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INTRODUCTION

A financial market is a broad term describing any marketplace where buyers and
sellers participate in the trade of assets such as equities, bonds, currencies and
derivatives. Financial markets are typically defined by having transparent pricing,
basic regulations on trading, costs and fees, and market forces determining the prices
of securities that trade.

Investors have access to a large number of financial markets and exchanges


representing a vast array of financial products. Some of these markets have always
been open to private investors; others remained the exclusive domain of major
international banks and financial professionals until the very end of the twentieth
century.

A financial

market is

a market in

which

people trade financial securities, commodities, and other fungible items of value at
low transaction costs and at prices that reflect supply and demand. Securities include
stocks and bonds, and commodities include precious metals or agricultural products.

In economics, typically, the term market means the aggregate of possible buyers and
sellers of a certain good or service 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 or commodity exchange. This may be a physical location (like
the NYSE,BSE, NSE) or an electronic system (like NASDAQ). Much trading of
stocks takes place on an exchange; still, corporate actions (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 and bonds 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.

TYPES OF FINANCIAL MARKETS AND THEIR ROLES


Within the financial sector, the term "financial markets" is often used to refer just to
the markets that are used to raise finance: for long term finance, the Capital markets;
for short term finance, the Money markets. Another common use of the term is as a
catchall for all the markets in the financial sector, as per examples in the breakdown
below.

Capital markets which to consist of:

Stock markets, which provide financing through the issuance of shares


or common stock, and enable the subsequent trading thereof.

Bond markets, which provide financing through the issuance of bonds,


and enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities.

Money markets, which provide short term debt financing and investment.

Derivatives markets, which provide instruments for the management


of financial risk.[1]

Futures markets, which provide standardized forward contracts for trading


products at some future date; see also forward market.

Foreign exchange markets, which facilitate the trading of foreign exchange.

Spot market

Interbanks market

The capital markets may also be divided into primary markets and secondary markets.
Newly formed (issued) securities are bought or sold in primary markets, such as
during initial public offerings. Secondary markets allow investors to buy and sell

existing securities. The transactions in primary markets exist between issuers and
investors, while secondary market transactions exist among investors.
Liquidity is a crucial aspect of securities that are traded in secondary markets.
Liquidity refers to the ease with which a security can be sold without a loss of value.
Securities with an active secondary market mean that there are many buyers and
sellers at a given point in time. Investors benefit from liquid securities because they
can sell their assets whenever they want; an illiquid security may force the seller to
get rid of their asset at a large discount.
Capital Markets
A capital market is one in which individuals and institutions trade financial securities.
Organizations and institutions in the public and private sectors also often sell
securities on the capital markets in order to raise funds. Thus, this type of market is
composed of both the primary and secondary markets.
Any government or corporation requires capital (funds) to finance its operations and
to engage in its own long-term investments. To do this, a company raises money
through the sale of securities - stocks and bonds in the company's name. These are
bought and sold in the capital markets.

Stock Markets
Stock markets allow investors to buy and sell shares in publicly traded companies.
They are one of the most vital areas of a market economy as they provide companies
with access to capital and investors with a slice of ownership in the company and the
potential of gains based on the company's future performance.
This market can be split into two main sections: the primary market and the secondary
market. The primary market is where new issues are first offered, with any subsequent
trading going on in the secondary market.
Bond Markets

A bond is a debt investment in which an investor loans money to an entity (corporate


or governmental), which borrows the funds for a defined period of time at a fixed
interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign
governments to finance a variety of projects and activities. Bonds can be bought and
sold by investors on credit markets around the world. This market is alternatively
referred to as the debt, credit or fixed-income market. It is much larger in nominal
terms that the world's stock markets. The main categories of bonds are corporate
bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are
collectively referred to as simply "Treasuries.
Money Market

The money market is a segment of the financial market in which financial instruments
with high liquidity and very short maturities are traded. The money market is used by
participants as a means for borrowing and lending in the short term, from several days
to just under a year. Money market securities consist of negotiable certificates of
deposit (CDs), banker's acceptances, U.S. Treasury bills, commercial paper,
municipal notes, eurodollars, federal funds and repurchase agreements (repos). Money
market investments are also called cash investments because of their short maturities.
The money market is used by a wide array of participants, from a company raising
money by selling commercial paper into the market to an investor purchasing CDs as
a safe place to park money in the short term. The money market is typically seen as a
safe place to put money due the highly liquid nature of the securities and short
maturities. Because they are extremely conservative, money market securities offer
significantly lower returns than most other securities. However, there are risks in the
money market that any investor needs to be aware of, including the risk of default on
securities such as commercial paper.
Cash or Spot Market

Investing in the cash or "spot" market is highly sophisticated, with opportunities for
both big losses and big gains. In the cash market, goods are sold for cash and are
delivered immediately. By the same token, contracts bought and sold on the spot
market are immediately effective. Prices are settled in cash "on the spot" at current
market prices. This is notably different from other markets, in which trades are
determined at forward prices.
The cash market is complex and delicate, and generally not suitable for inexperienced
traders. The cash markets tend to be dominated by so-called institutional market
players such as hedge funds, limited partnerships and corporate investors. The very
nature of the products traded requires access to far-reaching, detailed information and
a high level of macroeconomic analysis and trading skills.

Derivatives Markets

The derivative is named so for a reason: its value is derived from its underlying asset
or assets. A derivative is a contract, but in this case the contract price is determined by
the market price of the core asset. If that sounds complicated, it's because it is. The
derivatives market adds yet another layer of complexity and is therefore not ideal for
inexperienced traders looking to speculate. However, it can be used quite effectively
as part of a risk management program. (To get to know derivatives, read The
Barnyard Basics Of Derivatives.)
Examples of common derivatives are forwards, futures, options, swaps and contractsfor-difference (CFDs). Not only are these instruments complex but so too are the
strategies

deployed

by this

market's

participants. There

are

also

many

derivatives, structured products and collateralized obligations available, mainly in


the over-the-counter (non-exchange) market, that professional investors, institutions
and hedge fund managers use to varying degrees but that play an insignificant role in
private investing.

Forex and the Interbank Market

The interbank market is the financial system and trading of currencies among banks
and financial institutions, excluding retail investors and smaller trading parties. While
some interbank trading is performed by banks on behalf of large customers, most
interbank trading takes place from the banks' own accounts.
The forex market is where currencies are traded. The forex market is the largest, most
liquid market in the world with an average traded value that exceeds $1.9 trillion per
day and includes all of the currencies in the world. The forex is the largest market in
the world in terms of the total cash value traded, and any person, firm or country may
participate in this market.
There is no central marketplace for currency exchange; trade is conducted over the
counter. The forex market is open 24 hours a day, five days a week and currencies are
traded worldwide among the major financial centers of London, New York, Tokyo,
Zrich,

Frankfurt,

Hong

Kong,

Singapore,

Paris

and

Sydney.

