What Is a Financial Market?

A financial market is a market in which people and entities can trade financial securities, commodities and other financial assets at prices that are determined by pure supply and demand principles.  It also facilitates borrowing and lending by facilitating the sale by newly issued financial assets.

Key players in financial markets

1. Brokers

They are commissioned agents of a buyer (or seller) who facilitate trade by locating a seller (or buyer) to complete the desired transaction and does not maintain inventories in these assets. Their profit is determined by the commissions they charge to the users of their service.

2. Dealers

They facilitate trade by matching buyers with sellers of assets and maintain inventories in the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate sellers to match every offer to buy. They do not receive commissions.

3. Regulators

A regulator is an official or body that monitors the behavior of companies and the level of competition in particular markets. Financial regulations are a form of regulation or supervision, which subjects market participants to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system e.g CMA

4. Infrastructure Providers

They include:

a) Stock exchanges - places where buyers and sellers meet and decide on a price e.g. NSE

b) Depositories - holds securities in electronic form and provides all services related to transaction of shares / debt instruments.

c) Clearing House - takes responsibility for settling the obligations for the respective counter-parties on maturity of the trades as well as during their tenure. This ensures that trades done through exchanges have a very low settlement risk.

5. Intermediaries

These are institutions or individuals that channel funds between surplus and deficit agents and thus often act as middlemen e.g. commercial banks

6. Investment Banks

Assists in the initial sale of newly issued securities i.e. IPOs  by engaging in a number of different activities:

• Advice: Advising corporate on whether they should issue bonds or stock, and, for bond issues, on the particular types of payment schedules these securities should offer
• Underwriting: Guaranteeing corporate a price on the securities they offer, either individually or by having several different investment banks form a syndicate to underwrite the issue jointly;
• Helps clients raise money:It assists in the initial sale of newly issued securities by engaging in different activities:
• Assistance in legal and procedural formalities:Before securities are issued, there are a lot of legal formalities which need to be carried out. These include preparing the prospectus, submitting the same to the regulator, book running, etc.
• Advice on pricing:Investment bankers help the issuer get an optimum price for the security which is being issued.

Types of Financial markets

Financial markets are classified in the following ways:

1. Capital Market

A capital market is where both individuals and financial institutions trade financial securities. Organizations and financial institutions are able to sell securities on the capital markets in order to raise funds.

The capital market composed of both the stock and bond markets:

a) Stock Market – allows investors to buy and sell shares in publicly traded companies. They provide companies access to capital and investors the potential of gains based on the company's future performance.

The stock market consist of:

• Primary Market - 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 i.e.an IPO
• Secondary Market - where investors purchase previously issued securities such as stocks, bonds, futures and options from other investors, rather from issuing companies themselves e.g. through the Nairobi Securities Exchange.

b) Bond Market - provides financing by accumulating debt through bond issuance and bond trading.

2. Money Market

The money market is where financial instruments with high liquidity and very short maturities are traded.  It is used as a means for borrowing and lending in the short term, from several days to just under a year e.g. Treasury bills

3. Foreign Exchange Market

This is where different currencies from all over the world are bought and sold .

4. Derivatives Market

This is where derivatives (financial contract to exchange a certain underlying asset at a certain price in a specified future time) are traded.

Derivates can be traded through an exchange or over- the –counter.

• An Exchange Traded derivative  is standardized, has no counterparty risk as the parties require to pay an initial deposit to a clearing house, traded within fixed hours, governed by strict rules of how they are traded, there are limited number of derivatives listed on the exchange
• An Over-the-Counter (OTC) derivativeis customized between the two parties, the contracts are bilateral thus have counterparty risk, most are traded over the phone, contracts can be traded at any time of day, there is flexibility on how people can trade and more products are available for trading.

There are four common types of derivatives:

a) Options

The owner has the right, but not the obligation, to buy or sell the underlying asset at a specific time in future at a specific price (strike price).

b) Futures

They are exchange-traded derivatives.  They are contracts between two parties to exchange an underlying asset at a specified price in the future.  They have daily settlements and are traded in an active secondary market with a clearing house and require daily cash settlement.

c) Forwards

They are over- the- counter derivative. One party agrees to buy the asset at a specified date in future at a specified price. An investor would enter into this contract to hedge against an existing exposure to risk. The party that agrees to buy the underlying asset has a long forward position and the party that agrees to sell the underlying asset has a short forward position.

d) Swaps

They  are over –the- counter instruments . They are arrangements to exchange a series of payments on periodic settlement dates over a certain period of time.

5. Commodities Market

The commodity market manages the trading in primary products which takes place 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.