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A stock market typically refers to a financial market that handles the buying and selling of company stocks, derivatives and other securities. Stock markets trade company securities that are listed in the stock exchange. Investors and security issuers both participate in stock markets. Different sized entities participate in stock market activities, ranging from small investors to the governments, corporations, large hedge fund traders, and banks.

Corporations, governments, and companies issue securities on the stock market to collect funds. The stock market acts as a platform for companies to raise money for their business and investors to invest in securities.

When both the buyers and sellers in stock markets are institutions, rather than individuals, the stock market principle is more institutionalized.

The emergence of this institutional investor concept has brought some improvements to stock market operations around the world.

The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization. The stock market in the United States is NYSE while in Canada, it is the Toronto Stock Exchange. Major European examples of stock exchanges include the London Stock Exchange, Paris Bourse., and the Deutsche Bоrse. Asian examples include the Tokyo Stock Exchange, the Hong Kong Stock Exchange, the Bombay Stock Exchange and the Karachi Stock Exchange.

Participants in the stock market range from small individual stock investors to large hedge fund traders.

Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as open outcry. This type of auction is used in stock exchanges and commodity exchanges where traders may enter "verbal" bids and offers simultaneously. The other type of stock exchange is a virtual kind, composed of a network of computers where trades are made electronically via traders.

Actual trades are based on an auction market model where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. When the bid and ask prices match, a sale takes place, on a first-come-first-served basis if there are multiple bidders or askers at a given price.

The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). The exchanges provide real-time trading information on the listed securities, facilitating price discovery.

New York Stock Exchange.

The New York Stock Exchange is a physical exchange,only stocks listed with the exchange may be traded. Orders enter by way of exchange members and flow down to a floor broker, who goes to the floor trading post specialist for that stock to trade the order. The specialist's job is to match buy and sell orders using open outcry. If a spread exists, no trade immediately takes place--in this case the specialist should use his/her own resources (money or stock) to close the difference after his/her judged time. Once a trade has been made the details are reported on the "tape" and sent back to the brokerage firm, which then notifies the investor who placed the order. Although there is a significant amount of human contact in this process, computers play an important role, especially for so-called "program trading".

National Association of Securities Dealers Automated Quotation (NASDAQ)

The NASDAQ is a virtual exchange, where all of the trading is done over a computer network. The process is similar to the New York Stock Exchange. However, buyers and sellers are electronically matched. One or more NASDAQ market makers will always provide a bid and ask price at which they will always purchase or sell 'their' stock.

The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange provides affords investors the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate.

History has shown that the price of shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. In fact, the stock market is often considered the primary indicator of a country's economic strength and development. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market. Financial stability is the raison d'être of central banks.

Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction. In this way the financial system contributes to increased prosperity. An important aspect of modern financial markets, however, including the stock markets, is absolute discretion.

Market participants

A few decades ago, worldwide, buyers and sellers were individual investors, such as wealthy businessmen, with long family histories to particular corporations. Over time, markets have become more "institutionalized"; buyers and sellers are largely institutions (e.g., pension funds, insurance companies, mutual funds, index funds, exchange-traded funds, hedge funds, investor groups, banks and various other financial institutions). The rise of the institutional investor has brought with it some improvements in market operations.

Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. The bond market (also known as the debt, credit, or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds.

The bond market is a financial market that acts as a platform for the buying and selling of debt securities. The bond market is a part of the capital market serving platform to collect fund for the public sector companies, governments, and corporations. There are a number of bond indices that reflect the performance of a bond market.

The bond market can also called the debt market, credit market, or fixed income market. The size of the current international bond market is estimated to be $45 trillion. The major bond market participants are: governments, institutional investors, traders, and individual investors. According to the specifications given by the Bond Market Association, there are 4 types of bond markets, they are:

  • Corporate Bond Market;

  • Municipal Bond Market;

  • Government Bond Market;

  • Funding Bond Market.

The bonds are usually specific to individual issues and there is a lack of liquidity in the bonds. This is the reason that most of the bonds are held by institutions like banks, mutual funds, and pension funds. Bond markets are generally decentralized, and unlike stocks and futures, there exists no common exchange for the bond market. The bond market is less volatile in nature than the stock market, and thus investors purchase the bond coupon and holds it until it matures. As risk associated with bond investment is less, the return received is also less.

There are some risks that the investors have to face. The change in interest rate is the major risk that occurs in bond investment. The interest rate and value of bond are inversely proportional to one another.

When the rate of interest increases, the bond value falls considerably as the new issues pay a higher yield. Conversely, when the interest rate decreases, the bond value rises. The interest rate fluctuation may depend on the volatility of the bond market and also on the monetary policy of the country

The bond market indices consist of bond listings, and they are a tool to mirror the performance of a particular security. Bond indices may vary with the type of the bonds.

There are different indices for government bonds, high-yield bonds, corporate bonds, and mortgage-backed securities.

References to the "bond market" usually refer to the government bond market, because of its size, liquidity, lack of credit risk and, therefore, sensitivity to interest rates. Because of the inverse relationship between bond valuation and interest rates, the bond market is often used to indicate changes in interest rates or the shape of the yield curve.

  1. The foreign exchange market

The foreign exchange market (forex) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.

Foreign exchange markets, which facilitate the trading of foreign exchange. The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies. Though there is no physical existence of this market, the foreign exchange market is the largest financial market in the world, with its average daily traded amount reaching to US $2-2.5 trillion.