Until recently, forex trading in the currency market had largely been the domain of
large financial institutions, corporations, central banks, hedge funds and extremely
wealthy individuals. The emergence of the internet has changed all of this, and now it
is possible for average investors to buy and sell currencies easily with the click of a
mouse through online brokerage accounts. (For further reading, see The Foreign
Exchange Interbank Market.)

Primary Markets vs. Secondary Markets


A primary market issues new securities on an exchange. Companies, governments and
other groups obtain financing through debt or equity based securities. Primary
markets, also known as "new issue markets," are facilitated by underwriting groups,
which consist of investment banks that will set a beginning price range for a given
security

and

then

oversee

its

sale

directly

to

investors.

The primary markets are where investors have their first chance to participate in a
new security issuance. The issuing company or group receives cash proceeds from the
sale, which is then used to fund operations or expand the business. (For more on the
primary market, see our IPO Basics Tutorial.)
The secondary market is where investors purchase securities or assets from other
investors, rather than from issuing companies themselves. The Securities and
Exchange Commission (SEC) registers securities prior to their primary issuance, then
they start trading in the secondary market on the New York Stock Exchange, Nasdaq
or other venue where the securities have been accepted for listing and trading. (To
learn more about the primary and secondary market, read Markets Demystified.)
The secondary market is where the bulk of exchange trading occurs each day. Primary
markets can see increased volatility over secondary markets because it is difficult to
accurately gauge investor demand for a new security until several days of trading
have occurred. In the primary market, prices are often set beforehand, whereas in the
secondary market only basic forces like supply and demand determine the price of the
security.
Secondary markets exist for other securities as well, such as when funds, investment
banks or entities such as Fannie Mae purchase mortgages from issuing lenders. In any
secondary market trade, the cash proceeds go to an investor rather than to the
underlying company/entity directly. (To learn more about primary and secondary
markets, read A Look at Primary and Secondary Markets.)

The OTC Market


The over-the-counter (OTC) market is a type of secondary market also referred to as a
dealer market. The term "over-the-counter" refers to stocks that are not trading on a
stock exchange such as the Nasdaq, NYSE or American Stock Exchange (AMEX).
This generally means that the stock trades either on the over-the-counter bulletin
board (OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact,

they describe themselves as providers of pricing information for securities. OTCBB


and pink sheet companies have far fewer regulations to comply with than those that
trade shares on a stock exchange. Most securities that trade this way are penny
stocks or are from very small companies.

Third and Fourth Markets


You might also hear the terms "third" and "fourth markets." These don't concern
individual investors because they involve significant volumes of shares to be
transacted per trade. These markets deal with transactions between broker-dealers and
large

institutions

through

over-the-counter

electronic

networks.

The third

market comprises OTC transactions between broker-dealers and large institutions.


The fourth market is made up of transactions that take place between large
institutions. The main reason these third and fourth market transactions occur is to
avoid placing these orders through the main exchange, which could greatly affect the
price of the security. Because access to the third and fourth markets is limited, their
activities

have

little

effect

on

the

average

investor.

Financial institutions and financial markets help firms raise money. They can do this
by taking out a loan from a bank and repaying it with interest, issuing bonds to
borrow money from investors that will be repaid at a fixed interest rate, or offering
investors partial ownership in the company and a claim on its residual cash flows in
the form of stock.

Raising capital
Financial markets attract funds from investors and channel them to corporations
they thus allow corporations to finance their operations and achieve growth. Money
markets allow firms to borrow funds on a short term basis, while capital markets
allow corporations to gain long-term funding to support expansion (known as
maturity transformation).
Without financial markets, borrowers would have difficulty finding lenders
themselves.

Intermediaries

such

as banks, Investment

Banks,

and Boutique

Investment Banks can 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.

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
The lender temporarily gives money to somebody else, on the condition of getting
back the principal amount together with some interest/profit or charge.

Individuals & Doubles


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

Companies
Companies tend to be lenders 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. Alternatively, such
companies may decide to return the cash surplus to their shareholders (e.g. via a share
repurchase or dividend payment).

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 modernization 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 nationalized 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 nationalized 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.
Borrowers having similar needs can form into a group of borrowers. They can also
take an organizational form like Mutual Funds. They can provide mortgage on weight
basis. The main advantage is that this lowers the cost of their borrowings.

Derivative products
During the 1980s and 1990s, a major growth sector in financial markets was 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.[2] It is also called financial
economics.
Derivative products or instruments help the issuers to gain an unusual profit from
issuing the instruments. For using the help of these products a contract has to be
made. Derivative contracts are mainly 4 types:[3]
1. Future
2. Forward
3. Option
4. Swap

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.[4]
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


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 role of human psychology in
price variations also plays a significant factor. Large amounts of volatility often
indicate the presence of strong emotional factors playing into the price. Fear can
cause excessive drops in price and greed can create bubbles. In recent years the
rise of algorithmic and high-frequency program trading has seen the adoption of
momentum, ultra-short term moving average and other similar strategies which

are based on technical as opposed to fundamental or theoretical concepts of


market Behaviour.
The scale of changes in price over some unit of time is called the volatility. It
was discovered by Benot Mandelbrot that changes in prices do not follow
a Gaussian distribution, but are rather modeled better by Lvy 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.

Financial market slang


Poison pill, when a company issues more shares to prevent being bought out
by another company, thereby increasing the number of outstanding shares to
be bought by the hostile company making the bid to establish majority.
Bips, meaning "bps" or basis points. A basis point is a financial unit of
measurement used to describe the magnitude of percent change in a variable.
One basis point is the equivalent of one hundredth of a percent. For example,
if a stock price were to rise 100bit/s, it means it would increase 1%.
Quant,

a quantitative

analyst with

advanced

training

in 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 high
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.
IPO, stands for initial public offering, which is the process a new private
company goes through to "go public" or become a publicly traded company
on some index.
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.
Round-tripping
Smurfing, a deliberate structuring of payments or transactions to conceal it
from regulators or other parties, a type of money laundering that is often
illegal.
Spread, the difference between the highest bid and the lowest offer.

Role in the economy


One of the important sustainability requisite for the accelerated development of an
economy is the existence of a dynamic financial market. A financial market helps
the economy in the following manner.
Saving mobilization: Obtaining funds from the savers or surplus units such as
household individuals, business firms, public sector units, central government,
state governments etc. is an important role played by financial markets.
Investment: Financial markets play a crucial role in arranging to invest funds
thus collected in those units which are in need of the same.
National Growth: An important role played by financial market is that, they
contribute to a nation's growth by ensuring unfettered flow of surplus funds to
deficit units. Flow of funds for productive purposes is also made possible.
Entrepreneurship growth: Financial market contribute to the development of
the entrepreneurial claw by making available the necessary financial
resources.
Industrial development: The different components of financial markets help
an accelerated growth of industrial and economic development of a country,
thus contributing to raising the standard of living and the society of wellbeing.

