Financial Markets

HOT TOPIC OF THE ECONOMY

O. Senhadji
TRADING | LONDON, UNITED KINGDOM
O. Senhadji El Rhazi Trading Financial Services

Table of Contents

Introduction ............................................................................................................................................ 2
Types of financial markets .................................................................................................................. 2
Securities ................................................................................................................................................. 3
Definition ............................................................................................................................................ 3
Securities vs Economy ......................................................................................................................... 3
Derivatives Trading ................................................................................................................................. 4
Definition ............................................................................................................................................ 4
Types of Financial Derivatives ............................................................................................................. 4
Forex and the Interbank Market ............................................................................................................. 6
Price Volatility ......................................................................................................................................... 6

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O. Senhadji El Rhazi Trading Financial Services

Introduction

The Market is a series of exchanges where successful corporations trade to take a position,
make a trade or hedge a position.
The Stock Market is a series of exchanges where successful corporations go to raise large
amounts of cash to expand. The Bond Market is where organizations go to obtain very large
loans. The Commodities Market is where companies offset their risk of purchasing or selling
natural resources for future use.

Financial markets create an open and regulated system for companies to obtain large amounts
of financial capital to grow their businesses. This is done through the stock and bond markets.
Markets also allow these businesses to offset risk with commodities and foreign exchange
futures contracts, as well as other derivatives.

Since the markets are public, they provide an open and transparent way to set prices on
everything traded. These prices assume that all available knowledge about everything traded is
taken into consideration. This reduces the cost of getting information, because it's already
incorporated into the price.

Types of financial markets

Within the financial sector, the term "financial markets" is often used to refer just to the markets
that are used to raise finance: for long term finance, the Capital markets; for short term finance,
the Money markets. Another common use of the term is as a catchall for all the markets in the
financial sector, as per examples in the breakdown below.

Capital markets which consist of: Stock markets, Bond markets.

Commodity markets, which facilitate the trading of commodities.
Money markets, which provide short term debt financing and investment.
Derivatives markets, which provide instruments for the management of financial risk.
Futures markets, which provide forward contracts for trading products at future date.
Insurance markets, which facilitate the redistribution of various risks.
Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets may also be divided into primary markets and secondary markets. Newly
formed (issued) securities are bought or sold in primary markets, such as during initial public
offerings. Secondary markets allow investors to buy and sell existing securities. The
transactions in primary markets exist between issuers and investors, while secondary market
transactions exist among investors.

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Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers
to the ease with which a security can be sold without a loss of value. Securities with an active
secondary market mean that there are many buyers and sellers at a given point in time. Investors
benefit from liquid securities because they can sell their assets whenever they want; an illiquid
security may force the seller to get rid of their asset at a large discount.

Securities

Definition

Securities are a form of ownership that can be easily traded on a secondary market. Securities
allow you to own the underlying asset without taking possession. For this reason, securities are
very easily traded, or very liquid. They are easy to price, and so are a great indication of the
underlying value of the asset. Traders must be licensed to buy and sell securities to assure they
are trained to follow the laws set by the Securities and Exchange Commission (SEC). The
invention of securities helped create the huge success of the financial markets.

Securities vs Economy

Securities help the economy by making it easier for those with money to find those who need
investment capital. By making trading easy and available to many investors, securities make
markets more efficient. For example, the stock market makes it easy for investors to see which
companies are doing well, and which ones are not. Money can swiftly go to those companies
that are growing, thus rewarding performance and providing an incentive for further growth.

On the flip side, securities also create wider, more destructive swings in the business cycle.
Since securities are so easy to buy, individual investors can purchase them impulsively, without

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being fully informed or diversified. When stock prices fall, they can lose their entire life
savings. This happened on Black Thursday, which led to the Great Depression of 1929.

Derivatives can make this volatility even worse. Originally, investors thought derivatives made
the financial markets less risky, because they allowed them to hedge their investments. If they
bought stocks, they just purchased options to protect them if the stocks' prices fell. CDOs
allowed banks to make more loans, because they received money from investors who bought
the CDO and took on the risk. Unfortunately, all these new products created too much liquidity.
This ultimately created an asset bubble in housing, credit card and auto debt, creating too much
demand and a false sense of security and prosperity. CDOs allowed banks to loosen their
lending standards, further encouraging default.

Derivatives Trading

Definition

It's estimated that derivatives trading is now worth $600 trillion -- ten times more than the total
economic output of the entire world. In fact, 92% of the world's 500 largest companies use
them to lower risk. For example, a futures contract can promise delivery of raw materials at an
agreed-upon price. This way the company is protected if prices rise. They can also write
contracts to protect themselves from changes in exchange rates and interest rates.
In this way, derivatives make future cash flows more predictable. Companies can then forecast
their earnings more accurately, boosting stock prices. Businesses then need less cash on hand
to cover emergencies, allowing them to reinvest more into their business.

