Financial Markets

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Introduction and Overview of Financial Markets

Week001: INTRODUCTION AND

OVERVIEW OF FINANCIAL MARKETS
• Overview and Function of Financial Markets and financial institutions
• Financial Market instruments
• Understanding financial markets through the Financial Crisis
• An overview of Financial Risks
• Globalization of Financial Markets and Institutions
Learning Objectives:
After studying this module, the student will be able to:
1. Understand the concept of the financial market
2. Learn the function of the financial market
3. Understand how the financial market influences the economy on a global scale
4. Know the role of the financial market during the financial crisis.

The financial system, mainly the financial markets together with commercial banks and
other institutions, can be compared to a mosaic. The individual pieces seem to be different
and distinct when they are set apart. However, when they are joined together, they
represent a comprehensive and dynamic system. This system is influenced largely by
monetary policy, and monetary policy is communicated through the financial system to the
economy and inflation. The recent financial crisis and the Great Recession sufficiently
demonstrated the economy's need on a highly effective financial system. Disruptions in
certain areas of the financial market spread throughout the financial system and lead to the
most catastrophic economic downturn and job loss since the Great Depression of the
1930s.
The financial markets, institutions, and monetary regulations all touch our lives in
numerous ways. You have possibly been able to go to school because of a student loan or
money that your parents earned, saved, and invested while you were growing. When you
last purchase jeans in a clothing store and pay it with cash in your wallet or maybe a check,
a debit card, or probably thru a credit card. Even the car that you are driving was
purchased by having an auto loan. Your home where you live today, you are like to go to the
market or an institution to purchase it, but you will need a mortgage to make it happen.
You could also be looking for an apartment, and the owner of that unit or property goes
into a mortgage to buy the building.
Financial markets refer mainly to any marketplace where securities exchange occurs,
including the bond market, the stock market, the derivatives market, the forex market, and
other financial securities. Financial markets are very important to the smooth operation of
capitalist economies.

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Introduction and Overview of Financial Markets

The financial markets are places where a surplus of funds is moved towards those who
have a deficit and need funds. Those are intermediaries that direct funds from savers or
lenders towards sellers or borrowers.

In business and finance, the term ‘market’ refers to a place where potential buyers and
sellers get together to trade goods and services, as well as the transactions between them.
Prices in financial markets are transparent, and rules are set pertaining to costs, fees, and
even trading regulations.
The financial market mostly refers to the stock exchanges and commodity exchanges. They
can be physical places, like the London Stock Exchange, the New York Stock Exchange
(NYSE), the Philippine Stock Exchange (PSE), or an electronic platform or a system like
Nasdaq. These markets are where the corporations and governments generate funds or
cash, companies reduce risks, and investors aim to raise money. Some financial markets are
very discriminating, like exclusive groups, and only allow participants with a certain
limited amount of money, knowledge of markets, or certain professions.
Financial markets exist virtually in every country in the world. Some can be very small,
with fewer participants, while others are enormous, like the Forex markets that trade
trillions of dollars each day.
Financial markets play a vital role in enabling the smooth operation of capitalist economies
by allocating resources and handles liquidity for enterprises. The financial markets enable
an easy time for buyers and sellers to trade their financial securities. Financial markets
create securities products that deliver a return for those who have excess funds like
investors or lenders and make these funds available to those who need additional cash to
the borrowers.
The financial market is a large one, and the stock market is only one aspect of it. Buying and
selling a variety of financial products, such as bonds, shares, currencies, and derivatives, is
how financial markets are completed. To ensure that market prices are established
efficiently and appropriately, financial markets rely heavily on clear information. Because
of numerous macroeconomic variables such as taxation, market prices of securities may
not reflect their true value.
Some financial markets are small and have little activity, but others, such as the New York
Stock Exchange (NYSE), move trillions of dollars worth of assets every day. The equities
market, sometimes known as the stock market, is a financial market where investors can
purchase and sell shares in publicly traded corporations. New stock issues, known as initial
public offerings or IPOs, are sold on the major stock market. Any subsequent stock trading
takes place in the secondary market, which is where investors buy and sell assets they
already hold.