Functions of financial markets


Intermediary functions: The intermediary functions of financial markets
include the following:

Transfer of resources: Financial markets facilitate the transfer of real


economic resources from lenders to ultimate borrowers.

Enhancing income: Financial markets allow lenders to earn interest or


dividend on their surplus invisible funds, thus contributing to the
enhancement of the individual and the national income.

Productive usage: Financial markets allow for the productive use of


the funds borrowed. The enhancing the income and the gross national
production.

Capital formation: Financial markets provide a channel through


which new savings flow to aid capital formation of a country.

Price determination: Financial markets allow for the determination of


price of the traded financial assets through the interaction of buyers and
sellers. They provide a sign for the allocation of funds in the economy
based on the demand and to the supply through the mechanism
called price discovery process.

Sale mechanism: Financial markets provide a mechanism for selling


of a financial asset by an investor so as to offer the benefit of
marketability and liquidity of such assets.

Information: The activities of the participants in the financial market


result in the generation and the consequent dissemination of information
to the various segments of the market. So as to reduce the cost of
transaction of financial assets.

Financial Functions

Providing the borrower with funds so as to enable them to carry out


their investment plans.

Providing the lenders with earning assets so as to enable them to earn


wealth by deploying the assets in production debentures.

Providing liquidity in the market so as to facilitate trading of funds.

Providing liquidity to commercial bank

Facilitating credit creation

Promoting savings

Promoting investment

Facilitating balanced economic growth

Improving trading floors

Components of financial market


Based on market levels
Primary market: Primary market is a market for new issues or new financial
claims. Hence its also called new issue market. The primary market deals
with those securities which are issued to the public for the first time.
Secondary market: Its a market for secondary sale of securities. In other
words, securities which have already passed through the new issue market are
traded in this market. Generally, such securities are quoted in the stock
exchange and it provides a continuous and regular market for buying and
selling of securities.

Simply put, primary market is the market where the newly started company issued
shares to the public for the first time through IPO (initial public offering).
Secondary market is the market where the second hand securities are sold
(security Commodity Marketies).

Based on security types


Money market: Money market is a market for dealing with financial assets
and securities which have a maturity period of up to one year. In other words,
its a market for purely short term funds.
Capital market: A capital market is a market for financial assets which have a
long or indefinite maturity. Generally it deals with long term securities which
have a maturity period of above one year. Capital market may be further
divided into: (a) industrial securities market (b) Govt. securities market and
(c) long term loans market.

Equity markets: A market where ownership of securities are issued


and subscribed is known as equity market. An example of a secondary
equity market for shares is the Bombay stock exchange.

Debt market: The market where funds are borrowed and lent is known
as debt market. Arrangements are made in such a way that the borrowers
agree to pay the lender the original amount of the loan plus some
specified amount of interest.

Derivative markets: A market where financial instruments are derived and


traded based on an underlying asset such as commodities or stocks.
Financial service market: A market that comprises participants such as
commercial banks that provide various financial services like ATM. Credit
cards. Credit rating, stock broking etc. is known as financial service market.
Individuals and firms use financial services markets, to purchase services that
enhance the working of debt and equity markets.

Depository markets: A depository market consists of depository institutions


that accept deposit from individuals and firms and uses these funds to
participate in the debt market, by giving loans or purchasing other debt
instruments such as treasure bills.
Non-depository market: Non-depository market carry out various functions
in financial markets ranging from financial intermediary to selling, insurance
etc. The various constituency in non-depositary markets are mutual funds,
insurance companies, pension funds, brokerage firms etc.

FINANCIAL RISK
Financial risk is the possibility that shareholders will lose money when they invest in
a company that has debt, if the company's cash flow proves inadequate to meet its
financial obligations. When a company uses debt financing, its creditors are repaid
before its shareholders if the company becomes insolvent. Financial risk also refers to
the possibility of a corporation or government defaulting on its bonds, which would
cause those bondholders to lose money.

Financial risk management

Financial risk management is the practice of economic value in a firm by


using financial

instruments to

manage

exposure

to risk,

particularly credit

risk and market risk. Other types include Foreign exchange risk, Shape risk, Volatility
risk, Sector

risk, Liquidity

risk, Inflation

risk,

etc.

Similar

to

general risk

management, financial risk management requires identifying its sources, measuring it,
and plans to address them.[1]
Financial risk management can be qualitative and quantitative. As a specialization
of risk management, financial risk management focuses on when and how
tohedge using financial instruments to manage costly exposures to risk.[2]
In the banking sector worldwide, the Basel Accords are generally adopted by
internationally active banks for tracking, reporting and exposing operational, credit
and market risks.[3][4]
Risk management is the identification, appraisal, and prevention or minimization of
exposures to accidental loss for an organization or individual. Since risk offers not
only the opportunity for growth but also for harm, risk managers must predict and
prevent or control any potential harm. Risk management is essential for companies to

avoid costly mistakes and business losses. The practice of risk management utilizes
many tools and techniques, including insurance, to manage a wide variety of risks
facing any entity, from the largest corporation to the individual. The term "risk
management" has usually referred to property and casualty exposures to loss but
recently has come to include financial risk management, e.g., interest rates, foreign
exchange rates, derivatives, etc.
The term "risk management" is a relatively recent evolution of the term "insurance
management," and originated in the mid-1970s. The reason for this evolution is that
the concept of risk management encompasses a much broader scope of activities and
responsibilities than does insurance management. Risk management is now a widely
accepted description of a discipline within most large companies as well as a growing
number of smaller ones. The myriad risks faced by most businesses today necessitate
a department solely devoted to managing these risks. Basic risks such as fire,
windstorm, flood, employee injuries, and automobile accidents, as well as more
complex

exposures

such

as product

liability, environmental

impairment,

and employment practices, are the province of the risk management department in a
typical corporation.
These risks stem from various aspects of doing business and they generally fit into the
following categories, according to Kevin Dowd in Beyond Value at Risk:
1. Business risks: risks associated with a company's particular market or industry.
2. Market risks: risks stemming from changes in market conditions, such as
changes in prices, interest rates, and exchange rates.
3. Credit risks: risks arising from the possibility of not receiving payments
promised by debtors.
4. Operational risks: risks resulting from internal system failures because of
mechanical problems (e.g., machines breaking down) or human errors (e.g.,
poor management of funds).
5. Legal risks: risks stemming from the potential for other parties not to fulfill
their contractual obligations.

Generally, risk managers are insurance brokers who advise clients on insurance and
risk, independent consultants on risk who work for a fee, or salaried employees
frequently treasurers and chief financial officers (CFOs)who manage risk for
their companies. Because risk management has become an increasing part of
insurance brokers' responsibilities, many work for fees instead of for commissions.

