In the most general manner, one can describe financial markets as any marketplace that is associated with the participation of buyers and sellers in trading with financial instruments like equities, bonds, derivatives and other currencies. It is characteristic of financial markets to have a transparent pricing system. Even all forms of trading, costs and fees are based on certain regulations. There are market forces that are related to determining the prices of all the securities that are used for trade. It is also very selective in nature to trade in financial markets. Only those participants who satisfy certain fixed criteria are allowed to do so. Such criteria could be in the form of amount of money that the participant holds, the geographic location of the investors and the amount of knowledge that the participants have of the market. These markets can be found all around the world. Some of the very famous financial markets are NYSE (New York Stock Exchange) and LSE (London Stock Exchange). The markets trade of the order of trillions of dollars every day. There are periods in every financial market where the prices rise to above the historical norms. In such periods heavy trading is done and here the demands for securities also increase incessantly. There are also periods where downturns occur. Under these situations, the prices go below a certain intrinsic value. This value is based on certain factors like the low level of demands or some other factors of macroeconomic nature like tax rates, national production and also level of employment. Under all these situations, information is expected to be transparent hence resulting into a financial marketplace having a high degree of efficiency. (Financial Market, 2010)
In order to make a clear understanding of what financial markets are all about, it is also essential to know their use and the areas where the companies need to invest capital. It would be difficult for the borrowers to get money lent without the existence of financial markets. Here, the use of banks also comes into the picture. This is done in the form of loans and also in the form of mortgages. For the other, more complex transactions this process of borrowing and lending is done through the agents. One of the most well known examples of a financial market is stock exchange market. Here, every company is given the provision to raise money by virtue of issuing shares and also other shares which already exist, can be bought or sold as the case might be. Here there are four different types of users. They have been mentioned as follows:
This is the category that has enough money so as to start with the liquidity process. This category of people gives money under the condition that it would get back the principal amount with a certain interest or charge at the decided time.
There are also lenders who lend money without knowing that they are doing so. This can be done in the following different ways: Putting money in a savings bank account Making contribution to a pension plan Giving premiums to get insured Investment in Government bonds Investment in shares of company
Companies also have a major role to play in financial markets. They generally tend to be borrowers of capital. During those times, when it is felt that the companies have a surplus amount of cash which is not needed for a particular small period of time, they distribute the same in shirt term markets called as money markets. In the list of companies that play a role in the financial markets, there are some companies that have really high cash flows. Such companies are considered to be lenders rather than borrowers. They can use buyback schemes to return cash to lenders. Under alternate circumstances, they can also seek to make more money by lending cash.
The nest category is that of borrowers. Under conditions of house purchase, there are many individuals who borrow money in the form of bankers’ loans or in the form of long term mortgages. There are also companies who borrow money so that it could be of aid in their cash flows whether in the short run or in the long run. This can also be done for a complete modernization or for future expansion plans of the company. There are Governments who borrow money when the tax revenues collected are more than what they have to spend. This difference makes them borrow. This borrowing is also done on behalf of certain industries that are nationalised, certain municipalities and some local authorities as well. This is done in the form of bonds. There are municipalities which themselves borrow to raise money in their own name or in that of a certain Government. Also, there are a number of number of public corporations which include a number of nationalised industries. This can also include postal services, railway companies and also some utility companies to name a few. Some borrowers also take money locally or through Forex (Foreign Exchange). (Assistance with capital market transactions, 2011)
After the 1970s, financial markets saw a substantial rise in the derivatives section. It has to be understood that in form of trade in financial markets, which could be in the form of stock prices, bond prices, currency rates or dividend rates; there are always ups and down which have a capability to creating risks. Under the situations, derivatives are used to control risks or for a particular period they can also exploit risk. This is done under the concept of financial economics. The advantage of using derivatives is that it can generate certain unusual profits from the use of instruments in financial markets. A contract would have to be made in order to use such products. These contracts are mainly of three types: Future contracts, forward contracts ad also option contracts. (Derivative products, 2010)