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Introduction and Overview of Financial Markets

The OECD's Interim Economic Outlook, published in early March 2020, stated that the
coronavirus outbreak has already slowed China's economic growth, and that subsequent
outbreaks in other countries will have reduced economic growth prospects. Since then, the
coronavirus's rapid expansion across countries has prompted several governments to take
extraordinary measures to combat the fatal outbreak. While these steps are important to
combat the virus, they have caused many firms to temporarily close due to broad travel and
mobility restrictions, financial market turbulence, a loss of confidence, and increased
uncertainty. According to this perspective, the shutdowns might result in substantial drops
in output in many economies, with consumer spending potentially falling by one-third.
Changes of this size would far overshadow the global financial crisis's economic downturn.
The economic impact of COVID-19's global spread has increased market risk aversion to
levels not seen since the global financial crisis. The stock market has dropped 30%, implied
volatility in equities and oil has reached crisis levels, and credit spreads on non-investment
grade debt have expanded dramatically as investors seek to avoid risk (Figure 1). Despite
the extensive and comprehensive financial changes agreed upon by G20 financial
authorities in the post-crisis era, global financial markets are experiencing increased
volatility.

Figure 1. Equity prices of major benchmarks and selected implied volatility indices.

These difficulties are also distinct from prior financial crises. Understanding present
market instabilities, the path to market impurity, and policy consequences necessitates a
cautious examination of the post-crisis changes in global market structure and financial
intermediation.

OVERVIEW OF FINANCIAL INSTITUTIONS

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Introduction and Overview of Financial Markets

Consider a world without financial institutions to have a better understanding of the

economic role they play in financial markets. Suppliers of funds, such as households that
save more than they earn and consume less than they earn, would have a basic choice in
such a world. They might keep their money as an asset or invest it in securities issued by
fund users such as entrepreneurs and businesses.
In actuality, fund users issue financial claims, such as stock and debt securities, to bridge
the gap between their internal savings, such as retained earnings, and investment
expenditures.
It has been demonstrated throughout history that a solid financial system is an essential
component of a developing and prosperous economy. Financial markets and institutions
must be dynamic and successful in order for businesses to raise capital to finance capital
expenditures and investors to save for future usage.
Changing technology and enhanced communications have increased cross-border
transactions, expanded their scope, and improved the global financial system's efficiency
over the last few decades. Companies raise cash all over the world on a regular basis to
fund projects all over the world.
It is critical to remember that trust is the most fundamental foundation of well-functioning
markets and institutions. An investor who deposits money in a bank, buys stocks through
an online brokerage account, or contacts a broker to get a mutual fund places his money
and faith in the hands of the financial institutions that advise him and provide transaction
services. Similarly, when businesses contact commercial or investment banks for cash, they
want the banks to supply them with funds on the most favorable conditions possible, as
well as objective and solid counsel.
While ever-changing technology and globalization have enabled a variety of financial
transactions, the financial industry has been rocked by a series of corporate frauds and
scandals in recent years, prompting many to question whether some institutions are
serving their own or their clients' interests.
Individuals and small firms, as well as economies with less developed financial markets
and institutions, use direct cash transfers more frequently. While enterprises in more
developed economies may use direct transfers on occasion, they normally find it more
economical to engage the help of one or more financial institutions when obtaining funds.
A group of extremely efficient financial intermediaries has emerged in highly developed
countries. Their original functions were often rather specific, but many of them have now
broadened to the point where they now service a wide range of markets. As a result, the
distinctions between institutions have begun to blur. There is still a distinction and
institutional identity; the descriptions of the key categories of financial institutions are
provided below.

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• Investment banking - These are firms that assist enterprises in developing

