Organization of the Financial and Commodity Markets

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Introduction

A Financial market is a very paramount system that enables people to trade financial securities. In addition, it also trades commodities like agricultural goods and fungible items like currencies and crude oils at relatively transaction outlay and at reasonable prices in an efficient market hypothesis. Financial markets have grown significantly over time to facilitate the market liquidity. Market liquidity explains how quickly an asset can be sold without loss in value. Preda (43) argued that financial markets can be categorized into the capital market which entails stock/equity market and bond/debt market, commodity markets, money markets, derivatives markets, insurance markets and foreign exchange markets. The stock market facilitates issuance of shares of common stock by a company and also allows subsequent trading of those shares. Bond markets facilitate financing through bonds and facilitate their subsequent trading. Commodity market entails the trading of commodities like agricultural products and many others. Money markets are a market for short-time lending. It trades securities like treasury bills commercial papers et cetera (Hamilton 51). Derivatives markets on the other hand are a market for financial risk management assets. Foreign exchange is traded through foreign exchange markets. The insurance market for risk covers. The efficiency of the financial markets is enhanced by their key participants. These include the investors, the speculators, institutional investors and the regulators or the financial market authorities.

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The objective of this essay is to discuss the organization of both financial (debt, equity, foreign exchange and derivatives) and the commodity market and their role in international trade and economic performance. The organization of financial debt and equity markets shall be discussed under the capital markets. Then we shall discuss the organization foreign exchange and the derivatives markets and finally, we shall assess their role in international trade and economic performance

Organization of Capital Markets (debt and equity)

A capital market is a place where business enterprises or companies and governments raise long-term funds through the issuance of securities. These securities may be debt or equities. It is a market in which money is provided for periods exceeding a year, as the raising of short-term funds is done in other markets that are the money markets (Sheffrin 44). The operations of capital market are regulated by the capital market authorities such as the Financial Service Authority of the United Kingdom or the United States Securities and Exchange Commission. One of the key duties of the capital market authority is to oversee under their jurisdictions; that the investors are protected against frauds.

The other duties of the capital market authority are: They ensure that trading is conducted fairly and that the investors are treated fairly by the issuers and those that deal with securities on their behalf. They also enforce the existing laws on the conduct of the capital markets. They license the provider of the financial services to ensure that they are legally established and every business they do is legal. According to UK Sunday Times of 16th July 2002, the regulators are also charged with the duty of maintaining confidence in the capital market and also safeguarding its integrity. This encourages more investors to invest in the capital markets. It is also in the jurisdiction of the capital market authority to prosecute cases of misconduct such as insider trading (Harris 29). This ensures that there is no impunity in the capital markets and all the perpetrators of misconduct face the full force of the law. They also protect clients and investigate complaints to find out whether the client is in any way aggrieved as may be claimed in the complaint. Capital markets are classified as secondary and primary markets.

The primary market

The primary market deals with the issuance of new securities into the capital market commonly known as the initial public offer, preferential issue or right issue for the existing companies. Public sectors and governments wishing to float their securities into the stock exchange enter the market through the primary market a process called underwriting (Preda 49). Underwriting is done by the investment banks who take the risk of distributing the securities. Should there be not enough investors, underwrites have to retain with them the remaining securities. They earn a fee called underwriting spread which is the difference between the price they pay the issuer and what is collected from the investors and broker-dealers.

The main features of the primary market are as under.

It is a market where the securities are issued for the very first time. It is a market for the long-term equity capital obtained through initial public offers.

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In this market, the investors buy the securities directly from the company. Modigliani and colleagues (46) stated that since the company is entering the capital market for the first time to raise capital, the investors get the securities directly from the company and thereafter from other investors.

The investors are issued with a share certificate by the company. This is because they are buying directly from the company. Otherwise, they get a certificate from the stockbrokers.

The redemption of the sold securities can only be done by the original holder unlike in secondary markets where at the time of security redemption, the beneficially may not be the original holder.

It plays a big role in economic growth by facilitating formation of capital in the economy. This is because it enables the government and the public sectors to collect huge capital from the public which is not in form of debts.

It offers a means of starting new businesses by the company or expanding the existing one.

It provides new long-term external finance for the companies and the governments through going public strategy.

Secondary market/ aftermarket

According to Mish kin (64), in the secondary market, the previously issued securities and other stocks are traded. In this case, the investors buy the securities from other investors who bought them preciously. The investors buy shares from other investors. In the secondary market, the issuing company does not befit directly from the investors. The price of the shares is largely dependent on the existing market forces.

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The capital market can further be broken down into debt/bond and equity/stock markets.