Financial markets can be divided into various types. They have been mentioned as follows: Capital Markets: These financial markets are composed of Stock markets and bond markets. While stock markets are responsible for issue of common stock which can enable subsequent trading, bond markets are responsible for financing through issuing bonds and enable subsequent trading. Commodity Markets: This market is used for the trading of commodities which are more of a physical nature. Money Markets: This market as discussed above is used to provide financing and investment in the form of short term debts. Derivatives Market: This market provides instruments that are essential for management of financial risks. This has also been explained in the previous section. Futures Market: This market is related with providing standardized forward contracts which have a pre-defined trading date in the future. On many occasions, this has been referred as forward market. Insurance Market: This market is essential for the redistribution of a number of risks. This financial market also has a vital significance in the current corporate world. As a result a number of financial institutions are starting to trade in such markets. Foreign Exchange Market: This market is required for trading of foreign exchange. Also, talking more in detail about a capital market, it is composed of both primary and secondary market. All those securities which are newly formed are either bought or sold in primary market. As far as secondary market is concerned, here the investors are given an opportunity to sell securities that have been held for long or even to buy existing securities. Also, in a primary market, transactions basically take place between investors and public while in secondary markets, it takes place between investors only. (9 types of financial markets for capital raising, 2008)
From the time, this term has been coined, a lot of study has also been undertaken to study how prices vary from time to time. Of these various studies, the Dow Theory given by Charles Dow is of extreme significance. This is also called the technical analysis method to predict future changes in markets. This theory has deduced that the market trends indicate the future, for the short term if not for a long term. But, this theory has also been disputed on many occasions. Here, next change is not correlated to the last change. Also, it is important to study the scale of change in price over a unit of time. This is termed as volatility. It does not follow a Gaussian distribution but rather a Levy stable distribution. Here, the scale of change depends on the length of time unit to a power that is slightly greater than A½. Here, there are more chances of large changes either up or down as compared to what it would be by using the Gaussian distribution which has an estimated value of standard deviation. Today, one also needs to put interest in the proper analysis of international market effects. A global financial network can be a boon or a bane. So, one should make proper analysis of financial markets before making any decision.
In the most general terms, a financial institution is that which is responsible for collecting funds. These funds are collected from the public and they are put in the form of financial assets. Assets could be various types. They are deposits, loans and also bonds. The major aim of a financial institution is the conversion of public money in these mentioned financial assets rather than in tangible property. Also, one very important aspect of a financial institution which is also worth noting is that it provides a number of financial services to the clients and its members. On many occasions, financial institutions also act as financial intermediaries. As this is a highly risky affair, most of the financial institutions are regulated by the Government. (Financial Institutions, 2010)
There are broadly three types of financial institutions. These have been mentioned as under: The first of these are deposit-taking institutions which are responsible for accepting and managing deposits and also in making loans. They are of the type of banks, building societies, credit unions, trust companies and also mortgage loan companies. All these financial institutions have different functions. Distribution of such functions in these bodies makes it easier for the customers to make use of the functionalities that financial institutions have. In recent times, there has been a large degree of improvement in this respect. All financial markets that have been mentioned, take help of the deposit-taking institutions in order to run. Even money markets which have started to take effect nowadays run on the basis of the contributions of the deposit-taking institutions. The second category is that of the insurance companies and pension funds. Talking about the former first, one must have realized the consistent consciousness in the people of the society with respect to insurance. With technology developing, it has not only made the world look short but it has actually made the lives of people short. There are a number of reasons for which the people look for insurance. The need to security has increased more than ever. Under the conditions, a number of insurance companies have turned up these days. Many of the banks have also started their new division of financial institutions in the form of insurance companies. This is an example of the fact that companies have begun to see scope in the market and many new form of investing and financing options are coming up these days such as in the form if insurance companies. The other financial institution that has been mentioned here is pension funds. With the world, developing at a much accelerated rate, the provision of employment has also increased to a substantially large degree. As a