securities with qualities that are now appealing to investors, then purchase and
resell these securities to savers. Despite the fact that the securities are sold twice,
this is really just one primary market transaction, with the investment banker acting
as a conduit to help savers and corporations transfer capital. Morgan Stanley, Merrill
Lynch, Credit Suisse Group, and Goldman Sachs are examples of firms that provide a
variety of services to investors and businesses looking to raise finance.
• Commercial banks are financial institutions that manage checking accounts when
the Federal Reserve or other central banks change the money supply. Other
institutions now provide checking services and have a substantial impact on the
money supply. Commercial banks also provide a diverse range of services, such as
stock brokerage, insurance, and even mutual funds. Examples of this are J.P. Morgan
Chase, Banco de Oro (BDO), Bank of Philippine Islands (BPI), and Metrobank.
• Financial services are enormous organizations, which are sometimes referred to as
conglomerates, because they integrate several diverse financial institutions into a
single entity. Citigroup, American Express, Fidelity, and Prudential are examples of
financial services companies that began in one area but have since diversified to
encompass the majority of the financial spectrum.
• Savings and loan associations (S&Ls or SLAs) - These institutions used to service
individual savers as well as residential and commercial mortgage borrowers,
encouraging small savers to deposit money and then lending it to individuals and
other borrowers.
When short-term interest rates offered on savings accounts rose significantly above
the returns gained on the existing loan portfolio held by SLAs in the 1980s,
commercial real estate suffered a severe recession, resulting in high mortgage
default rates, the SLA business faced major issues. Many SLAs were compelled to
combine with larger institutions or close their doors as a result of the events.
• Mutual savings banks – They are similar to SLA’s; they primarily operate in
America, accepting savings primarily from individuals, and lending mostly on a long-
term basis to home buyers and consumers.
• Credit unions - Credit unions are cooperative organizations whose members are
expected to share a similar bond, such as working for the same company. Only other
members can borrow from the members' savings, which are typically used for auto
purchases, home improvement loans, and home loans. Individual borrowers will
find credit unions to be the most cost-effective source of funds.
• Pension funds are retirement plans funded by companies or government agencies
for their workers and administered primarily by the trust departments of
commercial banks or by life insurance companies. Pension funds invest primarily in
stocks, bonds, mortgages, and real estate.
• Life insurance firms collect savings in the form of annual premiums, invest them in
stocks, bonds, real estate, and mortgages, and then pay out to the beneficiaries of

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the insured parties. Today, life insurance companies provide a variety of tax-
deferred savings plans designed to give participants with rewards when they retire.
• Mutual funds are businesses that collect money from depositors and invest it in
stocks, long-term bonds, or short-term debt instruments issued by businesses or
government entities. These groups pool funds and thereby diversify risks, lowering
hazards. They also benefit from economies of scale when it comes to assessing
securities, portfolio management, and buying and selling assets.
Various funds are designed to satisfy the goals of various types of savers. As a result,
there are bond funds for individuals seeking safety, stock funds for those ready to take
large risks in exchange for bigger returns, and yet more funds that serve as interest-
bearing checking accounts (money market funds). There are thousands of mutual funds
available, each with its own set of goals and objectives. In recent years, mutual funds
have developed at a faster rate than most other organizations, owing in part to a shift in
how companies plan for their employees' retirement. "Come work for us, and when you
retire, we will provide you a retirement income based on the salary you earned during
the last five years before you retired," most firms said until the 1980s. The corporation
was then in charge of putting money aside each year to ensure that it had enough
money to pay the agreed-upon retirement benefits.
That scenario is fast changing. "Come work for us, and we'll give you some money each
payday that you may invest for your future retirement," new employees are likely to be
told today. You won't be able to use the funds until you retire (without incurring a
significant tax penalty), but if you invest correctly, you'll be able to retire comfortably."
Most workers realize they don't know enough about investing to make sensible
decisions, so they entrust their retirement assets to a mutual fund. As a result, mutual
funds are rapidly expanding.
Publications like Value Line Investment Survey and Morningstar Mutual Funds, which
are available in most libraries and on the Internet, provide excellent information on the
various funds' objectives and past performance.

• Hedge funds are similar to mutual funds in that they accept money from depositors
and invest it in a variety of securities, but there are a few key distinctions. The
Securities and Exchange Commission (SEC) registers and regulates mutual funds,
whereas hedge funds are essentially unregulated. The fact that mutual funds are
primarily aimed at small investors explains the discrepancy in regulation. Hedge
funds, on the other hand, often need substantial minimum contributions (sometimes
exceeding $1 million) and are effectively promoted to institutions and high-net-
worth individuals.
Hedge fund managers employ a variety of tactics. For example, a hedge fund
manager who believes the disparity between corporate and Treasury bond rates is
too wide can buy corporate bonds while selling Treasury bonds at the same time.