When to use financial risk management[edit]


Finance theory (i.e., financial economics) prescribes that a firm should take on a
project when it increases shareholder value. Finance theory also shows that firm
managers cannot create value for shareholders, also called its investors, by taking on
projects that shareholders could do for themselves at the same cost.[5]
When applied to financial risk management, this implies that firm managers should
not hedge risks that investors can hedge for themselves at the same cost. This notion
was captured by the so-called "hedging irrelevance proposition": [6] In a perfect
market, the firm cannot create value by hedging a risk when the price of bearing
that risk within the firm is the same as the price of bearing it outside of the firm. In
practice, financial markets are not likely to be perfect markets.[7][8][9][10]
This suggests that firm managers likely have many opportunities to create value for
shareholders using financial risk management, wherein they have to determine which
risks are cheaper for the firm to manage than the shareholders. Market risks that result
in unique risks for the firm are commonly the best candidates for financial risk
management.[11]
The concepts of financial risk management change dramatically in the international
realm. Multinational Corporations are faced with many different obstacles in
overcoming these challenges. There has been some research on the risks firms must
consider when operating in many countries, such as the three kinds of foreign
exchange exposure for various future time horizons: transactions exposure,
[12]

accounting exposure,[13] and economic exposure.[14]

FEATURES

How to measure and manage credit risk, interest rate risk, foreign exchange
risk, operational risk, off-balance sheet risk, etc. in any financial system.

How these risks have become omnipresent and significantly more complex
as a result of globalization and interconnectedness of banking and financial markets
across countries.

Liquidity and solvency issues in financial institutions and markets and how
they could be managed.

The structure of asset securitization and credit derivatives and their role in
managing (sometimes augmenting) risks in any financial system.

How to measure, quantify and analyze the level and degree of financial risk
over a stipulated time frame using different tools and techniques such as Value at Risk
(VaR), Stress Test, etc.

The role of regulation and monetary policy to: (a) ensure the stability and
longevity of any financial system and (b) minimize the impact of possible adverse
outcomes and contagion effects implicit in any financial crisis, particularly when the
financial systems are globally interconnected.

RISK MANAGEMENT TECHNIQUES


Risk management is an essential but often overlooked prerequisite to successful active
trading. After all, a trader who has generated substantial profits over his or her
lifetime can lose it all in just one or two bad trades if proper risk management isn't
employed. This article will discuss some simple strategies that can be used to protect
your trading profits.
Planning

Your

Trades

As Chinese military general Sun Tzu's famously said: "Every battle is won before it is
fought." The phrase implies that planning and strategy - not the battles - win wars.

Similarly, successful traders commonly quote the phrase: "Plan the trade and trade the
plan." Just like in war, planning ahead can often mean the difference between success
and failure.
Stop-loss (S/L) and take-profit (T/P) points represent two key ways in which traders
can plan ahead when trading. Successful traders know what price they are willing to
pay and at what price they are willing to sell, and they measure the resulting returns
against the probability of the stock hitting their goals. If the adjusted return is high
enough, then they execute the trade.
Conversely, unsuccessful traders often enter a trade without having any idea of the
points at which they will sell at a profit or a loss. Like gamblers on a lucky or unlucky
streak, emotions begin to take over and dictate their trades. Losses often provoke
people to hold on and hope to make their money back, while profits often entice
traders to imprudently hold on for even more gains.
Stop-Loss

and

Take-Profit

Points

A stop-loss point is the price at which a trader will sell a stock and take a loss on the
trade. Often this happens when a trade does not pan out the way a trader hoped. The
points are designed to prevent the "it will come back" mentality and limit losses
before they escalate. For example, if a stock breaks below a key support level, traders
often sell as soon as possible.
On the other side of the table, a take-profit point is the price at which a trader will sell
a stock and take a profit on the trade. Often this is when additional upside is limited
given the risks. For example, if a stock is approaching a key resistance level after a
large move upward, traders may want to sell before a period of consolidation takes
place.

How to Effectively Set Stop-Loss Points

Setting stop-loss and take-profit points is often done using technical analysis,
but fundamental analysis can also play a key role in timing. For example, if a trader is
holding a stock ahead of earnings as excitement builds, he or she may want to sell

before the news hits the market if expectations have become too high, regardless of
whether the take-profit price was hit.
Moving averages represent the most popular way to set these points, as they are easy
to calculate and widely tracked by the market. Key moving averages include the five-,
nine-, 20-, 50-, 100- and 200-day averages. These are best set by applying them to a
stock's chart and determining whether the stock price has reacted to them in the past
as either a support or resistance level.
Another great way to place stop-loss or take-profit levels is on support or
resistance trendlines. These can be drawn by connecting previous highs or lows that
occurred on significant, above-average volume. Just like moving averages, the key is
determining levels at which the price reacts to the trendlines, and of course, with high
volume.
When setting these points, here are some key considerations:

Use longer-term moving averages for more volatile stocks to reduce the
chance that a meaningless price swing will trigger a stop-loss order to be
executed.

Adjust the moving averages to match target price ranges; for example, longer
targets should use larger moving averages to reduce the number of signals
generated.

Stop losses should not be closer than 1.5-times the current high-to-low range
(volatility), as it is too likely to get executed without reason.

Adjust the stop loss according to the market's volatility; if the stock price isn't
moving too much, then the stop-loss points can be tightened.

Use known fundamental events, such as earnings releases, as key time periods
to be in or out of a trade as volatility and uncertainty can rise.

Calculating

Expected

Return

Setting stop-loss and take-profit points is also necessary to calculate expected return.

The importance of this calculation cannot be overstated, as it forces traders to think


through their trades and rationalize them. As well, it gives them a systematic way to
compare various trades and select only the most profitable ones.
This can be calculated using the following formula:
[ (Probability of Gain) x (Take Profit % Gain) ] +
[ (Probability of Loss) x (Stop Loss % Loss) ]
The result of this calculation is an expected return for the active trader, who will then
measure it against other opportunities to determine which stocks to trade. The
probability of gain or loss can be calculated by using historical breakouts and
breakdowns from the support or resistance levels; or for experienced traders, by
making an educated guess.
KEY TRENDS IN RISK MANAGEMENT
The Risk and Insurance Management Society (RIMS), the primary trade group for
risk managers, predicts that the key areas for risk management in the 21st century will
be operations management, environmental risks, and ethics. RIMS also believes
more small- and medium-size companies will focus on risk management and will hire
risk managers or assign risk management tasks to treasurers or CFOs.
As RIMS predicted, corporate risk managers began concentrating more on ensuring
their companies' compliance with federal environmental regulations during the 1990s.
According to Risk Management, risk managers started to assess environmental risks
such as those associated with pollution, waste management, and environmental
liability in order to help companies bolster profitability and competitiveness. In
addition, stricter environmental regulations also prompted companies to have risk
managers review their compliance with environmental policies to avoid any penalties
for failing to comply.
Furthermore, Risk Management indicated that there were five times as many natural
disasters in the 1990s as the 1960s and that insurers paid 15 times what they paid in
the 1960s. For instance, there were a record 600 catastrophes worldwide in 1996,
which caused 12,000 deaths and $9 billion in losses from insurance. Some experts

attribute the increase in natural disasters to global warming, which they believe will
lead to more and fiercer crop damage, droughts, floods, and windstorms in the future.
The trend towards mergers in the 1990s also affected risk management. More and
more companies called on risk managers to assess the risks involved in these mergers
and to join their merger and acquisition teams. Buyers and sellers both use risk
managers to identify and control risks. Risk managers on the buying side, for instance,
review a selling company's expenditures, insurance policies, loss experience, and
other aspects that could result in losses. After that, they develop a plan for preventing
or controlling the risks they identify.
A final trend in risk management has been the advent of nontraditional insurance
policies, providing risk managers with a new tool for preventing and controlling risks.
These insurance policies cover financial risks such as corporate profits and currency
fluctuation. Consequently, such policies ensure a level of profit even if a company
experiences unexpected losses from circumstances beyond its control, such as natural
disasters or economic problems in other parts of the world. In addition, they guarantee
profits for companies operating in international markets, preventing losses if a
currency appreciates or depreciates.

