CHAPTER-3 FINANCIAL MARKETS&FINANCIAL INSTRUMENTS

CHAPTER INTRODUCTION
Financial markets play a pivotal role in the global economy, serving as platforms where individuals,
institutions, and governments can trade financial securities, commodities, and other fungible items at prices
determined by market forces. These markets provide essential mechanisms for the efficient allocation of
capital, allowing for the transfer of funds from savers to borrowers. Financial markets can be classified based
on various criteria, including the type of financial assets traded, the maturity of the securities, and the nature of
the transactions. Understanding the classification of financial markets is crucial for investors and policymakers
to comprehend the diverse functions and dynamics of each market segment, from money markets dealing with
short-term debt securities to capital markets facilitating long-term investment through stocks and bonds.
Functions
Financial markets serve as platforms for buyers and sellers to transact in various financial
instruments, acting as a link that facilitates the transfer of assets to optimal investment
opportunities. They help determine the capital value of securities by allowing market forces to
set prices, while also mobilizing funds within the economy through the buying and selling of
securities, ensuring efficient savings allocation. The major functions of financial markets are:

 Price Determination: Financial markets facilitate the price discovery of financial

instruments through transactions between buyers and sellers. Prices are determined by the
demand and supply dynamics in the market, enabling efficient allocation of resources.
 Funds Mobilization: Financial markets facilitate the allocation of funds from surplus
units (investors) to deficit units (borrowers), contributing to economic growth by
mobilizing savings for investment purposes.
 Provide Liquidity: Financial markets ensure liquidity by providing a platform where
buyers and sellers can trade financial instruments, allowing investors to convert assets
into cash quickly and efficiently.
 Risk Sharing: Financial markets allow for the transfer of risk from those seeking to
minimize their risk to those willing to assume it, enabling effective risk management
through various financial instruments.
 Easy Access: Financial markets offer an organized platform for buyers and sellers to
interact, saving time and resources while making trading more accessible.
 Reducing Transaction Costs: By providing an organized technological platform,
financial markets reduce search and information costs, thereby lowering the overall
transaction costs for participants.
 Capital Formation: Financial markets facilitate the accumulation of capital, contributing
to economic growth by financing projects that enhance productivity and infrastructure

Illustration of the Role of Financial Markets in the Transfer of Financial Risks

Imagine a farmer who grows wheat. The farmer is worried that by the time the wheat is ready for
harvest, the price might drop due to market changes, and they won’t make enough money to
cover their costs. On the other side, there’s a bread-making company that depends on wheat to
produce bread, and they are concerned that prices might rise and hurt their profit margins.
To manage their risks, they can use a financial market tool called a futures contract. The farmer
can agree to sell the wheat at a fixed price before the harvest, while the bread company agrees to
buy it at that same price. This way:
  The farmer secures a guaranteed price for the wheat, protecting themselves from the risk
of prices falling.
 The bread company locks in the price they will pay for wheat, protecting themselves
from the risk of prices rising.

In this situation, the financial market allows the farmer to transfer the risk of price fluctuations to
the bread company, which is willing to take on this risk in exchange for the stability of knowing
their future costs. Both parties use this arrangement to manage their respective risks,
demonstrating how financial markets help in transferring risk from those who want to minimize
it to those willing to accept it.

Classification of Financial Markets

Financial markets can be classified in different ways. The most common classification of
financial markets is into primary and secondary markets using the seasoning of claim criterion.
However, the structure of financial markets can also be classified into different categories by the
nature of the claim (debt market and equity market), by the maturity claim (money and capital
market), by the timing of delivery (cash or spot and futures market), and the organizational
structure (exchange-traded vs. over-the-counter (OTC) market).

1 Primary and Secondary Markets

  Primary Markets: Primary markets facilitate the issuance of new securities, allowing
companies, governments, and other entities to raise capital by selling financial
instruments directly to investors.
 Secondary Markets: Secondary markets provide a platform for the trading of existing
securities, allowing investors to buy and sell securities among themselves. This market
provides liquidity to investors, enabling them to sell their holdings without holding them
until maturity.

