The Organization of Financial and Commodity Markets Finance Essay

The financial market is a system that allows investors to buy and sell financial securities such as bonds, stocks, currencies, and different forms of derivatives. Also traded in this market are commodities such as diamonds, precious metals and agricultural products. Due to the rapid growth in cross border trade, capital flows and technological advancements over the years, these markets have had to evolve with changing times because most companies have become international institutions, hence they need international agreements. (.Clark et al 1993). These markets act as an intermediary for buyers and sellers. It’s a place where potential lenders and borrowers come together.

Since its inception, various events have forced the financial markets to evolve dramatically into the market we know it as today. There are different types of financial markets. These are; The Capital market- This market can be divided into two which are the debt market and the equity market. Three main capital markets are the US, the UK and the Japanese market.. The Foreign exchange market which involves the trading of foreign currency for example the Eurocurrency market next the Derivative market- financial instruments such as options, futures, and forwards are sold in this kind of market. This is another category of the capital market. lastly, is the commodity market.

This does not deal with trading financial instruments but rather it deals with the trade of commodities. This discuss explicitly examine the role of financial and commodity in worldwide investment, production and consumption, the opportunities and risk arising from the international context. An Equity market is a market in which shares are traded and issued. It could either be public or private. In an equity market which is also called the stock exchange market, stocks are listed and traded between individuals and organizations.

Companies who are listed on the stock market take advantage of its benefits because the stock market is a vital way in which companies can raise capital by selling shares. By buying a company share, the investor owns a percentage of the company depending in the volume of shares purchased and in return the company pays dividend. Just like the bond market, issuing of shares requires an issuer, syndicate bank and an underwriter in order to ensure a successful listing. According to Clark, there are three major equity markets in the world; they are the US, Japan and the UK. (Clark. E et al, 1993 pg 507). These markets carry out the same function however they differ in their set up. The Debt market is another type of financial market; however this market is not as big as that of the FOREX on the basis of daily trading. However the market capitalization of this market is the biggest with only the US bond market which is largest bond market with a market capitalization of $31.2trillion (SIFMA website). Bonds are widely regarded as risk-free securities however this only applies to government bonds.

Bonds are debt instruments which are issued by governments or large company and they pay out a fixed cash flow during the life of the bond and at the end the principle is paid back bonds could either be short, medium or long-term. There are three types of international bonds. These are domestic, foreign and Eurobonds. Domestic bonds according to its name are bonds issued by a domestic company into the domestic market in the domestic currency. Foreign bonds share the same characteristics as the domestic bonds; the only difference is that they are issued by foreign companies.

Foreign bonds in the US market are known as Yankee Bonds whilst the ones in the Japanese market are called Samurai bonds. Finally, Eurobonds are bonds that are issued in countries other than the country in which the bond is denominated. Bonds can be issued by any government or large company; however the main bond markets are the U.S, U.K and Japanese markets. A foreign exchange market (FOREX) according to Ephraim Clark is “a market where an exchange of a demand deposit denominated in one currency for another demand deposit denominated in another currency takes place”. (Clark. E et al, 1993, pg142). The foreign exchange market evolved dramatically in d 1970’s due to the fall of the Bretton woods system and soon became the largest single most liquid financial market in d world with a daily turnover of $3.98 trillion, in April 2010, which represented a 20% from 2007. (BIS, Sept 2007). However participation in the foreign exchange market has increased tremendously and this is due to fund managers and investors. Investors has moved into the foreign exchange market and use it as hedge funds and pension funds with the most traded currencies being the US dollar, the pound sterling, the Japanese yen and the Euro.

According to Maurice.D Levi, The foreign exchange market is the most active market in the world, with the U.K accounting for 36.7% of the market followed by U.S and then Japan (Maurice,1996:31) Although the foreign exchange market involves the exchange of currencies, however, buyers and sellers don’t physically bring currencies to be exchanged Currencies are traded through the interbank market. This is an informal arrangement of large banks and foreign exchange brokers and this is done via SWIFT that links everyone together. Participating in a foreign market is open to anyone; however there are just a few players who are actively involved in the forex market. These include Commercial banks, Central banks, Multinational Corporation (MNC), Fund managers and hedge fund speculators. However central banks are present to control the money supply and to some extent control the exchange rate.

