) represents 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 market in almost every country that has one; that’s
why it is often called simply “the 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 one simple fact: It is a place
where people can get rich—or poor—quickly

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.

(b) Money market

The money market enables economic units to manage their liquidity positions through lending
and borrowing short-term loans, generally under 1 year. It facilitates the interaction between
individuals and institutions with temporary surpluses of funds and their counterparts who are
experiencing a temporary shortage of funds.

One can borrow money within a quite short period of time via a standard instrument, the so-
called “call money”. These are funds borrowed for one day, from 12:00 PM today until 12:00
PM on the next day, after which the loan becomes “on call” and is callable at any time. In
some cases, “call money” can be borrowed for a period of up to one week.

Apart from the “call money” market, banks and other financial institutions use the so-called
“Interbank market” to borrow funds within a longer period of time, from overnight to several
weeks and up to one year. Retail investors and smaller trading parties do not participate on the
Interbank market. While some of the trading is performed by banks on account of their clients,
most transactions occur in case a bank experiences extra liquidity, a surplus of funds, while
another has a shortage of liquidity.
Such loans are made at the Interbank rate, which is the rate of interest, charged on short-term
loans between banks. An intermediary between the counterparts, called a dealer, announces a bid
and an offer rate with the difference between the two representing a spread, or the dealer’s
income. The Interbank interest in London is known as LIBOR (London Interbank Offered Rate)
and LIBID (London Interbank Bid Rate). Respectively in Paris we have PIBOR, in Frankfurt –
FIBOR, in Amsterdam – AIBOR, and Madrid – MIBOR.

(c) Foreign exchange market

For funds to be transferred from one country to another, they have to be converted
from the currency in the country of origin (say, dollars) into the currency of the
country they are going to (say, euros). The foreign exchange market is where this
conversion takes place, so it is instrumental in moving funds between countries. It is
also important because it is where the foreign exchange rate, the price of one
country’s currency in terms of another’s, is determined.

Q. What does fluctuations in the exchange rate mean to the Kenyan public and
businesses?

A change in the exchange rate has a direct effect on consumers because it affects the cost
of imports.
A weaker shilling leads to more expensive foreign goods, makes vacationing abroad
more expensive, and raises the cost of indulging your desire for imported delicacies.
When the value of the shilling drops, Kenyans decrease their purchases of foreign goods
and increase their consumption of domestic goods (such as travel in Kenya or Kenyan-
made drinks).

A strong shilling means that Kenyan goods exported abroad will cost more in foreign
countries, and hence foreigners will buy fewer of them. A strong shilling benefit Kenyan
consumers by making foreign goods cheaper but hurt Kenyan businesses and eliminate
some jobs by cutting both domestic and foreign sales of their products.

(d) Commodity market

The commodity market manages the trading in primary products which takes place in about 50
major commodity markets where entirely financial transactions increasingly outstrip physical
purchases which are to be delivered. Commodities are commonly classified in two subgroups.

 Hard commodities are raw materials typically mined, such as gold, oil, rubber, iron ore
etc.
  Soft commodities are typically grown agricultural primary products such as wheat,
cotton, coffee, sugar etc.

(e) Derivatives market

It facilitates the trading in financial instruments such as futures contracts and options used
to help control financial risk. The instruments derive their value mostly from the value of an
underlying asset that can come in many forms – stocks, bonds, commodities, currencies or
mortgages.

The derivatives market is split into two parts which are of completely different legal nature and
means to be traded.

(i) Exchange-traded derivatives

These are standardized contracts traded on an organized futures exchange. They include
futures, call options, and put options. Trading in such uniformed instruments requires from
investors a payment of an initial deposit which is settled through a clearing house and aims at
removing the risk for any of the two counterparts not to cover their obligations.