2 Debt and Equity Markets

 Debt Market: A market where debt instruments such as Treasury bills, bonds and
mortgages are traded. These instruments represent a contractual agreement by the
borrower to pay the lender fixed amounts until maturity.
 Equity Market: A market where equity instruments such as common stock are traded.
Equity represents ownership in a company, and shareholders are entitled to a share in the
profits and assets of the business.

3 Money Markets vs. Capital Markets

 Money Markets: The money market is a segment of the financial market where short-
term instruments with maturities of less than one year are traded. These instruments are
highly liquid and are used by institutions to manage short-term funding needs.
 Capital Markets: The capital market is where long-term instruments, such as stocks and
long-term debt securities, are traded. It provides funds for long-term investments in
infrastructure, business expansion, and other projects.

4 Cash or Spot Markets vs. Futures Markets

 Cash or Spot Markets: In cash or spot markets, transactions are settled immediately or
within a short period after the trade is made.
 Futures Markets: Futures markets involve contracts for future delivery of assets at a
predetermined price. These markets are used for hedging risk or speculation.

5 Exchanges vs. Over-the-Counter Markets

 Exchanges: Organized exchanges are centralized platforms where securities are traded
under a set of rules and regulations. Examples include the Ethiopia Securities Exchange
(ESX) the New York Stock Exchange (NYSE), The London Stock Exchange Group
(LSEG), Nairobi Securities Exchange (NSE) etc.
 Over-the-Counter (OTC) Markets: OTC markets are decentralized networks where
participants trade financial instruments directly with each other. This market structure
allows for flexibility and is used for trading instruments that may not be listed on an
exchange.
6 Sharia-Compliant Capital Market
Sharia-compliant capital markets refer to financial markets that operate in accordance with
Islamic principles (Sharia). Sharia is an Arabic term, which literally means ‘the way’ or ‘a path
to a watering place’, ‘a clear path to be followed’, and more precisely, ‘the way which leads to a
source.’ The principles emphasize ethical and moral investing, prohibiting practices such as
usury (riba), gambling (maisir), and investing in haram (forbidden) activities (e.g., alcohol, pork,
gambling). Sharia-compliant capital markets represent a growing market within the global
financial landscape, marrying the principles of finance with ethical considerations rooted in
Islamic law. They offer a unique alternative for investors seeking to align their financial goals
with their ethical values. As these markets continue to evolve, they present opportunities and
challenges that require ongoing dialogue among stakeholders, regulators, and scholars within the
finance domain.
Examples of Sharia Compliant securities include:

 Sukuk (‘Islamic Bonds’): Sukuk are the Islamic equivalent of bonds. Unlike
conventional bonds that pay interest, sukuk represent ownership in a tangible asset,
project, or investment, and the returns come from profit-sharing or rental income rather
than interest.
 Islamic Mutual Funds: These funds pool money from investors to purchase a diversified
portfolio of Sharia-compliant equities, sukuk, and other permissible investments.
 Islamic ETFs (Exchange-Traded Funds): These are funds that track Sharia-compliant
indices and are traded on a securities exchanges like traditional ETFs.
 Sharia-Compliant Equities: Shares of companies that comply with Islamic principles,
such as those that do not engage in prohibited activities and have acceptable financial
ratios (e.g., low levels of debt).