Bond/debt market

A bond is debt security with a maturity period and the authorized issuer owes the holder debt and the holder is entitled to a fixed interest as agreed in the terms. The holder can redeem the principal value of the bond at its maturity. According to Sheffrin (43), a bond attracts interest in borrowed money at fixed intervals. It is a loan the issuer borrows from the holder to repay it at an interest called coupon interest. One advantage of the bonds to the holders is that they get the amount they invested and the interest earned by the bond to maturity. The coupon is also fixed and is not affected by the economic crisis unlike the securities whose price changes with the economic situations (Preda). Bonds have a maturity period and can only be redeemed upon redemption.

A bond market is a place where people can access debt securities.

The following are examples of the bond market:

  • Corporate bond market is where corporations issue bonds to the public to raise money.
  • The Government bond market is a market where the government or government agencies issue bonds to raise revenue.
  • Municipal bond market is a market where a city, a local government and their agencies issue bonds.
  • Other bond market includes mortgage-based and funding bond market.

The participants in the bond market are institutional investors which are organizations that invest huge sums of money in buying bonds. These are institutions like banks, insurance companies, mutual funds et cetera. The other participants are traders, governments and individuals. According to Modigliani and colleagues (40), Traders are the people who buy and sell financial instruments such as stocks, bonds or derivatives. Since the bond principle and the interest are received according to predetermined rates, the bond market volatility is irrelevant. Bonds cannot be held for speculative purposes because the interest received by the participants is fixed. When bonds are redeemed before maturity, they may incur the holder the risk of interest rate changes. When the interest rates are high, the price of the bonds goes down because the new issues pay higher yields and this means that the participants who wish to redeem the bonds before maturity will do it at that reduced price. On the other hand, when the interest rates are low, the value of the bonds rises because the new issues attract fewer yields. The prices of bonds are inversely related to interest rates.

Individual investors enter the bond markets through unit investment trusts, bond funds and closed-end funds created by the investment companies. A bond fund according to Sheffrin (45) is a collective investment scheme that invests in bonds and other debt securities. Bond funds pay dividends on monthly basis. These dividends include interest earned and any income on bond price. The frequency of bond divided payment is relatively higher than that of individual bonds. Closed-end funds on the other hand have a limited number of shares but are also done by individuals through collective investment schemes. In a collective investment scheme, individual investors invest money collectively in a wider range of investments than an individual would. This is more feasible because the investment is huge and the cost of investment is shared. However any return on that investment will also be shared among the individuals.

The distinguishing features of closed-end funds are: the shares involved in the trade are not redeemed directly by the fund but are traded in the stock exchange; they also usually attract a premium or a discount and can only be traded at the closing price at the end of the market day (Preda 47). Lastly, a unit investment trust sells assets with a maturity period. These assets may include stock, equity or bonds. The stock trusts earn dividends and any other income on the principle. Upon their termination dates, they are liquidated and the proceeds are distributed to the unitholders. The unitholders may opt to reinvest the principal in the same portfolio.

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The bond trust has assets that earn a monthly income in their lifetime (Harris 34). Then the bond redemption proceeds are distributed to the bond unitholders on a pro-rata basis.

Equity/stock/share markets

This is a place where companies trade their stock their securities/assets with the public at an agreed price. These transactions take place in the stock exchange. A stock exchange provides trading facilities for securities and for the issue and redemption of securities to its members (Preda 41). Any company wishing to trade its stock in the stock exchange must register with it. After the initial public offer through which the company enters the market, the company’s shares enter the secondary market and are freely traded in the stock exchange at a price prevailing in the market. The participants in the stock market do not see prices. The price of the share in the stock market depends on several factors which include political factors, company performance and the demand and the supply of the shares (Hamilton 52).

Participants in the stock market

Decades ago the participants in the stock market were only individual investors. The evolution in the stock market has ushered in institutional investors like banks, insurance companies among others (Hamilton 56). This evolution has improved market operations. Individuals could only manage to buy a limited number of shares but institutions are able to buy a large number of shares. This is advantageous to the issuers because they can be able to raise a lot of money through initial public offers than they would before. Currently, almost every company is willing to go public in order to raise funds for expansion and new investments. This is because the stock exchange can benefit them more. Entering the stock exchange can also be disadvantageous because people tend to measure the performance of accompanying with the performance of its shares in the stock market. This means that if the share is not performing well, the people may easily lose confidence in the company.

Functions and purpose of stock market

The purpose of the stock market is to allow companies to raise money from the public. The company raises capital for expansion through selling shares to the public in a public market.

Stock market also provides the investors with an alternative method of investment. Most of the investments like real assets are less liquid and investors cannot quickly and easily sell them (Preda 53). The liquidity in the stock exchange makes trade of shares efficient. This attracts many investors to invest in stocks.