Risk Management Benefits


The speed and volatility of business means that downside risks (threats) last longer
than upside risks (opportunities) and problems can fester and linger for a relatively
extended period of time whilst opportunities can come and go quickly. Therefore, an
effective risk management program must be able to prevent or reduce the impact of
downside risks, whilst providing management with the acumen and agility to seize the
right opportunities at the right time.
The Blackhall & Pearl risk management approach enables Board and Management to
effectively deal with uncertainty and the associated threats and opportunities, thereby
enhancing the capacity to build value. The key benefits of our model include:

Improved Risk Culture: Enhancing the individual and group perception and
behaviour that determines how the organisation identifies, understands,
discusses and acts on risk

Better Risk Appetite and Strategy Alignment: Ensuring that management


considers the organisation's risk appetite in evaluating strategic alternatives,
setting objectives and managing risk

Stronger Link between Growth, Risk and Return: Ensuring that the cost of
risk control is justifiable and the financial return from risk taking is
commensurate

Enhanced Management of Interrelated Risks: Effective identification,


evaluation and treatment of multiple and cross-enterprise risks with integrated
responses to compound risks

Accelerated Identification of Risks: Assessing the inherent relationships


between risks and their interdependence to enable more predictive
identification of threats and opportunities

Increased Transparency and Traceability: Adopting a framework that


provides risk accountability, responsibility and performance management from
the top whilst ensuring proper compliance, audit and analysis

Enhanced Risk Decision Making: Ensuring that the best risk decisions are
adopted when selecting risk management options whilst integrating risk
considerations into all key business decisions

Reduced Operational Surprises and Losses: Implementing a proactive


program to identify potential events and establish responses, reducing
surprises and associated costs and losses

Reduced

Costs

and

Expenses:

Minimising

business

disruption

and implementing business continuity measures, whilst shedding ineffective


resources and activities (particularly those with high risk and/or low return)

Improved Capital Management: Measuring and allocating financial capital


on a risk-adjusted basis to protect liquidity, enhance return on investment
and promote and reward desirable risk behaviour

Improved

Opportunity

Management:

Proactively

identifying

and analysing the full range of strategic options and their upside and downside
impact to promptly and confidently take advantage of opportunities

Manifestation of Risk in Financial Economy


We start by the description of the ideology that drives risk (Beck, 1992) and its
assessment in the financial economy. Using this ideological projection of risk in our
society, an argument is presented on the changed nature of risk in the world economy
since the 1970s, leading to an increased use of financial risk management tools.
Financial risk is managed by tools that enable the creations of a price in the present
for an asset or commodity which will be physically traded in the future. Originally the
purpose of such tools was to secure the profits of producers and consumers and render
smooth cycles of production and delivery, at a future date. The concept of Future
Value in this argument becomes the reproduction of risk as a mode of creating new
avenues for profit generation rather than profit securing against those identified
risks (Steinherr, 2000). This argument is put against the theory of financial derivatives
and futures trading to understand why derivatives are assumed to create
value/expectation from an uncertain future. The argument engages with the criticism
of the role of derivatives as tools of risk management and underlines the pervasive
risk vulnerabilities induced by such financial innovations.
1. Ideology of Risk
Risk has always prevailed in every society and its organization, in the history of time.
It is in the perception of risk within a particular society or a system that creates the
notion of estimated risk. It is an idea that can be observed surfacing or amplifying
with further developments in various fields in different societies around the world.
Risk can manifest itself into many forms like the risk related to agricultural produce,
weather unpredictability, production failure, unforeseen accidents, interest rate or
exchange rate change, supply and demand imbalance, etc. All these factors, although
they constitute very few modes in which risk can be understood within an economy,
appear to have relevance in respect to how the different agencies within a particular
economy perceive and calibrate the risk related to each of them. If we go back to
ancient times, knowledge about anticipated events was a prerogative of an esoteric
class of oracles and future predictors and the risk associated with the anticipated
future was calculated in terms of the possibility of a certain event happening in favour

of the agency involved. As noted by Bernstein (1998), the factor that separates the
modern society from their past is their understanding of risk and efforts to master the
tools that can control the unpredictability that is associated with risk. With a
theoretical standpoint of institutionalism in the literature on political economy, the
modern society is characterized by its nature of increased risk-taking that becomes the
defining quality that drives this modern society. For example, the Frontier or the
settlers were considered the more risk-taking and practical headed section of the
American society which shifted from east to west with an idea presented as the
survival of fittest or the social Darwinism as articulated by Thorstein Veblen in Van
Der Pijls (2007) analysis of Pragmatism and Institutionalism.
For the contemporary society risk has manifested in more complex forms as compared
to the past. These complex forms result from the inventions and innovations in the
social structures, the economic systems, and the political frameworks within which
these societies have evolved. To understand the changes in the global economic
system in the 1900s, especially the transition of different economies in the world from
1960s to 1970s, there is a conscious effort to bring out the incessantly growing
knowledge, importance, and impacts of risk associated with economic systems and
the financial systems.
2.

