Lesson two

Chapter 2

Financial Markets
A market is a place where firms and individuals can conveniently swap different types of assets as and
when required. The purpose of markets is to bring buyers and sellers together and one party agrees to
sell and the other agrees to buy an item in offer. Financial Market is the market where financial
securities like stocks and bonds and commodities like valuable metals are exchanged at efficient market
prices. Here, by efficient market prices we mean the unbiased price that reflects belief at collective
speculation of all investors about the future prospect. The trading of stocks and bonds in the Financial
Market can take place directly between buyers and sellers or by the medium of Stock Exchange.
Financial Markets can be domestic or international. Domestic market trades are aimed toward a single
market. A domestic market is also referred to as domestic trading. In domestic trading, a firm faces only
one set of competitive, economic, and market issues and essentially must deal with only one set of
customers, although the company may have several segments in a market. There are certain limitations
when competing in a domestic market, many of which encourage firms to expand abroad. The main
reasons why a business would decide to expand abroad is due to a limited market size and limited
growth within the domestic market. International financial markets can be taken to describe the
process by which regional economies, societies, and cultures have become integrated through a global
network of political ideas through communication, transportation, and trade.. In finance financial
markets facilitate:

The raising of capital (in the capital markets).

The transfer of risk (in the derivatives markets).
The transfer of liquidity (in the money markets).
International trade (in the currency markets).
Financial markets bring together people and organizations needing money with those having
surplus funds. There are many different financial markets in a developed economy dealing with
different types of Instruments, customers or geographical location.
Types of Financial Markets
The major types of markets are:

Physical asset markets which are also called tangible, real and commodity markets- This type of
markets deals with tangible commodities and products for example machinery, computers,
wheat and real state.
Financial asset markets on the other hand deals with financial instruments such as stocks,
bonds, notes and mortgages. Their value depends on what happens to the value of some other
assets which implies that they have contractual provisions that entitle the owners of these
instruments to specific rights and claims on real assets.

Spot markets versus future markets.

Spot markets (cash markets)

Spot markets and futures markets are terms that refer to whether the assets (in the physical assets
markets) are bought or sold for on-the-spot delivery (literally, within a few days) or for delivery at
some future date, such as six months or a year into the future. Also can refer to commodities or
securities market in which goods are sold for cash and delivered immediately.
Future markets

Futures Markets: is where a contract to buy a specific asset for a specific price on a
specific date in the future .Future markets is developed from forward markets. A forward
contract is an agreement negotiated between two parties for the delivery of physical assets e.g.
oil. A futures transaction for which commodities can be reasonably expected to be delivered in
one month or less. Though these goods may be bought and sold at spot prices, the goods in
question are traded on a forward physical market. These future markets are transferable,
exchange traded contracts and requires delivery of a commodity, bond, currency or stocks, at a
specific price and at a given specified future date. Future contracts are standardized across all
contracts of the same types and are cleared in a central clearing house.
o Money markets vs. capital markets
Money markets - refer to transactions in short-term debt instruments that are generally issued
by borrowers with very high credit ratings. The major instruments issued and traded in the
money markets are highly liquid debt securities and includes: treasury bills, bankers
acceptances, negotiable certificates of deposits and commercial papers. They have a maturity
period of one year or less or often within a month or less. Money market securities are
generally very safe investments which return relatively low interest rate that is most
appropriate for temporary cash storage or short term time needs.
Capital markets-Capital markets are different types of financial markets that deal with the trade
of certain types of bonds and stocks. Capital markets can either relate to newly issued bonds
and stocks. Or it may handle trades of pre-existing bonds and stocks. This market is typically
referred to as either the bond or stock market. The bond market oversees financing regarding
the issuance of various types of bonds. And the stock market does the same but for stock issues.
Can also refer to the markets for long-term financial instruments. It encompasses long- term
loans (bonds), financial leases, intermediate, long-term debt and corporate stocks. A good
example of a capital market is the New York Stock Exchange.
With regard to time factor in relation to markets, short term is generally a period of less than one year,
intermediate is period between one to five years and long term is more than a period of more than five
years.
o Primary markets vs. secondary markets
Primary markets are the markets in which corporations raise new capital through selling a new
issue of common stock to raise capital to potential investors. They can also be defined as that

