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Understanding Financial Markets - What are its Types & Functions?

Understanding Financial Markets - What are its Types & Functions?
LISTEN AUG 23, 2021

Financial markets broadly refer to a marketplace where assets or securities are bought and sold. The financial markets facilitate the smooth functioning of economies by creating liquidity for the buyers and sellers and capital for the expansion of corporates and governments.

Financial markets are also termed as 'capital market', 'money market', or simply 'market'. These markets may exist on a physical location or can also provide online services to buy and sell securities remotely.

Apart from matching buyers and sellers, financial markets play various other roles in the interest of the participants and the economy. Without an efficient marketplace of assets and securities, the economy can collapse leading to recession and unemployment on a large scale.

A brief description of major financial markets in Ghana and their functions have been discussed in this article.

Types of Financial market

Based on the type of assets and securities traded, financial markets can be divided into the following types.

1. Stock Market

Stocks or equities are the ownership claims on businesses. The price of a stock moves based on the investor sentiment regarding the performance of that business and several other factors. Stock market or equity market is a financial market where stocks of listed companies are traded. The stocks are listed and monitored on the stock exchange but are bought and sold through authorized brokers.

The Ghana Stock Exchange (GSE) is the only stock exchange of Ghana. A total of 39 equity securities are listed on the GSE including MTN Ghana. AngloGold Ashanti Limited, Standard Chartered Bank Ghana Ltd. GSE Composite Index (GSE-CI) is an all-shares index.

Shares of companies listed on GSE can be traded through brokerage firms that are licensed and regulated by the GSE. Retail investors and traders in Ghana can participate in the stock market by opening an account with any of the licensed stock brokerage firms or dealing members. Equity Securities that you buy will be held in the Central Securities Depository (CSD).

The stock market is one of the most popular financial markets in the world. The global market capitalization of the stock market is more than 70 trillion USD, and the market cap of all companies listed on GSE is 62.7 billion GH¢ as of August 2021. However, investing in the stock market involves a decent amount of risk factors and may not be ideal for everyone. One must check the price volatility, features, and factors affecting the stock market before entering.

2. Bond or Debt Market

This market involves buying and issuing government bonds, corporate bonds, treasury bills, and other fixed-income securities.

Bonds are financial instruments in which the issuer of the bond is obliged to repay the principal amount with predefined interest to the buyer. Some bonds also reward the buyer with regular payments called coupons. Bonds are further divided into fixed-rate bonds, floating-rate bonds, zero-coupon bonds, convertible bonds, etc.

Each bond has a different interest rate, maturity tenure, and rating. In case if the issuer fails to repay the debt within predefined tenure as per the bond contract, it is considered a default. Bonds with a lesser probability of default are given higher credit ratings (AAA, AA) while the ones with a high risk of default have lower ratings (CCC, D).

The interest rates of fixed income securities vary depending on market volatility, liquidity, and several other factors. Interest rates on government bonds of well-developed economies have higher ratings and are less volatile compared to that of developing and emerging economies.

The global market capitalization of the bond market is three times the equity market due to lower risk factors. Although, the risk factor in the bond market depends on the credit ratings. Lower-rated bonds tend to generate higher returns but have a high risk of default and counterparty risk. The returns on some of the best-rated bonds can be less than the inflation rate leading to the devaluation of money.

Individuals & Investors residing in Ghana can invest & trade in bond market which include Corporate & Government bonds, bills & notes through any of the Ghana Fixed Income Market (GFIM) dealing members.

You are required to fill the Complete Central Securities Depository (CSD) Form in which your securities will be held. Some banks like Standard Chartered Bank offer easy investing in bonds via their mobile app.

The issuers of the Corporate & Commercial bonds must meet the requirements & Guidelines by Ghana's SEC for Issuance of Corporate Bonds. Only the corporates that meet the requirements can issue their bonds.

3. Commodities Market

Commodities are raw materials that are grown through farming like maize, cocoa, sugar, etc, extracted in natural form like oil, gas, etc, or mined from earth like gold and silver. Commodities can be traded in their physical form but it is commonly traded through derivatives.

The futures, options, and forward contracts of commodities have been used by farmers & corporations for a long time to hedge the price risk. Commodity prices can fluctuate based on demand, supply, rainfall, natural phenomena, government policies, and economic trends. The commodity market can greatly impact the economic growth and development of a nation.