Role of Risk in Financialization

As Brenner (2002) cites in his analysis of the 1950s and 1960s, major economies in
the world were inclined maintain the capital controls and was followed by the
deregulation of most economies recuperating from the drastic effects of the WWII.
This was a period of domestic economic growth, with minimum levels of
international financial flows due to the capital controls maintained by economies like
the US, western Europe, and Japan. During this period of domestic economic
prosperity there was little pressure of international competition on corporations,
which saw a continuous rise in their profitability (Brenner, 2002). Within these
production economies, the risk was inherent to the process of production and changes
in the supply and demand, specifically within domestic markets. The risk appeared to
be controlled by the maintenance and creation of high demand within the economy as
to stabilize again from the destabilizing effects of the World War II. Understood in
this way, the risk is associated with a production economy within a framework of

capital being used for generating goods and services within a strongly regulated
capital flow environment. Therefore, it appears that the risk had lesser dependence on
external factors and thus was controlled with appropriate policy decisions made by
different political units within these economies.
However, Brenner (2002) strongly argues against these most embraced explanations
for decreasing rate of returns and incapability of states to regulate for a revival of
increase in profitability starting in the 1960s. Due to factors like like falling domestic
demand and the problems of overproduction and overcapacity, this period
comprised increased international competition (Brenner, 2002). These reasons lead to
falling profitability for various corporations around the world, especially in
economies like US, Germany, and Japan. This appeared to promote a disinterest in
maintaining industrial capital within the productive economy and to maintain tight
control over financial capital flows. These economies saw flight of productive capital
to offshore deregulated financial centres like the Euromarket (Helleiner, 2004).
This initiated a new age for financial capital. Deregulation was starting to appear in
most major economies by the 1970s. Furthermore, the US economy was under a
problematic condition because of the 1973 oil embargo (Helleiner, 2004) which
inflated most commodity prices and lead to the depreciation of the US dollar against
other major currencies in the world. This placed further pressure on the producers in
the real economy and slowly under transition the financial economy attracted more
capital flows. This marked the financialization of various economies around the
world.

Future Value and Financial Risk Management


A financial derivative is a tool which derives its value from an underlying
asset, where the asset can be anything that exists as a tradable entity (Bryan and
Rafferty, 2007). This value is derived on the future expectation of the asset price
movement to be experienced by the investors involved in the transaction of the
particular asset. This introduces a risk associated with the asset price movement. This
risk is calibrated in the form of price differentials and the observed value of a
derivative derives itself from the expected future price of the asset. Risk as an
opportunity is used in the form of future expectation that creates a value of the
derivative representing the risk. The uncertainty of the future is quantified as a value
that signifies the change in the price of an asset that is expected by the investor. This
process uses derivatives to protect profitability against price movements. It is a very
interesting phenomenon that uncertain futures are put into values that can be traded on
the secondary markets with a convergence of interest on the expected value on a
future date. This transforms risk into opportunities of generating profits by trading
derivatives with a view on future expectations. But risk will always remain a risk as it
cannot be reduced to any other form. Derivatives, as risk management tools, can only
spread or distribute the risk of price movements rather than reducing any risk that is
associated with the future change in price of the underlying asset. Hence, derivatives
cannot be said to control risk but spread risk so that producers or consumers have the
opportunity to secure their profits against possible negative price movements.
This poses the essential question that if derivatives secure profits of the producers and
consumers than who bears the cost of a price change? To understand the role of
financial derivatives as matching savers to investors (Stanford, 1999), it is essential to
see identify the savers and investors that are involved in a financial transaction over a
futures contract. On the other side of a derivative transaction is the speculator.
Speculators bet money on the price change in the opposite direction as the producer or
the consumer they are transacting with (Steinherr, 2000). Therefore, speculators are
looking to generate profit against a possible price movement. This is the ideological
divide on the use of derivatives. With the definition of this financial innovation in the
form of derivatives, they are profit securing tools that can be exercised by producers
or consumers to secure profits. Yet, simultaneously they are being used by speculators

to generate profit by using the same tools that are in place to secure profits for the
agents from the real economy involved in the transaction.
To elaborate on the origin, existence, and role of derivatives in the global economy
the next section engages with the financial derivatives in relation to the financial
markets theory. This helps to extend the argument that has been outlined in this
section in relation to risk and risk society to the risk in financial economy and
innovation of risk management tools. The problematic and contradictory nature of the
existence of the financial risk management tools as briefly outlined in this section is
presented to form the basis of the argument. The argument against financial risk
management tools is necessary focus and be able to identify the relationship between
risk of volatility in financial markets and the methodology that explains the control of
this risk. In essence the motivation is to interrelate the concept of increased risk due to
advancements financial economy and the role of this risk in the ways it affects the
framework of financial systems and the economy as a whole.

Derivatives Theory, Use, and Effects


The fundamental argument in theory of futures market presents financial derivatives
as an institutional mechanism of risk management. Futures markets can be used by
producers and consumers to sell or buy a certain actual physical commodity or other
financial assets on a future date at a price that is decided in the present. This mitigates
the risk of price change that could create unintended costs for the buyers and sellers.
In order to manage the risk of price change, one can hold a futures contract in the
futures market to either buy or sell a particular financial asset in the present to be
physically sold or bought on a future date. The standard futures contract describes a
certain quality and quantity of the commodity or the asset to be delivered on specified
date and place, in the future. In financial literature, the process of risk aversion
associated with price volatility in a transaction made in the actual physical commodity
market is made by making a concomitant opposite transaction in the futures market,
where this process is called hedging (Johnson, 1978). Hedging of risk in the futures
market is a method by which buyers and sellers can exercise a price lock-in for
ascertaining a preconceived cost or return. Futures trading is considered important for
an asset or commodity which has a lag between the demand and actual supply of the
physical commodity, for example, agricultural products and base metals etc. Based on
the expectation of price fall the sellers hold short future positions while buyers,
with an expected price rise, hold long future positions (Johnson, 1978). Although,
hedging strategies wipe out the possibility of any profits that could be made if the
prices were to go in the opposite direction than expected, it is still a mechanism for
price stability in the international trade of physical commodities and financial assets.
Due to this interlinking of different financial asset prices, the reflection of any
individual financial asset price is going to reflect the anchored value dependent on its
relationship with all other financial assets, or the relative value. Brian and Rafferty in
their analysis of the role of derivatives on the economy introduce two concepts of
Binding and Blending, where binding is of the future value of a financial asset
into the present and blending is the swift convertibility of different financial asset
forms, like swaps for interest rates to commodity futures (Bryan and Rafferty, 2006).
This view is problematic in terms of analyzing a derivative market which is based on
the assumption of real and rational valuations of future prices in the present.

With this assumption the whole system of derivative pricing gets deteriorated, as in
practice the pricing of financial assets in a futures market does not necessarily reflect
the real anchored future value. If this assumption was to be correct, abnormal price
fluctuations in stock and futures markets would cease to exist and derivatives would
become the real reflection of demand and supply created by forces of production and
consumption.