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The portfolio is "hedged" in this scenario against general interest rate fluctuations,
but it will do well if the spread between these assets narrows. Similarly, hedge fund
managers may profit from perceived inaccurate stock market valuations, such as
when a stock's market and intrinsic values diverge.

Hedge funds frequently demand high fees, which are typically a predetermined amount
plus 15 to 20% of the fund's capital gains. In recent years, the average hedge fund has
performed admirably. Citigroup believes that the typical hedge fund has generated an
annual return of 11.9 percent since 1990, according to a recent analysis. The broader
stock market returned 10.5 percent annually over the same time span, but mutual fund
returns were even lower at 9.2 percent. Due to the stock market's poor performance in
recent years, a growing number of investors have turned to hedge funds.
Between 1999 and 2004, the amount of money they managed more than doubled,
reaching almost $800 billion. However, the same BusinessWeek article that highlighted
these funds' outstanding growth and relative performance also warned that their
returns were exhibiting symptoms of weakening and that they were not without danger.

FUNCTIONS OF FINANCIAL MARKETS

• Determination of Price - In the financial market, an asset's price is determined by

its demand and supply. The funds are supplied by the investors, while the industries
require the finances. As a result, the interaction between the fund provider and
individuals in need, as well as other market forces, has a role in determining the
price.
The prices at which financial instruments are traded in the financial market are
governed by demand and supply forces, just as repeated contact between investors
helps set the price of stocks. As a result, one of the most important activities of the
financial market is the determination of security prices.
• Savings mobilization - In order for the economy to succeed, the money that
businesses, households, and individuals have must not be idle. As a result, a financial
market facilitates the exchange of surplus money between those who have it and
those who do not.
• Ensures liquidity - In the financial market, the assets that buyers and sellers trade
have a lot of liquidity. This means that investors can sell those assets rapidly and
convert them to cash at any time. Investors participate in trade for a variety of

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reasons, one of which is liquidity. One of the reasons why investors are interested in
trading is because of the liquidity.
The financial market makes securities trading easier by providing liquidity on
tradable assets and making it accessible to all participants, allowing them to readily
sell securities they own and convert an asset into cash.
• Saves time and money - Financial markets provide a forum for buyers and sellers
to meet without wasting time or exerting effort. In addition, because these markets
handle so many transactions, they can benefit from economies of scale, cutting
transaction costs and fees for all participants.
• With the help of the financial market, potential sellers and buyers can easily trade
with each other, saving them time, effort, and money in the process of finding other
required parties.
• With the help of the financial market, investors with savings can be linked with
industries that need the funds, mobilizing the savings and putting them to the most
productive uses.
• Different types of information are required by the various traders, while market
trading requires time and effort. The financial market provides different
information to the traders who can access it without the necessity of inserting time
and effort.

IMPORTANCE OF FINANCIAL MARKET

• Financial markets offer a place where participants like debtors and investors will
have fair and proper usage irrespective of their size.
• They provide companies, individuals, and government agencies with access to
capital.
• Financial markets help in lowering the unemployment rate because of the many job
opportunities it offers.
• It helps enable an open and regulated system for the companies to acquire large
amounts of capital from the market for its work.
• Using the savings of the potential investors provides a medium that flows in the
economy. This will lead to capital formation in the economy.
• It also helps in saving the time and efforts, most especially the hard earn money of
the participants, because the traders don't have to spend their money to find the
potential sellers or the buyers of the security.

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CLASSIFICATIONS OF FINANCIAL MARKETS

Financial Markets refers to a marketplace for the development and trading of financial
assets such as stocks, bonds, debentures, and commodities. Financial markets act as a
conduit between fund seekers, such as individuals, enterprises, and governments, and fund
providers, such as investors, individuals, and households. It encourages parties to exchange
funds and aids in the distribution of the country's scarce resources.
Financial Markets can be classified into four categories:
• By Nature of Claim
• By Maturity of Claim
• By Timing of Delivery
• By Organizational Structure

By Nature of Claim
Markets are classified according to the sort of claim investors have on the assets of the
company in which they have invested. There are two types of claims in general: fixed
claims and residual claims. There are two types of markets depending on the nature of the
claim.
• Debt Market

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The debt market refers to the exchange of debt instruments like debentures and bonds
between investors. These instruments have fixed claims on the entity's assets; their claim
on the assets is limited to a specified amount. These instruments generally have a coupon
rate, also known as interest that remains constant over time.
• Equity Market
The equity instruments are traded in this type of market. Equity, as the name implies,
refers to the owner's capital in the business and thus has the residual claim, implying that
whatever remains in the business after paying off fixed liabilities belongs to equity owners,
regardless of the face value of the shares owned by them.