Derivative refers to a broad classification of financial instrument which normally include options and futures. This instrument derive their value from the price and other related variables of the underlying asset (Vashishtha, 2010:16) Derivative can get its meaning from “deriving “something from something else like the you derive petrol from crude oil thus the price of petrol depends on the price of crude oil. A Derivative is a contract between a buyer and a seller entered today regarding a transaction to be completed at a future point in time (Deutsche borse Group: White paper:6) Section 2(ac) of Securities Contract Regulation (SCRA) 1956 defines a derivative as (a)”a security derived from a debt instrument, share, loan, whether secured and unsecured, risk instrument or contract for differences or any other form of securities. (b)”a contract which derives its value from the prices, or index of prices or underlying securities.

Derivatives is done on commodity, precious metal like gold and silver, foreign exchange rate like currencies, bonds of different types, different range of maturities also on shares. Participant in the derivative market are Hedgers who use derive market to reduce and eliminate risk associated with price of an asset, arbitrageurs who take advantage of discrepancy between prices of more or less the same asset or competing asset in different market and speculators. Instrument Traded on Derivative Market are Option, Futures and Swaps. An Option is a contract that gives its owner the right for a given period of time to buy or sell a given amount of an underlying asset at a fixed price, called the exercise or the strike price.(Clark,2002:181).An option is a contract that conveys the right, but not the obligation, to buy or sell a financial instrument.(Walmsley,(1996):194.We have options on foreign exchange and interest rate ,Options on currencies and debt instrument. Options are the standardized financial contracts that allow the buyer (holder) of the option, not an obligation to buy (call options) or sell (put options) a specified asset at a set price on or before a specified date through exchanges.

Options are of two types: Call options and Put options. A call option gives the owner the right, not the obligation, to buy the underlying financial asset or commodity. A put option gives the owner the right, but not the obligation, to sell the underlying financial asset or commodity. Future is a contract to deliver, or take delivery of, a financial instrument at a future date (Walmsey,1996:163).Futures contract are traded on exchanges that work as a buyer or seller for the counterparty..Future is a standardized derivative contract for the delivery or receipt of a specific amount of an underlying, at a set price, on a certain date in the future. Futures are traded on derivative markets (Deutsche borse Group: White paper:6 )Futures can be traded in currency, share/stock, bonds, commodities stock indexes,. Individuals, companies, and even market making commercial banks can trade on the floor of the futures exchange. A Swap may be defined as barter or exchange a swap is an agreement between two or more parties to exchange stream of cash flows over a period of time in the future. (Vashishtha, 2010:20)Swap can also be “to alternate “or give something in exchange.]The different party that agrees to swap are known as counter parties. The two most commonly used swaps are interest rate swaps and currency swap. Swaps are most desired to those who are investing or borrowing in foreign currency.

More importantly Swaps are most popular with banks because of the risk involved in future contracts. COMMODITY MARKETS: Commodities are physical goods like raw materials and they are measurable in size, Commodity markets is a place where this raw materials and good can be exchanged. These raw commodities are bought and sold at exchanges or over the counter markets. Commodity markets can be divided into: Markets for energy, Metals and Minerals, Agricultural commodities, and other miscellaneous commodities(Clark,2002:514)Data as regard commodities can be gotten from data vendors like Bloomberg ,Reuters, to mention a few and also from commodity exchanges websites for example www.cbot.com,www.lme.co.uk.. Some of the most important exchanges are Chicago Board of Trade, Chicago Mercantile Exchange, NYMEX/COMEX, London International Financial Futures Exchange, London Metal Exchange and the international Petroleum Exchange. The major market participants for commodity market are producers, the industrial end consumers and the trading companies that bring buyers and sellers together.

