The financial market is an exchange medium where financial transactions are facilitated. In this day and age, the financial market does not necessarily have to be a physical venue. The proliferation of online services or electronic trading has enabled more over-the-counter possibilities. With decades of economic globalisation, the financial market has been emerging rapidly. This has seen trading volumes of different levels and product markets experiencing significant growth, including the development of active underlying trading assets as foreign exchange, shares, fixed income securities, and financial derivatives.
Welcome to Topic 2: Introduction to the Financial Market. In this topic, you will learn about:
- Concepts of money and capital markets
- Concepts of primary and secondary markets
- Market efficiency
- The financial crisis 2008.
These relate to the Subject Learning Outcomes:
- Understand the role of the finance and accounting functions in an organisation.
- Develop analytical skills drawing from key finance theories, concepts, and techniques.
Welcome to your pre-seminar learning tasks for this week. Please ensure you complete these before attending your scheduled seminar with your lecturer.
Click on each of the following headings to read more about what is required for each of your pre-seminar learning tasks.
Read Chapter 2 of the prescribed text - Melicher, RW & Norton, EA 2017, Introduction to Finance: Markets, investments, and financial management 16th edn., John Wiley & Sons, Inc.
Read the following journal articles:
- Fama, EF 1970, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, The Journal of Finance, 25(2):28-30
- Obst, M & Taylor, AM 2003, ‘Globalization and capital markets’, in MD Bordo, AM Taylor, JG Williamson (eds.), Globalization in historical perspective, University of Chicago Press, pp. 121-187.
Identify the key takeouts from the articles and add these to your reflective journal. You can access the reflective journal by clicking on ‘Journal’ in the navigation bar for this subject.
If you are unsure of any concepts, reach out to your lecturer.
Read the following web article:
- Corporate Finance Institute [CFI] n.d., Financial markets
Read the case study, ‘Small business practice’ on p. 24 of the prescribed text. Answer the questions from the case study in a new post in the discussion forum, Topic 2, Forum Activity 3: Small businesses.
You can also navigate to the forum by clicking on 'FIN100 Subject Forum' in the navigation bar for this subject.
This topic has discussion forum activities, which will enhance your knowledge and give you the opportunity to interact with your peers. You can access the activities by clicking on the following links.
Read and watch the following content.
Participants of the financial market
Financial markets refer to the facilitating units where the exchange or trading of financial assets happens. The term ‘exchange’ implies that there will be at least two (2) interacting parties within a transaction. The major participants in the financial market include government entities, corporations, and individuals. Let us look a little more at each of these.
Governments are active in the financial market both as a participant and a regulator (Gitman & Zutter 2012, p. 34). As participants, governments regularly issue treasury bills and long-term bonds to finance new infrastructure buildings such as domestic airports, railways, and public hospitals. Think of it as lending money to the government. On the other hand, they also regulate the financial market, ensuring it is compliant with all relevant legal requirements through its various professional regulatory bodies, for example, the Australian Security and Investment Commission (ASIC) in Australia.
Corporations can be regarded as a significant participatants within all levels of financial markets. Equity and debt financing activities such as an Initial Public Offering (IPO) or debenture issuing are crucial instruments to provide operational or investing capital. These will be explained further in the upcoming topics.
For individuals participating in financial markets, they usually expect capital gains or cash income from investment activities in the share or fixed income market. Besides that, some individuals preferring short-term profits may also do so through speculation, arbitrage, and short-term hedging, which are all explained in the following two (2) videos.
Speculating and hedging
Watch the following video to learn about the main types of derivatives and how they are used to hedge risk.
Arbitrage
Watch the following video to learn about arbitrage through a simple example and how this applies to business and trade.
Types of financial markets
Categorised by the maturity of financial instruments
Due to the mature nature of different financial instruments, the financial market could be categorised into money markets and capital markets.
With the maturity of securities being one (1) year or less, the money markets are marketplaces to facilitate ‘short-term’ debt issuing and trading (Gitman & Zutter 2012, p. 35). ‘High liquidity’ is the main characteristic of this market, which means it has high trading activity, so trades frequently occur and participants do not have to wait for long. As a result, there are minor capital losses when the financial assets are sold in the market as both the buyers and sellers are actively joining in the market trading. Consequently, the risk and return of the assets are generally lower due to this short-term nature. For example, the three (3) month deposit rates from main commercial banks are provided with 1.2 %-1.5 % per annum, which is slightly higher than the risk-free interest rate.