By Maturity of Claim
When making an investment, it is crucial to keep in mind the time period because the
quantity of money invested is determined by the investment's time horizon. The risk
profile of an investment is also influenced by the time period. When compared to an
investment with a longer time period, a shorter time period was associated with lower risk.

There are two types of market-based on the maturity of claim:

• Money Market
Short-term funds are traded on the money market, where investors who want to invest for
at least a year join into a transaction. Treasury bills, commercial paper, and certificates of
deposit are examples of monetary assets traded in this market. All of these instruments
have a one-year maturation period.
Because these securities have a short maturity period, they have a lower risk and provide
investors with a practical return rate in the form of interest.
• Capital Market
The phrase "capital market" refers to a market where medium- to long-term instruments
are traded. This is the market where money is exchanged in a dynamic manner. It lets
businesses to raise funds through equity capital and preferred share capital, as well as
allowing investors to invest in the company's equity share capital and share in its earnings.
This market has two verticals:
Primary Market – The term "primary market" refers to the market where a corporation
first lists a security or when an already listed company issues a new security. In most cases,
this market involves the corporation and its shareholders interacting with one another.

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The sum paid by shareholders for the primary issue is received by the corporation. The
Initial Public Offering (IPO) and the Further Public Offer (FPO) are the two main forms of
primary market products (FPO).
Secondary Market – Once a corporation is listed on a stock exchange, its shares become
available for trading amongst investors. The secondary market, or more generally known
as the stock market, is the market that permits trading.
Simply said, it is a regulated market in which securities are traded between participants or
investors. Individuals, businesses, and merchant bankers, among others, could be investors.
The receipts or payments for such exchanges are handled between investors without the
involvement of the company, hence secondary market transactions have no impact on the
company's cash flow condition.

By Timing of Delivery
Aside from the characteristics listed above, another aspect divides the markets into two
parts: the period of security delivery. In the secondary market, or stock market, this
concept is widely accepted. There are two sorts of markets based on delivery timing:

• Cash Market
The transactions in this market are made in real time, and the complete amount of
investment must be paid by the investors, either with their own money or with borrowed
capital, known as margin, which is authorized on the account's current holdings.

• Futures Market
The settlement of a security or commodity takes happen at a later period in this market.
The majority of market transactions are settled on a cash basis rather than a delivery basis.
The total amount of assets does not have to be paid in order to make trades in the futures
market. Instead, a margin of up to a specific percent of the asset's value is sufficient to trade
it.

By Organizational Structure
The market structure also serves as a foundation for its category, such as how market
transactions are carried out. Based on organizational structure, there are two types of
markets:

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• Exchange-Traded Market
A controlled market that follows pre-determined and specified protocols is known as an
exchange-traded market. In this market, neither the buyer nor the seller know each other.
Transactions are entered into with the assistance of intermediaries, who are responsible
for ensuring that transactions between buyers and sellers are completed. In such a market,
standard products are traded; there is no need for customized or modified products.
• Over-the-Counter Market
This market is decentralized, and this allows customers to trade in customized products
based on the requirement.
In this case, the buyers and sellers interact with each other. Mainly, over-the-counter
market transactions involve transactions for hedging of foreign currency exposure and
exposure to commodities. These transactions occur over-the-counter as different entities
have different maturity dates for debt, which normally doesn't coincide with exchange-
traded contracts' settlement dates.
Over time, the financial markets have achieved importance in fulfilling the capital
requirements for companies and providing investment opportunities to the investors in the
country. Financial markets provide high liquidity, transparent pricing, and investor
protection from malpractices and frauds.