Aspect Conventional Finance Shariah Compliance Finance

Underlying Principles Secular laws and principles Shariah (Islamic Law)
Interest Central to the system Prohibited
Risk is transferred to the
Risk and Profit Sharing Risk is shared between parties
borrower
Asset-Backed Financing Loans often not asset-backed Must be linked to tangible assets
Ethical investments, Shariah-
Investment Guidelines Profit-driven, few restrictions
compliant
Social Justice and A key principle (e.g. zakat, qard al-
Secondary to profit
Welfare hasan)
Emphasizes partnerships and profit-
Contract Types Based on loans and interest
sharing
Governance and Financial regulations and Corporate as well as Shariah
Compliance corporate laws governance
Maximization of shareholders’
Purpose and Philosophy Equitable distribution of wealth
value
Roles of Securities Exchanges
Securities Exchanges (also often called Stock Exchanges, or Stock Market) play a crucial role in
the financial markets by providing a centralized platform where shares/stock and other securities
are bought and sold. They facilitate the trading of securities, allowing investors to purchase
ownership stakes in companies and participate in their growth, if the securities are shares, or
provide long term finance to companies, in a form of trading in debt instruments and in the
process earn interest. This process not only enhances liquidity, meaning that investors can
quickly buy or sell their holdings, but also contributes to price discovery, as the value of shares is
determined by supply and demand dynamics. Securities exchanges also provide transparency,
ensuring that all transactions are conducted according to regulations, which builds investor
confidence and helps maintain fair market practices.
Inside a securities exchange, trading operations involve various activities that ensure efficient
transactions. Market participants, including individual & institutional investors, send their orders
to securities brokers and dealers. The latter submit buy and sell orders, which are matched using
sophisticated electronic trading systems. These systems analyze orders in real-time, executing
trades at the best available prices. Exchanges also oversee the listing process for companies
wishing to sell shares to the public, requiring them to meet specific regulatory standards.
Exchanges also regulate the intermediaries that are their members. Additionally, they provide
market data, such as share prices and trading volumes, which are essential for investors to make
informed decisions. Overall, securities exchanges serve as vital intermediaries that connect
buyers and sellers, facilitating capital formation and contributing to the overall health of the
economy.
Clearing and Settlement Process
Clearing and settlement are key processes in the securities market that ensure transactions
between buyers and sellers are completed accurately and efficiently. Once a trade is executed on
the securities exchange, the clearing process begins. This involves verifying the details of the
trade, such as the number of shares and the price, and ensuring that both parties have the
necessary funds or securities to complete the transaction. A central Securities Depository (CSD)
or clearing houses act as intermediaries in this process, reducing the risk of default by
guaranteeing that trades will be settled, even if one party fails to fulfill their obligation.
Settlement occurs after a deal has been executed at the exchange or over the counter. While the
change in economic ownership is immediate, the transfer of securities from the seller and the
payment from the buyer takes some time. The process consists of several key stages, collectively
described as clearing and settlement:

 Pre-settlement and Clearing: As soon as a trade has been executed, several procedures
and checks must be conducted before settlement can be completed. These include
matching the trade instructions supplied by each counterparty to ensure that the details
they have supplied for the trade correspond. It also involves conducting checks to ensure
that the seller has sufficient securities to deliver and that the buyer has sufficient funds to
cover the purchase cost.
 Settlement: The process through which legal title (i.e., ownership) of a security is
transferred from seller to buyer in exchange for the equivalent value in cash. Usually,
these two transfers should occur simultaneously.
 Post-settlement: This entails the management of failed transactions and the subsequent
accounting of trades.

When a trade has been executed, a key step in the management of risk in the post-execution, pre-
settlement stage is for the two sides to the trade to compare trade details, and to eliminate any
mismatches prior to the exchange of cash and securities. This is broadly called the ‘trade
confirmation’ step.
Clearing is the process through which the obligations held by the buyer and seller to a trade are
defined and legally formalized. In simple terms, this procedure establishes what each of the
counterparties expects to receive when the trade is settled. It also defines the obligations each
must fulfill, in terms of delivering securities or funds, for the trade to settle successfully.
Specifically, the clearing process includes:

