In economics Economics is the social science that is concerned with the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek οἰκονομία from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)". Current, a financial market is a mechanism that allows people to buy and sell (trade Trade is the voluntary exchange of goods, services, or both. Trade is also called commerce or transaction. A mechanism that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and services. Later one side of the barter were the metals, precious metals , bill, paper money. Modern traders instead) financial securities A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities and equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security is called the issuer. A country's regulatory (such as stocks and bonds), commodities A commodity is a good for which there is demand, but which is supplied without qualitative differentiation across a market. It is fungible, i.e. equivalent no matter who produces it. Examples are petroleum, notebook paper, milk or copper. The price of copper is universal, and fluctuates daily based on global supply and demand. Stereo systems, on (such as precious metals or agricultural goods), and other fungible Fungibility is the property of a good or a commodity whose individual units are capable of mutual substitution. Examples of highly fungible commodities are crude oil, wheat, orange juice, precious metals, and currencies items of value at low transaction costs In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal. Or consider buying a banana from a store; to purchase the banana, your costs and at prices that reflect the efficient-market hypothesis In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information publicly available at the time the investment is made.

Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy A market economy is economy based on the power of division of labor in which the prices of goods and services are determined in a free price system set by supply and demand in contrast either to a command economy Planned economy is an economic system in which the state or workers' councils manage the economy. It is an economic system in which the central government makes all decisions on the production and consumption of goods and services. Its most extensive form is referred to as a command economy, centrally planned economy, or command and control or to a non-market economy A market economy is economy based on the division of labor in which the prices of goods and services are determined in a free price system set by supply and demand such as a gift economy In the social sciences, a gift economy is a society where valuable goods and services are regularly given without any explicit agreement for immediate or future rewards (i.e. no formal quid pro quo exists). Ideally, simultaneous or recurring giving serves to circulate and redistribute valuables within the community. The organization of a gift.

In finance Finance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and budgeted, financial markets facilitate:

• The raising of capital In economics, capital, capital goods, or real capital are factors of production used to create goods or services that are not themselves significantly consumed in the production process. Capital goods may be acquired with money or financial capital (in the capital markets A capital market is a market for securities , where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market ()
• The transfer of risk Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative. However, general usage tends to focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost or by failing to attain some (in the derivatives markets The derivatives markets are the financial markets for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets)
• International trade International trade is exchange of capital, goods, and services across international borders or territories.. In most countries, it represents a significant share of gross domestic product . While international trade has been present throughout much of history (see Silk Road, Amber Road), its economic, social, and political importance has been on (in the currency markets The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends)

– and are used to match those who want capital to those who have it.

Typically a borrower issues a receipt A receipt is a written acknowledgement that a specified article or sum of money has been received as an exchange for goods or services. The receipt acts as the title to the property obtained in the exchange[citation needed] to the lender promising to pay back the capital. These receipts are securities A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities and equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security is called the issuer. A country's regulatory which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is or dividends Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be paid to the shareholders as a dividend. Many corporations retain a.

In mathematical finance The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. Thus, for example, while a financial economist might study the structural reasons why, the concept of a financial market is defined in terms of a continuous-time Brownian motion stochastic process The Brownian motion models for financial markets are based on the work of Robert C. Merton and Paul A. Samuelson, as extensions to the one-period market models of Harold Markowitz and William Sharpe, and are concerned with defining the concepts of financial assets and markets, portfolios, gains and wealth in terms of continuous-time stochastic.

Definition

In economics Economics is the social science that is concerned with the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek οἰκονομία from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)". Current, typically, the term market means the aggregate of possible buyers and sellers of a thing and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange A stock exchange is an entity which provides "trading" facilities for stock brokers and traders, to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events including the payment of income and dividends. The securities or commodity exchange. This may be a physical location (like the NYSE The New York Stock Exchange is a stock exchange located at 11 Wall Street in lower Manhattan, New York City, USA. It is the world's largest stock exchange by market capitalization of its listed companies at US$12.25 trillion as of May 2010. Average daily trading value was approximately US$153 billion in 2008) or an electronic system (like NASDAQ The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations," but the exchange's official stance is that the acronym is obsolete. It is the largest electronic screen-based equity securities trading market in the). Much trading of stocks takes place on an exchange; still, corporate actions A corporate action is an event initiated by a public company that affects the securities issued by the company. Some corporate actions such as a dividend (for equity securities) or coupon payment (for debt securities (bonds)) may have a direct financial impact on the shareholders or bondholders; another example is a call (early redemption) of a (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.

Trading of currencies The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends and bonds The bond market is a financial market where participants buy and sell debt securities, usually in the form of bonds. As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82.2 trillion , of which the size of the outstanding U.S. bond market debt was $31.2 trillion according to BIS (or alternatively $34.3 is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges.

Financial markets can be domestic or they can be international.