INTRODUCTION TO FINANCIAL RISK

Individuals, organizations, and governments are all subject to financial risk. Risk refers to
the possibility of losing money on an investment or of the government or a firm being
unable to repay debts owed to various financial institutions.
Risk also encompasses a variety of elements that may impact the desired outcomes of
operations or produce unfavorable outcomes that have ramifications for business,
investors, and the entire market. A person's financial risk is the loss of an investment or the
inability to repay a debt. Corporate financial risk can arise from a variety of sources,
including business operations, credit risk (such as the inability to repay loans), and market
risk (such as when a company loses consumers due to upgrades, competitor inventions, or
changes in consumption habits). In the government, financial risk refers to the
government's incapacity to control inflation, as well as defaulting bonds and other debt
instruments.
Types of Financial Risk
• Market Risk

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Market risk occurs out of upgrades or innovation in technology, change in prices, or even
change in customers' consumption patterns affecting business revenues.
The market risk is composed of systematic and unsystematic risk, which results in a loss of
investment. A systematic risk includes the decline or recession, changes in interest rates,
natural disasters that cannot be avoided. While the unsystematic risks are those, which can
be managed or avoided through a change in operations, strategy, and planning.
• Credit Risk
The credit risk means the inability of a borrower to repay the debt according to contractual
obligations. Defaulting in repayment of debt will influence business reputation in the
market, borrow from other financial institutions, and lose investor confidence. While in the
case of the government, the credit risk can have vast effects on the entirety of the economy
and world, since defaulting the bonds and inability to control the inflation will affect
countries’ status, social stability, business transaction, and relations with other countries.

• Operational Risk
The operational risk can result from decisions from the management influencing business
output or providing undesirable results. Mostly, Operational risk does not mean complete
disappointment but the reduction in output capacity, which a change in a decision can
manage, maintenance, and upgrade of technology.
• Liquidity Risk
Due to a failure to sell assets swiftly in a market, an individual or business can fulfill its
short-term financial obligations with little or minor loss. Lack of purchasers, market
circumstances, and other factors can all contribute to an inability to sell assets or
investments for cash in a timely manner. Liquidity risk can be mitigated by diversifying
short-term asset investments and keeping enough cash in the business to meet short-term
obligations.
Advantages of Financial Risk
Growth – Risk is an important component of any organization, especially when it comes to
growth and expansion into new markets. It's possible that businesses will need to borrow
money. Though the financial risk appears to be a burden for the firm, it is necessary to
accept such a risk if a company is able to perform and earn higher revenues through
growth and expansion.
Tax Planning - Most companies use losses for tax deduction purposes, which can be
distributed over multiple years. A reduction in tax obligations and risk management risk
can turn financial risk into a long-term advantage.

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Alert for investors and management - Financial risk is an indicator for investors and
management to take certain precautions to avoid further damage.
Valuation assessment -Financial risk in particular enterprises or projects aids in the
evaluation of revenue via the risk-to-reward ratio, which typically indicates whether a firm
or project is worthwhile. Financial risk may be examined using numerous ratios, making
the role of risk in the organization much easier to comprehend.
Disadvantages of Financial Risk
Can Create Catastrophic Result – Financial risk in the government leads to defaulted
bonds and other debt obligations from finance institutions, which can harm the country as
well as the global economy in the long run. A crisis has had an impact on European Union
countries that invest in Greece through bonds, particularly in Greece..
Cannot be Control -Financial risk arising from global causes such as natural disasters, wars
in various regions of the world, interest rate changes, and changes in government policies
that are beyond the control of a company operating in a specific market.
Long-Term Effects –If a financial risk is not managed promptly and effectively, it can harm
financial institutions and their reputation, affecting the entire organization and causing a
loss of confidence among investors and lenders. Overcoming such setbacks can be
extremely difficult for a company.
Individual finances, businesses, and governments all face financial risk. Risk is not always a
bad thing; in fact, if used and managed appropriately, it may be a sign of progress. Financial
leverage measures such as interest coverage ratios, debt to asset ratios, and debt to equity
ratios are used in business to determine the amount of debt a company has. Financial risk
can be very beneficial if accepted in conjunction with revenue development and business
expansion, but if not managed effectively, it can lead to serious problems, including
business bankruptcy and losses for investors and lenders.
Financial Risk must be continuously managed in the case of the government in order to
avoid future negative impacts on the country and economy in particular. Individual
financial risk might be forgotten in investment, or accumulated financial debt can be a
warning sign for the future. With good management tactics, such a risk can be turned into a
bargain and deflected.