 Recording key trade information so that counterparties can agree on its terms
 Formalizing the legal obligation between counterparties
 Matching and confirming trade details
 Agreeing procedures for settling the transaction
 Calculating settlement obligations and sending out settlement instructions to the brokers,
custodians, and the CSD
 Managing margin and making margin calls, which relates to collateral paid to the clearing
agent by counterparties to guarantee their positions against default up to settlement
There are two further basic elements to the settlement of trades that can differ across different
instruments and/or markets:

 Timing of Settlement: The length of time it takes for a trade to settle is based on the
trade date plus a set number of business days after the trade is executed. This is
sometimes called the processing cycle. Settlement length is usually expressed as T (trade
date) + the number of days, for example, T+2 means transaction date plus two business
days. Settlement timing differs across different countries/exchanges and can differ within
the same country/exchange by type of security.
 Structure of the Settlement System: The Bank for International Settlements (BIS) has
identified three common structural approaches/models for linking delivery and payment
in a securities settlement system that are all typically described as achieving delivery
versus payment (DvP).

The bank of international settlement (BIS) identifies the following three models for DvP
settlement systems:
Model 1 – systems that settle transfer instructions for both securities and funds on a trade-by-
trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer
(delivery) occurring at the same time as final transfer of funds from the buyer to the seller
(payment).
Model 2 – systems that settle securities transfer instructions on a gross basis, with final
transfer of securities from the seller to the buyer (delivery) occurring throughout the processing
cycle, but settle funds transfer instructions on a net basis, with final transfer of funds from the
buyer to the seller (payment) occurring at the end of the processing cycle.
Model 3 – systems that settle transfer instructions for both securities and funds on a net basis,
with final transfers of both securities and funds occurring at the end of the processing cycle.
Financial markets are essential for promoting economic growth and stability by providing
mechanisms for resource allocation, liquidity, and risk management. A comprehensive
understanding of financial market classifications helps investors and policymakers make
informed decisions and navigate the complexities of the financial landscape.

Interactive exercises

1. Which financial market deals specifically with short-term debt instruments?

Capital market

Real estate market

Money market

Foreign exchange market

2. What is the primary role of financial markets in the economy?

To remove liquidity from the system

To facilitate the trade of financial securities and allocate capital

To regulate interest rates

To ensure that only wealthy individuals can invest

3. What is the primary difference between primary and secondary markets?

Primary market is a market for newly issued securities while secondary markets trade existing securities

Primary markets have lower liquidity than secondary markets

Secondary markets are only for government securities

There are no differences; they are the same

4. Which of the following is NOT a function of financial markets?

A) Price determination

Reduce transaction costs

Providing liquidity

Risk concentration
5. What is a key characteristic of futures markets compared to cash or spot markets?

Transactions occur immediately after agreement

Payment and transaction for assets happens at a future predetermined date

They only involve government bonds

They have no obligation for either party

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Financial Instruments
Financial instruments are contracts that represent an asset to one party and a liability to another,
playing a crucial role in the financial markets. They can be categorized into two main types:
equity instruments, such as stocks, which represent ownership in a company, and debt
instruments, such as bonds, which signify a loan made by an investor to a borrower. Financial
instruments also include derivatives, like options and futures, which derive their value from
underlying assets. These instruments facilitate various financial activities, including investment,
risk management, and capital raising, providing investors and institutions with tools to achieve
their financial goals and manage risk effectively. Depending on their maturity period, financial
instruments can also be classified as money market securities and capital market securities.
1 Money Market Instruments
Money market securities are debt securities with a maturity of one year or less. Money market
securities are commonly purchased by households, corporations (including financial institutions),
and government agencies that have funds available for a short-term period. Because money
market securities have a short-term maturity and can typically be sold in the secondary market,
they provide liquidity to investors. Money market securities tend to have a low expected return
but also a low degree of credit (default) risk. Most firms and financial institutions maintain some
holdings of money market securities for this reason.
The most popular money market securities are:

 Treasury Bills (T-bills)

 Commercial Paper
 Negotiable Certificates of Deposit
 Repurchase Agreements (Repos)