Types of financial markets

The financial markets can be divided into different subtypes:

• Capital markets A capital market is a market for securities , where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market ( which consist of:
  • Stock markets A stock market or equity market is a public market for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately, which provide financing through the issuance of shares or common stock The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in, and enable the subsequent trading thereof.
  • Bond markets The bond market is a financial market where participants buy and sell debt securities, usually in the form of bonds. As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82.2 trillion , of which the size of the outstanding U.S. bond market debt was $31.2 trillion according to BIS (or alternatively $34.3, which provide financing through the issuance of bonds In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals, and enable the subsequent trading thereof.
• Commodity markets Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts, which facilitate the trading of commodities.
• Money markets The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit, federal funds, and short-lived mortgage- and asset-, which provide short term debt financing and investment.
• Derivatives markets The derivatives markets are the financial markets for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets, which provide instruments for the management of financial Finance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and budgeted risk.
  • Futures markets A futures exchange or derivatives exchange is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future, which provide standardized forward contracts A forward contract or simply a forward is a non-standardized agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the for trading products at some future date; see also forward market The forward market is the over-the-counter financial market in contracts for future delivery, so called forward contracts. Forward contracts are personalized between parties . The forward market is a general term used to describe the informal market by which these contracts are entered into. Standardized forward contracts are called futures.
• Insurance markets In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the insurance; an insured or policyholder is the person or, which facilitate the redistribution of various risks.
• Foreign exchange markets The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends, which facilitate the trading of foreign exchange The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.

The capital markets A capital market is a market for securities , where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market ( consist of primary markets The primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called and secondary markets The secondary market, also known as the aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold.. The term "secondary market" is also used to refer to the market for any used goods or assets, or an alternative use for an existing. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.

Raising capital

To understand financial markets, let us look at what they are used for, i.e. what is their purpose?

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks Banking is generally a highly regulated industry, and government restrictions on financial activities by banks have varied over time and location. The current set of global bank capital standards are called Basel II. In some countries such as Germany, banks have historically owned major stakes in industrial corporations while in other countries help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages.

More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

The following table illustrates where financial markets fit in the relationship between lenders and borrowers:

Lenders

Individuals

Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:

• puts money in a savings account at a bank;
• contributes to a pension plan;
• pays premiums to an insurance company;
• invests in government bonds; or
• invests in company shares.

Companies

Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets.

There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks.)

Borrowers

Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernisation or future business expansion.

Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalised industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).

Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council.

Public Corporations typically include nationalised industries. These may include the postal services, railway companies and utility companies.

Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.

Derivative products

During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short.

In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics.

Currency markets

Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past,^[when?] when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements.^[1]

The picture of foreign currency transactions today shows:

• Banks/Institutions
• Speculators
• Government spending (for example, military bases abroad)
• Importers/Exporters
• Tourists

Analysis of financial markets

See Statistical analysis of financial markets, statistical finance

Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of "technical analysis" is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change.

The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modeled better by Lévy stable distributions. The scale of change, or volatility, depends on the length of the time unit to a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate using a Gaussian distribution with an estimated standard deviation.

A new area of concern is the proper analysis of international market effects. As connected as today's global financial markets are, it is important to realize that there are both benefits and consequences to a global financial network. As new opportunities appear due to integration, so do the possibilities of contagion. This presents unique issues when attempting to analyze markets, as a problem can ripple through the entire connected global network very quickly. For example, a bank failure in one country can spread quickly to others, which proper analysis more difficult.

Financial market slang

• Poison pill, measures taken by a company to prevent being bought out by another company by issuing a more number of shares, thereby increasing the no. of outstanding shares to be bought by the hostile company making the bid to establish majority.
• Quant, a quantitative analyst skilled in the black arts of PhD level (and above) mathematics and statistical methods.
• Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill. They are able to invent derivatives of frightening complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training; rocket scientists do not necessarily build rockets for a living.
• White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one organization to help prevent against a hostile takeover of that organization by another party.

See also

• Finance capitalism
• Financial instrument
• Financial market efficiency
• Brownian Model of Financial Markets
• Investment theory
• Quantitative behavioral finance
• Slippage
• Stock investor

Notes

1. ^ Steven Valdez, An Introduction To Global Financial Markets

References

• T.E. Copeland, J.F. Weston (1988): Financial Theory and Corporate Policy, Addison-Wesley, West Sussex (ISBN 978-0321223531)
• E.J. Elton, M.J. Gruber, S.J. Brown, W.N. Goetzmann (2003): Modern Portfolio Theory and Investment Analysis, John Wiley & Sons, New York (ISBN 978-0470050828)
• E.F. Fama (1976): Foundations of Finance, Basic Books Inc., New York (ISBN 978-0465024995)
• Marc M. Groz (2009): Forbes Guide to the Markets, John Wiley & Sons, Inc., New York (ISBN 978-0470463383)
• R.C. Merton (1992): Continuous-Time Finance, Blackwell Publishers Inc. (ISBN 978-0631185086)
• Steven Valdez, An Introduction To Global Financial Markets, Macmillan Press Ltd. (ISBN 0-333-76447-1)
• The Business Finance Market: A Survey, Industrial Systems Research Publications, Manchester (UK), new edition 2002 (ISBN 978-0-906321-19-5)

External links

• Financial Markets with Yale Professor Robert Shiller

Categories: Financial markets

See Also:

• Financial Markets
• Category:Financial Markets: Encyclopedia
• Market Trends
• Financial Economics
• Market Depth: Encyclopedia

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