Capital markets, however, refer to the trading market where the time maturities of the financial instruments are usually more than one year (Gitman & Zutter 2012, p. 35). Hence, the aim of trading activities is long-term focused. Both debt and equity instruments are the popular underlying assets in this market. Common stock shares traded on the share market is an example of equity instruments. While a typical example of debt instruments in the capital market would be large mortgage packs of commercial banks.
Categorised by financial functionalities
The financial markets can also be categorised by financial functionalities, which is generally the issuing and trading of financial instruments. The primary markets and secondary markets are places to facilitate these activities respectively:
The initial issuing steps of debt and equity securities are utilised in the primary market (Gitman & Zutter 2012, p. 34). An example of this is an Initial Public Offering (IPO), which refers to the first time issuing of new shares from a previously private company. The exciting new shares in the share market are open to the qualified investors involved in this market. This is a restating financial behaviour to define the primary function of the market demands.
After the primary market issuing, any subsequent trading of securities to exchange ownerships among investors will be facilitated in the secondary market (Gitman & Zutter 2012, p. 34). The daily buy and sell activities have been reported regularly through public media like television, website, and social media. For the share markets, the equity index is representative of the average market performance.
Categorised by financial instruments
In addition, the financial market could be additionally categorised by different financial instruments and underlying trading assets as stated in the following:
Foreign exchange (FX) markets
The foreign exchange market is the largest market to facilitate a single asset trading activity according to trading volumes. The high demands from international trade or government debt financing provide opportunities to trade between different currencies to complete any related commercial and business transactions. For example, the close trading partnership between the United States and other countries instigated a huge trading demand of US dollars as the preferred settlement currency in this process. The highest trading volumes in the FX markets include currencies such as USD (US dollar), GBP (British pound sterling), Euros, Japanese Yen and Chinese Yuan due to their global trading importance.
Derivative markets
Financial derivatives are innovative financial instruments derived from the common underlying assets like shares, commodities, FX or fixed-income security. The typical financial derivatives are options, futures, forwards and swaps. The trading volume of these derivatives has increased over the recent decades, which provides more risk management pathways and speculating opportunities for investors. Some financial institutions like investment banks or managed funds usually have independent departments to manage and operate derivatives trading. The high financial leverage involved in derivatives trading has attracted widespread debates with their simplifier effect of the risk.
The relationship between financial institutions and financial markets
As suppliers and demanders of capital, financial institutions are major participants in financial markets. As illustrated in the following figure that depicts the flow of funds for financial institutions and markets, the general capital flows can be seen clearly with multiple business parties in this dynamic circulation.
Individuals, households, corporations and governments can supply surplus funds and demand fund shortages by cooperating with financial institutions such as commercial and investment banks. However, there will be commissions or transaction fees charged when the financial institutions act as an intermediary to bridge the services for capital. Overall, the financial markets act as the facilitating unit and regulatory agency to construct optimal market efficiency and transparency.
Example
The United States government (specifically the treasury department) plans to issue 30-years treasury bills in the primary market to the public. Domestic and international investors would purchase the asset as it is financially safe and has a fixed interest rate. Through this process, the surplus funds from the saving accounts of investors will flow to the demand side of the government issuer. Commercial banks, as financial institutions, would then participate in this deal and charge any related service commissions. This transaction in the financial system increases the general efficiency and profitability among almost every stakeholder in the cycle.
Efficient market
An efficient market is a market that allocates financial resources to meet the demands of both profit-maximising companies and investors, with minimum levels of costs. From an information perspective, the efficient market reflects and conveys financial information effectively and simultaneously on the fair market price of the securities. From a company’s perspective, an efficient market works as a liquidity provider to finance its different needs externally. From an investor’s perspective, the part of an efficient market is to seek the most beneficial return of the funds.
It is a universal belief that the facilitated competition from multiple participants will value out the trading assets price fairly close to their long-term intrinsic values in an efficient market. For daily trading, the market price of a financial asset is determined by the general demand and supply. An efficient market will guarantee that the price of an asset is an unbiased estimator of its intrinsic value. Any change in the price reflects new information that investors have received and applied to their investing behaviours.