part of the capital 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. The
first stock issue first by a company to the public is referred to as initial public offers (IPO) for
example a corporation like Microsoft can decide to sell a new issue to raise its capital from the
proceeds, and then this can be referred to as primary market transaction.
A secondary market is where currently outstanding securities are traded. It exists for bonds,
mortgages and other financial assets. We can also define as the financial market where
previously issued securities and financial instruments such as stock, bonds, options, and futures
are bought and old. Nairobi Stock Exchange is an example of a secondary market as it deals in
outstanding as opposed to newly issued stocks. A secondary market can either be a physical
location exchange or a computer/telephone network.

The Nairobi stock exchange.

o Public offering versus private placements
Public offering markets- Refers to a security offering where all investors have the opportunity to
acquire a portion of the financial claims being sold. The securities are usually made available to
the public at large by an investment-banking firm specializing in helping other firms raise money.
The initial public offering market (IPO) is a subset of the primary market. In this market, firms go
public by offering their shares to the public mainly for the first time. The insiders sell some of
their shares and the company also sells newly created shares to raise additional capital. Locally,
mobile network Safaricom sold its shares through the initial public offering market to raise
capital.
Private markets. Are also called direct placement, the securities are offered and sold directly to
a limited number of investors. For these markets, transactions are mainly worked out directly
between two parties (the seller and prospective buyer). These transactions may be structured in
a manner that appeals to the two parties involved. Example of private market transactions are
bank loans and private placement of debt with insurance companies. Therefore, private markets
transactions are more tailor made but less liquid than public market securities which are more
liquid due to their diverse ownership, but subject to greater regulation and standardization.
World, national, regional and local markets depend on an organizations size and scope of operations.
It may have the capacity to borrow all around the globe or it may be confined to a strictly local
market.
Trading Procedures in Financial Market.
Secondary markets have three dimensions trading procedures.
1. Location. It can be either a physical location exchange or a computer/telephone network.

2. Way orders from seller to buyers are matched- It can occur through an open outcry auction system,
through dealers or by automatic order matching. In a dealer market there are market makers who
keep an inventory of the stock (or other financial instrument) in much the same way merchant keeps an
inventory. They list bid and asked quotes. Computerized quotation systems keep track of all bids and
asked prices, but they dont actually match buyers and sellers. Instead traders must contact a specific
dealer to complete the transaction.
3. The third method of matching orders is through an electronic communication network
(ECN).Participants in an ECN post their orders to buy and sell and the ECN automatically matches the
order E.g. if someone places an order to sell 1000 shares of KPLC and another participant had placed an
order to sell 1000 shares of KPLC at 26kshs and this was the lowest price of sale, the ECN would
automatically match this two orders, execute the trade and notify both participants that the trade has
occurred.
Benefits of Stock Exchange (functions of a stock exchange).
Both corporations and investors enjoy several benefits provided by existence of organized security
exchange. They include;
1.
Providing a continuous market- A continuous market provides a series of continuous security
prices. Prices change from trade to trade and tend to be smaller than they would be in the absence of
organized markets since there is relatively large sales volume in each security. Trading orders are executed
quickly like reducing price volatility. Very few people indeed would be attracted to investing their savings
in shares if they were not assured of prompt conversion of their holdings into cash.
2. Establishing and publicizing fair security prices- An organized exchange permits security prices to be
set by competitive sources. They are not set by negotiations at the stock of the exchange where one party
might have a bargaining advantage. It sets a price for every security, whether or not it is actually bought or
sold in a particular period. This is of great help to both the investors and the relevant company. Bidding
process flows from the supply and demand underlying each security. In addition, the security prices
determined at each exchange are widely publicized.
3. Helping business raise new capital- Since a continuous secondary market exists where prices are
competitively determined; it is easier for firms to float new security offering successfully. This continuous
pricing mechanism facilitates the determination of the offering price of a new issue, hence comparative
values are easily observed.
4. It helps in directing a large part of savings by members of the public to invest in joint stock
companies, which plays a very important role in the general development of the country.
5. Stock exchange facilitates the investors to sell their shares when they find a more attractive security
to buy hence making transferability of shares more meaningfully.