2 Capital Market Instruments

Capital market instruments are financial tools with an original term to maturity of more than one
year. Businesses and governments use these instruments to raise long-term funds. They are
essential for facilitating long-term investment and promoting economic growth by providing
entities with the capital needed for development and expansion. They primarily include::
Stocks (Equity Instruments): Represent ownership in a company and entitle shareholders to a
portion of profits, usually in the form of dividends. Stocks can be common or preferred, each
offering different rights and privileges. Bonds (Debt Instruments): Loans made by investors to
issuers (such as corporations or governments) that pay periodic interest and return the principal
at maturity. Bonds vary in terms of duration, credit quality, and interest rates.
3 Sharia-Compliant Financial Instruments
Islamic finance refers to financial activities that comply with the principles of Sharia Law. This
has been discussed in the preceding sections.
Derivative instruments are financial contracts whose value is derived from the performance of
underlying assets, indices, or rates. Common types of derivatives include futures, options,
forwards, and swaps. These instruments allow investors and traders to hedge risk, speculate on
price movements, and gain exposure to a variety of asset classes, including equities,
commodities, currencies, and interest rates. For example, a farmer might use futures contracts to
lock in prices for their crops, providing protection against potential price declines before harvest.
Similarly, investors might use options to speculate on the future price movements of stocks
without needing to purchase the underlying shares directly.
While derivatives can serve useful purposes in risk management and speculation, they also carry
significant risks and complexities. The leverage often involved in derivative trading can magnify
both gains and losses, which can lead to substantial financial difficulties if markets move
unfavorably. Additionally, derivatives can introduce counterparty risk, as the performance of
these contracts often relies on the financial stability of the other party involved. As a result,
regulatory bodies closely monitor derivative markets to ensure transparency and minimize
systemic risk, especially following the 2008 financial crisis, which highlighted the potential
dangers posed by unregulated derivatives trading. Overall, while derivatives play a critical role
in modern financial markets, understanding their complexities and risks is essential for effective
risk management.

CHAPTER KEY POINTS

 Role of Financial Markets: Financial markets serve as platforms for trading financial
securities, commodities, and other assets, facilitating the efficient allocation of capital
between savers and borrowers, thereby enhancing economic growth and stability.
 Functions of Financial Markets: Key functions include price determination through
supply and demand, mobilization of funds from savers to borrowers, providing liquidity
to ease transactions, risk sharing among investors, and reducing transaction costs while
promoting capital formation for economic development.
 Market Price Formation: Financial markets enable price discovery for financial
instruments based on market forces, allowing for the efficient setting of prices for newly
issued and existing securities.
 Classification of Financial Markets: Financial markets can be classified into primary
and secondary markets (new vs. existing securities), debt and equity markets (types of
financial claims), money and capital markets (based on maturity), cash vs. futures
markets (timing of transactions), and organized exchanges vs. over-the-counter (OTC)
markets (trading structures).
  Primary vs. Secondary Markets: The primary market is where new securities are issued
to raise funds for the issuer, while the secondary market allows for the trading of existing
securities, which provides liquidity and enables price discovery for those securities.
 Money Markets vs. Capital Markets: Money markets deal with short-term debt
instruments (less than one year), providing higher liquidity and lower risk, whereas
capital markets focus on long-term financing through equity and debt instruments,
necessary for extensive business investments.

 Cash/Spot Markets vs. Futures Markets: In cash (or spot) markets, transactions are
settled immediately, whereas in futures markets, contracts are made to buy or sell an asset
at a predetermined price at a future date, with no initial exchange of money.
 Exchanges and OTC Markets: Organized exchanges (e.g., stock exchanges) facilitate
trading in a central location, while OTC markets allow for decentralized trading where
dealers transact directly without a centralized exchange, promoting flexibility and
competition.
 Sharia-Compliant Capital Markets: These markets operate under Islamic law
principles, emphasizing ethical investments and prohibiting interest (riba), fostering risk-
sharing, and avoiding excessive uncertainty (gharar). This niche market appeals to
investors seeking socially responsible investment opportunities.
 Types of Financial Instruments: Financial instruments are broadly categorized into
money market securities (short-term debt instruments) and capital market securities
(long-term debt and equity instruments). Key examples of money market instruments
include Treasury bills and commercial paper, while capital market instruments include
stocks and bonds.