Example
A company’s share currently trades at the price of $20 per share. Suppose the company announced that its CEO had accepted medical treatments due to a health emergency. In that case, rational investors will lower their expectations of the company’s performance in the near future. The negative sentiments will mark the share as expensive in the market, so there will be more sellers than buyers temporarily, and its price will have to drop to re-establish equilibrium in the market. The more efficient the market is, the quicker the change will be delivered.
The financial crisis 2008
During the summer of 2008, share markets in the United States, and subsequently most essential share markets around the world, experienced a rapid and significant downturn over several months. The negative sentiments from the financial markets spread to other economic departments, and this quickly triggered the start of business recessions. As the impact of recession can affect businesses, its driving forces and causes need to be carefully analysed by looking at the history of financial markets.
Since the 1980s, the markets of securitisation, such as mortgage-backed security (MBS) have experienced fast growth, especially in the United States market. This is where a commercial bank sells its approved mortgage loans as a pooled asset to other investors. An MBS is seen as an asset assured with relative financial safety for the general investor because it is backed by the stable payments or cashflow from mortgages. The real evidence to support this view is the booming time for the real estate assets price in the United States and worldwide. The following figure demonstrates the mid-term trend of the Standard & Poor’s Case-Shiller Index, an index of home prices in ten major US cities, monthly from January 1987 to February 2010.
Due to the fast appreciated value between 1997 and 2004, financial institutions like commercial banks would increase the credit-issuing to the market by operating more MBS to grant mortgages to under-qualified borrowers in regular times. Some community or regional banks will even allow borrowers with an unstable capacity to make payments on their mortgages to access this home equity to refinance their loans and lower their regular payments. Both the growing property price and easy access to credit make the MBS popular and attractive for most investors, including some significant institutional investors such as investment banks and mutual funds.
Unfortunately, this came to a turning point after 2006. During the next three (3) years, real estate prices dropped around 30 %. Consequently, those under-qualified borrowers have difficulty repaying their debts on time due to the fluctuating employment status. At the beginning of 2009, nearly 25 % of sub-prime borrowers defaulted on their mortgage payments. In some extreme cases, borrowers moved out of their residential property to escape the unaffordable mortgage payments because they regarded the property values to be far lower than the initial purchase price. The following figure illustrates the drop in bank stock evaluation during the crisis:
These payment defaults opened a ‘Pandora’s box’ and had a flow-on effect on the global economy. The United States share market crashed, and its crash started to spread to other global capital markets. The market price of most assets experienced a sharp decline and this lasted for several months. Regarded as the second worst financial crisis after The Great Depression of the 1930s, the financial crisis in 2008 has been named ‘The Great Recession’ by economists.
Key takeouts
Congratulations, we made it to the end of the second topic! Some key takeouts from Topic 2:
- Money markets are marketplaces that facilitate short-term debt issuing and trading, with the maturity of securities being one year or less.
- Capital markets refer to the trading market where the time maturities of the financial instruments are usually more than one year.
- The initial issuing steps of debt and equity securities are utilised in the primary market. After the primary market issuing, the subsequent trading transaction to exchange the ownerships among investors will be facilitated in the secondary market.
- An efficient market is a market that allocates financial resources to meet the demand from both profit-maximising companies and investors, with the minimum level of costs.
- The financial crisis in 2008 has been regarded as the second-worst crisis after The Great Depression in the 1930s.
Welcome to your seminar for this topic. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your seminar.
The following learning tasks will be completed during the seminar with your lecturer. Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
In-seminar learning tasks
The in-seminar learning tasks identified below will be completed during the scheduled seminar. Your lecturer will guide you through these tasks. Click on each of the following headings to read more about the requirements for each of your in-seminar learning tasks.
Watch the video, An inside look at Wall Street's most famous trader, about one (1) of Wall Street’s most famous traders.
Working in a breakout room team assigned by your lecturer during the scheduled seminar, discuss the following questions with your teammates. Your lecturer will request that you present the findings back to the class.
- Where are the financial markets?
- Which institutions and professionals are participating in the financial markets?
- Do you believe the financial markets are efficient? Why or why not? Which part of financial markets is the most efficient or close to efficient in the globe?