Also, they exists financial companies such as banks, brokers and insurers and distribution/transportation service providers that balance the effort of the players. ORGANISATIONS REGULATING INTERNATIONAL THE FINANCIAL SYSTEM The international economic and financial environment we have today can be described as been comprised of a number of sovereign nation states with distinct internal organisation structures competing against one another according to a set of guidelines determined by multilateral negotiation and monitored by the moral authority of the international organization created for that purpose (Clark, 2002). The international monetary system is the structure inside which countries borrow, lend, buy, sell and make payment across political frontiers (Clark,2002:93)the whole financial system plays a very important and a crucial role in the well functioning of the economic stability of the world. Several bodies have been created to facilitate international trade which includes International Monetary Fund (IMF), World Bank, World Trade Organisation (WHO), European Community now European Union (EU), General Agreement on Tariffs and Trade (GATT). The International Monetary Fund is the Multilateral Organisation charged with encouraging global financial stability .As such conducts surveillance, lends to countries with balance of payment difficulties, to provide temporary financial support policies aimed at correcting the underlying problems and provides technical assistance and training.(IMF PROFILE) . The IMF was given the authority to collect and distribute reserves in order to promote international monetary cooperation, smooth the process of growth of trade, promote exchange rate stability, establish a system of multilateral payment and create a reserve base.(Clark,2002) The World Bank formally known as (International bank for Reconstruction and Development) is an institution whose objective is the promotion, worldwide, of sustainable economic investment and poverty reduction it pursues this objective through lending, through the production of research and economic analysis and through provision of policies advice and giving technical assistance. The World trade organization (WTO) it’s an organization for liberalizing trade. It’s a forum for governments to negotiate trade agreements among themselves member government go to the WTO to sort out any trade problems they have with one another. It helps trade flow as freely as possible to remove any obstacle as to do with trade among member government Another key player is the European Union (EU) formally known as European Community (EC) this has become a major economic and financial force. The European Union is primarily concerned with managing the European marketplace by eliminating barriers trade and facilitating movement across borders The EU ranks among the United States and Japan as a giant of world trade. The General Agreement on Tariffs and Trade (GATT) was first signed in 1947. This is an agreement that was designed to provide an international forum that encouraged free trade between member states by regulating and reducing tariffs on traded goods and by providing a common mechanism for resolving trade disputes, among member countries.

All the above institutions regulate the international financial system, and also facilitates relationships across borders. ROLES OF FINANCIAL AND COMMODITY MARKETS IN WORLDWIDE INVESTMENT, PRODUCTION AND CONSUMPTION. The international financial system comprises financial markets, products and institutions financial markets play a critical role in worldwide investment, production and consumption starting from Mobilization of funds, Allocation of funds, Hedging and reducing risk, Facilitate cross border transactions, Improve foreign direct investment, Fostering of entrepreneurial activity, Diversification of risk, Facilitate exchange of goods and services. First, Financial market play important role in mobilization of funds it mobilize the fund globally which is to generate funds from different suitable sources that assures cost effectiveness and time efficiency. To mobilize is to arrange or gather funds together this can be done in the financial market by using financial instruments such as equity, debt, foreign exchange and derivative, it is the role of the financial market to ensure that these funds are effectively mobilized.

Second, it has a role on effective allocation of funds; it looks for funds and transfer funds from those who have excess to those who need funds. And also to ensure funds are used in the way promised by the borrower. Financial market should be able to allocate funds in most profitable sectors that will offer the highest possible returns. Therefore it helps in worldwide investment.

Third, Financial system should be able to move risky long term, illiquid claims on borrowers into safer, short term that savers prefer. When savings are allocated more efficiently the national income in the country is increased and therefore makes the economy productive. Forth, Efficient and reliable financial markets will more willingly attract domestic and foreign investments which, in turn, will contribute to the Government’s broader policy objectives of increased employment and sustainable economic growth. Fifth, Financial markets facilitate cross border transactions, for example one can invest and own securities in another economy. This helps in international diversification and thus reducing country specific risk.

Foreign investment accelerates the productivity of host countries and promotes economic development. Higher levels of investment lead to positive spillovers growing the returns to and incentives for higher levels of investment Also, Financial markets fosters entrepreneurial activity by because without financial market households will be self financing and maybe just allocate the funds anyhow but financial market look at (1) how much you earn (2) how much to consume (3) how much to save and allocate to fund thus, the individual aspiring to be entrepreneur can borrow from the market and because of the ability to borrow and lend it help the individual to be productive and this hereby helps in production and smooth consumption levels. Financial and commodity market allows capital flows between countries, and this enhances the overall investment of a country. Financial market encourages people to save; lack of financial market makes it difficult for people to save, and this therefore will result in low savings rate which reduces the overall levels of investment and this will slow the economy down.

Low savings makes it difficult for entrepreneurs in the economy to borrow and thus will not be productive. The increase of technological marketing experience and other ideas across national borders has also contributed to a more productive economy. Commodity markets has been an alternative to investing in stocks and bond this is because it has created a channel for diversification therefore have played a key role as an alternative asset class for investors. Commodities also move up when stocks go down. Their roles in economic development include the following.