Shares can be used to gauge the rate at which the economy grows. Economic analysts may use the performance of shares in the market to assess the performance of the economy. Mostly, when the price of shares in the stock market rises, it shows there are increased business investments and improvement in the economy as whole. Opposite is true.

To the households, she increases in the price of the shares improve their wealth and consumption. This applies to those who invest in stocks. The stock market therefore contributes greatly to the performance of the economy. It allows people to invest in marketable securities instead of holding money in idle balances. People can hold stocks in the stock market for two purposes: There are those who hold them for speculative purposes and those who for investment purposes. A speculative purpose means that the stockholder is speculating the market so that they can sell their securities when their prices go up. This can be riskier in that if someone needs urgent cash, he may be compelled to sell the shares at a loss when their prices are lower than what they were bought. However, when the prices are high the stockholders can benefit. These investors only buy shares when their prices are low and sell them when their prices are high. Holding stocks for Investments purpose means that the investor is interested in earning the dividends of the company (Hamilton 52). They therefore buy the shares irrespective of the price

Derivatives markets

According to Weinberg (6), derivatives refer to a class of financial assets whose value is determined by other securities a derivative market trades futures, options and contracts.

Examples of Derivatives markets are:

  • Exchange-traded derivatives- These categories of derivatives are traded through intermediaries called derivative exchanges (Hull 62). The Korea and Eurex are the largest derivative exchanges.
  • Over-the-counter derivatives-Over, Counter derivatives market is the biggest market for derivatives. The parties to the transaction mostly consist of banks and other sophisticated parties. These markets are much unregulated. According to UK Business Finance Market Survey (25) the unregulated nature of Over Counter Derivatives poses a big challenge. For instance most of the transactions are done unnoticed and it is impossible to account for them. Due to lack of central counterparty in this market, the parties rely on each other to perform. The counterparty risk is therefore likely to be encountered by the parties.

Examples of derivative contracts

The three major derivative contracts are: futures/forwards, options and swaps.

Futures/forwards-these are contacting whereby the price of an asset to be sold on or before a future date is agreed today. a futures contract is a standardized contract and is written in a clearing and settlement financial institution called a clearinghouse that has an exchange for buying and selling contracts(Mish kin 29). Forward contracts on the other hand are not standardized and are written by the parties themselves.

Options- an option that gives a person the authority to buy or sell an asset at their own will. They are not obliged to enter into options. According to Hull (46) the asset sale price is called strike price or exercise price which is dictated by the contract regardless of the spot or market price. The contact has a maturity date.

Swaps- these contracts entail the exchange of cash on or before a set date based on the underlying value of the assets. The parties exchange certain benefits of one party’s financial assets for those of the other. According to Hull (46), this is a game between two counterparties exchanging cash flows.

The major classes of assets traded in the derivatives market are interest rate derivatives (where there is payment or receipt of money at a given interest rate on the underlying asset), foreign exchange derivatives (where a particular currency and exchange rate are the underlying asset), commodity derivatives (where the primary products are the underlying asset), equity derivatives and credit derivatives.

Foreign exchange market

This is a worldwide financial market that facilitates the trading of currencies. Its main purpose is to enable international trade and investment to be carried out smoothly. Businessmen and investors are able to execute transactions involving foreign currencies in foreign exchange market. For instance a Japanese business can import goods from US and pay in UD dollars and vice versa.

The participants in this market are banks, central banks, commercial companies, retail foreign exchange brokers, investment management firms, non-bank foreign exchange institutions, money transfer companies and hedge funds as speculators.

The transactions in these markets are characterized by the counter nature of the currency markets. Also different currencies are traded and therefore there is no single exchange rate but a number of different rates depending on the currency being traded and where the transaction is taking place.

The other features that characterize this market are:

  • The operation of the market is continuous. This means that the operation takes place 24 hours a week except on weekends. This allows businesses to take place throughout the working days
  • The exchange rates are affected by a number of factors that differ from one country to another
  • The main factors that affect the foreign exchange rates are economic factors, political factors, and market psychology (Harris 27). These factors are different in different countries.

The financial instruments in this market include spot, forward, future, swap, option and exchange-traded funds. These instruments were discussed in detail in earlier sections of this essay. A spot transaction is a direct exchange between two currencies that is executed within two days (Mish kin 59). The transaction involves cash and there is no interest included in the agreed transaction. Spot transaction has the shortest time frame of all the foreign exchange transactions.