Use of Financial Derivatives and Response of Financial Markets


Futures markets consist of the following two broad divisions of actors/agents Hedgers and Speculators. Fundamentally, hedgers engage in risk aversion of price
changes in the future by buying or selling a futures contract at the present price for a
future delivery of the financial asset or commodity. Speculators, on the other hand, are
actors which invest in the futures market to profit from the price change of a certain
financial asset, or an underlying commodity as in the case of commodity futures,
based on the expected price fluctuations. As the futures markets have witnessed that
the majority of the trading in popular commodities or critical financial assets is
undertaken by speculators (Minsky, 1986) as compared the volumes of futures
contracts used by hedgers, there appears a contradiction to the original argument
provided by the market oriented proponents of the futures market that hedgers and
speculators balance out the price fluctuations that can occur in the financial assets or
the underlying commodities. The contradiction arises because the more the
speculative activity exists the more will be the expectations of a price change in the
underlying commodity, as speculation dwells on price change or price volatility.
So, derivative tools in the form of futures contracts, swaps, etc. are not just basic tools
to hedge against the risk of asset price changes in the future, but an important
mechanism through which a large number of investors engage in making profit
without having any direct relation to the financial asset or underlying commodity that
they are trading in. For example in the case of volatile base metals or fluctuating
currencies, it is an added advantage that the price volatility is very high which in turn
attracts high volumes of speculative activity. Volatility is a major factor in speculation
as it provides the investors with short-term investments to make profits by trading
against frequent price changes with leverage of low capital costs and transaction costs

(Brown, Crawford, and Gibson, 2008). Derivatives have a form known as options
(Bernstein, 1998). Highlighting their use in the financial markets can provide an
elaborate understanding of the leverage that is provided to the investors, or
speculators in the financial markets, with which they can take higher risks for profits
while hedging against a maximum permissible limit for a possible loss into the
uncertain future. As Bernstein clearly outlines in his analysis of derivatives and
financial risk, options are the most convenient form of financial investments for
volatile markets.

Effects of Financial Derivatives and their Role in Financial Risk Management


Derivatives have an impact on the financial economy as well as the real
economy. The most important role of derivatives is to redistribute the risk associated
with price changes borne by the productive sector of the economy. As put in their
analysis on derivatives Brain and Rafferty articulate that system of derivatives
perform the role of an anchor to the pricing mechanism of all other assets. In this view
point on the role of derivatives there is an indication to the dependence of all assets to
the existing complex network of derivatives that creates an elaborate mesh which
introduces interdependence of events that results in price change of other assets
(Bryan and Rafferty, 2007). In other words this network of derivatives that are used
for a variety of different asset classes creates interlocks within their price determining
mechanisms, as each event has an impact on different assets values due to these inter
connections created by this network. For instance interest rate change, whether be
LIBOR or Federal Rates or Yen interest rate, all have an impact on the financial flows
into other asset classes resulting in a new adjusted level of stability in different asset
prices. Yen carry trade (Hartmann, 1998) is one of the most evident examples of this
network of interlocked asset classes due to price impacts of Yen borrowing into other
liquid assets like equity derivatives in other markets. With a change in the interest rate
of borrowing Yen, the Japanese currency, there is a direct consequence on how
corporations and institutions borrowing from the Japanese government react to this
change by changing their positions in other invested markets. This appears in the form
of a structural change in financial flows, which are highly liquid and create problems
for various financial market products as this nature of liquidity of capital on most
assets traded in these markets allow capital flight without regulation.
To understand this further we have to introduce the role of derivatives as suggested by
Brain and Rafferty to a more fundamental level of its association with the underlying
assets and commodities. In relation to the theoretical argument of derivatives it is
explicit that derivatives are risk management tools that mitigate the financial risk
involved in market economies. In practice derivatives trading do not involve the
principal or title of the underlying asset, commodity, or an event. Their purpose is to
capture the change in this principal price of the underlying asset class to which they
associate with. This price change could appear in the form of appreciation or

depreciation of the trade value of assets on the stock market, precisely the futures
market.
Derivatives do not trade on stocks or bonds, events or changes in conditions,
commodities, etc. Derivatives trade directly and only on uncertainty. That is the
purpose of their existence and their only link to secondary markets, where uncertainty
is to be minimized. Risk that derivatives work upon is not directly associated with a
fundamental value of the underlying asset, rather the derivatives engage with the
change in price or principal of the assets trading value. So, the derivative trading
becomes relevant only for volatility in the financial markets and is not in direct
correlation with the fundamental value of the assets that are being traded in the
derivatives market. Fundamental value becomes a superficial argument in terms of
derivative trading, or in general for financial markets, because the notion of arriving
at a fundamental concept of value for an asset is oriented from the processes of
production and consumption in a productive economy and cannot be channelized into
the financial economy in the same manner as is arrived at in a production economy
(Knafo, 2007). The reason for this divide is that the productive economy has the
capacity to bring in the value for inputs and create a margin of profit that leads to a
fundamental value of any asset that is being produced. But in the financial economy,
the analogy of inputs and profit margins does not find a place as investors are neither
putting physical labor nor any other form of inputs, except for investing money in the
form of financial capital on an expected future value that can maximize profits or
secure their profits by hedging against unforeseen losses on the invested capital.

5 WAYS TECHNOLOGY IS TRANSFORMING FINANCIAL


MARKET
For decades, banks and insurers have employed the same relatively static, highly
profitable business models. But today they find themselves confronted on all sides by
innovators seeking to disrupt their businesses. Crowdfunding, peer-to-peer lenders,
mobile payments, bitcoin, robo-advisers there seems to be no end to the diversity, or
to the sky-high valuations, of these fintech innovators.
Yet, some might note that they have heard this tune before. The direct banks and
digi-cash of the 90s captured the imagination of journalists and investors in a
similar fashion, but ultimately had little impact. In fact, the financial services industry
has been remarkably impervious to past assaults by innovators, partially due to the
importance that scale, trust and regulatory know-how have traditionally played in this
space.
However, as they say in investing, past performance is not an indicator of future
success and the same may be true for banks and insurers record of besting
innovators.
A new World Economic Forum report takes a look into what the future holds for the
industry. It draws on over 100 interviews with industry experts and a series of
workshops that put strategy officers from global financial institutions in the same
room as high-flying fintech innovators to discuss the issue. Their findings suggest this
round of innovation just might make the big names in financial services rethink their
business models in some very fundamental ways.

Here are five characteristics of todays innovators to suggest this time might really be
different when it comes to disruptive innovation in financial services:
1.

Theyre deploying highly focused products and services

Past innovators often tried to replicate the whole bank, resulting in business models
that

either

appealed

only

to

the

most

tech-savvy

or

price-conscious

customers. Todays innovators are aggressively targeting the intersection between


areas of high frustration for customers and high profitability for incumbents, allowing
them to skim the cream by chipping away at incumbents most valuable products. It
is hard to think of a better example of this than remittance banks have traditionally
charged very high fees for cross-border money transfers and offered a poor customer
experience, with transfers often taking up to three days to arrive at their destination.
UK-based company Transferwise is challenging this process using an innovative
network of bank accounts and a user-friendly web interface to make international

transfers faster, easier and much cheaper. Thanks to this business model, the company
now oversees over 500 million of transfers a month and has recently expanded into
the US.
2.

They are automating and commoditizing high-margin processes

Innovators are also using their technical skills to automate manual processes that are
currently very resource intensive for established players. This allows them to offer
services to whole new groups of customers that were once reserved for the elite.
Robo-advisers like Wealthfront, FutureAdvisor and Nutmeg have automated a full
suite of wealth management services including asset allocation, investment advice and
even complicated tax minimization strategies, all offered to customers via an online
portal. While customers must forego the in-person attention of a dedicated adviser,
they receive many of the services they would offer at a fraction of the cost and
without needing to have the $100,000 in investible assets typically required. As a
result, a whole new class of younger, less wealthy individuals are receiving advice
and support in their efforts to save, and it remains unclear if they will ever have the
desire to switch to a traditional wealth adviser, even as their savings grow to the point
where they become eligible for one.
3.

