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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.
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.
Money markets, which provide short term debt financing and investment.
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
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
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.)
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.)
institutions
through
over-the-counter
electronic
networks.
The third
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.
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
Importers/Exporters
Tourists
a quantitative
analyst with
advanced
training
Financial Functions
Promoting savings
Promoting investment
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).
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.
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.
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.
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.
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.
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.
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.
Improved Risk Culture: Enhancing the individual and group perception and
behaviour that determines how the organisation identifies, understands,
discusses and acts on 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 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
Costs
and
Expenses:
Minimising
business
disruption
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
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.
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.
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.
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.
(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.
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.
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.
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
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.
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.
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.
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.
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.
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.
A financial
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."
Examples of such
intermediaries are:
Private banks
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
Finance companies.
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