 SELF-ASSESMENT QUESTIONS

1. What type of market only deals with long-term debt and equity instruments?

Money market

Commodity market

Capital market

Foreign exchange market

2. What are derivative instruments primarily used for in financial markets?

To invest in real estate

To generate interest income

To hedge risk, speculate on price movements, and gain exposure to various asset classes
 To provide fixed-income returns
3. Which of the following financial instruments is classified as a money market security?

Common stock

Corporate bonds

Treasury bills

Real estate investment trusts

4. Which of the following statements is true about futures markets?

Transactions are settled immediately upon an agreement.

No money changes hands until a predetermined future date

Futures contracts guarantee ownership of an asset immediately

Futures markets only trade agricultural commodities

5. In financial markets, what does the term "liquidity" refer to?

The degree to which an investment is profitable

The ease with which an asset can be bought or sold without affecting its price

The risk involved in investing

The transaction costs associated with trades

6. What is the primary role of financial markets in the global economy?

To set fixed interest rates

To provide platforms for trading financial securities and allocating capital

To limit the participation of small investors

To regulate government spending

7. Which of the following best describes Sharia-compliant financial instruments?

They involve high interest rates and gambling.

They must adhere to Islamic law by avoiding interest and unethical investments

They can be traded without restrictions

 They are only available to Muslim communities
8. What is a key characteristic of Over-the-Counter (OTC) markets?

They are organized exchanges with fixed locations.

Securities are traded through a network of dealers, rather than centralized exchanges

All trades must be conducted electronically

Only government securities are traded

9. What does the term “Mudarabah” refer to in Sharia-compliant finance?

A type of short-term loan

A profit-sharing partnership where one party provides capital, and the other provides expertise

A direct equity investment in public companies

A government bond that yields interest

10. Which of the following functions of financial markets involves the determination of asset prices based on
supply and demand?

Funds mobilization

Price discovery

Easy access

Risk sharing

What is a key characteristic of Over-the-Counter (OTC) markets?

Securities are traded through a network of dealers, rather than centralized exchanges
Securities are traded through a network of dealers, rather than centralized exchanges
Correct 2
What does the term “Mudarabah” refer to in Sharia-compliant finance?
A profit-sharing partnership where one party provides capital, and the other provides expertise
A profit-sharing partnership where one party provides capital, and the other provides expertise
Correct 3
What type of market only deals with long-term debt and equity instruments?
Capital market
Capital market
Correct 4
Which of the following best describes Sharia-compliant financial instruments?
They must adhere to Islamic law by avoiding interest and unethical investments
They must adhere to Islamic law by avoiding interest and unethical investments
Correct 5
What is the primary role of financial markets in the global economy?
To provide platforms for trading financial securities and allocating capital
To provide platforms for trading financial securities and allocating capital
Correct 6
What are derivative instruments primarily used for in financial markets?
To hedge risk, speculate on price movements, and gain exposure to various asset classes
To hedge risk, speculate on price movements, and gain exposure to various asset classes
Correct 7
Which of the following financial instruments is classified as a money market security?
Treasury bills
Treasury bills
Correct 8
Which of the following functions of financial markets involves the determination of asset prices based on
supply and demand?
Price discovery
Price discovery
Correct 9
Which of the following statements is true about futures markets?
Futures contracts guarantee ownership of an asset immediately
No money changes hands until a predetermined future date
Incorrect 10
In financial markets, what does the term "liquidity" refer to?
The ease with which an asset can be bought or sold without affecting its price
The ease with which an asset can be bought or sold without affecting its price
Correct