They are using data strategically

Customer data has always been a central decision-making factor for financial
institutions bankers make lending decisions based on your credit score while
insurers might look at your driving record or require a health check before issuing a
policy. But as people and their devices become more interconnected, new streams of
granular, real-time data are emerging, and with them innovators who use that data to
support financial decision-making. FriendlyScore, for example, conducts in-depth
analyses of peoples social networking patterns to provide an additional layer of data
for lenders trying to analyse the credit-worthiness of a borrower. Does your small
business get lots of customer likes and respond promptly to complaints? If so, you
might be a good risk. Are all of your social connections drinking buddies checking
in at the same bar? Well that might count against your borrowing prospects.

Meanwhile, a new breed of insurance company is identifying ways to generate


streams of data that help them make better pricing decisions and encourage their
policy-holders to make smart decisions. Oscar, a US-based health insurer provides its
clients with a wearable fitness tracker free of charge. This lets Oscar see which
policy-holders prefer the couch to the gym and enables them to provide monetary
incentives (like premium rebates) to encourage customers to hit the treadmill. As the
sophistication of these analytic models and wearable devices improves, we will likely
see more and more financial services companies working to nudge their customers
towards better behaviour and more prudent risk management.
4.

They are platform based and capital light

Companies like Uber and Airbnb have shown that marketplace companies, which
connect buyers and sellers, are able to grow revenues exponentially while keeping
costs more or less flat. This strategy has not gone unnoticed by innovators in financial
services. Lending Club and Prosper, the two leading US marketplace lenders, saw
their total originations of consumer credit in the USgrow from $871 million in 2012 to
$2.4 billion in 2013. Lending Club alone issued $3.5 billion in loans in 2014. While
this is only a fraction of total US consumer debt, which stood at $3.2 trillion in 2013,
the growth of these platforms is impressive. Analysts at Foundation Capital predict
that marketplace lenders will issue $1 trillion in consumer credit, globally, by 2025.
Even more impressive, they have done so without putting any of their own capital at
risk. Instead, they have provided a place where borrowers looking to get a better rate
can meet with lenders (both individuals and a range of institutions such as hedge
funds) who are eager to invest their money.
Crowdfunding platforms have achieved something similar, becoming an important
source of funding for many seed-stage businesses. These platforms connect
individuals looking to make small investments in start-ups with an array of potential
investment targets, and allow the wisdom of the crowd to decide which companies
will and will not be funded (while taking a slice of the funds from those that are
successful).
5.

They are collaborating with incumbents

This one might seem strange. After all, disruptors are supposed to devour the old
economy, not work with it. But this is an oversimplified view. Smart investors have
realized that they can employ bifurcated strategies to compete with incumbents in the
arenas of their choosing while piggy-backing on their scale and infrastructure where
they are unable to compete. For their part, incumbents are realizing that collaborating
with new entrants can help them get a new perspective on their industry, better
understand their strategic advantages, and even externalize aspects of their research
and development. As a result, were seeing a growing number of collaborations
between innovators and incumbents.ApplePay, the most lauded financial innovation
of the past year, doesnt attempt to disrupt payment networks like Visa and
MasterCard, but instead works with them. Meanwhile, regional banks, like Union
Bank in California, are forming strategic partnerships with marketplace lenders,
providing referrals for customers they are unable to lend to. This helps them meet
their customers needs while avoiding the risk that they will leave for another fullservice financial institution.
Clearly, there is more to this story than simple disruption. How it will play out is still
to be seen, although we can safely say that innovators will force incumbents to
change, which should ultimately benefit the consumer. But it doesnt necessarily mean
that the brand names we know will be disappearing any time soon particularly those
who learn to play with the new kids on the block.

Risks of Financial Transactions

Borrowing and lending of money create certain risks, namely

That the borrower will not be able to repay the money

That the lender is receiving a fixed rate on his investment while market rates
fluctuate in such a way that the yield on his initial investment is now below
current market related rates

That the value of the capital invested could decrease due to movements in the
market.

To lower the risk of a financial transaction, the risk can be sold to people or
institutions that are willing to take on that risk without immediately taking over the
effects of the transaction. The institution willing to buy the risk associated with the
transaction would have to be compensated for taking on the risk. In monetary terms,
the compensation for taking on the risk would, however, be less than the possible
maximum loss associated with the risk.

The trading of these risks associated with

financial instruments resulted in the development of derivative products.


To hedge a position means to reduce the risk associated with a financial transaction or
position, by selling the risk or by taking an opposite financial position, with the effect
that a market movement would not result in substantial financial loss.

A financial

position which is not hedged, is called an open position.


The trading of risks created a market for the hedging of risks involved in financial
transactions, which is a market derived from the original financial transaction.
Contracts are drawn up for these kinds of transactions and because these contracts are
derived from the original financial transaction, they are called derivatives.

In a

publication by Paul Eloff of the South African Futures Exchange, the following
description of derivatives is given:
"Derivatives such as future contracts and options, are instruments whereby price risks
are reallocated from those not willing to accept the risk and placed with those who are
willing to accept the risk."

Institutions in the markets


A sophisticated financial services sector consisting of lenders, borrowers, financial
intermediaries, financial instruments and financial markets, has different institutions
participating in these markets.
Certain intermediaries in the financial markets take on deposits as principal. These
intermediaries are called deposit-taking intermediaries.

Examples of such

intermediaries are:

South African Reserve Bank (SARB) (deposits from selected clients)

Private banks

Land and Agricultural Bank

SA Post Office Limited.

There are other intermediaries operating in the market, who only manage funds on
behalf of clients as an agent for the client. They do not take on deposits, but bring
together the borrower and lender with similar needs regarding amount, term and rate
of the transaction. Such an intermediary is called a non-deposit-taking intermediary.
Examples of these intermediaries are:

Unit trusts

Insurers

Pension and provident funds

Finance companies.

The Bottom Line

Traders should always know when they plan to enter or exit a trade before they
execute. By using stop losses effectively, a trader can minimize not only losses, but
also the number of times a trade is exited needlessly. Make your battle plan ahead of
time so you'll already know you've won the war.

o understand the challenges that regulators and mangers are faced with the course
combines a historical and an institutional perspective on financial crises with practical
issues in the risk management of financial institutions. The course explains different
types of financial crises, why financial intermediaries exists, how to identify, measure
and manage risks in financial institutions. The focus is on interest rate risk, market
risk, credit risk, and foreign exchange and liquidity risks. The course gives a good
understanding of how to run financial institutions, sovereign debt crises and how to
regulate markets to avoid crises.