The purpose of the foreign exchange market 'Forex' is to assist international trade and investment. The foreign exchange market allows businesses to convert one currency to another foreign currency. Some experts, however, believe that the unchecked speculative movement of currencies by large financial institutions such as hedge funds impedes the markets from correcting global current account imbalances. This carry trade may also lead to loss of competitiveness in some countries.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The development of communication has helped the foreign exchange market more than any other field.

The computerized communication network that embraces all the major financial centers of the world is the main trait of the foreign exchange market, where the buyers and sellers of any country can trade currency quickly and efficiently.

The main players in the forex market are large banks, governments, central banks, multinational corporations, and currency speculators.

Individuals investing in the international currency market constitute a small fraction of the market.

Huge trading volume, extreme liquidity, and round the clock trading hours set the foreign exchange market apart from all other kinds of financial markets.

The exchange rate of a currency in the forex market depends on various factors. Some of the major factors that affect the exchange rate are: economic factors, political conditions of the corresponding countries, and market psychology.

The monetary value of a currency is another major determinant of the exchange rate. Some of the most traded currencies in the foreign exchange market are the US dollar, the Japanese yen, the Euro, the Swiss franc, the British pound sterling, the Australian dollar, the Swedish krona, the Canadian dollar, the Norwegian krone, and the Hong Kong dollar.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems.

Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates.

Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Central banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market.

Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful .

The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.

Hedge funds

About 70% to 90% of the foreign exchange transactions are speculative. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

  1. Money markets

Money markets, which provide short term debt financing and investment. In finance, the money market is the global financial market for short-term borrowing and lending. It provides short-term liquidity funding for the global financial system. The money market is where short-term obligations such as Treasury bills, commercial paper and bankers' acceptances are bought and sold

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of banks borrowing and lending to each other, using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt.

Trading companies often purchase bankers' acceptances to be tendered for payment to overseas suppliers.

  1. Derivatives markets

Derivatives markets, which provide instruments for the management of financial risk. The derivatives markets are the financial markets for derivatives. The market can be divided into two that for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.

Futures markets.

Futures markets, which provide standardized forward contracts for trading products at some future date.

Futures exchanges, such as the Chicago Mercantile Exchange, trade in standardized derivative contracts. These are options contracts and futures contracts on a whole range of underlying products. The members of the exchange hold positions in these contracts, who acts as central counterparty. When one party goes long (buys a futures contract), another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another.

Over-the-counter markets

Tailor-made derivatives not traded on a futures exchange are traded on over-the-counter markets. These consist of investment banks who have traders who make markets in these derivatives, and clients such as hedge funds, commercial banks, government sponsored enterprises, etc. Products that are always traded over-the-counter are swaps, forward rate agreements, forward contracts etc.

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract.

The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

Not only is this market extremely complicated and difficult to value, it is unregulated by the SEC. That means that there are no rules or oversights to help instill trust in the market participants.

  1. Insurance markets

Insurance markets, which facilitate the redistribution of various risks. Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed and known small loss to prevent a large, possibly devastating loss.

An insurer is a company selling the insurance; an insured or policyholder is the person or entity buying the insurance. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice

Thе transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to compensate (indemnify) the insured in the case of a large, possibly devastating loss. The insured receives a contract called the insurance policy which details the conditions and circumstances under which the insured will be compensated.

  1. Commodity markets

Commodity markets, which facilitate the trading of commodities. Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts.

Raising capital

To understand financial markets, let us look at what they are used for, i.e. what is their purpose?

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages.

More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

The following table illustrates where financial markets fit in the relationship between lenders and borrowers:

Relationship between lenders and borrowers

Lenders

Financial Intermediaries

Financial Markets

Borrowers

Individuals
Companies

Banks
Insurance Companies
Pension Funds
Mutual Funds

Interbank
Stock Exchange
Money Market
Bond Market
Foreign Exchange

Individuals
Companies
Central Government
Municipalities
Public Corporations

Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:

  • puts money in a savings account at a bank;

  • contributes to a pension plan;

  • pays premiums to an insurance company;

  • invests in government bonds; or

  • invests in company shares.

Companies

Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets.

There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks.)

Borrowers

Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernisation or future business expansion.

Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalised industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).

Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council.

Public Corporations typically include nationalised industries. These may include the postal services, railway companies and utility companies.

Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.

A financial intermediary is an entity that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.

Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.

As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers).

In the U.S., a financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.

Functions performed by financial intermediaries

Financial intermediaries provide 2 major functions:

  1. Maturity transformation

Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)

  1. Risk transformation

Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk).

Derivative products

During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short.

In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics.

Currency markets

Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past,[when?] when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements. The picture of foreign currency transactions today shows:

  • Banks/Institutions

  • Speculators

  • Government spending (for example, military bases abroad)

  • Importers/Exporters

  • Tourists

Market efficiency levels

Eugene Fama identified three levels of market efficiency:

1. Weak-form efficiency

Prices of the securities instantly and fully reflect all information of the past prices. This means future price movements cannot be predicted by using past prices.

2. Semi-strong efficiency

Asset prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have advantage on the market.

3. Strong-form efficiency

Asset prices fully reflect all of the public and inside information available. Therefore, no one can have advantage on the market in predicting prices since there is no data that would provide any additional value to the investors.

Financial instruments

Financial instruments are cash, evidence of an ownership interest in an entity, or a contractual right to receive, or deliver, cash or another financial instrument.

Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments:

Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer.

Derivative instruments are financial instruments which derive their value from the value and characteristics of one or more underlying assets. They can be divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.

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