result of this, many fresh candidates are getting options to take part in the functioning of companies. Now, this has led to retirement as well both in the public and in the private sector. Though, there is no such generalized agreement in private companies for pension funds. But in case of public companies, this has developed into a financial institution. This has become more important to those stock markets where the number of institutional investors is large. Though the provision for the same is not very high in case of private institutions, one significant pension fund is TAPILTAT, which is the fund for mutual assistance of the Employees of Ioniki Bank and Other bank. It functions as a multi-employer auxiliary pension fund. This has its operations in Greece. A number of private institutions in UAE have been inspired by the ideologies of this plan and it is expected that in times to come, it would expand its reach. The third category is that of brokers, underwriters and investment funds. In this context, as the name suggests, a broker is that party which makes arrangements to have transactions between buyers and sellers. In return, it also gets commission at the execution of the deal between them. There are also brokers who act as sellers or buyers as a result of which they become the principal party to the deals. Also, there are distinguishing agents who act on behalf of the principals as defined here. In reference with financial institutions, a broker could be of the following types: Commodity Broker Customs Broker Insurance Broker Investment Broker Joint Venture Broker Mortgage Broker Options Broker Stock Broker Serviced office Broker As far as underwriting is concerned, many financial institutions such as banks, insurance companies and investment houses assess the ability of a customer to receive their financial product which could be in the form of insurance, mortgage or credit. Here, there are a number of financial underwriters who do accept some risk adverse ventures in exchange of a premium. Because of the green flag shown by the underwriters, such deals are also considered. Then, it becomes the responsibility of the underwriters to take care of the transaction. Also, there are three types of underwriting in this context. They are securities underwriting, bank underwriting and also insurance underwriting. In all these cases, the underwriters evaluate the risks that are associated with the same and bases on their evaluation, they draw conclusions on whether they can allow transactions. The final segment in this category is that of investment funds. This is more widely known in the form of collective investment schemes. Here, one can invest money alongside other investors so that one could have the advantage of working as a group. The advantages of this form of financial services include- hiring investment managers to improve the prospects of a better return, benefit from cost sharing (economies of scale) and there would be more diversity which would further reduce risks. The entire institution in this respect is broadly composed of: A fund manager A fund administrator A board of directors The Shareholders A marketing company for promotion (Private equity, 2010)
In case of financial institutions, it is advised to use Equity Multiples rather than Enterprise Multiples. The reason is that the relative metrics used for the same are Price or Equity Price or Book Value. Valuing a financial institution’s balance sheet is different from that of a non-financial institution. This can be seen as to consider the way an industrial firm handles its assets and the loans that it requires to finance that asset. In case of financial institutions, the line is blurred. These institutions must hold certain deposits in form of liabilities so that they could fuel the issuance of loans required to manage the assets. Here, three different models can be used for corporate valuation. They have been mentioned as follows: Dividend Discount Model: This model uses Earnings per share (EPS) or also Dividend per share (DPS). Discounted Cash Flow (DCF) Model: Here, there is a basic requirement of a Free Cash Flow for Equity (FCFE). This is that amount of money which goes back to the shareholders. Now, one can calculate the Free Cash Flow to the Firm (FCFF) as: EBIT* (1-Tax rate) – Capital Expenditures + (Depreciation & Amortization) – (Net increase in working capital). Also, FCFF- Debt + Cash = FCFE. Cost of equity is calculated by using the Capital Asset Pricing Model rather than the Weighted Average Cost of Capital. This is another reason for which one uses equity multiples rather than enterprise multiples which is used for calculation of the cost of equity. Excess Return Model: In using this model, one could calculate the total valuation as the sum of capital invested in the firm and the present value of dollar – returns expected in the future.
As far as financial institutions are concerned, they are generally operated in a highly regulated environment because they form a critical part of the economies of a company. The structure of the regulation is certainly different in every company but in most cases it does include prudential regulation and consumer protection along with market stability. There are some companies which go for a single body that takes care of regulating the financial institutions where are there are others which have separate agencies for the same. Some of the major regulating bodies of financial institutions have been mentioned as under: Federal Financial Institutions Examination Council Office of the Comptroller Currency Federal Deposit Insurance Corporation National Credit Union Administration Federal Reserve Office of the Thrift Supervision (Regulations of Financial Institutions, 2008)
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