Working in the same breakout room as previously, go to the Yahoo! Finance website, click the top menu ‘Markets’, and choose the ‘Currencies’ option. You will find various trading foreign currencies around. Examine the financial information of a currency pair. With your teammates, describe the economic situations of these two countries and analyse the underlying factors for the recent trend.
Go back to the ‘markets’ menu, choose another ‘world indices’ option, find out your home country’s share exchange index, describe the recent trend to your teammates and explain the possible driving forces.
Welcome to your post-seminar learning task for this week. Please ensure you complete this after attending your scheduled seminar with your lecturer. Your lecturer will advise you if this is to be completed during your consultation session.
Prepare a list of key terms from this topic and add them to your reflective journal along with their definitions.
Take the following knowledge check quiz during the consultation session. You have only ONE attempt to complete this quiz. Therefore, await your lecturer's guidance as to when to attempt.
You will reflect on correct and incorrect answers and have the opportunity to seek clarification from your lecturer during your seminar.
If you are unable to attend the seminar, you may complete your knowledge check quiz prior to the scheduled seminar and submit any queries to your lecturer, who will aim to resolve them during class. This will be available to you through a recording, once the seminar has finished.
Knowledge check
Complete the following eight (8) tasks. Click the arrows to navigate between the tasks.
This task is to be completed during the consultation session.
Work in a breakout room assigned by your lecturer during the consultation session. Your lecturer will require your presentation of findings back to the class.
Select one (1) definition from ‘Key Terms’ at the end of Chapter 2 prescribed textbook (Melicher & Norton 2017). Your lecturer will require your presentation of findings back to the class.
Discuss the definition of the key term you have selected and prepare a 5-minute presentation using a tool of your choosing (PowerPoint, Canva, Word) inclusive of visuals. Your group will present the financial term to other candidates during the scheduled consultation time.
Knowledge check
Complete the following three (3) tasks. The following questions have been adapted from p. 16 of Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons Inc.
Click the arrows to navigate between the tasks.
Please ensure you complete Assessment 2, Quiz 1 by the nominated time and date. You can access this quiz by clicking on “Assessment 2” in the navigation bar for this subject, then selecting “Quiz 1 – Week 2”.
Each week you will have a consultation session, which will be facilitated by your lecturer. You can join in and work with your peers on activities relating to this subject. These session times and activities will be communicated to you by your lecturer each week. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your consultation session.
Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
- CNBC 2021, How The $1 trillion green bond market works, streaming video, YouTube
- Fight Finance n.d., Tags-Market efficiency
- Institute of economic affairs (IEA) 2010, Financial markets should be left to regulate themselves, IEA
- Netflix 2020, Explained | the stock market-full episode Netflix, streaming video, YouTube
- Saleha, R 2021, Imperial College biotech startup raises $4.8m for future-proof vaccines, Yahoo Finance
References
- CNBC 2021, How the $1 trillion green bond market works, streaming video, YouTube, https://www.youtube.com/watch?v=ruXLhpXvhOE
- CNN Business 2020, An inside look at Wall’s Street’s most famous trader, streaming video, YouTube, https://www.youtube.com/watch?v=ogbRyjeU1IQ
- Corporate Finance Institute [CFI] n.d., Financial markets, https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/financial-markets/
- Fama, EF 1970, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, The Journal of Finance, 25(2):28-30
- Gitman, LJ & Zutter, CJ 2012, Principles of Managerial Finance, 13th edn., Pearson.
- Institute of Economic Affairs (IEA) 2010, Financial markets should be left to regulate themselves, IEA, https://iea.org.uk/in-the-media/press-release/financial-markets-should-be-left-to-regulate-themselves
- Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
- Netflix 2020, Explained | The stock market FULL EPISODE Netflix, streaming video, YouTube, https://www.youtube.com/watch?v=ZCFkWDdmXG8
- Obst, M & Taylor, AM 2003, ‘Globalization and capital markets’, in MD Bordo, AM Taylor, JG Williamson (eds.), Globalization in historical perspective, University of Chicago Press, pp. 121-187.
- Saleha, R 2021, Imperial College biotech start-up raises $4.8m for future-proof vaccines, Yahoo Finance, https://finance.yahoo.com/news/imperial-college-biotech-startup-raises-48-m-for-future-proof-vaccines-130018032.html