One of the roles of commodity market is to set prices of goods and services this can also be a fair price determination role, all the available information in the market must be used to determine a suitable price in the market between the buyer and sellers of the commodity .They must ensure that they is no price mismatch in order to make the market efficient. The commodity market offers unique performance opportunities for investors in physical commodities giving investors the opportunity to hedge, especially during the time of inflation an investor can buy today to sell later; this thereby helps worldwide investment because cash benefit is produced in the period of unexpected inflation. It offers a means for trading linking producers and users, and between different products in the market, and thus enhances worldwide investment, production and consumption.

This is because the international framework for commodity market has expanded .If an economy for example Chicago Board of Trade can sell soybeans to Kansas City Market which in turn can sell wheat, and this will have a good effect on their balance of payment. Additionally, it reduces price volatility and risk Volatility is The relative rate at which the price of a security moves up and down when demand weakens price go down and when they is shortage of some products in the market prices go up and therefore the producers will produce more in this period, This is like swing and this constant re-balancing helps avoid boom and bust cycles. These therefore enhance production. In addition, it reduces risk as farmers, producers, to, and allows market participants to better plan their production yield, consumption and capital spending budgets. In conclusion it reduce the search, information and transaction cost this mean that even though you are your country you can trade another country commodity without having to go that country the financial commodity market bridges the gap between this countries. THE OPPORTUNITIES ARISING FROM INTERNATIONAL TRADE They are enormous opportunities that arise from international trade this includes opportunities for profit, growth, and career advancement and especially now that they is rapid expansion of worldwide financial market. The opportunities include.

They are opportunities for rapid growth and development because as the economy trades it has a significant effect on the GDP which is a major indicator of growth. Opportunities for arbitrage also exist because investors can take opportunities to buy low in a different market and sell high in a different market hereby making a risk free profit It gives opportunities for emerging markets like India,Argentina,Mexican,Russian and Brazil to also trade with developed market, this is also helping to develop this emerging markets gradually to make them developed. It gives investor the opportunity to choose among a wide range of choices of investments, different markets and different products this is an opportunity for diversification. It gives opportunity for comparative advantage, an economy can increase it balance of trade by specializing in the good that it has comparative advantage and trading the good for the other. This hereby allows both countries to become richer. It gives opportunities for idle or low wage labour markets to migrate to countries with reasonably low employment rates this has enabled workers to receive better incomes and learn new skills thus enhancing their production and consumption.(Isard,2005:5) In conclusion it gives the opportunity to have access to the whole world economy because different economies and individual can trade among themselves giving them access to advanced technologies. RISK ARISING FROM INTERNATIONAL TRADE International trade also has its own risk because they are two sides to a coin. The risks identified are discussed below. The most arguably considered is the exchange rate risk this is the most obvious risk of the international market.

Most times investors eventually pay far more than they bargained for due to the exchange rate. In the world today, international transactions and settlements are carried out at separate times, therefore companies know how much they are expected to pay in the future by estimating future spot rate however the expected future rate does not turn out to be the actual exchange rate. (D.O Cushman, Effects of exchange rate risk on international trade) Also most multinationals are at the risk of losing a share of their profits went requiting monies cross borders due to the instability of exchange rates. Also, is Labour-risk “the structural issue facing developed nations such as US and UK is that the amount of high quality, high productivity labour that will be mobilized over the next decade in the emerging markets (Brazil, Russia, India and China) is likely to be in the hundreds of millions and this would displace jobs that would otherwise be created in the developed markets therefore leading to unemployment” (Bryan, L, Globalization critical imbalances). Bryan fears that an international market would eventually lead to high unemployment in developed nations because companies would be able to outsource high quality labour at a cheaper rate. Due to discrepancy in the price of labour, companies might even move their whole operation cross borders thereby increasing the unemployment rate in the developed countries. Bryan’s fear is however fast becoming a reality, because in the world today most manufacturing companies are moving the operations to places like China and services are also being imported from places like India.

Transportation risk is also an important risk as regards commodities this includes freight risk as commodities are exported cross boarder which will definitely needs to be insured hereby giving opportunity for additional cost. Culture and institutional differences is also to be considered because the trade involves different countries and different investors which they might be unfamiliar with the local trading rules of the parties involved.

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