Traders who wish to trade commodities without owning physical commodities are called speculators. They only speculate and trade on the price movement of commodities via futures and options contracts.

In Ghana, the commodities can be traded on the Ghana Commodity Exchange (GCX), but only as spot contracts for physical products i.e., Maize, Soya, Bean, Sorghum, Sesame & Rice.

4. Derivatives Market

In this financial market, the value of the securities is derived from the prices of assets in other financial markets. Trading in the derivative market refers to buying and selling contracts like futures, options, forwards, and swaps. The underlying asset in these contracts can be equity stocks, commodities, indices, etc.

Following is a short description of the types of derivative instruments:

  • Forwards: It is an over-the-counter derivative contract between two parties to buy or sell the underlying asset at a fixed predefined date and price. It is not backed by a clearinghouse or exchange hence there is higher counterparty risk.
  • Futures: These are similar to forward contracts but are standardized with specific price, quantity, and quality of the underlying asset. The future contract holder has the right and obligation to deliver or receive the underlying asset on the expiration of the contract.
  • Option: In this derivative contract, the buyer has the right to exercise the terms of the contract but is not obliged to do so before expiration. He/she can choose whether to exercise the contract or not.
  • Swap: In this derivative contract, two parties agree to swap cash flows or other financial instruments depending on the prices of the underlying instrument held by the dealing parties.

Currently the trading of futures & options is not available on any exchanges in Ghana. But Ghana Stock Exchange had announced plans to introduce Options trading the near future.

5. Forex or Foreign Exchange Market

Foreign exchange simply means exchanging one currency in return for another. As the prices of each currency with respect to others can change every minute, the exchange can be speculated on b retail & institutional investors to book profits.

The forex market remains active 24*7 throughout the world. It is the largest financial market in the world as each cross-currency transaction across the globe adds up to the trading volumes of forex.

In research done by Forex Brokers SA there are over 2.4 million forex traders in Africa of which 60,000 traders are based in Ghana. Retail forex trading in Ghana is not illegal but there is no regulation for retail forex traders.

In 2020, SEC announced it has been given permission by the Bank of Ghana to draft regulatory framework, grant licenses to local forex brokers and forex trading platforms. It was reported that SEC will issue licenses to institutional forex traders to trade through domestic platforms by the end of 2020 but it was delayed due to Covid-19. It is expected the new regulatory framework would be announced by the end of this year.

Ghanaian traders currently seeking to trade forex & global CFDs mostly trade via foreign regulated forex brokers like Exness, Tickmill, Hotforex etc. Various forex brokers regulated by foreign top-tier entities are accepting clients from Ghana.

It must be noted that retail trading in the forex market involves high risk, especially with the use of high leverage and unregulated brokers. The currency prices can move anytime due to plenty of reasons. New traders should use demo accounts to trade before risking actual money in the forex market and always signup with top-tier regulated brokers.

Important Functions of Financial markets

Apart from creating a marketplace to match buyers and sellers, a financial market also plays other roles essential for the sustainable growth of the economy. Following are the major functions of financial markets.

  • Raising Capital: Financial markets can help to gather different amounts of investment from multiple individuals and channel the pooled amount to corporations or governments. This capital helps the businesses to grow further and financially supplement the government in funding projects for the development of the nation.
  • Speculation & Retail Investment: By creating a transparent market for buying and selling securities, speculators get the opportunity to make profits at low transaction costs. Long-term investments help individuals and entities to build long-term wealth through financial markets.
  • Borrowing/Lending: Banks take in small deposits from individuals and offer loans to those in need at interest rates. This creates a win-win situation for both parties as depositors also earn capital appreciation. Similarly, each financial market fulfils the desires of borrowers and lenders on a large scale augment the economy as a whole.
  • Price Determination: The prices of each asset or security majorly depend on the demand and supply. The financial markets consider several factors to identify the right price at any instant of time in order to stabilize the demand and supply. Without a centralized marketplace of financial instruments, it would be impossible to determine the prices of an asset.
  • Transparency: If there is no financial market, there would be no regulation on the trades. Each buyer and seller can transact at different rates for the same asset with no assurance of authenticity and credibility.
  • Promoting Investments: Financial markets enhance the trust factor of individuals in trading and investments. If the financial markets are transparent, rewarding, and well regulated, investments are promoted in the markets. This in turn augments the economic growth of a nation.

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