6.
Safety of Transaction: The membership of a stock exchange is well regulated and its dealings
are well defined according to the existing legal framework. This ensures that the investing public gets a
safe and fair deal on the market.
7.
Spreading of Equity Cult: The stock exchange can play a vital role in ensuring wider share
ownership by regulating new issues, better trading practices and taking effective steps in educating the
public about investments.
8.
Providing Scope for Speculation: The stock exchange provides sufficient scope within the
provisions of law for speculative activity in a restricted and controlled manner. It is generally accepted that
a certain degree of healthy speculation is necessary to ensure liquidity and price continuity in the stock
market
9.
Regulates company management- listed companies have to comply with rules and regulations
of concerned stock exchange and work under the vigilance of stock exchange authorities.
10.
Provides safety and security in dealings- Stock exchange provides safety, security and equity
(justice) in dealings as transactions are conducted as per well defined rules and regulations. The managing
body of the exchange keeps control on the members. Fraudulent practices are also checked effectively.
Due to various rules and regulations, stock exchange functions as the custodian of funds of genuine
investors.
11.
Provides clearing house facility- Stock exchange provides a clearing house facility to members.
It settles the transactions among the members quickly and with ease. The members have to pay or receive
only the net dues because of the clearing house facility.
12.
Facilitates healthy speculation- Healthy speculation, keeps the exchange active. Normal
speculation is not dangerous but provides more business to the exchange. However, excessive speculation
is undesirable as it is dangerous to investors & the growth of corporate sector.
13.
Contributes to Economic Growth: A stock exchange is a market in which existing securities are
resold or traded. Through this process of disinvestment and reinvestment savings get channelized into
their most productive investment avenues. This leads to capital formation and economic growth.
14.
Pricing of Securities: Share prices on a stock exchange are determined by the forces of demand
and supply. A stock exchange is a mechanism of constant valuation through which the prices of securities
are determined. Such a valuation provides important instant information to both buyers and sellers in the
market.
15.
Serves as Economic Barometer- Stock exchange indicates the state of health of companies and
the national economy. It acts as a barometer of the economic situation / conditions.
16.
It is useful in guiding both investors and the relevant companies by publishing useful
information, in statistical and summary form, about the various companies performance in the market. If
it discovers that a particular company is not acting properly, it strikes its name off the list of shares
members are allowed to buy or sell. This is an assurance to members of the public that their money is safe
if it is invested in the shares of a quoted company.
17. The stock exchange index is prepared on the basis and volume of the shares traded during
each week. This index is often taken as a barometer of the countrys economic progress.
The role of money in economic growth

The following are the roles of money in economic growth:

Medium of exchange- Money is used as a medium of exchange and is used to obtain goods and
services and must be accepted by all.
It is used as a measure of value- The value of goods and services can be expressed in terms of
money and this makes it possible to assess the values of different goods and services.
A store of value- Money is durable and hence not perishable in nature. This enables producers
like farmers to sell their products and store the money for future use.
It is used as a standard for future payments- The ability of money to remain relatively stable in
value makes it convenient for future payments.
Unit of account- The value of goods and services is usually recorded in monetary value for
example a shirt can be valued at ksh.300.
It acts as a means of transfer of immovable properties- Property such as buildings and land are
bought or sold using money. This allows movement as one can sell a piece of land in one
location and use the money to buy another piece of land in another geographical location.

Listing Requirements
To receive the benefit provided by an organized exchange, the firm must seek to have its securities
listed on the exchange. Enforceable set of primary and secondary priority trading rules provide a
transparent and equitable trading system.