However, the largest part of derivatives trading is done by hedge funds and other investors to
gain more leverage. That's because many derivatives only require a small down-payment,
called paying on margin. Since many derivatives contracts are offset, or liquidated, by another
derivative before coming to term, these traders don't worry about having enough money to pay
off the derivative if the market goes against them. If they win, they cash in.

Types of Financial Derivatives

Most derivatives require that the agreement be fulfilled, either by an exchange of the asset, a
cash payment, or another agreement that offsets the value of the first.

The most notorious are Collateralized Debt Obligations, which were a major cause of the 2008
financial crisis. These bundle debt, like auto loans, credit card debt, or mortgages, into a
security whose value is based on the promised repayment of the loans. There are two major
types. Asset-backed commercial paper is based on corporate and business debt. Mortgage-

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backed securities are based on mortgages. When the housing market collapsed in 2006, so did
the value of the MBS and then the ABCP.

The most common type of derivative is a swap. This is simply an agreement to exchange one
asset (or debt) for a similar one. The purpose is to lower risk for both parties. Most of them are
either currency swaps or interest-rate swaps. For example, a trader might sell a stock in the
U.S. and buy it in a foreign currency to hedge currency risk. These are OTC, or not traded on
an exchange. A company might swap the fixed-rate coupon stream of a bond for a variable-
rate payment stream of another company's bond.

The most infamous of these swaps were credit default swaps because they also helped cause
2008 financial crisis. They were sold to insure against the default of municipal bonds, corporate
debt or mortgage-backed securities (MBS). When the MBS collapsed, there wasn't enough
capital to pay off the CDS holders. That's why the Federal government had to nationalize AIG.
These are now being put under regulation of the CFTC.

Forwards are another OTC derivative. They are agreements to buy or sell an asset at an agreed-
upon price at a specific date in the future. Forwards are very customized between the two
parties. They are done to hedge risk in commodities, interest rates, exchange rates or equities.

Another influential type of derivative are futures contracts. These are traded on exchanges. The
most widely used are commodities futures. Of these, the most important are oil price futures.
That's because they set the price of oil and, ultimately, gasoline.

Another type of derivative simply gives the buyer the option to either buy or sell the asset at a
certain price and date. The most widely-used are stock options. The right to buy is a call option
and the right to sell a stock is a put option. These are traded on exchanges.

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Forex and the Interbank Market

The interbank market is the financial system and trading of currencies among banks and
financial institutions, excluding retail investors and smaller trading parties. While some
interbank trading is performed by banks on behalf of large customers, most interbank trading
takes place from the banks' own accounts.

The forex market is where currencies are traded. The forex market is the largest, most liquid
market in the world with an average traded value that exceeds $1.9 trillion per day and includes
all of the currencies in the world. The forex is the largest market in the world in terms of the
total cash value traded, and any person, firm or country may participate in this market.

There is no central marketplace for currency exchange; trade is conducted over the counter.
The forex market is open 24 hours a day, five days a week and currencies are traded worldwide
among the major financial centres of London, New York, Tokyo, Zrich, Frankfurt, Hong
Kong, Singapore, Paris and Sydney.

Until recently, forex trading in the currency market had largely been the domain of large
financial institutions, corporations, central banks, hedge funds and extremely wealthy
individuals. The emergence of the internet has changed all of this, and now it is possible for
average investors to buy and sell currencies easily with the click of a mouse through online
brokerage accounts.

Price Volatility

In general, price volatility can be caused by factors that produce wild swings in demand and
supply. One of these factors is seasonality. For example, resort hotel room prices rise in the
winter, when people want to get away from the snow, and fall in the summer, when vacationers
are content to travel nearby. This is an example of changes in demand.

Another factor affecting price volatility is the weather. Agricultural prices depend on the
supply, which itself depends on the weather being favourable to bountiful crops.

A third factor is emotion. Price volatility of commodities can be aggravated by the worried
expectations of commodities traders. For example, in February 2012, the U.S and Europe
threatened sanctions against Iran for developing weapons-grade uranium. In retaliation, Iran
threatened to close the Straits of Hormuz, restricting oil supply. Even though the supply of oil
did not change, traders bid up the price of oil to nearly $110 in March. By June, they bid down

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the oil price to $80 a barrel on fears of slowing growth in China. For more, see Why Gas Prices
Are So High.