Things you have to know about financial markets

[Blog #1 on this subject]

It is unwise for you to invest in financial markets from a basis of ignorance, especially if you are managing your own portfolio of securities. Safe investing and avoiding fraud are facilitated when you gain an understanding of financial markets and instruments. We will help you in this regard by providing a series of blogs about investing for beginners [note 1].

In the first series of blogs we will look at the various capital (share, bond) and money markets typically faced by a trader or available to an investor. We will introduce various cash instruments, and help you understand their function, price and mark-to-market their interim values, and risk management.

Further assistance will be provided in the form of financial market book reviews

[Note 1. A sort of "investing for dummies" or"investment 101"]

But. first we will look at financial system in general.

The financial system

Basically, the financial system is a set of arrangements embracing the lending and borrowing of funds by non-financial "economic units" and the intermediation of this function by financial institutions in order to facilitate the transfer of funds, to create additional money when required, and to create markets in debt instruments so that the price and allocation of funds are determined efficiently.

There are six essential elements of a financial system:
1. Lenders and borrowers - the non-financial economic units (eg individuals and companies) that undertake the lending and borrowing process.
2. Financial intermediaries, which interpose themselves between the lenders and borrowers.
3. Financial instruments, which are created to satisfy the needs of the various participants.
4. Money creation (when required) - the unique money creating ability of banks.
5. Financial markets - the institutional arrangements and conventions that exist for the issue and trading (dealing) of financial instruments.
6. Rate of interest, or the time value of money = the price of money.

Financial markets

The participants in the financial markets are the borrowers (issuers of securities), the lenders (buyers of securities), the financial intermediaries (buyers and issuers of securities) and the brokers, fund managers, speculators, exchanges and regulators.

The terminology used can sometimes be confusing. For example, reference is made to the primary market, the secondary market, the spot market, the options and futures markets, financial exchanges, the money market, the capital markets, the debt markets, the swap market. and so forth. We will endeavour to clarify the picture, over time in further blogs.

Primary and secondary markets
A fundamental distinction has to be drawn between the primary and secondary markets in securities. The market for the issue of new securities to borrow money for consumption or investment purposes is referred to as the primary market.

The markets in non-negotiable instruments, eg mortgage loans, savings deposits and life policies, are entirely primary markets, while negotiable certificates of deposit, shares and bonds, for example, are issued in the primary market, but traded in the secondary market.

Secondary market is the term used for the markets in which previously issued securities are traded. These markets exist in many of the securities referred to in the previous section, but they differ in terms of so-called breadth and depth or liquidity, sometimes vastly.

When discussing the secondary market, it is important to distinguish between brokers and market makers. Brokers act on behalf of other financial market participants (principals) in return for a commission (although sometimes they may take speculative positions - act as principals for their own profit). Market makers are financial intermediaries, mainly banks, who are appointed by the issuers to perform, this function.

Market making means that the market makers are prepared to quote buying and selling prices/rates simultaneously for certain securities; the spreads quoted by them are small, and they are prepared to deal in reasonable volumes. Because these institutions are prepared to hold portfolios of securities for this purpose, they need to be adequately capitalised - usually the large domestic and international banks.

An active secondary market in securities is important for five reasons:

1. It assists the primary market - improves the ability of issuers to place securities, by providing investors with the assurance that they will be able to dispose of securities If they so desire.
2. It provides the basis for the determination of rates to be offered on new issues.
3. It registers changing market conditions rapidly, indicating the receptiveness of the market for new primary issues.
4. It enables investors to rapidly adjust their portfolios in terms of size, risk, return, liquidity and maturity.
5. It enables the central bank to buy and sell securities in order to influence liquidity in the financial markets (open-market operations).

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Our next blog will look at the share market.