THE GLOBALISATION OF FINANCIAL MARKETS

The advancement of technology has made it feasible to connect computer machines in a
very effective manner. As a result, cross-border financial transactions have grown simpler
and safer, thereby removing the barrier posed by distance, which can be dictated by
geography or a variety of other factors. Furthermore, financial markets have become a

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source for a diverse range of fast expanding financial products, most commonly referred to
as derivatives instruments, particularly in the previous two decades. Lenders and
borrowers can customize their risk exposures and alter them over time with these
products. With derivative products, borrowers and lenders can consequently mitigate
some of the problems associated with irregularities of information in financial markets,
which are particularly severe in the international context.
Global markets are a venue in which the rule of one price applies, in the sense that it will be
possible to buy or sell products for a similar price regardless of geographical location and
local circumstances. When products are bought and sold outside state boundaries, price
differentials may stay as long as costs are specifically associated with cross-border
exchange compared to exchange within national boundaries. Therefore, the process of
internationalization of financial markets is just a step towards global financial markets.
This dissimilarity between globalization and internationalization seems to apply to
financial markets as well as to markets for goods and non-financial services. Over the
current decades, financial markets have achieved a clear cross-border orientation, but,
overall, it can be claimed that they are still not truly global.
Cross-border financial flows might limit the worldwide positioning of financial markets.
Bordo, Eichengreen, and Kim (1998) believe that the absolute value of the current account
balance over GDP, averaged across a number of nations, is a good predictor of cross-border
financial movements. They show that this indicator has risen steadily since the mid-1960s,
but that it remains well below the levels reached between the mid-1870s and 1914.
Furthermore, the levels of this index in highly developed countries were more steady prior
to 1914 than in recent years. These findings show that, while net financial flows are
increasing, they are neither as large or as unpredictable as they were during the previous
World War. According to Flandreau and Rivière (1999), when the time series and cross-
sectional dimensions are taken into consideration in econometric study, this analysis of
advances in current account balances can be enhanced even further. The findings of
Flandreau and Rivière confirm that, when assessed in terms of net current account
balances, the degree of financial integration has increased in recent years but has stayed
below levels seen before 1914.
The benefits and risks associated with the globalization of financial markets, and what
are the implications for monetary policy
There has been a steady increase in cross-border financial flows around the world in recent
years. To begin with, a variety of financial organizations, including banks and institutional
investors, have broadened their geographic scope. They operated as an intermediary in this
process, facilitating the transfer of monies from lenders to borrowers across national
borders. Second, as securities markets have matured, a clear cross-border tendency has
emerged. Newly issued securities are frequently manufactured and sold to the public in
order to boost demand from overseas investors.

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These changes matched the gradual elimination of cross-border financial barriers, as well
as the substantial liberalization of national financial markets. As a result, the number of
borrowing and lending options available to economic agents around the world has
increased. The range of financial options available for financing current account deficits
and recycling current account surpluses has significantly increased.
Both technology advancements and financial progress play a vital role in the evolving
internationalization of financial markets seen in recent years. Information systems have
improved their ability to compute and store more data more quickly over the last few
decades. Telecommunications networks have grown in complexity and capacity, while
more reliable data exchange methods have emerged. Obstfeld (1994) offers a succinct
summary of the economic benefits associated with financial market globalization, writing,
"In theory, individuals gain the ability to smooth consumption by borrowing or diversifying
abroad, while world savings are directed to the world's most productive investment
opportunities." Globally integrated financial markets allow more flexible ways of financing
current account deficits and recycling current account surpluses, according to one practical
aspect of the theory. Furthermore, the free play of market mechanisms should ensure that
borrowers and lenders do not accept unintentionally high risks.
Additional advantages of financial market globalization include the faster dissemination of
technical advancements, financial innovation, and, more broadly, financial performance to
different parts of the world.
Technological advancements in payment, settlement, and trading systems, as well as
financial information systems, can be made available to all market participants promptly in
a global financial market. Various significant financial institutions, for example, provided
new techniques of computation they had created to quantify their market risk exposures
and, later, their credit risk exposures for free or at a low cost in the 1990s. This contributed
to the fairly rapid diffusion of new risk measuring technology among numerous financial
institutions, particularly those in the eurozone, that sought to improve their risk
assessment systems.

