Financial System
Every economy has a Financial System. Financial Systems “help organize the settlement of payments, to raise and allocate finances, and manage the risks associated with financing and exchanges. They are developed to secure payment systems, security markets, and financial intermediaries that arrange financing for derivative markets and financial institutions that provide access to risk management instruments”. A Financial System acts as a financial intermediary between people and organizations with a budgetary surplus, and organizations and individuals facing a deficit and in need of additional funds. The mobilized funds are used to generate returns for the surplus entities, by enabling deficit entities to augment their productive and purchasing capacities. A financial system contains something called financial markets. A financial market is a mechanism that allows people to easily buy and sell financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect efficient market hypothesis.
Definitions
Securities:
Contracts that can be assigned a value and traded.
Commodities:
Tangible goods or products that are subject to sale or barter, such as grains, metals, and foods traded on commodity exchanges or on spot markets.
Fungibles:
Specific types of commodities that must be given without any changes in a contract and can be quickly exchanged for currency or securities of equal value.
Transaction costs:
Costs incurred when buying or selling securities, which include commissions and spreads (the price difference between what a broker/dealer pays for a security and the price the broker/dealer sells a security).
Efficient Market Hypothesis:
Each share price in a financial market reflects all relevant information.
Investors:
Investors are people who invest in any type of market, such as equities, commodities, derivatives, currencies and real estate. This term is associated with individuals who are looking to profit from any type of investment. Investors are classified based on criterion that includes risk appetite (the possibility of suffering damage or loss). Risk is calculated by dividing the standard deviation over historical average returns. Risk = Standard Deviation / Average Returns
Speculators:
Investors that make trading decisions that are associated with above average risks in an effort to generate abnormally high profits. Speculators are primarily focused on future prices of a certain asset, such as a currency or commodity. They are mainly involved in short-term buying and selling of future and option contracts. This type of investor has a large presence in most financial trading markets.
Hedgers:
Investors who try to avoid or cancel risk associated with certain investment types. They try to take positions that might prevent them from any potential losses. Hedgers are widely found in markets that are full of uncertainties and high volatility. There are many types of hedging positions, such as natural hedges, hedging credit risk, hedging currency risk, and hedging equity and equity futures.
Arbitragers:
Investors who buy a security in one market and immediately resell it on another market in order to profit from small price differences. This type of investment is only suggested for well experienced investors, as any delay in transactions could result in significant losses. The effect of these transactions could result in correcting any price difference between markets.
Market Types
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Factor market:
markets that include all features of production like land, labor and capital.
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Product market:
markets that include all distributing products like food, goods and services.
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Financial markets:
markets that include financial securities, commodities and specific fungible items.
Types of Financial Markets
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Primary market:
type of market that only sells newly issued securities.
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Secondary market:
type of market where buyers buy from the seller rather than getting it from issuing company.
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Over The Counter market (OTC):
type of market where trades occur via phone or a network instead of a physical trading. These types of markets are commonly employed by companies that do not meet the exchange listing requirements.
Over The Counter markets include:
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Market makers:
Individuals or institutions that display buy and sell price quotations for a certain number of shares. When an order is executed, the market maker instantly sells his inventory. For example, NASDAQ is considered to be a market maker. The market maker profits from the spread, which is the price difference between buying a share and selling a share. As a rule of thumb, narrower spreads are better for investors.
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Ask prices:
the price of a security set by market makers and brokers that traders are required to pay when purchasing a security
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Bid prices:
the price of a security set by market makers and brokers that the traders receive when selling that security
Definitions
Money market:
Markets that contain highly liquid trading instruments that mature in less than one year. Money market instruments have fixed income and low risk, such as treasury bills and commercial papers.
Capital market:
Markets that contain more risky trading instruments with longer maturity dates. Capital markets consist of primary and secondary markets.
Bond market:
"the place were the issuance and the trading of debt securities occur", Most bond market instruments are traded in an Over The Counter market.
Stock market:
An exchange where financial securities are traded. Also known as an equity market, this type of market allows investors to have partial company ownership. Stock holders benefit from company performance in the form of dividends and stock value appreciation.
A stock is defined as a share of ownership in a certain company. The more stocks you acquire, the bigger your share in a company. Stock ownership is confirmed by a certain piece of paper called a certificate. Company managers try to increase the value of investment stocks, by increasing company investor confidence through improved performance and profits.
There are two types of stocks, preferred stocks and common stocks. A common stock is a type of share that anybody can purchase. A preferred stock is a type of share that is sold to certain people, and not publicly traded. In the event of company default and subsequent liquidation, preferred stock holders have priority when the remaining funds are distributed to company investors.