(ii) Over-the-counter derivatives

Those contracts that are privately negotiated and traded directly between the two
counterparts, without using the services of an intermediary like an exchange. Securities
such as forwards, swaps, forward rate agreements, credit derivatives, exotic options and other
exotic derivatives are almost always traded this way. These are tailor-made contracts that remain
largely unregulated and provide the buyer and the seller with more flexibility in meeting their
needs.

(f) Insurance market

It helps in relocating various risks. Insurance is used to transfer the risk of a loss from one entity
to another in exchange for a payment. The insurance market is a place where two peers, an
insurer and the insured, or the so-called policyholder, meet in order to strike a deal
primarily used by the client to hedge against the risk of an uncertain loss.
Characteristics of a good financial market

1. To determine the appropriate price, participants must have timely and accurate
information on the volume and prices of past transactions and on all currently outstanding
bids and offers.
2. Liquidity – the ability to buy or sell an asset quickly and at a known price – i.e. a price not
substantially different from the prices for prior transactions, assuming no new information is
available. Price continuity means that prices do not change much from one transaction to the
next unless substantial new information becomes available.
3. Transaction costs – an efficient market is one in which the cost of the transaction is minimal.
This attribute is referred to as internal efficiency.
4. Finally, a buyer or seller wants the prevailing market to adequately reflect all the information
available regarding supply and demand factors in the market. Therefore, participants want
prices to adjust quickly to new information regarding supply or demand, which means that
prices reflect all available information about the asset. This attribute is referred to as
external efficiency or informational efficiency

Functions/Roles of financial markets

(i) Intermediary functions

(a) Transfer of resources – financial markets facilitate the transfer of real economic
resources from lenders to ultimate borrowers. Financial markets channel funds
from household, firms, governments and foreigners that have saved surplus
funds to those who encounter a shortage of funds(for purposes of
consumption and investments. They allow funds to move from people who lack
productive investment opportunities to people who have such opportunities.
(b) Enhancing income – financial markets allow lenders to earn interest or
dividends on their surplus invisible funds, thus contributing to the enhancement
of the individual and national income.
(c) Risk sharing and distribution – financial markets allow transfer of risk from those
undertaking investments to those who provide funds for those investments
(d) Productive usage – financial markets allow for the productive use of the funds
borrowed. Thus enhancing income and the gross national production
(e) Capital formation – financial markets provide a channel through which new
savings flow to aid capital formation of a country
(f) Price determination – financial markets allow for the determination of price of the
traded financial assets through the interaction of buyers and sellers. They
provide a sign for the allocation of funds in the economy based on the demand
and supply through the mechanism called price discovery process.
(g) Sale mechanism – financial markets provide a mechanism for selling of a
financial asset by an investor so as to offer the benefit of marketability and
liquidity of such assets.
 (h) Information – the activities of the participants in the financial market result in the
generation and the consequent dissemination of information to the various
segments of the market. So as to reduce the cost of transaction of financial
assets.
(i) Financial efficiency – financial markets reduce information asymmetry and
transaction costs. The facilitation of financial transactions through financial
markets leads to a decrease in informational cost and transaction costs, which
from an economic point of view leads to an increase in efficiency.

(ii) Financial functions

(a) Providing borrower with funds so as to enable them to carry out their investment
plans
(b) Liquidity – the existence financial markets enables the owners of financial assets
to buy and resell these assets. Generally this leads to an increase in the liquidity of
these financial instruments.
(c) Providing the lenders with earning assets so as to facilitate trading of funds
(d) It provides liquidity to commercial banks
(e) It facilitates credit creation
(f) It promotes savings
(g) It promotes investments
(h) It facilitates balanced economic growth
(i) It improves trading floors

Effects of an efficient financial markets on the economy

(a) provide opportunity to increase future consumption

(b) it encourages thrift by allowing individuals to defer current consumption and build wealth
in the future
(c) investors benefit from excess to real resources that efficient markets permits
(d) expansion of profit opportunities
(e) better standards of living to people
(f) high consumption made possible by greater capital intensity and greater output.
(g) Provide economic growth to country
(h) Very specialized projects financed through financial institutions