Commodity market

This is a market of exchange of raw and primary markets. They are traded in standardized markets on regulated commodities exchanges. In the past the commodities money used included sheep, goats, pigs, rare seashells, and other items. According to Mish kin (63), the biggest challenge was to value the commodities money and how to validate the health of these living things. Some commodities were given the value they were not worth and others were undervalued. In today’s trade market, the commodities are exchanged for cash. The participants in the commodity market are the buyers and the sellers there are normally no intermediaries in the commodity market.

The commodity markets allow people to access foodstuffs and other goods. They provide a ready market for the buyers and the sellers. The buyers know where to get the commodities and the sellers know where to sell their commodities. This allows the market to be more efficient as the participants do not struggle to look for the trading partners.

The role of the financial (debt, equity, foreign exchange and derivatives) and the commodity market in international trade and economic performance

The financial markets play a big role in international trade and economic performance.

International trade

The foreign exchange market facilitates international trade in that businessmen are able to buy goods and services from foreign markets and pay in the currency of that country. For instance, a United States businessman can buy goods from Europe and pay for them in Euros. In some countries, Companies can sell securities in foreign countries. This allows foreign investors to invest in foreign countries. In most the cases, the local investor may not be able to raise the capital that the company is in need of. In this case, the companies can solicit the foreign investors to buy their stock even during the initial public offer.

With the foreign investment in a company, the company becomes international in nature and it becomes easier for it to start operations in those foreign countries.

Economic performance

The economic analysts use the performance of financial markets to assess the performance of the economy as whole. For instance, when the shares are performing well in the stock market, then it means that the whole economy is performing well. This can be justified by the fact that the performance of shares in the stock market is greatly influenced by the political situation in the country. When the share prices are increasing, it means there is political calmness in the economy.

The financial market also increases the circulation of money in the economy. Due to the high liquidity in the financial market, the circulation of money is very high. This increases the velocity of a currency that is the number of times a currency changes hand. The higher the velocity of a currency, the higher the number of transactions it performs and the higher the value attached to it (Sheffrin 38).

Hagstrom, (48) stated that the financial market also provides an alternative and more liquid method of investment. The securities traded in the stock market are more liquid than the real assets and other such assets. The investors trade their securities easily and get money mare easily and this improves their standard of living. When the price of shares increases, the household’s consumption pattern improves and they earn more income. The per capita income also goes up and the economy improves. The dependency ratio also decreases making the economy more stable.

The financial markets also facilitate borrowing and lending. The companies are able to borrow money from the public and expand their operations or start new operations. This also creates employment opportunities and reduces the unemployment rate. The reduction in the unemployment rate is an indicator of a high performing economy (Hamilton 47)

The trade efficiency is also improved. This is because the companies have a market where they take their stocks for the investors to buy. This spares them of the cost of looking for investors. This reduces the companies cost of capital and improves their returns. When the company returns increase, the economy also improves because the company will pay the taxes.

Aggregation of information- The financial markets gather information about the stock market and other kinds of the financial markets. For example the information regarding the companies joining the stock exchange is made available to the investors. This information helps the investors to make informed investment decisions (Preda 67). The investors are also made aware of the stocks that are in the stock market and their performance. This spares the investors the risk of making huge losses by investing in the non-performing shares and makes them build confidence in the stock market. When the investors are contented and make profit, the economy also benefits from their taxes.

Conclusion

The financial markets are the most important tool for measuring the economic performance of an economy. They also contribute a lot to economic performance and international trade. The countries should therefore ensure stability in the financial markets

Works Cited

Hagstrom, Robert. The Essential Buffett: Timeless Principles for the New Economy. New York: John Wiley & Sons, 2001. Print.

Hamilton, Peterson. The Stock Market Barometer. New York: John Wiley & Sons, 1998. print

Harris Larry. Trading & Exchanges: insider trading. London. Oxford Press, 2003. print

Hull, John. Options, Futures and Other Derivatives (6th edition).New Jersey: Prentice Hall,2006. print

Mish kin, Stanley. Financial markets and Institutions. Chicago. University of Chicago, 2008. print

Modigliani F, Frank Fabozzi and Frank Jones. Foundations of Financial Markets and Institutions. New York: Elsevier, Academic Press, 2009. print

Preda, Alex. Framing Finance: The Boundaries of Markets and Modern Capitalism. Chicago. University of Chicago Press, 2009.print

Sheffrin, Steven. Economics: Principles in action. Upper Saddle River: Pearson Prentice Hall, 2003. print

The Business Finance Market: A Survey, Industrial Systems Research Publications, Manchester (UK), new edition, 2002.

The Sunday Times (UK), 2006

Weinberg, Ari. “The Great Derivatives Smack down.” Forbes magazine, 2003.

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