IMPLICATIONS FOR MONETARY POLICY

Financial markets that operate efficiently can only be regarded useful to the economy if the
international financial system is founded on the free functioning of market forces.
Monetary policy can contribute to financial market efficiency in two ways, both of which
contribute to medium-term economic growth.
Primarily, monetary policy will provide a solid anchor to establish opportunities about
future developments in consumer prices by decisively maintaining price stability. When
inflation is low and projected to remain low over the medium term, financial asset prices

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do not need to include as much of an inflation risk premium as they would in a situation
where inflation is high or unclear. Other factors, such as credit risk, can play a larger role in
the price formation mechanism as the inflation risk premium becomes less relevant as a
predictor of financial prices.
In the end, this leads to a more efficient use of financial resources. There are, of course,
other advantages to price stability. Price stability, in particular, helps to improve the
functioning of the price formation mechanism by minimizing relative price instability,
therefore improving the quality of price signals.
Second, monetary policy can help to improve market efficiency by decreasing the
occurrence of surprises connected to monetary policy decisions as much as possible.
Monetary policy would reduce unnecessary volatility in long-term interest rates in this
way, which would improve the quality of price formation on interest rate markets.
Surprises can be avoided by giving financial market participants and the general public
with a clear, detailed, and honest statement of the central bank's monetary policy strategy.
It is also beneficial to disclose the central bank's analysis of economic events on a regular
basis so that the public may learn more about the central bank's views on price stability
risks.
Monetary policy faces two major issues as a result of the globalization of financial markets.
One challenge is that monetary policy should consider the speed with which information is
disseminated around the world when communicating with the public. Because of the
increased speed with which information is transmitted, reactions to monetary policy
decisions can be quick and widespread. As a result, decisions must be explained in a
straightforward manner as soon as possible after they are made.
The second difficulty is that monetary policy should take structural changes in the economy
into account as a result of financial market globalization. Financial integration must be
regarded alongside economic integration arising from growing cross-border commerce in
products and services, as Okina, Shirakawa, and Shiratsuka (1999) point out, however the
two integration types may not necessarily progress at the same rate. In any event, as the
economy becomes more internationalized, economic interdependence will grow. With the
growth of more international markets, the importance of numerous economic variables for
assessing price stability concerns will shift. Furthermore, the transmission of the monetary
policy stance to the economy may vary and become more complex in the process.
Globalization is a still-developing process that will lead to a world in which countries and
economic areas grow increasingly interdependent. The development of the globalization
process has led to the perception that central banks are becoming increasingly ineffectual
in some cases. As has been demonstrated, the increasing globalization of financial markets
poses two distinct difficulties to monetary policy. First, monetary policy decisions can elicit

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swift and extensive reactions. Second, monetary policy should take into consideration
structural changes in the economy, such as increased interdependence between economies.
These issues necessitate the central bank's clear and forthright communication, as well as a
powerful and all-encompassing monetary policy framework capable of dealing with
structural economic change. It is critical that monetary policy pursues its core goal of
maintaining price stability in the setting of globalized financial markets. This is the most
effective long-term contribution that monetary policy can make to economic growth, as
well as the most efficient and stable financial markets.
Apart from monetary policy, the interdependence of economies has ramifications in other
areas of economic policy. Overall, economic policy goals should be pursued with a stability
focus to avoid creating excessive uncertainty, especially in financial markets. To avoid the
consequence of rapid adjustments that market forces might impose on unsound or
unpredictable policies, fiscal and tax policy must be implemented sensibly and with a
forward-looking focus.
Globalization offers up access to borrowing, lending, and investing in financial markets all
around the world. It also plays an important role in policy enforcement. Our economies will
reap the full benefits of globalization of financial markets while controlling the risks
associated with it if monetary and economic policy pursues stability-oriented objectives.

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Reference:
Simpson, T. (2015). Financial Markets, Banking, and Monetary Policy, Financial Markets
Saunders, A. and Cornett, M. (2016). Financial Markets and Institutions, The McGraw-Hill
Inc. New York
https://www.oecd.org/coronavirus/policy-responses/global-financial-markets-policy-
responses-to-covid-19-2d98c7e0/
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/financial-
markets/
https://www.ecb.europa.eu
https://www.educba.com/

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